Unit – IV

Cost and Markets: Cost Classification – Price and

Output determination under Perfect Competition and
Imperfect Competition (Monopoly – Monopolistic
Competition – Oligopoly)

Cost concept and its classification:

In today’s competitive scenario, the main aim of
every organization is to earn maximum profit.
The organization’s decision of maximizing profit
depends on the behavior of its costs and revenues.
In general terms, cost refers to an amount to be paid
or given up for acquiring any resource or service.
Cost, a key concept in economics, is the monetary
expense incurred ‘by organizations for various purposes,
such as acquiring resources, producing goods and
services, advertising, and hiring workers. In other words,
cost can be defined as monetary expenses that are
incurred by an organization for a specified tiling or
activity.
According to Institute of Cost and Work Accountants
(ICWA), cost implies “measurement in monetary terms of
the amount of resources used for the purpose of
production of goods or rendering services.” In terms of
manufacturing, costs refer to sum total of monetary value
of resources used in producing or manufacturing a
product. These resources can be raw material, labor, and
land.

Cost classification:
There are several types of costs that a firm may
consider relevant under various circumstances. Such
costs include accounting costs, opportunity costs, implicit
costs, fixed costs, variable costs etc.
1. Accounting Cost:
Accounting costs are also called as money costs or
entrepreneur’s costs. These are the expenses of an
organization incurred during action and are entered in the
books of accounts of the organization. Accounting costs
are also known as actual cost or acquisition cost or
absolute cost.
2. Opportunity Costs:
The cost incurred on the next best alternative that
is foregone to acquire or produce a particular good is
known as opportunity cost. In other words, opportunity
cost can be defined as the lost opportunity of not being
able to produce some other product. Opportunity cost is
also known as alternative cost or displacement cost or
transfer cost.
3. Explicit Costs and Implicit Costs:
Explicit costs refer to the payments incurred by an
organization in exchange of acquiring various resources,
such as labor, material, plant, machinery, and technology.
In other words, explicit costs can be defined as the
payments incurred by organizations for outsiders who
supply labor services, transport services, electricity, and
raw materials.
According to Leftwitch, “explicit costs are those cash
payments which firms make to outsiders for their services
and goods.” Explicit costs are recorded in the books of
accounts of an organization. Apart from this, there are
certain costs that are neither converted into cash outlays
nor added in the accounting system. Such costs are termed
as implicit costs or imputed costs. These costs are
considered as the costs of organization’s self-owned
resources. Opportunity cost is the important example of
implicit costs.
4. Fixed Costs and Variable Costs:

Fixed costs refer to those that remain constant for a

certain amount of output. The fixed costs include costs
incurred on managerial and administrative staff,
depreciation of machinery, and maintenance of lands and
buildings.
These costs are incurred in the short- run. On the
other hand, variable costs are those costs that differ
according to changes in the quantity of output. These
costs include costs incurred on raw materials,
transportation, and labor.
5. Total Cost, Average Cost, and Marginal Cost:
Total cost refers to the total sum of the cost incurred
on production of goods or services. It involves all implicit
and explicit costs as well as fixed and variable costs
incurred on acquiring resources for the production of
goods or services. On the other hand, average cost is the
total cost of production per unit of output. It is not
considered as actual costs and is statistical in nature.
Average cost can be calculated as follows:
Average Cost = Total Cost/ Output
Marginal cost is the addition to the total cost for
producing an additional unit of the product.
6. Short-run and Long-run Costs:
Short run refers to a period in which organization can
change its output by changing only variable factors, such
as labor and capital. In this period, the fixed factors, such
as land and machinery, remain the same. The expansion is
done by hiring more labor and purchasing more raw
materials.
On the other hand, long run refers to a period in
which all the factors are variable. The existing size of the
plant or building can be increased in case of the long run.
Long run costs vary with variation in the size of
manufacturing plant or organization. Long-run costs
include costs incurred on plant, building, and machinery.
7. Incremental Costs and Sunk Costs:
Incremental costs are those costs that are incurred
during the expansion of an organization. These are the
added costs that are involved in changing the level of
production or the nature of business activity. Expansion
can be in the form of men, materials, and machinery.
Incremental costs are incurred by an organization for
various purposes, such as purchasing new machines,
changing distribution channel, and launching a new
product.
On the other hand, sunk costs are those costs that
are incurred whether there is an expansion or not. These
are the costs which are made once and cannot be altered,
increased, or decreased. These types of costs are based on
the prior commitment; thus, cannot be revised or
recovered. For instance, if an organization hires a
machine; it has to bear the rent and other operational
charges, which are the sunk costs of the organization.
8. Historical and Replacement Costs:
Historical costs are those costs that are incurred in the
past by an organization for acquiring assets, such as land,
building, and machinery. These costs help in assessing the
net worth of the organization. Historical costs reduce on
an annual basis due to depreciated value of assets, such as
machinery and equipment. On the contrary, historical cost
increases in case of land, buildings, and metals, such as
gold and silver.
On the other hand, replacement cost is incurred when
an asset depreciates and is replaced with the new asset.

Price and Output determination under

Perfect Competition:
Perfect competition refers to a market situation in
which there are large number of buyers and sellers of
homogeneous products. The price of the product is
determined by industry with the forces of demand and
supply. There must be one price prevailing throughout
the market. Thus, perfect competition in a market
structure is characterised by the complete absence of
rivalry among individual firms.
According to Boulding, “Perfectly competitive
market is a situation where large number of buyers and
sellers are engaged in the purchase and sale of identically
similar commodities, who are in close contact with one
another and who buy and sell freely among themselves.”

Assumptions or Features of Perfect Competition:

1. Large Number of Buyers and Sellers:
It means no single buyer or seller can affect the price.
If a firm enters into the market or exit the market, there
will be no effect on the supply. Similarly, if a buyer
enters into the market or exit from the market, demand
will not be affected. Thus no individual buyer or seller
can affect the price.
2. Homogeneous Products:
The second assumption of perfect competition is that
all sellers sell homogenous product. In such a situation,
the buyers have no reason to prefer the product of one
seller to another. This condition is present only when the
commodity is a substance of definite chemical and
physical composition i.e., salt, tin, specified grade of
wheat etc.
3. No Discrimination:
Under perfectly competitive market, buyers and
sellers must buy and sell freely among themselves, it
implies that buyers and sellers must be willing to deal
openly with one another to buy and sell at the market
price. This may be true of one and all that may wish to do
so without offering any special deals, discounts, or
favours to selected individuals.
4. Perfect Knowledge:
A competitive market is one in which the buyers and
sellers are in close contact with each other. It means that,
there is perfect knowledge of the market on the part of
buyers and sellers. It implies that a large number of
buyers and sellers in the market exactly know how much
is the price of the commodity in different parts of the
market.
5. Free Entry and Exit of the Firms:
In the long run, under perfect competition, firm can
enter into or exit from the industry. There is no let or
hindrance on firms as far as their entry into or exit from
the market. In other words, there is no legal or social
restriction on the firm. Large number of sellers can be
possible only if there is free entry of firms.
6. Perfect Mobility:
There must be perfect mobility of factors of
production within the country which ensures uniform cost
of production in the whole economy. It implies that
different factors of production are free to seek
employment in any industry that they may like.
7. Profit Maximization:
Under perfect competition, all firms have a common
goal of profit maximization. Thus there is absence of
social welfare of the general masses.
8. No Selling Cost:
Under perfect competition, there are no selling costs.
If transport cost is incurred, prices should be different in
different sectors of the markets. We have stated that in
perfect competition there will be no price difference and
the commodity will be sold at uniform price throughout
the market. If the firms incur transport charges on supply,
then firms nearer to the market can charge lesser price
than the firms far away.
9. No Transport Costs:
There shall not be any cost of transport between
sellers. If transport costs exist buyers are prevented from
moving from one seller to another to take advantage of
price difference. This means that transport cost has no
influence on the pricing of a product.

Price and Output determination under Perfect

Competition:
Under perfect competition, the buyers and sellers
cannot influence the market price by increasing or
decreasing their purchases or output, respectively. The
market price of products in perfect competition is
determined by the industry. This implies that in perfect
competition, the market price of products is determined
by taking into account two market forces, namely market
demand and market supply.
In perfect competition, the price of a product is
determined at a point at which the demand and supply
curve intersect each other. This point is known as
equilibrium point as well as the price is known as
equilibrium price. In addition, at this point, the quantity
demanded and supplied is called equilibrium quantity.
Short-run Equilibrium with Super-normal Profit:
When the average revenue of the firm is greater than
its average cost, the firm is earning super-normal profit.
Short-run equilibrium with super-normal profits

In figure 8.1, output is measured along the x-axis and

price, revenue and cost along the y-axis. OP is the
prevailing price in the market. PL is the demand curve or
average and the marginal revenue curve. SAC and SMC
are the short run average and marginal cost curves. The
firm is in equilibrium at point ‘E’ where MR = MC and
MC curve cuts MR curve from below at the point of
equilibrium. Therefore the firm will be producing OM
level of output. At the OM level of output ME is the AR
and MF is the average cost. The profit per unit of output
is EF (the difference between ME and MF). The total
profits earned by the firm will be equal to EF (profit per
unit) multiplied by OM or HF (total output). Thus the
total profits will be equal to the area HFEP. HFEP is the
supernormal profits earned by the firm.
Long-run Equilibrium with Super-normal Profit:
In the long run, all factors are variable. The firms can
increase their output by increasing the number and plant
size of the firms. Moreover, new firms can enter the
industry and the existing firms can leave the industry. As
a result, all the existing firms will earn only normal profit
in the long run.
If the existing firms earn supernormal profit, the new
firms will enter the industry to compete with the existing
firms. As a result, the output produced will increase.
When the total output increases, the demand for factors of
production will increase leading to increase in prices of
the factors. This will result in increase in average cost.
On the other side, when the output produced
increases, the supply of the product increases. The
demand remaining the same, when the supply of the
product increases, the price of the product comes down.
Hence the average revenue will come down. A fall in
average revenue and the rise in average cost will continue
till both become equal. (AR = AC). Thus, all the perfectly
competitive firms will earn normal profit in the long run.
Figure 8.3 represents long run equilibrium of firm
under perfect competition. The firm is in equilibrium at
point S where LMC = MR = AR = LAC. The long run
equilibrium output is ON. The firm is earning just the
normal profit. The equilibrium price is OP. If the price
rises above OP, the firm will earn abnormal profit, which
will attract new firms into the industry. If the price is less
than OP, there will be loss and the tendency will be to
exit. So in the long run equilibrium, OP will be the price
and marginal cost will be equal to average cost and
average revenue. Thus the firm in the long run will earn
only normal profit. Competitive firms are in equilibrium
at the minimum point of LAC curve. Operating at the
minimum point of LAC curve signifies that the firm is of
optimum size i.e. producing output at the lowest possible
average cost.
Monopoly:
The word monopoly has been derived from the
combination of two words, ‘Mono’ and ‘Poly’. Mono
refers to a single and poly to control. In this way
monopoly refers to a market situation in which there is
only one seller of a commodity. There are no close
substitutes for the commodity it produces and there are
barriers to entry. The single producer may be in the form
of individual owner.
In other words, under monopoly there is no
difference between firm and industry. Monopolist has
full control over the supply of commodity. Having
control over the supply of the commodity he possesses the
market power to set the price. Hence, Monopoly is a
market structure in which there is a single seller, there are
no close substitutes for the commodity it produces and
there are barriers to entry.
According to Prof. Bilas. “Pure Monopoly is
represented by a market situation in which there is a
single seller of a product for which there are no
substitutes; this single seller is unaffected by and does not
affect the prices and outputs of other products sold in the
economy.”
Characteristics of Monopoly
1. Single Seller:
There is only one seller; he can control either price or
supply of his product. But he cannot control demand for
the product, as there are many buyers.
2. No close Substitutes:
There are no close substitutes for the product. The
buyers have no alternatives or choice. Either they have to
buy the product or go without it.
3. Price:
The monopolist has control over the supply so as to
increase the price. Sometimes he may adopt price
discrimination. He may fix different prices for different
sets of consumers. A monopolist can either fix the price
or quantity of output; but he cannot do both, at the same
time.
4. No Entry:
There is no freedom to other producers to enter the
market as the monopolist is enjoying monopoly power.
There are strong barriers for new firms to enter. There are
legal, technological, economic and natural obstacles,
which may block the entry of new producers.
5. Firm and Industry:
Under monopoly, there is no difference between a
firm and an industry. As there is only one firm, that single
firm constitutes the whole industry.

Price and Output Determination under Monopoly:

A monopolist like a perfectly competitive firm tries
to maximise his profits.
A monopoly firm faces a downward sloping demand
curve, that is, its average revenue curve. The downward
sloping demand curve implies that larger output can be
sold only by reducing the price. Its marginal revenue
curve will be below the average revenue curve.
The average cost curve is ‘U’ shaped. The
monopolist will be in equilibrium when MC = MR and
the MC curve cuts the MR curve from below.
In figure 8.4, AR is the Average Revenue Curve and
MR is the Marginal revenue curve. AR curve is falling
and MR curve lies below AR. The monopolist is in
equilibrium at E where MR = MC. He produces OM units
of output and fixes price at OP. At OM output, the
average revenue is MS and average cost MT. Therefore
the profit per unit is MS-MT = TS. Total profit is average
profit (TS) multiplied by output (OM), which is equal to
HTSP. The monopolist is in equilibrium at point E and
produces OM output at which he is earning maximum
profit. The monopoly price is higher than the marginal
revenue and marginal cost.

Price Discrimination:
Price discrimination means the practice of selling the
same commodity at different prices to different buyers. If
the monopolist charges different prices from different
consumers for the same commodity, it is called price
discrimination or discriminating monopoly.
Definition:
Price discrimination may be defined as “the sale of
technically similar products at prices which are not
proportional to marginal cost”. For example, all cinema
theatres charge different prices for different classes of
people.
Conditions of Price Discrimination:
Price discrimination is possible only if the following
conditions are fulfilled.
1. The demand must not be transferable from the high
priced market to the low priced market. If rich people do
not buy the high-priced deluxe edition of the book, but
wait for the low-priced popular edition to come out, then
personal discrimination will fail.
2. The monopolist should keep the two markets or
different markets separate so that the commodity will not
be moving from one market to the other market. If it is
possible to buy the product in the cheaper market of the
monopolist and sell it in the dearer market, there can
never be two prices for the commodity. If the industrial
buyer of cheap electricity uses it for domestic
consumption, then trade discrimination will fail.
The above two conditions are essential to adopt price
discrimination.
Price and Output determination under
Monopolistic Competition:
The concept of imperfect competition was introduced
in economics by Mrs. Joan Robinson in 1933 in her book
“Economics of Imperfect Competition” in England.
Imperfect competition is real situation found in the market
while perfect competition and monopoly are rare
situations. Imperfect completion possesses some features
of perfect completion and monopoly. Therefore imperfect
competition is a wider term which comprises of
monopolistic competition, oligopoly and duopoly.

The concept of monopolistic competition was put-

forth by an American economist Prof. E.H. Chamberlin in
his popular book, “The theory of Monopolistic
Competition” published in 1933. In simple words,
monopolistic competition refers to a market situation
where there are many sellers of a commodity, but the
product of each seller differs from each other. Thus
product differentiation is the hall mark of the
monopolistic competition.
According to Leftwitch, “Monopolistic competition
is a market situation in which there are many sellers of a
particular product, but the product of each seller is in
some way differentiated in the minds of consumers from
product of every other seller.”

Characteristics of Monopolistic Competition:

(i) Existence of Large Number of firms:
Under monopolistic competition, the number of firms
producing a commodity will be very large. The term ‘very
large’ denotes that contribution of each firm towards the
total demand of the product is small. Each firm will act
independently on the basis of product differentiation and
each firm determines its price-output policies. Any action
of the individual firm in increasing or decreasing the
output will have little or no effect on other firms.
(ii) Product differentiation:
Product differentiation is the essence of monopolistic
competition. Product differentiation is the process of
altering goods that serve the same purpose so that they
differ in minor ways. Product differentiation can be
brought about in various ways. Product differentiation is
attempted through (a) physical difference; (b) quality
difference; (c) imaginary difference and (d) purchase
benefit difference. It may be by using different quality of
the raw material and different chemicals and mixtures
used in the product. Difference in workmanship,
durability and strength will also make product
differentiation. Product differentiation may also be
effected by offering customers some benefits with the sale
of the product. Facilities like free servicing, home
delivery, acceptance of returned goods, etc. would make
the customers demand that particular brand of product
when such facilities are available. Product differentiation
through effective advertisement is another method. This is
known as sales promotion. By frequently advertising the
brand of the product through press, film, radio, and TV,
the consumers are made to feel that the brand produced by
the firm in question is superior to that of other brands sold
by other firms.
(iii) Selling Costs:
From the discussion of ‘product differentiation’, we
can infer that the producer under monopolistic
competition has to incur expenses to popularise his brand.
This expenditure involved in selling the product is called
selling cost. According to Prof. Chamberlin, selling cost
is “the cost incurred in order to alter the position or shape
of the demand curve for a product”. Most important form
of selling cost is advertisement. Sales promotion by
advertisement is called non-price competition.
(iv) Freedom of entry and exit of firms:
Another important feature is the freedom of any firm
to enter into the field and produce the commodity under
its own brand name and any firm can go out of the field if
so chosen. There are no barriers as in the case of
monopoly Monopolistic competition presupposes that
customers have definite preferences for particular
varieties or brand of products. Hence pricing is not the
problem but product differentiation is the problem and
competition is not on prices but on products. Thus in
monopolistic competition, the features of monopoly and
perfect competition are partially present.
(v) Lack of Perfect Knowledge:
The buyers and sellers do not have perfect knowledge
of the market. There are innumerable products each being
a close substitute of the other. The buyers do not know
about all these products, their qualities and prices.
Determination of Equilibrium price and output under
Monopolistic Competition:
1. Short-run with Abnormal Profit:
The monopolistic competitive firm will come to
equilibrium on the principle of equalising MR with MC.
Each firm will choose that price and output where it will
be maximising its profit. Figure 8.5 shows the equilibrium
of the individual firm in the short period.
MC and AC are the short period marginal cost and
average cost curves. The sloping down average revenue
and marginal revenue curves are shown as AR and MR.
The equilibrium point is E where MR = MC. The
equilibrium output is OM and the price of the product is
fixed at OP. The difference between average cost and
average revenue is SQ. The output is OM. So, the
supernormal profit for the firm is shown by the rectangle
PQSR. The firm by producing OM units of its commodity
and selling it at a price of OP per unit realizes the
maximum profit in the short run.
The different firms in monopolistic competition may
be making either abnormal profits or losses in the short
period depending on their costs and revenue curves
2. Long-run with Normal Profit:
Long period refers to that time period in which each
firm can change its production capacity by changing the
fixed as well as variable factors. New firms can enter the
industry and old firms can exit it. Basically, the firms in
the long run will get the normal profits. If the existing
firms are making super normal profits, it will attract some
of the new firms in the industry. The entry of new firms
will results into over production which will have a
depressing effect on price. Hence, all the firms in the
long run will get normal profits.
 In Figure-4, P is the point at which AR curve touches
the average cost curve (LAC) as a tangent. P is regarded
as the equilibrium point at which the price level is MP
and output is OM.
In the present case average cost is equal to average
revenue that is MP. Therefore, in long run, the profit is
normal. In the short run, equilibrium is attained when
marginal revenue is equal to marginal cost. However, in
the long run, both the conditions (MR=MC and AR=AC)
must hold to attain equilibrium.

Oligopoly:
The term ‘oligopoly’ is coined from two Greek words
‘Oligoi’ meaning ‘a few’ and ‘pollein’ means ‘to sell’. It
occurs when an industry is made up of a few firms
producing either an identical product or differentiated
product. In simple words, “Oligopoly is a situation in
which there are so few sellers that each of them is
conscious of the results upon the price of the supply
which he individually places upon the market’. The
number of sellers is greater than one, yet not big enough
to render negligible the influence of any one upon the
market price.
 According to P.C. Dooley, “An oligopoly is a market
of only a few sellers, offering either homogeneous or
differentiated products. There are so few sellers that they
recognize their mutual dependence.”

Characteristics of Oligopoly:
1. Interdependence: The most important feature of
oligopoly is interdependence in decision - making. Since
there are a few firms, each firm closely watches the
activities of the other firm. Any change in price, output,
product, etc., by a firm will have a direct effect on the
fortune of its rivals. So an oligopolistic firm must
consider not only the market demand for its product, but
also the possible moves of other firms in the industry.
2. Group Behaviour: Firms may realise the importance
of mutual co-operation. Then they will have a tendency of
collusion. At the same time, the desire of each firm to
earn maximum profit may encourage competitive spirit.
Thus, co-operative and collusive trend as well as
competitive trend would prevail in an oligopolistic
market.
3. Price Rigidity: Another important feature of oligopoly
is price rigidity. Price is sticky or rigid at the prevailing
level due to the fear of reaction from the rival firms. If an
oligopolistic firm lowers its price, the price reduction will
be followed by the rival firms. As a result, the firm loses
its profit. Expecting the same kind of reaction, if the
oligopolistic firm raises the price, the rival firms will not
follow. This would result in losing customers. In both
ways the firm would face difficulties. Hence the price is
rigid.
4. Advertising: Under oligopoly a major policy change
on the part of a firm is likely to have immediate effects on
other firms in the industry. Therefore, the rival firms
remain all the time vigilant about the moves of the firm
which takes initiative and makes policy changes. Thus,
advertising is a powerful instrument in the hands of an
oligopolist. A firm under oligopoly can start an
aggressive advertising campaign with the intention of
capturing a large part of the market. Other firms in the
industry will obviously resist its defensive advertising.
Price and Output under Oligopoly is indeterminate.
There is no general theory which can explain pricing and
output decisions in all kinds of oligopoly situation. Thus,
it is said that price and output under oligopoly is
indeterminate. It is due to interdependence of other firms
and absence of well defined goods. However, the price of
commodity is determined by its demand and supply. In
monopoly and competition, firms make decisions and take
action without considering how these actions will affect
other firms and how, in turn, other firm’s reactions will
affect them. Thus they have definite demand (Revenue)
curve.
In case of Oligopoly, there is interdependence of the
firms. Hence the decisions of a firm will affect the other
firms which in turn will react in a way that affects the
initial firm, this causes uncertainty. Thus it is difficult to
take decisions of the demand curve of an oligopolist. We
cannot use the downward sloping curve as oligopolist is
not a monopolist. We cannot use a horizontal demand
curve because the oligopolist is not a perfect competitor.
We can simply make an assumption about the interaction
among the oligopolist there is a new model of price
determination under oligopoly.