Module III

Market Structure

I Equilibrium of a Firm

A firm is said to be in equilibrium when it has no incentive to expand or contract its output. A
firm would not like to change its level of output when its total profits are the maximum. A rational
entrepreneur will expand output if he thinks he can increase his total profits by doing so, and likewise,
he will contract or reduce his output if he thinks he can avoid losses and thus increase his total profits.
Therefore, a firm is in equilibrium position when it is earning maximum money profits.

Assumptions:-

a) The entrepreneur is rational that he tries to maximize his money profits.

b) The firm produces only one product.

The equilibrium of a firm can be explained in two ways:-

1 Equilibrium of a firm: By TR and TC curves:-

A rational entrepreneur will be in equilibrium position at the level of output where his money
profits are the maximum. He will not increase or decrease his output when he is earning maximum
money profits.

Profits are the difference between Total Revenue (TR) and Total Cost (TC). Hence, the point
where this difference is the maximum will represent the position of maximum profits and therefore, of
equilibrium.
 The curve TC represents total cost and TR total revenue. The TR curve starts from point O. TC
curve starts from point F at the height of O F. This denotes that, even the firm produces nothing or shut
down, it has to bear certain costs of production due to fixed factors. These are the fixed costs.

From the figure, it is clear that at any output smaller than OL, TC exceeds TR and the firm is
having a loss. At the output level OL, TC and TR are equal i.e., the firm has neither loss nor profit. This
point L is called breakeven point. Between OL and ON will lie the optimum point of maximum profits.

The maximum profit is where the vertical distance between the total revenue and total cost
curves is the greatest. The maximum profit point in the diagram is M where PP1 is the longest vertical
distance between the two curves. Hence at this point, the firm is in equilibrium position and is earning
maximum profits PP1 by producing OM output.

Limitations:-

a) The maximum vertical distance between the TR and TC curve is difficult to see at a glance.

b) In this method, it is not possible to discover price per unit at various outputs at first sight.

2 Equilibrium of Firm: By Marginal Revenue (MR) and Marginal Cost (MC) curves:-

A firm to makes maximum profit, two conditions are essential;

a) Marginal Revenue = Marginal Cost (MR =MC)

b) MC curve cuts MR curve from below at the equilibrium point.

The total profit of a firm can be increased by expanding output as long as addition to the total
revenue resulting from the sale of extra unit of output is greater than the addition to the total cost of
producing an extra unit. This additions are Marginal Revenue (MR) and Marginal Cost (MC).

Thus, a firm will go on expanding output as long as MR exceeds MC. The level of output where
marginal revenue (MR) and marginal cost (MC) are equal is the point of maximum profit.
 In the figure, MC is the marginal cost, MR is marginal revenue, AC is the average cost and AR is
average revenue. At the output OM, MC equals MR at point E. This is the point of maximum profit and
hence the point of equilibrium.

At output smaller than OM, MR exceeds MC and hence there is a scope of increasing profits by
increasing output. By producing the Lth unit, the firm is adding more to revenue than its cost and it will
be profitable for it to produce the Lth unit.

Similarly, for every other unit till the Mth one, the marginal revenue exceeds marginal cost and
therefore, the firm can increase its total profits by producing up to OM output.

But, if the output is increased beyond OM, MC would exceed MR and TC exceeds beyond TR i.e.,
at ON output, marginal cost is KN and marginal revenue is SN. Thus production of more units than OM
would involve losses.

Hence, we conclude that, firm's profits at OM output are the maximum and the firm is in
equilibrium when;

MC = MR

At an equilibrium position, the marginal cost curve must cut the marginal revenue from below.
This means that, beyond the equilibrium output, marginal cost must be greater than marginal revenue.
This is shown in the figure given below:-
 In this figure, MR is the straight line like that of perfect competition. MC is the marginal cost
curve. At point T, where MC and MR intersect, MC and MR are equal, but at this point marginal cost
(MC) curve cuts MR curve from above and therefore, marginal cost is less than marginal revenue
beyond the point T. Obviously T cannot be an equilibrium position, because it will be profitable for the
firm to expand production beyond T. At point T, ON is the output. Point P shows the marginal cost
(MC) curve from below and marginal cost beyond this point is higher than marginal revenue
(MR).Hence, if the firm expands its production beyond this point P (OM output) it may incur losses.
Hence, point P is the equilibrium point.

II Market Structure

In economics, the term “market” does not mean a particular place but the whole area where the
buyers and sellers of a product are spread. This is because, in the present age, the sales and purchase of
goods are with the help of agents and samples. Hence, the buyers and sellers of a particular product are
spread over a large area. Thus, market in economics does not refer to a particular market place but the
entire region in which goods are bought and sold.

In the words of A. Cournot, “Economists understand by the term ‘market’, not any particular
place in which things are bought and sold but the whole of any region in which buyers and sellers are
in such free intercourse with one another that the price of the same goods tends to equality, easily and
quickly”.

Characteristics of Market:-

The essential features of a market are:-

1. An Area:- In economics, the term “market” does not mean a particular place but the whole area
where the buyers and sellers of a product are spread. Modern modes of communication and
transport have made the market area for a product very wide.
 2. One commodity:- In economics, the market is not related to a place but to a particular product.
Hence, there are separate markets for various commodities. For example; there are separate
markets for cloths, grains, jewelry etc.

3. Buyers and sellers:- The presence of buyers and sellers is necessary for the sale and purchase of
a product in the market. In the modern age, buyers and sellers can do transactions through letter,
telephones, business representatives, internet etc.

4. Free competition:- There should be free competition among buyers and sellers in the market.
This competition is relation to the price determination of a product among buyers and sellers.

5. One price:- The price of a product is the same in the market because of free competition among
buyers and sellers.

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 for service (factor) market are determined by the
nature of competition prevailing in a particular market. There are a number of determinants for a
particular market structure. They are:-

1. The number and nature of sellers.

2. The number and nature of buyers.
3. The nature of the product.
4. The conditions of entry into and exit from the market.
5. Economies of scale.

Market Morphology:-

Type of Number Nature of Number Freedom Examples

market of units product of of entry
buyers and exit

Perfect Very Homogeneous Very Unrestricted Agricultural

competition large (undifferentiated) large commodities,
shares,
unskilled
labor force

Monopolistic Many Differentiated Many Unrestricted Retail stores,

competition detergents

Oligopoly Few Undifferentiated Few Restricted Cars,

or Differentiated computers,
universities
 Monopoly Single Unique Many Restricted Indian
Railways,
Microsoft

Forms of Market Structure:-

On the basis of various parameters, a market can be classified in the following ways:-

1. Perfect Competition:-

A perfectly competitive market is one in which the number of buyers and sellers is very large, all
engaged in buying and selling a homogenous 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 characterized by a complete absence of rivalry among the individual firms”.

Features:-

1. Large number of buyers and sellers:- The 1st 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.

2. Freedom of entry and exist:- The freedom of entry and exit 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. Homogenous product:- Each firm produces and sells a homogenous product so that, no buyer
has any preference for the product of any individual seller over others. This is possible if units of
the same product produced by different sellers are perfect substitutes.

4. Absence of artificial restrictions:- In perfect competition, sellers are free to sell their goods to
any buyers and the buyers are free to buy from any seller. There are no efforts on the part of
producers, government or any other agency to control the demand, supply or price of the
products.

5. Perfect knowledge of market conditions:- 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.

6. Every firm has only one goal of profit maximization.

7. Absence of selling cost:- Under perfect competition, the cost of advertising, sales- promotion etc
does not arise because all firms produce a homogeneous product.

8. Perfectly elastic demand curve:- The demand curve of a perfectly competitive firm is perfectly
elastic. If a particular firm decides to charge a price higher than the existing market price, its
 demand will be reduced to zero. This is because, buyers have perfect knowledge about the
product and if a firm increases the price of the product; they will move away from that firm and
shift over to its rival firms. On the other hand, if the firm tries to gain the advantage of increased
demand by lowering the price, its demand would increase to infinity.

9. Firm is a price taker:- A perfectly competitive firm is so small in comparison to the entire
market, that it has no influence on market conditions. The price is determined by the market
mechanism and the individual firms follow it.

Price and output determination under Perfect Competition:

Under perfect competition, price of the commodity is determined by the interaction of demand
and supply and not by any one seller or a firm. The price at which demand and supply are equal is
known as equilibrium price, since at this price the forces of demand and supply are balanced, or are in
equilibrium. The quantity bought and sold at this price is equilibrium amount.

In the figure a) shown, the total demand curve DD intersects industry’s supply curve SS at point
E. Thus point E is the equilibrium point at which OP is the equilibrium price. Figure b) refers to firm’s
demand curve. The firm will have to sell all its output at the prevailing price OP. It may sell more units
or fewer units, but it will charge only OP price. The firm can neither increase nor decrease this price;
because the price is determined by the industry and not by the firm. Firm is a price taker and not price
maker. As such firm’s demand curve(PP) will be parallel to X axis signifying that the firm can sell any
number of units at OP price. Firm’s demand curve PP is also its Average Revenue and Marginal Revenue
curve. I.e., AR= MR
B. Imperfect Competition:-

Imperfect competition occurs in a market when one of the conditions in a perfectly competitive
market are left unmet. This type of market is very common. Every industry has some type of imperfect
competition. This includes a market place with different products and services, prices that are not set
by demand and supply, competition for market share, buyers who may not have complete information
about products and prices, and high barriers to entry and exit. The various forms of imperfect
competition are; Monopoly, Monopolistic Competition, Oligopoly, Duopoly etc.

Key difference between Perfect competition and Imperfect competition:-

a) The competitive market, in which there are large number of buyers and sellers, and the sellers supply
identical products to buyers is known as perfect competition. Imperfect competition occurs when one
or more conditions of the perfect competition are not met.

b) Perfect competition is a hypothetical situation, which does not apply in the real world. Conversely
imperfect competition is a situation that is found in the present day world.

c) There are many sellers in the perfect competition. But in imperfect competition, there can be few to
many sellers depending upon the type of market structure.

d) In perfect competition, the sellers produce or supply identical products. In imperfect competition,
the products offered by the sellers can either be homogenous or differentiated.

e) There are no barriers to entry and exit. But just the opposite is the case of imperfect competition.

f) In perfect competition, the firms do not influence the price of the product. But in imperfect
competition, firms are the price makers.
C Monopoly Market:-

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 evey other
product is very low. Here the firm itself is the industry. Since the firm and industry are one and the
same, the demand functions and demand curve of a monopoly firm will be same as the industry demand
function and curve.

Features:-

1. Single seller:-The entire market is under the control of a single firm. Production, distribution
and selling of the product are all controlled by the same firm; hence there is no competition.
Example; Indian railway, State electricity board etc.
2. Single product:-A monopoly exists when a single seller sells a product which has no substitute
or at least no close substitutes in the market.
3. No difference between firm and industry:-In monopoly, the firm and industry are the same.
This is because there is a single firm in the industry. The demand curve facing an industry and
firm are same.
4. Independent decision making:- Since the entire market is under control of a single firm, this
firm can take decisions about the price and output of its products without any worry about
decisions of rival firms. It decides its own price and output, based on individual demand and cost
conditions and is hence regarded as a price maker.
5. Restricted entry:- A monopoly is characterized by restricted entry of firms. In fact it is the
existence of barriers that leads to the emergence and/ or survival of a monopoly.

Price and output determination under Monopoly:

The aim of the monopolist like every producer is to maximize his profit. Therefore, he will
produce up to a point and charge price which gives him the maximum profits. The monopolist will be
in equilibrium position at that level of output at which marginal revenue (MR) equals marginal
cost(MC).
 In the above figure, AR is the average curve/ demand curve facing a monopolist. MR is the
marginal revenue curve which lies below the AR curve. AC is the average cost curve and MC is the
marginal cost curve. Up till OM output, MR is greater than MC, but beyond OM, MR< Mc. Therefore,
the monopolist will be in equilibrium at the output OM, and price OP or MP1.

Regulation of Monopoly:-

A monopolist is a suspect in the public eye. He generally exploits the consumer. All governments,
therefore, consider it necessary to curb his profit making propensity in the interest of the consumers
and the community at large. The two common methods are; Price regulation and Taxation.

a) Price regulation:- It is usual for the government to regulate the prices charged by public utilities like
gas, and electric companies. The underlying objective is to call forth the maximum output consistent
with the monopolist's cost and consumer demand.

In the absence of government's regulation, the monopolist may charge a higher price. But when
government fixes and regulates the price, the demand may increase as the price decreases. Although
the monopolist has been compelled to charge a lower price, yet the consuming public has taken a larger
quantity, this compensates the monopolist. The consumers are benefited by a larger amount being
made available to them at a lower price.

b) Taxation:- Taxation is regarded as a very suitable device for getting monopoly. Such taxes are of two
types:-

i. Lump sum tax irrespective of the quantity of the output and, ii) a fixed tax per unit of the output.

The lump sum tax has to be borne entirely by the monopolist since it cannot be shifted to the
consumers by way of price rise. Since the monopolist already fixed price and output which brings him
maximum profit, he cannot now touch them. Hence, by imposing a lump sum tax, the government can
take away all or any portion of his profit without adversely affecting the general welfare.

As for the tax per unit of output, the monopolist will be induced to reduce output and raise the price
in order to maximize his profit after paying the per unit tax. The price rise affects the consumer. The
total cost of the monopolists at the various levels of output are increased, but the total revenue remains
the same. Hence, the prices being higher and the output smaller, the general welfare adversely affected.

Other methods to control monopoly:-

c) Reducing barriers to entry:- The government should ensure that the barriers to the entry outside
firms into the monopolized industry are kept at the minimum. This would create the fear of potential
competition which would check the monopoly.

d) Preventing collusion:- The government's antimonopoly agency should keep a close watch so that
there is no collusion among the monopolist forms to raise price and control supply. They should make
sure that the price fixed is not higher than the true marginal cost.
e) Breaking large firms:- The government's antitrust policy should be such that the big firms do not
become bigger. They are not permitted to issue more capital. Further, they may not be given the supply
of scarce materials. In these and other ways, large firms should be prevented from expanding.

f) Monopolies Commission:- Periodical report on the working of monopolies by a Commission may

focus public opinion on the evil doings of the monopolists. This it may keep them straight, failing which
legislation may be adopted to weed out the known evils. Greater attention should be paid to preventing
a bad market behavior than to punishment after the misbehavior.

In India, the Monopolies and Restrictive Trade Practices Act (MRTP Act) was introduced in the
year 1969, which had it's genesis in the Directive Principles of State Policy embodied in the Constitution
of India. This act was intended to curb the rise of concentration of wealth in a few hands and of
monopolistic practices.

D. Monopolistic Competition:-

Monopolistic competition refers to a market situation in which there are many producers
producing goods which are close substitutes of one another or where output is differentiated.

Features:-

1. The Product differentiation: The product under monopolistic competition are neither
homogeneous as in perfect competition nor remote product as in monopoly. Rather, they are
close substitutes. But, these competing monopolists do not produce identical products. There
presents product differentiation which means that the products are different in some ways, but
not altogether so. (Tooth Paste: - Colgate, Close-up, etc., Soaps: - Lux, Dove, etc.)

2. Many Firms:- Under monopolistic competition, there are many firms but not alike perfect
competition. It requires only a fairly large number, say 25, 30, 60, or 70.

3. Independent Pricing Power:- The producer of each competing brand has some control over the
price of his product and the extent of his power to control price depending upon how strongly
the buyer are attached to his brand .

4. Freedom of entry and exit.:-There are neither any legal nor any economic barriers against the
entry of new firms into the market. New firms are free to enter the market and existing firm are
free to leave the market.

Price - Output determination under Monopolistic competition

The price and output will be determined at a point where MR = MC v. At this point profit will be
at maximum.

In short run, the firms will be in equilibrium when it is maximizing its profits.

Ie , when MR = MC
 AR is the average revenue curve, MR is Marginal Revenue curve, SAC is the short run average
cost curve, and SMC is the Short run Marginal cost curve. In this figure, MR and SMC intersect each
other at the output OM at which price is OP1 or MP because, P is point on AR ie; price.

In the long run, the super normal profits earned by monopolistic firms disappear. This is because
of the free entry of new firms attracted by the firms. As new firms start production, the supply will
increase and price will fall. Therefore, in long run, equilibrium is established when firms are earning
only normal profits. Profits are normal when AR = AC.

In the figure, the AR is tangent to the LAC curve at P. Therefore, the equilibrium output in the long run
is OM and the corresponding price is MP or OP1.
E. Oligopoly:-

Such a market structure is characterized by a few sellers. The price- output decisions are
independent. The degree of competition here is less than monopolistic competition but higher than that
in monopoly.

Features:-

1. Few sellers:- The term oligopoly itself implies a market dominated by a few sellers. Any market in
which a small number of large firms compete may be termed as oligopoly. Automobile industry is a vert
good example for oligopoly market, where one can count the number of players. Example, in Indian
market the major players are Maruti, Hyundai, Toyota and Ford (Differentiated oligopoly, as the
products are different by name, size, features etc.). Indian Oil, IPCL, HP (Pure oligopoly, as the
products are identical) is another set of examples. In FMCG sector, Coke and Pepsi represent an
extreme case of oligopoly where there are only two players (Duopoly).

2. Product:- The products may be differentiated (like cars, motorbikes, TV, soft drinks etc) or
homogenous (like petrol, cement, steel and aluminum). Thus, it is a combination of perfect competition
and monopolistic competition.

3. Entry Barriers:- There are no legal barriers as such to enter the market under oligopoly. However at
the same time, there are various economic barriers which restrict the number of firms in the market.
These are:-

a) Huge investment requirements (Eg:- Huge investment is needed for starting a cement
manufacturing plant or petroleum products or cars.)

b) Strong customer loyalty for existing brands (Eg:- Xerox for photocopying, Godrej for almirah and
Jeep for SUV)

c) Economies of scale. (Eg:- HP printers as they are sold at such a low price than other players have
become almost extinct, Newspapers like Indian Express, Malayala Manorama etc)

4. Interdependent decision making:- One firm cannot take any independent decision without
considering the reaction of the rival firms. This interdependence of decision making is the consequence
of continuous consciousness of rival’s moves and countermoves and is quintessential to oligopoly.

5. Kinked demand curve:- An oligopolist’s demand curve is not only affected by its own price or
advertisement or quality but also affected by the prices of rival products, their quality, packaging,
promotion and placement. Due to this fact, in oligopoly, each firm faces two demand curves,. One of
these two demand curves is highly elastic and the other one is less elastic. The demand curve of a firm
under oligopoly is known as Kinked Demand Curve.
 The demand curve of the Oligopoly firm is D1D2 with a kink at point K. The curve is more elastic
above the kink and less elastic below the kink. OP is the current price at which the oligopolist can sell
OQ quantity of output. D1K shows the highly elastic portion of the demand curve due to no reaction by
rivals in the event of increase in price, KD2 shows the less elastic portion when the rival firms react with
a price reduction. This discontinuity in the demand curve (AB) creates a discontinuity in the MR curve
as well. At the kink, MR is constant between points

A & B. Hence, the producer will produce the same amount of output OQ whether it is operating
on MC, or MC2, since the profit maximizing conditions are being full filled at points S as well as T. If
the marginal cost fluctuates between A & B, the firm will neither change its output nor its price. It will
change its output and price only if MC moves above A or below B.

6. Non- price competition:- Suppose, there are only two firms in the industry, firm A and B, both are
selling a homogeneous product. At a point of time the prevailing price is P1, but firm A in an attempt to
increase customers, lowers the price below the price line. By this act of firm A, firm B fears loss of its
customers and restores by lowering the price below that of A. Firm A further reduces the price and this
process continues, till the firms reach P2. This is the point where both firms realize that this price war
is not helping either of them and decide to end the war. With this, price stabilizes at P2.
 Since in most of the cases, the prevailing price is fixed after a series of such price wars and firms
know through their experience that price war benefits only consumers and not the firms, hence
oligopoly firms keep the price untouched. Instead, they resort to other strategies like highly aggressive
advertising, product bundling, and influencing value perception of consumers, branding and offering
better service packages.

The extreme case of non-price competition is the formation of cartels or collusive oligopoly,
where all the firms openly or tacitly agree to sell their products at the same price. Oil and Petroleum
Exporting Countries (OPEC) is an international cartel, in which all the suppliers of crude oil have openly
declared to charge a single price for the product all over the world. Firms may also tacitly agree to sell
their products in separate market, and at the same price, like in the case of soft drinks and cellular
phones services.

Collusive Oligopoly

An important characteristic of oligopoly is collusion, in which rival firm enter into an agreement
in mutual interest on various accounts such as price, market share etc. Firms either openly declare their
decision of collusion, or may collude tacitly. Basic oligopoly characteristics like interdependence of
firms, constant consciousness of rival actions, fear of price war etc. create a good opportunity for
collusion.

When a number of producers or sellers enters into a formal agreement, it is called explicit
collusion, on the other hand, collusion which is over is known as tacit collusion. The most commonly
found form of explicit collusion is known as cartel. The aim of such collusion is to reduce competition
and increase profits of individual members. However, governments do not encourage collusions
because it creates monopoly like situation.
Cartel

A cartel is a formal (explicit) agreement among firms. Cartels usually occur where there care a
small number of sellers and the product is usually homogeneous. Formation of cartel normally involves
agreement on price fixation, total industry output, market share, allocation of customers, allocation of
territories, establishment of common sales agencies, division of profits, or any combination of these.
The immediate impact of cartelization is a hike in price and a reduction in supply.

Empirical studies have shown that the mean duration of cartels is from 5 to 8 year. When firms
deviate from the terms of cartels, such an act is called cheating. Whether the members of a cartel will
choose to cheat in the agreement will depend on short term returns from cheating and long term losses
from the possible breakdown of the cartel.

III. Product Pricing:-

Price denotes two aspects, on one hand it is the revenue to the seller and on the other, it is the
recognized value of a good or service to the buyer. The right price is the one which keeps all stakeholder
happy; consumers feel happy that they got value for their money; sellers are happy because they could
sell the desired volume; and shareholders are satisfied that they eared higher profits. Price determines
sales revenue, market share and profits.

Factors determining pricing decisions:-

a) Objective of the firm

b) Demand and supply conditions

c) Competition

d) Suppliers

e) Cost of production

f) Government

g) Marketing methods used.

h) Economic conditions

i) Seasonal effects.
Various Pricing Strategies adopted by firms:-

1) Cost based pricing:-

The natural basis of determination of price should be the cost of production with some margin.

a) Cost plus or markup pricing:- Under this system of cost plus pricing, price of the product is the sum
of cost plus a profit margin.

Firms which aim to maximize profit would use total cost of production as the basis of price. For
fixation of price per unit of output, average cost (AC) would be considered. Therefore, cost plus pricing
is also called Average Cost Pricing or Full Cost Pricing. Hence, a firm will consider total cost per unit or
Average cost (AFC + AVC) and determine a markup, depending upon various considerations such as
target rate of return, degree of competition, price elasticity and availability of substitutes. The price
arrived at would be;

Price = AL + m

Where 'm' is the percentage of mark up.

E.g.:- Technologies Pvt has invested rupees 10 Cr. in plant and machinery with a capacity to produce
10,000 units of TV per month. Total variable cost is estimated at rupees 5 Cr and the firm expects a
return of 20% on total investment. What should be the price of TV if we suppose that the firm can sell
its entire output?

Base Price = TC = 10 +5 =15 Cr

Margin = 20% of 15 = 3 Cr

Total Revenue= 151 3 = 18 Cr.

Price = 18, 00, 00,000 / 10000 = 18,000/- per TV

This method of markup pricing or cost plus pricing is very simple and convenient. It helps firms
determine their break even points. But its major limitation is that, it is not suitable when competition
is tough or when a new (or existing) firm is trying & enter a new mkt.

b) Marginal Cost Pricing:

When demand is slack (loose) and market is highly competitive, full cost pricing may not be the
right choice; an alternative in such a situation is to fix the price on the basis of variable cost, instead of
full cost. The method remains the same except that only variable cost is considered instead of total cost
for the purpose of price determination. Marginal cost pricing is also known as Incremental Cost Pricing.
E.g. - Technologies Pvt has invested rupees 10 Cr. in plant and machinery with a capacity to produce
10,000 units of TV per month. Total variable cost is estimated at rupees 5 Cr and the firm expects a
return of 20% on total investment. What should be the price of TV if we suppose that the firm can sell
its entire output?

Base price = VC = Rupees 5 Cr

( i) Margin = 20% (of TC) 15 = 3 Cr

Total revenue = 5+3 = 8 cr. (

Price = 800 000 00/10000 = 8,000/- per TV

( ii) Margin. = 20% of VC = 1 cr

Total Revenue = 5+1 = 6 cr.

Price = 60000000 / 10000 = 6000 per TV

We can see that the highest price by using marginal cost pricing method would be 8000/- when
margin is calculated on total investment, this is less than half of the price charged under full costing. If
the company charges a margin on variable cost (VC), the price would be further lower namely 6000/-.

This method is very useful to beat competitors, it is also used by firms to enter a new market. It
is very useful in case of goods of public utility (or social justice) where profitability is not the objective.
The only limitation of this method is that it cannot be adopted as a long term strategy as it ignores the
element of fixed cost. Hence marginal cost pricing should be used as a short term strategy.

c) Target Return Pricing:

Under target return pricing, a producer rationally decides the minimum rate of return that the
product must earn. The methodology of price determination is the same as the cost plus and marginal
cost pricing, but the margin is decided on target rate of return determined on the company's experience,
consumer's paying capacity, risk involved and similar other factors. At target return refers to the future
value, or profit, that an investor expects from their investment. Target return take into account the time
value of money.

2) Pricing Based on firm's objectives:- Selection of the right price that a firm would charge largely
depend upon its objectives

a) Profit maximization:-

A firm which aim to earn maximum profit would naturally consider the total cost (TC) of the
production for determination of price and hence will adopt markup pricing. The price charged by such
firm would be the highest.
b) Sales maximization:-

Some firms would like to maximize sales instead of profit maximization. Such firms would have
to adopt competitive pricing; one such method could be marginal costing.

3) Competition Based Pricing: Degree of competition is a very significant determinant of

pricing. Degree of competition largely depends upon entry and exit barriers.

a). Penetration Pricing:-

When a firm plans to enter a new market which is dominated by existing players, its only option
is to charge a low price, even lower than the ongoing price. This price is called penetration pricing.

Eg: Reliance brought a kind of revolution in Indian mobile phone industry by using this strategy in a
market which was dominated by BSNL. Similarly, Air Deccan had entered the civil aviation market
with its low cost air travel opportunity. Nirma is another example of success of this strategy to
entering a market largely catered by big brands like HLL and P&G.

The principles of marginal costing may be used for determining penetration pricing. This
method is also short term in perspective and its success largely depends upon the price elasticity of
demand of the product because in the long run ultimately factors other than price may become
important.

b) Entry Deterring pricing: -

One of the barrier created by a large player to eliminate or reduce competition is to keep the
price low, thus making the market unattractive for other players. If the prevailing price is already very
low, new entrants with high fixed cost will not be able to enter the mkt at a price lower than the
prevailing price. On the other hand, existing small players may not be able to survive at this price due
to highest average cost (AC). Thus, this price is also known as for "Limit pricing".

Success of entry deterring pricing strategy depends on the fact that the firm earns economies of
scale and hence can afford to charge low price.

c) Predatory pricing: -

Predatory pricing is somewhat similar to entry deterring pricing. In this scheme, prices are set
low to attempt to drive out competitors and create a monopoly. Consumers may benefit from lowering
prices in the short term, but they suffer if the scheme succeeds in eliminating competition, as this would
trigger a rise in prices and a decline in choice.

d) Going Rate Pricing:-

The going rate pricing is a method adopted by the firms wherein the product is priced as per the
rates prevailing in the market. This strategy is adopted when most of the players do not indulge to
separate pricing but prefer to follow the prevailing market price. Normally, the price is fixed by the
dominant firm and other firms accept its leadership and follow that price.
Eg:- packaged drinking water, packs of fruit juices, pasteurized milk packets etc.

The success of this strategy is dependent on the fact that most of the firms do not want to enter
into a price war kind of a situation. Secondly, small or new firms may not be sure of shift in demand by
charging a price different form the prevailing market price. Thirdly, the products sold by the players
are very close substitutes, hence their Cross elasticity is very high.

Going rate pricing strategy is popular in monopolistic and oligopoly markets where product
differentiation is minimal, and consumers switching cost is almost negligible. It is mostly adopted when
the product has reached maturity and has become generic to the extent that consumers ask for a good
soap or soft tooth brush instead of a particular brand.

4. Price Skimming: -

Producers know that there is a segment of consumers who have deep pockets and who would
like to be among the first few proud possessors of the latest product. These consumers have very low
price elasticity of demand, and are mostly governed by the status symbol factor and not by the intrinsic
value of the product. Hence producers (or sellers) charge a very high price in the beginning to skim the
market and earn super margins on sales.

In price skimming strategy, a firm charges the highest initial price that customers will pay and
then lowers it over time. As the demand of the first customers is satisfied and competition enters the
market, the firm lowers the price to attract another, more price sensitive segment of the population.

Price skimming strategy deals with a complete pricing package suitable for different life stages
of a product, ie; high price at the time of introduction and lower price during maturity. Good examples
of price skimming include innovative electronic products, such as Apple iPhone and Sony Play Station.
Price skimming strategy can be expand with the help of an example and its diagram:-

The impact of this strategy can be experienced whenever we buy the ticket of a movie on the very
first day of it' release. Those who wait for the rush to settle down pay almost half of what we had paid.
 Consumers who must watch the movie on the first day are shown on the dd curve D1 D1.
Obviously, these consumers have low price elasticity. The firm (here the owner of the movie theatre)
charges OP1 price from these viewers. Naturally, there would not be too many of them, therefore total
demand at price OP1 is OQ1. Once the product (film) reaches maturity, the firm reduces the price to
OP2 and thus allows others who have a demand curve D₂ D₂ to see the movie at lower rates. This way,
the firm is able to serve a large section of the consumers and also maximize its sales and revenue. Total
sale of tickets would be equal to the sum of OQ1 and OQ2 and total revenue (TR) is equal to the sum of
areas OP1AQ1 and OP2BQ2.