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MODULE 5:MARKETS 2011

FYBCOM/BE - I 1

Perfect Competition Market

A perfectly competitive market is one in which the number of buyers and sellers is very large, allengaged in buying and selling a homogeneous product without any artificial restrictions and havingperfect knowledge of market at a time. In the words of A. Koutsoyiannis, “Perfect competition ismarket structure characterised by a complete absence of rivalry among the individual firms.”

Characteristics or Features of Perfect Competition

1. Large number of buyers and sellers:There are large number of buyers and sellers of theproduct, and each seller and buyers is too small in relation to the market to be able to affectthe price of the product by his or her own actions. This means that a change in the output ofa single firm will not noticeably affect the market price of the product. Similarly, each buyerof the product is too small to be able to extract from the seller such things as quantitydiscounts and special credit terms.

2. Homogeneous Product: The product of each competitive firm is homogeneous, identical,or perfectly standardized. An example of this might be Grade – A wheat. As a result buyerscannot distinguish between the output of one firm and the output of another, so they areindifferent from which firm they buy the product. This refers to not only the physicalcharacteristics of the product but also the environment.

3. Freedom of Entry or Exit: It implies that whenever the industry is earning excess profits,some new firms attracted by these profits and enter the industry. In case of loss faced by theindustry, some firms leave it.

4. Perfect Mobility of Goods and Factors: It implies that goods and factors of production caneasily move geographically from one job to another and can respond quickly to monetaryincentives. In other words, goods are free to move to those places where they can earn thehighest price. Factors can also move from a low-paid to a high-paid industry.

5. Perfect Knowledge: Consumers, factors of production and firms in the market have perfectknowledge about present and future prices, costs, and economic opportunities in general.Thus, consumers will not pay a higher price than necessary for the product and producersknow exactly how much to produce.

6. Absence of Transport Cost: There are no transport costs in carrying of product from oneplace to another. If transport costs are added to the price of the product, even ahomogeneous commodity will have different prices depending upon transport costs from theplace of supply.


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Monopoly Market

Monopoly is a market situation in which there is only one seller of a product with barriers to entryof others. The product has no close substitutes. The cross elasticity of demand with the every otherproduct 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 singly firm selling acommodity for which there are no close substitutes.”

Characteristics or Features of Monopoly

1. Under monopoly, there is one producer or seller of a particular product and there is nodifference between a firm and an industry.

2. A monopoly may be individual proprietorship or partnership or Joint Stock Company or aco-operative society or a government company.

3. A monopolist has full control on the supply of a product. Hence, the elasticity of demand fora monopolist’s product is zero.

4. There is no close substitute of a monopolist’s product in the market.5. There are restrictions on the entry of other firms.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 at the same time.8. Monopolist’s demand curve slopes downwards to the right. That is why, a monopolist can

increase his sales only by increasing the price of his product and thereby maximize hisprofit.

Sources of Monopoly

There are four basic reasons that can give rise to monopoly.

1. The firm may control the entire supply of raw materials required to produce the product. Forexample, until World War II, the Aluminum Company of America (Alcoa) controlled almostevery source of bauxite (the raw material to produce aluminum) and thus has monopoly overthe production of aluminum in the US. Similarly, till the introduction of new economicpolicy in 1991, the government of India had a monopoly over most of the services likerailways, air, postal, electricity, etc.

2. The firm may own a patent or copyright that prevents other firms from using a particularproduction process or producing the same product. For example, Xerox has a monopoly oncopying machines and Polaroid on instant cameras. Patents are granted by the governmentfor a period of 17 years as an incentive to inventors.

3. In some industries, economies of scale operate (i.e., the long run average cost curve mayfall) over a sufficiently large range of outputs as to leave only one firm supplying the entiremarket. Such a firm is called a natural monopoly. Examples of these are public utilities(electric, gas, water, and local transportation companies).


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4. A monopoly may be established by a government franchise. In this case, the firm is set up asthe sole producer and distributor of a product or service but is subjected to governmentalregulation. The best example of a monopoly established by government franchise is the postoffice.

Monopolistic Competition

Monopolistic competition refers to a market situation where there are many firms selling adifferentiated product. No firm can have any significant influence on the price-output policies of theother sellers nor can it be influenced much by theirs actions.

Characteristics or Features of Monopolistic Competition

1. Large Number of Sellers:In monopolistic competition the number of seller is large. Theyare “many and small enough” but none controls a major portion of the total output. No sellerby changing its price-output can have significant effect on the sales of others and it turn beinfluenced by them.

2. Product Differentiation: Product differentiation implies that products are different in someways from each other. They are heterogeneous rather than homogeneous so that each firmhas an absolute monopoly in the production and sale of a differentiated product. However,there is slight difference between one product and other in the same category. Productdifferentiation can be both real and imaginary, real difference are with respect to size,design, strength and durability, colour, taste, smell, etc. The imaginary differences withrespect to trade mark, brand name, colour scheme of packages, etc.It may also take placedue to the differences in conditions surrounding the sale of the product.

3. Free Entry and Exit: There are no entry barrios in monopolistic competition. As firms areof small size and are capable of producing close substitutes, they can quit or enter theindustry in the long run.

4. Nature of Demand Curve: Under monopolistic competition each firm share only a smallportion of the total output of a product. The products are different but are close substitutes toeach other’s. As a result, a reduction in the product price will increase the sales of the firmbut it will have little effect on the price-output conditions of other firms, each will lose onlya few of its customers and vice-versa. Therefore, the demand curve (AR curve) of a firmslopes downward to the right.

5. Independent Behaviour: In monopolistic competition, every firm has independent policy,since the number of seller is large, none controls a major portion of the total output. Noseller by changing its price-output policy can have any significant effect on the sales ofothers and in turn influenced by them.


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6. The Groups: Chamberlin introduced the concept of ‘group’ in the place of traditionalconcept of ‘Industry’. The term industry refers to the collection of firms producinghomogeneous products; the term group refers to the collection of firms which producesimilar and differentiated products which are close substitutes to each other.

7. Selling Cost: The firm under monopolistic competition has to create demand for thedifferentiated products. Huge expenditure is to be incurred for this purpose. Thereforeselling cost is the expenditure on advertisement which has the objective of increasing thesale of the product.

8. Two Dimensional Competition: Monopolistic competition has two aspectsa) Price Competitionb) Non-price Competition

The price competition takes place when the firms compete with each other to reduce theprice and increase the sales. Non-price competition takes place in terms of productvariation and selling cost.

Oligopoly

Oligopoly is a market situation charaterised by a few sellers, producing and selling eitherhomogeneous product or heterogeneous (differentiated) product.

Characteristics or Features of Oligopoly

1. Few Sellers:Since the number of firms is limited, each firm has got a substantial share in thetotal product market.

2. Interdependence: There is very strong interdependence between firms under oligopoly thisis mainly because of the limited number of firms operating under oligopoly.Interdependence means that the business and sales of one firm is affected by the decisionmade by another firm and therefore a change in the business policy of one firm can costappropriate reaction by another firm.

3. Group Behaviour: Since competition can be mutually destructive, it is possible that thefirms in oligopoly can reach some sort of agreement on price and output. Such agreementcan be formal or informal so this is known as collusive oligopoly.

4. Advertisement and Selling Cost: There is a very important craze for advertising andselling cost in oligopoly. Perhaps they have greater significance in oligopoly than inmonopolistic competition.

5. Indeterminate Demand Curve: Because of the interdependence of the firms and becauseof the inability of a particular firm to predict the behaviour of another firm the demand curvefacing an oligopolistic firm losses its definiteness.


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Kinky Demand Curve

Kinky demand curve as a toll of analysis originated from Chamberlin explanation of individual firmdemand curve (dd) and the market share demand curve (DD). However Chamberlin himself do notuse Kinked demand in his analysis.

Hall and Hitch used the Kinked demand curve to explain why the price in oligopoly will remainsticky.

Paul Sweezy in the year 1939 used the concept of Kinked demand curve as an operational tool forthe determination of equilibrium in the oligopoly market. The following diagram explains theKinked demand curve.

In the above diagram, demand curve faced by the firm is ‘dED’ with a Kink at ‘E’. The Kinkeddemand curve is due to the behaviour pattern of oligopoly firms. If one oligopoly firm reduces theprice, its competitors will also reduce the price. As a result, individual share in the market demandincreases by a small amount. Hence the lower portion of the demand curve relates to the marketshare demand curve ‘DD’ which is less elastic.

On the other hand if the firm raises the price, there will be a greater fall in demand, as nobody elseincreases the price. Hence the relevant demand curve for an increase in price is ‘dE’ which is notelastic.

The upper portion of the demand curve ‘dE’ is a part of the individual firm demand curve ‘dd’ andthe lower portion ‘ED’ is a part of market share demand curve ’DD’ which is less elastic. Due to theKink in demand curve, the MR curve is discontinuous of the level of output corresponding to theKink.

The MR curve has two segments, segment dA relates to the elastic part of the demand (dd) curveand segment BMR related to the lower or inelastic part of the demand curve (DD).

icePr

Cost

Output

PE

A

QO

B

1MC2MC

3MC

MR

D

d

d

D

&


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The equilibrium of the firm is defined by the condition of equality between MC and MR and theMC > MR beyond equilibrium. These conditions are satisfied at the level of output correspondingto Kink to any point to the left of Kink, MR is greater than MC. And to any point to the right ofKink, MC > MR. Therefore OQ is equilibrium output.

The discontinuity in the MR curve implies that there is a range within which cost may changewithout affecting the equilibrium price quantity combination of a firm. The range is given by thegap ‘AB’. Suppose the original MC curve is MC1. Even if the cost increases and the MC curve shiftto MC3, the output and the price remain the same. Similarly a fall in the cost upto ‘B’ does not leadto a fall in the price.

___________________________________________________MODULE 6: PRICING METHODS

F.Y.B.COM./BUSINESS ECONOMICS I 1

Full Cost Pricing

In the real world, firms may not be able to collect exact market revenue (MR) and marginal cost(MC) data to examine the optimal level of output and price at the point at which MR = MC.Therefore, firms have developed rules of thumb or short-cut methods for pricing their products. Themost widely used of such pricing rules is full cost pricing (also called “markup pricing” and “cost-plus pricing). The common method is for the firm to first calculate approximately the averagevariable cost (AVC) of producing or purchasing and marketing the product for a normal or standardlevel of output (generally taken to be between 70 and 80 percent of capacity). The firm then adds tothe AVC an average overhead charge (generally expressed as a percentage of AVC), so as to getthe estimated fully allocated average cost (C). To this fully allocated average cost, the firm thenadds as markup on cost (m) for profits.

The formula for the markup on cost can, thus, be expressed as

Where m is the markup on cost, P is the product price, and C is the fully allocated average cost ofthe product. The numerator i.e. P – C is called profit margin. Solving for P, we get the price of theproduct in a cost-plus pricing scheme. That is,

For example, suppose that a firm takes 80 percent of its capacity output of 125 units as the normalor standard output, that it projects total variable and overhead costs for the year to be, respectively,Rs.1000 and Rs.600 for the normal output or standard output is 100 units, the AVC = Rs.10, andaverage overhead cost is Rs.6. Thus, C = Rs.16 and P = 16 (1 + 0.25) = Rs.20) with m = (Rs.20 –Rs.16) / Rs.16 = 0.25. Markups of 25 percent have been traditional in some major industries, suchas automobiles, electrical and aluminum, in order for firms in these industries to achieve a targetrate of return on investment for the normal or standard level of output.

Marginal Cost Pricing

Economic analysis relies upon marginal cost and marginal revenue analysis for determining theequilibrium output. The equilibrium output is at the point where MC = MR. The price is determinedby the corresponding point on the demand line (AR) which may be = or > or < than the averagecost.

Public sector enterprises for various reasons may follow a price policy based on the marginal cost.

CCPm

mCP 1



The above diagram explains the price based on MC and also the result of charging price equal toAC. Given the demand DD1, OQ1 output is produced and sold at Q1P1 price where DD1 cuts AC atP1. At this price the total cost including normal profit is covered. The price is equal to AC.

Public sector undertakings producing essential public goods may decide to charge lower price equalto MC. The lower price will have more demand. Now the output will be OQ2, and sold at P2Q2 pricewhere DD1 cuts MC. Here Price = MC. A loss to the extent of P2N per unit is incurred. Thecommodity is supplied at a lower price in the interest of public welfare and accordingly the loss ismet by the government. Commodities like water, kerosene, cooking gas are some of the examples.If the people are able and willing to buy more and also demand more quantity at price higher thanP2Q2, i.e., OQ quantity at PQ price, then optimum output (OQ) is produced and sold at OP price,equal to AC = MC, earning a normal profit.

In case, a public sector undertaking decides to produce commodities which are mainly purchased byhigher income group such as mineral water, petrol, services like air travel, etc. and the demand isassumed to be sufficiently large as shown by DD2 in the diagram, the price can be equal or higherthan AC. With DD2 demand, OQ3 quantity is produced and sold at P3Q3 since where DD2 cuts MC,earning excess profit of R1P3 per unit. It is possible, in this case too, to produce more at a lowerprice, i.e., P4Q4 which is equal to AC and earn normal profit. At Q4 output people are not willing topay R2Q4 price which is equal to MC but higher than AC by P4R2. In this case where thecommodity is not essential, it is advisable to charge a price equal to MC > AC and earn profit whichcan be spent for providing more of other essential goods and services.

D

1D

D

2D

3P

4P

1N

2N1R

2RAC

MC

Q1Q

2Q 3Q4Q

Price

Output

2P

1P

P

0



Price Discrimination

Price discrimination as a pricing practice is a option available to a monopolist. Monopolist being asingle producer and seller is a price maker and not a price taker like a firm in perfect competition.“The act of selling the same article, produced under single control at different prices to differentbuyers” is called price discrimination.

Degrees of Price Discrimination

First Degree Price Discrimination takes place where, each customer can be charged a differentprice for a good or service. It is usually possible in the case of sevices which cannot be transferredfrom one person to another. For e.g. a doctor can charge different fees for each patients. Patientswill have to pay these fees as long as they do not have any other good doctor.

In the above diagram each unit of the commodity is charged a different price. The seller takes awayall the consumer’s surplus i.e. PRD.

Second Degree Price Discrimination practiced by charging different prices by dividing the supply indifferent quantity or bulk or purposewise. For e.g. Electricity supplying authority can chargedifferent rates Rs. 4.50/unit and Rs.6.50/unit for domestic and commercial uses respectively.Telephone company may charge different rates for calls made during the day and night time.

In the above diagram different prices are charged for the different segments shown on X axis whichmay represent different group of people, different uses or different time period.

D

P R

1P

2P

3P

4P

1X 2X 3X 4X

D

0

D

D0



Third Degree Price Discrimination practiced by charging different prices in different markets.Markets are located geographically at a distance so that transfer of goods from one market to theother is not possible.

In the above diagram if the consumer is charged OP2 price, monopolist’s revenue is OX2SP2. Asagainst this if the monopolist sells OX1 at OP1 and X1X2 at OP2, his revenue would increase byP2NTP1. The consumer loses his surplus by the amount equal to the increase in sellers revenue.

Dumping – A case of International Price Discrimination

Dumping refers to a situation where the monopolist enjoys a monopoly power in the home marketand accepts a competitive price in the other market i.e. the world market. At home the monopolist isprice maker and in the world market a price taker. Accordingly he charges a higher price in thedomestic market and accepts the price determined by the market forces in the world market.Dumping resulting in international price discrimination is referred to as Persistent Dumping.Dumping is called Predatory – when there is temporary sale of a commodity at a lower priceabroad.

0

1P

2P

1X 2X

D

D

T

N S

MC

Price

Output0

A

L M

S

R T D

HP

WP

HMR

WMR

HAR

WAR



In the above diagram the download sloping AR and MR show the home market indicated bysubscript H where demand is less elastic. Similarly ARW = MRW point out the world market. Thehorizontal straight line showing ARW = MRW shows the perfectly elastic demand in the worldmarket. The ARTD line indicated combined MR of both home and world market. Equilibriumoutput is decided at T where MC = MR and MC is increasing. The total output OM is distributedbetween the two markets in such a way that MR in the home market is equal to MR in the worldmarket (MRH = MRW). Accordingly the OL is sold in the home market and LM in the worldmarket. Home market being less elastic, less quantity is sold at a higher price OPH and largerquantity i.e. LM is sold in the world market at a lower price OPW. At R marginal revenue in bothmarket is equalized LR = MT. Total profit of the discriminating monopolist is equal to STRA i.e.TR – TC = OMTRA – OMTS = STRA. This is the maximum profit the discriminating monopolistearns from both markets.



b) Capital Budgeting

Q.1 What is Project Planning? Explain its features and need.

Ans: Project planning is an important branch of business economic. A project refers to a scheme forinvesting resources.

Project planning may be defined as, “Determining a route or manner in which the project or schemeis to be executed or implemented.”

Features of Project Planning:

Project planning involves decision making

1. It is concerned with capital expenditure.

2. Project planning is dynamic.

3. It is non-repetition.

4. It is long-term phenomenon.

5. It involves cost benefit approach.

6. It is goal determined.

7. Project planning is futuristic

8. It is one off undertaking.

Need or Importance:

1. Project planning involves capital budgeting to avoid losses.

2. Project planning implies decision about capital expenditure, which have long-term effect.

3. Huge outlay is involved in a project so considerable care (necessary)

4. Investment on capital assets is sunk (Double) which influences conduct of business over along period of time.

5. Profit planning is essential for the completion from various stages of project with a timeperiod.

6. It is necessary for ensuring optimum utilization of resources.

7. The main of project planning is to direct the flow of capital fund into specific uses.



Q. 2 Discuss the meanings and importance of Capital Budgeting.

Ans: Introduction:-

Capital Budgeting is a process involving planning, analysis, evaluation and selection of the mostprofitable project for investing the funds available to the firms. Capital budgeting refers tosystematic investment programme. It is related to a decision making procedures involved in longterm investment.

According to Peterson,

“Capital budgeting refers to the process of planning capital projects, raising funds andefficiently allocating resources to those capital projects”.

It should be noted that capital expenditure items such as inventories and receivables are excludedfrom the capital budget.

Importance of Capital Budgeting:

Capital budgeting decisions are of great importance in business planning on account of thefollowing reasons:

1) Profitability:

Capital budgeting decisions affect the profitability of the firm. They relate to fixed assets. A rightinvestment decision can yield large returns, while an incorrect investment decisions can yield lowreturns. Capital budgeting can help to select most profitable projects for investing the fundsavailable to the firm.

2) Limited Resources:

Since capital resources are limited and investment opportunities are plenty and varied in terms ofreturns, so there is need for thoughtful, wise and correct investment decisions. A groupinvestment decision can bring returns to the investors. Incorrect decision would result in lowreturns and sometimes in losses.

3) Future Cost Structure:

Since capital expenditure decisions have their effects spread over long time span, they will affectthe firms future cost structure. The future activities and position of the firm depends on capitalbudgeting.

4) Worth Maximisation of the Shareholders:

Capital budgeting is very important as their impact on the well being and economic health of theenterprise is far reaching. The main aim of this process is to avoid over investment and underinvestment in fixed assets. By selecting the most profitable capital project, the management canmaximize the worth of equity shareholders investment.

Thus, the significance of Capital budgeting decisions is quite obvious.

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