CHAPTER-5

PRICE - OUTPUT DECISIONS

What is price?
The amount of money is expected or require or given in payment for something denotes price.
In commerce, price is determined by what a buyer is willing to pay, a seller is willing to accept, and the
competition is allowing to be charged. In ordinary usage, a price is
the quantity of payment or compensation given by one party to another in return for one unit
of goods or services.
What is profit?
Profit is financial gain, especially it is the difference between the amount earned and the amount spent in
buying, operating, or producing something.Profit, also called net income, is the amount of earnings that
exceed expenses for the period. In other words, it’s the amount of income left over after all the necessary
and matched expenses are subtracted for the period. Profit means a business excess revenues left over
after all expenses have been paid for the period.
CONCEPT OF DIFFERENT MARKET STRUCTURES
One of the important functions of firm is to fix appropriate price for its product. If a firm fixes a high
price, it will be unable to compete with its competitive firms and it can not sell its product in the market.
Similarly, if it charges very low price, it will be unable to cover even variable cost and unable to earn
even normal profit. The pricing decision of firm depends on the structure of the market. There are four
basic types of market structures on the basis of number or size of buyers and sellers of the product, types
of product, and the degree of mobility of resources, degree of knowledge of seller and buyer about goods
and market cost, demand and supply conditions of the product. They are:
(i) Perfect Competition Market
A market structure is said to be perfect competition in which these are large number of sellers and buyers
in the market. Each individual firm supplies only a small part of the total quantity offered in the market.
Similarly, buyers have no monopolistic power. The products are identical, there is perfect mobility of
resources, free entry and exit of firms into and from the industry, the goal of firm is profit maximization,
and all sellers and buyers have complete knowledge of the conditions of the market.
(ii) Monopoly Market
A market is said to be monopoly market in which there is a single seller, there are no close substitutes for
the commodity it produces and there are barrier to entry into the industry. The producer and/or the
supplier have market power over price and quantity.
(iii) Monopolistic Competition Market
A market structure is said to be in monopolistic competition market in which there are large number of
sellers and buyers of a good or service. The products of the sellers are differentiated, and still they are
close substitutes of one another, there is free entry and exit for the firms. The objective of the firms in the
group is profit maximization under the given technology and given prices of factors.
(iv) Oligopoly Market
A market structure is said to be oligopoly, in which there are few sellers of homogeneous or differentiated
product in the market, there are large number of buyers, firms have market power and there is high degree
of rivalry (competition) among firms unless they make a collusive agreement.
The limiting case of oligopoly is “Duopoly Market”. An oligopoly market is said to be duopoly in which
there are only two sellers of a homogeneous or differentiated product.
Perfect Competition
Perfect competition is a market structure characterized by completely absence of price rivalry among the
individual firms. It is a market in which there are large number of buyers and sellers of an identical goods
and neither a seller or nor a buyer has any control on the price of the product.

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In practical life, perfectly competitive market is a rare phenomenon. However analysis of price and output
determination lays 'the foundation' of pricing theory. This kind of market is therefore created by the
assumptions for theoretical purpose.
In general, it has the following characteristics.
Features
(i) Large Number i.e. too many Sellers and Buyers
(ii) Price constant whatever quantity sold
(iii) Product Homogeneity/ substitutability of goods
(iii)Free Entry and Exit of the Firms i.e.no Government Regulation/intervention
(iv)Profit Maximization objective
(v)Perfect Mobility of Factors of Production
(vi) Perfect Knowledge about price and quality of goods
Meaning of Monopoly
Monopoly, in economics, refers to that market form in which a single producer controls the whole supply
of a commodity, which has no close substitutes. In other words, monopoly is a market structure in which
there is a single seller, there are no close substitutes for the commodity which it produces and there are
barriers to entry of the firms.
Features
(i) Single Seller of single Product
(ii) Barriers to Entry new firms i.e. government intervention
(iii)No Close Substitutes goods
(iv)Firm itself price and supply maker
(v) Price change as quantity sold increase or decrease
Monopolistic Competition
Monopolistic competition is defined as the market structure in which a large number of sellers sell
differentiated product, which is close substitute for one another. Monopolistic competition combines the
basic element of both perfect competition and monopoly.
Features
(i) Large Number of Buyers and Sellers
(ii) Product Differentiation to some extent on size, color, taste, packaging etc.
(iii)Freedom of Entry or Exit i.e. no government control
(iv) Non Price Competition like; advertisement, home delivery, coupon scratch etc.
(v) Price change as quantity sold increase or decrease
In this market, sellers try to compete on the basis other than price, as for example of aggressive
advertising, product development, better distribution arrangements, efficient offer-sales service and so on.
A key basis of non-price competition is a deliberate policy of product differentiation.
Oligopoly
The Oligopoly is a reduced form of monopolistic competition. The term Oligopoly has a Greek base and
means few sellers, Oligopoly as such, refers to market with small number of large firms, each selling
either differentiated or homogeneous product. A few sellers imply a number so small or a few market
share of each firm in so large that it can influence the market price .It also implies that each seller
commands a sizeable proportion of the total market supply. The products traded by the Oligopolies may
be differentiated or homogeneous.
The limiting case of oligopoly is Duopoly Market. An oligopoly market is said to be duopoly in which
there are only two sellers of a homogeneous or differentiated product.
Since we have to learn more about pricing under oligopoly market, we have to know a little bit more
about oligopoly market here.
Features

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 (i) Small Number of Large Firms
An oligopolistic industry is dominated by a small number of large firms, each of which is relatively large
compared to the overall size of the market. This generates substantial market control, the extent of market
control depending on the number and size of the firms.
(ii) Identical or Differentiated Products
Some oligopolistic industries produce identical products, while others produce differentiated products.
Identical product oligopolies tend to process raw materials or intermediate goods that are used as inputs
by other industries. Notable examples are petroleum, steel, and aluminum. Differentiated product
oligopolies tend to focus on consumer goods that satisfy the wide variety of consumer wants and needs. A
few examples of differentiated oligopolistic industries include automobiles, household detergents, and
computers.
(iii) Barriers to Entry
Firms in a oligopolistic industry attain and retain market control through barriers to entry. The most
common barriers to entry include patents, resource ownership, government franchises, start-up cost, brand
name recognition, and decreasing average cost. Each of these make it extremely difficult, if not
impossible, for potential firms to enter an industry.

PRICE AND OUTPUT DETERMINATION UNDER PERFECT COMPETITION

We know that there are a large number of firms under perfect competition. Firm is only a price-taker and
not a price-maker. Price is determined by the industry. Industry is a group of firms producing identical
goods. The industry and firms should be in equilibrium to determine the price and output in this market.
Equilibrium is that point in which there is no tendency to move from the equilibrium point. Firm and
industry in perfect competition, are in equilibrium when they make maximum profit.
(a) Total Revenue (TR) – Total Cost (TC) Approach
The firm is in equilibrium when it has no incentive to change its level of output. In perfect competition, a
firm is said to be in equilibrium when it maximizes its profits (π), which is defined as the difference
between total revenue and total cost. It can be expressed as:
π = TR – TC Where, π refers profit, TR refers total revenue and TC refers total cost.
Given that the normal profit rate is included in the cost items of the firm, π is the profit above the normal
rate of return on capital and the remuneration for the risk bearing function of the entrepreneur. The firm is
in equilibrium when it produces the output that maximizes the differences between total receipts
(revenue) and total costs. The equilibrium of the firm can be explained with the help of the figure 7.2.

Figure 7.2: Equilibrium of the Firm by TR-TC Approach

(b) Marginal Revenue (MR) – Marginal Cost (MC) Approach

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According to this approach, marginal revenue should be equal to the marginal cost i.e., MR = MC. If MR
is greater than MC, there is always an incentive for the firm to expand its production further and gain by
sale of additional units. If MR is less than MC, the firm will have to reduce output since an additional unit
adds more cost than to revenue. Profits are maximum only at the point where MR = MC.
MC curve should cut MR curve from below. In other words, MC should have positive slope. It is
shown in the figure as below:
(i) Excess Profit
When a firm earns super normal profit, its average revenue is more than its average cost (i.e.; AR >
AC). Thus in additional to normal rate of profit, the firm earns additional profits.

Figure 7.4: Excess Profit Situation

The diagram 7.4 shows that how a firm makes excess profit. The firm tries to equate marginal revenue
with marginal cost. MR curve is horizontal and the marginal cost curve is U-shaped which cuts MR at
point E. At point E, MR = MC. OQ is the equilibrium output for the firm. The firm's profit per unit is EB
(AR – AC), AR is EQ and AC is BQ. Total profit is shown by the shaded area ABEP.
(ii) Normal Profit
When the firm earns normal profits its average revenue is equal to its average cost.

Figure 7.5: Normal Profit Situation

In the figure, the firm just meets its average cost from average revenue; it earns normal profit. The figure
shows that MR = MC at E. The equilibrium output is OQ. Since, here AR = AC or OP = EQ, the firm is
just earning normal profit.

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(iii) Loss
The firm can be in equilibrium position and still makes loss. When the firm is able to meet the variable
cost and a part of fixed cost, it will try to continue production because fixed cost is incurred and in such a
case it will be able to recover a part of it. If a firm is unable to meet average variable cost, it should be
better to shut down the production.
In the figure, E is the equilibrium point and at this point AR = EQ and AC = BQ since BQ > EQ, firm
bearing BE per unit loss and total loss is shown by the shaded area APEB.
C. Long-run Equilibrium of the Industry
When all firms are earning normal profits only (i.e., all the firms are in equilibrium) and there is no
further entry or exit from the market, the industry is said to be attained long-run equilibrium.
The above figure shows that, AR = MR = LAC = LMC at point E 1. Since E, is the minimum point of
LAC curve, the firm produces equilibrium output OQ at the minimum cost. The firm producing at
minimum cost is called an optimum firm. The entire firm in the perfect competition is optimum firms
having optimum size and the firms charge minimum possible price just covers their marginal cost.
Thus in the long run
(a) AR =MR = P = LMC = LAC
(b) The firm just earns normal profit
(c) Competitive firms are of optimum size.
Thus we notice that in perfect competition, the market mechanism tends to an optimal allocation of
resources in the long run. But it should be remembered that the perfectly competitive market system is a
myth. This is because of the incompletion market where this system is never found in the real.

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 Figure 7.6 : Loss Situation

Figure 7.7: Long-run Equilibrium of the Industry

PRICE AND OUTPUT DETERMINATION UNDER MONOPOLY MARKET

In the perfectly competitive market, the firms are price taker so that they are only concerned about
determination of output. But this is not the case of the monopolist. A monopolist has to determine not
only output but also price for his product. Since he faces a downward sloping demand curve, if he raises
price of products, his sales will go down. On the other hand, if he wants to improve his sales volume, he
will have to be countered with lesser price. He will try to reach that level of output at which profit is
maximum i.e., he will try to attain the equilibrium level of output. It can be explained as follows:
MR – MC Approach
Given the downward sloping demand curve and U-shaped AC and MC curve, equilibrium of monopolist
requires the following conditions under MR – MC approach. According to this approach, there should be
(a) MR = MC, and (b) MC cuts MR from below.
These two conditions guarantee the equilibrium of monopolist under two assumptions.
i. The objective of monopolist is profit maximization.
ii. In the input market, the monopolist cannot effect to the input price i.e., monopolist is the
price taker in the input market.
Figure 7.11 : Excess Profit Condition of the Firm

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The figure 7.11 shows that MC cuts MR at E to give equilibrium output as OQ. The firm produces OQ
quantity output at OP price level which are equilibrium output and price for the firm. The firm's cost per
unit is B'Q and average revenue is OP'. Therefore, profit per unit is PB', which is the difference between
AR (= PQ) – AC(= BQ) the shaded area PB' CP' is the excess profit of the monopolist.
Does a Monopolist incur losses?
One of the misconceptions about a monopolist is that he always makes profits. It is to be noted that
nothing guarantees that a monopolist makes profit. It all depends upon the demand and cost conditions. If
he faces the highly inelastic demand curve being the cost curve constant, he incurs losses. This is depicted
in the following figure:

Figure 7.12 : Loss Situation of Firm

In the figure 7.12, MC cuts MR at point E. Here, E is the point of equilibrium even in incurring loss (i.e.,
point of loss minimization). At point E, equilibrium output is OQ and equilibrium price is OP. Cost
corresponding to OQ is QB. Cost per unit of output i.e., QB is greater than revenue per unit, which is QP.
Thus the monopolist incurs losses to the extent of PB per unit or total loss is BPP 1C. Whether the
monopolist stays in business in the short run depends upon whether he meets his average variable cost or
not. If he covers average variable cost and at least a part of fixed cost, he will not shut down his business
because he contributes something towards fixed costs, which are already incurred. If he is unable to meet
his average variable cost even, he will shut down his business.
Long-run Equilibrium
The long-run equilibrium of monopolist requires the same conditions mentioned in short-run equilibrium.
Long-run is a period long enough to allow the monopolist to adjust his plant size or use of his existing

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plant at any level that maximizes his profit. In the absence of competition, the monopolist need not
produce at the optimum level. He can produce at sub-optimal scale also. In other words, he needs not to
reach the minimum of LAC curve; he can stop at any place where his profit becomes maximum.
The difference between monopoly market and monopolistic competition
S.No. Monopoly Market Monopolistic Competition
1. Monopoly refers to that market form in Monopolistic competition is defined as the market
which a single producer controls the structure in which a large number of sellers sell
whole supply of a commodity, which differentiated product, which is close substitute for
has no close substitutes. one another. Monopolistic competition combines
the basic element of both perfect competition and
monopoly.

2. In the monopoly market, there is only There are a large number of firms producing
one firm producing or supplying a closely related product (but not identical).Under
product. The single firm constitutes the monopolistic competition, the collection of firms
industry and as such there is no producing closely substitutable products is called
distinction between the firm and the 'group' not the industry.
industry in the monopolistic market.
3. In a monopoly market, there are strong New firms are free to enter into the market and
barriers to entry. The barriers to entry existing firms are free to quite it. Entry of new
could be economic, institutional, legal firms reduces the market share of the existing one
or artificial. and exit of firms does the opposite.

4. The monopolist generally sells a In this market, the product of different sellers is
product, which has no close substitutes. differentiated on the basis of brands. These brands
In such a case, the cross elasticity of are generally so much advertised that a consumer
demand for the monopolist's product starts associating the brand with a particular
and others product is either zero or manufacturer and a type of brand loyalty is
very less. The price elasticity of developed. Similarly, the producer of an individual
demand for monopolist's product is brand can raise the price of this product knowing
also less than one. that they will not lose all the customers to other
brands because of absence of perfect
substitutability.
5. Under monopoly, monopolist has full In this market, sellers try to compete on the basis
control over the supply of the other than price, as for example of aggressive
commodity. But due to large number of advertising, product development, better
buyers, demand of any one buyer distribution arrangements, efficient offer-sales
constitutes an infinitely small part of service and so on. A key basis of non-price
the total demand. Thus, buyers have to competition is a deliberate policy of product
pay the price determined by the differentiation.
monopolist.

The difference between perfect competition and monopolistic competition is explained as below
S. No. Perfect Competition Monopolistic Competition
(i) Large In the perfect competition, there There are a large number of firms producing closely
number are a large number of buyers and related product (but not identical). The concept of
of sellers. This means, the industry industry is replaced by the concept of 'group'. Under

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 sellers or market includes a large monopolistic competition, the collection of firms
and number of firms, so that each producing closely substitutable products is called
buyers individual firm, however large the 'group' not the industry.
supplies only a small part of the
total quantity offered in the
market. The buyers are also
numerous so that no
monopolistic power can affect
the working of the market and
each firm alone cannot also
affect the price in the market by
changing its output.
(ii) In the perfect competition, the In the monopolistic market, the product of different
Product products produced in the sellers is differentiated on the basis of brands. These
industry are supposed to be brands are generally so much advertised that a
homogenous (identical) in consumer starts associating the brand with a
perfect competition. The particular manufacturer and a type of brand loyalty
technical characteristics of the is developed. Similarly, the producer of an
product as well as the services individual brand can raise the price of this product
associated with its scale and knowing that they will not lose all the customers to
delivery are identical. other brands because of absence of perfect
substitutability.
(iii) Entry There is no barrier to entry or New firms are free to enter into the market and
and exit exit from the industry. This existing firms are free to quite it. Entry of new firms
implies that there does not exist reduces the market share of the existing one and exit
the monopoly or monopolistic of firms does the opposite. These consequences lend
practices in the market. There is to intensive competition among the firms for both
no restriction in the entry and retaining and increasing their market share.
exit of firm in the industry.
Entry or exit may take time but
firms have freedom of
movement in and out of the
industry.
(iv) Price The price of the product is The price of the product is determined by the
determi determined by the interaction producers by comparing reveals price strategy.
nation between demand and supply
with perfect competition.
(v) It is assumed that there is no Sometimes, the government controls the market
Govern government intervention in the mechanism.
ment market (tariffs, subsidies,
role rationing of production or
demand and so on are need out).
(vi) The factors of production are However there should be the mobility of factors of
Mobilit free to move from one firm to production, but not necessity.
y of another throughout the economy.
factors It is also assumed that worker
of can move between different jobs,
product which implies that skills can be
ion learnt easily.

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Example-1
Tamakoshi power company has following demand and cost functions;
P=2000-10Q (demand function) C = 1000 + 200Q (cost function)
Calculate price (P), output (Q), total profit (л) and total revenue ® of the company under the objective of
profit maximization.
Solution ; We know, profit (л) = TR –TC = (P x Q) – TC
= 2000Q -10Q2 – 1000 - 200Q
= 1800Q – 10Q2 – 1000
First order condition for profit maximization; dл/dQ = 0
dл/dQ = 1800 – 20Q = 0. By solving get, Q = 90
Second order condition; d2л/dQ2 < 0 (i.e. must be negative)
Since, d2л/dQ2 = -20 i.e. it satisfied for maximization profit.
We can say, profit maximization output (Q) = 90 units
Price (P) = 2000- 10x90 = 1100
Profit (л) = 1800 x 90 – 10 x 902 – 1000 = 80000
Total Revenue (TR) = P x Q = 1100 x 90 = 99000
Or; 2000 x 90 – 10 x 902 = 99000
Total Cost (TC) = 1000 + 200 x 90 = 19000
Example- 2
If the total cost function; C = Q3/3 – 8.5 Q2 + 60Q + 27 find at what level of output cost is minimum. Also
find the minimum cost.
Solution;
For minimization cost,
First order condition is; dC/dQ = 0
We have, dC/dQ = Q2 – 17Q + 60 = 0;Solving it, Q = 5 and 12
Second order condition; d2C/dQ2 > 0 (i.e. positive)
We have, d2C/dQ2 = 2Q – 17
When Q = 5; d2C/dQ2= 10 – 17 = -7 < 0 which is not possible.
When Q = 12; d2C/dQ2= 24 – 17 = 7 > 0 i.e. positive.
Hence, the total cost will be minimum at output level Q =12
Minimum cost at Q = 12; 123/3 – 8.5 (12)2 + 60 x 12+27 = 99
Hence, Min cost = 99 and output for that Q = 12units.
2016 spring
Q.N.4-a
Find equilibrium price, quantity, total revenue, total cost and total profit under the given condition.
i) Profit maximization objective
ii) Revenue/ sales maximization objective
iii) Profit constraint objective
where, P = 12 – 0.4Q C = 0.6Q2 + 4 Q + 5 and profit constraint at 10
Solution;
i) We know TR = P x Q = (12 – 0.4Q) x Q = 12Q – 0.4 Q2
TC = 0.6Q2 + 4 Q + 5
We know profit (л) = TR –TC = 12Q – 0.4 Q2 - 0.6Q2 - 4 Q – 5 = 8Q – Q2 – 5
For profit maximization; dл/dQ = 0 and d2л/dQ2 < 0 i.e. negative
dл/dQ = 8 – 2Q = 0 By solving we get, Q = 4 units
d2л/dQ2 = -2 < 0 i.e. negative
Hence, profit maximization output Q = 4 units

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 Profit maximization price P = 12 -0.4 (4) = 10.4
TR = 12 (4) – 0.4 (42) = 48 – 6.4 = 41.6
TC = 0.6 (42) + 4 (4) + 5 = 9.6 + 16 + 5 = 30.6
Profit (л) = 8 (4) – 42 – 5 = 32 – 16 – 5 = 11 (Or, profit = TR – TC = 41.6 – 30.6 = 11)

ii) Quantity and price for sales maximization objective

We know sales maximization refers TR maximization which is possible when it fulfills the following
two conditions.
dTR/dQ = 0 and d2TR/dQ2 < 0 i.e negative
dTR/dQ = 12 – 0.8Q = 0 By solving Q = 15
d2TR/dQ2 = -0.8 < 0 i.e negative
Hence, sales maximization output is required 15 units.
Similarly, sales maximization price P = 12 – 0.4 (15) = 12 – 6 = Rs.6
At Q = 15; TR = 12 (15) – 0.4 (152) = 180 – 90 = Rs. 90
At Q = 15; TC = 0.6 (152) + 4 (15) + 5 = 135 + 60 + 5 = Rs. 200
At Q = 15; loss = TR – TC = 90 – 200 = Rs.110

iii) Quantity for profit constraints 10

We know profit (л) = TR –TC
Or, 10 = 8Q – Q2 – 5
15 + Q2 -8Q = 0
By solving, Q = 3 and 5
When objective is sales maximization, output must be higher i.e. Q = 5
At Q = 5; P = 12- 0.4 (5) = 12 – 2 = 10 and TR = P x Q = 10 x 5 = 50
At Q = 3; P = 12- 0.4 (3) = 12 – 1.2 = 10.8 and TR = P x Q = 10.8 x 3 = 32.4
Example 3;
If demand function P = 20 – Q and cost function C = Q2 + 8Q + 2
Required; Q, P, TR, TC and profit (л)
i) Profit maximization objective
Ans; Q = 3 units P = Rs.17 TR = Rs.51 TC = Rs.35 and Profit = Rs. 16
ii) Sales revenue maximization objective
Ans; Q = 10 units P = Rs.10 TR = Rs.100 TC = Rs.182 and loss = Rs. 82
iii) Profit constraint 8 with sales revenue maximization
Ans; Q = 1 or 5
When Q = 5; P = Rs.15 TR = Rs.75 TC = Rs.67 Profit = Rs.8

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