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MGT 105: MANAGERIAL ECONOMICS: UNIT-III

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Unit III
Pricing under various market including Perfect Competition, Monopoly, Monopolistic Competition,
Oligopoly, Cartels; Price discrimination, Measurement of Monopoly Power.
Pricing Strategies and Methods- Cost Plus Pricing, Marginal Cost Pricing, Cyclical Pricing, Penetration
Pricing, Price Leadership. Price Skimming, Transfer Pricing

VARIOUS MARKET STRUCTURE


MARKET: Market refers to an arrangement that contact between the buyers and seller for the sale and
purchase of goods.
MARKET STRUCTURE: Market structure refers to combination of four components constituting the
market viz. number of seller, number of buyer, nature of products, and entry- exit barriers,
On the basis of Market Structure, following markets can be easily identified:
1. Perfect Competition Market
2. Monopoly Market
3. Monopolistic Competition
4. Oligopoly

SUMMARY CHART
Type of
Market
Perfect
Competiti
on
Monopoly
Monopolis
tic
Competiti
on

Numb
er of
Seller
s
Large

Numb
er of
Buyer
s
Large

Nature of
Product

Entry-Exit
Barriers

Pricing
Power of
the Firm

One

Homogeneou
s

Very Low

None/Pric
e Taker

Output Level

Large

Homogeneou
s

Very High

High/Price
Setter

Any one of the Price or


Output level

Many

Large

Differentiated

Product
Differentiati
on

Lower
than
Monopoly

Product differentiation ,
Advertising, Output Level,
Prices

Few

Large

High

High/Price
Setter

Large

One

Can be
homogeneou
s or
Differentiated
Homogeneou
s

Very Low

None/Pric
e Taker

Product differentiation ,
Advertising, Output Level,
Prices,
Competitors
Strategy
Output level at expected
price

Large

Few

Very Low

None/Pric
e Taker

Oligopoly
Monopson
y
Oligopson
y

Can be
homogeneou
s or
Differentiated

Decision Variable for


Manager

Buyers strategy

By Pashupati Nath Verma

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MGT 105: MANAGERIAL ECONOMICS: UNIT-III

REVENUE CONCEPT
REVENUE: Money receipt by a firm by selling a commodity.
TYPES OF REVENUE
1. Total Revenue (TR) = Total Revenue is total money receipt of a firm on account of the total
sale.
TR = Q X P
2. Marginal Revenue (MR) = Marginal Revenue is the change in total revenue as sale of one
more unit of output.

MR=

TR

Average Revenue (AR) = Average


Revenue is the per unit revenue
received from sale of a commodity.
AR= TR/Q

Total Revenue

3.

dTR TR
=
=TRnTR n1
dq
Q

RELATIONSHIP BETWEEN
AR & MR AND THE NATURE
OF AR & MR CURVES
UNDER DIFFERENCE
MARKET CONDITIONS
1. UNDER PERFECT
MARKET

X
Units sold

Revenue

Under perfect competition, an individual firm


by its own action cannot influence the market
MR=AR=Price
price. The market price is determined by the
interaction between demand and supply
forces. A firm can sell any amount of
goods at the existing market prices.
Hence, the TR of the firm would increase
X
proportionately with the output offered for
O
Units sold
sale. When the total revenue increases in
direct proportion to the sale of output, the AR would remain constant. Since the market price of it is
constant without any variation due to changes in the units sold by the individual firm, the extra output
would fetch proportionate increase in the revenue. Hence, MR & AR will be equal to each other and
remain constant. This will be equal to price.

Price per Unit Rs. 8.00


Number of Units sold
AR

TR

MR

16

By Pashupati Nath Verma

24

32

40

48

Total Revenue

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MGT 105: MANAGERIAL ECONOMICS: UNIT-III

Units sold

Revenue

Under perfect market condition, the AR curve will be a


horizontal straight line and parallel to OX axis. This is
because a firm has to sell its product at the constant
existing market price. The MR cure also coincides with
AR curve. This is because additional units are sold at
same constant price in the market.

TR

the
the

AR
O

Units sold
MR

2. UNDER IMPERFECT MARKET

Under all forms of imperfect markets, the relation between TR, AR, and MR is different. This can be
understood with the help of the following hypothetical revenue schedule.

Numb
er of
Units
sold

T
R

AR or
price
in Rs.

MR

1
0

10

10

1
8

By Pashupati Nath Verma

2
4

2
8

3
0

3
0

2
8

-2

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MGT 105: MANAGERIAL ECONOMICS: UNIT-III

From the above table it is clear that:


In order to increase the sales, if a firm is reduces its price, AR will fall.
1.
2.
3.
4.
5.

As a result of fall in price, TR increases but at a diminishing rate.


TR will be maximum when MR is zero
TR falls when MR becomes negative
AR and MR both declines. But fall in MR will be greater than the fall in AR.
The relationship between AR and MR curves is determined by the elasticity of demand on the
average revenue curve.

Y
Price/Average Revenue

Under imperfect market, the AR curve of an


individual firm slope downwards from left to
right. This is because; a firm can sell larger
quantities only when it reduces the price. Hence, AR
curve
has a negative slope.
The MR curve is similar to that of the AR curve. But
MR is
5
less than AR. AR and MR curves are different.
AR/D
Generally MR curve lies below the AR curve.
X
The AR curve of the firm or the seller and the
O
10
demand curve of the buyer is the same
Units sold
MR
Since, the demand curve represents graphically the
quantities demanded by the buyers at various prices it shows the AR at which the various amounts of
the goods that are sold by the seller. This is because the price paid by the buyer is the revenue for the
seller (One mans expenditure is another mans income). Hence, the AR curve of the firm is the same
thing as that of the demand curve of the consumers.
Suppose, a consumer buy 10 units of a product when the price is Rs.5 per unit. Hence, the total
expenditure is 10 x 5 = Rs.50/-. The seller is selling 10 units at the rate of Rs.5 per unit. Hence, his total
income is 10 x 5 = Rs.50/-. Thus, it is clear that AR curve and demand curve is really one and the same

By Pashupati Nath Verma

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MGT 105: MANAGERIAL ECONOMICS: UNIT-III

PRODUCERS EQUILIBRIUM
MEANING: It is the situation where producer get maximum profit.
DETERMINATION OF PRODUCER EQUILIBRIUM:
T
Rw
eo
T
CA
ap
cp
r
o
a
c
h
e
s

e
a

o
h

t
p

e
n
t

1. Total Revenue and Total Cost Approach


Equilibrium Conditions: Difference between Total Revenue (TR) and Total Cost (TC) is maximum
Positive.
Outputs
(Units)

TR

TC

Profit

Reference on X-Axis

30

-30

At O

40

50

-10

In between O to L (Breakeven
Point)

70

60

10

In between L to M

90

70

20

At M

100

90

10

In between M to H

100

120

-20

After H

By Pashupati Nath Verma

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MGT 105: MANAGERIAL ECONOMICS: UNIT-III

2. Marginal Revenue and Marginal Cost Approach


Conditions:1. MR=MC
2. At Equilibrium Point MC curve intersect to MR curve from below
The firm will be making maximum profits by expanding output to the level where marginal revenue is
equal to marginal cost. If it goes beyond the point of equality between marginal revenue and marginal
cost, it will be incurring losses on the extra units of output and therefore will be reducing its total
profits. Thus, the firm will be in equilibrium when it is producing the amount of output at which marginal
revenue equals marginal cost. It will be earning maximum profit at the point of equality between
marginal revenue and marginal cost. Therefore, the condition for the equilibrium of the firm is that the
marginal revenue should be equal to the marginal cost. In Fig. 8.2 firms marginal revenue curve MR is
sloping downward and firms marginal cost curve MC is sloping upward and they cut each other at point
E which corresponds to output OM. Up to OM level of output MR (Marginal Revenue) exceeds MC
(Marginal Cost) and at OM the two are just equal to each other. The firm will be maximizing its profits by
producing OM output.
The equality between marginal revenue and marginal cost is a necessary but not a sufficient condition
of firms equilibrium. The second order condition requires that for a firm to be in equilibrium marginal
cost curve most cut marginal revenue curve from below at the point of equilibrium.
Producer is in Equilibrium at Point E where both equilibrium conditions are satisfied.

By Pashupati Nath Verma

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MGT 105: MANAGERIAL ECONOMICS: UNIT-III

PERFECT COMPETITION MARKET


A perfectly competitive market is one in which the number of buyers and sellers are very large, all
engaged in buying and selling a homogeneous product without any artificial restriction and
possessing perfect knowledge of market at a time. According to Bilas, the perfect competition is
characterized by the presence of many firms: They all sell
identically the same product. The seller is the price taker.
Special Features of Perfect
Competition
Agricultural markets are examples of nearly perfect
It is an extreme form of market
competition as well. Imagine shopping at your local farmers'
situation rarely found in the real
market: there are numerous farmers, selling the same fruits,
world.
vegetables and herbs. You can easily find out the prices for It is a mere concept, a myth, an
the goods, but they are usually all about the same.
illusion and purely theoretical in
nature.
FEATURES OF THE PERFECT COMPETITION

It
is a hypothetical model.
1. Existence of very large number of buyers and

It
is supposed to be an ideal market
sellers
situation.
Equilibrium/
Market
By Pashupati
Nath Verma
Price=AR=MR

MGT 105: MANAGERIAL ECONOMICS: UNIT-III


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2. Homogenous products: Different firms constituting the industry produce homogenous goods.
They are identical in character. Hence, no firm can raise its price above the general level.
3. Free entry and exit of firms: There is absolute freedom to firms to get in or get out of the
industry. If the industry is making profits, new firms are attracted into the industry.
4. Existence of single price: Each unit bought and sold, in the market commands the same price
since products are homogeneous.
5. Perfect knowledge of the market: All sellers and buyers will have perfect knowledge of the
market. Sellers cannot influence buyers and buyers cannot influence sellers.
6. Perfect mobility of factors of Production: Factors of production are free to move into any use
or occupation in order to earn higher rewards. Similarly, they are also free to come out of the
occupation or industry if they feel that they are under remunerated.
7. Full and unrestricted competition: Perfectly competitive market is free from all sorts of
monopoly, oligopoly conditions. Since there are very large number of buyers and sellers, it is difficult
for them to join together and form cartels or some other forms of organizations. Hence, each firm acts
independently.
8. Absence of transport cost: All firms will have equal access to the market. Market price charged
by the sellers should not vary because of differences in the cost of transportation.
9. Absence of artificial Government controls: The Government should not interfere in matters
pertaining to supply and price. It should not place any barriers in the way of smooth exchange. Price of
a commodity must be determined only by the interaction of supply and demand forces.
10. The market price is flexible over a period of time:Market price changes only because of
changes in either demand or supply force or both. Thus, price is not affected by the sellers, buyers,
firm, industry or the Government.
11. Normal Profit: As the market price is equal to cost of production, the firm can earn only normal
profits under perfect competition. Normal profits are those which are just sufficient to induce the firms
to stay in business. It is the minimum reasonable level of profit which the entrepreneur m
ust get in
the long run. It is a part of total cost of production because it is the price paid for the services of the
entrepreneur, i.e., profit is an item of expenditure to a firm.

A FIRM UNDER PERFECT COMPETITION IS A PRICE TAKER NOT A PRICE MAKER?


A firm under perfect competition is a price taker not a price maker because the price is determined by
the market forces of demand of supply. This price is known as equilibrium price. All the firms in the
industry have to sell their outputs at this equilibrium price. The reason is that, number of firms under
perfect competition is so large. So no firm can influence the price by its supply. All firms produce
homogeneous
Y product.
Y

Industry

Firm

Price

AR/MR

S
O

Q
Demand & Supply

X
O

Output

PERFECT COMPETITION SUMMARY

By Pashupati Nath Verma

PRICE

DETERMINATION

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MGT 105: MANAGERIAL ECONOMICS: UNIT-III

UNDER PERFECT
COMPETITION

When

equal

quantity

demanded is
to the quantity

supplied of a

particular
at a specified price a market
price is known as Equilibrium
role
the

commodity
equilibrium is achieved and this
Price. Time also play an important
in determining the price of a
product
in
market.
As
the
time
under

consideration is
demand will have a more decisive
than
in the

short,
role
supply

determination of price. Longer the time under consideration, supply becomes more important than
demand in the determination of price. The price determined in the long run is called as normal price
and it remains stable.

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Market price: It refers to that price which is determined by the forces of demand and supply in the
very short period where demand plays a major role than supply. Supply plays a passive role. Market
price is unstable.
Normal price:It is determined by demand and supply forces in the long period. It includes normal
profits also. It is stable in nature.
Y
Y
Price

Price (Rs)

Quantity
Demand

Quantity
Supply

Market State

10

Excess Demand

Excess Demand

Market Equilibrium

Excess Supply

10

Excess Supply

E1

P1

E1

M a r k e t e q u ilib r iu m
X
E xcess D em and

O1

Q1

YS
Y

D1
O D / O S

EFFECT ON EQUILIBRIUM PRICE WHEN


1. CHANGE IN DEMAND
a) Increase in demand
Causes:1. Increase in Income of a consumer of Normal
Goods
2. Increase in Price of Substitute goods.
3. Decrease in price of complimentary goods
4. Rise in expected future price.
Effects:Equilibrium price and Quantity of supply increase.

E x c e s s S u p p ly

P r ic e

S1

S1

P1

P1

E1
E1

E
E

D1
X
O

Q Q1
Y
YD1

b) Decrease in Demand
P1
Causes:1. Decrease in Income of a consumer for normal goods. P
2. Decrease in price of Substitute goods.
3. Increase in Price of Complimentary goods
4. Decrease in expected future price.
Effect:Price and Quantity both decrease

D
S

D1

S1

Price

E1
P
P1

E1
E
X

CHANGE IN SUPPLY
a) Increase in supply
Causes:1. No. of firms increase
2. Technology improvement
3. Decrease in input price
4. Decrease in indirect tax and rise in subsidy
5. Decrease in expected future price.

Q1 Q
Y

S1
D1

E1

S1

P
P1

E1
Price

O1

E1

Effect:Equilibrium price decrease and equilibrium Quantity increases


Decrease in supply
Causes:1. No. of firms decrease

X
Q

Q1

By Pashupati Nath
Verma
Q
Q1

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2. Technology backwardness1
3. Increase in input price
4. Increase in indirect tax and rise in subsidy
5. Increase in expected future price.
Effects:Equilibrium price increases and Equilibrium Quantity decreases.

2. WHEN BOTH DEMAND AND SUPPLY CHANGES SIMULTANEOUS


A) Simultaneous increase in the demand and increase in supply and decrease in supply
a) Increase in demand is more than increase in supply.
D and S curves shift rightwards to D1 and S1
Effect:- Equilibrium price increase and equilibrium quantity increases
b) Increase in demand is less than increase in supply
D and S curves shift rightward to D1 and S1
Effect:- Equilibrium price decreases and equilibrium quantity increases.

c) Increase in Demand is equal to increase in supply


DD and SS curves shift rightward to D1 and S1
Effect:- Equilibrium price constant and equilibrium quantity increases.
B) Simultaneous decrease in the demand and decrease in supply
a) Decrease in demand is less than decrease in supply.
DD and SS curves shift leftward to D1D1 and S1S1
Effect:- Equilibrium price increases
And equilibrium quantity decreases
b) Decreases in demand is more than decreases in supply
DD and SS curves shift leftward to D1D1 and S1S1
Effect:- Equilibrium price decreases and Equilibrium quantity decreases.
c) Decrease in Demand is equal to decrease in supply
DD and SS curves shift leftward to D1D1 and S1S1
Effect:- Equilibrium price remain constant and Equilibrium Quantity decreases.

By Pashupati Nath Verma

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MONOPOLY MARKET
Features Summary
The word monopoly is made up of two syllables MONO means single
1. Single seller
and POLY means to sell. Thus, monopoly means existence of a single
2. Restricted entry
seller in the market. Monopoly is that market form in which a
3. No
close
single producer controls the whole supply of a single
substitutes
commodity which has no close substitutes. Monopoly may be
4. Full control
defined as a condition of production in which a person or a number of
5. Price
persons acting in combination have the power to fix the price of the commodity or the output of the
commodity. It is a situation where there exists a single control over the market producing a commodity
having no substitutes and no possibilities for anyone to enter the industry to compete.
According to Prof. Watson A monopolist is the only producer of a product that has no close
substitutes.

FEATURES OF MONOPOLY
1. Anti-Thesis of competition
Absence of competition in the market
creates a situation of monopoly and hence
the seller faces no threat of competition.
2. Existence of a single seller
There will be only one seller in the
market who exercises single control over
the market.
3. Absence of substitutes
There are no close substitutes for his
product with a strong cross elasticity of
demand.
Hence,
buyers
have
no
alternatives.
4. Control over supply
He will have complete control over
output and supply of the commodity.
5. Price Maker
The monopolist is the price maker and
in taking decisions on price fixation, he is
independent. He can set the price to the
best of his advantage. Hence, he can
either charge a high price for all
customers or adopt price discrimination
policy.
6. Entry barriers
Entry of other firms is barred somehow.
Hence, monopolist will not have direct
competitors or direct rivals in the market.
7. Firm and industry is same
There will be no difference between
firm and an industry.
8. Nature of firm
The monopoly firm may be a
proprietary concern, partnership concern,
Joint Stock Company or a public utility
which pursues an independent priceoutput policy.
9. Existence of super normal profits
There will be place for supernormal profits
under monopoly, because market price is
greater than cost of production.
There are different kinds of monopolies
Private and public, pure monopoly, simple

PROFIT MAXIMIZATION UNDER MONOPOLY


MONOPOLISTS PROFIT

OF

DEGREE
MONOPLOY OR
MARKET

POWER
OR
MONOPLOY POWER: Market power is the ability to
charge a price above marginal cost. A firm in a
competitive market produces where P=MC. Any time a
firm is able to charge a price such that P>MC, it has a
degree of market power. Theres a nice tool to use which
gives us an indication of amount of market power a firm
has, called the Lerner Index.
The Lerner Index is

L=

PMC 1
=
P
ep

By Pashupati Nath Verma

monopoly and discriminatory monopoly. It


is to be clearly understood that with the
exception of public utilities or institutions
of a similar nature, whose price is set by
regulatory bodies, monopolies rarely exist.
Just like perfect competition, pure
monopoly does not exist. Hence, we make
a detailed study of simple monopoly and
discriminatory monopoly in the foregoing
analysis.

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MONOPOLY MARKET SUMMARY

By Pashupati Nath Verma

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IMPERFECT COMPETITION MARKET SUMMARY


By Pashupati Nath Verma

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MGT 105: MANAGERIAL ECONOMICS: UNIT-III

MONOPOLISTIC COMPETITION
By Pashupati Nath Verma

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Perfect competition and monopoly are the two extreme forms of market situations, rarely to be found in
the real world. Generally, markets are imperfect. A number of attempts have been made by different
economists like Piero Shraffa, Hotelling, Zeuthen and others in
Features Summary
1. Large Numbers of buyers
the early 1920s, Mrs Joan Robinson and Prof Chamberlin in
and seller
1930s to explain the behavior of imperfect competition. Prof.
2. Product Differentiation
3. Freedom of entry and exit of
Chamberlin is the main architect of the theory of
firms
Monopolistic Competition. This market exhibits the
characteristics of both competition and monopoly. Since modern markets are combined and integrated
with monopoly power and competitive forces they are called as Monopolistic Competition. It is a
market structure in which a large number of small sellers sell differentiated products which
are close, but not perfect substitutes for one another. Under this market, the products produced
and sold are different, but they are close substitutes for one another. This leads to competition among
different sellers. Thus, in this market situation every producer is a sort of monopolist and between such
mini-monopolists there exits competition. It is one of most popular and realistic market situation to be
found in the present day world.

Monopolistically competitive firms are most common in industries where differentiation is


possible, such as:
The restaurant business.
Hotels and pubs.
General specialist retailing.
Consumer services, such as hairdressing.

A number of examples may be given for this kind of market. Tooth paste, blades, bicycles, cigarettes,
cosmetics, biscuits, soaps and detergents, shoes, ice creams etc.
CHARACTERISTICS OF MONOPOLISTIC COMPETITION
1. Existence of a large Number of firms:
Under Monopolistic competition, the number of firms producing a product will be large. The size of each
firm is small. No individual firm can influence the market price. Hence, each firm will act independently
without worrying about the policies followed by other firms. Each firm follows an independent priceoutput policy.
2. Market is characterized by imperfections
Imperfections may arise due to advertisements, differences in transport cost, irrational preferences of
consumers, ignorance about the availability of different brands of products and prices of products etc.,
sellers may also have inadequate knowledge about market and prices existing at different segments of
markets.
3. Free entry and exit of firms
Each firm produces a very close substitute for the existing brands of a product. Thus, differentiation
provides ample opportunity for a firm to enter with the group or industry. On the contrary, if the firm
faces the problem of product obsolescence, it may be forced to go out of the industry.
4. Element of monopoly and competition
Every firm enjoys some sort of monopoly power over the product it produces. But it is neither absolute
nor complete because each product faces competition from rival sellers selling different brands of the
product.
5. Similar products but not identical
Under monopolistic competition, the firm produces commodities which are similar to one another but
not identical or homogenous. For E.g. toothpastes, blades, cigarettes, shoes etc,
6. Non-price competition
In this market, there will be competition among Mini-monopolists for their products and not for the
price of the product. Thus, there is product competition rather than price competition.
7. Definite preference of the consumers
Consumers will have definite preference for particular variety or brands loyalty owing to the special
features of a product produced by a particular firm.
8. Product differentiation
The most outstanding feature of monopolistic competition is product differentiation. Firms adopt
different techniques to differentiate their products from one another. It may take mainly two forms:
a. Real product difference: It will arise
When they are produced out of materials of higher quality, durability and strength.

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When they are extraordinary on the basis of workmanship, higher cost of material, color, design,
size, shape, style, fragrance etc.
When personal care is taken to produce it.
b. Imaginary product difference: Producers adopt different methods to differentiate their
products from that of other close substitutes in the following manner.
Proper location of sales depots in busy and prestigious commercial centers.
Selling goods under different trademarks, patenting rights, different brands and packing them in
attractive wrappers or containers.
Providing convenient Working hours to customers.
Home delivery of goods with no extra cost.
Courteous treatment to customers, quick and prompt delivery of goods in time and developing
cordial, personal and friendly relations with them.
Offering gifts, discounts, lucky dip schemes, special prices, guarantee of repairs and other free
services, guarantee of products, fair dealings, sales on credit or credit cards & debit cards etc.
Agreement to take back goods if they are unsatisfactory.
Air conditioned stores etc.
9. Selling Costs
All those expenses which are incurred on sales promotion of a product are called as selling
costs. In the words of Prof. Chamberlin selling Costs are those which are incurred by the producers
(sellers) to alter the position or shape of the demand curve for a product. In short, selling costs
represents all those selling activities which are directed to persuade buyers to change their preferences
so as to maximized the demand for a given commodity. Selling costs include expenses on sales depots,
decoration of the shop, commission given to intermediaries, window displays, demonstrations,
exhibitions, door to door canvassing, distribution of free samples, printing & distributing pamphlets,
cinema slides, radio, T.V., newspaper advertisements (informative and manipulative advertisements)
etc.
10. The concept of Industry & Product Groups
Prof. Chamberlin introduced the concept of group in place of industry. Industry in economics refers to a
number of firms producing similar products. Under monopolistic competition no doubt, different firms
produce similar products but they are not identical. Hence, Prof. Chamberlin has made an attempt to
redefine the industry. According to him, the monopolistically competitive industry is a groupof firms
producing a closely related commodity referred to as product group thus group refers to a
collection of firms that produce closely related but not identical products.
11. More elastic demand curve
Product differentiation makes the demand curve of the firm much more elastic. It implies that a slight
reduction in the price of one product assuming the price of all other products remaining constant leads
to a large increase in the demand for the given product.

MARKET EQUILIBRIUM IN MONOPOLISTIC MARKET


Short Run
In the short run, no new firms can
establish themselves in the market
(since the quantity of capital, by the
definition of the short run, is fixed). To
the left in Figure DS is the short-run
demand curve an individual firm faces
in
a
market
with
monopolistic
competition,
and
MRS is
the
corresponding
marginal
revenue.
Similar to a monopoly, the MR curve is
twice as steep as the demand curve.
The firm, as always, maximizes its
profit by choosing the quantity, q1*,
that makes MC = MRS. Since the
average cost, AC, is below the price at that quantity, the firm makes a profit, q1*(p1* - AC),
corresponding to the grey rectangle in the figure.
Long Run
Since the firms make a short run profit and there are no barriers to entry, new firms will establish
themselves in the market. Thereby, the demand curve that the individual firm faces changes so that at
each price it is now possible to sell a smaller number of goods. This means that to the right in Figure,
where we have the situation in the long run, the demand curve, D L, and the marginal revenue, MR L,

By Pashupati Nath Verma

MGT 105: MANAGERIAL ECONOMICS: UNIT-III


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have shifted inwards. They shift until there is no profit. Remember that, the firms choose the quantity
that maximizes profit, i.e. the quantity that makes MC = MR. The demand curve, D L, will consequently
shift until the quantity where the firm maximizes its profit, q2*, is such that the price the firm can take
for the good, p2*, is exactly equal to the average cost, AC. At that point, the profit is q2*(p2* - AC) = 0.
Thus, the firm no longer sells its goods above average cost and can no longer claim an economic profit

Note that the production is not efficient. Even in the long run we have that p > MC, which means that
the cost of producing additional goods is lower than the consumers valuations. If we compare to the
results for perfect competition in the long run, we see that one difference is that long-run production in
the
case
of
monopolistic
competition
does
not
end
up
at
the
lowest
point of the AC curve. This, in turn, means that there are unexploited economies of scale ).

OLIGOPOLY

The term oligopoly is derived from two Greek words Oligoi means a few and Poly means to sell.
Under oligopoly, we come across a few producers specializing in the production of identical
goods or differentiated goods competing with one another. The products traded by the
oligopolies may be differentiated or homogeneous. In the
Features Summary
case of former, we can give the example of automobile
1. Few firms
industry where different model of cars, ambassador, fiat etc.,
2. interdependence
are
manufactured.
Other
examples
are
cigarettes,
3. no price competition
refrigerators, T.V. sets etc., pure or homogeneous oligopoly
4. Group behavior
includes such industries as cooking and commercial gas
5. undetermined demand curve
cement, food, vegetable oils, cable wires, dry batteries,
petroleum etc., In the modern industrial set up there is a strong tendency towards oligopoly market
situation. To avoid the wastes of competition in case of competitive industries and to face the
emergence of new substitutes in case of monopoly industries, oligopoly market is developed.
Examples:

The petroleum and gas industry is dominated by Indian Oil, Bharat Petroleum, Hindustan
Petroleum, Reliance Petroleum, and Tata Power.
Most of the telecommunication in India is dominated by Airtel, Vodafone India, Idea
Cellular, Reliance Communications, as well as Tata Teleservices and Tata Sky
Airlines industry
Power generation and supply in most of the parts of the country
Automobile industry
Long distance road transportation by bus. Many of there routes have buses operated by limited
numbers of operators.
Mobile telephony.
Internet service providers

CHARACTERISTICS OF OLIGOPOLY
1. Interdependence: Each and every firm has to be conscious of the reactions of its rivals. Since
the number of firms is very few, any change in price, output, product etc., by one firm will have direct
effect on the policy of other firms. Therefore, economic calculations must be made always with
reference to the reactions of the rival firms, as they have a high degree of cross elasticitys of demand
for their products.
2. Indeterminateness of the demand curve: Under oligopoly, there will be the element of
uncertainty. Firms will not be knowing the particular factors which could affect demand. Naturally rise or
fall in the demand for the product cannot be speculated. Changes that would be taking place may be
contrary to the expected changes in the product curve.. Thus, the demand curve for the product will be
indeterminate or indefinite. Prof. Sweezy explains it as a kinky demand curve.
3. Conflicting attitude of firms: Under oligopoly, on the one hand, firms may realize the
disadvantages of competition and rivalry and desire to unite together to maximize their profits. On the
other hand firms guided by individualistic considerations may continuously come in clash and conflict
with one another. This creates uncertainty in the market.

By Pashupati Nath Verma

MGT 105: MANAGERIAL ECONOMICS: UNIT-III


Page19

4. Element of monopoly and competition: Under oligopoly, a firm has some monopoly power
over the product it produces but not on the entire market. But monopoly power enjoyed by the firm will
be limited by the extent of competition.
5. Price rigidity: Generally, prices tend to be sticky or rigid under oligopoly. This is because of the
fact that if one firm changes its price, other firms may also resort to the same technique.
6. Aggressive or defensive marketing methods: Firms resort to aggressive and sometimes
defensive marketing methods in order to either increase their share of the market or to prevent a
decline of their share in the market. If one adopts extensive advertisement and sales promotion policy
it provokes others to do the same. Prof. Boumal rightly remarks in this connection- Under oligopoly,
advertising can become a life and death matter where a firm which fails to keep up with the advertising
budget of its competitors may find its customers drifting off to rival firms.
7. Constant struggle: Competition is of unique type in an oligopolistic market. Hence, competition
consists of constant struggle of rivals against rivals.
8. Lack of uniformity: Lack of uniformity in the rise of different oligopolies is another remarkable
feature.
9. Small number of large firms: The numbers of firms in the market are small. But the size of each
firm is big. The market share of each firm is sufficiently large to dominate the market.
10. Existence of kinked demand curve: A kinked demand curve is said to occur when there is a
sudden change in the slope of the demand curve. It explains price rigidity under oligopoly.

PRICE OUTPUT DETERMINATION UNDER OLIGOPOLY


KINKED-DEMAND THEORY
Consider a firm in an oligopoly that wants to change its price. How will the other firms react? There are
2 possibilities: they can either match the price changes or ignore them. But what the other firms will
actually do will probably depend on the direction of the price change. If one firm raises its price, the
others probably will not follow, since that will allow them
to take market
share from the price changer. This makes the demand
curve more
elastic, since as the firm raises its price, then many of its
customers
will buy from the other firms, lowering the revenue of
the
higherpriced firm.
If the firm lowers its price, then the other firms would
prevent any loss of market share. This part of the
curve is much more inelastic, since all of the firms are
concert. This creates a kink in the demand curve,
change in demand goes from very elastic at higher
inelastic at lower prices. Since the marginal revenue
depends on prices, the marginal revenue curve is also
lower prices, the marginal revenue curve drops
creating a gap. The marginal cost curves of both
scenarios will intersect the same quantity being
produced by the oligopoly, represented by the vertical
in the graph; therefore, there is no change in quantity
produced as prices are lowered, as long as the change in
marginal cost is within the marginal revenue gap.

surely

follow, to
demand
acting
in
where
the
prices
to
curve
kinked. At
downward
line

The kinked-demand curve explains why firms in an oligopoly resist changes to price. If one of them
raises the price, then it will lose market share to the others. If it lowers its price, then the other firms
will match the lower price, causing all of the firms to earn less profit.
Critics of the kinked-demand model point out that while the model explains why oligopolies maintain
pricing, it doesn't explain how its products were initially priced. The other thing it doesn't explain is that

By Pashupati Nath Verma

MGT 105: MANAGERIAL ECONOMICS: UNIT-III


Page20

when the economy changes significantly, especially when there is high inflation, then the firms of an
oligopoly do change prices often. In some cases, oligopolistic firms may engage in a price war, where
each firm charges a successfully lower price to gain market share.
CARTEL MODEL
Sometimes firms in an oligopoly try to form a cartel by agreeing to fix prices or to divide the market
among themselves, or to restrict competition some other way. The primary characteristic of the Cartel
Model is collusion among the oligopolistic firms to fix prices or restrict competition so that they can
earn monopoly profits.
If the dominant firms in an oligopoly can successfully collude to fix prices, then they can be certain of
each other's output, which will allow maximizing their profits by producing that quantity of output
where marginal revenue equals marginal cost, just as it would be for a monopoly. However, if any of the
firms cheat, then a price war may ensue, lowering the profits of all firms, and maybe even causing
them to operate a loss. In most modern economies, collusion is generally against the law, however
there are certain countries that engage in collusion to maximize their profits from their natural
resources.

There are different types of cartel agreements. On the one extreme, the firms surrender all their
rights to a central authority which sets prices, determine output, marketing quotas for each firm,
distributes profits etc. This is called as centralized cartels. A centralized or perfect cartel is an
arrangement where the firms in an industry reach an agreement which maximizes joint profits. Hence,
the cartel can act as a monopolist. Since the firms in the cartel are assumed to produce homogeneous
goods, the market demand for the product is the cartels demand. It is also assumed that the cartel
management knows the demand at each possible price and also the marginal costs of all its firms, it
can therefore, find out the MR and MC for the industry. The desire of the firms to have large joint profits
gives impulse to form cartels. But such a desire is short lived and therefore, the formal arrangement or
cartels cannot be a long term phenomenon.
Under the second type of cartel agreement, market sharing cartel, the firms in the industry
produce homogeneous products and agree upon the share each firm is going to have. Each firm sells at
the same price but sells with in a given region. Such a system can function only if the firms having
identical costs. Market sharing model has a very restrictive assumption of identical costs for all firms.
Since in practice the firms have unequal costs and every firm wants to have some degree of
independent action, the market-sharing cartels are not long-lived.

The best example of a cartel today is the Organization of Petroleum Exporting Countries, otherwise
known as OPEC, which comprises 12 oil-producing nations that supply 60% of all oil traded
internationally. Prices are maintained by restricting each country of the OPEC cartel to a specific
production allocation. The OPEC cartel is largely responsible for the large fluctuations in gasoline prices
that have occurred earlier, although recently, speculation in the commodity markets has also increased
volatility.

OLIGOPOLY MARKET SUMMARY

By Pashupati Nath Verma

Page21

MGT 105: MANAGERIAL ECONOMICS: UNIT-III

MARKET STRUCTURE SUMMARY


By Pashupati Nath Verma

Page22

MGT 105: MANAGERIAL ECONOMICS: UNIT-III

PRICING STRATEGIES AND METHODS


By Pashupati Nath Verma

MGT 105: MANAGERIAL ECONOMICS: UNIT-III


Page23

Pricing Strategies and Methods- Cost Plus Pricing, Marginal Cost Pricing, Cyclical Pricing, Penetration
Pricing, Price Leadership. Price Skimming, Transfer Pricing
Pricing strategy is an instrument to achieve the objective of a firm and it should be formulated in such a
way as to maximize the sales revenue and profit. Maximum profit refers to the highest possible profit.
And, a firm not only should be able to recover its total costs, but also should get excess revenue over
costs as soon as possible.
OBJECTIVES OF PRICING STRATEGY
The firm's pricing strategy objectives must be identified in order to determine the optimal pricing in
different market situations. Common objectives include the following:
Current profit maximization - seeks to maximize current profit, taking into account revenue and
costs. Current profit maximization may not be the best objective if it results in lower long-term profits.
Current revenue maximization - seeks to maximize current revenue with no regard to profit
margins. The underlying objective often is to maximize long-term profits by increasing market share
and lowering costs.
Maximize quantity - seeks to maximize the number of units sold or the number of customers served
in order to decrease long-term costs as predicted by the experience curve.
Maximize profit margin - attempts to maximize the unit profit margin, recognizing that quantities will
be low.
Quality leadership - use price to signal high quality in an attempt to position the product as the
quality leader.
Partial cost recovery - an organization that has other revenue sources may seek only partial cost
recovery.
Survival - in situations such as market decline and overcapacity, the goal may be to select a price that
will cover costs and permit the firm to remain in the market. In this case, survival may take a priority
over profits, so this objective is considered temporary.
Status quo - the firm may seek price stabilization in order to avoid price wars and maintain a
moderate but stable level of profit.

COST-PLUS PRICING

Cost-plus pricing is also known as 'mark-up pricing', 'average cost pricing' or 'full cost pricing'.
The cost-plus pricing is the most common method of pricing used by the manufacturing firms. It is used
primarily because it is easy to calculate and requires little information. There are several varieties, but
the common thread in all of them is you first calculate the cost of the product, and then include an
additional amount to represent profit.
Calculating price using the cost-plus method: There are several ways of determining cost, and the
profit can be added as either a percentage markup or an absolute amount. One example is:
P = (AVC + FC%) x (1 + MK%)
Where:
P = price
AVC = average variable cost
FC% = percentage allocation of fixed costs
MK% = percentage markup/profit margin
To make things simpler, some firms, particularly retailers, ignore fixed costs and just use the purchase
price paid to their suppliers as the cost term. They indirectly incorporate the fixed cost allocation into
the markup percentage. To simplify things even further, sometimes a fixed amount is applied rather
than a percentage. This fixed amount is usually determined by head-office to make it easy for
franchisees and store managers. This is sometimes referred to as turnkey pricing.
For example: If variable costs are Rs.30, the allocation to cover fixed costs is Rs.10, and you feel you
need a 50% markup then
P = (30 + 10) x (1 + 0.50)
P = 40 x 1.5
P = 60
And you would charge a price of Rs.60.
Another variant of cost plus pricing is activity based pricing. This involves being more careful in
determining costs. Instead of using arbitrary expense categories when allocating overhead, every
activity is linked to the resources it uses.
Advantages of cost-plus pricing:
1. easy to calculate
2. Minimal information requirements
3. easy to administer
4. Tends to stabilize markets - insulated from demand variations and competitive factors
5. Ethical advantages
Disadvantages of cost-plus pricing:

By Pashupati Nath Verma

MGT 105: MANAGERIAL ECONOMICS: UNIT-III


Tends to ignore the role of consumers
Tends to ignore the role of competitors
use of historical accounting costs rather than replacement value
Inclusion of sunk costs rather than just using incremental costs
Ignores opportunity costs
Page24

1.
2.
3.
4.
5.

By Pashupati Nath Verma

MGT 105: MANAGERIAL ECONOMICS: UNIT-III


Page25

INCREMENTAL/MARGINAL COSTING

Correct pricing and output decisions require incremental analysis. That is, a firm should change the
price of a product, introduce a new product, and accept new orders, and so on if the incremental
revenue exceeds incremental costs. Incremental/marginal/direct cost pricing implies that price of a
product is based on incremental cost of production.
When excess capacity exists in the short run, overhead or fixed costs are irrelevant in determining
whether or not a firm should undertake a particular course of action. Since fixed or overhead costs have
already been covered, any action on the part of the firm that increases revenues more than costs leads
to an increase in total profits of the firm and should be undertaken. Long run effects should be
considered if the firm anticipates the demand to increase in future if it decides to introduce a new
product or lower prices of existing product in the short run to use idle capacity.
In case firm is operating at full capacity, then a lower price to increase sales or introduce a new product
will increase all costs, including those for plant and equipment. Full cost and incremental cost pricing in
such a case should be considered. Thus, a product can
be produced profitably if its price exceeds incremental
costs of supplying the product.
Unlike the full cost pricing that is based on average
cost, incremental cost pricing considers only variable
cost. The two differ on grounds of fixed cost. Figure
differentiates between the two. In a competitive
situation, a firm will shut down in the short run only
when the price is below the AVC, while in the long run
the firm tries to cover its total average cost. That is
ATC = AVC + AFC, which is equal to fully distributed
costs. If the firm considers incremental cost, it will not
shut down in the short run. Point A is the shutdown
point at which the firm sells Q1 quantity at price P1.
Point B is the breakeven point where total revenue of the firm is equal to total cost.

CYCLICAL PRICING

Cyclical pricing is based on the cyclical variations of economic activity overtime. Time series data
reveals that economic/business activity exhibits cyclical variations that are termed as business/trade
cycles. Each cycle has four phases as shown in Figure. The trough is the point where national output is
lowest relative to its full employment level (full employment level is defined as the total amount of
goods and services that could have been produced if there had been full employment). The firm should
reduce prices to operate when economic activity is at its ebb. Expansion is the subsequent phase
during which national output rises. The peak occurs when national output is highest relative to its full
employment level during which the firm should increase prices. Finally, recession is the subsequent
phase during which national output falls.

Business Cycles and Cyclical Pricing

The firm can set a standard (full) cost and adjust his mark-up according to macroeconomic changes.
Discounts and allowances are sometimes used as a part of cyclical pricing.
Apart from cost of production, the firm can take the industry price level, price of substitutes, disposable
income, and competitive environment into account to set prices in various phases of business cycles.

By Pashupati Nath Verma

MGT 105: MANAGERIAL ECONOMICS: UNIT-III


Page26

But it has been observed that under cyclical pricing cost is not the sole determinant. The firm may have
to make adjustments in price despite no change in cost of production.

PRICING A NEW PRODUCT

Pricing policy in respect of a new product depends on whether or not close substitutes are available.
Depending on whether or not close substitutes are available, in pricing a new product, generally two
kinds of pricing strategies are suggested, viz., (i) price skimming and (ii) price penetration.
PRICE SKIMMING
It is a pricing strategy in which a marketer sets a relatively high price for a product or service at first,
and then lowers the price over time. It is a temporal version of price discrimination/yield management.
It allows the firm to recover its sunk costs quickly before competition steps in and lowers the market
price.
Du Pont is a major follower of this practice. With each innovation cellophane, nylon Teflon and so on, it
estimates the highest price it can charge given the comparative benefits of its new products versus the
available substitutes. The company sets a price that makes it just worthwhile for some segments of the
market to adopt the new material. Each time sales slowdown, Du Pont lowers the price to draw the next
price sensitive layer of customers. In this way, Du
Pont skims a maximum amount of revenue from the various market segments.
Price skimming is sometimes referred to as riding down the demand curve. The objective of a price
skimming strategy is to capture the consumer surplus. If this is done successfully, then theoretically no
customer will pay less for the product than the maximum they are willing to pay. In practice, it is almost
impossible for a firm to capture this entire surplus. The initial high price would generally be
accompanied by heavy sales promoting expenditure.
This policy succeeds for the following reasons.
First, in the initial stage of the introduction of product, demand is relatively inelastic because of
consumers' desire for distinctiveness by the consumption of a new product.
Second, cross-elasticity is usually very low for lack of a close substitute.
Third, step-by-step skimming consumers' surplus available at the lower segments of demand curve.
Du Pont is a major follower of this practice. With each innovation cellophane, nylon Teflon and so on, it
estimates the highest price it can charge given the comparative benefits of its new products versus the
available substitutes. The company sets a price that makes it just worthwhile for some segments of the
market to adopt the new material. Each time sales slowdown, Du Pont lowers the price to draw the next
price sensitive layer of customers. In this way, DuPont skims a maximum amount of revenue from the
various market segments.
PENETRATION PRICING
It is the pricing technique of setting a relatively low initial entry price, often lower than the eventual
market price, to attract new customers. The strategy works on the expectation that customers will
switch to the new brand because of the lower price. Penetration pricing is most commonly associated
with a marketing objective of increasing market share or sales volume, rather than to make profit in the
short term.
The success of penetration price policy requires the existence of the following conditions.
First, the short run demand for the product should have elasticity greater than unity. It helps in
capturing the market at lower prices.
Second, economies of large-scale production are available to the firm with the increase in sales.
Otherwise, increase in production would result in increase in costs which might reduce the
competitiveness of the price.
Third, the product should have a high cross-elasticity in relation to rival products for the initial lower
price to be effective.
Finally, the product, by nature should be such that it can be easily accepted and adopted by the
consumers.
In 1996, Amul launched its MithaiMate Rs 10 lower than the same quantity of Nestles Milkmaid, in
condensed milk segment, with an eye on the market share.

By Pashupati Nath Verma

MGT 105: MANAGERIAL ECONOMICS: UNIT-III


Page27

PRICE LEADERSHIP

It often happens that in an industry there are one or many big firms whose cost of production is low and
they dominate the industry. In such situation, the small firms will not like to enter into price war with
these big firms. They may, therefore, follow the price fixed by the leader. For example, Cadbury may
be accepted as a leader in the chocolate industry, HLL in the soap industry, and so on. Small firms may
change the price only when there is a general change in the cost of production and the price leader has
recognized and adjusted his price on that basis.
It is not necessary that the price charged by small firms must be equal to that charged by price-leader.
But, any change in the prices charged by one will be accompanied by other in the same direction and ,
generally but not necessarily, in same proportion. As a result, both the price-leader and the others will
be catering their own market without any diversion in customer.
Price under the pattern of price-leadership does not fluctuate much. However, it is easier to maintain
price leadership pattern when prices are rising but difficult when prices are falling.

TRANSFER PRICING

Many large vertically integrated (vertical integration refers to operation of a firm at more than one
stage of production process) firms are decentralized and made semiautonomous profit centre. One
division of a firm sells its product to another division of the same firm. The Reliance Industries has
vertically integrated manufacture chain from naphtha to textiles. Oil refining unit produces naphtha,
which is used to produce polymers like polyethylene and polypropylene. At a later stage, polyester
staple fiber and filament yarn is manufactured by using these polymers that are again used to produce
fabric.
The price at which transfer takes place is called the transfer price. Pricing problem arises because if one
unit provides intermediate good to the other, the revenue of the unit will depend on the price charged.
A high price will increase profits of the unit at the earlier stage of production, whereas a low price will
make later stage production more profitable. While, an incorrect price can affect the total profit earned
by the firm. Thus, one of the vital problems of a large firm while dealing with transfer pricing is: what
should be the price at which one division must transfer its output to the another division.
The transfer price rules which the group-management lays down must be such that they pursue the
following goals simultaneously:
1. Maximization of group profit, and
2. Maximization of profits at each profit center as an autonomous unit
On the basis of above criteria, the transfer pricing for most often discussed cases is given below:
Case I: Transfer Pricing with No External Market-Interdivisional transfer should be priced at the
level of the marginal cost of production to maximize group profit.
Case II: Transfer Pricing with Perfectly Competitive Market-Transferred product can be bought
and sold at market price only i.e. transfer Price= Market Price
Case III: Transfer Pricing with Imperfectly Competitive Market- Interdivisional transfer should be
priced at the level of the marginal cost of production to maximize group profit.
Explanation Case I: Transfer Pricing with No External Market
We assume that the Orion Corporation, a chemical firm has only two separate divisions, a production
division and a marketing division. The production division manufactures the basic chemical, which is
sold to the marketing division; the marketing division packages the basic chemical into the final product
and sells it to outside customers. We assume that there is no external market for the basic chemical
produced by the firm and all of the chemical produced during the period must be sold i.e., no
inventories is carried over. Then the marketing division of the firm is completely dependent on the
production division for the supply of basic chemical. Figure (a) shows the optimal price and output for
the firm as a whole.

By Pashupati Nath Verma

MGT 105: MANAGERIAL ECONOMICS: UNIT-III


Page28

Looking at the two divisions combined, the marginal cost to


the firm, MC, at any level of output is the sum of the
marginal cost of production, MC p and the marginal cost of
marketing, MCM. The firm will maximize profit by choosing
the output where MC = MR M. To sell this output, it should
establish a price PM for its final product.
If each division maximizes its own divisional profit, the
transfer price, Pt should equal MCP, the marginal production
cost at the optimal output Q. To see this, note that once this
transfer price is set, the production division will encounter a
horizontal demand curve for the basic chemical it produces,
and its marginal revenue will equal Pt. To maximize its profit,
it will choose the output level where MCP = Pt. As shown in
the figure, this output level is Q which is the optimal output
for the firm as a whole.
The marketing division equals the transfer price Pt to its
marginal cost curve MCt which is the sum of the marginal
cost of marketing MCM and the transfer price Pt. This division
will maximize profits by setting its output level at Q, where its marginal cost MC t equals its marginal
revenue MRM. To sell this amount it charges a price PM. Thus, this division like the production division
acts to promote overall interests of the firm. It establishes the output level Q and the price P M that
maximizes the overall profits of the firm.
Explanation Case II: Transfer Pricing with Perfectly
Competitive Market In many
cases, there is a market outside the firm for the product
that is transferred from one
division to the other. The marketing division can buy more basic
chemical from external suppliers,
if required. Similarly, the production division can sell more of the
basic chemical in the external
market.
Since there is a perfectly competitive market for the basic
chemical,
the
production division faces a horizontal demand curve Dp as
shown in Figure
(b) for its output where Pt is the price of basic chemical in
external
market. To maximise profit, the production division should
produce the output Qp where MCp = Pt.
To maximise the overall profit, the transfer price should equal Pt
the price of
the basic chemical in the perfectly competitive market outside
the firm. Since the production division can sell any amount of
basic chemical in the external market at price Pt, it has no
incentive to sell it at a price below Pt to the marketing division.
Similarly,
since the marketing division can buy the chemical from external
suppliers, it has no incentive to buy it from production division
at a price above Pt.
The marginal cost curve of marketing division is MCt which is the sum of the
marketing marginal cost MCM and the price of basic chemical Pt. To maximise
profit,
marketing division must choose output level Q M where its marginal cost equals its marginal revenue
(MCt = MRM). Figure (b) shows that the output of the marketing division Q M is less than the output of the
production division Qp, the optimal solution is to sell part of output ( Q P QM units) to the external
customers.

By Pashupati Nath Verma

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