Business Economics

UNIT IV – Pricing
Course Code: F010101T
 Suggested Readings:

1. Varsney & Maheshwari, Managerial Economics

2. Mote Paul & Gupta, Managerial Economics: Concepts &
cases
3. D.N.Dwivedi, Managerial Economics
4. D.C.Huge, Managerial Economics 5.
5. Peterson & Lewis, Managerial Economics
 MARKET
• Place or an area where buyers and sellers generally
meet so as to buy and sell a particular commodity.

• Any effective arrangement for bringing buyers and

sellers into contact with one another is defined as a
market in economics

• ‘Market’ does not refer to a specific place. Rather, it is

a mechanism through which buyers and sellers come
into contact with each other and buy and/or sell
goods at mutually agreed prices.
 Characteristics of Market

(a) Buyers and Sellers: Buyers and sellers must come into
contact with each other for a market to exist.
(b) Area: Market is not limited to a particular place. Today, in
the age of Internet, we have a rapidly growing online
market which is not limited to any geographical area. A
buyer can place order to buy a good online. So modern
Market exists physically and virtually.
(c) Commodity: The transaction between buyer and seller has
to be over some good or service.
(d). Interaction: There should be free interaction between
buyers and sellers so that only one price is agreed upon for the
commodity.
 Characteristics of Market

(e) Money transaction: Money is the mediums of

exchange in the modern day world. Consumers pay
money to the seller to buy goods as services in the
market. So money and market are inseparable.
 PERFECT COMPETITION

• A market is said to be perfect when there is a large

number of buyers and sellers of the product and
there is a complete absence of rivalry among the
firms. The firms sell products which are
homogeneous.
 Features of Perfect Competition

(1) Large number of buyers and sellers. The number of buyers and
sellers is so large that no individual buyer or seller can influence
the market price and output by his independent action. The
reason for this is that every buyer and seller purchases or sells a
very insignificant amount of the total output.

(2) Homogeneous products. A firm produces a product which is

accepted by customers as homogeneous or identical. The
assumptions of large numbers of sellers and buyers and of product
being homogeneous indicate that a single firm is a price-taker.
Demand curve or average revenue curve is infinitely elastic, i.e.,
demand curve is horizontal straight line parallel to output axis.
Therefore, a firm under perfect competition sells any amount of
output at the prevailing market price.
 Features of Perfect Competition

(3) Free entry and exit of the firms. Every firm is free to join or
leave the industry. If the industry is making profits new firms
can enter the market to share these profits. Similarly, if the
industry suffers losses the individual firms can quit the market.

(4) No government regulation. There is no government

interference in the market in the form of taxes, subsidies,
rationing of essential goods etc.

(5) Uniform price. At a particular time uniform price of a

commodity prevails all over the market.
 Features of Perfect Competition

(6) Perfect knowledge of market conditions. Buyers and sellers

have full knowledge of the price at which transactions take
place in the market.

(7) Firm is a Price taker

 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 the prevailing market price and they are
indifferent about a particular firm; if one firm increases the
price, buyers would promptly move away from this firm and
shift over to its rival firms.
• On the other hand, if a firm tries to gain advantage of
increased demand by lowering the price, its demand would
increase to infinity. Either of these would lead to a perfectly
elastic demand curve.
 Perfectly Elastic Demand Curve

• Under perfect competition all the units are sold at the same
price. As a result the Average Revenue comes equal to the
price per unit of the commodity. Also each additional unit is
also sold at the same price per unit which makes Marginal
Revenue also equal to the price per unit of the commodity.

• MR is the revenue by selling one additional unit.

• AR = TR/Q = PQ/Q = P

• AR = MR = P FOR PERFECT MARKET

 Perfectly Elastic Demand Curve

• The market demand curve for the whole industry is a

standard downward sloping curve, which shows alterative
combinations of price and output available to the buyers,
such that an individual buyer is able to get the maximum
amount of output at each existing price, at a given time.
Definitely, the buyer would demand more of the product at
lower prices, and less at higher prices, other things remaining
equal.
• The market demand curve is the horizontal summation of
individual demand curves. The demand cure for an individual
firm is a horizontal straight line showing that the firm can sell
infinite volume of out at the same price
 Perfectly Elastic Demand Curve

• The marker supply curve is upward sloping, giving various

combinations of price and output it shows the maximum
output any firm is willing to produce and supply at each
specified price, at a given time Firms definitely are willing to
sell larger quantities of output at higher prices, and lower
quantities at lower prices, other things remaining constant.
• The market supply curve is the horizontal summation of all
the individual supply curves of the firms. In Figure 10.2
market equilibrium is reached at the point of intersection of
the market demand an market supply curves, at E,
equilibrium output for the industry is given at Q*
 Perfectly Elastic Demand Curve

• Each perfectly competitive firm, being a price taker, takes the

equilibrium price from the market as given at P. Since a firm can sell all
it wants at this price, it faces an infinitely elastic demand curve for its
product.
• Such a shape of the demand curve also implies that the firm can sell not
even a single unit of its product at even a slightly higher price. It is not
worthwhile for the firm to offer any quantity at a lower price either,
since it can sell as much as it wants at the prevailing market price.
• This would imply that Total Revenue of a firm would increase at a
constant rate, i.e. Marginal Revenue would be constant. In other words
Average Revenue will be equal to Marginal Revenue. Hence, the
demand curve of the firm will be a straight horizontal line, showing
perfect elasticity of demand, and this infinitely elastic demand curve,
drawn at market price, coincides with the AR and MR curves.
 SHORT RUN EQUILIBRIUM

• In the short run, an individual firm under perfect competition

may either earn super normal profit, or normal profit, or can
incur losses. This depend on the position of the shor run cost
curves. These three possibilities are shown by the three short
run equilibriums positions of a competitive firm.
• The point of market equilibrium is amazed by the intersection
of market demand curve and market apply curve at point E,
An individual firm takes the equilibrium price P* as given, and
faces an infinitely elastic demand curve given by P = AR =MR
as shown in Figure 10.2.
 Case of Supernormal Profit

• In the short run a perfectly competitive firm can earn

supernormal profits (when revenue exceeds cost). The Average
Cost (AC) and Marginal Cost (MC) curves are the usual short run
cost curves. As the firm maximises profits at the point where
MR is equal to MC and also where MC cuts MR from below, the
point of equilibrium of the firm in Figure 10.3 is at point E;
output at this price OQ* So, by selling OQ* equilibrium output
at equilibrium price P* the total revenue earned by the firm is
rectangular area OP*EQ* area below the AC curve, since TR =
AR *Q) To produce this output the total cost incurred by the
firm is given as rectangular area oabQ* area below the AC
curve, since TC = AC *Q). Therfore profit earned by the firm is
given by the rectangular region AP*EB. This is the super normal
profit earn by the firm in short run, because the ruling market
price P* is greater than average cost
 Case of Normal Profit

• Not all firms earn supernormal profits in the short run; some
of them may also earn normal profits (when revenue is equal
to cost). As in the previous case, equilibrium of the firm is
shown at E in Figure 10.4, the output that maximises profit is
OQ*. Total revenue earned by the firm by selling OQ* is the
rectangular area OP* EQ*. Similarly, the total cost of
producing OQ* is also given by the res OP* EQ*. Profit is
thereby nil, in other words, the firm makes normal profit and
actually ends: producing at the break-even level of output.
This situation occurs because the average cost curve is
tangent to the average revenue line.
 Meaning of Monopoly

• The word monopoly has been derived from the combination

of two words i.e., ‘Mono’ and ‘Poly’.

• Mono refers to a single entity and poly to control.

• In this way, monopoly refers to a market situation in which

there is only one seller of a commodity.

 Meaning of Monopoly

• There are no close substitutes for the commodity that

monopoly firm produces and there are barriers to entry. The

single producer may be in the form of individual owner or a

simple partnership or a joint stock company. In other words,

under monopoly there is no difference between firm and

industry.
 Definition

• “Monopoly is a market situation in which there is a single

seller. There are no close substitutes of the commodity it
produces, and there are barriers to entry”.
-Koutsoyiannis

• “Under pure monopoly there is a single seller in the market.

The monopolist’s demand is market demand. The monopolist
is a price-maker. Pure monopoly suggests no substitute
situation”.
-A. J. Braff
 Characteristics of Monopoly

1) Single Seller: There is only one seller; he can control

supply of his product. But he cannot control
demand for the product, as there are many buyers.

2) No close Substitutes: There are no close substitutes

for the product. Either they have to buy the product
or go without it.

3) Control over price: The monopolist has control over

the supply and thereby on price. Sometimes he may
adopt price discrimination. He may fix different prices
for different sets of consumers.
 Characteristics of Monopoly

4) Very High Barrier to Entry: There is no freedom to other

producers to enter the market as the monopolist is enjoying
monopoly power. Barriers for new firms to enter are strong.
There are legal, technological, economic and natural
obstacles, which may block the entry of new producers.

5) No difference between Firm and Industry: Under monopoly,

there is no difference between a firm and an industry. As
there is only one firm, that single firm constitutes the whole
industry.
 Characteristics of Monopoly

• Shape of Demand Curve: Since a monopolist has full

control over the price, therefore, he can sell more by
lowering the price. This makes the demand curve
downward sloping.

• Price determine by the Seller : Price Maker

 Price Discrimination

• Having considerable control over the market on

account of being single seller with no entry of other
firms, the monopolist can exercise policy of price
discrimination, it means that the monopolist can sell
different quantities of the same product to a
consumer at different price or same quantity to
different consumers at different prices by adjudging
the standard of living of the consumer.
 Causes of Monopoly

1) Natural: A monopoly may arise on account of some natural

causes. Some minerals are available only in certain regions.
For example, South Africa has the monopoly of diamonds;
nickel in the world is mostly available in Canada and oil in
Middle East. This monopoly is caused by natural availability
of resources.

2) Technical: Monopoly power may be enjoyed due to technical

reasons. A firm may have control over raw materials,
technical knowledge, special know-how, scientific secrets and
formula that enable a monopolist to produce a commodity,
e.g., Microsoft Internet Explorer
 Causes of Monopoly

3) Legal: Monopoly power is achieved through patent rights,

copyrights and trade marks by the producers. This is called
legal monopoly. Eg Pharmaceutical company investing in new
formula new R&D. hence protection to pharma company to
sell their composition for particular time period.

4) Large Amount of Capital: The manufacture of some goods

requires a large amount of capital or lumpiness of capital. All
firms cannot enter the field because they cannot afford to
invest such a large amount of capital. This may give rise to
monopoly. power generation plant
 Causes of Monopoly

• State: Government will have the sole right of producing and

selling some goods. They are State monopolies. For example,
in India we have public utilities like electricity, railways, postal
service, water supply. These public utilities are generally run
by the State.
 DEMAND AND REVENUE CURVES UNDER MONOPOLY

• The demand curve facing the whole industry under

Monopoly is sloping downward.

 DEMAND AND REVENUE CURVES UNDER MONOPOLY

• An individual firm under perfect competition does not

face a downward-sloping demand curve. But in the
case of monopoly one firm constitutes the whole
industry.

• Therefore, the entire demand of the consumers for a

product faces the monopolist. Since the demand
curve of the consumers for a product slopes
downward, the monopolist faces a downward sloping
demand curve.
 DEMAND AND REVENUE CURVES UNDER MONOPOLY

• Consider Fig. 10.1. DD is the demand curve facing a

monopolist. At price OP the quantity demanded is
OM, therefore he would be able to sell OM quantity
at price OP. If he wants to sell a greater quantity ON,
then he has to price it OL. If he restricts his quantity
to OG, the price will rise to OH.
 DEMAND AND REVENUE CURVES UNDER MONOPOLY

• Thus, every quantity change by him entails a change in price

at which the product can be sold. The problem faced by a
monopolist is to choose a price quantity combination which is
optimum for him, that is, which yields him maximum possible
profits. Demand curve facing the monopolist will be his
average revenue curve.

• Thus, the average revenue curve of the monopolist slopes

downward throughout its length. Since average revenue
curve slopes downward, marginal revenue curve will lie
below it. This follows from usual average-marginal
relationship. The implication of marginal revenue curve lying
below average revenue curve is that the marginal revenue
will be less than the price or average revenue.
 DEMAND AND REVENUE CURVES UNDER MONOPOLY

• When monopolist sells more, the price of his product

falls; marginal revenue therefore must be less than
the price. In Fig. 10.2, AR is the average revenue
curve of the monopolist and slopes downward. MR is
the marginal revenue curve and lies below AR curve.
At quantity OM, average revenue (or price) is MP and
marginal revenue is MQ which is less than MP. The
same can be shown by a numerical example in the
Table 10.1 below: