UNIT - III: Production, Cost, Market Structures & Pricing

Production Analysis: Factors of Production, Production Function, Production

Function with one variable input, two variable inputs, Returns to Scale, Different
Types of Production Functions.
Cost analysis: Types of Costs, Short run and Long run Cost Functions.
Market Structures: Nature of Competition, Features of Perfect competition,
Monopoly, Oligopoly, Monopolistic Competition.
Pricing: Types of Pricing, Product Life Cycle based Pricing, Break Even Analysis,
Cost Volume Profit Analysis.

INTRODUCTION AND DEFINITION OF PRODUCTION FUNCTION

The concept of a production function is fundamental in economics. It provides a framework for

understanding how businesses transform inputs (resources) into outputs (goods or services).

Production is the process of transforming or converting resources into commodities over time.
Economists perceive production as an activity aimed at creating or enhancing utility for a
product. This transformative process is crucial for generating goods and services that meet
societal needs and demands.

In the words of Watson, “Production Function is the relationship between a firm’s production
(output) and the material factors of production (input).”

Samuelsson defines the production function as “The technical relationship which reveals the
maximum amount of output capable of being produced by each and every set of inputs”

Michael R Baye defines the production function as” That function which defines the
maximum amount of output that can be produced with a given set of inputs.”

Production Function: A production function is a mathematical or graphical representation

that illustrates the relationship between inputs (factors of production) and the maximum output
that can be produced with those inputs. In its general form, it is expressed as:
Mathematically a Production Function

Mathematically, a production function refers to a function that describes the relationship

between the quantity of outputs (Q) and the levels of various inputs (factors of production)
used in the production process. Here's a breakdown of the common mathematical
representation:

Q = f (K, L ...)

Where:

Q represents the total output (quantity of the good or service produced)

f represents the function itself, defining the specific relationship between inputs and output

K represents capital input (e.g., machinery, equipment, buildings)

L represents labor input (e.g., person-hours worked)

The ellipsis (...) indicates that other input variables may be included in the function besides
capital and labor, depending on the specific production process being modeled.

PRODUCTION FUNCTION WITH TWO VARIABLES OR ISOQUANTS:

Definition: Isoquants are graphical representations used in economics to show various

combinations of inputs (typically labor and capital) that can produce the same level of output or
product.

Basic Idea: Isoquants help illustrate the different ways inputs can be combined to achieve a
specific level of production. The term "isoquant" is derived from "iso," meaning equal, and
"quant," referring to quantity.

Assumptions:
  There are only two factors of production, viz. labour and capital.
 The two factors can substitute each other up to certain limit
 The shape of the isoquant depends upon the extent of substitutability of the two inputs.
 The technology is given over a period.

Isoquant Example:

Suppose the bakery can produce 100 pies using different combinations of labor and ovens, as
shown in the table below:

Labor Ovens Total Output

Combination (L) (K) (Pies)

A 10 2 100

B 5 4 100

C 20 1 100

D 8 3 100

In this example:

 Combination A uses 10 units of labor and 2 ovens to produce 100 pies.

 Combination B uses 5 units of labor and 4 ovens to produce 100 pies.
 Combination C uses 20 units of labor and 1 oven to produce 100 pies.
 Combination D uses 8 units of labor and 3 ovens to produce 100 pies.

Features of an ISOQUANT:

 Downward Sloping: Isoquants slope downward, which means if you reduce one input,
you must increase the other to keep the same level of output. You can't decrease both
inputs and maintain the same output.
 Do Not Touch the Axes: Isoquants never touch either the X-axis or the Y-axis. This is
because both inputs (e.g., labor and capital) are always needed to produce a product. If an
 isoquant touches the X-axis, it suggests you can produce output with only one input,
which is unrealistic.
 Do Not Intersect: Isoquants representing different output levels never cross, touch, or
overlap. If they did, it would mean that the same amount of labor and capital could
produce two different output levels, which doesn't make sense.
 Convex to Origin: Isoquants have a curved shape that is convex to the origin. This curve
shows that labor and capital are not perfect substitutes for each other. When you increase
one input (e.g., labor), you give up less of the other input (e.g., capital) to maintain the
same output. This indicates diminishing returns.
 Higher Isoquants Mean More Output: Each isoquant represents a specific level of
output. Higher isoquants represent greater output levels. Moving to a higher isoquant
requires using more of both inputs, which results in increased production.

RETURNS TO SCALE:

Law of increasing returns to scale:- if a proportionate/percentage increase in the output is

larger than the proportionate/percentage increase in inputs, there are increasing returns.

For example: If a 5% increase in inputs, results in 10% increase in the output, a firm is said
to attain increased returns.

If PFC > 1, it means increasing returns to scale If PFC = 1, it means constant returns to scale

If PFC < 1, it means decreasing returns to scale

Law of constant returns to scale:- if the proportionate increase in all the inputs is equal to the
proportionate increase in output, then situation of constant returns to scale occurs.
For Example:- If the inputs are increased at 10% and if the resultant output also increases a
10% then the organization is said to achieve constant returns to scale.

Law of decreasing returns to scale:- if the proportionate increase in output is less than the
proportionate increase in input, then a situation of decreasing returns to scale occurs.

For Example:- If the inputs are increased by 10% and if the resultant output increases only by
5% then the organization is said to achieve decreasing returns to scale.

The following table illustrates these laws clearly.

Different Types of Production Functions.

There are two main types of production functions

Short-Run Production Function: This refers to the relationship between input (variable
factors) and output when at least one factor of production is fixed. In the short run, a company
typically has a fixed amount of capital, such as machinery, buildings, and land. The company can
only change its output level by varying the amount of variable factors, such as labor or raw
materials.

Long-run production function: This refers to the relationship between input (all factors) and
output when all factors of production are variable. In the long run, a company can change its
output level by varying any or all factors of production, including capital (machinery, buildings,
and land) as well as labor and raw materials.

Cost analysis: Types of Costs, Short run and Long run Cost Functions.

Cost Concepts:

Cost concepts are fundamental principles in economics and accounting that help businesses and
individuals understand, analyze, and manage their expenses. These concepts are crucial for
decision-making, pricing strategies, and financial planning. Here are some key cost concepts:

1. Fixed Costs:

Definition: Fixed costs are expenses that remain constant in the short run, regardless of the level
of production or output. These costs do not vary with changes in production volume.

Examples: Rent, salaries of permanent employees, insurance premiums.

2. Variable Costs:

Definition: Variable costs are expenses that change in direct proportion to changes in production
or output. They increase as production increases and decrease as production decreases.

Examples: Raw materials, direct labor, sales commissions.

3. Total Costs:

Definition: Total costs are the sum of both fixed and variable costs. They represent the overall
cost incurred to produce a specific quantity of goods or services.

Formula: Total Cost = Fixed Costs + Variable Costs.

4. Average Costs:

Definition: Average costs, also known as unit costs, are calculated by dividing total costs by the
quantity of output produced. They provide insights into the cost per unit of production.

Formula: Average Cost = Total Cost / Quantity of Output.

5. Marginal Costs:

Definition: Marginal costs represent the additional cost incurred when producing one more unit
of a product or service. They are essential for determining optimal production levels.

Formula: Marginal Cost = Change in Total Cost / Change in Quantity of Output.

Opportunity Costs:

Definition: Opportunity costs refer to the value of the next best alternative that is forgone when a
decision is made. These costs are not always monetary but can include time and resources.

6. Sunk Costs:

Definition: Sunk costs are expenses that have already been incurred and cannot be recovered or
changed. They should not influence future decision-making because they are irrelevant to the
decision at hand.

7. Opportunity Cost:

This refers to the potential benefit you give up when you choose one option over another. It's
not an explicit expense but represents the sacrificed value of the forgone alternative.

Example: You decide to open a bakery instead of investing in the stock market. The potential
return you could have earned on your investment is the opportunity cost of opening the bakery.

8. Short-Run Cost:

These are costs incurred within a time frame where at least one factor of production is fixed.
Typically, this refers to a period where capital (buildings, machinery) cannot be significantly
adjusted.

Examples: Rent, salaries of permanent staff, depreciation on equipment (considered fixed cost
in the short run even though the equipment value declines over time).

9. Long-Run Cost:

This concept applies when all factors of production can be varied. In the long run, a company
can adjust its capital, labor, and other resources to meet its production needs.

Examples: Costs associated with building a new factory, hiring additional staff, or purchasing
new equipment.

10. Direct Cost:

These costs can be easily identified and directly traced to a specific product or service. They
vary in proportion to the level of production.

Examples: Raw materials used to produce a particular good, direct labor costs associated with
creating that good, commissions paid on sales of a specific product.

11. Indirect Cost:

These costs are not directly attributable to a single product or service. They are incurred to
support overall production but cannot be easily linked to specific units of output.

Examples: Factory overhead costs (electricity, utilities), salaries of administrative staff,

insurance costs for the entire facility.

Short run and Long run Cost Functions

Aspect Short-Run Cost Function Long-Run Cost Function
Fixed period of time, where at least one No factors of production are fixed, allowing
Time Frame factor of production is fixed. for adjustments in all inputs.
Limited flexibility as at least one factor
of production is fixed, leading to less Higher flexibility as all factors of production
Flexibility scope for adjustments. can be varied, enabling more adjustments.
Types of
Costs Includes both fixed costs and variable Encompasses only variable costs, as there
Included costs. are no fixed factors of production.
Typically exhibits diminishing marginal May exhibit economies or diseconomies of
Shape of returns, leading to U-shaped average scale, resulting in a variety of shapes for
Cost Curves total cost curves. average total cost curves.
Fixed Costs Constant in the short run Can be changed
Variable
Costs Vary with output level Can be changed
Total Costs Fixed + Variable Costs Fixed + Variable Costs
Average
Costs Total Cost / Output Total Cost / Output
Marginal Change in Total Cost / Change in
Costs Output Change in Total Cost / Change in Output

Market Structures: Nature of Competition, Features of Perfect competition, Monopoly,

Oligopoly, Monopolistic Competition.

MARKET
Market is a place where buyer and seller meet, goods and services are offered for the sale and transfer
of ownership occurs
 Market Structures
Market structure describes the competitive environment in the market for any good or
service. A market consists of all firms and individuals who are willing and able to buy or
sell a particular product. This includes firms and individuals currently engaged in buying
and selling a particular product, as well as potential entrants. The determination of price is
affected by the competitive structure of the market. This is because the firm operates in
a market and not in isolation. In making decisions concerning economic variables it is
affected, as are all institutions in society by its environment.

1.1 CLASSIFICATION OF MARKET STRUCTURES

Market structures are classifications that economists use to categorize markets based on key
characteristics that influence how firms compete and prices are determined. Here's a
breakdown of the four main classifications:

1. Perfect Competition: This is the ideal scenario with a large number of buyers and sellers
trading identical products (homogeneous goods) with perfect information. No single buyer or
seller has significant power to influence the market price. Firms are price takers, meaning they
must accept the prevailing market price set by supply and demand. There are also very few
barriers to entry or exit from the market, allowing for a high degree of competition.

Examples: Agricultural markets (wheat, corn)

2. Monopoly: On the opposite end of the spectrum, a monopoly is a market with only one
seller of a particular good or service with no close substitutes. This single seller has significant
control over the market price, acting as a price maker rather than a price taker. High barriers to
entry, such as government regulations, patents, or economies of scale, prevent other firms
from entering the market and challenging the monopoly's dominance.

Examples: Public utilities (water, electricity), companies with patented products.

3. Oligopoly: An oligopoly features a small number of large, interdependent sellers. The products
may be homogeneous (like steel) or differentiated (like cars), but each seller has a significant
influence on the market price. Oligopolies are aware of each other's actions and strategic
decisions, making their behavior more complex than in a perfectly competitive market. There
can be various forms of competition, including price competition, non-price competition
(advertising, product development), or tacit collusion (where firms act cooperatively to avoid
price wars).

Examples: Telecommunications industry, automobile industry, airline industry.

4. Monopolistic Competition: This structure combines elements of both perfect competition and
monopoly. There are many sellers, but they offer differentiated products (not identical) based
on factors like brand, quality, features, or location. Firms have some control over price due to
this differentiation, but they are still limited by competition from other sellers offering similar
products. Barriers to entry are lower than in a monopoly but may exist in the form of brand
loyalty, advertising costs, or product differentiation.

Examples: Restaurants, clothing stores, hair salons.

Understanding these classifications helps us predict firm behavior, analyze market efficiency,
and assess the potential impact of government policies on competition.

PERFECT COMPETITIONS
Perfect competition is an idealized market structure characterized by a high degree of
competition and perfect information. It represents a theoretical benchmark against which real-
world markets can be compared. Here's a breakdown of its key features:

Definition:

Perfect competition is a market structure where a large number of buyers and sellers freely
engage in the buying and selling of identical products (homogeneous goods) with perfect
information. In this ideal scenario, no single buyer or seller has significant power to influence
the market price.

Characteristics:

Large Number of Buyers and Sellers: There are many buyers and sellers in the market, none of
whom are large enough to individually influence the overall price. This ensures that each
participant acts as a price taker, accepting the market price determined by supply and demand.

Homogeneous Products: All firms sell identical products that are perfect substitutes for each
other. This means there are no brand preferences or quality variations that could influence
buyer decisions.

Perfect Information: All buyers and sellers have complete and costless access to all relevant
market information, including prices, product quality, and the actions of other buyers and
sellers. This allows for rational decision-making and eliminates any information asymmetry.

Free Entry and Exit: There are no barriers or restrictions for firms to enter or exit the market.
This allows for efficient resource allocation and ensures that firms earn only normal profits in
the long run.

Price Takers: Due to the large number of buyers and sellers, individual firms cannot influence
the market price. They are price takers, meaning they must accept the prevailing market price
set by the forces of supply and demand.
Profit Maximization: Firms in a perfectly competitive market aim to maximize their profits by
producing at the output level where marginal cost (MC) equals marginal revenue (MR).

Efficient Market: Perfect competition is considered an efficient market structure because it

promotes resource allocation based on consumer demand and eliminates economic profits in
the long run.

Examples (limited in reality):

 Agricultural markets (wheat, corn) where many farmers sell similar commodities.
 Stock exchanges where individual investors have access to a vast amount of information.

MONOPOLY

A monopoly is a market structure with only one seller of a particular good or service. This single
seller has significant control over the market, unlike perfect competition where many sellers
compete. Here's a breakdown of monopolies and their key features:

Introduction:

Monopolies exist when there are high barriers to entry that prevent other firms from competing
in the market. These barriers can be due to various factors, such as:

Government regulations: For example, a government-issued patent gives a firm the exclusive
right to produce a particular good for a certain period.

Natural monopolies: Certain industries, like public utilities (water, electricity), exhibit natural
monopolies where a single provider is more efficient due to economies of scale. The high cost
of infrastructure investment discourages competition.

Ownership of a key resource: A firm that controls a critical resource essential for production
can act as a monopoly.

3.1 FEATURES OF A MONOPOLY

Single Seller: The defining characteristic of a monopoly is the presence of only one seller. This
seller has significant control over the market and the power to influence price.

No Close Substitutes: The good or service offered by a monopoly has no close substitutes. This
means buyers have limited choices and may be forced to purchase from the monopoly seller,
even if they aren't entirely happy with the price or quality.

High Barriers to Entry: High barriers to entry prevent other firms from entering the market and
challenging the monopoly's dominance. These barriers can be legal (patents), technological,
economic (economies of scale), or resource-based.

Price Maker: Unlike firms in perfect competition who are price takers, a monopoly acts as a
price maker. They have some control over the price they charge because of the lack of
competition. However, this control is not absolute, and they still need to consider factors like
consumer demand and production costs.

Potential for Profit Maximization: Monopolies have the potential to earn economic profits in
the long run due to the lack of competition. They can restrict output and raise prices above the
perfectly competitive level to maximize profits.

Allocative Inefficiency: Monopolies may not allocate resources efficiently. By restricting output
and raising prices, they can create a situation where society would be better off if there were
more competition.

Limited Innovation: In the absence of competition, monopolies may have less incentive to
innovate and improve their products or services.

Examples of Monopolies:

Public utilities (water, electricity)

Companies with patented products (certain pharmaceuticals)

 Firms with control of a key resource (diamond mines De Beers)

MONOPOLISTIC COMPETITION

Monopolistic competition bridges the gap between the two extremes of perfect competition
and pure monopoly. It provides a more realistic framework for understanding how many
markets function in the real world. Here's an introduction to monopolistic competition and its
key features:

Introduction:

Perfect competition assumes a large number of identical sellers, perfect information, and free
entry and exit. In reality, many markets exhibit some degree of product differentiation and
brand loyalty.Monopolistic competition incorporates these aspects, offering a more nuanced
view.

4.1 FEATURES OF MONOPOLISTIC COMPETITION

Many Firms: Similar to perfect competition, there are a large number of sellers in monopolistic
competition. However, unlike perfect competition where firms are price takers, firms in
monopolistic competition have some degree of control over price due to product
differentiation.

Product Differentiation: This is the defining characteristic of monopolistic competition.

Products can be differentiated by various factors, including:

Physical characteristics (features, design, quality)

Branding (image, reputation, customer loyalty)

Location (convenience, accessibility)

o Services (warranties, customer support)

Marketing and advertising (creating brand awareness and product perception)

Large Number of Buyers: Similar to perfect competition, there are many buyers in the market.
However, due to product differentiation, buyers may have preferences for certain brands or
product features. This gives firms some influence over their customer base.

Free Entry and Exit: As in perfect competition, firms can relatively easily enter or exit the
market in monopolistic competition. This is because there are typically no significant barriers to
entry, unlike a pure monopoly.

Selling Costs: Due to product differentiation and the need to influence buyer preferences, firms
in monopolistic competition tend to incur higher selling costs compared to perfect competition.
These costs include advertising, marketing, promotions, and other efforts to create brand
awareness and attract customers.

Imperfect Information: Consumers may not have perfect information about all the available
options. Advertising and marketing play a role in influencing consumer choices, even if the
products are close substitutes.

Downward-Sloping Demand Curve: While firms have some control over price due to
differentiation, they still face a downward-sloping demand curve. If they raise the price too
much, consumers may switch to close substitutes offered by other firms.

In essence, monopolistic competition allows firms to:

Differentiate their products to attract a specific customer base.

Exercise some control over price due to differentiation, but not as much as a pure monopoly.

Compete with other firms through product features, marketing, and pricing strategies
Monopolistic Competition: Examples in the Real World

Monopolistic competition is all around us! Here are some real-world examples to illustrate the
key features of this market structure:

Restaurants:

Differentiation factors: Cuisine type (Italian, Mexican, etc.), ambiance (fine dining, casual), price
point, service style.

Many restaurants exist, but consumers may have preferences for specific cuisines,
atmospheres, or familiar brands.

Clothing Stores:

Differentiation factors: Brand names, target demographics (men's, women's, children's),

fashion styles (casual, athletic, formal), quality levels.

Numerous clothing stores compete, but consumers may have brand loyalty or preferences for
certain styles or price ranges.

Cell Phone Companies:

Differentiation factors: Network coverage, data plans, phone features (camera quality,
processing power), customer service.

Several cell phone companies compete, but consumers may choose based on network coverage
in their area, preferred data plans, or loyalty to a specific brand.

Coffee Shops:

Differentiation factors: Coffee blends, beverage options (teas, smoothies), store atmosphere
(cozy, modern), convenience location.
Many coffee shops compete, but consumers may have preferences for specific coffee roasts,
drink options, or the ambiance of a particular chain.

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
sellers in the market, producing either a homogeneous product or producing products,
which are close but not perfect substitute of each other.

An Oligopoly Market is a system of Markets where there are more than one Vendor (or firm) for
trading of a particular good but there are very few Vendors. This is imperfect competition as
the decision of one Vendor affects the decision of others in the Market, although the
competition is very limited. The main characteristics of this type of Market is the
interdependence of the Vendors that urge them to collaborate and compete with each other to
control the Market, affecting the demand and supply based on the prices.

5.1 DEFINITION AND FEATURES OF OLIGOPOLY

An oligopoly is a market structure characterized by a small number of firms dominating the

market for a particular good or service. Here's a breakdown of its definition and key features:

Definition:

Oligopoly comes from the Greek words "oligoi" (few) and "polein" (to sell). It refers to a market
with a limited number of powerful sellers who influence prices and overall industry conditions.

According to P.C. Dooley “An oligopoly is a market of only a few sellers, offering either
homogeneous or differentiated products. There are so few sellers that they recognize their
mutual dependence.”
According to J.Stigier “Oligopoly is that situation in which a firm bases its markets policy in part
on the expected behaviour of a few close rivals.”

In simple words Oligopoly is that market situation in which there are so few sellers that each of
them is conscious of the results upon the price of the supply which he individually places upon
the market

Features of Oligopoly:

Few Sellers, Big Impact: A small number of firms control a significant share of the market. Each
firm's actions significantly impact the others, creating interdependence.

Homogeneous or Differentiated Products: Oligopolistic firms can sell products that are:

Homogeneous: Products are nearly identical, with competition focused on price and marketing
(e.g., aluminum).

Differentiated: Products have distinct features or branding, allowing for some variation in
pricing and competition based on those unique selling points (e.g., smartphones).

Interdependence and Strategic Behavior: Decisions by one firm (like pricing or product launch)
trigger reactions from competitors. This creates a strategic environment where firms anticipate
and counter each other's moves.

Barriers to Entry: Oligopolies often have high barriers to entry, making it difficult for new firms
to compete. These barriers can be things like economies of scale, government regulations, or
brand loyalty.

Potential for Collusion: Firms might be tempted to collude, meaning secretly agreeing on prices
or output to maximize profits. This behavior restricts competition and harms consumers (it's
often illegal).
Imperfect Competition: Oligopolistic markets exhibit imperfect competition. There are few
sellers, and their interdependence reduces pressure to drive prices down to the most efficient
level.

Price Setting and Market Power: Oligopolistic firms have some degree of control over prices
due to their limited numbers and potential for coordination. However, the extent of this control
depends on factors like the level of product differentiation and the threat of government
intervention.

Pricing: Types of Pricing, Product Life Cycle based Pricing, Break Even Analysis, Cost
Volume Profit Analysis.

TYPES OF PRICING POLICIES

Here are the common types of pricing policies companies use, with examples:

Cost-based pricing policy

A cost-based pricing policy calculates the average cost of production for a good or service and
then accounts for the profit margin your company desires. This policy is a traditional approach
to doing business because it considers the costs of doing business in a straightforward and
adjustable manner. If a material you require for production goes up in price, you simply raise
the price of the good proportionally. One downside of this policy is that it can be difficult to
know what you need to charge ahead of time or if the scale of production changes.

Example: A painter wants to sell paintings for twice as much as they cost to make. Each painting
uses an average of $20 worth of paint, a $10 canvas and one day's labor, which the painter
values at $150. Since the total cost of production is $180, the painter doubles the cost for a sale
price of $360.

Cost plus Pricing:

Cost plus pricing involves adding a predetermined profit margin to the total cost of production
to determine the selling price. This profit margin is often expressed as a percentage of the
production cost.

Example: Continuing with the bakery example, if the bakery decides on a profit margin of 50%,
the cost plus price would be the production cost ($5 per cupcake) plus 50% of the production
cost. The selling price would then be $5 + ($5 * 0.50) = $7.50 per cupcake.

Competition-based pricing policy

Your business might use a competition-based pricing policy to respond to what competitors are
charging for similar products. When pricing based on competition, your company considers
what segment of the market it wants to appeal to and the competitors from which it seeks to
take market share.

Competition-based pricing policy can be useful because it's a simple way to determine price. It
also can be both accurate and low-risk, since you likely understand what your consumers
already pay for what you're offering. However, sometimes, this approach might lead your
company to overlook strengths of your product that could command higher prices. Since many
companies use a competitive-based pricing policy, one firm's inaccurate pricing can also result
in widespread pricing mistakes.

Example: A furniture company produces a new coffee table with a unique design. It researches
what competitors charge for tables of similar size and materials and concludes the competition-
based price is $350. Consumers think the table's design is exceptional and better than even
some of the luxury brand offerings that are twice the price. The furniture company makes a
profit selling hundreds of tables but could have made much more money with a different
approach.

Sealed Bid Pricing:

Sealed bid pricing is a method commonly used in tenders and contracts. In this approach, firms
submit sealed bids or proposals containing their proposed prices for a particular project or
contract. The bids are opened at a specified time, and the contract is typically awarded to the
bidder with the lowest price.

Example: Consider a government agency soliciting bids for the construction of a new highway.
Several construction companies submit sealed bids with their proposed prices for the project.
After opening the bids, the agency selects the construction company with the lowest bid as the
winner of the contract.

Going Rate Pricing:

Going rate pricing involves charging the prevailing market price for a product or service. This
pricing strategy is often used in commodity markets where products are similar, and pricing is
primarily influenced by market conditions and competitors.

Example: Imagine a company that produces a common household item, such as paper towels.
In a market where several competitors offer similar products, the company might set its prices
based on the going rate, which is the average price established by competitors. If the prevailing
market price for a roll of paper towels is $2, the company would likely set its price in a similar
range to remain competitive.

These pricing strategies are adapted to specific market conditions and types of transactions:

Demand-based pricing policy

Perceived Value Pricing: price is fixed

Perceived value pricing is a strategy where the price of a product is determined based on the
perceived value it provides to customers. This approach involves understanding how customers
value the product and setting a price that aligns with that perceived value.

Example: Consider a high-end smart phone manufacturer that releases a new model with
advanced features, a sleek design, and cutting-edge technology. The company conducts market
research to understand how consumers perceive the value of these features. Based on the
findings, the company sets a premium price for the smart phone, as it believes that the
perceived value of the product justifies the higher cost.

Price Discrimination (Differential Pricing):

Price discrimination involves charging different prices to different customers for the same
product or service. This strategy relies on segmenting the market and setting prices based on
various factors, such as location, customer type, quantity purchased, season, or timing.

Example: Airlines commonly use price discrimination based on factors such as timing and
customer type. Consider a situation where an airline offers different prices for the same flight
depending on when the ticket is purchased. Early bookings may receive lower prices, while last-
minute bookings may incur higher costs. Additionally, airlines often use different pricing tiers
for business class, economy class, and other categories, tailoring prices to different customer
segments.

Both pricing strategies highlight the importance of understanding customer perceptions and
market conditions to set prices that maximize revenue and meet consumer expectations.

Strategy-Based Pricing:

Strategy-based pricing involves setting prices in alignment with the overall business strategy.
This approach considers various factors, such as the positioning of the product or service in the
market, the brand image, and the long-term goals of the business. It goes beyond simply
covering costs or responding to market conditions and aims to use pricing as a strategic tool to
achieve broader business objectives.
Skimming Pricing:

Setting a high initial price for a new product when it's introduced to capture the highest
possible profit from early adopters.

Example: When Apple releases a new iPhone model, it often adopts a skimming pricing
strategy. The initial price is set high to capitalize on the enthusiasm and willingness to pay
among early adopters who want the latest technology. Over time, as demand subsides, Apple
may gradually lower the price to attract a broader market.

Penetration Pricing:

Offering a low initial price to gain market share quickly and attract a larger customer base.

Example: Consider a new streaming service entering a competitive market. To quickly gain
subscribers, it may adopt a penetration pricing strategy by offering a low monthly subscription
fee. The goal is to encourage a large number of customers to try the service, with the
expectation of increasing prices or introducing additional features once a significant market
share is achieved.

Product Life Cycle based Pricing

Product life cycle pricing is a strategy that adjusts a product's price based on the stage it's in
within its lifecycle. There are typically four stages: introduction, growth, maturity, and decline.
Each stage has its own pricing considerations:

1. Introduction Stage:

Pricing Strategies:

 Price Skimming: Setting a high initial price to capture early adopters willing to pay a
premium for a new and innovative product. This helps recoup development costs quickly.
 Penetration Pricing: Setting a low introductory price to gain market share quickly and
establish brand awareness. This is often used for mass-market products.

2. Growth Stage:

Pricing Strategies:
  Maintain Price: If demand is strong, companies may maintain the current price to
maximize profits.
 Moderate Price Reductions: Small price cuts can encourage wider adoption without
sacrificing too much profit margin.

3. Maturity Stage:

Pricing Strategies:

 Competitive Pricing: Focus on maintaining a competitive price to stay in the game as

the market becomes saturated with similar products.
 Promotional Pricing: Use discounts, sales, and bundles to stimulate demand and defend
market share.

4. Decline Stage:

Pricing Strategies:

 Price Reductions: Lower prices to clear out remaining inventory and maximize profit
before discontinuing the product.
 Loss Leaders: Sell products below cost to attract customers and potentially sell them
higher-margin products.

Stage Description Pricing Strategies

New product enters the Price skimming, Penetration

Introduction
market Pricing

Maintain Price, Moderate Price

Growth Demand increases
Reductions

Competitive Pricing, Promotional

Maturity Market saturation
Pricing

Decline Sales decline Price Reductions, Loss Leaders

BREAK EVEN ANALYSIS

Break-Even Analysis (BEP), also known as Cost-Volume-Profit (CVP) Analysis, is a key business
tool used to:

Identify the break-even point (BEP): This is the sales level where total revenue equals total
cost, resulting in zero profit (no profit, no loss).

Understand cost structure: BEP analysis helps businesses break down their costs into fixed
costs (those that don't change with production volume) and variable costs (those that change
with production volume).

Optimize production levels: By understanding the relationship between costs and volume,
businesses can determine production levels that ensure profitability.
Key Components:

Total Revenue (TR): This is the total income generated from selling products or services. It's
calculated by multiplying the selling price per unit (P) by the total number of units sold (Q): TR =
PxQ

Total Cost (TC): This is the sum of all costs incurred in production and sales. It can be further
broken down into:

Total Fixed Cost (TFC): These are costs that remain constant regardless of production level (e.g.,
rent, insurance, salaries of administrative staff).

Total Variable Cost (TVC): These costs change in proportion to production level (e.g., raw
materials, direct labor costs, utilities).

KEY TERMS USED IN BREAK EVEN ANALYSIS

1. Total Revenue (TR): The total income generated from selling products or services, calculated
by multiplying the price per unit by the quantity sold.

2. Total Cost (TC): The sum of all costs incurred in production and sales, including both fixed
and variable costs.

3. Fixed Costs (TFC): Costs that remain constant regardless of the production level, such as rent,
insurance, and salaries of administrative staff.

4. Variable Costs (TVC): Costs that change in proportion to the production level, including raw
materials, direct labor costs, and utilities.

5. Break-Even Point (BEP): The production or sales volume at which total revenue equals total
cost, resulting in neither profit nor loss.

6. Selling Price (P): The price at which a product or service is sold to customers.
7. Average Variable Cost (AVC): The total variable cost divided by the number of units
produced, representing the variable cost per unit.

8. Contribution Margin (CM): The difference between the selling price and the variable cost per
unit, indicating the amount available to cover fixed costs and contribute to profit.

FORMULAS:

Topic Formula Description

P/V Ratio = (Contribution / This formula calculates the
Sales) x 100 percentage of each sales
(Or) rupee that contributes to
1. Profit Volume Ratio (P/V P/V Ratio=Sales-Variable covering fixed costs and
Ratio) Cost / Sales*100 generating profit. OR
This formula calculates the
P/V Ratio based on changes
P/V Ratio = (Change in in profit and sales, useful for
2. P/V Ratio (Using Profit and Profit / Change in Sales) x analyzing the impact of sales
Sales Changes) 100 growth on profit.
3. Break-Even Point (BEP in a) BEP (in Units) = Total Fixed
units) Costs / Contribution Margin
Per Unit
where:
This formula calculates the
Contribution Margin Per number of units that need to
Unit =Selling Price Per Unit - be sold to cover all fixed
Variable Cost Per Unit costs (no profit, no loss).

Break-Even Point(in Rupees) BEP=Fixed Cost / Profit

Volume Ratio(P/V Ratio)

a) MOS (in Units) = Actual

Sales (in Units) – BEP (in This formula calculates the

Units) number of units sold above

b) MOS(in Rupees)=Profit / the break-even point.

5. Margin of Safety (MOS) P/V Ratio