Price and Output determination

Under various market structures

Importance of pricing

• Price affects profit position of the business.• How??• It influences cost and revenue• Total revenue realized by the firm depends on the price per

unit and the total units sold• The quantity sold changes with variations in price• Total cost depends on output produced.

Factors influencing pricing

• Demand for a commodity• Cost of production• Objectives of the firm• Competition• Govt. policy

Price and Output determination under perfect competition

• Features• Price is determined by the market forces: demand and supply• Equilibrium price• Effect of shift in equilibrium• Illustration• Change in price due to change in demand/supply

Role of time in pricingVery short period

• Supply is fixed• Demand plays a decisive role• Perishables

D

D

D

S

S

D2

D

D1

Q2

Q

Q1

P2

P

P1

QUANTITY

• So, in the very short period, demand decides price as supply is fixed.

• Market supply depends on nature of the product, seller’s anticipation of prices, availability of storage facilities and cost of production

Role of time in pricingShort period

• Supply of commodities is alterable• Commodities are durable and reproduceable• Sellers are not willing to sell below a minimum price• Hence Supply decides the price in the short period• Sellers are willing to sell the entire stock at a maximum price• Beyond the minimum price, demand has a decisive influence• Below the minimum price, demand doesn’t influence supply• 3 phases of supply curve• Demand plays a major role• Output cannot be increased beyond OM2

Short period

D1

D1

D

D

P2

P1

P

O M M1 M2

Long period equilibrium

Output

S

Q Q2

Q1

D

D1

D

D1S

S1

S1

M1 M2MO

Long period

• Price in the long period: normal price• Determined by demand and supply• Cost of production plays a decisive role(decides supply)• If the normal price remains above the cost of production,

profits will accrue. Hence production will increase…(how?)• If normal price is below cost of production , production will be

curtailed.• For a given output, normal price must be equal to cost of

production.

Equilibrium of the Firm

• Equilibrium is a condition which brings maximum profit.• MR=MC• Firms under perfect competition has no choice regarding the

price policy. It has no control over the price. Price is determined by demand and supply.

• Demand curve that the firm faces is perfectly elastic• It can sell any quantity at the existing price• Demand curve itself is the AR curve.• When all the units of the product are sold at the same price,

AR=price.• Since AR is neither rising nor falling, AR=MR• Firm arrives at equilibrium at a point ‘E ’, where MR=MC and

the equilibrium output is OM.

• At equilibrium production, OM, average cost is only FM and the average revenue is EM. Profit per unit of output is EF.

• Total profit earned by the firm is profit per unit multiplied by the number of units sold which is equal to PEFH.

• In short run, all firms will be earning supernormal profits.• Industry is not in equilibrium as entry of firms continue.• In the long run, firms will earn only normal profits.• In the long run, P=MC=MR=AR. Profits of the firm will be

normal. Now the industry will be in equilibrium.

Short run equilibriumy

MC AC

AR/MR/PRICE

P

H

O MX

OUTPUT

E

F

Long run equilibriumy

LMC LAC

AR=MR=PRICE

P

O MX

OUTPUT

E

Price and Output determination under Monopoly

• Monopoly producer is a Price maker• Sufficient control over price or output in order to earn

maximum net monopoly revenue .• Monopolist firm will have a sloping down demand curve and

his average revenue will dwindle as the output is increased.• MR curve will be falling , steeper and at a lower level than AR

curve. Since AR is falling, the extra units sold will fetch lesser and lesser revenue in the market.

• Principle of profit maximization, MC=MR.• Monopolist will be in equilibrium, where he gets the

maximum profit.• He will go on producing until every unit sold adds up revenue

than cost. He will stop at the point beyond which additional units cost him more than the revenue realized.

MONOPOLY EQUILIBRIUM AND PRICE FIXATION

Y

MR

M

R

ACPROFIT

O OUTPUT

P

E

X

S

AR

Q

MC

• The monopolist comes to equilibrium at ‘E’ where MR=MC and produces OM units of the commodity at price OP.

• At this price and output, the monopolist realizes the maximum profit shown by the rectangle PQRS.

• Upto OM output, the MR is greater than MC and beyond that, MR is less than MC. Hence equilibrium output is OM.

• The output OM can be sold in the market at a price OP according to the demand curve (AR curve).

• Profit average is QR and total profit is PQRS(average profit*output)

• The equilibrium for the short period is also same for the long period under monopoly, as there will not be any competitor entering the field.

Price and Output determination under Monopolistic competition

• Product differentiation is the fundamental feature.• Hence there is no unique price.• Each firm enjoys a monopoly position for its product.• Demand for the product will be highly elastic, not perfectly

elastic.• Each firm is faced with a downward sloping demand curve.• Price and output determination under monopolistic

competition is governed by the cost and revenue curves of the firm.

• Cost curves are governed by laws of production.• AR curve(demand) of the firm will be sloping down.

Equilibrium of the individual firm

• The monopolistic competitive firm will come to equilibrium when MR=MC.

• Short period marginal cost and average cost curves SMC and SAC.

• The sloping down average revenue and marginal revenue curves are AR and MR.

• Equilibrium point is ‘E’ where MR=MC.• The equilibrium output is OM and the price is fixed at OP. • The difference between AC and AR is RQ, output is OM, so the

supernormal profit of the firm is PQRS.• The firm, by producing OM units and selling at a price of OP

per unit realizes the maximum profit in the short run.

EQUILIBRIUM OF INDIVIDUAL FIRM UNDER MONOPOLISTIC COMPETITION IN THE SHORT PERIOD

Y

MR

M

R

SACPROFIT

OOUTPUT

P

E

X

S

AR

Q

SMC

• The different firms in monopolistic competition may be making either abnormal profits or losses in the short period depending on their cost and revenue curves.

• Price of commodity of different firms will be different.• Based on consumer preference and cost of production , each

firm will be fixing its price which may be different from the price of other firms.

• Established firms will be making abnormal profits in the short period.

• Newly started firms may have to fix the price at low level to establish themselves. The profit may not be very high.

• Abnormal profits earned in a short period will attract newcomers to the group. Newcomers will fix lower prices than the prices charged by existing firms. This will compel the existing firms to reduce prices. Prices will fall.

• AR curve will shift to a lower position.• AC curve will shift to a higher position.• Distance between AR curve and AC curve will be narrowed

down and the abnormal profits will be removed.• Ultimately the firms will earn only normal profits.

GROUP EQUILIBRIUM IN THE LONG RUN UNDER MONOPOLISTIC COMPETITION

Y

LPMR

M

LPAC

OOUTPUT

P

E

X

LPAR

K

LPMC

Price and Output determination under Oligopoly• Price rigidity under oligopoly is explained by the kinky

demand curve.• Kinked demand model represents a condition in which the

firm has no incentive either to increase the price or to decrease the price , but to keep the price rigid at a particular level.

• The firm believes that the rival firm does not follow suit if it increases the price . But if it cuts down the price, the rival firms will follow suit. Only in the event of any drastic changes in demand and cost conditions, the firm could think of changing the price.

• Under such a condition, the demand curve of the firm] as anticipated by the firm would be kinked(Kink at the present price).

KINKED DEMAND CURVE IN OLIGOPOLY

Y

MR

N MR1

K

B

P

O OUTPUT

D

L

X