Chapter 3

Theory of Production and Cost

 Definition of a Market

In economics, a market is a system or place

where buyers and sellers interact to exchange
goods, services, or resources. This interaction
determines the price and quantity of goods or
services exchanged. A market can be physical
(such as a grocery store) or virtual (such as an
online marketplace like Amazon).
On the basis of competition among the seller or producers of firms Markets can be classified into
two types. They are
1. Perfect competition market
2. 2. Imperfect competition market
Perfect competition market
In a perfectly competitive market there are numerous buyers and sellers selling homogenous
products and no one is able by his own actions to influence the market price, since all have access
to full and immediate knowledge of the price at which the trading is currently talking place.
Example: Agricultural markets (Wheat, Rice, Corn)
Features of Perfect Market: The perfect competition market has the following features.
3. Large number of sellers and buyers: There will be a large number of sellers and buyers
for a good in this market. It means the output of a buyer or a seller is a small part of the total
output. A single producer or seller cannot change the price by his actions. None of them is
large enough to influence the price. Therefore a seller takes the price decided by the market.
The producer is a price taker.
4. Homogeneous Commodities: Products in this market are similar in every aspect. A
consumer gets the same good whenever he purchases. As a result there will be one price all
over the market.
5. Free entry and exit: Any firm can enter into the production as per its desire. Finally it can
leave the production at any time. This helps new firms to enter into business when
conditions are favourable. As long as a firm earns super normal profits, it usually stays in
competition. But when the firm ends up with losses, it would leave the market .
4. Mobility of factors of production: Factors of production will move from
one production to another easily. This is also useful for free entry and exit of
firms factors (land, labour, capital) move to the production activities where
they get higher incomes.
5. Absence of transport cost: Under perfect market transport costs should
not be added in the price. If transport costs are added the goods are available
at the fewer prices at the near markets and they are available at the higher
prices at distant markets. Existing of two prices for the same thing in different
parts is against for perfect market. So transport cost should not be added.
6. Perfect knowledge of market: Buyers and sellers in this market will have
a clear knowledge about market conditions. So that there will be one price
throughout the market. Because of perfect knowledge, sales and purchases of
commodities take place as one price.
 Price Determination in a Perfect
Competition Market
• In a perfectly competitive market, the price of a good is determined by
the interaction of supply and demand. Since individual firms are price
takers, they must accept the market price. The market naturally balances
the quantity supplied by producers and the quantity demanded by
consumers, leading to the establishment of an equilibrium price.
Equilibrium Price Determination
• The equilibrium price is the price at which quantity demanded equals
quantity supplied.
• If the price is above equilibrium, there is a surplus (excess supply),
leading firms to reduce prices.
• If the price is below equilibrium, there is a shortage (excess demand),
causing prices to rise.
• The market automatically adjusts until it reaches equilibrium, where no
shortages or surpluses exist.
Imperfect Competition Market: The imperfect market is appeared in various forms. They are
1. Monopoly 2. Duopoly 3. Oligopoly 4. Monopolistic competition.

Monopoly Market: The word Monopoly is derived from two words ‘Mono’ and ‘Poly’. Mono means Single
and Poly means seller. Where there is an only one seller or one producer or one firm it is said to be monopoly
market. The single seller supply the commodities to the entire market the product supplied by the monopolist is
not have close substitutes. They are some many restrictions for other produces to enter into the market as a
result monopoly has no competition in the market. Example: Bangladesh Railway. Titas Gas, WASA.
Features of Monopoly: The monopoly market has the following features:
2. Single firm: A single firm produces the commodity in the market there is only one seller or one
producer or one firm.
3. No close substitutes: The produce supplied by the monopolist will not have close substitutes in the
market. A consumer will not find a substitutes commodity for the monopoly products.
4. Strong barriers to enter: New firms cannot enter in the production due to the certain restrictions in
market i.e. huge investment, lack of technology; patents etc. prevent the new firms to enter the market.
5. Firm and Industry are same: As there is one firm in monopoly market there is no difference between
firm and industry.
6. Price maker: In this market the producer can determine the price of the commodity so the producer in
the market is said to be price maker.
7. Nature of AR & MR curves: The average Revenue Curve (AR) and Marginal Revenue Curve (MR)
both are slopes downwards from left to right because when a seller wants to sell the more of output he
must reduce the price when the price is decreased both AR & MR are declining.
8. Price discrimination: The monopolist can charge the different prices from the different customers for
the same thing or services. The price is not uniform as in the perfect market competition.
9. Maximum profits: The main aim of monopoly is to earn to get the maximum profits.
 Price and output determination
In monopoly market as there is a single
producer, he can control either the price of the
commodity or supply of the commodity. But he
can’t control both at the same time. He can
increase the price by decreasing the output or he
can sell more output by decreasing the price.
Maximization of profits is the sole objective of
the monopolist.
Monopolistic Competition Market: The concepts of monopolistic competition was introduced by Prof.
Chamberlin. It is a market with many sellers for a product but the products are different in certain respects.
The features of monopoly and competition are combined in this market. Hence, it is called monopolistic
competition. Example: Cosmetics, Soaps etc.
Example: Banking Sector, Fast Food Chains (McDonald's, Burger King, KFC)
Features of Monopolistic Competition
The main features are:
1. A considerable number of producers: A commodity is produced by a considerable number of producers.
Since there are more number of producers no one controls the output in the market. Competition will be
high among the producers.
2. Product differentiation: The commodity of each producer will be different from that of other producers.
The difference may be due to material used, colour design, smell, packaging, trademark etc. Because of
this each product will have specific identification in the market.
3. Entry and exit: Firms are allowed to enter into production and leave the market. When profits are high new
firms will join. In case of losses inefficient firms will leave.
4. Selling costs: An important feature of this market is every firm makes expenditure to sell more output.
Advertisement through newspapers, journals, electronic media, sales representatives, exhibitions, free
sampling help to promote the sales. Lot of expenditure is made on these items under this market.
5. Imperfect knowledge: Buyers will have an imperfect knowledge about commodities. Sometimes products
may be the same but consumers think that a particular good is superior than another. Due to the
advertisements and other devices consumers purchase the commodities.
6. Price decision: Each firm produces a commodity with small differences. It is due to this reason that a firm
will decide the price for its product. The demand curve for a firm will be downwards sloping and more
elastic.
Duopoly
A duopoly is a type of oligopoly where two firms have dominant or exclusive control over a market, and most
(if not all) of the competition within that market occurs directly between them. Example: bKash & Nagad.
Key Features of a Duopoly
• Two Dominant Firms:
A duopoly market structure consists of just two firms that hold the majority of the market share. These two
firms dominate the industry and often engage in competitive or cooperative behavior to maximize their
profits. Examples of duopolies include industries like Coca-Cola and Pepsi in the soft drink market, or
Boeing and Airbus in the aircraft manufacturing industry.
• Interdependence:
In a duopoly, the decisions made by one firm significantly impact the other firm. Each firm must consider the
likely response of the competitor when setting prices, choosing production levels, or making other business
decisions. This interdependence is a fundamental characteristic of duopoly competition.
• Barriers to Entry:
Due to high capital costs, brand loyalty, technological expertise, and economies of scale, entry barriers are
typically very high in a duopoly. This prevents new competitors from entering the market easily, helping the
two dominant firms maintain their control.
• Price and Output Decisions:
Both firms in a duopoly often set their prices and output levels based on the anticipated reactions of the
competitor. In a competitive scenario, they may engage in price wars, while in a cooperative scenario, they
might tacitly agree on prices or output levels.
• Potential for Collusion:
Since there are only two firms in a duopoly, there is a high likelihood of collusion, either overt or tacit. Overt
collusion is illegal and involves an explicit agreement between firms to set prices or output. Tacit collusion,
on the other hand, occurs when firms cooperate implicitly without direct communication, often through
parallel pricing or market-sharing.
Oligopoly
An oligopoly is a market structure where a small number of large firms dominate an industry. Unlike a duopoly (which
consists of exactly two firms), an oligopoly can have two or more firms that control most of the market share. Example:
Coca-Cola & Pepsi (Soft Drinks), Boeing & Airbus (Aircraft Manufacturing).
Telecommunications: Major players like Grameenphone, Robi, Banglalink and Teletalk dominate the market. Cement
Industry: Companies such as Shah Cement, Bashundhara Cement, and Heidelberg Cement control significant market shares.
Below are the key characteristics of an oligopoly:
Key Features of an Oligopoly
1. Few Large Firms
– A small number of firms dominate the market.
– Examples: The automobile industry (Toyota, Ford, Volkswagen), the smartphone industry (Apple, Samsung,
Google), and the airline industry (Delta, American Airlines, United).
2. Interdependence
– The decisions of one firm significantly impact the other firms.
– If one firm lowers prices, others may follow to stay competitive.
3. Barriers to Entry
– High startup costs, economies of scale, brand loyalty, and government regulations make it difficult for new firms to
enter the market.
4. Non-Price Competition
– Since price wars can reduce profits, firms often compete through advertising, branding, product differentiation, and
customer service.
5. Price Rigidity & Collusion Possibilities
– Prices tend to be stable because firms avoid aggressive price competition.
– Firms may engage in tacit collusion (indirect cooperation) or explicit collusion (illegal agreements like cartels,
e.g., OPEC in the oil industry).