Session 2

Theory of Production and Cost

Contents:
1. Meaning of Production
2. Production Function
3. Production with one variable input-Law of variable
proportions
4. Cost Concepts
5. Theory of costs in short run and long run
6. Concept of Economies and Diseconomies of Scale
 1 Meaning of Production

Production is an important activity, which directly or indirectly satisfies the

wants and needs of the people. It is concerned with the supply side of the
market. Without production there cannot be consumption. Richness or poverty
of the nation and performance of the economy is judged by its level of
production.
Production refers to the transformation of resources into products or it is the
process whereby inputs are turned into outputs. Economic efficiency of the
production process is the issue under analysis. Economic efficiency calls for
minimizing the cost of producing any output level during a period of time.For
a profit maximizing firm, the revenues and the costs are the two important
components. The costs will be related to the production of the good or service
by using the different categories of inputs.
Factors of Production (Inputs)
Each distinct input into the production process can be regarded as a factor of
production. All these factors of production help in the process of production.
For eg, for the production of garments, piece of land is required to build a
factory, where the production takes place. This also requires the services of
labour. Capital is required to meet capital expenditure on the purchase of
machines, tools, etc. Finally, the service of entrepreneur are required to
organise, supervise and coordinate the whole process of production including
the services of land ,labour and capital. These are (four) primary inputs in the
sense that they participate in the production activity in the first instance.
Types of Production Function

a) Short –run production function:-A Short run production function

shows the maximum quantity of a good or service that can be produced
by a set of inputs, assuming that the amount of at least one of the inputs
used remains constant.

b) Long-run production function:-A Long run production function shows

the maximum quantity of a good or service that can be produced by a set
of inputs, assuming that the firm is free to vary the amount of all the
inputs being used.
 Distinction between various aspects of production:
1 Short –run versus Long-run:
Short-run- Short –run refers to a period in which some of the factors of
production like land and capital are in fixed supply and others like labour are
in variable supply.
Long-run- Long- run refers to a period long enough to permit changes in all
factors of production
2 Fixed factors of Production versus variable factors of production:
Fixed factors of Production: Fixed factors refer to those factors whose
supply cannot be changed during short-run. For e.g. land, machinery, plant,
equipment etc. These factors remain in fixed supply during short-run.
Variable factors of production: variable factors refer to those factors whose
supply can be varied or changed. For e.g. raw materials, labour, power, fuel
etc. These factors are in variable supply in the short run as well as in the long-
run.
 3 Level of production versus scale of production

Level of production: Level of production can be changed by changing the

quantity of variable factors like raw materials, labour, fuel etc. Level of
production is related to short-run.

Scale of production: Scale of production is related to capacity of production.

scale of production can be changed by changing the quantity of all variable
factors of production. Scale of production is related to long run.
Terminology:
1)Total product(TP)
TP is defined as the total quantity of goods produced by a firm during
a specified period of time.TP can be increased by employing more and more
units variable factor, labour.
2) Marginal product (MP)
Marginal product is the change in total product resulting from the
employment of an additional unit of a variable factor (labour).
Change in total product
MPL =-----------------------------------
Change in labour input
MPL for nth unit =TPn-TPn-1
n= Number of labour units.
3Average product
Average product is the per unit product of a variable input per period of time.
It is obtained after dividing the total product by the units of a variable input.AP
Measures the productivity of the firm’s labour in terms of how much output
each labour produces on an average.
Symbolically
AP=Total Product
--------------------
Labour Input
TPL
= -----------
L
The assumptions of the law of variable proportions include:

1. One input is variable and other inputs are held constant

2. Units of the variable factor are equal in efficiency
3. It is possible to vary the proportions in which the factors units are
combined
4. The law is applicable in the short run
5. The state of the technology is given
6. Prices of the factors of the production do not change
7. Output is measured in the physical units
 3 Production in Short run
Production with one variable input- Law of Variable proportion or Law
of Diminishing returns

Production involves the use of both the fixed factor and variable factor of
production. The fixed factor of production includes capital whose supply in
the course of production can not be changed in short period of time. They are
generally very expensive and involves an installation cost such as large
machineries etc .Where as the variable factor of production includes labor,
raw materials etc
When the production is taking place with the involvement of one variable
factor then this explains the case of the production in the short run. At each
additional level of production the proportion of variable factor units (for
example labor units) changes with respect of the given fixed units of the
fixed factor of production.
The given table below illustrates the law of variable proportion

Fixed factor Variable Total Average Marginal

(land or factor product product product
capital) (labor)
20 1 8 8 8
20 2 20 10 12
20 3 36 12 16
20 4 48 12 12
20 5 55 11 7
20 6 60 10 5
20 7 63 9 3
20 8 64 8 1
20 9 64 7.11 0
20 10 60 6 -4
Diagram of stages of production
As per the law of variable proportion there are three stages of the production
Stage 1
1. It is called the stage of increasing returns
2. The total product increases at an increasing rate up to a point the marginal
product of the labor MP is increasing and reaches its highest point
vertically downward to that point.
3. Beyond point of maximum of the marginal product of labor the total
product increases but at the diminishing rate. Marginal product curve
correspondingly starts falling but continues to be positive.
4. In this stage the average product of the labor continues to rise.
5. The stage comes to an end when the average product curve is the highest
and is equal to the marginal product of the labor.
 Stage 2
1. It is called the stage of Diminishing returns.
2. The total product continues to increase but at the diminishing rate but
eventually becomes highest.
3. Both average product curve and the marginal product curve diminishes
but are positive.
4. The stage comes to an end when the total product curve is the highest.
5. Throughout this stage average product curve remains above the marginal
product curve.
Stage 3
1. It is called the stage of negative returns.
2. In this stage the total product curve declines in the absolute terms.
3. The marginal product curve becomes negative.
4. Average product curve continues to diminish.

To summaries, the returns to the variable factor may be increasing, diminishing

or negative. A rational producer will prefer to operate in the range of
diminishing returns described by stage II. The law of diminishing returns
implies a declining marginal product.
 Multiple Choice questions
Q1 Factors of production can be :
a) Land b) Labour c) Organisation
d) All of the above

Q2 Production function means :

a) Physical relationship between inputs used and output
b) Technical relationship between inputs used and output
c) Financial relationship between inputs used and output
d) Both physical and technical relationship between inputs used and output
 3 Short –run production function means
a) At least one factor is in fixed supply
b) Two factor are in fixed supply
c) All factors are in fixed supply
d) One factor is in variable supply
4 Law of variable proportion holds when
a) State of technology is same
b) All units of variable factor are homogeneous
c) There is at least one fixed factor
d) All of the above
 6 THE COST CONCEPT
a) Accounting cost versus economic cost
Accounting cost of production includes all cost incurred by the firm in
acquiring various inputs from the outside suppliers. Therefore accounting cost
represents actual transfer of money recorded in the book of the firm. There are
generally in the nature of contractual payments. For example purchase of raw
materials, payment of wages, rent on hired land etc. They are also called
explicit cost or nominal costs.
Economic cost of production includes not only the accounting cost but also
implicit cost ,implicit cost arises when certain inputs are owned by the
employer himself and employed in the production process. For example
interest on the capital where the capital is contributed by the entrepreneurs
himself.
 b) Private Cost Vs. social Cost
Private cost is money cost incurred by a firm in producing a commodity. It
does not include the effect of the produced commodity on the society i.e. it
exclude externalities.
Social cost are costs of producing a commodity to the society as a whole. It
includes real costs which are costs borne by the society, directly or indirectly,
due to the produced commodity. For e.g., when people go for picnic in parks
and throw wrappers, then it imposes a real cost on the residents of that area
who have to clean up the parks.
c) Explicit Cost vs. Implicit Cost
Explicit cost or direct cost is the actual expenditure incurred by a firm to
purchase or hire the inputs it needs in the production process. This includes
wages, rent, interest etc.
Implicit cost or imputed cost is the cost of inputs owned by the firm and used
by the firm in its own production process. It include payment for owned
premises, self invested capital etc
d) Short-run Cost vs. Long-run Cost
Short-run costs are the cost over a period during which some factors are in
fixed supply, like plant, machinery, etc. Production in the short-run can be
increased only to the extent possible by using fixed factors to the full capacity
and by increasing the use of variable factors.
Long-run costs are the costs over a period long enough to permit changes in
all factors of production. In this period, firms can increase production by using
more of all factors. Supply of a commodity can be adjusted to changes in
demand.
Costs in the Short run
Costs and inputs
costs and the productivity of factors
costs and the price of factors
Fixed costs and variable costs
Total costs
total fixed cost (TFC)
total variable cost (TVC)
TVC and the law of diminishing returns
total cost (TC = TFC + TVC)
 Output TFC
100
(Q) (£) Total costs for firm X
0 12
1 12
80 2 12
3 12
4 12
60 5 12
6 12
7 12
40

20

0
0 1 2 3 4 5 6 7 8
 Output TFC
100
(Q) (£) Total costs for firm X
0 12
1 12
80 2 12
3 12
4 12
60 5 12
6 12
7 12
40

20
TFC
0
0 1 2 3 4 5 6 7 8
 Output TFC TVC
100
(Q) (£) (£) Total costs for firm X
0 12 0
1 12 10
80 2 12 16
3 12 21
4 12 28
60 5 12 40
6 12 60
7 12 91
40

20
TFC
0
0 1 2 3 4 5 6 7 8
 Output TFC TVC
100
(Q) (£) (£) Total costs for firm X
0 12 0 TVC
1 12 10
80 2 12 16
3 12 21
4 12 28
60 5 12 40
6 12 60
7 12 91
40

20
TFC
0
0 1 2 3 4 5 6 7 8
 Output TFC TVC TC
100
(Q) (£) (£) (£) Total costs for firm X
0 12 0 12 TVC
1 12 10 22
80 2 12 16 28
3 12 21 33
4 12 28 40
60 5 12 40 52
6 12 60 72
7 12 91 103
40

20
TFC
0
0 1 2 3 4 5 6 7 8
 Output TFC TVC TC
100
(Q) (£) (£) (£) Total costs for firm
TC X
0 12 0 12 TVC
1 12 10 22
80 2 12 16 28
3 12 21 33
4 12 28 40
60 5 12 40 52
6 12 60 72
7 12 91 103
40

20

TFC
0
0 1 2 3 4 5 6 7 8
100
Total costs for firm
TC X
TVC
80

Diminishing marginal
60
returns set in here

40

20

TFC
0
0 1 2 3 4 5 6 7 8
 Costs in the Short run

Marginal cost

marginal cost (MC) and the law of diminishing

returns
 Average and marginalMCcosts

Diminishing marginal
returns set in here
Costs (£)

Output (Q)
 Costs in the Short run

Marginal cost

marginal cost (MC) and the law of diminishing

returns

the relationship between MC and TC curves

 Average and marginal costs
MC
Costs (£)

Output (Q)
 Costs in the Short run

Average cost

average fixed cost (AFC)

average variable cost (AVC)

average (total) cost (AC)

Relationship between average and marginal cost

 Average and marginal costs
MC
AC

AVC
Costs (£)

x
AFC

Output (Q)
Production in the Long run

All factors variable in long run

The scale of production:

constant returns to scale

increasing returns to scale

 Short-run and long-run increases in output

Short run Long run

Input 1 Input 2 Output Input 1 Input 2 Output

3 1 25 1 1 15

3 2 45 2 2 35

3 3 60 3 3 60

3 4 70 4 4 90

3 5 75 5 5 125
 Short-run and long-run increases in output

Short run Long run

Input 1 Input 2 Output Input 1 Input 2 Output

3 1 25 1 1 15

3 2 45 2 2 35

3 3 60 3 3 60

3 4 70 4 4 90

3 5 75 5 5 125
 Short-run and long-run increases in output

Short run Long run

Input 1 Input 2 Output Input 1 Input 2 Output

3 1 25 1 1 15

3 2 45 2 2 35

3 3 60 3 3 60

3 4 70 4 4 90

3 5 75 5 5 125
 Short-run and long-run increases in output

Short run Long run

Input 1 Input 2 Output Input 1 Input 2 Output

3 1 25 1 1 15

3 2 45 2 2 35

3 3 60 3 3 60

3 4 70 4 4 90

3 5 75 5 5 125
Production in the Long run

All factors variable in long run

The scale of production:

constant returns to scale

increasing returns to scale

decreasing returns to scale

Production in the Long run

All factors variable in long run

The scale of production:

constant returns to scale

increasing returns to scale

decreasing returns to scale

Returns to scale and economies and

diseconomies of scale
Production in the Long run

Economies of scale
specialisation & division of labour
indivisibilities
container principle
greater efficiency of large machines
by-products
multi-stage production
organisational & administrative economies
financial economies
Economies of scope
Production in the Long run

Diseconomies of scale
managerial diseconomies
effects of workers and industrial relations
risks of interdependencies
External economies of scale
External diseconomies of scale
Location
balancing the distance from suppliers and
consumers
importance of transport costs
 Production in the Long run

Optimum combination of factors

MPPa/Pa = MPPb/Pb ... = MPPn/Pn
Decision making in different time periods
very short run
short run
long run
very long run
decisions can be made for all time periods at the
same time
Costs in the Long run
Long-run average costs
shape of the LRAC curve
assumptions behind the curve
 Alternative long-run average cost curves

Economies of Scale
Costs

LRAC

O Output
 Alternative long-run average cost curves

LRAC
Diseconomies of Scale
Costs

O Output
 Alternative long-run average cost curves

Constant costs
Costs

LRAC

O Output
 A typical long-run average cost curve

LRAC
Costs

O Output
 A typical long-run average cost curve

Economies Constant Diseconomies LRAC

of scale costs of scale
Costs

O Output
Costs in the Long run
Long-run average costs
shape of the LRAC curve
assumptions behind the curve

Long-run marginal costs

 Long-run average and marginal costs

Economies of Scale
Costs

LRAC
LRMC

O Output
 Long-run average and marginal costs
LRMC

LRAC
Diseconomies of Scale
Costs

O Output
 Long-run average and marginal costs

Constant costs
Costs

LRAC = LRMC

O Output
 Long-run average and marginal costs
LRMC
Initial economies of scale,
then diseconomies of scale
LRAC
Costs

O Output
 Costs in the Long run
Long-run average costs
shape of the LRAC curve
assumptions behind the curve
Long-run marginal costs
Relationship between long-run and short-run
average costs
 Costs in the Long run
Long-run average costs
shape of the LRAC curve
assumptions behind the curve
Long-run marginal costs
Relationship between long-run and short-run
average costs
the envelope curve
 Deriving long-run average cost curves: factories
of fixed size
SRAC1 SRAC SRAC5
2 SRAC4
SRAC3

5 factories
Costs

1 factory
2 factories
3 factories4 factories

O
Output
 Deriving long-run average cost curves: factories
of fixed size
SRAC1 SRAC SRAC5
2 SRAC4
SRAC3

LRAC
Costs

O
Output
 Deriving a long-run average cost curve: choice of
factory size
Costs

Examples of short-run
average cost curves

O
Output
 Deriving a long-run average cost curve: choice of
factory size

LRAC
Costs

O
Output
 Costs in the Long run
Long-run average costs
shape of the LRAC curve
assumptions behind the curve
Long-run marginal costs
Relationship between long-run and short-run
average costs
the envelope curve
Long-run cost curves in practice
 Costs in the Long run
Long-run average costs
shape of the LRAC curve
assumptions behind the curve
Long-run marginal costs
Relationship between long-run and short-run
average costs
the envelope curve
Long-run cost curves in practice
the evidence
 Costs in the Long run
Long-run average costs
shape of the LRAC curve
assumptions behind the curve
Long-run marginal costs
Relationship between long-run and short-run
average costs
the envelope curve
Long-run cost curves in practice
the evidence
minimum efficient plant size
 Theory of Cost:

Cost is a sacrifice of some kind -- the

monetary and opportunity costs outlays in
pursuit of business operations..
Costs include wage and salary payments,
interest and rental payments, and payments
to entrepreneurs.
 Cost Categories

•Opportunity Cost involves the value or worth of a

good/service in its best alternative use.
•Economic Cost involves both explicit (direct expenses)
and implicit (non-expenditure) costs and are the payments
which must be made to secure and retain the needed
amounts of factors of production.
•Accounting Costs involves only explicit costs
 7 Short run theory of cost
The key terms incorporated in the short run theory of cost, such as-
Total cost
It is the actual cost that must be incurred to produce a given quantity of output
in the short run using both fixed and variable inputs.
Total fixed cost
It refers to the total obligations incurred by the firm per unit of time for
all fixed inputs. For example – property tax, insurance fee, payment of
factory rent etc.
Total variable cost
They are the cost incurred on the employment of variable factors,
whose amount can be altered in the short run. Variable cost varies
directly with the change in output level. For example – cost of raw
materials, cost of labor, cost of fuel and electricity.
 Average cost
It is defined as cost per unit of output produced. It is obtained in two ways.
1 AC=TC/X
2 AC= AFC+AVC
 Marginal Cost
It is addition made to TC or TVC as output is increased by one more unit.
It is U shaped
MC =d TC
---------
dX
 The postulates of short run costs includes:-

1. Total variable cost curve is an inverse s- shaped curve

2. In the short run average variable cost(AVC) average
cost(AC) and marginal cost (MC) are U-shaped curves
3. The marginal cost curve cut the average cost curve average
cost curve at their minimum points from below.
At the point of minimum of the average cost curve the combination of fixed
and variable factors is optimal

Where ATC=Average Total Cost

AVC=Average Variable Cost
MC=Marginal Cost
8 Long run theory of cost
Introduction to the long run theory of cost
In the long period, no factors of production remain fixed. The firm can alter
the size and the scale of plant to meet the changed demand conditions. In other
words, the firm has no fixed costs in the long run.
Key terms in the explanation of the long run theory of the cost
Long run average cost curve:
The long run average cost curve is defined as total cost per unit output when
the entrepreneur has the time to vary all the factors of production so that he has
the most profitable size of the plant and the best proportion of fixed and
variable factors for any given output.
Diagram of Long run Average Cost Curve
Characteristics of the long run average cost
curve
1.They are called the envelope curve as it envelops the short run average cost
curve (SAC) .
2.No portion of the LAC curve be above any portion of SAC curves.
3.The firm chooses that short run plant which allows it to produce the expected
output at the minimum cost in the long run. therefore LAC helps the firm in
the decision making .
4.Each point on the LAC is a point of tangency with the corresponding SAC
curve.
Explanation to the long run theory of the cost
The U-shape of the LAC reflects the law of returns to scale.
Initially due to the economies of scale the long run average costs decreases as
the output increases.
When the economies of scale are fully expected and the diseconomies of scale
is yet to set in the LAC curve reaches its minimum point. At its minimum the
firm is employing the optimal plant size and operating this plant at full
capacity. If the plant size increases further than the optimal size there will be
dis-economies of scale and cause the LAC to turn upwards.
The LAC curve is U-shaped but the sides are more flat than the u-shaped
SACs.
9 CONCEPT OF ECONOMIES AND DIS-ECOMNOMIES
OF SCALE
Economies of scale broadly mean reductions in per unit cost of production
or benefits derived by expanding the scale of business.
Diseconomies of scale are the forces that cause larger firms to produce
goods and services at increased per unit cost.
The economies and dis-economies of scale are broadly categorized into
internal and external economies and dis-economies of scale.
The internal economies of scale
They are internal to the firm. They are available to the firm independent of the
action of other firms. They are further categorized into
Technical economies they arises due to the use of state of art
technology in the production process. They are:-
1. Economies of the use of by-products-The firm may use the by-product
with the financial, technical and managerial resource.
2. Economies of superior technique-The large firms are able to purchase
and install not only general purpose machines but also specialized
machines. The per- unit cost of production would fall.
3. Economies of specialization-A large firm is in a position to divide its
production processes into sub-processes leading to greater division of
operations and increased specialization which would increase the
productive efficiency of each-sub processes band result in overall
efficiency in operations.
Managerial economies
The manager for each of the various departments would results in the
improvement of the productive efficiency of each and every worker across the
organization.

Financial economies
Large firms command goodwill in the market and could have accessibility to
the cheap finance from the commercial banks, development banks and also
from the general public by issue of shares and debentures.
Economies of in-house research and development
This tend to reduce the cost of consultancy and would contribute to the making
of the production system an efficient one.

Economies of employees’ welfare schemes

This tends to improve the motivational aspect of the workers. Provision for the
housing facilities, medical facilities and the educational facilities for the
employees and their family are covered under the employees’ welfare schemes.
External economies of large scale production
They are the benefits which accrued to the firm because of the growth of the
whole industry. Such benefits cannot be monopolized by a single firm when it
grow in size, but are conferred on it when some other firms grow larger.
Types of external economies of large scale production

Economies of concentration
When the industry develops in a particular region it brings with it all the
advantages of concentration such as availability of skilled manpower,
transportation and communication facilities, banking and insurance and
marketing services
Economies of ancillarisation
Ancillary industry may develop in and around industrial townships
manufacturing inputs such as parts of machinery, nuts and bolts, raw materials
etc.
Dis -economies of scale
They are broadly categorized into internal and external dis -economies of
scale
Internal economies of the scale
They are the demerits which are internal to the firm and accrue to the firm
when it over expands its scale of production such as distortion in flow of the
information due to complexity bin the managerial hierarchy.
External dis -economies of scale
They are the disadvantages which are generated outside the firm with the
expansion of the industry as a whole such as increase of input price in course
of keen competition among the firms for the limited factors of the production,
increasing pressure on the infrastructure as in the form of bottlenecks and
delays .
 5 Returns to scale occur :
a) In the long –run
b) When all inputs are increased
c) When the increase in inputs is in the same proportion
d) All of the above
6 Cost of next best alternatives opportunity given up is called
a) Outlay cost b) Opportunity cost
c) Explicit Cost d) Implicit Cost
 7 Fixed cost is also called:
a) Sunk cost b) Supplementary cost
c) Overhead Cost d) All of the above

8 MC curve is ……… shaped.

a) L-shaped b) Straight line
c) U –shaped d) Inverse S-shaped
 9 Long-run AC curve is also called:
a) Planning curve b) Envelop curve
c) Cost frontier d) All of the above

10 Total cost at zero level of output will be= ………….?

a) TFC b) TVC c) AC d) AFC
Key of Multiple choice Questions
1. D
2. D
3. A
4. D
5. D
6. B
7. D
8. C
9. D
10. A
• Markets
• Types of market
 What is market ?

“ Market is a set of conditions through which buyers and sellers come in contact
with each other for the purpose of exchange of goods and services for value.”
 Market classification
On the basis of area
- Local Market
- Regional Market
- National Market
- International Market
On the basis of Nature of transactions
- Spot Market
- Future Market
On the basis of Volume of business
- Wholesale Market
- Retail Market
On the basis of Time
- Very short period Market
- Short period Market
- Long period Market
On the basis of Status of sellers
- Primary Market
- Secondary Market
- Terminal Market
On the basis of Regulations
- Regulated Markets
- Unregulated Markets
On the basis of Competition

- Pure and perfect competition

- Monopoly
- Oligopoly
- Monopolistic
 Features of the four market structures
Type of Number Freedom of Nature of Examples Implications for
market of firms entry product demand curve
faced by firm

Perfect Very Homogeneous Cabbages, carrots Horizontal:

competition many Unrestricted (undifferentiated) (approximately) firm is a price taker

Monopolistic Many / Builders, Downward sloping,

Unrestricted Differentiated but relatively elastic
competition several restaurants

Undifferentiated Cement Downward sloping.

Oligopoly Few Restricted Relatively inelastic
or differentiated cars, electrical (shape depends on
appliances reactions of rivals)

Local water Downward sloping:

Monopoly One Restricted or Unique company, train more inelastic than
completely operators (over oligopoly. Firm has
blocked particular routes) considerable
control over price
Type of Number Freedom of Nature of Examples Implications for
market of firms entry product demand curve
faced by firm

Perfect Very Homogeneous Cabbages, carrots Horizontal:

competition many Unrestricted (undifferentiated) (approximately) firm is a price taker

Monopolistic Many / Builders, Downward sloping,

Unrestricted Differentiated but relatively elastic
competition several restaurants

Undifferentiated Cement Downward sloping.

Oligopoly Few Restricted Relatively inelastic
or differentiated cars, electrical (shape depends on
appliances reactions of rivals)

Local water Downward sloping:

Monopoly One Restricted or Unique company, train more inelastic than
completely operators (over oligopoly. Firm has
blocked particular routes) considerable
control over price
Type of Number Freedom of Nature of Examples Implications for
market of firms entry product demand curve
faced by firm

Perfect Very Homogeneous Cabbages, carrots Horizontal:

competition many Unrestricted (undifferentiated) (approximately) firm is a price taker

Monopolistic Many / Builders, Downward sloping,

Unrestricted Differentiated but relatively elastic
competition several restaurants

Undifferentiated Cement Downward sloping.

Oligopoly Few Restricted Relatively inelastic
or differentiated cars, electrical (shape depends on
appliances reactions of rivals)

Local water Downward sloping:

Monopoly One Restricted or Unique company, train more inelastic than
completely operators (over oligopoly. Firm has
blocked particular routes) considerable
control over price
Type of Number Freedom of Nature of Examples Implications for
market of firms entry product demand curve
faced by firm

Perfect Very Homogeneous Cabbages, carrots Horizontal:

competition many Unrestricted (undifferentiated) (approximately) firm is a price taker

Monopolistic Many / Builders, Downward sloping,

Unrestricted Differentiated but relatively elastic
competition several restaurants

Undifferentiated Cement Downward sloping.

Oligopoly Few Restricted Relatively inelastic
or differentiated cars, electrical (shape depends on
appliances reactions of rivals)

Local water Downward sloping:

Monopoly One Restricted or Unique company, train more inelastic than
completely operators (over oligopoly. Firm has
blocked particular routes) considerable
control over price
Type of Number Freedom of Nature of Examples Implications for
market of firms entry product demand curve
faced by firm

Perfect Very Homogeneous Cabbages, carrots Horizontal:

competition many Unrestricted (undifferentiated) (approximately) firm is a price taker

Monopolistic Many / Builders, Downward sloping,

Unrestricted Differentiated but relatively elastic
competition several restaurants

Undifferentiated Cement Downward sloping.

Oligopoly Few Restricted Relatively inelastic
or differentiated cars, electrical (shape depends on
appliances reactions of rivals)

Local water Downward sloping:

Monopoly One Restricted or Unique company, train more inelastic than
completely operators (over oligopoly. Firm has
blocked particular routes) considerable
control over price
Type of Number Freedom of Nature of Examples Implications for
market of firms entry product demand curve
faced by firm

Perfect Very Homogeneous Cabbages, carrots Horizontal:

competition many Unrestricted (undifferentiated) (approximately) firm is a price taker

Monopolistic Many / Builders, Downward sloping,

Unrestricted Differentiated but relatively elastic
competition several restaurants

Undifferentiated Cement Downward sloping.

Oligopoly Few Restricted Relatively inelastic
or differentiated cars, electrical (shape depends on
appliances reactions of rivals)

Local water Downward sloping:

Monopoly One Restricted or Unique company, train more inelastic than
completely operators (over oligopoly. Firm has
blocked particular routes) considerable
control over price
 Multiple choice questions
1 Homogenous products exist under:
a) Perfect Competition b) Monopoly
c) Monopolistic Competition d) All of the above

2 One seller exist under:

a) Perfect Competition b) Monopoly
c) Monopolistic Competition d) All of the above
 3 Monopolistic competition means:
a) Large number of sellers b) Product differentiation
c) Free entry and exit of firms d) all of the above

4 Homogenous product means product are:

a) Perfect substitutes b) Identical c) Cross
elasticity between products is infinity d) All of the above
 Perfect
Competition
Pure
Monopoly

More competitive (fewer imperfections)

 Perfect Pure
Competition Monopoly

Less competitive (greater degree of

imperfection)
 Pure
Perfect
Monopoly
Competition

Monopolistic Competition Oligopoly Duopoly Monopoly

The further right on the scale, the greater the degree of

monopoly power exercised by the firm.
 Perfectly Competitive Market Structure

•Many buyers and sellers

•Each buys and sells only a tiny fraction of the total amount exchanged in
the market

•Standardized or homogeneous product

•Buyers and sellers are fully informed about the price and availability of
all resources and products

•Firms and resources are freely mobile  over time they can easily enter
or leave the industry
•Individual participants have no control over the price

•Price is determined by market supply and demand  the

perfectly competitive firm is a price taker  it must “take” or
accept, the market price

•Firm is free to produce whatever quantity maximizes profit

 Market Equilibrium and the
Firm’s Demand Curve in Perfect
Competition
 Exhibit: 1 Market price of wheat of $5 per bushel is determined in the left panel by the
intersection of the market demand curve and the market supply curve. Once the market
price is established, farmer can sell all he or she wants at that market price  price taker

(a) Market Equilibrium (b) Firm’s Demand

P r i c e p er b u s h e l
Price per bushel

$5 $5 d

D
Bushels of Bushels of
0 1,200,000 wheat per day 0 5 10 15 wheat per day
•The firm maximizes economic profit by finding the rate of output
at which total revenue exceeds total cost by the greatest amount

•Total revenue is simply output times the price per unit

•Exhibits 2 and 3 provide us with the needed information

 Exhibit 2: Short-Run Costs and Revenues

(1) (2) (3) = (1)  (2) (4) (5) (6) = (4) + (1) (7) = (3) - (4)
Bushels of Marginal 
Wheat Revenue Total Total Marginal Average Economic
per day (Price) Revenue Cost Cost Total Cost Profit or
(q) (p) (TR = q  p) (TC) MC=TC/  Q ATC = TC / q Loss = TR - TC

0 -- $0 $15.00 -- -$15.00
1 $5 5 19.75 $4.75 $19.75 -14.75
2 5 10 23.50 3.75 11.75 -13.50
3 5 15 26.50 3.00 8.83 -11.50
4 5 20 29.00 2.50 7.25 -9.00
5 5 25 31.00 2.00 6.20 -6.00
6 5 30 32.50 1.50 5.42 -2.50
7 5 35 33.75 1.25 4.82 1.25
8 5 40 35.25 1.50 4.41 4.75
9 5 45 37.25 2.00 4.14 7.75
10 5 50 40.00 2.75 4.00 10.00
11 5 55 43.25 3.25 3.93 11.75
12 5 60 48.00 4.75 4.00 12.00
13 5 65 54.50 6.50 4.19 10.50
14 5 70 64.00 9.50 4.57 6.00
15 5 75 77.50 13.50 5.17 -2.50
16 5 80 96.00 18.50 6.00 -16.00
 Exhibit 2a: Short-Run Profit Maximization

Total revenue
At output less than 7 (= $5 × q )
bushels and greater
Total cost
than 14 bushels, total $60

Total dollars
Maximum economic
cost exceeds total profit = $12
revenue  economic 48
loss measured by the
vertical distance
between the two
curves
Total revenue 15
exceeds total cost
between 7 and 14
bushels per day 
0 5 7 10 12 15 Bushels of wheat
economic profit is per day
maximized at the rate
of 12 bushels of wheat
per day
 Exhibit 3: Short-Run Costs and Revenues

(1) (2) (3) = (1)  (2) (4) (5) (6) = (4) + (1) (7) = (3) - (4)
The firm will Bushels of Marginal

increase quantity Wheat Revenue Total Total Marginal Average Economic
supplied as long per day (Price) Revenue Cost Cost Total Cost Profit or
(q) (p) (TR = q  p) (TC) MC=TC/ Q ATC = TC / q Loss = TR - TC
as each additional
unit adds more to 0 -- $0 $15.00 -- -$15.00
total revenue that 1 $5 5 19.75 $4.75 $19.75 -14.75
2 5 10 23.50 3.75 11.75 -13.50
to total cost – as 3 5 15 26.50 3.00 8.83 -11.50
long as MR 4 5 20 29.00 2.50 7.25 -9.00
exceeds MC 5 5 25 31.00 2.00 6.20 -6.00
6 5 30 32.50 1.50 5.42 -2.50
MR exceeds 7 5 35 33.75 1.25 4.82 1.25
MC for the first 8 5 40 35.25 1.50 4.41 4.75
12 bushels 9 5 45 37.25 2.00 4.14 7.75
10 5 50 40.00 2.75 4.00 10.00
Profit 11 5 55 43.25 3.25 3.93 11.75
maximizer will 12 5 60 48.00 4.75 4.00 12.00
limit output to 12 13 5 65 54.50 6.50 4.19 10.50
14 5 70 64.00 9.50 4.57 6.00
bushels per day 15 5 75 77.50 13.50 5.17 -2.50
16 5 80 96.00 18.50 6.00 -16.00
 Exhibit 3a: Short-Run Profit Maximization
The MC curve intersects
the MR curve at point e,
where output is 12 bushels Marginal cost
per day
Average total cost
At rates of output less than
12 bushels, MR > MC – firm Dollars per unit
can increase profit by $5 e d = Marginal revenue
expanding output Profit = average revenue
At higher rates of output 4 a
MC > MR – firm can
increase profits by reducing
output
Profit appears in the blue
shaded rectangle and equals
the price of $5 minus the
average cost of $4, or $1 per
bushel 0 Bushels of wheat
5 10 12 15 per day
 Marginal Revenue Equals Marginal Cost

•Golden rule of profit maximization:

•Marginal revenue, MR, is the change in total revenue from selling another unit
of output
•Since the firm in perfect competition is a price taker, marginal revenue from
selling one more unit is the market price  MR = P
•Marginal cost is the change in total cost resulting from producing another unit
of output
•Generally, a firm will expand output as long as marginal revenue exceeds
marginal cost and will stop expanding output before marginal cost exceeds
marginal revenue
 Economic Profit in the Short Run

•Because the perfectly competitive firm can sell any quantity for the
same price per unit, marginal revenue is also average revenue
•Average revenue, AR, equals total revenue divided by quantity 
AR = TR / q

•Regardless of the rate of output, the following equality holds along the
firm’s demand curve
•Market price = marginal revenue = average revenue
 Minimizing Short-Run Losses

•Sometimes the price that the firm is required to “take” will be so low
that no rate of output will yield an economic profit
•Faced with losses at all rates of output, the firm has two options
•It can continue to produce at a loss, or
•Temporarily shut down
•It cannot shut down in the short run because by definition the
short run is a period too short to allow existing firms to leave or
new firms to enter
Exhibit 4: Minimizing Losses
 (1) (2) (3) = (1)  (2) (4) (5) (6) = (4) + (1)
(7) (8) = (3) - (4)
Bushels of Marginal Average
Wheat Revenue Total Total Marginal Average Variable Economic
per day (Price) Revenue Cost Cost Total Cost Cost Profit or
(q) (p) (TR = q  p) (TC) MC=TC/Q ATC = TC /q AVC = TVC / q Loss = TR - TC

0 -- $0 $15.00 -- -- -$15.00
1 $3 3 19.75 $4.75 $19.75 $4.75 -16.75
2 3 6 23.50 3.75 11.75 4.25 -17.50
3 3 9 26.50 3.00 8.83 3.83 -17.50
4 3 12 29.00 2.50 7.25 3.50 -17.00
5 3 15 31.00 2.00 6.20 3.20 -16.00
6 3 18 32.50 1.50 5.42 2.92 -14.50
7 3 21 33.75 1.25 4.82 2.68 -12.75
8 3 24 35.25 1.50 4.41 2.53 -11.25
9 3 27 37.25 2.00 4.14 2.47 -10.25
10 3 30 40.00 2.75 4.00 2.50 -10.00
11 3 33 43.25 3.25 3.93 2.57 -10.25
12 3 36 48.00 4.75 4.00 2.75 -12.00
13 3 39 54.50 6.50 4.19 3.04 -15.50
14 3 42 64.00 9.50 4.57 3.50 -22.00
15 3 45 77.50 13.50 5.17 4.17 -32.50
16 3 48 96.00 18.50 6.00 5.06 -48.00

Marginal revenue exceeds marginal cost for the first 12 bushels of wheat. Because of the lower price, total
revenue is lower at all rates of output and economic profit has disappeared  column (8)
Column (8) indicates that the firm’s loss is minimized at $10 per day when 10 bushels are produced  the
net gain of $5 total cost. Exhibit 5 illustrates this same conclusion graphically
Exhibit 5: Minimizing Short-Run Losses
 (a) Total Cost and Total Revenue
In panel (a), Total revenue is
lower because of the lower price Total cost
Total revenue now lies below the Total revenue
total cost curve at all output rates. (= $3 × q )
The vertical distance between the

Total dollars
two curves measures the loss at $40
each rate of output 30 Minimum economic
The vertical distance is loss = $10
minimized at an output rate of 10 15
bushels where the loss is $10 per
day 0 5 10 15 Bushels of wheat per day
Same result in panel b
b) Marginal Cost Equals Marginal Revenue
Firm will produce rather than
Dollars per bushel

shut down if MR = MC at a rate of Marginal cost

output where price equals or Average total cost
exceeds average variable cost
At point e, output is 10 bushels $4.00 Average variable cost
per day and the price of $3 exceeds Loss e
3.00 d = Marginal revenue
the average variable cost of $2.50 2.50 = average revenue
 Total economic loss shown by
shaded area
0 5 10 15 Bushels of wheat per day
 Shutting Down in the Short Run

•As long as the loss that results from producing is less than the
shutdown loss, the firm will remain open for business in the short run
•If the average variable cost of production exceeds the price of all
rates of output, the firm will shut down
•A re-examination of previous exhibit indicates that if the price of wheat
were to fall to $2 per bushel, average variable cost exceeds $2 at all
rates of output
•Shutting down is not the same as going out of business

•In the short run, even a firm that shuts down keeps its productive
capacity intact  that when demand increases enough, the firm
will resume operation

•If market conditions look grim and are not expected to increase,
the firm may decide to leave the market  a long run decision
 Exhibit 6: Summary of Short-Run Output Decisions

At p1, the firm will Marginal cost

shut down rather than Break-even
operate because price point
is below average
p5 5
variable cost at all d
Dollars per unit

Average total cost 5

output rates.
If the price is p3, the 4
p4 d
firm will produce q3 Average variable cost 4
p3 3
to minimize its loss d3
while at p4, the firm p2 2
will produce q4 to 1 d2
p1
earn just a normal d1
profit: break-even
point
Shutdown The short-run supply
At p2, the firm is point
indifferent: shutdown curve is the upward-
point sloping portion of the
0 marginal cost curve
If the price rises to q1 q2 q3 q4 q5
p5, the firm will earn a beginning at point 2.
short-run economic Quantity per period
profit by producing q5
 Short-Run Firm Supply Curve

•As long as the price covers average variable cost, the firm will supply
the quantity resulting from the intersection of its upward-sloping
marginal cost curve and its marginal revenue, or demand curve

•Thus, that portion of the firm’s marginal cost curve that intersects and
rises above the lowest point on its average variable cost curve becomes
the short-run firm supply curve
 Exhibit 7: Aggregating Individual Supply to Form Market Supply
(a) Firm A (b) Firm B (c) Firm C (d) Industry, or market, supply

SA SB SC SA+ SB+ SC = S
Price per unit

p' p' p' p'

p p p p

0 10 20 0 10 20 0 10 20 0 30 60
Quantity per period Quantity per period Quantity per period Quantity per period

At a price below p, no output is supplied

At a price of p, each firm supplies 10 units: a market supply of 30 units
At a price of p', each firm supplies 20 units: a market supply of 60 units
The short-run industry supply curve is the horizontal sum of all firms’ short-run supply
curves: horizontal summation of the firm level marginal cost curves
 Exhibit 8: Relationship Between Short-Run Profit Maximization
and market equilibrium

Price per unit

(a) Firm (b) Industry, or market
ΣMC = S
MC = s

ATC
AVC
$5 d $5
Profit
4
D

Bushels of wheat per day 0 1,200,000 Bushels of wheat per day

0 5 10 12

•If there are 100,000 identical wheat farmers, their individual supply curves are summed horizontally
to yield the market supply curve, panel b, where market price of $5 is determined.
•At this price, each farmer produces 12 bushels per day, as in panel a, for a total quantity supplied of
1,200,000 bushels per day
•Each farmer earns an economic profit of $12 per day as shown by the shaded rectangle.
 Perfect Competition in Long Run

•Firms have time to enter and exit and to adjust their scale of their operations:
there is no distinction between fixed and variable cost because all resources
under the firm’s control are variable
•Short-run economic profit will in the long run encourage new firms to enter
the market and may prompt existing firms to expand the scale of their
operations: the industry supply curve shifts rightward in the long run, driving
down the price
•New firms will continue to enter a profitable industry and existing firms will
continue to increase in size as long as economic profit is greater than zero
 Exhibit 9: Long Run Equilibrium for the Firm and the Industry
(a) Firm (b) Industry, or market

MC S
Dollars per unit

ATC

Price per unit

LRAC

e
p d p

q Quantity per period 0 Q Quantity per period

0

In the long run, market supply adjusts as firms enter or leave, or change their size. This process
continues until the market supply intersects the market demand at a price that equals the lowest point
on each firm’s long-run average cost curve, at point e with each firm producing q units. At point e,
marginal cost, short-run average total cost and long-run average cost are all equal.
 Exhibit 10: Long-Run Adjustment to an Increase in Demand
(a) Firm (b) Industry, or Market
S
MC S'
Dollars per unit

p' d' p' b

Price per unit

ATC
Profit
LRAC
a c
p d p S*

D'

D
0 q q' Quantity per period 0 Qa Qb Qc Quantity per period

Initial point of equilibrium is a in panel b: individual firm supplies q units and earns a normal profit
Suppose market demand increases from D to D': market price increases in short run to p'
Firms respond by expanding output along the short-run supply curve – quantity supplied increases
to q‘: economic profits attract new firms, market supply curve shifts to S' where it intersects D' at
point c: price returns to initial equilibrium level
Demand curve facing the individual firm shifts back down from d' to d
 Exhibit 11: Long-Run Adjustment to a Decrease in Demand
(b) Industry
(a) Firm S" S
MC

Price per unit

ATC
Dollars per unit

LRAC

e g a
p d p S*
Loss
p" f D
p" d"
D"

0
q" q Quantity per period 0 Qg Qf Qa Quantity per period

Initial long-run equilibrium shown by point a in the market and e for the firm
Market demand declines from D to D” – market price falls to p” – demand curve facing each firm
drops to d” – firm responds by reducing its output to q” and market output falls to Qf: each firm faces
a loss
In the long run some firms go out of business: market supply will decrease from S to S" – price
increases back to p and the new market equilibrium is shown by point g. Market output has fallen to
Q and the remaining firms are just earning a normal profit as demand shifts back to d.
 Long-Run Industry Supply Curve

•Beginning at an initial long-run equilibrium point, with demand shifting,

we found two more long-run equilibrium points
•Connecting these long-run equilibrium points yields the long-run
industry supply curve, labeled S* in both of these exhibits
•Shows the relationship between price and quantity supplied once firms
fully adjust to any short-term economic profit or loss resulting from a shift
in demand
 Constant-Cost Industry

Firm’s long-run average cost curve does not shift as

industry output expands
Resource prices and other production costs remain constant in
the long run as industry output increases or decreases
Each firm’s per-unit production costs are independent
of the number of firms in the industry: the firm’s long-run
average cost curve remains constant in the long run as
firms enter or leave the industry
The industry uses such a small portion of the resources
available that increasing industry output does not bid up resource
prices
The long-run supply curve for a constant-cost industry
is horizontal
 Increasing-Cost Industry

Firms in some industries encounter higher average

costs as industry output expands in the long run

Firms in these increasing-cost industries find that

expanding output bids up the prices of some
resources or otherwise increases per-unit production
costs: each firm’s cost curves shift upward
 Perfect Competition and Efficiency

There are two concepts of efficiency used to

judge market performance
Productive efficiency refers to producing output at
the least possible cost
Allocative efficiency refers to producing the output
that consumers value the most
Perfect competition guarantees both allocative and
productive efficiency in the long run
 Productive Efficiency

Productive efficiency occurs when the firm

produces at the minimum point on its long-run
average-cost curve  the market price equals the
minimum average total cost

The entry and exit of firms and any adjustment in

the scale of each firm ensure that each firm produces
at the minimum point on its long-run average cost
curve
 Allocative Efficiency
Occurs when firms produce the output that is most
valued by consumers

The demand curve reflects the marginal value that

consumers attach to each unit
the market price is the amount of money that people are willing
and able to pay for the final unit they consume

In both the short run and the long run, the equilibrium
price in perfect competition equals the marginal cost of
supplying the last unit sold
 Marginal cost measures the opportunity cost of all
resources employed by the firm to produce the last unit
sold
Supply and demand curves intersect at the
combination of price and quantity at which the marginal
value, benefit that consumers attach to the final unit
purchased, just equals the opportunity cost of the
resources employed to produce that unit
There is no way to reallocate resources to increase the
total utility consumers reap from production
 What’s So Perfect About Perfect Competition?

Market exchange benefits both consumers and

producers
Recall that consumers garner a surplus from market
exchange because the maximum amount they would be
willing to pay for each unit of the good exceeds the
amount they in fact pay
 Exhibit 13: Consumer Surplus and Producer Surplus
Consumer surplus is the
area below the demand
curve but above the market Dollars per unit
clearing price of $10
Producers also derive a
net surplus from market
exchange because the Consumer S
amount they receive for surplus
their output exceeds the
e
minimum amount they $10
would require to supply the
Producer
amount
surplus
The short-run market D
supply curve is the sum of 5
that portion of each firm’s m
marginal cost curve at or
above the minimum point Quantity per period
on its average variable cost,
point m on the market 0 100,000 120,000 200,000
supply curve S
If price increases from
$5 to $6, firms increase
quantity supplied until
marginal cost equals $6:
output increases from
100,000 to 120,000 and Dollars per unit
Consumer S
total revenue increases surplus
from $500,000 to $720,000.
e
In the short run, $10
producer surplus is total Producer
revenue minus variable surplus
6
cost of production. D
Market clearing price is 5
m
$10
Productive and
allocative efficiency in the
short run occurs at point e.
0 100,000 120,000 200,000 Quantity
per period
 Producer Surplus

Not the same as economic profit

Any price that exceeds average variable cost will result

in a short-run producer surplus, even though that price
could result in a short-run economic loss

Ignores fixed cost, because fixed cost is irrelevant to the

firm’s short-run production decision
Monopoly
Monopoly is a well defined market structure where there
is only one seller who controls the entire market supply, as
there are no close substitutes for that product.
Features of monopoly
- Monopolist is the single producer of the product in the
market
- under monopoly firm and industry are identical
- No close competitive substitutes
- It’s a complete negation of competition
- A monopolist is a price maker and not a price taker.
 Bases of monopoly
- Natural factors
- Control of raw material
- Legal restrictions
- Economies of large scale production
- Business Reputation
- Business combines
Types of monopoly
- Pure & Imperfect Monopoly
- Legal monopoly
- Natural monopoly
- Technological monopoly
- Joint monopoly
- Simple & discriminating monopoly
- Public & private monopoly
 Monopoly Equilibrium
The monopolist can control both price and supply of the product. But
at any point of time she can fix only one of them. Either she can fix the
quantity of output and let the market demand determine the price of the
product; or she can fix the price of the product and let the market demand
determine the quantity which she can sell at the given price.
Having profit maximising objective, she adopts the rationale of
equating MC with MR and fixes the level of output which gives her the
maximum profits or where the losses are minimum. Thus when
equilibrium output is decided, the price is automatically determined in
relation to the demand for the product.
A monopolist may be earning profits or incur losses in
the short run.
 Features of Monopoly price
-It is not the highest possible price.
-This price does not bring the highest average profit to the seller
-Monopoly price is often associated with the output, the AC of which is
still falling.
-Under perfect competition, the price charged is equal to MC but in
monopoly the price is above MC.

Long run equilibrium of monopoly firm

Price discrimination
Price discrimination implies the act of selling the output of the same
product at different prices in different markets or to different buyers.
 Types of price discrimination
- Personal discrimination
- Age discrimination
- Sex discrimination
- Locational or territorial discrimination
- Size discrimination
- Use discrimination
- Time discrimination
Objectives of price discrimination
- To maximise the profits.
- To convert the consumers’ surplus into producer’s profit.
- To capture new markets.
 -To keep hold on export markets.
-To exploit the unutilised capacity by widening the size of
market through price discrimination.
-To clear off surplus stock.
-To augment future sales by quoting lower rates at present to
the potential buyers who may develop the taste for the
product in future.
-To weed out the potential competition from the market or
destroy a rival firm.
 Conditions necessary for price discrimination
- Separate markets
- Apparent product differentiation
- Prevention of re-exchange of goods
- Non-transferability nature of product
- Let go attitude of buyers
- Legal sanctions
- Buyer’s illusion
When price discrimination is profitable?
Even though circumstances are favourable to practice price discrimination, it
may not always be profitable. It is profitable only when the following two
conditions are prevailing.
- Elasticity of demand differs in each market
- The cost-differential of supplying output to different markets should not be
large in relation to the price differential based on elasticity differential.
 If the seller faces iso-elastic curves in two markets, the price
discrimination will not be profitable, as the AR and MR of those
two markets will also be equal in that case. Hence if any amount of
output transferred from one market to the other and different prices
are charged, the gains realised in one market is lost in the other.
MR = P [e-1/ e ]
When the monopolist considers separate markets, he takes the
combined marginal revenue (∑ MR) by aggregating the MR of
different markets and distributes equilibrium total output in
different markets so that marginal revenues in each market are the
same.
 The monopolist’s demand curve
downward sloping
MR below AR

Equilibrium price and output

Equilibrium output, where MC = MR
Equilibrium price, found from demand curve
 Equilibrium price and output

MC
ATC
P*

MR AR
Q
Q*
Disadvantages of monopoly
high prices / low output: short run
high prices / low output: long run
lack of incentive to innovate
Advantages of monopoly
economies of scale
profits can be used for investment
Monopolistic Competition
“
Monopolistic competition is defined as a market setting in
which a large number of sellers sell differentiated
products”
“ Monopolistic competition is a market situation in which
there is keen competition, but neither perfect nor pure,
among a group of large number of small producers or
suppliers having some degree of monopoly power because
of their differential products” – Prof. E.H. Chamberlin
 Main Features

Monopolistic Competition is a Market Structure in which multiple

Producers make similar, but not identical, products.
The goods are similar enough to be Substitutes for each other.
The Producers must engage Consumers in areas beyond Price in
order to sell their goods.
This is referred to as Non-Price Competition.
Multiple Participants

In Monopolistic
Competition, multiple
Monopolies co-exist while
producing Goods that are
similar enough to readily
act as Substitutes for each
other.
Similar Products

In Monopolistic Competition,
the products available in the
Market must be Similar, but not
Identical.
This allows the Consumer to
select the Good best suited to
their tastes and needs at Prices
comparable to their Substitutes.
Limited Price Control

In Monopolistic
Competition, Producers
have limited control over
the Prices that they can
charge because
Consumers have a
number of alternatives
readily available to them.
Differentiated Products

In Monopolistic Competition,
Producers must act to separate
their good from those offered
by their competitors.
They do this by creating both
perceived and actual
differences between their
products to make them more
desirable to select Consumers.
 Price and output determination under monopolistic competition

- Monopolistic demand curve (AR) is more elastic than monopoly.

- If the group consists less number of firms and great
product differentiation, then the elasticity is comparatively less.
- If the group consists of large number of firms and the product differentiation
is weak, then the elasticity is comparatively more.
- The extent of monopoly power of the firms on the basis of differentiation and
the resultant elasticity of demand decides the super normal profits of the firms in
short run.
- The firms under monopolistic competition normally earn only normal profits
in the long run.
- Some firms may earn super normal profits even in the long run with high
product differentiation / good will etc.
Product differentiation is the major feature of
monopolistic competition
- Product differentiation may broadly be defined as anything that causes
buyer to prefer one product to another. Therefore, in the real sense,
product differentiation exists in the mind of consumer. That is it is not
necessary for the difference to be real-it is only necessary for the
consumer to think it is real.( The role of advertising and brand name )
- The real differentiation among products may arise due to :
 Patents, trademarks and copy rights
 Differences in colour and packaging
 Conditions relating to sale of the product
 Method, time and cost of delivery
 Availability of service
 Guarantees and warranties
 Non price competition - selling cost
‘ Expenditure incurred by a firm on advertising and sale
promotion of its products is known as selling cost’. It
includes,
Advertising and publicity expenditure of all sorts
Expenses of sales department viz, commission and salaries
of sales staff
Margin granted to dealers
Expenditure for window display, demonstration of goods,
free distribution of samples etc.
 Examples
Restaurants
Plumbers/electricians/local builders
Solicitors
Private schools
Plant hire firms
Insurance brokers
Health clubs
Hairdressers
Funeral directors
Estate agents
Damp proofing control firms
 Monopolistically Competitive
Firm in the Short Run

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Cost/Revenue This
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andsold
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At because
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MR D (AR)
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 Monopolistically Competitive
Firm in the Long Run

MC This is the long run

Cost/Revenue
equilibrium position of a
firm in monopolistic
competition.
AC

AR = AC

AR1
MR1
Q2 Output / Sales
 Short run
Downward sloping demand – differentiated product
Demand is relatively elastic – good substitutes
MR < P
Profits are maximized when MR = MC
This firm is making economic profits
 Long run
Profits will attract new firms to the industry (no
barriers to entry)
The old firm’s demand will decrease to DLR
Firm’s output and price will fall
Industry output will rise
No profit (P = AC)
 Oligopoly
Market structure that is dominated by just a
few firms

Each must consider the effect of its own actions

on competitors’ behavior  the firms in an
oligopoly are interdependent
 Varieties of Oligopoly

Homogeneous or differentiated products

Interdependence: the behavior of any
particular firm is difficult to analyze
Domination by a few firms can often be traced
to some form of barrier to entry
 High Costs of Entry

Total investment needed to reach the minimum

size
Advertising a new product enough to compete
with established brands
High start-up costs and presence of established
brand names: the fortunes of a new product are
very uncertain
 Models of Oligopolies

Interdependence: no one model or approach explains

the outcomes

At one extreme, the firms in the industry may try to

coordinate their behavior so they act collectively as a
single monopolist, forming a cartel

At the other extreme, they may compete so fiercely that

price wars erupt
 Collusion

Collusion: an agreement among firms in the

industry to divide the market and fix the price

Cartel: a group of firms that agree to collude so

they can act as a monopolist and earn monopoly
profits

Colluding firms usually reduce output, increase

price, and block the entry of new firms
 Differences in Cost

The greater the differences in average costs across

firms, the greater will be the differences in economic
profits among firms
If cartel members try to equalize each firm’s total
profit, a high-cost firm would need to sell more than a
low-cost firm
This allocation scheme violates the cartel’s profit-
maximizing condition of finding the output for each
firm that results in identical marginal costs across
firms
 Number of Firms in the Cartel

The more firms in the industry, the more

difficult it is to negotiate an acceptable allocation
of output among them

Consensus becomes harder to achieve as the

number of firms grows
 New Entry Into the Industry

If a cartel cannot block the entry of new firms

into the industry, new entry will eventually force
prices down, squeezing economic profit and
undermining the cartel

The profit of the cartel attracts entry, entry

increases market supply and market price is
forced down
 Malpractices

Perhaps the biggest obstacle to keeping the

cartel running smoothly is the powerful
temptation to cheat on the agreement

By offering a price slightly below the

established price, a firm can usually increase its
sales and economic profit

Because oligopolists usually operate with excess

capacity, some cheat on the established price
 Price Leadership

An informal, or tacit, type of collusion occurs in

industries that contain price leaders who set the price
for the rest of the industry

A dominant firm or a few firms establish the

market price, and other firms in the industry follow
that lead, thereby avoiding price competition

Price leader also initiates price changes

 The greater the product differentiation among
sellers, the less effective price leadership will be as a
means of collusion
There is no guarantee that other firms will follow
the leader
Some firms will try to cheat on the agreement by
cutting price to increase sales and profits
Unless there are barriers to entry, a profitable price
will attract entrants
 Price Stability with a Kinked Demand Curve
P

MC1
P* MC2

b AR

Q
Q*
MR
For any MC between a and b, the profit maximizing price and
output remain unchanged
 Game Theory and Oligopoly

Game theory examines oligopolistic behavior as a series

of strategic moves and countermoves among rival firms

It analyzes the behavior of decision-makers, or players,

whose choices affect one another

Provides a general approach that allows us to focus on

each player’s incentives to cooperate or not
 Payoff Matrix

Payoff matrix is a table listing the rewards or

penalties that each can expect based on the strategy
that each pursues
Each prisoner pursues one of two strategies,
confessing or clamming up
The numbers in the matrix indicate the prison
sentence in years for each based on the
corresponding strategies
Ben’s payoff is in
red and Jerry’s in
blue.
The incentive for
both to confess is the
dominant-strategy
equilibrium of the
game because each
player’s strategy
does not depend on
what the other does.
 Price Setting Game

The prisoner’s dilemma applies to a broad range of

economic phenomena such as pricing policy and
advertising strategy

Consider the market for gasoline in a rural community

with only two gas stations: a duopoly

Suppose customers are indifferent between the two

brands and consider only the price
Each station sets its daily price early in the
morning before knowing the price set by the
other
Suppose only two prices are possible: a low
price and a high price
If both charge the low price, they split the market
and each earns a profit of $500 per day
If both charge the high price, they also split the
market and earn $700 profit
If one charges the high price but the other the low
one, the low-price station earns a profit of $1,000 and
the high-price station earns $200
What price for each would
maximize profits?
Texaco: If Exxon charges
the low price, Texaco earns
$500 by charging the low price,
but only $200 by charging the
high price: better off charging
the low price.
If Exxon charges the high
price, Texaco earns $1,000 by
charging the low price and
$700 by charging the high
price: Texaco earns more by
charging the low price.
Exxon faces the same
incentives
Each seller will charge the
low price, regardless of what
the other does: each earns
$500 a day.
 One-Shot versus Repeated Games

The outcome of a game often depends on whether it is a

one-shot game or the repeated game

The classic prisoner’s dilemma is a one-shot game: the

game is to be played only once

However, if the same players repeat the prisoner’s

dilemma, as would likely occur in the price setting game,
other possibilities unfold
 In a repeated-game setting, each player has a
chance to establish a reputation for cooperation
and thereby can encourage the other player to do
the same

The cooperative solution makes both players

better off than if they fail to cooperate
Thank You