Market.

In ordinary language, the term market refers to a public place in which goods and services are bought and
sold. In economics, market stands for any effective arrangement for bringing buyers and sellers into
contact with one another such that the prices of same goods tend to equalize easily and quickly.

Definition: (Modern Economic Theory by K.K.Dewett. Page no 162)

Economists understand by the term market not any particular market place in which things are bought
and sold but the whole of any region in which buyers and sellers are in such free intercourse with one
another that the price of the same goods tends to equality easily and quickly

- Cournot

Market is any area over which buyers and sellers are in close touch with one another, either directly or
through dealers, that the price obtainable in one part of the market affects the price paid in other parts

- Benham

Thus the market has the following basic components. (Managerial Economics by R.Cauvery. Page no. 174)

A commodity should be offered for sale in the market. Otherwise there is no question of buying the
commodity. Therefore, existence of sellers is a necessary for any market.
Buyers and sellers should have close contact with each other.
There should be price for the commodity. The exchange of commodities between buyers and sellers
occurs at a particular price which is mutually agreeable to both the buyers and sellers.
There should be buyers of the product. If a country consists of people who are poor, there can hardly
be market for luxuries like cars, VCR etc.

Classification of Market: (Managerial Economics by R.Cauvery. Page no. 175)

Market may be classified into different types.

1. On the basis of Area.

Markets may be classified on the basis of area into local, national and international markets. If the buyers
and sellers are located in a particular locality, it is called as local market. e.g., fruits, vegetables etc. When
a commodity is demanded and supplied all over the country, national market is said to exist. When a
commodity commands international market or buyer and sellers all over the world, it is called
international market.

2. On the basis of time.

Time element has been used by Marshell for classifying the market on the basis of time, market has been
classified into very short period, short period, long period and very long period. Very short period market
refers to the market in which commodities that are fixed in supply or are perishable are transacted. Since
the supply is fixed, only the changes in demand influence the price. The short period markets are those
where supply can be increased but only to a limited extent. Long period market refers to a market where
adequate time is available for changing the supply by changing the fixed factors of production. The
supply of commodities may be increased by installing a new plant or machinery and the output can be
changed accordingly. Very long period or secular period is one in which changes take place in factors like
population, supply of capital and raw material, etc.
3. On the basis of nature of transaction.
Market is classified on the basis of nature of transaction into two broad categories viz., Spot market and
future market. When goods are physically transacted on the spot, the market is called as spot market. In
case the transactions involve the agreement of future exchange of goods, such markets are known as
future markets.

4. On the basis of Volume of business.

Based on the volume of business, market is broadly classified into wholesale and retail markets. In the
wholesale markets, goods are transacted in large quantities. Wholesale markets are in fact, a link between
the producer and the retailer while the retailer is a link between the wholesaler and the consumer.

5. On the basis of status of sellers.

During the process of marketing, a commodity passes through a chain of sellers and middlemen. Markets
can be classified into primary, secondary and terminal markets. The primary market consists of
manufacturers who produce and sell the product to the wholesalers. The wholesalers who are an
international link between the manufacturers and retailers constitute secondary markets while the retailers
who sell it to the ultimate consumer constitute the terminal market.

6. On the basis of competition.

Markets are classified on the basis of nature of competition into perfect competition and imperfect
competition.

Perfect Competition/Pure competition: (Modern Economic Theory by K.K.Dewett. Page No 163)

A market is said to be perfect when all the potential sellers and buyers are completely aware of
the prices at which transactions take place and all the offers made by other sellers and buyers, and when
any buyer can purchase from any seller and conversely.

Under such a condition, the price of a commodity will tend to be the same after allowing for the
cost of transport including import all over the market.

Perfect competition refers to the market structure where competition among the sellers and buyers
prevails in its most perfect form.
 In theory perfect competition implies no rivalry among firms. Perfect competition, therefore can
be defined as a market structure characterized by a complete absence of rivalry among the individual
firms.

Features/Characteristics/Conditions of perfect competition:

The term perfect competition refers to a set of conditions prevailing in the market. a perfectly competitive
market is one which has the following characteristics.

1. Large number of sellers and buyers. (Managerial Economics by D.N.Dwivedi. Page no. 217)
Under perfect competition, the number of sellers and buyers is very large. The number of sellers and
buyers is so large that the share of each seller in total supply and the share of each buyer in total demand
is so small that no single seller can affect the market price by changing his supply, nor can a single buyer
by changing his demand.

2. Homogeneous Product. (Principles of Economics by D.N.Dwivedi. Page no233)

The commodities supplied by all the firms of an industry are assumed to be homogeneous. Homogeneity
of the product implies that buyers do not distinguish between products supplied by the various firms of an
industry. In other words, units of products sold by various firms are identical in every respect in colour,
quality, packing, size, etc. Product of each firm is regarded as a perfect substitute for the products of other
firms.

3. Free entry and free exit. ( Principles of Economics by D.N.Dwivedi. Page no234)
There is no legal, technological, economic, financial barrier on entry of new firms to the industry. Nor is
there any restriction on exit of the firms from the industry. That is, a firm may enter the industry and quit
it at its will. Thus, when normal profit of the industry increases, new firms enter the industry and if profits
decrease and better opportunities are available, firms leave the industry.

4. No Government Interference. ( Principles of Economics by D.N.Dwivedi. Page no234)

Government does not interfere in any way with the functioning of the market. There are no taxes, tariffs,
subsidies, no licensing system, no allocation of inputs by the government, or any kind of other direct
control. That is, the government allows the free enterprise policy. Where there is intervention by the
government it is intended to correct the market imperfections.

5. Perfect knowledge of Market condition. (Fundamentals of Business Economics by D.M.Mithani. Pg no. 230)
Perfect competition requires that all the buyers and sellers must possess perfect knowledge about the
existing market condition, especially regarding the market price, quantities and sources of supply. When
there is such perfect knowledge, no buyer could be charged a price different from the market price.
Similarly no seller would unnecessarily lose by selling at a lower price than the prevailing market price.
This way, perfect knowledge ensures transaction at a uniform price.

6. No transport costs. (Business Economics by V.G.Mankar. Page No. 236)

In a perfect competitive market, it is assumed that there are no transport costs. It is assumed that
producers work sufficiently close to each other. If they are producing at different and distant places, they
have to incur different transport costs, and prices will then be different for different producers. Those near
the market will enjoy a special advantage. Then, there will be no effective competition among sellers or
firms. Hence, transport costs are ignored.

The perfect competition, as characterized above, is considered as an unrealistic phenomenon in

the real business world. However, the actual markets that approximate to the conditions of perfectly
competitive model include the share markets, securities and bond markets, and agricultural products
markets, e.g., local vegetable markets. Although perfectly competitive markets are uncommon
phenomenon, perfect competition model has been the most popular model used in economic theories due
to its analytical value.

Price determination under perfect competition: (Economics for Managers by D.M.Mithani. Page no.158)

Under perfect competition, there is a single ruling market price the equilibrium price,
determined by the interaction of forces of total demand (of all the buyers) and total supply (of all the
sellers) in the market.

Thus, both the market or equilibrium price and the volume of production in a market under
perfect competition are determined by the intersection of total demand and total supply. To elucidate the
price of intersection, let us consider hypothetical data on market demand for and market supply of wheat,
as in table below.

Market Demand and Supply Schedule for Wheat

Possible Price Total Demand Total Supply Pressure on Price

(Rs. Per Kg) (Kg. per week) (Kg. per week)
20 1,000 10,000 Downward
19 3.000 8,000 Downward
18 4,000 6,000 Downward
17 5,000 5,000 Neutral
16 7,000 4,000 Upward
15 10,000 2,000 Upward

Comparing the market demand and supply position at alternative possible prices, we find that
when the price is Rs. 20, supply of wheat is 10,000 kg., but demand for wheat is only 1,000 kg. Hence,
9,000 kg. of wheat supply remains unsold. This would bring a downward pressure on price, as the seller
would compete and the force will push down the price. When the price falls to Rs. 19, demand rises to
3,000 kg., while the supply will contract to 8,000 kg. Still the supply is in excess of demand. Thus, the
surplus of the supply causes a further downward pressure on price. Eventually, the price will tend to fall.
This process continues till the price settles at Rs. 17 per kg at which the same amount (5000 kg) is
demanded as well as supplied. This is termed as equilibrium price. Equilibrium is the market clearing
price. In this price, a market demand tends to be equal to the market supply.
 If, however, we begin from a low price (Rs. 15 per kg.) we find that the demand (10,000 kg.)
exceeds the supply (2,000 kg.). Thus, there is a shortage at Rs. 15 per kg. This causes an upward pressure
on the price, so the price will tend to move up. When the price rises, the demand contracts and the supply
expands. This process continues till the equilibrium price is reached, at which the demand becomes equal
to supply. At equilibrium price, there is neutral pressure of demand and supply forces as both are equal in
quantity. In general, a pictorial depiction of price is determined at the intersection point of the demand
curve and the supply curve.

In the above fig PM is the equilibrium price, at which OM is the quantity demanded as well as
supplied. At point P, the demand curve intersects the supply curve. To understand the process of
equilibrium, suppose the price is not at the equilibrium point. Now, if the price is higher than the
equilibrium price, as OP1, then at this price the supply is P 1b, while the demand is P1a. Thus, there is a
surplus amounting to ab. That is to say, more is offered for sale than what the people are willing to buy at
the prevailing price. Hence, to clear the stock of unsold output, the competing sellers will be induced to
reduce the price. Eventually, a downward movement and adjustment, as shown by the downward pointed
arrows, will begin, which would lead to

(i) The contraction of supply as the firms will be prompted to reduce their resources in the industry,
(ii) The expansion of demand, as the marginal buyers and other potential buyers will be attracted to buy in the
market and old buyers also may be induced to buy more at the falling price. Similarly if the price is
below the equilibrium level, the demand tends to exceed the supply.

At OP2 price, for instance, the demand is P 2d, while the supply is P2c. thus, there is a shortfall of
supply amounting to cd. That is to say, buyers want to purchase more than what is available in the market
at the prevailing price. This induces the competing buyers to bid up the price. So, an upward push and
adjustment will develop as shown by the arrows pointed upwards. Thus, the demand contracts as marginal
buyers will be driven away from the market and some buyers will buy less than before. On the other hand,
the supply expands as the existing firms will increase their output to which new firms will also add their
output. Evidently when the price is set at an equilibrium point at which the demand curve intersects the
supply curve, shortages and surpluses disappear, hence, there is perfect adjustment between demand and
supply under the given conditions.

Monopoly (Managerial Economics by R.Cauvery. Page no. 186)

Monopoly is that market form in which a single producer controls the entire supply of a single
commodity which has no close substitutes. There must be only one seller or producer. This sole seller in
the market is called monopolist. The commodity produced by the producer must have no close
substitutes. Monopoly can exist only when there are strong barrier to entry. The barriers which prevent the
entry may be economic, institutional or artificial in nature.

Features/Characteristics/Conditions of Monopoly: (Managerial Economics by R.Cauvery. Page no. 186)

From the above discussion, let us summarize the main characteristics of monopoly as follows.

1. There is a single producer or seller of the product.

2. There are no close substitutes for the product. If there is a substitute, then the monopoly power is lost.
3. No freedom to enter as there exists strong barriers to entry.
4. The monopolist may use his monopolistic power in any manner to get maximum revenue. He may
also adopt price discrimination.
5. There is absence of competition. (Business Economics by V.G.Manker. Page no. 272)
6. Cross-elasticity of demand for a monopoly product is zero.
7. The monopoly firm has control over supply of its commodity.
8. There is no distinction between firms and industry under monopoly.

Price and Output Determination under Monopoly. (Fundamentals of Business Economics by

D.M.Mithani. Page no. 264)

A monopolist is a price maker and not a price taker. In fact, he is independent in making the price
decisions. He need not take into account, while determining his own price/prices, the possible reactions of
other firms, as the products of these firms are not closely competitive substitute for his product in any
significant way. So he can afford to ignore them. The monopolist, as such is in a position to fix the price
for the product as he likes.

A monopolist has control over the market supply; hence he is a price maker. Thus, under the
given cost and demand situation of his product in any period, he has to determine price and output
simultaneously. His price output decision is obviously motivated by profit maximization. Evidently, he
will adjust output and price in such a way that marginal cost and marginal revenue are equal, whereby he
reaps maximum profit. Thus, the profit maximizing combination of output and price is determined by
comparing the cost and revenue schedules at different price and output levels, as shown in Table.
 A comparison of column 6 and 7 in table shows that when a monopolist produces 4 units, his
MR=MC (Rs. 80 in both cases) at price Rs. 140 per unit. In this situation, total revenue is Rs. 560, while
total cost is Rs. 500; hence total profit is Rs. 60. Considering per unit basis, the average revenue per unit
is Rs. 140 while the average cost is Rs. 125, so profit per unit is Rs. 15. For 4 units of output, thus the
total profit is Rs. 15 * 4 = Rs. 60.

Revenue and Cost Schedules of a Monopoly Firm

(Hypothetical Data)

1 2 3 4 5 6 7 8 9
Quantit Price Total Total Average Margina Margina Remark Profit
y of (Rs.) Revenue cost Cost l Cost l s (+)
Output Average (Rs.) (Rs.) (Rs.) (Rs.) Revenue or
(Q) Revenue (TR) (TC) (AC) (MC) (Rs.) Loss (-)
(AR) (MR)

0 200 0 100 - - -
1 200 200 250 250 150 200 MR>MC -50
2 180 360 350 175 100 160 MR>MC +10
3 160 480 420 140 70 120 MR>MC +60
4 140 560 500 125 80 80 MR=MC +60
5 120 600 600 120 100 40 MR<MC 0
6 100 600 720 120 120 0 MR<MC -120
7 80 560 870 120 150 -40 MR<MC -310

The maximum profit equilibrium position of a monopoly firm is graphically shown

 It can be seen that the equilibrium point E is determined by the intersection of the MR curve and
the MC curve, so that MC = MR. Thus, OM equilibrium output is produced by the firm. The firm can sell
this output only at price OP. the price is determined by drawing a perpendicular AM which intersects the
demand curve (AR curve) at point A. Evidently, once the output is decided, the price is determined
automatically in relation to the given demand curve.

Alternatively, if the monopolist fixes the price, the output will be determined accordingly. But, for
profit maximization he adopts the rationale of equating MC with MR and the process of adjustment is
easily described graphically. Anyway, though a pure monopolist has full control over the market supply,
he cannot determine price independently of the market demand for his product. Thus, when equilibrium
output is decided at the point of equality between MC and MR, the price is automatically determined in
relation to the demand for the product. In our illustration, the monopolist will not charge a price higher
than OP, because if he does so, he will not be able to sell OM output.

He would not like to lower the price, either because that will reduce his maximum profit. Thus,
when OP price is charged and OM output is sold, the monopolist obtains a maximum profit, which is
represented by the shared rectangle PABC. This is termed as monopoly profit and it is over and above the
normal profit, which is already estimated in the total costs of the firm. Another important point that must
be observed in the diagram is that the monopolist is in equilibrium on the elastic segment of his demand
curve (the AR curve). Secondly, the monopoly equilibrium output is determined at the falling path of the
AC curve, which means that the monopolist restricts output before producing it at the optimum level of
minimum average cost in order to maximize his profit.
Monopolistic Competition. (Principles of Economics by D.N.Dwivedi Page no.268 and

(Modern Economic Theory by K.K.Dewett. Page no 225)

Perfect competition and pure private monopolies are rare phenomena in the real world.
Monopolistic competition approximates most closely to the real business world. Monopolistic
competition is a market structure in which a large number of sellers sell differentiated products which are
close, but not perfect substitutes for one another. Monopolistic competition combines the characteristics
of perfect competition and monopoly. The important distinguishing characteristics are (a) Product
differentiation (b) Existence of many firms supplying the market, and (c) The goods made by them are
close substitutes. i.e., their product are similar but not identical.

Many examples of monopolistic competition and product differentiation can be cited. Many firms
in India produce toothpaste, but the product of each differs from its rivals in one or more respects.
Different toothpaste like Colgate, Pepsodent, Close-up, Babul etc provides example of monopolistic
competition.

Another example of monopolistic competition consumer knows for sure the difference between
different brands of mobile phones Nokia, Samsung, Sony, Reliance, LG, etc. Since each firm produces a
product distinguishable from that of other firms, each firm holds a monopoly power over its own
products. Although products are differentiated, they remain a close substitute for one another. This creates
condition for competition among the firms which are monopolists in their own rights. This kind of
competition is the genesis of monopolistic competition.

Features/Characteristics/Conditions of Monopolistic Competition:

Monopolistic competition, as the term suggest, entails the attributes of both monopoly and pure
competition. The following are the main features of monopolistic competition.

1. Large numbers of Sellers. (Managerial Economics by R.Cauvery. Page no. 206)

In monopolistic competition the number of sellers is large. No one controls a major portion of the total
output. Hence each firm has a very limited control over the price of the product. Each firm decides its
own price output policy without considering the reaction of rival firms. Thus there is no
interdependence between firms and each sellers pursues an independent course of action.

2. Large number of Buyers. (Economics for Managers by D.M.Mithani. Page no.390)

There are a large numbers of buyers in this type of market. However, each buyer has a preference for a
specific brand of the product. He, thus becomes a patron of a particular seller. Unlike perfect competition,
here buying is by choice and not by chance.

3. Product Differentiation. (Managerial Economics by R.Cauvery. Page no. 206)

One of the most important features of monopolistic competition is product differentiation. Product
differentiation implies that products are different in some ways from each other. There is slight difference
between one product and others in the same category. Products are close substitutes but not perfect
substitutes. The products are differentiated on the basis of materials used, durability, size, style, shape,
design, colour, fragrance, packing etc.
4. Free entry and exit of firms. ( Business Economics by V.G.Manker. Page no. 297)
Under monopoly, the entry of new firms is blocked or prevented because of technical or institutional
factors. But under monopolistic competition, there is no such difficulty. New firms can and do enter or
existing firms may leave the industry. The entry of new firms is not blocked because of the simplicity of
production techniques and smallness of capital requirement those firms which are unfortunate continue to
incurring losses leave the group in the long run, whereas existing of supernormal profits attracts new
entrepreneurs into the field.

5. Selling Cost. (Managerial Economics by R.Cauvery. Page no. 206)

It is an important feature of monopolistic competition. As there is keen competition among the firms, they
advertise their product in order to attract the customers and sell more. Thus selling cost has a bearing on
price determination under monopolistic competition.

6. Perfect Knowledge. (Economics for Managerial Decisions by K.M.Pandey and M. Pandey. Page no 174)
All sellers and buyers are aware of all current opportunities. Onces knowledge of what others are doing
is sufficient to prevent him from taking a lower or paying a higher price than what are doing. It is true for
both the finished goods as well as the factors of production.

7. Rational Behaviour. (Economics for Managerial Decisions by K.M.Pandey and M. Pandey. Page no 174)
All buyers behave in the manner that maximizes their utilities (i.e., satisfactions) and all sellers behave to
maximize their profits. In other words, both the parties are aware of their own interests and try to
maximize them.

8. Non price competition. (Industrial Economics & Management by S.P.Singh. Page no. 89)
Through non price competition firms in the market try to win over customers. There are many methods of
competing rivals other than price cutting such as guarantee for repairs with a particular time, after sales
service, a gift scheme with particular purchases, a discount not declared in the price list or transport free
of cost etc. All these methods are secrete ways of attracting customers to particular brands.

Oligopoly. (Business Economics by V.G.Manker. Page no. 312)

(Managerial Economics by R.Cauvery. Page no. 217) and (Economics for Managers by ICFAI. Page no 107)

Oligopoly is a situation where there are few firms producing a product. The word oligopoly originates
from the Greek word Oligos meaning few and the Latin word Polis meaning Seller. The product sold
by the firms may be homogeneous or differentiated.

Oligopoly is a form of imperfect competition in which a few firms produce either a homogeneous product
or products which are close but not perfect substitutes for each other. This kind of market structure has a
small number of large producers. The number of firms may vary from two to ten firms. A market in which
there are only two players is called a duopoly.

Oligopoly is a situation in which few large firms compete against each other and there is an element of
interdependence in the decision making of these firms. A policy change on the part of one firm will have
immediate effects on competitors, who react with their counter policies.
Definition: Competition among the few - Feller

Example: In auto mobile industry, Marutis Alto, Hyudais Santro, Daewoos Matiz, Fiats Palio and
Tatas Indica, etc., are the outstanding examples of differentiated oligopoly. Similarly cooking gas of
Bharat, Hindustan Petroleum(HP) and Indane are the example of homogeneous oligopoly.

Features/Characteristics/Conditions of Oligopoly:

The following are the main features of an oligopoly market:

1. Small numbers of Large sellers. (Economics for Managers by V.G.Mankar. page no 377)
There are small numbers of large sellers supplying either homogeneous products or differentiated
products.

2. Interdependence. (Managerial Economics by R.Cauvery. Page no. 217)

Unlike perfect competition and Monopoly, the Oligopolist is not independent to take decisions. The
oligopolist has to take into account the actions and reactions of his rivals while deciding his price and
output policies. As the products of the oligopolist are close substitutes, the cross elasticity of demand is
very high.

3. Price Rigidity. (Managerial Economics by R.Cauvery. Page no. 217)

Any change in price by one oligopolist invites retaliation and counter-action from others, the oligopolist
normally sticks to one price. If an oligopolist reduces his price, his rivals will also do so and therefore, it
is not advantageous for the oligopolist to reduce the price. On the other hand, if the oligopolist tries to
raise the price, others will not do so. As a result they capture the customers of this firm. Hence the
oligopolist would never try to either reduce or raise the price. This results in price rigidity.

4. Monopoly element.
As products are differentiated the firms enjoy some monopoly power. Further, when firms collude with
each other they can work together to raise the price and earn some monopoly income.

5. Advertising.
The only way open to the oligopolists to raise his sales is either by advertising or improving the quality of
the product. Advertisement expenditure is used as an effective tool to shift the demand in favour of the
product. Quality improvement will also shift the demand favorably. Usually, both advertisements as well
as variation in designs and quality are used simultaneously to maintain and increase the market share of
an oligopolist.

6. High Cross Elasticities.

The firms under oligopoly have a high degree of cross elasticities of demand for their products, so there
is always a fear of retaliation by rivals. Each firm consciously considers the possible action and reaction
of its competitors while making any change in the price or output.

7. Constant Struggle.
Competition is of unique type in an oligopolistic market. Here, competitions consist of constant struggle
of rivals against rivals.
8. Lack of Uniformity.
Lack of uniformity in the size of different oligopolies is also a remarkable characteristic.

Price Determination under Oligopoly. (Business Economics by V.G.Mankar. Page no. 314)

Due to indeterminate nature of demand curves of oligopoly there is no single and simple solution to the
price determination problem under oligopoly. This is due to uncertainty regarding the reactions of the
rivals to any move by an individual firm.

Again the objective of the firm in an oligopoly situation may not necessarily be profit maximization. Prof.
Rothschild says that an oligopolists objective in price output fixation is maximizing security or achieving
reasonable amount of profit over a long period of time. According to Prof. Boumal, it is maximizing of
sales which is an objective of an oligopolist.

It is for these reasons, viz., indeterminancy of demand curve and variety of objectives, that there is no
single determinate solution of the oligopoly price problem. There are many possible solutions. We may
discuss here a few of them.

Collusive Oligopoly Model (Common price policy by agreement). (Business Economics by

V.G.Mankar. Page no. 321)

After indulging in price-war and cut-throat competition, the firms in oligopoly may reach an express or
implied agreement on a common price policy to be followed by all. They realize after the experience that
such price war is against their collective and individual interest. By pulling together, they would like to
promote the interest of all in the group. This pulling together and entering into a formal agreement is
known as a Cartel. A Cartel originally refers to a common sales agency, undertaking selling operations
of all the firms in a group selling and identical or similar (i.e., differentiated product). A Cartel in its
present form is defined as a group of firms that coordinate their activities in order to maximize the total
profits of the group.

The Game Theory Model. (Business Economics by V.G.Mankar. Page no. 323)

The theory of games model is developed by Prof. Von Neumann and Morgenstern. An industrial firm
under oligopoly has to select a rational course of action assuming possible reaction of its rivals, which in
return would affect itself. The firm has to prepare its own strategies as regards (i) the price variation, (ii)
changing quality of the product and (iii) Expanding promotional expenditure, such as on advertisement,
exhibition displays, home to home canvassing, and etc. Then the likely strategies of the other firms are to
be prepared. Then with the help of a matrix is showing respective profits resulting from the strategies to
firm A and other firm B (in a two firm model) is prepared. Then firm A will find out various alternatives
which would give minimum gain to the firm. It will choose the one which maximum among the minimum
gains. This is the policy of Playing it safe. The outcome of the gain is only known at the end of the
game.

Critically speaking, the game theory assumes that the firm is pessimistic and wants to play safe in the
game. It is assumed that the rival firm will follow the worst strategy as a reaction. This is questioned by
many economists. This will not apply to a dynamic businessman who may like to take risk and get as
much profit as possible.

Secondly, the game theory assumes the advance knowledge of the strategies open to the firm and other
rival firms. But this is not realistic. The real world is full of uncertainties.

Depreciation.

The word depreciation is derived from the Latin word depretium where de means reduce, and
pretium means price. Thus, literally the term stands for a decrease in the value of fixed or capital assets.
With proper care and maintenance we can keep a machine or equipment in a good running condition.
However, we cannot stop its wear and tear which is bound to occur. After a lapse of time, the efficiency of
that machine or equipment is reduced to such a great extent that it becomes uneconomical to be used
further and needs replacement by another unit. This process by which the efficiency and value of machine
or any other assets goes on reducing with lapse of time, during use, is known as depreciation.

Definition.

In practice, the term depreciation is commonly used in a very wide sense covering diminution in the
value of the assets caused by outside fluctuations in realizable and replacement values, and also
amortization in the cost of assets over the period of its use.

- De Paula

Depreciation may either be due to

(1) Physical conditions, or due to

(2) Functional conditions as explained below.

1. Depreciation due to Physical conditions.

It occurs on account of
(a) Wear and Tear.
In the process of production when the plant and machinery works constantly, wear and tear of that plant
and machinery is bound to occur, even though, we had taken proper care and precautions for its
maintenance and operation. This is known as the depreciation on account of wear and tear.

(b) Depreciation due to physical decay.

There is the climatic and atmospheric on certain such items in a factory like furniture, electric cables,
poles, vessels, etc., by which they get decayed and after some time become quite useless, defective or
dangerous to such an extent that their replacement becomes essential.

(c) Depreciation due to accident.

Inspite of our best care accident occurs in a factory due to some wrong operation or some loose
component or some other cause altogether unpredictable, which may result in a heavy demand to the
plant. The depreciation due to this reason is called accidental depreciation.

(d) Depreciation due to deferred maintenance and neglect.

The manufacture of a plant or machinery while delivering his product always issues certain instructions
for the smooth and efficient running of the plant and machinery and expects us to follow them properly.
But it is our general experiences that these instructions are not properly followed. This is called
depreciation due to deferred maintenance and neglect.

2. Depreciation due to Functional conditions.

It occurs on account of

(a) Depreciation due to inadequacy.

The plant and machinery may require replacement either because it has become less efficient after a lapse
of time or is inadequate to cope up with the increased demand of the product in the market. in both the
cases the depreciation due to inadequacy is said to have occurred.

(b) Depreciation due to obsolescence.

Because of the advancement of science and technology new machines and equipment which are more
efficient and productive are entering into the market and in comparison to them the old fashioned
machines become obsolete. If they are not replaced the industry cannot stand in competition to other
industries and, as such, they will have to replace them. This is known as the depreciation by obsolescence.

Objectives:

The various objectives in recording depreciation on building, plant and equipment cost revenue are as at
follows:

To find out the actual cost of production or servicing.

To show the assets their true values over their useful life.
To keep the capital intact by distributing the loss in its value over a number of years under use.
To make a replacement of the assets possible when it becomes useless, and
 Provision of depreciation is legally required before divisible profits are ascertained. The amount
obtained for tax purposes is called capital cost allowances and this must be provided for the true
profits are computed.

Methods of Calculating Depreciation.

Because so many factors need to be considered in arriving at the annual figure of depreciation, no one
single system or method could be prescribed. A variety of methods of allocating depreciation expense
have been employed over the years, and these are discussed and illustrated below:

1. Straight line method/Fixed installment method.

Under this method the approximate life of a plant or machinery is calculated and a fixed portion of the
original cost of that article is written off every year so that by the time it becomes useless, sufficient fund
is accumulate for replacing it. This method assumes that the loss of value of machine is directly
proportionately to its age. This method is also known as fixed installment method because every year
some fixed sum is deducted. This will be clear from the following formula:

Let C be the initial cost of a machine

S be the scrap value

N be the number of years of life of machine

D be the depreciation amount per year

Then,

D = C S Rupees

If the original cost of machinery is Rs. 1,00,000 and its salvage value is Rs. 20,000 after a useful life of 5
years. The annual depreciation cost will come to Rs.

S = 1,00,000 20,000

= 80,000

= Rs. 16,000

2. Reducing Annual balance method/Diminishing balance method.

Under this method, alternatively called as the diminishing balance method, depreciation is charged at
fixed rate on the written down value of the asset every year. The rate of depreciation under this method
can be calculated as under
 P= 1 -
n R
C

Where C = Cost of asset.

R = Residual value of asset.

n = Length of life asset in periods.

P = Proportion of reducing balance of cost of asset written off.

Under this method, a fairly high rate of depreciation is to be fixed, so as to reduce the assets account to nil
or to its break-up value. The method is usually applied in case of plant and machinery, furniture and
fixtures, etc., and is probably most popular among businessmen. Its chief advantage is that the revenue
charge is equitably averaged over by year.

3. Sinking fund method.

In this method a fund for depreciation is created by keeping aside a certain amount every year and the
same is invested properly so that by the time the replacement is required this accumulated fund can meet
the cost of replacement. A depreciation fund equal to the actual loss in the value of the asset or machine is
estimated taking into account, the interest on the so accumulated fund. The rate of depreciation will be
constant through out the life of machine.

The equation for calculating the rate of depreciation charges under the sinking fund method is:

D = R (C - S)

(1 + R)n 1

Where D = Rate of depreciation per year.

R = Rate of interest on accumulated fund.

C = Total cost of machine.

S = Scrap value.

N = Number of years of life of machine.

4. Insurance Policy method.

In this method the machine or any other asset is insured with the insurance company and premiums are
paid regularly on their insurance policies. The insurance policy covers the risk and replace the machine if
it becomes unserviceable before its estimated life. When the policy matures, the company provides
sufficient sum to replace the machine.
5. Machine Hour basis method.
In this method, a work hour chart of every machine is maintained so that the total number of hours the
machine runs can be known. Then the rate of depreciation is calculated on the basis of knowledge which
is supplied in respect of that machine about its working capacity. For example, a machine costing Rs.
22,000 is expected to run for 20 years if it works 4,000 hours per year on the average and its scrap value
is likely to be Rs. 2,000 after 20 years; the depreciation charges per hour the machine would be:

Cost of machine = Rs. 22,000

Scrap value = Rs. 2,000

Depreciation Fund = 22,000 2,000

= 20,000

Life of machine = 20 years

= 20 * 4,000

= 80,000 hours

Depreciation charges per hour = 20,000

80,000

= 25 paisa/hour

6. Sum of the Digit Method.

This method is based on the assumption that when a new equipment is installed the reduction in its value
is more in its initial stage and it goes on decreasing gradually. On account of this, great amount of
depreciation is charged during the early years of that machines life and it goes on decreasing as the life of
equipment decreases. Therefore, for calculating depreciation, the next amount (total cost Scrap value) is
spread over whole life in a decreasing proportion. If a machine is expected to last for 5 years the
numerator for the first year would be 5, for second year 4, for the third year 3, and for the fourth year 2
and so on. In this way, the total sum of the digit of the years will be:

5+4+3+2+1 = 15

If the cost of a machine is Rs. 20,000 and its scrap value is Rs 5,000 the depreciation charges for
each year of its estimated life of 5 year, would be as here under:

Cost of machine = Rs. 20,000

Scrap Value = Rs. 5,000

Depreciation fund = Rs. 20,000 5,000

 = Rs. 15,000

Now Depreciation charges for the 1st Year

= 5 15,000 = Rs. 5,000

15

Depreciation charges for the 2nd Year

= 4 15,000 = Rs. 4,000

15

Depreciation charges for the 3rd Year

= 3 15,000 = Rs. 3,000

15

Depreciation charges for the 4th Year

= 2 15,000 = Rs. 2,000

15

Depreciation charges for the 5th Year

= 1 15,000 = Rs. 1,000

15

7. Regular Valuation method.

In this method, every, year the value of machine is revalued and the difference between the book value
and revalued value is charged as a depreciation fund. It is particularly suited to those assets which
constantly and the life of which is uncertain, eg., live stock or motor vehicles. An inventory of all the
assets is prepared and their apparent values are noted. The sum of the values thus found is then compared
to the original records and then the depreciation is worked out. This method though, seems to be most
practical and satisfactory involves much time, trouble and expense and even at times, requires the
suspension of work for making inventories,