Category: Management Notes

The workers are paid wages or salaries for the work done by them. Thus, the return to the workers should be according to their efforts and the pay standards prevailing in the industry.

There are several theories of wage determination propounded by different scientists and are based on varied assumptions.

Theories of Wage Determination

1. Subsistence Wage Theory

This theory was propounded by David Ricardo and called this theory as an “iron law wages.” According to this theory, the labor is paid the minimum amount of wage that is sufficient to subsist and perpetuate their race without either increase or decrease. It is based on the assumption that the law of diminishing returns applies to the industry, and the population tends to increase.

If the labor is paid below the subsistence level, they will die out of malnutrition, disease or hunger and therefore, the number of workers gets reduced. On the other hand, if the wage increases above the subsistence level, the number of workers will get attracted to procreate and thus, with the increase in labors the wage rate comes down. Thus, there is a subsistence level, which is maintained and is not either increased or decreased.

2. Wage Fund Theory

This theory was developed by Adam Smith, and is based on the assumption that the wage is paid out of the pre-determined wealth or fund, which lays surplus with the wealthy persons, as a result of savings. The amount of wage to be paid to the worker depends on the size of the fund. Larger the fund, more labor would be employed and given higher wages, whereas in the case of less funds, the wage would reduce to the subsistence level.

This theory was further expounded by J.S.Mill, and according to him the wage fund is fixed, and the wages can be determined on the basis of demand for and supply of labor. And thus, the fund size decides the demand for the labor. To have an increased wage, the number of labor is to be reduced, and the fund is to be enlarged.

3. Surplus Value Theory

This theory is given by Karl Marx,and according to him, like other articles, labor is also an article of commerce and could be purchased by paying a subsistence price.

The price of a product is determined by the amount of time; a labor devotes for its production. And the proportion of time spent by the labor on work is much less and, therefore, paid a minimum price and the surplus amount is utilized for the other expenses.

4. Residual Claimant Theory

Francis. A Walker propounded this theory, and according to him there four factors of production viz. Land, labor, capital and entrepreneurship.

The wage is the amount given in return for the amount of production and thus is paid after the payment of all other factors. Thus, the wage is considered to be a residual claimant, and is computed as:

Wage= Whole production- (Rent+ Interest+ Profit)

5. Marginal Productivity Theory

This theory is given byPhillips Henry Wicksteed and John Bates Clark, and it is based on the assumption that wage is determined on the basis of last worker’s contribution in the production i.e. the marginal production.

This theory assumes that wage depends on demand for and supply of labor. As far as, the marginal productivity is equal to the wages paid, a firm will continue employing more labor.

6. Bargaining Theory

John Davidson has given this theory, and according to him, the wages are determined on the basis of a bargaining capacity of workers or their unions and employers. If the trade union is stronger, then the wages will be high, and if the employer is powerful, the wages tend to be low.

7. Behavioral Theory

Several behavioral scientists (viz.March and Simon, Robert Dubin, Eliot Jacques,) have presented their research on the wage determination. According to them, there are various factors such as employer’s concern for the workers, the strength of unions, size and prestige of company, etc. that determines the amount of wage to be disbursed among the workers.

Thus, the firm can adopt either of the wage methods depending on the nature of a job and the worker’s contribution towards the accomplishment of a work.

According to modern economists, rent is considered as the payment made against the use of land by a tenant. They explained the concept of rent with respect to demand and supply of land.

The demand of land is not direct but derived demand. It is derived from the demand of products that are produced on the land.

In case, the demand of a product increases, then the demand of land also increases and vice-versa. This results in the increase or decrease of rent. For example, with increase in the population of a country, the demand for food increases. This results in the increase of requirement for land and its rent.

The demand of land depends on the marginal productivity of land, which is governed by the law of diminishing returns. Therefore, the demand curve would slope downwards. In such a case, it can be said that the rent of land can be obtained with the help of marginal productivity.

On the other hand, the supply of land is constant for the whole industry; however, an individual organization can increase its supply of land by purchasing more land. The supply of land is perfectly inelastic. This implies that the supply of land would remain the same even if the rent increases or decreases. Therefore, the supply price of land is zero.

For determining rent with the help of demand and supply of land, certain assumptions are made, which are as follows:

(i) Assumes that only one type of land and crop is used for cultivation. In such a case, there would only be one demand and supply curve.

(ii) Assumes that rent exists only in a perfectly competitive market.

Figure:1 shows how demand and supply forces of land interact to obtain rent of land:

In Figure-1, SS represents the supply curve of land that remains constant. Firstly, the demand curve of land was DD that intersects SS at point E. At point E, the rent is equal to OR (= SE). In case, the rent decreases to OR”, then the demand of land increases and rent come back to OR.

Similarly, if rent increases to OR’, then the demand of land declines and rent reaches OR again. D”D” is representing the no-rent condition when the cultivation of land occurs in a new country with plenty of good land. Therefore, OR is the rent at the equilibrium position where supply and demand of land becomes equal.

However, in case the land is of different types, then the demand and supply curve would be different for different lands. In case of an industry, the supply of land does not remain constant. The supply can be increased or decreased by purchasing or selling land or by paying more or less rent. Therefore, in case of a single industry the supply of land is elastic. The supply curve has an upward slope.

Figure: 2 shows the determination of rent in case of an industry:

In Figure-2, at demand DD the rent is OR and the quantity of land is OM. In case the demand reaches D’D’, the rent becomes OR’ with OM’ quantity of land. The land that was previously used for various purposes is now used for a specific industry. In case, the demand of land decline to D”D”, then the rent of land would be OR” and the quantity of land would be OM”. The modern theory of rent is based on the concept of transfer earnings.

Some of the modern economists have defined rent as follows:

According to Hibbdon, “Rent is the difference between the actual payment to a factor and its supply price or transfer earning.”

As per Boulding, “Economic rent may be defined as any payment to a factor of production which is in excess of the minimum amount necessary to keep the factor in its present occupation.

Factors of production can be defined as inputs used for producing goods or services with the aim to make economic profit.

In economics, there are four main factors of production, namely land, labor, capital, and enterprise. The price that an entrepreneur pays for availing the services of these factors is called factor pricing.

An entrepreneur pays rent, wages, interest, and profit for availing the services of land, labor, capital, and enterprise respectively. The theory of factor pricing deals with the price determination of different factors of production.

The determination of factor prices is always assumed to be similar to the determination of product prices. This is because in both the cases, the prices are determined with the help of demand and supply forces. Moreover, the demand for factors of production is similar to the demand for products.

However, there are two main differences on the supply side of factors of production and products. Firstly, in product market, the supply of a product is determined by its marginal cost of production. On the other hand, in factor market, it is not possible to determine the supply of factors on the basis of marginal cost.

For example, it is difficult to ascertain the exact cost of production for factors, such as land and capital. Secondly, the supply of factors of production cannot be readily adjusted as in the case of products. For instance, if the demand for a land increases, then it is not possible to increase its supply immediately.

Concept of Factor Pricing:

Factor pricing is associated with the prices that an entrepreneur pays to avail the services rendered by the factors of production. For example, an entrepreneur needs to pay wages to labor, rents for availing land, and interests for capital so that he/she can earn maximum profit. These factors of production directly affect the production process of an organization.

In context of an economy, these four factors of production when combined together produce a net aggregate of products, which is termed as national income. Therefore, it is important to determine the prices of these four factors of production. The theory of factor pricing deals with the determination of the share prices of four factors of production, namely land, labor, capital and enterprise.

In other words, the theory of factor pricing is concerned with the principles according to which the price of each factor of production is determined and distributed. Therefore, the theory of factor pricing is also known as theory of distribution. According to Chapman, the theory of distribution, “accounts for the sharing of the wealth produced by a community among the agents, or the owners of the agents, which have been active in its production.”

There are two aspects of each factor of production, which are as follows:

1. Price Aspect:

Refers to the aspect in which an organization pays a certain amount to avail the services of factors of production. For example, wages, rents, and interests constitute the price of factors of production.

1. Income Aspect:

Refers to another aspect in which a certain amount is received by a factor of production. For instance, rents received by a landlord and wages received by labor constitute the income generated from the factors of production.

Generally, it is assumed that factor pricing theory is similar to product pricing theory. However, there are certain differences between the two theories. Both the theories assume the determination of prices by the interaction of two market forces, namely demand and supply.

However, there are differences in the nature of demand and supply of factors of production with respect to that of products. The demand for factors of production is derived demand, while demand for products is direct demand. Moreover, the demand for the factors of production is joint demand.

This is because a product cannot be produced using a single factor of production. On the other hand, the supply of products is closely related with the cost of production, whereas there is no cost of production for factors. For example, there is no cost of production for land, labor, and capital. Therefore, the factor pricing is separated from product pricing.

Theories of Factor Pricing:

The theory of factor pricing is concerned with the principles according to which the price of each factor of production is determined and distributed. The distribution of factors of production can be of two types, namely personal and functional. Personal distribution is concerned with the distribution of income among different individuals.

It is associated with the amount of income generated not with the source of income. For example, an individual earns Rs. 20,000 per month; this income can be earned by him/her by wages, rents, or dividends. On the other hand, functional distribution is associated with the distribution of income among different factors of production as per their functions.

It is concerned with the source of income, such as wages, rents, interests, and profits. In regard of distribution of factors of production, there are two theories, namely marginal productivity theory and modern theory of factor pricing.

Feature

1. Derived Demand:

It is observed that the demand for a factor, unlike the demand for a commodity, is a derived demand. It means that the demand for any factor of production depends on the existence of a demand for the goods that it helps to make. Thus the demand for computer program­mers or TV repairers is growing, as more and more electronic computers or TV sets are used. The demand for college teachers increases whenever the number of students in colleges increases.

2. Joint Demand:

The demand for a factor of production is essentially a case of joint demand. It means that as one particular factor cannot produce anything, almost all the factors are demanded jointly and at a time to produce a particular thing. But, the goods are not jointly demanded except in the case of some special goods like bread and butter or rubber-stamp and stamp-pad, etc.

3. Difficulties in Changing Factor Supply:

The supply of a factor has some peculiarities. The supply of most of the goods can, in general be increased or decreased according to their demand or prices. A rise in the price of a commodity would encourage the producers to produce and supply more of the same.

But any increase in factor price such as rent or wage does not bring about an increase in the supply of land at all or an immediate increase in the supply of labour even. Similarly, a fall in the price of a commodity generally brings about a fall in its supply, but this is not so in the case of land or labour or any other factor.

4. No Full Control over the Factor Supply:

It is also observed the owners of factors do not have full control over the conditions which determine factor supply. Thus the supply of money-capital depends in large measure on the country’s national income, law and order situation, banking system etc. The suppliers of capital or savers do not have any control over these’ conditions. But this characteristic is not normally found in the case of the supply of goods.

5. A Separate Theory for Each Factor:

In general no separate theory is needed for determining the prices of different types of goods; a single theory is enough for most of the goods (except for interrelated goods like joint products, etc.). But a separate theory is needed for each and every type of factor earnings, like rent, wages, interest and profits.

6. No Homogeneous Units of a Factor:

The different units of a product may be homogeneous, but the units of a factor are not generally so Besides the cost of production of a commodity can easily be determined, but the cost for a factor, land or labour, cannot be so determined.

Owing to the above reasons a separate theory is needed for determining factor prices, but the determination of factor prices becomes more complex than the determination of the prices of goods. This happens so, because in the former case the conditions (i.e., market situations) in both factor and product markets are to be considered at the same time, but in the latter case the prices of goods are determined in different market situations assuming factor-price constant.

The Modern theory of factor pricing provides a satisfactory explanation of the problem of distribution.

It is known as the demand and supply theory of distribution. According to the modem theory of factor pricing, the equilibrium factor prices can be explained by the forces of demand and supply.

Prices paid for productive services are like any other price and they are basically determined by demand and supply conditions. Incomes are received as payments for the services of factors of production. Wages are payments for the services rendered by labour.

Rents are payments for the services of land and interest is payment for the services of capital. In this way most incomes are remunerations or prices paid for services rendered by factors of production in the process of production. This theory is superior to the marginal productivity theory, because it takes into account both the forces of demand and supply in the determination of factor prices. Marshall held the view that no separate theory is required to explain factor prices. The principles which govern commodity pricing also govern factor-pricing. The following paragraphs touch upon the salient aspects of the theory.

“The theory of factor prices is just a special case of the theory of price. We first develop a theory of the demand for factors, then a theory of the supply of factors and finally combine them into a theory of determination of equilibrium price and quantities.” Lipsey and Stonier

Assumptions of Modern Theory of Distribution

1. Every producer tries to get maximum profit
2. Producers have perfect knowledge of the MRP
3. Active competition exists in the factor market
4. There is active competition among the different units of factors
5. The state does not intervene to equate the prices of the factor service

Demand for Factors of Production

The demand for factors of production is different from that of the demand for goods. The demand for goods is direct while the demand for factors of production is derived demand. The factors of production are demanded because they assist the process of production. Productivity of a factor refers to the contribution made by it in the process of production. If the demand for goods which the factor produces is more, its own demand will also be high and vice-versa. The elasticity of demand for industry with identical costs will be high.

It means that the total demand of a factor unit at OP price level is OM i.e. OX’ x 200. Further, at price level OP’, the demand is OM’ = (OX” X 200) and so on. Now, by taking all the possible combinations of factors price and the total demand for it we can draw the demand curve DD for the whole industry. In Figure, the factor price is determined by the quantity of the factor, possibility of substitutes, and elasticity of demand for final product. Thus, the demand for the factor is determined by its marginal revenue productivity.

The total demand for the factor in an industry, the demand for the factors by all the firms has to be added. It can be shown with the following fig. 1:

Factors Affecting Demand

The demand for factors is influenced by the following factors:

(i) The Elasticity of Demand for the Final Product

The demand for the services of a factor will be elastic if a slight fall in its price brings about a large responsiveness in its employment. Since the demand for the factor service is a derived demand, the elasticity of demand for the final product will determine the elasticity of demand for the factor service.

(ii) The Amount of Factor Required

The elasticity of demand for the factor service also depends upon the extent to which the factor service in question is required in the production of the commodity. If the factor service plays an insignificant role, then, demand for it would be inelastic i.e., demand for the factor service will not be affected by a change in the price.

(iii) Substitutability

Elasticity of demand for a factor service also depends upon the extent to which factor service in question can be substituted by other factors “The greater the ease with which factors of production can be substituted for each other, the more elastic is likely to be the demand for them.

Supply of Factors of Production

Like the demand for factors of production, supply of factors of production also differs from that of the goods. The supply of goods increases with the increase in price. But in the ease of factors of production, there exists no simple relation between supply and price. But for the sake of our convenience, we presuppose that there exists the positive relation between supply and price. It cannot be unrealistic because the higher prices attract the factors to work more.

Factors Affecting Supply

(i) Supply of Land

For an economy, supply of land is perfectly inelastic. Supply of land is free for an economy because it has no case of production. But for an industry, supply of land depends on opportunity cost. If opportunity cost of land increases in one industry as compared to another industry then more of it will be used in the former industry than the latter. Thus, for an industry supply curve will be upward sloping.

(ii) Supply of Labour

Supply of labour refers to the number of hours for which a labourer is willing to sell his services at a given price. There exists no definite relation between supply of labour and wage rate. Ordinarily, it is opined that up to a limit supply of labour increases with increase in wage. But after a given level, as the wage rate increases labour prefers leisure to work. In this situation, supply curve becomes backward sloping as seen in fig. 2.

In Fig. 2 SS is backward sloping supply curve of labour. It shows that up to OW wage rate supply of labourer is increasing but when wage rate rises from OW to OW] then supply of labour decreases from ON to ON₁,

(iii) Supply of Capital

Supply of capital depends on savings. Price of capital is called interest. According to classical economists with the increase in rate of interest, supply of savings will increase and vice-versa. Thus, supply curve of capital will slope upward.

(iv) Supply of Entrepreneur

There exists no definite relation between supply of entrepreneur and his price. Besides profits, supply of an entrepreneur depends on many non-economic factors.

In the words of J.B. Clark, “Under static conditions, every factor including entrepreneur would get a remuneration equal to marginal product.” As per Mark Blaug, “The marginal productivity theory contends that in equilibrium each productive agent will be rewarded in accordance with its marginal productivity.”

When an organization increases one unit of a factor of production (while keeping the other factors constant), the marginal productivity increases to a certain level of production. After reaching a certain level, the marginal productivity starts declining. This is because when an organization keeps on increasing the amount of a particular factor of production, the marginal cost also increases.

Types of Marginal Productivity

The theory of marginal productivity can be understood more clearly by gaining knowledge regarding the different types of marginal productivity.

The different types of marginal productivity are explained as follows:

(i) Marginal Physical Productivity

Refers to an increase in output occurred due to the increase in one unit of factor of production. According to M.J. Ulmer, “Marginal physical productivity may be defined as the addition to total production resulting from employment of one unit of a factor of production, all other things being constant.”

Example:- Suppose one labor is able to produce four quintals of wheat. If one more labor is hired, then the yield of wheat would reach to eight quintals. In such a case, the marginal physical productivity for the additional labor is four quintals of wheat (8-4=4).

The general formula for marginal physical productivity is as follows:

MPP_n = TPP_n -TPP_n-1

Where MPP_n = Marginal physical productivity for nth unit of labor

TPP_n = Total physical productivity of n units of labor

TPP_n-1 = Total physical productivity of n-1 units of labor

(ii) Marginal Revenue Productivity

Refers to the concept of marginal productivity with respect to change in total revenue. As per M.J. Ulmer, “Marginal revenue productivity may be defined as the addition to total revenue resulting from employment of one unit of a factor of production, all other things being constant.”

Let us understand the concept of marginal revenue productivity with the help of an example. Suppose one labor is able to produce wheat, which is worth of Rs. 50. If one more labor is hired, then the revenue generated from wheat would be Rs. 60. In such a case, the marginal revenue productivity for the second labor is Rs. 10 (60-50-10).

The formula for calculating marginal revenue productivity is as follows:

MRP = MPP * MR

Where MRP = Marginal Revenue Productivity

MR= Marginal Revenue

(iii) Value of Marginal Productivity

Refers to the value obtained by multiplying marginal physical productivity with the price of product produced. According to Ferguson, “The value of marginal product of a variable factor is equal to its marginal product multiplied by the market price of the commodity in question.”

The formula of value of marginal productivity is as follows:

VMP = MPP* AR

Where, VMP = Value of marginal productivity

MPP = Marginal physical productivity

AR = Market price of product

Let us understand the concept of value of marginal productivity with the help of an example. Suppose the market price of wheat is Rs. 10 per quintal and the marginal physical productivity for the additional labor is four quintals of wheat. In such a case, the value of marginal productivity for the additional labor would be Rs. 40 (4*10=40).

Assumptions of Marginal Productivity Theory:

The assumptions of marginal productivity theory are as follows:

(i) Perfect competition in product market

Refers to one of the main assumptions of marginal productivity theory. In marginal productivity theory, it is assumed that there is perfect competition in the product market. Thus, the change in output of an organization would not affect the market price of the product. In such a case, marginal revenue is equal to the average revenue of the product.

(ii) Perfect competition in factor market

Implies that organizations are required to purchase the factor of production at the prevailing market price only. In case of perfect competition, all the factors of production are perfectly mobile. In addition, the supply of factors of production is perfectly elastic.

(iii) Homogeneity of factors

Assumes that all the units of a factor of production are homogeneous in nature. Therefore, the units are perfect substitutes of each other.

(iv) Substitutability of factors

Assumes that various factors of production act as substitutes of each other. For example, capital act as the substitute of labor.

(v) Divisible factors

Assumes that various factors of production can be divided in small parts.

(vi) Maximum profit

Assumes that the main aim of every organization is to maximize their profit.

(vii) Full employment

Refers to one of the assumptions of marginal productivity theory. Under full employment condition, the supply of a factor of production is fixed in quantity.

(viii) Variable input coefficient

Assumes that an organization can use the factors of production in different quantities. In other words, the quantity of a factor can be changed, while keeping the other factors constant. For example, a land owner can employ two to three workers to plough a one hectare land.

(ix) Same state of technology

Assumes that the technology used in production is constant.

Limitations of Marginal Productivity Theory

Marginal productivity theory contributes a significant role in factor pricing.

In spite of its major contribution in factor pricing, the theory suffers from certain limitations, which are as follows:

(i) Unrealistic assumptions

Refer to one of the major limitations of marginal productivity theory. Marginal productivity theory stands true only under certain conditions, such as homogeneity of factors of production, perfect competition, and perfect mobility of factors of production.

(ii) Difficulty in measurement

Implies that the marginal productivity of a factor of production cannot be measured accurately. This is because while determining the marginal productivity of a factor, other factors are kept constant, which is not possible in the real scenario. For example, if the number of labor is increasing, then the other factors of production, such as tools, machinery, and raw material, needs to be increased for increasing the output.

Features of Perfect Competition

There are various market forms like perfect competition, monopoly, monopolistic competition, and oligopoly. Suppliers provide commodities based on the market demand, their cost and revenue functions. Each market structure leads to a different demand and revenue function. In this article, we will look at the features of perfect competition.

An essential aspect of perfect competition is the absence of any monopolistic element. These are the three essential features of perfect competition:

1. The number of buyers and sellers in the market is very large. These buyers and sellers compete among themselves. Due to the large number, no buyer or seller influences the demand or supply in the market.
2. The commodity sold or bought is homogeneous. In other words, goods produced by different firms are identical in nature.
3. Firms can enter or exit the market freely.

Additional Features of Perfect Competition

(i) Buyers and Sellers have a perfect knowledge of:

• The quantities of stock of goods in the market
• The conditions of the market
• Prices at which transactions of sale or purchase are happening.

(ii) There are facilities that help the movement of goods from one center to another.

(iii) Buyers have no preference between different sellers.

(iv) Also, buyers have no preference between different units of the commodity offered for sale.

(v) Sellers have no preference between different buyers.

(vi) At any given point in time, the goods are bought or sold at a uniform price. In other words, all firms must accept the price determined by the market forces to total demand and supply.

DETERMINATION OF PRICE UNDER PERFECT COMPETITION

Perfect competition is defined as a market situation where there are a large number of sellers of a homogeneous product. An individual firm supplies a very small portion of the total output and is not powerful enough to exert an influence on the market price.

A single buyer, however large, is not in a position to influence the market price. Market price in a perfectly competitive market is determined by the interaction of the forces of market demand and market supply. Market demand means the sum of the quantity demanded by individual buyers at different prices.

Similarly, market supply is the sum of quantity supplied by the individual firms in the industry. Each seller and buyer takes the price as determined. Therefore, in a perfectly competitive market, the main problem for a profit-maximizing firm is not to determine the price of its product but to adjust its output to the market price so that profit is maximized.

Price determination under perfect competition is analyzed under three different time periods:

(a) Market Period

(b) Short Run

(c) Long Run

(a) Market Period

In a market period, the time span is so short that no firm can increase its output. The total stock of the commodity in the market is limited. The market period may be an hour, a day or a few days or even a few weeks depending upon the nature of the product.

For example, in the case of perishable commodities like vegetables, fish, eggs, the period may be a day. Since the supply of perishable commodities is limited by the quantity available or stock in day that neither can be increased nor can be withdrawn for the next period, the whole of it must be sold away on the same day, whatever may be the price.

Fig. 1 shows that the supply curve of perishable commodities like fish is perfectly inelastic and assumes the form of a vertical straight line SS. Let us suppose that the demand curve for fish is given by dd. Demand curve and supply curve intersect each other at point R, determining the price OP. If the demand for fish increases suddenly, shifting the demand curve upwards to d’d’.

The equilibrium point shift from R to R” and the price rises to OP’. In this situation, price is determined solely by the demand condition that is an active agent.

Similarly, if the demand for a product is given, as shown in demand curve SS in figure 2. If the supply of the product decreases suddenly from SS to S’S’, the price increases from P to P’. In this case price is determined by supply, the supply being an active agent.

In this case supply curve shifts leftward causing increase in price of the reduced supply goods. Given the demand curve dd and supply curve SS, the price is determined at OP. Demand curve remaining the same, the decrease in supply shifts the supply curve to its left to S’S’. Consequently, the price rises from OP to OP’.

The supply curve of non-perishable but reproducible goods will not be a vertical straight line throughout its length. This is for certain goods can be withdrawn from the market if the price is too low as the seller would not sell any amount of the commodity in the present market period and would like to hold back the whole stock.

The price below which the seller declines to offer for any amount of his product is known as ‘reserve price’. Thus, the seller faces two extreme price-levels; at one he is ready to sell the whole stock and the other he refuses to sell any. The amount he offers for sale will vary with price.

The seller will be ready to supply more at a higher price rather than at a lower one will depend upon his anticipations of future price and intensity of his need for cash. The supply curve of a seller will, therefore, slope upwards to the right up to the price at which he is ready to sell the whole stock. Beyond this point, the supply curve will become a vertical straight line whatever the price.

(b) Pricing in the Short Run- Equilibrium of the Firm

Short period is the span of time so short that existing plants cannot be extended and new plants cannot be erected to meet increased demand. However, the time is adequate enough for producers to adjust to some extent their output to the increase in demand by overworking their fixed capacity plants. In the short run, therefore, supply curve is elastic.

Figure 3 shows the average and marginal cost curves of the firm together with its demand curve. Demand curve, in a perfectly competitive market, is also the average revenue curve and the marginal revenue curve of the firm. The marginal cost intersects the average cost at its minimum point. The U-shape of both the cost curves reflects the law of variable proportions operative in the short run during which the size of the plant remains fixed.

The firm is in equilibrium at the point B where the marginal cost curve intersects the marginal revenue curve from below:

The firm supplies OQ output. The QC is the average cost and the firm earns total profit equal to the area shown by ABCD. The firm maximizes its profit. Earlier to the point of equilibrium, the firm does not attain the maximum profit as each additional unit of output brings more revenue that its cost. Any level of output greater than OQ brings less marginal revenue than marginal cost.

For the equilibrium of a firm the two conditions must be fulfilled:

(a) The marginal cost must be equal to the marginal revenue. However, this condition is not sufficient, since it may be fulfilled and yet the firm may not be in equilibrium. Figure 4 shows that marginal cost is equal to marginal revenue at point e’, yet the firm is not in equilibrium as Oq output is greater than Oq’.

(b) The second and necessary condition for equilibrium requires that the marginal cost curve cuts the marginal revenue curve from below i.e. the marginal cost curve be rising at the point of intersection with the marginal revenue curve.

Thus, a perfectly competitive firm will adjust its output at the point where its marginal cost is equal to marginal revenue or price, and marginal cost curve cuts the marginal revenue curve from below.

The fact that a firm is in equilibrium does not imply that it necessarily earns supernormal profits. In the short-run equilibrium firms may earn supernormal profits, normal profits or may incur losses.

Whether the firm makes supernormal profits, normal profits or incurs losses depends on the level of the average cost at the short run equilibrium. If the average cost is below the average revenue, the firm earns supernormal profits. Figure 5 illustrates that the average cost QC is less than average revenue QB, and the firm earns profits equal to the area ABCD.

If the average cost is above the average revenue the firm makes a loss. Figure 6 shows that the Average cost QF is higher than QG average revenue and the firm is incurring loss equal to the shaded area EFGH. In this case the firm will continue to produce only if it is able to cover its variable costs.

Otherwise it will close down, since by discontinuing its operations the firm is better off; it minimizes its losses. The point at which the firm covers its variable costs is called ‘the closing-down point’. If the price falls below or average costs rise, the firm does not cover its variable costs and is better off if it closes down. Figure 7 explains shut- down point.

Equilibrium of the Industry

An industry is in equilibrium at that price at which the quantity demand is equal to the quantity supplied.

Figure 8 explains that DD is the industry demand and SS the industry supply. The point E at which industry demand and industry supply equalizes, the price OP is determined. OQ is the quantity demanded and quantity supplied. This, however, is a short run equilibrium where at the market-determined price some firms may be making supernormal profits, normal profits or making losses. In the long run the firms may not continue incurring losses. Loss making firms that cannot adjust their plant will close down.

Firms that are making supernormal profits will expand their capacity. Simultaneously new firms will be attracted into the industry. Free movement of firms in and outside the industry and readjustment of the existing firms in the industry will establish a long run equilibrium in which firms will just be earning normal profits and there will be no tendency of entry or exit from the industry.

(c) Pricing in the Long Run

The long run is a period of time long enough to permit changes in the variable as well as in the fixed factors. In the long run, accordingly, all factors are variable and non- fixed. Thus, in the long run, firms can change their output by increasing their fixed equipment. They can enlarge the old plants or replace them by new plants or add new plants.

Moreover, in the long run, new firms can also enter the industry. On the contrary, if the situation so demands, in the long run, firms can diminish their fixed equipments by allowing them to wear out without replacement and the existing firm can leave the industry.

Thus, the long run equilibrium will refer to a situation where free and full scope for adjustment has been allowed to economic forces. In the long run, it is the long run average and marginal cost curves, which are relevant for making output decisions. Further, in the long run, average variable cost is of no particular relevance. The average total cost is of determining importance, since in the long run all costs are variable and none fixed.

In the short run a firm under perfect competition is in equilibrium at that output at which marginal cost equals price or Marginal Revenue. This is equally valid in the long run. But, in the long run for a perfectly competition firm to be in equilibrium, besides marginal cost being equal to price, price must also be equal to average cost. If the price is greater than the average cost, the firms will be making supernormal profits.

Lured by these supernormal profits, new firms will enter the industry and these extra profits will be competed away. When the new firms enter the industry, the supply or output of the industry will increase and hence the price of the output will be forced down. The new firms will keep coming into the industry until the price is depressed down to average cost, and all firms are earning only normal profits.

On the other hand, if the price happens to be below the average cost, the firms will be incurring loses. Some of the existing firms will quit the industry. As a result, the output of the industry will decrease and the price will rise to equal the average cost so that the firms remaining in the industry are making normal profits. Hence, in the long run, firms need not be forced to produce at a loss since they can leave the industry, if they are having losses. Thus, for a perfectly competitive firm to be in equilibrium in the long run, price must equal marginal and average cost.

Now when average cost curve is falling, marginal cost curve is below it, and when average cost curve is rising, marginal cost curve must be above it. Hence, marginal cost can be equal to the average cost only at the point where average cost curve is neither falling nor rising, i.e. at the minimum point of average cost curve. Therefore, it is at the point of minimum average cost curve, and the two are equal there.

Thus, the conditions for long run equilibrium of perfectly competitive firm can be written as:

Price = Marginal Cost = Minimum Average Cost.

The conditions for the long run equilibrium of the firm under perfect competition can be easily understood from the Fig. 4.9, where LAC is the long run average cost curve and LMC in the long run marginal cost curve. The firm under perfect competition cannot be in long run equilibrium at price OP’, because though the price OP’ equals MC at G (i.e., at output OQ) but it is greater than the average cost at this output and, therefore, the firm will be earning supernormal profits.

Since all the firms are assumed to be identical, all would be earning supernormal profits. Hence, there will be attraction for the new firms to enter the industry. As a result, the price will be forced down to the level Op at which price, the firm is in equilibrium at F and is producing OQ” output.

At point F or equilibrium output OQ”, the price is equal to average cost, and hence the firm will be earning only normal profits. Therefore, at price OP, there will be no tendency for the outside firms to enter the industry. Hence, the firm will be in equilibrium at OP price and OQ output.

On the contrary, a firm under perfect competition cannot be in the long run equilibrium at price OP”. Though price OP” is equal to marginal cost at point E, or at output OQ” but price OP” is lower than the average cost at this point and thus the firm will be incurring losses.

Since all the firms in the industry are identical in respect of cost curves, all would be incurring losses. To avoid these losses, some of the firm will leave the industry. As a result, the price will rise to OP, where again all firms are making normal profits. When the price OP is reached, the firms would have no further tendency to quit.

Thus, to conclude that at price OP, the firm under perfect competition is in equilibrium in the long run when:

Price = MC = Minimum AC

Now, at price OP, besides all firms being in equilibrium at output OQ, the industry will also be in equilibrium, since there will be no tendency for new firms to enter or the existing firms to leave the industry, because all will be earning normal profits. Thus, at OP price, full equilibrium, i.e. equilibrium of all the individual firms and also of the industry, as a whole, is achieved in the long run under perfect competition.

Cost and revenue analysis refers to examining the cost of production and sales revenue of a production unit or firm under various conditions. The objective of a firm is to earn profit, and not to make loss. However, a firm’s profit or loss is primarily determined by its costs and revenue. In simple terms, profit / loss is defined as the difference between the total revenue and the total cost i.e.,

Profit (or) Loss = Total Revenue – Total Cost

As costs and revenue are very important to decide the production behaviour of a firm and its supply behaviour in the market, it is necessary to understand the cost and revenue concepts.

Costs

Companies incur costs in many ways. Costs result from the production of goods, the purchase of inventory, the operating of the business, and the purchase of assets. These costs include the fixed and variable costs associated with production, depreciation and investment costs, and general and administrative costs. Costs also include opportunity costs, sunk costs and marginal costs. Cost analysis identifies and investigates the sources and components of these costs. Cost analysis has several different names, including cost allocation, cost-benefit analysis and cost-effectiveness analysis.

What Cost Analysis Reveals

Cost analysis helps a company determine the expected costs and benefits of a particular asset, new product, or plan of action before it makes the requisite investment. An in-depth cost analysis can reveal hidden costs embedded in a company’s normal way of doing business and the unanticipated costs of certain actions. Identifying and then stripping out costs can help a company increase its profitability and long-term viability. Cost analysis also aids companies in changing their service and product delivery procedures to those that are more cost-efficient and effective.

Revenues

Companies generate revenues from sales of their products and services. To generate more revenues, companies can increase the prices of existing products and services, offer add-on services for an additional price, or introduce new products or services at a higher price point. Companies can also increase revenues by increasing the quantity sold. Firms accomplish this by lowering prices or increasing their marketing efforts to stimulate demand.

What Revenue Analysis Reveals

Revenue analysis helps companies determine how to increase their revenues significantly. When combined with cost analysis, it helps companies do this while keeping costs at a minimum. Revenue analysis aids companies in assessing which course of action produces the highest increase in revenue with the least effort. For example, a company determines that it takes a series of press releases, website testimonials, and well-placed classified ads to drastically increase sales of a particular product, but it also determines that adding a low-cost add-on to a higher priced service would have the same effect.

Break-Even

The break-even point for a product or service occurs when revenue generated by the product equals the costs incurred in producing, selling and delivering the product. Break-even analysis blends cost and revenue analysis to help companies determine if a new product or service makes financial sense. While companies may focus solely on cost analysis for the purpose of cost reduction, most companies use revenue analysis combined with cost analysis to choose the revenue option that produces the most profit.

A monopoly refers to when a company and its product offerings dominate one sector or industry. Monopolies can be considered an extreme result of free-market capitalism in that absent any restriction or restraints, a single company or group becomes large enough to own all or nearly all of the market (goods, supplies, commodities, infrastructure, and assets) for a particular type of product or service. The term monopoly is often used to describe an entity that has total or near-total control of a market.

Monopolies typically have an unfair advantage over their competition since they are either the only provider of a product or control most of the market share or customers for their product. Although monopolies might differ from industry-to-industry, they tend to share similar characteristics that include:

• High or no barriers to entry:Competitors are not able to enter the market, and the monopoly can easily prevent competition from developing their foothold in an industry by acquiring the competition.
• Single seller:There is only one seller in the market, meaning the company becomes the same as the industry it serves.
• Price maker:The company that operates the monopoly decides the price of the product that it will sell without any competition keeping their prices in check. As a result, monopolies can raise prices at will.
• Economies of scale:A monopoly often can produce at a lower cost than smaller companies. Monopolies can buy huge quantities of inventory, for example, usually a volume discount. As a result, a monopoly can lower its prices so much that smaller competitors can’t survive. Essentially, monopolies can engage in price wars due to their scale of their manufacturing and distribution networks such as warehousing and shipping, that can be done at lower costs than any of the competitors in the industry.

Determination of price under monopoly

Under Monopoly every seller wants to earn maximum Profit.

This fact Prof. Marshall has stated that monopolist wants to earn “Maximum Monopoly Gain” by selling his goods.

This thing Mrs. Robinson has stated as Net Monopoly Revenue.

Now, the important question arises that how monopolist should fix his price, so that he may earn maximum profit? On this point two economists written above are of this opinion the price determination under monopoly condition is similar to those of perfect competition.

The only difference is that in perfect competition the average revenue curve and marginal revenue curve are same and parallel to X-axis where as in Monopoly these curves are downwards sloping curves. The Monopolist behaves like a firm. His aim is maximization of profits and if there are losses, then minimization of losses. The profits are maximized when marginal cost is equal to marginal revenue. The losses are minimum where marginal cost is equal to marginal revenue but afterwards marginal cost must be rising.

A Monopolist being the only producer and seller of that commodity can determine its price and the quantity of its production or supply. He cannot do both the things simultaneously. Either he fixes the price and leaves the output to be determined by the consumer demand at that price or he can fix the output to be produced and leave the price to be determined by the consumers’ demand for his product. But it is a common experience that he leaves the price to the market mechanism and determines the volume of output. Under no circumstances, he will be ready to bear losses.

If, in a short period, the cost of production of a commodity is zero, he will go on producing it to the extent or so long the marginal revenue from the sale of that commodity does not fall to zero. As soon as the marginal reserve is zero he will not increase its supply.

Some economists think that, in a short period, three different situations may arise before the monopolist:

(i) When the monopolist earns abnormal profits,

(ii) When he gets only normal profits, and

(iii) When he suffers losses.

The explanation and diagrams of these situations are given below:

On the point E the firm is in equilibrium when MC = MR. Thereafter MC curve starts to rise. Under the condition, OP is the price and OQ is the ‘total production’ of the commodity so determined. In order to calculate profits or losses, we will have to measure the difference between AR and AC. If AR > AC, the difference between the two is profit per unit and by multiply it with total number of units produced we can get total profit.

In the first figure RQ = OP is the price, TO is the cost of production per unit. Thus, RS =PT is unit for profit. On the OQ quantity of production, total profit is PTSR shaded area which is abnormal profit. In the second figure RQ = OP is the determined price and RQ is the average cost. Under this condition, there will be only normal profit.

In the figure three also price per unit is RQ = OP but cost per unit is SQ. Thus, SR (TP) is loss per unit. As a result TPRS shaded area will be the total loss. But this loss is only short period phenomenon. In the long period, this loss will disappear, under that condition and situation, only profit will be earned.

Determination of Price in the Long Period

In the long period the monopolist introduces changes in his equipment’s and techniques of production. During this period in order to gain excess profit, he will change efficiency and capacity of his resources according to his need. But the determination of the quantity of production follows, the same line as under short period.

This is clear from the following figure:

In this figure LMC and LMR intersect each other at the point E and after that LMC goes on rising. Thus OQ production is determined and OP is the price. But average cost is SQ. So profit per unit is RS and at OQ output the total profit is PTSR.

Under Price Competition AR =MR, where-as under Monopoly MR <AR.

Under perfect competition price is determined by the interaction of total demand and supply. This price is acceptable to all the firms in the industry. No firm can change this price. So, average revenue and marginal revenue, at every level of production, will be constant and equal. Their curves are parallel to X-axis.

Under Monopoly, to sell every additional unit of the commodity price will have to be lower. In this way, with the sale of every additional unit, average and marginal income goes on falling. But the decrease in average revenue is relatively less sharp than the decrease in marginal revenue, It is because marginal revenue is limited to one unit, whereas in case of average revenue, the decrease price is divided by the number of units. Therefore, the fall in average revenue has relatively less slope. That is the reason why marginal revenue is less than average revenue.

In monopolistic competition, since the product is differentiated between firms, each firm does not have a perfectly elastic demand for its products. In such a market, all firms determine the price of their own products. Therefore, it faces a downward sloping demand curve. Overall, we can say that the elasticity of demand increases as the differentiation between products decreases.

Fig. 1 above depicts a firm facing a downward sloping, but flat demand curve. It also has a U-shaped short-run cost curve.

Conditions for the Equilibrium of an individual firm

The conditions for price-output determination and equilibrium of an individual firm are as follows:

1. MC = MR
2. The MC curve cuts the MR curve from below.

In Fig. 1, we can see that the MC curve cuts the MR curve at point E. At this point,

• Equilibrium price = OP and
• Equilibrium output = OQ

Now, since the per unit cost is BQ, we have

• Per unit super-normal profit (price-cost) = AB or PC.
• Total super-normal profit = APCB

The following figure depicts a firm earning losses in the short-run.

From Fig. 2, we can see that the per unit cost is higher than the price of the firm. Therefore,

• AQ > OP (or BQ)
• Loss per unit = AQ – BQ = AB
• Total losses = ACPB

Long-run equilibrium

If firms in a monopolistic competition earn super-normal profits in the short-run, then new firms will have an incentive to enter the industry. As these firms enter, the profits per firm decrease as the total demand gets shared between a larger number of firms. This continues until all firms earn only normal profits. Therefore, in the long-run, firms, in such a market, earn only normal profits.

As we can see in Fig. 3 above, the average revenue (AR) curve touches the average cost (ATC) curve at point X. This corresponds to quantity Q₁ and price P₁. Now, at equilibrium (MC = MR), all super-normal profits are zero since the average revenue = average costs. Therefore, all firms earn zero super-normal profits or earn only normal profits.

It is important to note that in the long-run, a firm is in an equilibrium position having excess capacity. In simple words, it produces a lower quantity than its full capacity. From Fig. 3 above, we can see that the firm can increase its output from Q₁ to Q₂ and reduce average costs. However, it does not do so because it reduces the average revenue more than the average costs. Hence, we can conclude that in monopolistic competition, firms do not operate optimally. There always exists an excess capacity of production with each firm.

In case of losses in the short-run, the firms making a loss will exit from the market. This continues until the remaining firms make normal profits only.