Unit – 5
Theory of Product Pricing
In economics, the theory of production and cost states that the cost of a product is determined by the sum total of the cost of all the resources that went into making it. There are multiple factors to be considered when determining the cost of a product. The various theories and types of costs that come under this topic are given as follows.
A. EQUILIBRIUM CONDITIONS
A firm applies the principle of marginal cost (MC) and marginal revenue (MR) while deciding to produce its output.
We have explained how an individual firm accepts its price determined in the market by aggregates demand and supply. At that price (per units) a firm can sell all that it wants to sell. The price line here is a straight horizontal one. In perfect competition we can obtain a firm’s average revenue (AR) by PxQ=TR/Q=AR, that is
PxQ=
=AR
Therefore, P=AR
Here price line and average revenue line are identical. Marginal (MR)is equal to ∆TR, that is a change in TR. Since the firm sells the total quantity for the same price per unit, it is change in TR (∆TR) which is equal to P.
Since P=AR and also P=MR, therefore P=AR=MR.
Bringing MC and MR together, we can decide the equilibrium output of a firm in perfect competition
The firm cannot stop its production at E, as the marginal cost till that point is higher than marginal revenue resulting in loss. From point E to E1, marginal cost is lower than marginal revenue bringing more revenue than cost. Therefore, to maximise profit the firm must produce upto the point where (i)MC=MR and (ii)MC must cut MR from below or MC at the point of equilibrium must be increasing.
When the above two conditions are fulfilled, the firm’s output is at equilibrium point.
We analysis the equilibrium of the firm with the help of the following assumptions:
- The firm is rational i.e. it tries to maximise profit.
- Perfect competition in product market.
- Perfect competition in factor market. This assumption implies identical cost of production to all the firms.
- The firm operates under U shape cost curve.
- Price of the product is determined by the aggregate demand and aggregate supply.
- The firm is a price taker.
B. SHORT-RUN EQUILIBRUIM OF A FIRM
We are familiar with the concept of short-run as discussed under the cost analysis. In the short run there is a distinction between fixed cost and variable cost. The firm operates within the given cost structure and capacity. The number of firms in the market remains constant. There is no entry or exit from the market. The price is determined in the market by demand for and supply of industry’s output. The price thus determined is accepted by the firm, turning the firm into a price taker. Given the price, demand and cost, the rational firm aiming at maximization of profit produces output upto the point of equilibrium i.e. MC=MR and MC is increasing at the point of equilibrium.
A firm being in equilibrium does not necessarily earn profit. It only means the firm observes the equilibrium rules to determines its output and sells it at the prevailing price. By doing so the firm may earn excess profit, normal profit or even may incur loss.
(a) Excess Profit:
The firm accepts the market price OP. At OP price the firm is in equilibrium at N. At point N the firm fulfils the equilibrium conditions i.e. MC = MR and MC is increasing at that point. By dropping a perpendicular from N to the X-axis, we measure the total output produced i.e. OQ.
The firm’s total revenue (TR) is worked out by multiplying output (OQ) by price (OP).
TR=OPxOQ=OQNP
Total cost is worked out by multiplying output by average cost which is obtained at the point where QN line cuts average cost (AC) curve at point R.
TC=OQxQR=OQRS
The firm’s equilibrium position with excess profit is explained below.
Price = OP
Output = OQ
TR = OQNP
TC = OQRS
Profit = TR –TC
=OQNP – OQRS
=SRNP
The firm earns excess profit = SRNP
Excess profit is the profit earned by a firm over and above the normal profit.
It is also called supernormal profit.
(b) Normal Profit:
The second possibility is that a firm fails to earn excess profit but earns only normal profit. In fig. The firm is in equilibrium at N1 with normal profit. The firm’s operational position is:
Price = OP1 AC= Q1N1
Output = OQ1 TC= OQ1N1P1
TR = OQ1N1P1 π = TR – TC
= OQ1N1P1 – OQ1N1P1
= Normal Profit
As, TR = TC, there is no excess profit.
The firm in this case earns only normal profits.
Normal Profit is that amount of profit which keeps a person in business. Opportunity cost is one of the important factors that decides the normal profit to be earned by a firm. In economic analysis normal profit is part and parcel of the cost. When a firm covers the total cost it earns normal profit. In the short-run a business firm may not earn normal profit, but it must earn it in long-run. In fig. At OP1 price TR = TC, where the firm earns only normal profit.
The possibility of earning normal profits in the short-run is rather rare. It implies that the entire industry will settle-down in the short-run itself which is highly imporabables.
(c) Loss or Sub-normal profit
When the firm fails to earn normal profits it still continues to operates but incurring loss. Fig. Shows the loss incurred
If the market price happens to be OP2, the firm is in equilibrium at N2, producing OQ2 output.
TR = OQ2N2P2
TC = OQ2TS
= TC>TR
Loss = P2N2TS
The loss is termed as sub normal profit.
The firm operates in the short-run with loss. The important question that does arise is, should the firm continue to function with loss? How much loss can it bear? The answer to this question depends on the nature of cost, i.e. fixed and variable cost, in other word unavoidable and avoidable cost. In the short-run a firm must endure what it cannot avoid and must not suffer from what it can avoid. Fig. Brings out the distinction between the two types of costs.
.OP price, the firm is in equilibrium at R, producing OQ output. Its revenue and costs are:
Output = OQ TC = ACxOQ = OQLT
Price = OP TFC = KJLT
TR = OQRP TVC = OQJK
TR>TC but TR>TVC
The loss incurred is equal to a part of the fixed cost i.e. PRLT. It covers the entire variable cost (OQJK) and also a part of the TFC i.e. KJRP. What is necessary for the firm is to cover the total variable cost which otherwise is an avoidable cost. The fixed cost has to be incurred even if the firm is closed, unless the firm wants to quit the business which is not a wise decision in the short-run. The firm continue to function since its TR is more than its TVC which enables it to cover a part of TFC.
(d) Shut-Down Point
At price OP1, in fig. The firm produces OQ1, output and earns total revenue just equal to total variable cost (TR=TVC). The firm is in equilibrium at S, where its TR (OQ1 SP1) is equal to TVC (OQ1 SP1).S is the shut down point. It is the shut-down point in the sense that any further decline in price will compel the firm to close down its operation. In fact one could term this point as starting point since the production starts at this point where TR = TVC.
Fig. Explains the situations where the firm requires to close down and wait for better times to come.
At price OP, if the firm decides to produce its equilibrium output OQ, its TVC = OQSN and TR = OQRP. The TR<TVC by the amount PRSN> the firm’s total loss is PRMT which is made up partly of PRSN of TVC and NSMT the total fixed cost. At this price (OP), the firm is not in position to cover even the variable cost. Therefore, the best advice for the firm is to close down and wait for the price to go up or the cost to decline so that it can cover atleast the TVC and possibly cover the TFC too.
LONG-RUN EQUILIBRIUM OF A FIRM
Long-run is a time period where all the costs are variable. The firm can expand or contract its capacity as required. New firms may enter the market if the existing firms earn excess profit. Those firms who cannot cover the total cost would leave the market. Thus in the long-run there is entry to and exist from the market. The firm which remains in the market will earn only normal profit. Fig. Shows the long-run equilibrium of the firm.
The long-run position of the firm is-
Output = OQ TC = ACxQ = OQxQS = OQSP
Price = OP TR = ARxQ = OPxOQ = OQSP
The firm earns normal profit as its TR = TC.
The firm earns normal profit at a technical point where
P = AR = MR = AC = MC.
In fig. At point S the firm is at technical point mentioned above. At this point, the firms TR = TC giving the firm only the normal profit.
EQUILIBRUIM OF INDUSTRY AND FIRM
Industry is in equilibrium when all firms are equilibrium. It usually takes place only in the long-run. New firms are attracted to the industry due to excess profit earned by the existing firms. Those who incur loss leave the industry. Entry of new firms out the excess profits. Similarly, the exist of loss incurring firms, will enable the remaining firms to earn normal profits. Thus, the firms earning normal profit alone will remain in the long run as shown in fig. A & B.
Fig . A depicts the industry where aggregate demand and supply determine the price. Fig .B shows the equilibrium position of a firm. At OP1 price in the market, the firm produces OQ1 output and earns excess profit=NLTP1. Attracted by this supernormal profit, more firms enter the market and supply curve shifts to right. The increased supply shown by SS supply curve brings down the price to OP. At OP which is a lower price the firm produces less and earns only normal profit and is in equilibrium at E. Its (OQEP) is equal to its TC (OQEP).
SHORT-RUN EQUILIBRUIM OF A FIRM
We are familiar with the concept of short-run as discussed under the cost analysis. In the short run there is a distinction between fixed cost and variable cost. The firm operates within the given cost structure and capacity. The number of firms in the market remains constant. There is no entry or exit from the market. The price is determined in the market by demand for and supply of industry’s output. The price thus determined is accepted by the firm, turning the firm into a price taker. Given the price, demand and cost, the rational firm aiming at maximization of profit produces output upto the point of equilibrium i.e. MC=MR and MC is increasing at the point of equilibrium.
A firm being in equilibrium does not necessarily earn profit. It only means the firm observes the equilibrium rules to determines its output and sells it at the prevailing price. By doing so the firm may earn excess profit, normal profit or even may incur loss.
(a) Excess Profit:
The firm accepts the market price OP. At OP price the firm is in equilibrium at N. At point N the firm fulfils the equilibrium conditions i.e. MC = MR and MC is increasing at that point. By dropping a perpendicular from N to the X-axis, we measure the total output produced i.e. OQ.
The firm’s total revenue (TR) is worked out by multiplying output (OQ) by price (OP).
TR=OPxOQ=OQNP
Total cost is worked out by multiplying output by average cost which is obtained at the point where QN line cuts average cost (AC) curve at point R.
TC=OQxQR=OQRS
The firm’s equilibrium position with excess profit is explained below.
Price = OP
Output = OQ
TR = OQNP
TC = OQRS
Profit = TR –TC
=OQNP – OQRS
=SRNP
The firm earns excess profit = SRNP
Excess profit is the profit earned by a firm over and above the normal profit.
It is also called supernormal profit.
(b) Normal Profit:
The second possibility is that a firm fails to earn excess profit but earns only normal profit. In fig. The firm is in equilibrium at N1 with normal profit. The firm’s operational position is:
Price = OP1 AC= Q1N1
Output = OQ1 TC= OQ1N1P1
TR = OQ1N1P1 π = TR – TC
= OQ1N1P1 – OQ1N1P1
= Normal Profit
As, TR = TC, there is no excess profit.
The firm in this case earns only normal profits.
Normal Profit is that amount of profit which keeps a person in business. Opportunity cost is one of the important factors that decides the normal profit to be earned by a firm. In economic analysis normal profit is part and parcel of the cost. When a firm covers the total cost it earns normal profit. In the short-run a business firm may not earn normal profit, but it must earn it in long-run. In fig. At OP1 price TR = TC, where the firm earns only normal profit.
The possibility of earning normal profits in the short-run is rather rare. It implies that the entire industry will settle-down in the short-run itself which is highly imporabables.
(c) Loss or Sub-normal profit
When the firm fails to earn normal profits it still continues to operates but incurring loss. Fig. Shows the loss incurred
If the market price happens to be OP2, the firm is in equilibrium at N2, producing OQ2 output.
TR = OQ2N2P2
TC = OQ2TS
= TC>TR
Loss = P2N2TS
The loss is termed as sub normal profit.
The firm operates in the short-run with loss. The important question that does arise is, should the firm continue to function with loss? How much loss can it bear? The answer to this question depends on the nature of cost, i.e. fixed and variable cost, in other word unavoidable and avoidable cost. In the short-run a firm must endure what it cannot avoid and must not suffer from what it can avoid. Fig. Brings out the distinction between the two types of costs.
.OP price, the firm is in equilibrium at R, producing OQ output. Its revenue and costs are:
Output = OQ TC = ACxOQ = OQLT
Price = OP TFC = KJLT
TR = OQRP TVC = OQJK
TR>TC but TR>TVC
The loss incurred is equal to a part of the fixed cost i.e. PRLT. It covers the entire variable cost (OQJK) and also a part of the TFC i.e. KJRP. What is necessary for the firm is to cover the total variable cost which otherwise is an avoidable cost. The fixed cost has to be incurred even if the firm is closed, unless the firm wants to quit the business which is not a wise decision in the short-run. The firm continue to function since its TR is more than its TVC which enables it to cover a part of TFC.
(d) Shut-Down Point
At price OP1, in fig. The firm produces OQ1, output and earns total revenue just equal to total variable cost (TR=TVC). The firm is in equilibrium at S, where its TR (OQ1 SP1) is equal to TVC (OQ1 SP1).S is the shut down point. It is the shut-down point in the sense that any further decline in price will compel the firm to close down its operation. In fact one could term this point as starting point since the production starts at this point where TR = TVC.
Fig. Explains the situations where the firm requires to close down and wait for better times to come.
At price OP, if the firm decides to produce its equilibrium output OQ, its TVC = OQSN and TR = OQRP. The TR<TVC by the amount PRSN> the firm’s total loss is PRMT which is made up partly of PRSN of TVC and NSMT the total fixed cost. At this price (OP), the firm is not in position to cover even the variable cost. Therefore, the best advice for the firm is to close down and wait for the price to go up or the cost to decline so that it can cover atleast the TVC and possibly cover the TFC too.
LONG-RUN EQUILIBRIUM OF A FIRM
Long-run is a time period where all the costs are variable. The firm can expand or contract its capacity as required. New firms may enter the market if the existing firms earn excess profit. Those firms who cannot cover the total cost would leave the market. Thus in the long-run there is entry to and exist from the market. The firm which remains in the market will earn only normal profit. Fig. Shows the long-run equilibrium of the firm.
The long-run position of the firm is-
Output = OQ TC = ACxQ = OQxQS = OQSP
Price = OP TR = ARxQ = OPxOQ = OQSP
The firm earns normal profit as its TR = TC.
The firm earns normal profit at a technical point where
P = AR = MR = AC = MC.
In fig. At point S the firm is at technical point mentioned above. At this point, the firms TR = TC giving the firm only the normal profit.
Like in perfect competition, there are three possibilities for a firm’s Equilibrium in Monopoly. These are:
- The firm earns normal profits – If the average cost = the average revenue
- It earns super-normal profits – If the average cost < the average revenue
- It incurs losses – If the average cost > the average revenue
Normal Profits
A firm earns normal profits when the average cost of production is equal to the average revenue for the corresponding output.
In the figure above, you can see that the MC curve cuts the MR curve at the equilibrium point E. Also, the AC curve touches the AR curve at a point corresponding to the same point. Therefore, the firm earns normal profits.
Super-normal Profits
A firm earns super-normal profits when the average cost of production is less than the average revenue for the corresponding output.
In the figure above, you can see that the price per unit = OP = QA. Also, the cost per unit = OP’. Therefore, the firm is earning more and incurring a lesser cost. In this case, the per unit profit is
OP – OP’ = PP’
Also, the total profit earned by the monopolist is PP’BA.
Losses
A firm earns losses when the average cost of production is higher than the average revenue for the corresponding output.
In the figure above, you can see that the average cost curve lies above the average revenue curve for the same quantity. The average revenue = OP and the average cost = OP’. Therefore, the firm is incurring an average loss of PP’ and the total loss is PP’BA. In the short-run, a monopolist sometimes sets a lower price and incurs losses to keep new firms away.
Summary of Short-run Equilibrium in Monopoly
In the short-run, a monopolist firm cannot vary all its factors of production as its cost curves are similar to a firm operating in perfect competition. Also, in the short-run, a monopolist might incur losses but will shut down only if the losses exceed its fixed costs. Further, if the demand for his product is high, then the monopolist can also make super-normal profits.
The figure shown above depicts a firm’s short-run Equilibrium in Monopoly. The quantity is along the X-axis and price and cost of production along the Y-axis.
There are three curves – the average variable cost (AVC) curve, the average total cost (ATC) curve, and the marginal cost (MC) curve. Further, there are three demand curves to explain the possible positions of the equilibrium:
Demand Curve D1 is tangent to the AVC curve at point E1
Its corresponding MC curve intersects the MR1 curve from below at point A1. Therefore, while the monopolist satisfies the first condition of equilibrium, he is unable to recover his complete cost of production.
However, even if he closes the plant down, he cannot reduce the losses since they are fixed costs.
Therefore, he decides to produce – OM1 quantity of output and sells it at a price E1M1. This ensures that he suffers a loss which is equal to his fixed costs.
It is important to note that if the demand curve lies left to the position of D1, then there is no production since the monopolist would simply add to his losses by operating the plant. In such cases, a monopolist would close down the plan and restrict his losses to the fixed costs.
Demand curve D2
If the demand curve lies to the right of D1, then the monopolist can recover a part of his fixed costs. Further, if this demand curve is tangent to the ATC curve (demand curve D2), then the monopolist can also recover his complete cost of production.
If D2 is the demand curve, then the equilibrium position of the monopolist is at the intersection of the MC curve and the MR2 curve at point A2. This corresponds with the point of tangency between D2 and the ATC curve (point E2).
Therefore, the MC curve cuts the MR2 curve from below and AR = ATC. Hence, the monopolist earns normal profits by producing a quantity OM2 and selling it at a price E2M2.
Demand Curve D3
If the demand curve lies further to the right of D2 (like D3), the monopolist can earn super-normal profits. The equilibrium position is the point of intersection between the MC curve and the MR3 curve at point A3. Therefore, the monopolist produces a quantity OM3 and sells it at a price E3M3.
A Firm’s Long-run Equilibrium in Monopoly
In the long-run, a monopolist can vary all the inputs. Therefore, to determine the equilibrium of the firm, we need only two cost curves – the AC and the MC. Further, since the monopolist exits the market if he is operating at a loss, the demand curve must be tangent to the AC curve or lie to the right and intersect it twice.
As you can see above, there are two alternative cases for the determination of Equilibrium in Monopoly:
- With normal profits
- With super-normal profits
We have not taken the loss scenario here because if the monopolist incurs losses in the long-run, he will stop operating.
Case 1
The demand curve AR1 is tangent to AC or LAC at point E. Remember, if the demand curve lies to the left of the AC curve, then the monopolist is unable to recover his costs and closes down.
However, if the AR curve is tangent to the AC curve, then the monopolist can recover his costs and stay in the market.
Further, note that the perpendicular drawn from point E to the X-axis, the MC curve, and the MR curve are concurrent at point A.
Therefore, all the conditions of equilibrium are satisfied. The monopolist produces OM quantity and sells it at a price of EM per unit which covers its average costs + normal profits.
Case 2
The marginal revenue curve MR2 cuts the MC curve from below at point B. The corresponding height of the AR2 curve is E’M1.
Hence, the monopolist produces OM1 quantity and sells it at E’M1 per unit to earn an extra profit of E’B per unit. Being a monopoly, this extra profit is not lost to competition or newer firms entering the industry.
The conditions for Equilibrium in Monopoly are the same as those under perfect competition. The marginal cost (MC) is equal to the marginal revenue (MR) and the MC curve cuts the MR curve from below. In this article, we will understand Equilibrium in Monopoly in detail.
A Firm’s Short-Run Equilibrium in Monopoly
Like in perfect competition, there are three possibilities for a firm’s Equilibrium in Monopoly. These are:
- The firm earns normal profits – If the average cost = the average revenue
- It earns super-normal profits – If the average cost < the average revenue
- It incurs losses – If the average cost > the average revenue
In this article, we shall take up two forms of imperfect competition:
(a) Monopoly
(b) Monopolistic competition
Monopoly
There is only one firm prevailing in a particular industry called A Monopoly Market Structure. When a single firm controls 25% or more of a particular market is known as monopoly power from a regulatory view. Indian Railway is an example.
A Natural Monopoly Market Structure comprises various natural advantages like strategic location and/or abundant mineral resources.
Various gulf countries have a monopoly in crude oil exploration because of abundant naturally occurring oil resources.
Key features of a Monopoly Market Structure
Lack of Substitutes
Barriers to Entry
Competition
Price Maker
Profits structure
1. Lack of Substitutes
In monopoly structure firms normally produce a good without close substitutes. The product is generally often specific and unique.
For example, when Apple started producing the iPad, it arguably had a monopoly over the tablet market.
2. Barriers to Entry
There are significant barriers exists to entry set up by the monopolist. If new firms want to enter the industry, the monopolist will not have complete control of a firm on the supply.
This implies that there is no difference between a firm and an industry Under monopoly.
3. Competition
In a monopoly market structure, there are no close competitors in the market for that product.
4. Price Maker
The term Price Determination under Imperfect Competition symbolizes monopoly market. The monopolistic sets the price of the product. Since it has market power, This power makes the monopolist a price maker.
5. Profits
A monopolist can maintain supernormal profits in the long run but it not necessary that he earns profits too. He can be making a loss or maximizing revenues. This can never happen under perfect competition.
In the case where the abnormal profits are available in the long run, other firms will also enter the market and as a result, abnormal profits will be eliminated.
Revenue curves under a Monopoly
A monopolistic firm is a price-maker, not a price-taker. Therefore, a monopolist can increase or decrease the price. Also, when the price changes, the average revenue, and marginal revenue changes too. Take a look at the table below:
Quantity Sold Price per unit Total Revenue
(TR) Average Revenue
(AR) Marginal revenue
(MR)
1 6 6 6 6
2 5 10 5 4
3 4 12 4 2
4 3 12 3 0
5 2 10 2 -2
6 1 6 1 -4
Let’s look at the revenue curves now:
Monopoly definition
As you can see in the figure above, both the revenue curves (Average Revenue and Marginal Revenue) are sloping downwards. This is because of the decrease in price. If a monopolist wants to increase his sales, then he must reduce the price of his product to induce:
The existing buyers to purchase more
New buyers to enter the market
Hence, the demand conditions for his product are different than those in a competitive market. In fact, the monopolist faces demand conditions similar to the industry as a whole.
Therefore, he faces a negatively sloped demand curve for his product. In the long-run, the demand curve can shift in its slope as well as location. Unfortunately, there is no theoretical basis for determining the direction and extent of this shift.
Talking about the cost of production, a monopolist faces similar conditions that a single firm faces in a competitive market. He is not the sole buyer of the inputs but only one of the many in the market. Therefore, he has no control over the prices of the inputs that he uses.
A Firm’s Short-Run Equilibrium in Monopoly
Like in perfect competition, there are three possibilities for a firm’s Equilibrium in Monopoly. These are:
The firm earns normal profits – If the average cost = the average revenue
It earns super-normal profits – If the average cost < the average revenue
It incurs losses – If the average cost > the average revenue
Normal Profits
A firm earns normal profits when the average cost of production is equal to the average revenue for the corresponding output.
Equilibrium in Monopoly
In the figure above, you can see that the MC curve cuts the MR curve at the equilibrium point E. Also, the AC curve touches the AR curve at a point corresponding to the same point. Therefore, the firm earns normal profits.
Super-normal Profits
A firm earns super-normal profits when the average cost of production is less than the average revenue for the corresponding output.
a firm’s short-run Equilibrium in Monopoly. The quantity is along the X-axis and price and cost of production along the Y-axis.
There are three curves – the average variable cost (AVC) curve, the average total cost (ATC) curve, and the marginal cost (MC) curve. Further, there are three demand curves to explain the possible positions of the equilibrium:
Demand Curve D1 is tangent to the AVC curve at point E1
Its corresponding MC curve intersects the MR1 curve from below at point A1. Therefore, while the monopolist satisfies the first condition of equilibrium, he is unable to recover his complete cost of production.
However, even if he closes the plant down, he cannot reduce the losses since they are fixed costs.
Therefore, he decides to produce – OM1 quantity of output and sells it at a price E1M1. This ensures that he suffers a loss which is equal to his fixed costs.
It is important to note that if the demand curve lies left to the position of D1, then there is no production since the monopolist would simply add to his losses by operating the plant. In such cases, a monopolist would close down the plan and restrict his losses to the fixed costs.
Demand curve D2
If the demand curve lies to the right of D1, then the monopolist can recover a part of his fixed costs. Further, if this demand curve is tangent to the ATC curve (demand curve D2), then the monopolist can also recover his complete cost of production.
If D2 is the demand curve, then the equilibrium position of the monopolist is at the intersection of the MC curve and the MR2 curve at point A2. This corresponds with the point of tangency between D2 and the ATC curve (point E2).
Therefore, the MC curve cuts the MR2 curve from below and AR = ATC. Hence, the monopolist earns normal profits by producing a quantity OM2 and selling it at a price E2M2.
Demand Curve D3
If the demand curve lies further to the right of D2 (like D3), the monopolist can earn super-normal profits. The equilibrium position is the point of intersection between the MC curve and the MR3 curve at point A3. Therefore, the monopolist produces a quantity OM3 and sells it at a price E3M3.
A Firm’s Long-run Equilibrium in Monopoly
In the long-run, a monopolist can vary all the inputs. Therefore, to determine the equilibrium of the firm, we need only two cost curves – the AC and the MC. Further, since the monopolist exits the market if he is operating at a loss, the demand curve must be tangent to the AC curve or lie to the right and intersect it twice.
Equilibrium in Monopoly
As you can see above, there are two alternative cases for the determination of Equilibrium in Monopoly:
With normal profits
With super-normal profits
We have not taken the loss scenario here because if the monopolist incurs losses in the long-run, he will stop operating.
Case 1
The demand curve AR1 is tangent to AC or LAC at point E. Remember, if the demand curve lies to the left of the AC curve, then the monopolist is unable to recover his costs and closes down.
However, if the AR curve is tangent to the AC curve, then the monopolist can recover his costs and stay in the market.
Further, note that the perpendicular drawn from point E to the X-axis, the MC curve, and the MR curve are concurrent at point A.
Therefore, all the conditions of equilibrium are satisfied. The monopolist produces OM quantity and sells it at a price of EM per unit which covers its average costs + normal profits.
Case 2
The marginal revenue curve MR2 cuts the MC curve from below at point B. The corresponding height of the AR2 curve is E’M1.
Hence, the monopolist produces OM1 quantity and sells it at E’M1 per unit to earn an extra profit of E’B per unit. Being a monopoly, this extra profit is not lost to competition or newer firms entering the industry.
Price discrimination refers to the charging of different prices by the monopolist for the same product.
The difference in the product may be on the basis of brand, wrapper etc. This policy of the monopolist is called price discrimination.
Definitions:
“Price discrimination exists when the same product is sold at different prices to different buyers.” -Koutsoyiannis
“Price discrimination refers to the sale of technically similar products at prices which are not proportional to their marginal cost.” -Stigler
“Price discrimination is the act of selling the same article produced under single control at a different price to the different buyers.” -Mrs. Joan Robinson
“Price discrimination refers strictly to the practice by a seller of charging different prices from different buyers for the same good.” -J.S. Bain
“Discriminating monopoly means charging different rates from different customers for the same good or service.” -Dooley
Types of Discriminating Monopoly:
Price discrimination is of following three types:
1. Personal Price Discrimination:
Personal price discrimination refers to the charging of different prices from different customers for the same product. For example, a doctor charges different fees for the same operation from rich and poor patients.
2. Geographical Price Discrimination:
Under geographical price discrimination, the monopolist charges different prices in different markets for the same product. It also includes dumping where a producer may sell the same commodity at one price at home and at the other price abroad.
3. Price Discrimination according to Use:
ADVERTISEMENTS:
When the monopolist charges different prices for the different uses of the same commodity is called the price discrimination according to use.
Conditions for Price Discrimination:
For price discrimination to exist, it requires the basic conditions.
These are:
1. Difference in Elasticity of Demand:
Price discrimination is possible only when elasticity of demand will be different in different markets. The monopolist will fix higher price where demand is inelastic and low price where the demand will be elastic. In this way, he will be able to increase his total revenue.
2. Market Imperfections:
Generally, price discrimination is possible only when there is some degree of market imperfections. The individual seller is able to divide his market into separate parts only if it is imperfect.
3. Differentiated Product:
Price discrimination is possible when buyers need the same service in connection with differentiated products. For example, railways charges different rates for the transport of coal and copper.
4. Legal Sanction:
In some cases price discrimination is legally sanctioned. As, Electricity Board charges lowest for electricity for domestic use and highest for commercial houses.
5. Monopoly Existence:
Price discrimination is also called discrimination monopoly. It is evident that price discrimination is possible only under conditions of monopoly.
In ordinary language national income refers to the sum total value of goods and services produced during a year in a country. It is the aggregate money value of all final goods and services produced annually in a country.
Definition:-
According to Prof. Marshall, “The labour and capital of a country, acting upon its natural resources, produce annually a certain net aggregate of commodities, material & immaterial, including services of all kinds… This is the true net annual income or revenue of the country or the national dividend.”
According Marshall’s definition national income is arrived by adding together net output of all productive activities. The term ‘net’ implies that depreciation of machineries and plant to be deducted from Gross National Product. The net income from abroad must be added.
Features of National Income:-
1) National income is a Macro Economic concept: Macroeconomic deals with aggregate or the economy as a whole. National income data present the picture of the performance of the country’s economy as a whole in course of a given period of time.
2) National income is a flow concept: National income is the flow of goods and services produced in the country during a year. It includes only those goods or services which are actually produced.
3) National income is the money valuation of goods: National income is always expressed in monetary terms. It represents only those goods and services which are exchanged for money.
4) National income includes value of only final goods and services: In order to avoid double counting, while estimating national income, we include only value of final goods and services, and not the value of intermediate goods or raw material. For example, while estimating the production of sugar, there is no need to take the value of sugarcane, as it is already included in the price of sugar.
5) National income is the net aggregate value: National income includes net value of goods and services produced and do not include depreciation cost i.e. wear and tear of capital goods, due to their use in the process of production.
6) Net income from abroad is included in national income: While estimating national income, net income received from international trade is the net export value (X – M) as well as net receipts (R – P).
7) Financial Year: It is always expressed with reference to time period, that is, generally a financial year, which in India is from 1st April to 31st March of every year.
Key Points: - Macro, Flow, Money Valuation, Final goods & services, Aggregate Value, Financial year. |
Circular Flow of National Income:-
The Circular Flow of National Income and expenditure refers to the process, whereby the national income and expenditure of an economy flow in a circular manner continuously through time.
Circular flow in a simple economy:-
We begin with a simple hypothetical economy, where there are only two sectors, the household and business.
- Households are the owner of factors of production and consumers of goods and services.
- Business sector produce goods and services and sell them to the household sector.
- The household sector receives income by selling the services of these factors to the business sector.
- The business sector consists of producers who produce goods and services and sell them to the household sector of consumers.
- Thus, the household sector buys the goods and services from the business sector.
- Thus, one man’s income is another man’s expenditure.
The circular flow can be understood with the help of diagram –
HOUSEHOLD FIRM
The outer circle of diagram shows the real flow i.e. flow of factor services from household sector to business sector and corresponding flow of goods and services, from business sector to household sector.
The inner circle shows the money flow, that is, flow of factor payments from business sector to household sector and corresponding flow of consumption expenditure from household sector to business sector.
It must be noted that entire amount of money which is paid by business sector as factor payments, is paid back by the factor owners to the business sector. So here is a circular and continuous flow of money income. In the circular flow of income, production generates factor income, which is converted into expenditure. This flow of income continues as production is a continuous activity due to never ending human wants. It makes the flow of income circular.
Different Concept of National Income:-
National income refers to the monetary value of goods and services produced in a country during a year. The following are the various concepts associated with national income:
GDP, NDP, GNP and NNP are measured at market price as well as factor cost. Market price is the price paid by the consumers i.e. it is monetary value of goods and services. Factor cost refers to the prices of products and services as received by producer i.e. market price minus taxes plus subsidies. Factor cost can also be referred as the payment received by or made to the factors of production in the form of rent, wages, interest, profit, etc. Basically, the amount that is received by producers is paid to the factors of production (including the producer himself who is the entrepreneur in this case).
1) Gross National Product (GNP): GNP is the gross market value of all final goods and services produced in a country during a year. It includes net income from abroad and depreciation.
GNP = C+ I + G+ (X – M) + (R – P)
2) GNP at Market price (GNPMP): GNPMP is the gross market value of final goods and services produced in the country during a year. The Market value refers to the prices prevailing in the market GNP is the basic social accounting measure for total output.
GNPMP = C+ G+ (X – M) + (R – P)
3) GNP at Factor cost (GNPFC): GNPFC is the money value of the income produced and accruing to the factors of production who were involved in producing goods and services during a year. The money received from consumers is distributed among factors of production and therefore GNPMP should be equal to GNPFC. However, government intervention in the form of indirect taxes and subsidies leads to a difference in GNPMP and GNPMP and. The effect of indirect taxes and subsidies has to be adjusted from GNPMP to arrive at GNPFC.
GNPFC = GNPMP - indirect taxes + Subsidies
4) Gross Domestic Product at Market Price (GDPMP): GDPMP is the gross market value of final goods and services produced in the country during a year. Since, it is gross “domestic” product, the net income from abroad is not considered in its calculation. GDPMP = C+ I + G+ (X – M) OR GDPMP = GNPMP – Net income from abroad
5) Gross Domestic Product at Factor cost (GDPFC): GDPFC is the gross market value of final goods and service produced in the country during a year. The value of indirect taxes and subsidies is adjusted from GDPMP to arrive at GDPFC
GDPFC = C+ I + G+ (X – M) – Indirect Taxes + Subsidies OR GDPFC = GDPMP – Indirect taxes + Subsidies
6) Net Domestic Product at Market Price (NDPMP): NDPMP is the net market value of goods and services produced in the country during a year. Since, it is net “domestic” product, the net income from abroad is not considered in its calculation. Further, since it is a “net” market value of goods and services, depreciation is not included while calculating NDPMP. NDPMP = GDPMP – Depreciation
7) Net Domestic Product at Factor Cost (NDPFC): NDPFC is the net market value of goods and services produced in the country during a year. It is also known as “domestic income” or “domestic factor income”. The value of indirect taxes and subsidies is adjusted for GDPMP to arrive at NDPFC. Further, since it is a “net” market value of goods and service, depreciation is not included while calculating NDPFC.
NDPFC = GDPMP – Depreciation – Indirect Taxes + Subsidies OR
NDPFC = NDPMP – Indirect Taxes + Subsidies.
8) Net National Product at Market Price (NNPMP): NNPMP is the net market value of goods and services produced by the residents of a country during a year. Since it is a “net” market value of goods and services, depreciation is not included while calculating NNPMP. NNPMP can be calculated by deducting depreciation from GNPMP. NNPMP = GNPMP – Depreciation.
9) Net National Product at Factor Cost (NNPFC): NNPFC is the net market value of goods and services produced by the resident of a country during a year. It includes income earned by factors of production. NNPFC = NNPMP – Indirect Taxes + Subsidies
10) National Income at Factor cost (NIFC): NIFC refers to sum of all income earned by resources suppliers for their contribution of land, labour, capital and entrepreneurial ability which are utilized in the production of the year. In short, it is the sum total of all income received and accrued to the factors of production. NIFC = NNPMP – Indirect Taxes + subsidies OR NI FC = NNPFC
11) Personal Income: Personal income is the sum of all incomes actually received by and accrued to all individuals or households from all the sources during a given year. Accrued income means the income which is earned but not received.
12) Personal Disposable income: Personal disposable income is the personal income which is left after the payment of direct taxes like personal income tax, property tax, etc.
Methods of National Income:-
National income refers to the total value of final goods and services produced in a year. It is also equal to the incomes of the factors of production obviously the income received is equal to income spent on goods services.
On the basis of this, there are three different approaches to calculate national income. They are –
1) Aggregate Output method 2) Aggregate Income method
3) Aggregate Expenditure method
1) Aggregate output method:
Under this method national income is calculated by aggregating the value of all final goods and services produced in a country during a year. Whatever goods and services are produced in a country by different sectors is multiplied by their current market price. The sum total of all this obtained is actually GNP at market price. From GNP when depreciation cost is deducted we get NNP at market price.
In using this method, to avoid double counting, only the value of final goods and services should be taken into account. For this economist have suggested two alternative approaches for measuring national income by output method.
i) Final goods method ii) Value added method
i) Final goods method: Under this method, only the value of final goods and services is taken into account to estimate GNP. The value of intermediate goods and the raw material should not be taken as it would result in double counting. For e.g. – When the value of cloth is taken, value of raw-cotton should not be included because cloth includes the value of raw-cotton.
Ii) Value added method: Under this method, we calculated the value added at each stage of production and total finally sum-up the values to get the total value of the output produced. This is explained with the help of following example:
Stage of Production | Market value of goods (Rs.) | Value added in Production (Rs.) |
Cotton | 40 | 40 |
Yarn (Thread) | 55 | 15 |
Cloth | 75 | 20 |
Shirt [Final goods] | 100 | 25 |
Total Value added | 270 | 100 |
In this table market value of final goods i.e. shirt is Rs. 100. The sum total of value added at each stage of production is also Rs. 100. Thus, GNP by value added approach is equal to the value of final goods approach. Economists consider value added method a better method and it helps to avoid double counting.
Precautions: While estimating national income by output method, the following precautions should be taken:
1) To avoid double counting, only the value of final goods and services must be taken into account.
2) Goods used for self consumption by farmers should be estimated by a guess work that is imputed value of goods produced for self consumption, is included in national income.
3) Indirect taxes included in the market prices are to be deducted and subsidies given by the government to certain products should be added for accurate estimation of national income.
4) While evaluating output, changes in the price level between different years must be taken into account.
5) Value of exports should be added and value of imports should be deducted.
6) Depreciation of capital assets should be deducted.
7) Sale and purchase of second hand goods should be ignored as it is not part of current production.
2) Aggregate income method:
This method is also known as factor cost method. Under this method, national income is obtained by adding the incomes such as rent, wages, interest and profit received by all persons and enterprises in the country during a year. The total income earned by all the factors of production will be equal to the value of all type of final goods and services produced during a year.
Precautions: While estimating national income by income method, the following precautions should be taken:
1) Transfer incomes or transfer payments like scholarships, gifts, donations, charity, old age, pensions, unemployment allowance etc., should be ignored.
2) All unpaid services like services of housewife, teacher teaching her/his child, should be ignored.
3) Any income from sale of second hand goods like car, house, etc., should be ignored.
4) Income from sale of shares and bonds should be ignored, as they do not add anything to the real national income.
5) Revenue received by the government through direct taxes, should be ignored, as it is only a transfer of income.
6) Undistributed profits of companies, income from government property and profits from public enterprise, such as water supply, should be included.
7) Imputed value of production kept for self consumption and imputed rent of owner occupied houses should be included.
3) Aggregate Expenditure method:
Under expenditure method the national income is viewed as the total expenditure on goods and services produced during the year. Major part of the total goods and services are consumed by households, firms and Government. The unsold goods are held by producer as stock or inventories. Hence they are assumed to be bought by the producers. The total expenditure incurred by household, Firms and Government are added up to obtain the national income.
To add up total expenditure, we include the following items:
1) Personal consumption expenditure. This is the expenditure on consumer goods and services. (C)
2) Gross domestic private investment (I). This includes the expenditure of business firms on capital goods like building, machinery, equipment etc.
3) Government purchase of goods and services. (G)
4) Net foreign investment – The expenditure on exports is added and expenditure on import is deducted. (E)
E = X – M + (R – P)
Now Gross national expenditure = C + I + G + E
This is called Gross national income. We can obtain Net National Income by deducting depreciation from the Gross National expenditure thus obtained.
Net National Income = Gross National Expenditure – Depreciation
Precautions: While estimating national income by Expenditure method, the following precautions should be taken:
1) Expenditure on all intermediate goods and services should be ignored, in order to avoid double counting.
2) Expenditure on the purchase of second hand goods should be ignored, as it is not incurred on currently produced goods.
3) Expenditure on transfer payments like scholarships, old age pensions, unemployment allowance etc., should be ignored.
4) Expenditure on purchase of financial assets such as shares, bonds, debentures etc., should not be included, as such transactions do not add to the flow of goods and services.
5) Indirect taxes should be deducted.
6) Expenditure on final goods and services should be included.
7) Subsidies should be included.
Difficulties in measuring National Income:- The calculation of the national income of a country is a task full of difficulties and complexities. The following difficulties generally arise while estimating national income.
A] Theoretical difficulties B] Practical difficulties
A] Theoretical difficulties:
1) Transfer payments: Monetary benefits received by persons like pensions, scholarships are personal incomes but government expenditures. Since all these are transfer payment, these cannot be included in national income. Hence this leads to under estimation of nation income.
2) Income of foreign firms: According to IMF view-point, income of a foreign firm should be included in the national income of the country, where the firm actually undertakes production work. However, profits earned by foreign firms are credited to the parent concern.
3) Unpaid services: National income is always measured in money, but there are a number of goods and services which are difficult to be assessed in terms of money. For example, painting as a hobby by an individual, the bringing up of children by the mother, these services are not included in national income as remuneration is not given to them. Services rendered by housewives are not estimated in national income, as they are not paid for their work. A cook when employed at home is paid for his services but when the same work is done by housewife, she is not paid. Hence this leads to under estimation of national income.
4) Incomes from illegal activities: Income earned through illegal activities such as gambling, black marketing, theft, smuggling etc., is not included in national income. Such goods and services do have value and meet the needs of the consumers. Thus to that extent national income is underestimated.
5) Treatment of government sector: Government provides a number of public services like defence, public administration, law and order etc. Measuring the market value of such government services is difficult, as the real value of these services is not known; therefore it has become a convention to treat all such services as final consumption. Hence, it is included in national income.
6) Production for self- consumption: In agricultural sectors a large part of farm products are directly consumed by farmers. In the industrial sector also, cloth producers, oil producers etc. keep some products for their family. Estimates are usually taken for those products which are sold in the market. Hence absence of money value of products kept for self consumption will lead to under estimation of national income.
7) Changes in price level: National income is estimated at current market price. But because of general rise in price, national income may increase, even if national output remains constant or less.
B] Practical difficulties:
1) Possibility of double counting: To avoid double counting only the value of final goods should be taken into account. But it is very difficult to determine whether the good is intermediate or final good. For e.g. – For a restaurant, rice is an intermediate product but for a farmer rice is a final product. Because of such difficulties sometimes there is double counting and this may lead to over estimation of national income.
2) Existence of non-monetized sector: There is a large non-monetized sector in the developing economy like India. Agriculture, still being in the nature of subsistence farming in the developing countries, a major part of the output is consumed at the farm itself and a part of production is partly exchanged for other goods and services. Such production and consumption cannot be calculated in national income.
3) Lack of occupational specialization: There is the lack of occupational specialization, which makes the calculation of national income by product method difficult. For instance, besides the crop, farmers in a developing country are engaged in supplementary occupations like dairy farming, poultry farming, cloth making etc. But income from such productive activities may not be revealed and thus is not included in the national income estimates.
4) Inadequate and unreliable data: Reliable facts and figures of personal income are generally not available. Professional does not disclose their actual income earned, salaried people may do some part time work in their spare time which they do not disclose. Inadequate & unreliable information of all this results in underestimated of nation income.
5) Capital gains or losses: Capital gains or losses, which accrue to the property owners by increases or decreases in the market value of their capital assets or changes in demand, are not included in the gross national product, because these changes do not result from current economic activities.
6) Depreciation: The calculation of depreciation on capital consumption is one more difficulty. Depreciation refers to wear and tear of capital assets, due to their use in the process of production. Depreciation of capital assets will depend on technical life of the regular and careful maintenance etc. There are no uniform, common or accepted standard rates of depreciation applicable to the various capital assets. In case of depreciation, one has to make many reasonable assumptions, which involve an element of subjectivity. So it is difficult to make correct deduction for depreciation.
7) Valuation of inventories: Raw materials, intermediate goods, semi-finished and finished products in the stock of the producers are known as inventory. All inventory changes, whether negative or positive, are included in the gross national product. Any mistake in measuring the value of inventory, will distort the value of the final production of the producer. Therefore, valuation of inventories requires careful assessment.
8) Illiteracy and Ignorance: Majority of the small producers in developing countries are illiterate and ignorant, and are not in a position to keep any account of their productive activities. So they cannot give information about the quantity or value of their output. Hence, the estimates of production and earned income simply guess.
The theory of distribution is that incomes are earned in the production of goods and services and that the value of the productive factor reflects its contribution to the total product. Distribution refers to the way total output, income, or wealth is distributed among individuals or among the factors of production such as labour, land, and capital. In general theory and the national income and product accounts, each unit of output corresponds to a unit of income.It is the systematic attempt to account for the sharing of the national income among the owners of the factors of production i.e., land, labour, and capital. Economists have studied how the costs of these factors i.e., rent, wages, and profits and the size of their return are fixed.
Advantages of Distribution theory
The great advantages of the theory of distribution is that
• It treats wages, interest, and land rents in the same way.
• Is its integration with the theory of production.
• Itlends itself to a relatively simple mathematical statement.
Aspects of distribution
The aspects of distribution can be as follows:
a. Personal distribution
Personal distribution is primarily a matter of statistics and the conclusions that can be drawn from them. The inequality seems to be greatest in poor countries and diminishes somewhat in the course of economic development. Some authorities point to the natural inequality of human beings (differences in intelligence and ability), others to the effects of social institutions (including education); some emphasize economic factors such as scarcity; others invoke political concepts such as power, exploitation, or the structure of society.
b. Functional distribution
The theory of functional distribution, which attempts to explain the prices of land, labour, and capital, is a standard subject in economics. It sees the demand for land, labour, and capital as derived demand, stemming from the demand for final goods. Behind this lies the idea that a businessman demands inputs of land, labour, and capital because he needs them in the production of goods that he sells. The theory of distribution is thus related to the theory of production, one of the well-developed subjects of economics.
Influences on distribution
• Price
The traditional inflationary sequence was that as prices rose, profits would increase, with wages lagging behind; this would tend to diminish the share of labour in the national income.
• Technology
Another dynamic influence is technological progress. The concept of the production function assumes a constant technology.
Marginal Productivity alias Theory of Distribution
The theory explains how the prices of the various factors of production would be determined under conditions of perfect competition and full employment.
According to the Marginal Productivity Theory, the price of any factor will be equal to the value of its marginal product. For example, we know that a consumer will demand a commodity up to the point at which its marginal utility is proportional to the price he pays for it. Similarly, a firm will go on employing more and more units of a factor until the price of the factor is equal to the value of the marginal product. This is equal to the value of the additional product, which an employer gets when he employs an additional unit of that factor, the supply of all other factors remaining constant.
Factors of production can be defined as inputs used for producing goods or services with the aim to make economic profit.
In economics, there are four main factors of production, namely land, labor, capital, and enterprise. The price that an entrepreneur pays for availing the services of these factors is called factor pricing.
An entrepreneur pays rent, wages, interest, and profit for availing the services of land, labor, capital, and enterprise respectively. The theory of factor pricing deals with the price determination of different factors of production.
The determination of factor prices is always assumed to be similar to the determination of product prices. This is because in both the cases, the prices are determined with the help of demand and supply forces. Moreover, the demand for factors of production is similar to the demand for products.
However, there are two main differences on the supply side of factors of production and products. Firstly, in product market, the supply of a product is determined by its marginal cost of production. On the other hand, in factor market, it is not possible to determine the supply of factors on the basis of marginal cost.
For example, it is difficult to ascertain the exact cost of production for factors, such as land and capital. Secondly, the supply of factors of production cannot be readily adjusted as in the case of products. For instance, if the demand for a land increases, then it is not possible to increase its supply immediately.
Books Recommended :
1. Dewett K. K.—Adhunik Arth Shastra Ke Sidhant (Modarn Econoinic Theory).
2. Marshall—Principles of Economics.
3.Roy, L. M.—Arthshastra.
4. Sundharam K. P. M. And Vaish M. C.—Principles of Economics.
5. Stonier and Hague -A Text Book of Economic Theory.
6. Jain K. P.—Arthshastra Ke Sidhanta.
7. Ahuja, H. L.—Advanced Economic Theory,
8. Ahuja, H. L.—Uchatar Arthic Sidhanta
