UNIT 4

Market Structure and Pricing: Classification of Markets, Competitions and its features; Price
Output determination in Perfect Competition, Monopoly, Monopolistic Competition and
Oligopoly. Pricing Methods and Strategies. Profit Management: Nature, Scope, and Theories of
Profit including Modern Theory Measurement Policies, Cost volume Profit Analysis.

Introduction:
The number of firms and the level of product differentiation are useful parameters for
classifying various market structures. The level of competition also gets influenced by product
and production related factors, potential competitors, number of buyers and their behavior and
the governmental policies. We are now ready to analyze the various market forms in greater
detail. That will be attempted in the subsequent units in this block.
Usually, Market means a place where buyer and seller meets together in order to carry on
transactions of goods and services.
But in Economics, it may be a place, perhaps may not be. In Economics, market can exist even
without direct contact of buyer and seller. This fact can be explained with the help of the
following statement.
"Market refers to arrangement, whereby buyers and sellers come in contact with each other
directly or indirectly, to buy or sell goods."
Thus, above statement indicates that face to face contact of buyer and seller is not necessary
for market. E.g. in stock or share market, buyer and seller can carry on their transactions
through internet. So internet, here forms an arrangement and such arrangement also is
included in the market.

Markets and competition

While all of us often use the word-'Market, we do not realize that very few, markets possess a
well defined place in a geographical area or have a postal address. The Bombay, Stock
Exchange is one such market with a building and an area earmarked for transacting shares.
The central phenomenon in the functioning of any market is competition. Competitive behavior
is molded by the market structure of the product under consideration. It is therefore necessary
to have a thorough understanding of this concept.

Market structure
In economics, market structure is the number of firms producing identical products which are
homogeneous. The types of market structures include the following:
Monopolistic competition, also called competitive market, where there is a large number of
firms, each having a small proportion of the market share and slightly differentiated products.
Oligopoly, in which a market is run by a small number of firms that together control the majority
of the market share.
Duopoly, a special case of an oligopoly with two firms.
Monophony, when there is only one buyer in a market.
Oligopoly, a market where many sellers can be present but meet only a few buyers.
Monopoly, where there is only one provider of a product or service.
Natural monopoly, a monopoly in which economies of scale cause efficiency to increase
continuously with the size of the firm. A firm is a natural monopoly if it is able to serve the entire
market demand at a lower cost than any combination of two or more smaller, more specialized
firms.
Perfect competition, a theoretical market structure that features no barriers to entry, an
unlimited number of producers and consumers, and a perfectly elastic demand curve.
The imperfectly competitive structure is quite identical to the realistic market conditions where
some monopolistic competitors, monopolists, oligopolists, and duopolists exist and dominate
the market conditions. The elements of Market Structure include the number and size
distribution of firms, entry conditions, and the extent of differentiation.
These somewhat abstract concerns tend to determine some but not all details of a specific
concrete market system where buyers and sellers actually meet and commit to trade.
Competition is useful because it reveals actual customer demand and induces the seller
(operator) to provide service quality levels and price levels that buyers (customers) want,
typically subject to the sellers financial need to cover its costs. In other words, competition can
align the sellers interests with the buyers interests and can cause the seller to reveal his true
costs and other private information.
In the absence of perfect competition, three basic approaches can be adopted to deal with
problems related to the control of market power and an asymmetry between the government
and the operator with respect to objectives and information: (a) subjecting the operator to
competitive pressures, (b) gathering information on the operator and the market, and (c)
applying incentive regulation.

Quick Reference to Basic Market Structures

Market Structure

Seller Entry Barriers

Seller Number

Buyer Entry Barriers

Buyer
Number

Perfect Competition

No

Many

No

Many

Monopolistic
competition

No

Many

No

Many

Oligopoly

Yes

Few

No

Many

Oligopsony

No

Many

Yes

Few

Monopoly

Yes

One

No

Many

Monopsony

No

Many

Yes

One

Market Structure Example

Market structure can be said to be the classification or composition of the different types of
market as described from their unique characteristics of how they choose to allocate prices of
commodity in the market. The different types of market structure can be grouped majorly into
two main categories the perfect and the imperfect market. Under the perfect market structure
we have the perfect competitive market. Under the imperfect market we have the monopoly,
oligopoly, monopolistic competition and other special categories based on the number of
buyers. There are different examples of the different types of market structure based on the
special characteristics possessed by each type of market structure.
An example of monopoly market structure is when there is one supplier firm in the market that
dictates the prices of a specific commodity. The firms in the market will sell highly differentiable
products. Examples are two types of firm in the market that all sell ladies oil. Firm a sell ladies
oil for skin care and the other firm b sells ladies oil that is used for hair coloring. The two
products might seem to be the same but there is a great differentiation according to their use.

The two products are therefore not close substitute and the firm that sell this oil are said not to
be in competition. There are very high levels of barrier to entry under the monopoly type of
market. The two types of firm A and B will do anything to keep other firms from entering in the
ladies oil supply market.
The other example of market structure as defined by its characteristics is the perfect
competition. The firms that operate in this market are very many and will sell closely related
products. The consumers will be able to differentiate the different products and their supplier
hence it is hard to overcharge consumers. An example is two shops that sell fast food in any
town. Their number in any big city is large enough to fit the characteristics of a perfect
competitive market. If we assume the fast food shops sell beverages like tea and coffee then
the products will be the same or homogenous in all the fast food shops. Therefore when one
fast food shop increases its tea or coffee prices it will lose its customers to the other fast food
shop. The fast food shops will therefore increase their profit by increasing their sales. If the fast
food shops want to increase its sales it will have to lower the prices of that commodity in the
market.
Classification or Types of Market - Chart
The classification or types of market are depicted below.

On the basis of Place, market is classified into:

 Local Market or Regional Market.

National Market or Countrywide Market.
International Market or Global Market.
On the basis of Time, market is classified into:
Very Short Period Market.
Short Period Market.
Long Period Market.
Very Long Period Market.
On the basis of Competition, market is classified into:
Perfectly competitive market structure.
Imperfectly competitive market structure.
Both these market structure widely differ from each other in respect of their features, price etc.
Under imperfect competition, there are different forms of markets like monopoly, duopoly,
oligopoly and monopolistic competition.

Pricing Introduction
Pricing is an important, if not the most important function of all enterprises. Since every
enterprise is engaged in the production of some goods or/and service. Incurring some
expenditure, it must set a price for the same to sell it in the market. It is only in extreme cases
that the firm has no say in pricing its product; because there is severe or rather perfect
competition in the market of the good happens to be of such public significance that its price is
decided by the government. In an overwhelmingly large number of cases, the individual
producer plays the role in pricing its product.
It is said that if a firm were good in setting its product price it would certainly flourish in the
market. This is because the price is such a parameter that it exerts a direct influence on the
products demand as well as on its supply, leading to firms turnover (sales) and profit. Every
manager endeavors to find the price, which would best meet with his firms objective. If the
price is set too high the seller may not find enough customers to buy his product. On the other
hand, if the price is set too low the seller may not be able to recover his costs. There is a need
for the right price further, since demand and supply conditions are variable over time what is a
right price today may not be so tomorrow hence, pricing decision must be reviewed and
reformulated from time to time.

Price

Price denotes the exchange value of a unit of good expressed in terms of money. Thus the
current price of a maruti car around Rs. 2,00,000, the price of a hair cut is Rs. 25 the price of a
economics book is Rs. 150 and so on. Nevertheless, if one gives a little, if one gives a little
thought to this subject, one would realize that there is nothing like a unique price for any good.
Instead, there are multiple prices.

Price concepts
Price of a well-defined product varies over the types of the buyers, place it is received, credit
sale or cash sale, time taken between final production and sale, etc.
It should be obvious to the readers, that the price difference on account of the above four
factors are more significant. The multiple prices is more serious in the case of items like cars
refrigerators, coal, furniture and bricks and is of little significance for items like shaving blade,
soaps, tooth pastes, creams and stationeries. Differences in various prices of any good are due
to differences in transport cost, storage cost accessories, interest cost, intermediaries profits
etc. Once can still conceive of a basic price, which would be exclusive of all these items of cost
and then rationalize other prices by adding the cost of special items attached to the particular
transaction, in what follows we shall explain the determination of this basis price alone and thus
resolve the problem of multiple prices.

Price determinants Demand and supply

The price of a product is determined by the demand for and supply of that product. According to
Marshall the role of these two determinants is like that of a pair of scissors in cutting cloth. It is
possible that at times, while one pair is held fixed, the other is moving to cut the cloth. Similarly,
it is conceivable that there could be situations under which either demand or supply is playing a
passive role, and the other, which is active, alone appear to be determining the price. However,
just as one pair of scissors alone can never cut a cloth, demand or supply alone is insufficient
to determine the price.

Perfect Competition and Its Significance

Perfect Competition is a market structure where there is a perfect degree of competition and
single price prevails.
The concept of Perfect Competition was introduced by Dr. Alfred Marshall
In the prefect market condition no individual firm or seller is able to influence the prices of
commodity. The price is determined by the forces of demand and supply of the industry as a

whole and the individual firms has to accept the prices set by the industry and try to adjust its
output to the ruling market prices so that the average revenue is equal to the marginal revenue.
In the perfect competitive market a firms marginal revenue is equal to the prices. Since the
prices does not change irrespective of the output solved by the firm. When the prices of a
commodity equal to the marginal revenue the demand curve and the marginal revenue are the
same. From the characteristics of the firm in a perfect competitive market we see that the
demand curves will be perfectly elastic.

Characteristics of a Perfect Competition:

There is free entry and exit for different firms operating in this market. The only
hindrances to entry are firms related constraints like costs and lack of raw materials.
The goods sold in this market are homogenous. Homogenous means that the products
are almost identical and the consumer does not prefer one product to the other.
The perfect competition market has also a very large number of buyers and sellers.
This way there is no individual firm in the market that can influence the prices of goods and
services.
The individual firms are price takers and have to accept the prices set by the laws of
demand and supply.
In a perfectly competition market there is no information asymmetry and Perfect
information is available to the buyers and sellers.

Main Features of Perfect Competition

The following are the characteristics or main features of perfect competition :1. Many Sellers
In this market, there are many sellers who form total of market supply. Individually, seller is a
firm and collectively, it is an industry. In perfect competition, price of commodity is decided by
market forces of demand and supply. i.e. by buyers and sellers collectively. Here, no individual
seller is in a position to change the price by controlling supply. Because individual seller's
individual supply is a very small part of total supply. So, if that seller alone raises the price, his
product will become costlier than other and automatically, he will be out of market. Hence, that
seller has to accept the price which is decided by market forces of demand and supply. This
ensures single price in the market and in this way, seller becomes price taker and not price
maker.
2. Many Buyers

Individual buyer cannot control the price by changing or controlling the demand. Because
individual buyer's individual demand is a very small part of total demand or market demand.
Every buyer has to accept the price decided by market forces of demand and supply. In this
way, all buyers are price takers and not price makers. This also ensures existence of single
price in market.
3. Homogenous Product
In this case, all sellers produce homogeneous i.e. perfectly identical products. All products are
perfectly same in terms of size, shape, taste, color, ingredients, quality, trademarks etc. This
ensures the existence of single price in the market.
4. Zero Advertisement Cost
Since all products are identical in features like quality, taste, design etc., there is no scope for
product differentiation. So advertisement cost is nil.
5. Free Entry and Exit
There are no restrictions on entry and exit of firms. This feature ensures existence of normal
profit in perfect competition. When profit is more, new firms enter the market and this leads to
competition. Entry of new firms competing with each other results into increase in supply and
fall in price. So, this reduces profit from abnormal to normal level.
When profit is low (below normal level), some firms may exit the market. This leads to fall in
supply. So remaining firms raise their prices and their profits go up. So again this ensures
normal level of profit.
6. Perfect Knowledge
On the front of both, buyers and sellers, perfect knowledge regarding market and pricing
conditions is expected. So, no buyer will pay price higher than market price and no seller will
charge lower price than market price.
7. Perfect Mobility of Factors
This feature is essential to keep supply at par with demand. If all factors are easily mobile
(moveable) from one line of production to another, then it becomes easy to adjust supply as per
demand.
Whenever demand is more additional factors should be moved into industry to increase supply
and vice versa. In this way, with the help of stable demand and supply, we can maintain single
price in the Market.
8. No Government Intervention

Since market has been controlled by the forces of demand and supply, there is no government
intervention in the form of taxes, subsidies, licensing policy, control over the supply of raw
materials, etc.
9. No Transport Cost
It is assumed that buyers and sellers are close to market, so there is no transport cost. This
ensures existence of single price in market.

Main Assumptions of Perfect Competition

Each firm produces only a small percentage of total market output. It therefore exercises no
control over the market price. For example it cannot restrict output in the hope of forcing up the
existing market price. Market supply is the sum of the outputs of each of the firms in the
industry
No individual buyer has any control over the market price - there is no Monopsony power. The
market demand curve is the sum of each individual consumers demand curve essentially
buyers are in the background, exerting no influence at all on market price
Buyers and sellers must regard the market price as beyond their control
There is perfect freedom of entry and exit from the industry. Firms face no sunk costs that
might impede movement in and out of the market. This important assumption ensures all firms
make normal profits in the long run
Firms in the market produce homogeneous products that are perfect substitutes for each
other. This leads to each firms being price takers and facing a perfectly elastic demand curve
for their product
Perfect knowledge consumers have perfect information about prices and products.
There are no externalities which lie outside the market

Imperfect competition
An imperfect competitive market is a type of market where the conditions of the perfect
competitive markets are not satisfied. Perfect competitive makes indicate that no one firm in the
market can influence market prices, there are no barriers to entry and there is free exit from this
market, suppliers offer homogenous goods and there exist information asymmetry that
encourages price and costs asymmetry. The imperfect market will have characteristics that are

opposite of the perfect competition market. The types of imperfect competition are
the monopoly (single seller), monopolistic competition (many sellers manufacturing highly
differentiated goods), oligopoly (few sellers), duopoly, monopsony (single buyer) and
oligopsony (few buyers).Imperfect might also be caused by other characteristics other than the
firms behavior. An example is imperfect competition due to different time lag in the market.

Characteristics of monopolistic competition

Under these types of market structure there are many buyers and sellers hence no
individual buyer or seller can influence the market to his/her own favor.
The products sold in this market are highly differentiable and consumers will choose to
buy any product according to their taste and preference, brand loyalty, level of
advertisement and the purchasing power of consumers.
There is a relatively small freedom for firms entry and exit from this market.
A firm has the capability of forming a tiny monopoly because of product differentiation in
the market. This will happen if the firms have created brands for their products, or have
superior advertising policy.
Some firms will have a significant level of influence on the prices they charge for their
goods and services.

Characteristics of oligopoly market structure

The market structure is composed of few but large numbers of firms.

A huge number of the firms in this market structure will make up the industry
The products sold in this market are highly differentiable due to branding. Therefore
although the products seem to be homogenous branding makes them very unique.
There exists a high level of barrier to entry by the already established players.
There is no price competition.
The product prices are very stable and do not fluctuate constantly this is shown by the
kinked demand curve.
There is potential collusion by firms in this market either to set prices or drive some
firms out of the market.
The firm in this market has the potential to earn abnormal profits.
There is high degree of interdependence between the firms in the market

The level of oligopoly is a measured quantity .the concentration ratio will be used to calculate
the market share accounted for by each firm operating in the industry. A special type of the
oligopoly market structure is the duopoly. In this type of market there are only two large firma
that dominate the market. There will be the price lead between the two market who will dictates
the market prices will the other firm will be reduced to a price follower. The two firms will also
create restriction for firm that want to join the market hence creating a free market for
themselves to earn abnormal profits.

Buying and Selling Imperfection

The four market structures that are technically included in the category of imperfect competition
are monopolistic competition, oligopoly, monopsonistic competition, and oligopsony. The first
two are the most noted participants. The second two are often overlooked, but justifiably
included.
Monopolistic Competition: This market structure is characterized by a large number
of relatively small competitors, each with a modest degree of market control on the
supply side. A key feature of monopolistic competition is product differentiation. The
output of each producer is a close but not identical substitute to that of every other firm,
which helps satisfy diverse consumer wants and needs.
Oligopoly: This market structure is characterized by a small number of relatively large
competitors, each with substantial market control. Oligopoly sellers exhibit
interdependent decision making which can lead to intense competition among the few
and the motivation to cooperate through mergers and collusion.
Monopsonistic Competition: This market structure is characterized by a large number
of relatively small competitors, each with a modest degree of market control on the
demand side. Monopsonistic competition represents the demand-side counterpart to
monopolistic competition on the supply side. A key feature of monopsonistic competition
is also product differentiation as each buyer seeks to purchase a slightly different
product.
Oligopsony: This market structure is characterized by a small number of relatively
large competitors, each with substantial market control on the buying side. Oligopsony
represents the demand-side counterpart to oligopoly on the supply side. Oligopsony
buyers exhibit interdependent decision making which can lead to intense competition
and the motivation to cooperate.

Price and output determination under perfect competition:

Meaning of perfect competition
Perfect competition is wider concept than pure competition. Pure competition is said to be exist
when following conditions are fulfilled:

Large number of buyers and sellers: It is assumed that in pure competition market there
should be a large number of buyers and sellers. If it is so, the output of any single firm is only a
small proportion of the total output and each consumer buys small part of the total. Hence no
individual purchaser can influence the market price by varying his own demand and no single
firm is in the position to affect the market price by varying its own output.
Homogenous product: The commodity produced by all firms should be identical in pure
competition. Thus the commodity produced by different firms are perfect substitutes. Hence the
buyers are indifferent as to the firm from which they purchase.
Perfect competition is wider term than pure competition. Besides the two conditions of pure
competition mentioned above several other conditions must be fulfilled to make it a perfect
competition.
Free entry and exit: There should be no restrictions legal or other on the firms to entry and
exit the industry. In this situation all the firms can earn only normal profit. Because if the profit is
more than the normal, new firms will enter and extra profit will be reduced and if the profit is
less than normal, some firms will leave the industry raising the profits for the remaining firms.
Hence the firms can earn normal profit in long run.
Perfect knowledge: Another assumption of perfect competition is that the purchasers and
sellers should have perfect knowledge about costs, price and quality. Due to this fact neither
the seller can charge more than the ruling price nor the purchaser are willing to pay more.
Free mobility of the resources: The mobility of resources is essential to the firms in order to
adjust their supply to demand. If the demand exceeds supply additional factors of production
move into the industry and vice versa.

Distinction between Normal Price and Market Price

Market Price
1. It is a very short period price.
2. Supply curve is vertical.
3. It is influenced more by demand factors.
4. All goods have a market price.
5. Market price may be higher or lower than the cost of production.
6. A firm with a market price can earn super normal profits or incur losses.
7. There will be a temporary equilibrium between demand and supply.
8. Market price fluctuates frequently (even daily).

Normal Price
1. It is a long period price.
2. Supply curve is horizontal.
3. It is influenced more by supply factors and the cost of production.
4. Only reproducible goods alone have a normal price.
5. Normal price is equal to the cost of production.
6. A firm with a normal price can earn only normal profits.
7. There will be a permanent equilibrium between demand and supply.
8. Normal price is relatively stable.

Pure competition and perfect competition

The term perfect competition is used in a wider sense. Pure competition has only limited
assumptions. When the assumptions, that large number of buyers and sellers, homogeneous
products, free entry and exit are satisfied, there exists pure competition. Competition becomes
perfect only when all the assumptions (features) are satisfied. Generally pure competition can
be seen in agricultural products.

Pricing under perfect competition

The price or value of a commodity under perfect competition is determined by the demand for
and the supply of that commodity.
Under perfect competition there is large number of sellers trading in a homogeneous product.
Each firm supplies only very small portion of the market demand. No single buyer or seller is
powerful enough to influence the price. The demand of all consumers and the supply of all
firms together determine the price. The individual seller is only a price taker and not a price
maker. An individual firm has no price policy of its own. Thus, the main problem of a firm in a
perfectly competitive market is not to determine the price of its product but to adjust its output
to the given price, So that the profit is maximum. Marshall however gives great importance to
the time element for the determination of price. He divided the time periods on the basis of
supply and ignored the forces of demand. He classified the time into four periods to determine
the price as follows.
1.
2.
3.
4.

Very short period or Market period

Short period
Long period
Very long period or secular period

Very short period: It is the period in which the supply is more or less fixed because the time
available to the firm to adjust the supply of the commodity to its changed demand is extremely
short; say a single day or a few days. The price determined in this period is known as Market
Price.
Short Period: In this period, the time available to firms to adjust the supply of the commodity to
its changed demand is, of course, greater than that in the market period. In this period altering
the variable factors like raw materials, labor, etc can change supply. During this period new
firms cannot enter into the industry.
Long period: In this period, a sufficiently long time is available to the firms to adjust the supply
of the commodity fully to the changed demand. In this period not only variable factors of
production but also fixed factors of production can be changed. In this period new firms can
also enter the industry. The price determined in this period is known as long run normal price.
Secular Period: In this period, a very long time is available to adjust the supply fully to change
in demand. This is very long period consisting of a number of decades. As the period is very
long it is difficult to lay down principles determining the price.

Price Determination in the market period

The price determined in very short period is known as Market price. Market price is determined
by the equilibrium between demand and supply in a market period. The nature of the
commodity determines the nature of supply curve in a market period. Under this period goods
are classified in to (a) Perishable goods and (b) Non-perishable goods.
Perishable Goods: In the very short period, the supply of perishable goods like fish, milk
vegetables etc. cannot be increased. And it cannot be decreased also. As a result the supply
curve under very short period will be parallel to the Y-axis or Vertical to X-axis. Supply is
perfectly inelastic. The price determination of perishable goods in very short period may be
shown with the help of the following fig. 6.5

In this figure quantity is represented along X-axis and price is represented along Y-axis. MS is
the very short period supply curve of perishable goods. DD is demand curve. It intersects
supply curve at E. The price is OP. The quantity exchanged is OM. D1 D1 represents increased
demand. This curve cuts the supply curve at E1. Even at the new equilibrium, supply is OM
only. But price increases to OP1. So, when demand increases, the price will increase but not
the supply. If demand decreases new demand curve will be D2 D2. This curve cuts the supply
curve at E2. Even at this new equilibrium, the supply is OM only. But price falls to OP2. Hence
in very short period, given the supply, it is the change in demand that influences price. The
price determined in a very short period is called Market Price.
Non-perishable goods: In the very short period, the supply of non-perishable goods like cloth,
pen, watches etc. cannot be increased. But if price falls, preserving some stock can decrease
their supply. If price falls too much, the whole stock will be held back from the market and
carried over to the next market period. The price below, which the seller will refuse to sell, is
called Reserve Price.
The Price determination of non-perishable goods in very short period may be shown with the
help of the following fig 6.6.

In the given figure quantity is shown on X-axis and the price on Y-axis. SES is the supply curve.
It slopes upward up to the point E. From E it becomes a vertical straight line. This is because
the quantity existing with sellers is OM, the maximum amount they have is thus OM. Till OM
quantity (i.e., point E) the supply curve sloped upward. At the point S, nothing is offered for
sale.
It means that the seller with hold the entire stock if the price is OS. OS is thus the reserve price.
As the price rises, supply increases up to point E. At OP price (Point E), the entire stock is
offered for sale.
Suppose demand increases, the DD curve shift upward. It becomes D1D1 price raises to OP1.
If demand decreases, the demand curve becomes D2D2. It intersects the supply curve at E3.
The price will fall to OP3. We find that at OS price, supply is zero. It is the reserve price.

Price Determination in the short period

Short period is a period in which supply can be increased by altering the variable factors. In this
period fixed costs will remain constant. The supply is increased when price rises and vice
versa. So the supply curve slopes upwards from left to right.
The price in short period may be explained with the help of a diagram.

In the given diagram MPS is the market period supply curve. DD is the initial demand curve. It
intersects MPS curve at E. The price is OP and output OM. Suppose demand increases, the

demand curve shifts upwards and becomes D1D1. In the very short period, supply remains
fixed on OM. The new demand curve D1D1 intersects MPS at E1. The price will rise to OP1.
This is what happen in the very short-period.
As the price rises from OP to OP1, firms expand output. As firms can vary some factors but not
all, the law of variable proportions operates. This results in new short-run supply curve SPS. It
interests D1 D1 curve at E4. The price will fall from OP1 to OP4.
It the demand decreases, DD curve shifts downward and becomes D2D2. It interests MPS
curve at E2. The price will fall to OP2. This is what happens in market period. In the short
period, the supply curve is SPS. D2D2 curve interests SPS curve at E3. The short period price
is higher than the market period price.

Price determination in the long period (Normal Price)

Market price may fluctuate due to a sudden change either on the supply side or on the demand
side. A big arrival of milk may decrease the price of that production in the market period.
Similarly, a sudden cold wave may raise the price of woolen garments. This type of temporary
change in supply and demand may cause changes in market price. In the absence of such
disturbing causes, the price tends to come back to a certain level. Marshall called this level is
normal price level. In the words of Marshall Normal value (Price) of a commodity is that which
economics force would tend to bring about in the long period.
In order to describe how long run normal price is determined, it is useful to refer to the market
period as short period also. The market period is so short that no adjustment in the output can
be made. Here cost of production has no influence on price. A short period is sufficient only to
allow the firms to make only limited output adjustment. In the long period, supply conditions are
fully sufficient to meet the changes in demand. In the long period, all factors are alterable and
the new firms may enter into or old firms leave the; industry.
In the long period all costs are variable costs. So supply will be increased only when price is
equal to average cost.
Hence, in long period normal price will be equal to minimum average cost of the industry. Will
this price be more or less than the short period normal price? The answer depends on the
stage of returns to which the industry is subject. There are three stages of return on the stage
of returns to which the industry is subject. There are three stages of returns.
1. Increasing returns or decreasing costs.
2. Constant Returns or Constant costs.
3. Diminishing returns or increasing costs.

1. Determination of long period normal price in decreasing cost industry:

At this stage, average cost falls due to an increase in the output. So, the supply curve
at this stage will slope downwards from left to right. The long period Normal price
determination at this stage can be explained with the help of a diagram.

In the diagram, MPS represents market period supply curve. DD is demand curve. DD
cuts LPS, SPS and MPS at point E. At point E the supply is OM and the price is OP. If
demand increases from DD to D1D1 market price increases to OP1. In the short period it
is OP2. In the long period supply increases considerably to OM3. So price has fallen to
OP3, which is less than the price of market period.
2. Determination of Long Period Normal Price in Constant Cost Industry:
In this case average cost does not change even though the output
increases. Hence long period supply curve is horizontal to X-axis. The determination of
long period normal price can be explained with the help of the diagram. In the fig. 6.9,
LPS is horizontal to X-axis. MPS represents market period supply curve, and SPS
represents short period supply curve. At point E the output is OM and price is OP. If
demand increases from DD to D1D1 market price increases to OP1. In the short period,
supply increases and hence the price will be OP2. In the long run supply is adjusted fully

to meet increased demand. The price remains constant at OP because costs are
constant at OP and market is perfect market.

3. Determination of long period normal price in increase cost industry:

If the industry is subject to increasing costs (diminishing returns) the supply curve slopes
upwards from left to right like an ordinary supply curve. The determination of long period
normal price in increasing cost industry can be explained with the help of the following diagram.
In the diagram LPS represents long period supply curve. The industry is subject to diminishing
return or increasing costs. So, LPS slopes upwards from left to right. SPS is short period supply
curve and MPS is market period supply curve. DD is demand curve. It cuts all the supply
curves at E. Here the price is OP and output is OM. If demand increases from DD to D1D1 in
the market period, supply will not change but the price increases to OP1. In the short period,
price increase but the price increases to OP1. In the short period, price increases to OP2 as
the supply increased from OM to OM2. In the long period supply increases to OM3 and price
increases to OP3. But this increase in price is less than the price increase in a market period or
short period.

Monopoly
This is a type of market structure where there is one seller that dictates the market. The monopoly
will influence the prices it charges for its output. This way the firms demand curve is equal to the
industry demand curve. Monopoly market structure can be categorized using the level of market
share that the firm has in the market. Under pure monopoly the firm has a hundred percent market
share in that industry. In an actual monopoly the firm will have market share that exceeds twenty
five percent. Natural monopoly will exist when there are high fixed costs in producing goods in that
industry. Examples of natural monopoly will exist in the oil industry, electricity generation and
transmission, telecommunication and rail.

Characteristics of a monopoly market

There are high barriers to entry. The barriers can be natural such as those ones caused by
the economies of scale or can be imposed by the firms in the market to prevent more firms
joining this market.
The firms in this market are both the price setters and the price taker. The firm therefore
has control over the prices of output and the quantities of output to be supplied.
Firms in this market structure have abnormal profits both in the long run and in the short
run.
Price discrimination is possible under this type of market structure. Price discrimination is
the act of charging different prices for one commodity in different market segment.
Consumers has limited choice on the types of goods to buy and how much to pay for this
goods. This is because the monopoly is the sole distributor and producer.
The prices if commodity in this market is in the excesses of the marginal costs.

Advantages of a monopoly structure

It is appropriate is the monopoly is caused by the natural factors (economies of scale).

Monopoly encourages research and development to take place. The abnormal profits
achieved are used to fund research and development.
Monopoly encourages innovation because firm will want to join this market to also start
enjoying the abnormal profits.
It makes it possible for production of some sensitive goods such goods are military
equipments, supply of government services.
The economies of scale achieved may in the long run benefit the consumers in terms of
superior products.

Disadvantages of monopoly

The consumers are highly exploited by the monopoly charging high prices for their goods.

The consumers have limited choices due to the limited choices given by the monopoly.

If not properly managed the monopoly might lead to inefficiency. The inefficiency can be in
the use of inputs or lack of control on the costs of production.
Price determination under the monopoly is determined at the level where the marginal revenue is
equal to the marginal cost. When the marginal revenue is greater than the marginal costs the firm
will tend to produce more and more units resulting into an increase in supply which will bring the
prices down.

Natural Monopoly
This occurs when the economies of large scale production, distribution, marketing etc. kick
in.
It means that one single firm by producing at a very large scale can reduce its long term
cost of production lower than if there were more firms producing the same good.
Thus one single firm can service the whole market place by producing at a lower average
total cost.
Thus it is beneficial for the consumer because they can get the goods at a lower price.
Natural monopolies generally arise where the fixed costs or set up costs or infrastructural
costs are very large compared to the variable cost of producing one extra unit.
The best example is that of the electricity generating projects, which are very expensive to
construct.
The running of the transmission lines over miles of service area is also costly.
Thus they need huge initial investment, but once the expenditure has been done, it is quite
cheap to produce and transmit one extra unit of electricity.
In such a case, one single financially large company would be able to service the public
better than with competitors producing duplication of goods and services.

Monopoly example
Monopoly market structure has been defined as the ability of a single firm to influence a market
through its action. The demand curve for the firm that enjoys a market monopoly will slope
downwards from right to left. This is so because when the firm charges higher prices for it
commodity less will be demanded and when the monopoly charges low prices for its commodity
more will be demanded. If we assume that a monopoly is charging $ 150 for its product and was
selling 20 units of its output. Then if the firm wants to increase its total sales it must reduce its
prices. Monopolies are created by various reasons in the market. There are positive types of
monopoly and negative type of monopoly. Positive monopoly is caused by economies of scale,
firms efficiency and branding. Examples in the real world of positive monopoly are company that

has been able to outdo the others through branding and therefore ending up as the sole
producers in the market.
If there were three firms in a market namely firm A, firm B and firm C , all producing beverages and
each firm has different type of management policy. If firm A is more efficient in its management and
ends up creating a brand that takes up to 95% of the whole market and the others take only the
remaining five percent then there is a possibility that firm A will drive the other firms out of the
market hence forming a monopoly. The other positive type of monopoly exists when the
government wants to protect consumers from exploitation or for the provision of essentials goods
to its citizen. If the governments want to protect its citizens or maintain a certain living standards for
its citizens it will take the initiative of providing that service. The reason for this is that the
government do not have profits motive and will provide the goods even to the most non profitable
geographical region. The services are electricity, water, and transport services. If we assume that
the government gave firms the freedom to provide railway services to its citizens then transport by
means of railway services will be provided to the profitable market leaving out the poor without any
mode of transportation.
This way the monopoly in railway transport is beneficial to the citizen hence defined by economist
as positive monopoly. Another example of government monopoly is in the provision of state
security. The government cannot leave this sensitive sector to the hand of private companies who
are out to make profit. The private Companies will provide security to the rich and will not act to
provide just services to all. If it is the business of the security organs to manufacture weapons then
the nature of this activity cannot be left to competing firm. If competing firms rather than a
monopoly firm were given this tender they would aim at increasing sales without considering the
destination of these weapons.

The second type of monopoly is the negative monopoly. This is where one firm has superior and
unfair advantage over the other firms in the market. The unfair advantage or superiority can be
caused by cartels, control of natural resources by some company, and when the economy operates
under the capitalism structure.

Types of Monopoly
Monopoly may be classified into various types. The different types of monopolies are explained
below:
1. Legal Monopoly: If monopoly arises on account of legal support or as a matter of legal

2.

3.

4.

5.

6.
7.

8.

9.

privilege, it is called Legal Monopoly. Ex. Patent rights, special brands, trade means,
copyright etc.
Voluntary Monopoly: To get the advantages of monopoly some private firms come
together voluntarily to control the supply of a commodity. These are called voluntary
monopolies. Generally, these monopolies arise with industrial combinations. These
voluntary monopolies are of three kinds (a) cartel (b) trust (c) holding company. It may be
called artificial monopoly.
Government Monopoly: Sometimes the government will take the responsibility of
supplying a commodity and avoid private interference. Ex. Water, electricity. These
monopolies, created to satisfy social wants, are formed on social considerations. These are
also called Social Monopolies.
Private Monopoly: If the total supply of a good is produced by a single private person or
firm, it is called private monopoly. Hindustan Lever Ltd. Is having the monopoly power to
produce Lux Soap.
Limited Monopoly: if the monopolist is having limited power in fixing the price of his
product, it is called as Limited Monopoly. It may be due to the fear of distant substitutes or
government intervention or the entry of rivals firms.
Unlimited Monopoly: If the monopolist is having unlimited power in fixing the price of his
good or service, it is called unlimited monopoly. Ex. A doctor in a village.
Single Price Monopoly: When the monopolist charges same price for all units of his
product, it is called single price monopoly. Ex. Tata Company charges the same price to all
the Tata Indiaca Cars of the same model.
Discriminating Monopoly: When a Monopolist charges different prices to different
consumers for the same product, it is called discriminating monopoly. A doctor may take
Rs.20 from a rich man and only Rs.2 from a poor man for the same treatment.
Natural Monopoly: Sometimes monopoly may arise due to scarcity of natural resources.
Nature provides raw materials only in some places. The owner of the place will become
monopolist. For Ex. Diamond mine in South Africa.

Monopolistic competition
Perfect competition and pure monopoly are rate phenomena in the real world. Instead, almost
every market seems to exhibit characteristics of both perfect competition and monopoly. Hence in
the real world it is the state of imperfect competition lying between these two extreme limits that
work. Edward. H. Chamberlain developed the theory of monopolistic competition, which presents a
more realistic picture of the actual market structure and the nature of competition.

Characteristics of Monopolistic Competition

The important characteristics of monopolistic competition are:
1. Existence of Many firms: Industry consists of a large number of sellers, each one of
whom does not feel dependent upon others. Every firm acts independently without
bothering about the reactions of its rivals. The size is so large that an individual firm has
only a relatively small part in the total market, so that each firm has very limited control over
the price of the product. As the number is relatively large it is difficult for these firms to
determine its price- output policies without considering the possible reactions of the rival
forms. A monopolistically competitive firm follows an independent price policy.
2. Product Differentiation: Product differentiation means that products are different in some
ways, but not altogether so. The products are not identical but the same time they will not
be entirely different from each other. IT really means that there are various monopolist firms
competing with each other. An example of monopolistic competition and product
differentiation is the toothpaste produced by various firms. The product of each firm is
different from that of its rivals in one or more respects. Different toothpastes like Colgate,
Close-up, Forehans, Cibaca, etc., provide an example of monopolistic competition. These
products are relatively close substitute for each other but not perfect substitutes.
Consumers have definite preferences for the particular verities or brands of products
offered for sale by various sellers. Advertisement, packing, trademarks, brand names etc.
help differentiation of products even if they are physically identical.
3. Large Number of Buyers: There are large number buyers in the market. But the buyers
have their own brand preferences. So the sellers are able to exercise a certain degree of
monopoly over them. Each seller has to plan various incentive schemes to retain the
customers who patronize his products.
4. Free Entry and Exist of Firms: As in the perfect competition, in the monopolistic
competition too, there is freedom of entry and exit. That is, there is no barrier as found
under monopoly.
5. Selling costs: Since the products are close substitute much effort is needed to retain the
existing consumers and to create new demand. So each firm has to spend a lot on selling
cost, which includes cost on advertising and other sale promotion activities.

6. Imperfect Knowledge: Imperfect knowledge about the product leads to monopolistic

competition. If the buyers are fully aware of the quality of the product they cannot be
influenced much by advertisement or other sales promotion techniques. But in the business
world we can see that thought the quality of certain products is the same, effective
advertisement and sales promotion techniques make certain brands monopolistic. For
examples, effective dealer service backed by advertisement-helped popularization of some
brands through the quality of almost all the cement available in the market remains the
same.
7. The Group: Under perfect competition the term industry refers to all collection of firms
producing a homogenous product. But under monopolistic competition the products of
various firms are not identical through they are close substitutes. Prof. Chamberlin called
the collection of firms producing close substitute products as a group.

Price Output Determination under Monopolistic Competition

Since under monopolistic competition different firms produce different varieties of products,
different prices for them will be determined in the market depending upon the demand and cost
conditions. Each firm will set the price and output of its own product. Here also the profit will be
maximized when marginal revenue is equal to marginal cost.

Short-run equilibrium of the firm:

In the short-run the firm is in equilibrium when marginal Revenue = Marginal Cost. In Fig 6.15 AR is
the average revenue curve. NMR marginal revenue curve, SMC short-run marginal cost curve,
SAC short-run average cost curve, MR and SMC interest at point E where output in OM and price
MQ (i.e. OP). Thus the equilibrium output or the maximum profit output is OM and the price MQ or
OP. When the price (average revenue) is above average cost a firm will be making supernormal
profit. From the figure it can be seen that AR is above AC in the equilibrium point. As AR is above
AC, this firm is making abnormal profits in the short-run. The abnormal profit per unit is QR, i.e., the
difference between AR and AC at equilibrium point and the total supernormal profit is OR X OM.
This total abnormal profits is represented by the rectangle PQRS. As the demand curve here is
highly elastic, the excess price over marginal cost is rather low. But in monopoly the demand curve
is inelastic. So the gap between price and marginal cost will be rather large.

If the demand and cost conditions are less favorable the monopolistically competitive firm may
incur loss in the short-run fig 6.16 Illustrates this. A firm incurs loss when the price is less than the
average cost of production. MQ is the average cost and OS (i.e. MR) is the price per unit at
equilibrium output OM. QR is the loss per unit. The total loss at an output OM is OR X OM. The
rectangle PQRS represents the total loses in the short run.

Long Run Equilibrium of the Firm:

A monopolistically competitive firm will be long run equilibrium at the output level where marginal
cost equal to marginal revenue. Monopolistically competitive firm in the long run attains equilibrium
where MC=MR and AC=AR Fig 6.17 shows this trend.

Oligopoly
The term oligopoly is derived from two Greek words, oligos meaning a few, and pollen meaning to
sell. Oligopoly is the form of imperfect competition where there are a few firms in the market,
producing either a homogeneous product or producing products, which are close but not perfect
substitute of each other.

Characteristics of Oligopoly
The main features of oligopoly are:
1. Few Firms: There are only a few firms in the industry. Each firm contributes a sizeable
share of the total market. Any decision taken by one firm influence the actions of other firms
in the industry. The various firms in the industry compete with each other.
2. Interdependence: As there are only very few firms, any steps taken by one firm to increase
sales, by reducing price or by changing product design or by increasing advertisement
expenditure will naturally affect the sales of other firms in the industry. An immediate
retaliatory action can be anticipated from the other firms in the industry every time when
one firm takes such a decision. He has to take this into account when he takes decisions.
So the decisions of all the firms in the industry are interdependent.
3. Indeterminate Demand Curve: The interdependence of the firms makes their demand
curve indeterminate. When one firm reduces price other firms also will make a cut in their
prices. So he firm cannot be certain about the demand for its product. Thus the demand
curve facing an oligopolistic firm loses its definiteness and thus is indeterminate as it
constantly changes due to the reactions of the rival firms.
4. Advertising and selling costs: Advertising plays a greater role in the oligopoly market
when compared to other market systems. According to Prof. William J. Baumol it is only
oligopoly that advertising comes fully into its own. A huge expenditure on advertising and
sales promotion techniques is needed both to retain the present market share and to
increase it. So Baumol concludes under oligopoly, advertising can become a life-and-death
matter where a firm which fails to keep up with the advertising budget of its competitors
may find its customers drifting off to rival products.
5. Price Rigidity: In the oligopoly market price remain rigid. If one firm reduced price it is with
the intention of attracting the customers of other firms in the industry. In order to retain their
consumers they will also reduce price. Thus the pricing decision of one firm results in a loss
to all the firms in the industry. If one firm increases price. Other firms will remain silent there
by allowing that firm to lost its customers. Hence, no firm will be ready to change the
prevailing price. It causes price rigidity in the oligopoly market.

Examples:

Breakfast cereals
Cigarettes
Home electronics as washer, dryer etc.
Glass products
Chocolate
Bulbs / batteries

Advertisement and Oligopoly

Oligopoly firms compete to retain / capture customers and increase market share or both.
A commonly used tool for this is advertisement.
Through extensive use of ads over all possible media outlets, they try to distinguish their product
and its attributes in the eyes of the customer form their competitor's offerings.
Sometimes the distinction is qualitative superiority, and sometimes it is just cosmetic differences.
Nevertheless they try to convince the customer of the advantages of their offering vis--vis the
others that are available.

OTHER MARKET STRUCTURES

Duopoly
Duopoly refers to a market situation in which there are only two sellers. As there are only two
sellers any decision taken by one seller will have reaction from the other Eg. Coca-Cola and Pepsi.
Usually these two sellers may agree to co-operate each other and share the market equally
between them, So that they can avoid harmful competition.
The duopoly price, in the long run, may be a monopoly price or competitive price, or it may settle at
any level between the monopoly price and competitive price. In the short period, duopoly price may
even fall below the level competitive price with the both the firms earning less than even the normal
price.

Monopsony
Mrs. Joan Robinson was the first writer to use the term monopsony to refer to market, which there
is a single buyer. Monoposony is a single buyer or a purchasing agency, which buys the show, or
nearly whole of a commodity or service produced. It may be created when all consumers of a
commodity are organized together and/or when only one consumer requires that commodity which
no one else requires.

Bilateral Monopoly
A bilateral monopoly is a market situation in which a single seller (Monopoly) faces a single buyer
(Monoposony). It is a market of monopoly-monoposy.

Oligopsony
Oligopsony is a market situation in which there will be a few buyers and many sellers. As the
sellers are more and buyers are few, the price of product will be comparatively low but not as low
as under monopoly.

PRICING METHODS
The micro economic principle of profit maximization suggests pricing by the marginal analysis.
That is by equating MR to MC. However the pricing methods followed by the firms in practice
around the world rarely follow this procedure. This is for two reasons; uncertainty with regard to
demand and cost function and the deviation from the objective of short run profit maximization.
It was seen that there is no unique theory of firm behavior. While profit certainly on important
variable for which every firm cares. Maximization of short run profit is not a popular objective of a
firm today. At the most firms seek maximum profit in the long run. If so the problem is dynamic and
its solution requires accurate knowledge of demand and cost conditions over time. Which is
impossible to come by?
In view of these problems economic prices are a rare phenomenon. Instead, firms set prices for
their products through several alternative means. The important pricing methods followed in
practice are shown in the chart.

Cost Based Pricing

There are three versions of the cost based pricing. Full cost or break even pricing, cost plus
pricing and the marginal cost pricing. Under the first version, price just equals the average (total)
cost. In the second version, some mark-up is added to the average cost in arriving at the price. In
the last version, price is set equal to the marginal cost. While all these methods appear to be easy
and straight forward, they are in fact associated with a number of difficulties. Even through
difficulties are there, the cost- oriented pricing is quite popular today.
The cost based pricing has several strengths as well as limitations. The advantages are its
simplicity, acceptability and consistency with the target rate of return on investment and the price
stability in general. The limitations are difficulties in getting accurate estimates of cost (particularly
of the future cost rather than the historic cost) Volatile nature of the variable cost and its ignoring of
the demand side of the market etc.
Competition based pricing
Some commodities are priced according to the competition in their markets. Thus we have the
going rate method of price and the sealed bid pricing technique. Under the former a firm prices its
new product according to the prevailing prices of comparable products in the market. If the product
is new in the country, then its import cost inclusive of the costs of certificates, insurance, and
freight and customs duty, is used as the basis for pricing, Incidentally, the price is not necessarily
equal to the import cost, but to the firm is either new in the country, or is a close substitute or
complimentary to some other products, the prices of hitherto existing bands or / and of the related
goods are taken in to a account while deciding its price. Thus, when television was first
manufactures in India, its import cost must have been a guiding force in its price determination.
Similarly, when
maruti car was first manufactured in India, it must have taken into account the prices of existing
cars, price of petrol, price of car accessories, etc. Needless to say, the going rate price could be
below or above the average cost and it could even be an economic price.
The sealed bid pricing method is quite popular in the case of construction activities and in the
disposition of used produces. In this method the prospective seller (buyers) are asked to quote
their prices through a sealed cover, all the offers are opened at a preannounce time in the
presence of all the competitors, and the one who quoted the least is awarded the contract
(purchase / sale deed). As it sound, this method is totally competition based and if the competitors
unit by any change, the buyers (seller) may have to pay (receive) an exorbitantly high (too low)
price, thus there is a great degree of risk attached to this method of pricing.
Demand Based Pricing
The demand based pricing and strategy based pricing are quite related. The seller knows
rather well that the demand for its product is a decreasing function of the price its sets for product.
Thus if seller wishes to sell more he must reduce the price of his product, and if he wants a good
price for his product, he could sell only a limited quantity of his good. Demand oriented pricing rules

imply establishment of prices in accordance with consumer preference and perceptions and the
intensity of demand.
Two general types demand oriented pricing rules can be identified.
i.
ii.

Perceived value pricing and

Differential pricing

Perceived value pricing considers the buyers perception of the value of the product as the basis of
pricing. Here the pricing rule is that the firm must develop procedures for measuring the relative
value of the product as perceived by consumers. Differential pricing is nothing but price
discrimination. In involves selling a product or service for different prices in different market
segments. Price differentiation depends on geographical location of the consumers, type of
consumer, purchasing quantity, season, time of the service etc. E.g. Telephone charges, APSRTC
charges.
Strategy based pricing (new product pricing)
A firm which products a new product, if it is also new to industry, can earn very good profits it if
handles marketing carefully, because of the uniqueness of the product. The price fixed for the new
product must keep the competitors away. Earn good profits for the firm over the life of the product
and must help to get the product accepted. The company can select either skimming pricing or
penetration pricing.
There are other pricing methods which may be used by operators depending on their
individual operation and some may use a mixture of a number of methods.

Forward Pricing
The marketer will calculate the total cost of the ingredients and then add additional money as the
Gross Profit. This is often expressed as a percentage (and referred to as the Gross Margin) and
similar groups of products (e.g. all starters) will often have a similar percentage of profit applied to
them in order to ensure that an overall gross profit target is achievable.

Backward Pricing
Backward pricing is used when the marketer has an idea of what the market will pay and has an
idea of the amount of Gross Profit required. This allows them to perform a calculation which will
give a value for the amount of money which can be spent on ingredients. This is often used when
pricing products on a competitive basis. Eg. Sunday lunches are offered at many establishments
at a variety of prices. The astute operator will use backward pricing to ensure his competitive
selling price will deliver the expected gross profit by setting a maximum amount of money which
can be spent on all the ingredients used in the production of the meal.

Product Line Pricing.

Where there is a range of product or services the pricing reflect the benefits of parts of the range.
For example car washes. Basic wash could be 2, wash and wax 4, and the whole package 6.

Optional Product Pricing.

Companies will attempt to increase the amount customer spend once they start to buy. Optional
'extras' increase the overall price of the product or service. For example airlines will charge for
optional extras such as guaranteeing a window seat or reserving a row of seats next to each other.

Captive Product Pricing

Where products have complements, companies will charge a premium price where the consumer
is captured. For example a razor manufacturer will charge a low price and recoup its margin (and
more) from the sale of the only design of blades which fit the razor.

Product Bundle Pricing.

Here sellers combine several products in the same package. This also serves to move old stock.
Videos and CDs are often sold using the bundle approach.

Promotional Pricing.
Pricing to promote a product is a very common application. There are many examples of
promotional pricing including approaches such as BOGOF (Buy One Get One Free).

Value Pricing.
This approach is used where external factors such as recession or increased competition force
companies to provide 'value' products and services to retain sales e.g. value meals at McDonalds.

Categories of Pricing Methods:

1.Cost-based pricing
2.Demand-based pricing
3.Competition-oriented pricing
4.Value pricing
5.Product Line-oriented pricing
6.Tender pricing
7.Affordability-based pricing

Definition of Value Based Pricing

Value based pricing is the practice of setting the price of a product or service at its perceived value
to the customer. This approach does not take into account the cost of the product or service, nor
existing market prices. Value based pricing tends to result in very high prices and correspondingly
high profits for those companies that can persuade their customers to agree to it.
Value based pricing is usually applied to very specialized services. For example, an attorney
experienced in defense against criminal charges can charge a very high price to his or her clients,
since the value to them of not being incarcerated is presumably quite high. Similarly, an attorney
skilled in initial public offerings can use value pricing, since clients might not otherwise raise
millions of dollars without their services. Other areas where value based pricing may be an option
include:

Product design
Bankruptcy work outs
Cost reduction analysis
Lawsuit defense
Pharmaceuticals engineering
Value based pricing is also more applicable to situations where customer approval is made at the
executive level, rather than by the procurement department. The purchasing staff is more skilled in
evaluating supplier prices, and so would be less likely to allow such pricing.

Advantages of Value Based Pricing

The following are advantages to using the value based pricing method:

Increases profits. This method results in the highest possible price that you can charge,
and so maximizes profits.
Customer loyalty. Despite the high prices charged, you can achieve extremely high
customer loyalty for repeat business and referrals, but only if the service or product provided
justifies the high price. This advantage tends to also derive from the nature of the sales
relationship, which needs to be both close and trusting before value based pricing can even be
contemplated.

Disadvantages of Value Based Pricing

The following are disadvantages of using the value based pricing method:

Niche market. The very high prices to be expected under this method will only be
acceptable to a small number of customers. It may even alienate some prospective customers.

Not scalable. This method tends to work best for smaller organizations that are highly
specialized. It is difficult to apply it in larger businesses where employee skill levels may not be so
high.
Competition. Any company that persistently engages in value based pricing is leaving a
great deal of room for competitors to offer lower prices and take away their market share.
Labor costs. Assuming that a service is being provided, you are likely offering such a highend skill set that the employees needed to provide the service will be quite expensive. There is also
a risk that they may leave to start competing firms.
Definition of Dynamic Pricing
Dynamic pricing is a partially technology-based pricing system under which prices are altered to
different customers, depending upon their willingness to pay.
Several examples of dynamic pricing are:

Airlines. The airline industry alters the price of its seats based on the type of seat, the
number of seats remaining, and the amount of time before the flight departs. Thus, many different
prices may be charged for seats on a single flight.
Hotels. The hotel industry alters its prices depending on the size and configuration of its
rooms, as well as the time of year. Thus, ski resorts increase their room rates over the Christmas
holiday, while Vermont inns increase their prices during the Fall foliage season, and Caribbean
resorts reduce their prices during the hurricane season.
Electricity. Utilities may charge higher prices during peak usage periods.
Some industries, such as airlines, use heavily computerized systems to alter prices constantly,
while other industries institute pricing changes at longer intervals. Thus, dynamic pricing can be
adopted along a broad continuum, ranging from constant to infrequent pricing changes.
Dynamic pricing works best in the following situations:

When it is used in concert by all of the major players in an industry. Thus, if a single hotel
were to keep its prices low during the peak tourist season, it could likely steal business away from
competitors.
When demand fluctuates considerably in comparison to a relatively fixed amount of supply.
In this situation, sellers reduce prices as demand falls and increase it as demand increases.
Advantages of Dynamic Pricing
The following are advantages of using the dynamic pricing method:

Profit maximization. If a seller constantly updates its prices with dynamic pricing, it will likely
maximize its potential profits.

Clear out slow-moving inventory. Dynamic pricing involves a considerable amount of

inventory monitoring, with price reductions in response to higher inventory levels. This approach
tends to eliminate excess inventory quickly.
Disadvantages of Dynamic Pricing
The following are disadvantages of using the dynamic pricing method:

Customer confusion. If prices change constantly, customers can become confused by the
situation and be attracted to those sellers who do not use dynamic pricing. Thus, it can result in a
loss of market share.
Inventory management. Sudden changes in price can alter the demand for goods, which
makes it difficult to plan for inventory replenishment.
Increased marketing activity. It may require an expanded marketing presence in the
marketplace to communicate pricing changes to customers.
Printed price changes. If used in a retail environment, it requires considerable activity to
update prices on products as soon as the system alters prices.
Competitor monitoring. If the entire industry adopts dynamic pricing, then a company
must invest in competitor price monitoring systems, to see if its prices are similar to those offered
by competitors.

Definition of Loss Leader Pricing

Loss leader pricing is the practice of selling a small number of products either at or below cost, on
the assumption that buyers will purchase other products at the same time that are considerably
more profitable. The resulting combined sale transaction is assumed (or hoped) to be profitable.
The loss leader concept can be used to bring customers into a physical store location or to access
a website - in either case, selected merchandise that is much more profitable will be positioned
near the loss leader product, so that buyers have every opportunity to make additional purchases.
Example of Loss Leader Pricing
One of the heaviest users of loss leader pricing is grocery stores, which routinely advertise low
prices on selected items. This practice is also used by the manufacturers of ink jet printers, as well
as a variety of stores just before Christmas, when they advertise deep discounts for early-morning
shoppers.
Advantages of Loss Leader Pricing
The following are advantages to using the loss leader pricing method:

Sales increase. When buyers purchase other items in addition to the loss leader, the seller
can make a larger profit than would have been the case if it had not offered the loss leader.

New stores. Loss leader pricing is an excellent way to attract shoppers to a new location,
since they might otherwise never enter the store, but will do so to take advantage of a particular
pricing deal. Thus, it can be used to build a customer base.
Merchandise elimination. The strategy can be used to clear out older merchandise, so the
seller can restock its warehouse with newer products.
Marketing. Loss leader pricing is an alternative form of marketing, where the seller is
essentially paying customers in the amount of any losses sustained on its loss leader products to
enter the company store.
Disadvantages of Loss Leader Pricing
The following are disadvantages of using the loss leader pricing method:

Risk of loss. A company may incur a substantial loss from this pricing strategy if it does not
closely monitor sales of other items positioned alongside the loss leader; the risk is that customers
may buy only the loss leader, and in large quantities.
Stockpiling. If the loss leader price is unusually good, and it is for a necessary item that a
consumer may use in bulk, it is possible that each buyer will purchase the largest possible quantity
of the item, and then stockpile it for later use. A seller can avoid this issue by limiting purchase
quantities or only offering products that have a limited shelf life and which therefore cannot be
stockpiled.
Pricing perception. Retaining a deep discount for too long can give buyers the impression
that a product should have a lower price at all times, which can reduce its unit sales once
management stops the loss leader promotion and returns the product to its normal price.

Definition of Penetration Pricing

Penetration pricing is the practice of initially setting a low price for one's goods or services, with the
intent of increasing market share. The price may be set so low that the seller cannot earn a profit.
However, the seller is not irrational.

Advantages of Penetration Pricing

The following are advantages of using the penetration pricing method:

Entry barrier. If a company continues with its penetration pricing strategy for some time,
possible new entrants to the market will be deterred by the low prices.
Reduces competition. Financially weaker competitors will be driven from the market, or into
smaller niches within the market.
Market dominance. It is possible to achieve a dominant market position with this strategy,
though the penetration pricing may have to continue for a long time in order to drive away a
sufficient number of competitors to do so.

Disadvantages of Penetration Pricing

The following are disadvantages of using the penetration pricing method:

Branding defense. Competitors may have such strong product or service branding that
customers are not willing to switch to a low-price alternative.
Customer loss. If a company only engages in penetration pricing without also improving its
product quality or customer service, it may find that customers leave as soon as it raises its prices.
Perceived value. If a company reduces prices substantially, it creates a perception among
customers that the product or service is no longer as valuable, which may interfere with any later
actions to increase prices.
Price war. Competitors may respond with even lower prices, so that the company does not
gain any market share.

Nine laws of price sensitivity and consumer psychology

In their book, The Strategy and Tactics of Pricing, Thomas Nagle and Reed Holden outline nine
"laws" or factors that influence how a consumer perceives a given price and how price-sensitive
they are likely to be with respect to different purchase decisions.
They are:
1. Reference Price Effect buyers price sensitivity for a given product increases the higher

2.
3.
4.

5.
6.

the products price relative to perceived alternatives. Perceived alternatives can vary by
buyer segment, by occasion, and other factors.
Difficult Comparison Effect buyers are less sensitive to the price of a known or more
reputable product when they have difficulty comparing it to potential alternatives.
Switching Costs Effect the higher the product-specific investment a buyer must make to
switch suppliers, the less price sensitive that buyer is when choosing between alternatives.
Price-Quality Effect buyers are less sensitive to price the more that higher prices signal
higher quality. Products for which this effect is particularly relevant include: image products,
exclusive products, and products with minimal cues for quality.
Expenditure Effect buyers are more price sensitive when the expense, accounts for a
large percentage of buyers available income or budget.
End-Benefit Effect the effect refers to the relationship a given purchase has to a larger
overall benefit, and is divided into two parts: Derived demand: The more sensitive buyers
are to the price of the end benefit, the more sensitive they will be to the prices of those
products that contribute to that benefit. Price proportion cost: The price proportion cost
refers to the percent of the total cost of the end benefit accounted for by a given
component that helps to produce the end benefit (e.g., think CPU and PCs). The smaller
the given components share of the total cost of the end benefit, the less sensitive buyers
will be to the component's price.

7. Shared-cost Effect the smaller the portion of the purchase price buyers must pay for

themselves, the less price sensitive they will be.

8. Fairness Effect buyers are more sensitive to the price of a product when the price is
outside the range they perceive as fair or reasonable given the purchase context.
9. The Framing Effect buyers are more price sensitive when they perceive the price as a
loss rather than a forgone gain, and they have greater price sensitivity when the price is
paid separately rather than as part of a bundle.

Kinds of Pricing (pricing strategies)

Pricing policy means a policy determined for normal conditions of the market. Pricing strategy is a
policy determined to face a specific situation and is of temporary nature. Simply pricing policies
provide guidelines to carry out pricing strategy. Following are the important pricing strategies.
1. Psychological pricing: Here manufacturers fix their prices of a product in the manner that it
may create an impression in the mind of consumers that the prices are low. E.g. Prices of Bata
shoe as Rs.99.99. This is also called odd pricing.
2. Mark up pricing. This method of pricing is followed by whole salers and retailers. When the
goods are received, the retailers add a certain percentage of the whole salers price.
3. Administered pricing: Here the pricing is done on the basis of managerial decisions and not on
the basis of cost, demand, competition etc.
4. Other pricing strategies: Geographical pricing, base point pricing, zone pricing, dual pricing,
product line pricing etc. are some other pricing strategies.

PROFIT MANAGEMENT:
Introduction :
A Business firm is an organization designed to make profits and profits are the primary measures
of success
Joel Dean .
Joel Dean highlighted three issues regarding profit.
1. Profit Measurement: economic analysis of accounting data for policy making.
2. Policy Decisions on profit standards and profit goals.
3. Use of profits for control purposes in complex business organizations.

Theories of Profit in Economics

In Economics profit is called Pure Profit, which may be defined as a residual left after all
contractual costs have been met, including the transfer costs of management insurable risks,
depreciation and payment to shareholders, sufficient to maintain investment at its current level

Theories of Profit
There are various theories of profit, given by several economists, which are as follows:

1. Walkers Theory of Profit as Rent of Ability

This theory is pounded by F.A. Walker. According to Walker, Profit is the rent of exceptional
abilities that an entrepreneur may possess over others. Rent is the difference between the yields
of the least and the most efficient entrepreneurs. In formulating this theory, Walker assumed a state
of perfect completion in which all firms are presumed to possess equal managerial ability each firm
receives only the wages which in Walker view forms no part of pure profit. He considered wages of
management as ordinary wages thus, under perfectly competitive conditions, there would be no
pure profit and all firms would earn only wages, which is known as normal profit.

2. Clarks Dynamic Theory

This theory is propounded by J.B. Clark According to him, Profits arise in a dynamic economy and
not in static economy.
A static economy and the firms under it, has the following features:

Absolute freedom of competition.

Population and capital are stationary.

Production process remains unchanged over time.

Homogeneous goods.

Factors of production enjoy freedom of mobility but do not move because their marginal
product in very industry is the same.

There is no uncertainly and risk. If there is any risk, it is insurable

All firms make only normal profit.

A dynamic economy is characterized by the following features:

Increase in population.

Increase in capital.

Improvement in production techniques.

Changes in the forms of business organization.

The major function of entrepreneurs or managers in a dynamic economy is to take the advantage
of all of the above features and promote their business by expanding their sales and reducing their
costs of production.
According to J.B. Clark, Profit is an elusive sum, which entrepreneurs grasp but cannot hold. It
slips through their fingers and bestows itself on all members of the society. This result in rise in
demand for factors of production and therefore rises in factor prices and subsequent rise in the
cost of production. On the other hand, because of rise in cost of production and the subsequent fall
in selling price of the commodities, the profit disappears. Disappearing of profit does not mean that
profit arise in dynamic economy once only, but it means that the managers take the advantage of
the changes taking place in the economy and thereby making profits.

3. Hawleys Risk Theory of Profit

The risk theory of profit is propounded by F.B. Hawley in 1893. Risk in business may arise due to
obsolescence of a product, sudden fall in prices, non-availability of certain materials, introduction of
a better substitute by a competitor and risks due to fire, war, etc. Hawleys considered risk taking as
an inevitable element of production and those who take risk are more likely to earn larger profits.
According to Hawley, Profit is simply the price paid by society assuming business risks. In his
opinion in excess of predetermined risk. They also look for a return in excess of the wags for
bearing risk is that the assumption of risk is irrelevant and gives to trouble and anxiety. According to
Hawley, Profit consists of two part, which are as follows:

One Part represents compensation for actual or average loss supplementing the various
classes of risk.

The other part represents a penalty to suffer the consequences of being exposed to risk in
the entrepreneurial activities.
Hawley believed that profits arise from factor ownership as long as ownership involves risk.
According to Hawley, an entrepreneur has to assume risk to earn more and more profit. In case of
absence of risks, an entrepreneur would cease to be an entrepreneur and would not receive any
profit. In this theory, profits arise out of uninsured risks. The amount of reward cannot be
determined, until the uncertainly ends with the sale of entrepreneur products profit in his opinion is
a residue and therefore Hawley theory is also called as Residual theory.

4. Knights Theory of Profit

This theory of profit is propounded by frank H. Knight who treated profit as a residual return
because of uncertainly, and not because of risk bearing. Knight made a distinction between risk

and uncertainly by dividing risk into two categories, calculable and non-calculable risks. They are
explained as below:

Calculable risks are those, the prodigality of occurrence of which van be calculated on the
basis of available data. For example risk, due to fire theft accidents etc. are calculable and such
risks are insurable.

Incalculable risks are those the probability of occurrence of which cannot be calculated. For
Instance there may be a certain elements of cost, which may not be accurately calculable and the
strategies of the competitors may not be precisely assessable. These risk are called includable
risks. The risk element of such incalculable costs is also insurable.
It is in the area of uncertainly which makes decision-making a crucial function for an entrepreneur.
If his decisions prove to be right, the entrepreneur makes profit, Thus according to knight profit
arises from the decisions taken and implemented under the conditions of uncertainly. The profits
may arises as a result of decision related to the state of market such as decision, which increase
the degree of monopoly, decisions regarding holding of stocks that give rise to windfall gains and
the decisions taken to introduce new techniques or innovations.

5. Schumpeters Innovation Theory of Profit

Joseph A. Schumpeter developed the innovation theory of Profit. According to Schumpeter, factors
like emergence of interest and profits, recurrence of trade cycles only supplement the distinct
process of economic development. To explain the phenomenon of economic development and
profit, Schumpeter starts from the state of a stationary equilibrium, which is characterized by the
equilibrium in all the spheres. Under these conditions stationary equilibrium, the total receipts from
the business are exactly equal to the cost. This means that there will be no profit. The profit can be
earned only by introducing innovations in manufacturing technique and the methods of supplying
the goods innovations may include the following activities.

Introduction of a new commodity or new quality goods.

Introduction of a new method of production.

Introduction of a new market.

Finding the new sources of raw material.

Organizing the industry in an innovative manner with the new techniques.

The factor prices tend to increase while the supply of factors remains the same. As a result, cost of
production increase. On the other hand with other firms adopting innovations, supply of goods and
services increases resulting in a fall in their prices. Thus, on one hand, cost per unit of output goes
up and on the other revenue per unit decrease. Finally, a stage comes when there is no difference
between costs and receipts. As a result there are no profits at all. Here, economy has reached a

state of equilibrium, but there is the possibility of existence of profits. Such profits are in the nature
of quasi-rent arising due to some special characteristics of productive services. Furthermore,
where profits arise due to factors such as patents, trusts, etc. they will be in the nature of monopoly
revenue rather than entrepreneurial profits

various theories of profit which have been offered from time to time
Rent theory of profit :This theory is offered by Prof. Walker. He says, that profit is determined just like the rent of land.
The main points of this theory are given below :
1. Profit is like run :He says that as superior grade of land earned more rent then the inferior grade of land, similarly
superior entrepreneur earn more than the inferior.
2. Marginal entrepreneur :Just as the rent is measured from no rent land in the same way profits of the superior businessman
are calculated from the marginal entrepreneur.
3. Profit is not included in cost :Profit is not included in the cost of production, it is something extra just like the theory of Ricardo.
CRITICISM
1. difference in land and entrepreneur :Marshall says that there is much difference between the rent of land and entrepreneur's profit.
2. Objection on superior ability :Profit cannot arise only due to the superior ability but there are so many other factors which are
responsible for profit.
3. Nature of profit ignored :This theory does not throw light on the nature of profit which is more important.
4. Profit is the part of cost :It is also stated that profit is not included in cost , it is not correct.
5. Case of loss :In case of land, there is no chance of loss but in case of entrepreneur loss can also be suffered.

Risk-bearing theory of profit :F.B Hawley. says that profit is the reward of risk taking in business. In a business activity we know
that there is a chance of loss very moment. The greater the risk, the higher must be the profit. If

there would be equal rate of profit in all the business, then nobody would invest the capital in a
risky enterprise.
CRITICISM
1. Demand and supply side ignored :This theory is ignored the demand and supply aspect.
2. Better management :The profit can arise on account of better management instead of risk taking only.
3. Monopoly and by chance profit ignored :This theory does not throw light on the monopoly gains and by chance gains.
4. Superiority of entrepreneur :Superior entrepreneurs are able to reduce the risks, so it is not correct to say that profit raises due
to risk.
Uncertainty theory of profit :This theory is offered by Prof. Knight. He says that profit is the reward for uncertainty bearing and not of

risk taking in business. He divides the risks in to two kinds.

1. Insurable risks. 2. Non insurable.
Those risks which cannot be insured, such as the change in demand due to fashion, these are
called uncertainty bearing. According to him profit is the reward of uncertainty bearing rather than
risk taking, which are insurable.
CRITICISM
1. Other services ignored :The total profit cannot be reward of uncertainty in a business because the entrepreneur also
performs other functions like bargaining and co-coordinating the business.
2. Demand and supply ignored :This theory ignored the demand and supply side.
3. Monopoly and by chance profit ignored :This theory does not throw light on the monopoly gains and by chance gains.
4. Restricted supply :Profit is not simply reward of uncertainty bearing but it is paid due to restricted supply of the
entrepreneur.

Dynamic theory of profit :This theory is offered by Prof. Clark. He says that profit is reward of entrepreneurs ability that he
uses his creative forces and bringing many changes the makes the business dynamic. Every
entrepreneur wants that the cost of his production should be minimum and profit should be
maximum.
Prof. Schumpeter says that entrepreneur earns profit by using innovations. So profit is the reward
of innovations.
CRITICISM
Prof. Knight criticisms that all profits are not due to the dynamic changes.
This theory also fails to explain that how profit is determined in the market.

Marginal productivity theory :According to "Chapman" The profit tends to equal to the marginal social worth of the employer as
the labourer gets his marginal net product from the employer." The marginal net product is an
amount which the community is able to produce with his help over and above what it could produce
without his help. If the marginal productivity is higher than the profit will high. If the
marginal product is low then profit will also be low.
CRITICISM
It is very difficult to know the marginal net productivity of entrepreneur.

Cost Volume Profit Analysis

Cost-Volume-Profit (CVP) analysis is a managerial accounting technique that is concerned with the
effect of sales volume and product costs on operating profit of a business. It deals with how
operating profit is affected by changes in variable costs, fixed costs, selling price per unit and the
sales mix of two or more different products.

Meaning Of Cost-Volume-Profit Analysis(CVP Analysis)

Every firm has a prime motive of not only earning profit but also maximizing it. A profit does not
happen by chance. It has to be managed. Cost-volume-profit analysis (CVP Analysis) is a tool of
planning for profit. CVP analysis is helpful for developing alternative strategies in sales planning
and cost estimation. Certain relationship exists among the variables like selling price, sales volume
and taxes. Cost-volume-profit analysis (CVP analysis) is an accounting technique showing the
relationship among these variables. CVP analysis, though most often illustrates business cases, is
equally applicable for not profit making organizations to allocate scarce economic resources most
effectively among the competing alternatives. Allocation of scarce resources among the various
demanding sectors is the most important issue of national planning.

CVP analysis is the analysis of the relationship between cost and volume of activities and the effect
of the relationship on profit. Managers can use the concept of cost-volume-profit analysis to
forecast volume of activity at which the firm will break-even or attain target profits.CVP analysis is
therefore, a useful tool that helps managers, business owners and entrepreneurs to determine the
profit potential of a new firm or the impact on profit due to changes in selling price, cost or level of
activities
of
current business.

Costs-Volume Relationship
Costs show important behavior in relation to the volume of activity such as:
* Total variable costs change in the same proportion and in the same direction as the volume by
output change.
* Per unit variable costs remain fixed.
* Total fixed costs remain unchanged for the same period of time whatever is the level of output
within the relevant range.
* Per unit fixed costs are variable.
CVP Analysis Formula

The basic formula used in CVP Analysis is derived from profit equation:
px = vx + FC + Profit
In the above formula,
p is price per unit;
v is variable cost per unit;
x are total number of units produced and sold; and
FC is total fixed cost
Besides the above formula, CVP analysis also makes use of following concepts:
Contribution Margin (CM)
Contribution Margin (CM) is equal to the difference between total sales (S) and total variable cost
or, in other words, it is the amount by which sales exceed total variable costs (VC). In order to
make profit the contribution margin of a business must exceed its total fixed costs. In short:
CM = S VC
Unit Contribution Margin (Unit CM)
Contribution Margin can also be calculated per unit which is called Unit Contribution Margin. It is
the excess of sales price per unit (p) over variable cost per unit (v). Thus:
Unit CM = p v
Contribution Margin Ratio (CM Ratio)
Contribution Margin Ratio is calculated by dividing contribution margin by total sales or unit CM by
price per unit.

Mathematical Approach to CVP Analysis:

Defining Revenue:
The first step in CVP analysis is to define revenue as a linear relationship between the selling price
and the quantity sold. The selling price is determined after considering customers, cost, and other
influences on price as discussed previously. We define total revenue as a positive straight-line
relationship between the selling price per unit and the number of units sold. That is:
Total revenue = Selling price Number of units sold
or
TR = SP(Q)
In general it is possible to increase total revenue by increasing selling price, the quantity of units
sold, or both. While this may not always be true, within the relevant range, we assume that once
set, selling prices remain the same at all volumes.
Defining Cost:
Next We define total cost as having a linear relationship between the cost and the number of units
purchased or produced. Analyst determine the total amount of fixed costs over the relevant range
and the variable cost per unit produced or purchased by using a cost estimation technique such as
the high/low method or linear regression analysis. This results in the following equation:
Total cost = (Variable cost per unit Number of units produced) + Fixed cost
or
TC = VC(Q) + FC
Therefore, total cost increases beyond the level of fixed costs as the quantity of units purchased or
produced increases. We assume that, throughout the relevant range, the fixed cost component
remains constant in total, and the variable cost component remains constant per unit.
Defining Profit:
Now that we have defined total revenue and total cost, it is possible to determine profit. In CVP
analysis, profit is the excess of revenues over costs. Because both revenues and costs are stated
in a mathematical form, so, too, is profit:
Total revenue - Total cost = Profit
or

SP(Q) - VC(Q) - FC = P
Notice that both total revenue and total variable cost are dependent on the number of units
produced and sold. The difference between selling price per unit and variable cost per unit is
known as the contribution margin per unit (SP -VC). It is so named because it represents the
portion of each sales dollar available to contribute to fixed costs. Once fixed costs are covered, the
contribution margin contributes to profit.
Using CM to represent the contribution margin per unit, we represent the CVP relationship as
follows:
SP(Q) - VC(Q) - FC = P
(SP - VC)Q - FC = P
CM(Q) = P
CM(Q) - FC = P
CM(Q) = FC+P
Q = (FC + P)/CM
Thus (FC + P)/CM = Q is a short-cut way to calculate the number of units that must be produced
and sold in order to cover the fixed costs and contribute to profit. It is also known as the
contribution margin

Assumptions of Cost Volume Profit Analysis:

It is very important that users understand the assumptions under which CVP operates because the
assumptions establish the limits of cost volume profit applicability and its effectiveness in
forecasting.
1. Selling price remains constant per unit regardless of the volume sold. There are no
volume discounts (a reduced price when large quantities are ordered), nor are prices
changed at various volume levels. The total revenue function is represented by a straight
line, where total revenue changes in direct proportion to changes in volume of units sold
and
only
in
response
to
those
changes.
2. Variable cost remains constant per unit regardless of the volume produced. There are
no volume production efficiencies resulting from efficiencies that lower the cost per unit as
more units are produced, nor are extremely high-or low-volume units more expensive to
produce and sell. The variable cost portion of the total cost function is represented by a
straight line where total variable cost (versus variable cost per unit) change in direct
proportion

3. Fixed cost remains constant in total regardless of the volume produced and sold
throughout the relevant range. Additional capacity cannot be obtained, nor can facilities
be abandoned in the short run. The fixed cost portion of the total cost function is
represented by a straight line where total fixed cost does not increase or decrease with
changes
in
volume
of
units
produced
and
sold.
4. For manufacturing firms, the number of units produced equals the number of units
sold during the period; for merchandising firms, the number of units purchased
equals the number of units sold during the period. As a result of this assumption, there
are no changes in the inventory levels from the beginning to the end of the period.
Therefore the volume number used for cost determination is the same volume number used
for
revenue
determination.
5. If more than one product is sold, the sales mix (the relative proportion of units sold)
remains constant. At all levels of activity, the mix of product sales remains the same; that
is, if twice as much product A is sold as product B at lower volume levels, then twice as
much product A as product B is also sold at higher volume levels. This assumption implies
that the relative contribution margins remain the same.
While these assumptions may seem limiting, they are sufficiently realistic within the relevant range
to provide a useful first approximation of reality.