Um19mb504 Unit Iv 1574775493426

Managerial
Economics
(UM19MB504)
Unit IV :
Production Analysis in Different
Market Structure
PES University
Managerial
Economics
(UM19MB504)
Session 24:
Organization of Production and Production
Function
PES University
Production
Production is the act of converting or transforming input

into output. In technical sense, production is the
transformation of resources into commodities over time
and/or space.
PES University - MBA - Managerial Economics (UM19MB504) 3

Production Process

Fixed Inputs and Variable Inputs
• Inputs are the resources used in the production of goods and

services. Inputs are classified into a) land or natural resources, b)
labour, and c) capital.
• Fixed inputs are those that cannot be readily changed during the time
period under consideration, excepts perhaps at very great expense.
Example.
• Variable inputs are those that can be varied easily and on very short
notice. Example.

Time Element and Production Function
• Short-run: The term “short run” is defined as a period of time over

which the inputs of some factors of production cannot be varied.
Factors which cannot be altered in the short run are called fixed
factors.
• Long-run: The term “long run” is defined as a period of time long
enough to permit variations in the inputs of all factors of
production employed by a firm. In other words, the long run is such
a time period over which all factors become variable.

The Concept of Production Function
• A production function refers to the functional

relationship, under the given technology, between
physical rates of input and output of a firm at a given
time period.

Algebraic Statement of Production Function
• In algebraic terms, the production function may be written as:

Q = f (a, b, c, d, ………., n, T)
Q = Physical quantity of output per unit of time.
f = functional relationship
A, b, c, d, ….., n = Quantities of various inputs
T = Prevailing state of technology.

Simple Production Function
• Often economist present a simple production function, assuming a

two-factor model, as under
Qx = f (K, L)
Qx = Quantity of commodity X per unit of time
K = Units of capital used
L = Units of labour used

Cobb-Douglas Production Function
Thus taking two Factors Labour (L) and Capital (K) we can define the production
function as given by Cobb-Douglas through their empirical study as below
Qp = f (L, K) ; keeping Technology, Land & Building Constant.
where:
• Y = total production (the real value of all goods produced in a year)
• L = labor input (the total number of person-hours worked in a year)
• K = capital input (the real value of all machinery, equipment, and buildings)
• A = total factor productivity
• α and β are the output elasticities of capital and labor, respectively. These values are
constants determined by available technology.

Types of Production Functions
• Short Run Production function : Also called single variable input

production function. Here either Capital (K) or Labour (L) is
constant and the other is varying.
• Long Run Production function : Hers both Capital (K) and Labour
(L) varies. Cobb-Douglas production function is the best example
for the Long run production function.

Production Function with Two Inputs

Total Product (TP), Average Product (AP), and
Marginal Product (MP)
• Total Product (TP): It refers to the total amount of final output

produced by a firm given inputs in a given period of time.
• Average Product (AP): It refers to the output produced using per
unit of factors of production.
• Marginal Product (MP): It refers to the additional output produced
as a result of employing an additional unit of the variable factor
input, all other factors being held constant, is known as marginal
product (MP).



Managerial
Economics
(UM19MB504)
Session 25:
Production Function with one Variable Input,
Law of Variable Proportion
PES University
The 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.

Illustration of the Law

Assumptions
• The law of variable proportions holds good under the following

conditions:
1) Constant state of technology
2) Fixed amount of other factors
3) Possibility of varying the factor proportions

Three Stages of the Law of Variable
Proportions
• Stage 1: Stage of Increasing Returns
• Stage 2: Stage of Diminishing Returns
• Stage 3: Stage of Negative Returns

Three Stages of the Law of Variable
Proportions

Managerial
Economics
(UM19MB504)
Session 26:
Production Function with Two Variable
Inputs, Isoquant, Ridge Lines
PES University
Production Function with Two Variable
Inputs
• In this class, we examine the production function when there ate

two variable inputs. This can be represented graphically by
isoquants.
• We define isoquants and discuss their characteristics.
• Isoquant will then be used to develop the conditions for the
efficient combination of inputs in production.

Two Production Function with Two Variable
Inputs

Production Isoquant

Production Isoquant
• An isoquant shows the various combinations of two inputs (say,

labour and capital) that the firm can use to produce a specific level
of output.

Economic Region of Production: Ridge Lines

Economic Region of Production
• The economic region of production is given by the negatively

sloped segment of isoquants between ridge lines OVI and OZI.
• The firm will not produce in the positively sloped portion of the
isoquants because it could produce the same level of output with
both less labour and less capital.
• Ridge line separate the relevant (i.e., negatively sloped) from the
irrelevant (or positively sloped) portions of the isoquants.
• Ridge line join points on the various isoquants where the
isoquants have zero or infinite slope.

Managerial
Economics
(UM19MB504)
Session 27:
Returns to Scale, Innovation Process and
Global Competitiveness
PES University
Returns to Scale
• Returns to scale refers to the degree by which output changes as

a result of a given change in the quantity of all inputs used in
production.
• We will have
• Constant returns to scale if output increases in the same
proportion as input.
• Increasing returns to scale if output increases by a greater
proportion than input.
• Decreasing returns to scale if output increases by a smaller
proportion than input.

Returns to Scale
Constant Returns Increasing Decreasing

to Scale Returns to Scale Returns to Scale

Returns to Scale
• Simple production function, assuming a two-factor model, is

given as
Qx = f (K, L)
• If now, L and K are changed by a factor of h, and Q consequently
changes by a factor of λ
λ Qx = f (hK, hL), this will result in
• Constant Returns to scale if λ =h
• Increasing Returns to scale if λ >h
• Decreasing returns to scale if λ <h

Assumptions
• The law of returns to scale assumes that:

1) All factors (inputs) are variable but enterprise is fixed.
2) A worker works with given tools and implements.
3) Technological changes are absent.
4) There is perfect competition.
5) The product is measured in quantities.
Given these assumptions, when all inputs are increased in unchanged proportions
and the scale of production is expanded, the effect on output shows three stages:
constant returns to scale, increasing returns to scale, and decreasing returns to scale.

Constant Returns to Scale
• During this stage, the economies accrued during the first stage start
vanishing and diseconomies arise. Diseconomies refers to the limiting
factors for the firm’s expansion.
• Emergence of diseconomies is a natural process when a firm expands
beyond certain stage.
• In the stage II, the economies and diseconomies of scale are exactly in
balance over a particular range of output. When a firm is at constant
returns to scale, an increase in all inputs leads to a proportionate increase
in output but to an extent.
• A production function showing constant returns to scale is often called
‘linear and homogeneous’ or ‘homogeneous of the first degree.’ For
example, the Cobb-Douglas production function is a linear and
homogeneous production function.

Increasing Returns to Scale
• During this stage, the firm enjoys various internal and external
economies such as dimensional economies, economies flowing
from indivisibility, economies of specialization, technical
economies, managerial economies and marketing economies.
• Due to these economies, the firm realizes increasing returns to
scale. Marshall explains increasing returns in terms of “increased
efficiency” of labor and capital in the improved organization with
the expanding scale of output and employment factor unit.
• It is referred to as the economy of organization in the earlier stages
of production.

Decreasing Returns to Scale
• The stage III represents diminishing returns or decreasing returns.

• This situation arises when a firm expands its operation even after
the point of constant returns.
• Decreasing returns mean that increase in the total output is not
proportionate according to the increase in the input.
• Because of this, the marginal output starts decreasing (see table 1).
Important factors that determine diminishing returns are
managerial inefficiency and technical constraints.

Returns to Scale
• Increasing returns to scale results because as scale of operations increases,

there is
• Greater division and specialization of Labour, and
• Specialized and productive machinery
• Financial reasons such as bulk discounts in purchase of raw materials,
favourable cost of financing, lower per unit advertising and marketing costs
• Decreasing returns to scale results because as scale of operations increases,
there is
• Difficulty in managing the entire workforce, and
• Difficulty in co-ordinating various operations and divisions of the firm

Cobb- Douglas Production Function
Taking two Factors Labour (L) and Capital (K) we can define the production function as given by
Cobb-Douglas through their empirical study as below
α +goods
Y = total production (the real value of all β > 1produced in a year)
L = labor input (the total number of person-hours worked in a year)
K = capital input (the real value of all machinery, equipment, and buildings)
A = total factor productivity
α and β are the output elasticities of capital and labor, respectively. These values are
constants determined by available technology.
If α + β = 1, then we have constant returns to scale,

α + β > 1, then we have increasing returns to scale
α + β < 1, then we have decreasing returns to scale

Innovation Process
• Innovation is the single-most important determinant of a

firm’s long –term competitiveness
• Two types of Innovations :
• Product Innovation
• Process Innovation
• Innovations are usually incremental, involve continuous small
improvements in product/process rather than major
technological breakthroughs
Methods of Acquiring New Technology for
Product and Process innovation
• Independent R&D
• Licensing
• Publications or technical meetings
• Reverse Engineering
• Hiring employees of Innovating firm
• Patent disclosures
• Conversations with employees of innovating firms
Innovation Process - Stimulants
• Strong domestic rivalry

• Forces firms to constantly innovate or lose market share
• Geographic Concentration
• Leads to spread of new ideas and development of
specialized machinery for the industry
• Exemplified by innovation shown by Japanese firms in high
tech industries in the 1980s ( Televisions, photocopiers,
cameras etc .)
Innovation Models – Closed Vs Open
• Companies are increasingly thinking of ways of getting new

technology and introducing new products
• Closed Innovation Model – Old way of developing and
commercializing a company’s own ideas and innovations
• Open Innovation Model – New way of developing and
commercializing company’s own ideas and innovations as
well as innovations of other firms through licensing, joint
ventures and other arrangements

Open Innovation Models – New Developments
• Companies are opening up their product – development

process to new ideas from outsiders : Suppliers, Independent
inventors, University labs and Consumers
• Objective is to make Innovations cheaper and quicker
• Ownership of Intellectual property and technology to link a
Company’s project development to outsiders are the obstacles
to this new development in Open innovation models
•

Managerial
Economics
(UM19MB504)
Session 28:
Concepts of Cost; Short-run Cost Functions and
Long-run Cost Functions; Economics of Scale
PES University
Introduction to Cost
• In economics, cost is normally considered from the producer’s or

firm’s point of view.
• Producing a commodity, a firm has to employ an aggregate of various
factors of production such as land, labour, and capital. These factors
are to be compensated by the firm for their efforts or contribution
made in producing the commodity. This compensation is known as
the cost.

Explicit and Implicit Cost
• Explicit costs refer to the actual expenditures of the firm to hire

labour, rent, or purchase the inputs it requires in production.
• Implicit costs refer to the value of the inputs owned and used by the
firm in its own production activity. Even though the firms does not
incur any actual expenses to use these inputs, they are not free,
since the firm could sell or rent them out to other farms.

Explicit Costs
• Cost of raw materials

• Wages and salaries
• Power charges
• Rent of business or factory premises
• Interest payment of capital invested
• Insurance premiums
• Taxes like property tax, duties, license fees etc.
• Miscellaneous business expenses like marketing and advertising
expenses, transport cost etc.

Implicit Costs
• Remuneration of labour rendered by the entrepreneur

himself.
• Interest on capital supplied by him.
• Rent of land and premises belonging to the entrepreneur
himself and used in the production.
• Normal returns (profits) of entrepreneur, a compensation
needed for his management and organizational activity.

Accounting Cost and Economic Cost
• Accounting costs refer only to the firm’s actual expenditures or

explicit costs incurred for purchased or rented inputs. Accounting
costs are important for financial reporting by the firm and for tax
purposes.
• Economic costs refer to both explicit and implicit cost incurred by

the firm in its production activity. For managerial decision making
purposes, however, economic costs are the relevant cost concept
that must be used.

Fixed Cost and Variable Cost
• Fixed costs (supplementary costs or overhead costs) are those costs

that are incurred as a result of the use of fixed factor inputs. They
remain fixed at any level of output in the short-run.
• Variable costs (prime costs) are those cost that are incurred by the
firm as a result of the use of variable factor inputs. The are
dependent upon the level of output.

Fixed Costs
• Payments of rent for building.

• Interest paid on capital.
• Insurance premiums.
• Depreciation and maintenance allowances.
• Administrative expenses – salaries of managerial and office
staff etc.
• Property and business taxes, license fees etc.

Variable Costs
• Value of raw materials.

• Wages of labour.
• Fuel and power charges.
• Excise duties, sales tax etc.
• Transport expenditure

Opportunity Cost or Alternative Cost
• The real cost of production of something using a given resources in

an objective sense is the benefit forgone (or opportunity lost) of
some other thing by not using that resources in its best alternative
use.
• Some economist, therefore, describe it as alternative cost of
production. “The alternative or opportunity cost of one unit of
product A is the amount of product B that has been sacrificed by
allocating the resources to produce A rather than B”.

Types of Production Costs and their
Measurement
• Total cost (TC)
• Total fixed cost (TFC)
• Total variable cost (TVC)
• Average fixed cost (AFC)
• Average variable cost (AVC)
• Average total cost (ATC)
• Marginal cost (MC)
• Incremental cost

Measurement
• Total cost (TC) is the aggregate of expenditures incurred by the
firm in producing a given level of output. Total cost is measured in
relation to the production function by multiplying factor prices
with their quantities. In the short-run,
TC = TFC + TVC
• Total fixed cost (TFC) corresponds to fixed inputs in the short-run

production function. It is obtained by summing up the product of
quantities of the fixed factors multiplied by their respective unit
prices. TFC remains same at all levels of output in the short-run.

Measurement
• Total variable cost (TVC) corresponds to variable inputs in the

production function. It is obtained by summing up the product of
quantities of input multiplied by their unit prices.
• Average fixed cost (AFC) is total fixed cost divided by total units of
output.
where Q stands for the number of units of the product.

Measurement
• Average variable cost (AVC) is total variable cost divided by total
units of output.
• Average total cost (ATC) or average cost is total cost divided by total
units of output.

Measurement
• Marginal Cost (MC) refers to the addition made to the total cost by
producing one more unit of output. In other words, marginal cost is
the cost of producing an extra unit of output.
The marginal cost of the nth unit of output is the total cost of
producing n units minus the total cost of producing (n-1) units of
output.

Measurement
• Incremental cost refers to the change in total costs from

implementing a particular management decision, such as the
introduction of a new product line, the undertaking of a new
advertising campaign, or the production of a previously purchased
component etc.

Short-run Total Cost Schedule of a Firm
(Hypothetical Data)

Short-run Total Cost Curves
• TFC remains constant at

all levels of output.
• TVC varies with the
output.
• TC varies at the same
proportion as the TVC.

Short-run per unit Cost (Hypothetical Data)

Short-run Marginal and Average Cost Curves

The Relationship between Marginal Cost and
Average Cost
• When AC is falling, MC is also
falling initially, after a point MC
will start rising but AC continues
to fall.
• When AC is minimum, the MC is
equal to AC.
• Once MC is equal to AC, then as the
output increases AC will start
rising and MC continues to rise
further but now MC will be greater
than AC. When both the costs are
rising, MC curve will always lie
above the AC curve.

Derivation of the LAC Curve

The Relationship between IMC and LAC

Managerial
Economics
(UM19MB504)
Session 29:
Concepts of Revenue
PES University
Revenue
• Revenue is the amount of money that a business has from its

normal business activities, usually from the sale of goods and
services to customers.
• Revenue is calculated by multiplying the price at which goods or

services are sold by the number of units or amount sold.
• Expenses are deducted from revenue in order to obtain net income

or profit.
• A firm’s revenue can be estimated as: a) total revenue, b) average

revenue, and c) marginal revenue.

Total Revenue (TR)
• Total Revenue is the total sales receipts of the output produced

over a given period of time.
• Total revenue depends on two factors: a) the price of the product,

and b) the quantity of the product. It is obtained by multiplying
the quantity sold (Q) by its selling price (P) per unit.
TR = P x Q

Average Revenue (AR)
• Revenue obtained per unit of output sold is termed as “average

revenue”.
• Average revenue is simply the total revenue divided by the number
of units of output.

Marginal Revenue (MR)
• Marginal revenue is the addition made to the total revenue by

selling one more unit of item.
• The marginal revenue of nth unit per period of time of a given

product is the difference between the total revenue earned by
selling n units and total revenue earned by selling n-1 units per
period of time.

Relationship between Price and Revenue
under Perfect Competition

Relation between Price and Revenue under
Perfect Competition
• Price is constant.
• Since price is constant, the average
revenue is also constant. AR is same
as P.
• Since price is unchanged, for each
additional unit sold, the same
addition is made to the total
revenue; therefore, the marginal
revenue also remain constant.
• AR = MR =P
• Total revenue increases at a constant
rate.

under Monopoly

under Monopoly
• It can be seen that since the AR

curve has a downward slope, the
MR curve too slopes downward.
• The MR curve lies below or to the

left of the AR curve.
• The MR curve lies at half the

distance between the AR curve
and Y-axis.

Relationship between Marginal Cost and
Marginal Revenue under Perfect Competition

Relationship between Marginal Cost and
Marginal Revenue under Monopoly

Managerial
Economics
(UM19MB504)
Session 30:
Market Structure – Perfect Competition,
Monopoly, Monopolistic Competition, Oligopoly
PES University
Market Structure
• Market structure refers to the nature and degree of competition in

the market for goods and services. The structures of market both for
goods market and service market are determined by the nature of
competition prevailing in a particular market.
• Structures are classified in term of the presence or absence of
competition. When competition is absent, the market is said to be
concentrated. There is a spectrum, from perfect competition to pure
monopoly.

Types of Market Structure
• Perfect Competition – many firms, freedom of entry, homogeneous

product, normal profit.
• Monopoly – One firm dominates the market, barriers to entry,
possibly supernormal profit.
• Monopolistic Competition – Freedom of entry and exit, but firms have
differentiated products. Likelihood of normal profits in the long term.
• Oligopoly – An industry dominated by a few firms.

Perfect Competitive Market
• A perfectly competitive market is one in which the number of buyers

and sellers is very large, all engaged in buying and selling a
homogeneous product without any artificial restrictions and
possessing perfect knowledge of market at a time.
• In the words of A. Koutsoyiannis, “Perfect competition is a market
structure characterised by a complete absence of rivalry among the
individual firms.”
• According to R. G. Lipsey, “Perfect competition is a market structure in
which all firms in an industry are price- takers and in which there is
freedom of entry into, and exit from, industry.”

Characteristics of Perfect Competition
(1) Large Number of Buyers and Sellers:

• The first condition is that the number of buyers and sellers must be so large
that none of them individually is in a position to influence the price and
output of the industry as a whole. The demand of individual buyer relative
to the total demand is so small that he cannot influence the price of the
product by his individual action.
• Similarly, the supply of an individual seller is so small a fraction of the total
output that he cannot influence the price of the product by his action alone.
In other words, the individual seller is unable to influence the price of the
product by increasing or decreasing its supply.
• Rather, he adjusts his supply to the price of the product. He is “output
adjuster”. Thus no buyer or seller can alter the price by his individual
action. He has to accept the price for the product as fixed for the whole
industry. He is a “price taker”.

(2) Freedom of Entry or Exit of Firms:

The next condition is that the firms should be free to enter or leave the industry. It implies that whenever the
industry is earning excess profits, attracted by these profits some new firms enter the industry. In case of loss being
sustained by the industry, some firms leave it.
(3) Homogeneous Product:

• Each firm produces and sells a homogeneous product so that no buyer has any preference for the
product of any individual seller over others. This is only possible if units of the same product
produced by different sellers are perfect substitutes. In other words, the cross elasticity of the
products of sellers is infinite.
• No seller has an independent price policy. Commodi-ties like salt, wheat, cotton and coal are
homogeneous in nature. He cannot raise the price of his product. If he does so, his customers
would leave him and buy the product from other sellers at the ruling lower price.
• The above two conditions between themselves make the average revenue curve of the individual
seller or firm perfectly elastic, horizontal to the X-axis. It means that a firm can sell more or less at
the ruling market price but cannot influence the price as the product is homogeneous and the
number of sellers very large.

(4) Absence of Artificial Restrictions:

• The next condition is that there is complete openness in buying and selling
of goods. Sellers are free to sell their goods to any buyers and the buyers
are free to buy from any sellers. In other words, there is no discrimination
on the part of buyers or sellers.
• Moreo-ver, prices are liable to change freely in response to demand-supply
conditions. There are no efforts on the part of the producers, the
government and other agencies to control the supply, demand or price of
the products. The movement of prices is unfettered.
(5) Profit Maximization Goal:
Every firm has only one goal of maximizing its profits.

(6) Perfect Mobility of Goods and Factors:

Another requirement of perfect competition is the perfect mobility of goods
and factors between industries. Goods are free to move to those places where
they can fetch the highest price. Factors can also move from a low-paid to a
high-paid industry.
(7) Perfect Knowledge of Market Conditions:
This condition implies a close contact between buyers and sellers. Buyers and
sellers possess complete knowledge about the prices at which goods are being
bought and sold, and of the prices at which others are prepared to buy and sell.
They have also perfect knowledge of the place where the transactions are
being carried on. Such perfect knowledge of market conditions forces the
sellers to sell their product at the prevailing market price and the buyers to
buy at that price.

(8) Absence of Transport Costs:

Another condition is that there are no transport costs in carry-ing of
product from one place to another. This condition is essential for the
existence of perfect compe-tition which requires that a commodity
must have the same price everywhere at any time. If transport costs
are added to the price of the product, even a homogeneous
commodity will have different prices depending upon transport costs
from the place of supply.
(9) Absence of advertising costs:
Under perfect competition, the costs of advertising, sales-promotion,
etc. do not arise because all firms produce a homogeneous product.

Examples of Perfect Competitive Market
In the real world it is hard to find examples of industries which fit all the criteria of
‘perfect knowledge’ and ‘perfect information’. However, some industries are close.
• Foreign exchange markets. Here currency is all homogeneous. Also traders will have
access to many different buyers and sellers. There will be good information about
relative prices. When buying currency it is easy to compare prices
• Agricultural markets. In some cases, there are several farmers selling identical
products to the market, and many buyers. At the market, it is easy to compare prices.
Therefore, agricultural markets often get close to perfect competition.
• Internet related industries. The internet has made many markets closer to perfect
competition because the internet has made it very easy to compare prices, quickly and
efficiently (perfect information). Also, the internet has made barriers to entry lower.
For example, selling a popular good on internet through a service like e-bay is close to
perfect competition. It is easy to compare the prices of books and buy from the
cheapest. The internet has enable the price of many books to fall in price, so that firms
selling books on internet are only making normal profits.

Monopoly Market
• A pure monopoly is defined as a single seller of a product, i.e. 100% of market share.
• Monopoly is a market situation in which there is only one seller of a product with barriers
to entry of others. The product has no close substitutes. The cross elasticity of demand with
every other product is very low. This means that no other firms produce a similar product.
According to D. Salvatore, “Monopoly is the form of market organisation in which there is a
single firm selling a commodity for which there are no close substitutes.” Thus the
monopoly firm is itself an industry and the monopolist faces the industry demand curve.
• The demand curve for his product is, therefore, relatively stable and slopes downward to
the right, given the tastes, and incomes of his customers. It means that more of the product
can be sold at a lower price than at a higher price. He is a price-maker who can set the price
to his maximum advantage.
• However, it does not mean that he can set both price and output. He can do either of the two
things. His price is determined by his demand curve, once he selects his output level. Or,
once he sets the price for his product, his output is determined by what consumers will take
at that price. In any situation, the ultimate aim of the monopolist is to have maximum
profits.

Characteristics of Monopoly Market
1) Under monopoly, there is one producer or seller of a particular product

and there is no differ-ence between a firm and an industry. Under
monopoly a firm itself is an industry.
2) A monopolist may be individual proprietorship or partnership or joint
stock company or a co-operative society or a government company.
3) A monopolist has full control on the supply of a product. Hence, the
elasticity of demand for a monopolist’s product is zero.
4) There is no close substitute of a monopolist’s product in the market. Hence,
under monopoly, the cross elasticity of demand for a monopoly product
with some other good is very low.
5) There are restrictions on the entry of other firms in the area of monopoly
product.

Characteristics of Monopoly Market
6) A monopolist can influence the price of a product. He is a price-maker,

not a price-taker.
7) Monopolist cannot determine both the price and quantity of a
product simultaneously.
8) Monopolist’s demand curve slopes downwards to the right. That is
why, a monopolist can increase his sales only by decreasing the price
of his product and thereby maximise his profit. The marginal revenue
curve of a monopolist is below the average revenue curve and it falls
faster than the average revenue curve. This is because a monopolist
has to cut down the price of his product to sell an additional unit.

Monopolistic Competition
• Monopolistic competition refers to a market situation where there

are many firms selling a differ-entiated product. “There is
competition which is keen, though not perfect, among many firms
making very similar products.”
• No firm can have any perceptible influence on the price-output
policies of the other sellers nor can it be influenced much by their
actions.
• Thus monopolistic competition refers to competition among a large
number of sellers producing close but not perfect substitutes for each
other.

Characteristic of Monopolistic Competition
1) Large Number of Sellers:

In monopolistic competition the number of sellers is large. They are “many and small enough” but
none controls a major portion of the total output. No seller by changing its price-output policy can
have any perceptible effect on the sales of others and in turn be influenced by them. Thus there is
no recognized interdependence of the price-output policies of the sellers and each seller pursues
an independent course of action.
(2) Product Differentiation:
• One of the most important features of the monopolistic competition is differentiation. Product
differentiation implies that products are different in some ways from each other. They are
heterogeneous rather than homogeneous so that each firm has an absolute monopoly in the
production and sale of a differentiated product. There is, however, slight difference between one
product and other in the same category.
• Products are close substitutes with a high cross-elasticity and not perfect substitutes. Product
“differentiation may be based upon certain characteristics of the products itself, such as exclusive
patented features; trade-marks; trade names; peculiarities of package or container, if any; or
singularity in quality, design, colour, or style. It may also exist with respect to the conditions
surrounding its sales.”

(3) Freedom of Entry and Exit of Firms:

Another feature of monopolistic competition is the freedom of entry and exit of firms. As
firms are of small size and are capable of producing close substitutes, they can leave or
enter the industry or group in the long run.
(4) Nature of Demand Curve:
• Under monopolistic competition no single firm controls more than a small portion of the
total output of a product. No doubt there is an element of differentiation nevertheless the
products are close substitutes. As a result, a reduction in its price will increase the sales of
the firm but it will have little effect on the price-output conditions of other firms, each
will lose only a few of its customers.
• Likewise, an increase in its price will reduce its demand substantially but each of its rivals
will attract only a few of its customers. Therefore, the demand curve (average revenue
curve) of a firm under monopolistic competition slopes downward to the right. It is
elastic but not perfectly elastic within a relevant range of prices of which he can sell any
amount.

(5) Independent Behaviour:

In monopolistic competition, every firm has independent policy. Since the
number of sellers is large, none controls a major portion of the total output. No
seller by changing its price-output policy can have any perceptible effect on the
sales of others and in turn be influenced by them.
(6) Product Groups:
There is no any ‘industry’ under monopolistic competition but a ‘group’ of
firms producing similar products. Each firm produces a distinct product and is
itself an industry. Chamberlin lumps together firms producing very closely
related products and calls them product groups, such as cars, cigarettes, etc.

(7) Selling Costs:

Under monopolistic competition where the product is differentiated,
selling costs are essential to push up the sales. Besides, advertisement,
it includes expenses on salesman, allowances to sellers for window
displays, free service, free sampling, premium coupons and gifts, etc.
(8) Non-price Competition:
Under monopolistic competition, a firm increases sales and profits of
his product without a cut in the price. The monopolistic competitor
can change his product either by varying its quality, packing, etc. or by
changing promotional programmes.

Oligopoly
• Oligopoly is a market situation in which there are a few firms selling

homogeneous or differenti-ated products. It is difficult to pinpoint the
number of firms in ‘competition among the few.’ With only a few firms
in the market, the action of one firm is likely to affect the others. An
oligopoly industry produces either a homogeneous product or
heterogeneous products.
• The former is called pure or per-fect oligopoly and the latter is called
imperfect or differentiated oligopoly. Pure oligopoly is found primarily
among producers of such industrial products as aluminium, cement,
copper, steel, zinc, etc. Imperfect oligopoly is found among producers
of such consumer goods as automobiles, cigarettes, soaps and
detergents, TVs, rubber tyres, refrigerators, typewriters, etc.

Characteristics of Oligopoly
(1) Interdependence:
• There is recognized interdependence among the sellers in the oligopolistic market.
Each Oligopolist firm knows that changes in its price, advertising, product
characteristics, etc. may lead to counter-moves by rivals. When the sellers are a few,
each produces a considerable fraction of the total output of the industry and can
have a noticeable effect on market conditions.
• He can reduce or increase the price for the whole oligopolist market by selling more
quantity or less and affect the profits of the other sellers. It implies that each seller is
aware of the price-moves of the other sellers and their impact on his profit and of the
influence of his price-move on the actions of rivals.
• Thus there is complete interdependence among the sellers with regard to their price-
output policies. Each seller has direct and ascertainable influences upon every other
seller in the industry. Thus, every move by one seller leads to counter-moves by the
others.

(2) Advertisement:
• The main reason for this mutual interdependence in decision making
is that one producer’s fortunes are dependent on the policies and
fortunes of the other producers in the industry. It is for this reason that
oligopolist firms spend much on advertisement and customer services.
• As pointed out by Prof. Baumol, “Under oligopoly advertising can
become a life-and-death matter.” For example, if all oligopolists
continue to spend a lot on advertising their products and one seller
does not match up with them he will find his customers gradually
going in for his rival’s product. If, on the other hand, one oligopolist
advertises his product, others have to follow him to keep up their
sales.

(3) Competition:
This leads to another feature of the oligopolistic market, the presence
of competition. Since under oligopoly, there are a few sellers, a move
by one seller immediately affects the rivals. So each seller is always on
the alert and keeps a close watch over the moves of its rivals in order
to have a counter-move. This is true competition.
(4) Lack of Uniformity:
Another feature of oligopoly market is the lack of uniformity in the
size of firms. Firms differ considerably in size. Some may be small,
others very large. Such a situation is asymmetrical. A symmetrical
situation with firms of a uniform size is rare.

(5) Barriers to Entry of Firms:

• As there is keen competition in an oligopolistic industry, there are barriers to
entry into or exit from it. In the long run, there are some types of barriers to
entry which tend to restraint new firms from entering the industry.
• They may be:
• (a) Economies of scale enjoyed by a few large firms; (b) control over essential
and specialized inputs; (c) high capital requirements due to plant costs,
advertising costs, etc. (d) exclusive patents and licenses; and (e) the
existence of unused capacity which makes the industry unattractive. When
entry is restricted or blocked by such natural and artificial barriers, the
oligopolistic industry can earn long-run super normal profits.

Managerial
Economics
(UM19MB504)
Session 31:
Price and Revenue under Perfect Competition
and Monopoly
PES University
Equilibrium in Perfect Competitive Market
In the Short Run

In the Short Run
• The single firm takes its price from the industry, and is, consequently,
referred to as a price taker. The industry is composed of all firms in
the industry and the market price is where market demand is equal
to market supply. Each single firm must charge this price and cannot
diverge from it.
• Under perfect competition, firms can make super-normal profits or
losses.
• The industry price is determined by the interaction of Supply and
Demand, leading to a price of P. The individual firm will maximise
output where MR = MC at Q.

In the Long Run

In the Long Run
• However, in the long run firms are attracted into the industry if the incumbent
firms are making supernormal profits. This is because there are no barriers to
entry and because there is perfect knowledge.
• The effect of this entry into the industry is to shift the industry supply curve to
the right, which drives down price until the point where all super-normal
profits are exhausted. If firms are making losses, they will leave the market as
there are no exit barriers, and this will shift the industry supply to the left,
which raises price and enables those left in the market to derive normal
profits.
• The super-normal profit derived by the firm in the short run acts as an
incentive for new firms to enter the market, which increases industry supply
and market price falls for all firms until only normal profit is made.
Monopoly Pricing under Short Run
• In monopoly, there is only one producer of a product, who influences the price of the
product by making change in supply. 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.
• As we know, there is no difference between organization and industry under monopoly.
Accordingly, the demand curve of the organization constitutes the demand curve of the
entire industry. The demand curve of the monopolist is Average Revenue (AR), which
slopes downward. In addition, in monopoly, AR curve and Marginal Revenue (MR) curve
are different from each other. However, both of them slope downward.
• Single organization constitutes the whole industry in monopoly. Thus, there is no need
for separate analysis of equilibrium of organization and industry in case of monopoly.
The main aim of monopolist is to earn maximum profit as of a producer in perfect
competition.
• Unlike perfect competition, 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.
Monopoly Pricing under Short Run
• 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.
• 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.

Determining Price and Output under Perfect
Competitive and Monopoly Market
1) Determine the best level of output for a perfectly competitive

firm that sells its product at P = $4 and
TC = 0.04 Q3 – 0.9 Q2 + 10 Q + 5.
2) Suppose demand function for monopoly is P= 1000-10Q,

Cost function is TC= 100 + 40Q + Q2
Find out the price, output, and maximum profit under monopoly.

Determining Price and Output under
Monopoly
Suppose demand function for monopoly is P= 1000-10Q,
Cost function is TC= 100 + 40Q + Q2
Maximum profit is achieved where MR=MC

TR= (1000-10Q) Q = 1000Q-10Q2
MR = ∆TR/∆Q= 1000 – 20Q
MC = ∆TC/∆Q = 40 + 2Q
MR = MC
1000 – 20Q = 40 + 2Q
Q = 43.63 (44 approx.) = Profit Maximizing Output
Profit maximizing price = 1000 – 20*44 = 120

Total maximum profit= TR-TC= (1000Q – 10Q2) – (100+ 40Q+Q2)
At Q = 44 Total maximum profit = Rs. 20844

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Managerial

Production is the act of converting or transforming input

PES University - MBA - Managerial Economics (UM19MB504) 3

PES University - MBA - Managerial Economics (UM19MB504) 4

• Inputs are the resources used in the production of goods and

PES University - MBA - Managerial Economics (UM19MB504) 5

• Short-run: The term “short run” is defined as a period of time over

PES University - MBA - Managerial Economics (UM19MB504) 6

• A production function refers to the functional

PES University - MBA - Managerial Economics (UM19MB504) 7

• In algebraic terms, the production function may be written as:

PES University - MBA - Managerial Economics (UM19MB504) 8

• Often economist present a simple production function, assuming a

PES University - MBA - Managerial Economics (UM19MB504) 9

PES University - MBA - Managerial Economics (UM19MB504) 10

• Short Run Production function : Also called single variable input

PES University - MBA - Managerial Economics (UM19MB504) 11

PES University - MBA - Managerial Economics (UM19MB504) 12

• Total Product (TP): It refers to the total amount of final output

PES University - MBA - Managerial Economics (UM19MB504) 13

PES University - MBA - Managerial Economics (UM19MB504) 14

PES University - MBA - Managerial Economics (UM19MB504) 15

• The law of variable proportions states that as the quantity of one

PES University - MBA - Managerial Economics (UM19MB504) 17

PES University - MBA - Managerial Economics (UM19MB504) 18

• The law of variable proportions holds good under the following

PES University - MBA - Managerial Economics (UM19MB504) 19

• Stage 1: Stage of Increasing Returns

• Stage 2: Stage of Diminishing Returns

• Stage 3: Stage of Negative Returns

PES University - MBA - Managerial Economics (UM19MB504) 20

PES University - MBA - Managerial Economics (UM19MB504) 21

• In this class, we examine the production function when there ate

PES University - MBA - Managerial Economics (UM19MB504) 23

PES University - MBA - Managerial Economics (UM19MB504) 24

PES University - MBA - Managerial Economics (UM19MB504) 25

• An isoquant shows the various combinations of two inputs (say,

PES University - MBA - Managerial Economics (UM19MB504) 26

PES University - MBA - Managerial Economics (UM19MB504) 27

• The economic region of production is given by the negatively

PES University - MBA - Managerial Economics (UM19MB504) 28

• Returns to scale refers to the degree by which output changes as

PES University - MBA - Managerial Economics (UM19MB504) 30

Constant Returns Increasing Decreasing

PES University - MBA - Managerial Economics (UM19MB504) 31

• Simple production function, assuming a two-factor model, is

PES University - MBA - Managerial Economics (UM19MB504) 32

• The law of returns to scale assumes that:

PES University - MBA - Managerial Economics (UM19MB504) 33

PES University - MBA - Managerial Economics (UM19MB504) 34

PES University - MBA - Managerial Economics (UM19MB504) 35

• The stage III represents diminishing returns or decreasing returns.

PES University - MBA - Managerial Economics (UM19MB504) 36

• Increasing returns to scale results because as scale of operations increases,

• Difficulty in co-ordinating various operations and divisions of the firm

PES University - MBA - Managerial Economics (UM19MB504) 37

If α + β = 1, then we have constant returns to scale,

PES University - MBA - Managerial Economics (UM19MB504) 38

• Innovation is the single-most important determinant of a