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Managerial Economics
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MANAGERIAL ECONOMICS
METHODS OF DEMAND FORECASTING
Interview and survey approach• Buyer’s Interview• Sales force polling• Consumer field survey• Panel or Experts• Delphi Method• Forecast based on composite management opinion Projecting Past Experience
• Correlation Analysis• Regression Analysis• Projection of Trends into Future
Some other methods
• Barometric Techniques• Controlled Experiments
INTRODUCTION
Meaning of production
• Important economic activity• Performance of economy is judged by the level of its
production
In Economics• A process by which man utilizes or converts the resources of
nature, working upon them so as to make them satisfy human wants.
• Any economic activity which is directed to the satisfaction of the wants of the people.
• Therefore, manufacture of goods or rendering services are also termed as production.
• E.g. water made drinkable, cotton made wearable, retailers, doctors, lawyers.
Production can also be defined as creation or addition of utility – Not creation of matter
UTILITY
The satisfying power of goods & services is called utility.
Utilities can be created in different ways
• Form utility – log into wood, iron into machine• Place utility – oil from Malaysia, apples• Time utility – preservation/storage• Possession utility – flat/house/office• Service utility – teachers/singers/musicians
PRODUCTION FUNCTIONThe relationship between the inputs and outputs of a firm is referred as production function
• Also defined as the minimum quantities of various inputs that are required to yield a given quantity of output
Outputs – volume of goods or services
Inputs – factors of production
PF can be studied in short term or long term basis
• Short period – too short for the firm to make changes in equipments and therefore capital employed remains fixed – Law of variable Proportion
• Long period – all the factors of production are variable – Law of returns to scale
SCALE OF PRODUCTION
A firm must decide how much to produce
• Increase in scale of productions means increase in output
Economies of large scale production – Advantages of producing more.
Classified in to Internal and External economies of scale
• Internal Economies –Benefits observed within the firm and its department• External Economies – Benefits observed as a result in expansion of Industry as a whole.
INTERNAL ECONOMIES OF SCALE
Technical economies• Economies of increased dimensions • Economies of linking of processes• Economies of Superior Technique• Economies of specialization and Division of LabourManagerial & Commercial Economies
Marketing Economies
Financial Economies
Risk-Bearing Economies
EXTERNAL ECONOMIES OF SCALE
Economies of concentration
Economies of information
Economies of Disintegration/ Growth of Ancillary Industries
Economies of Developmental Steps – Techno Park, Campus Bus facility
INTERNAL DISECONOMIES OF SCALESupervision & Management becomes difficult
Obstruction to work like Strike, Lockout, Disputes increases Product are standardized and thus personal touch with consumer is many a times not possibleMay cause overproduction and results into losses
Fight hard to maintain the market
Not flexible
EXTERNAL DISECONOMIES OF SCALE
Encouraging competition
Over crowding of cities, traffic congestion, pollution
Strain on whole Industrial System
Highlighted in the eyes of government & tax department
FACTORS OF PRODUCTIONLand:
• refers to all free gifts of nature which would include besides land, the natural resources.
Labor: • mental or physical exertion directed to produce goods or services. • Anything done out of love & affection does not represent labor in
economics.• E.g. wife & maid, singing
Capital: • part of wealth of an Individual or community which is used for
further production of wealth • Produced means of production • E.g. machines, tools, dams, transport equipment.
Entrepreneur:• is a factor which mobilizes above factors, combines in the right
proportion, then initiates the production and bears the risk involved in it.
SHORT RUN PRODUCTION FUNCTION: THE LAW OF VARIABLE PROPORTIONS
Statement of the law:
• “The law of variable proportions states that when more and more units of the variable factor are added to a given quantity of fixed factors, the total product may initially increase at an increasing rate reach the maximum and then decline”.
Assumptions
• The law applies only in the short run.• One factor of production is variable & others are fixed.• All units of variable factor are homogeneous.• State of technology is given & remains the same.• Factor proportions can he changed.
Key terms in production analysis
• The total amount of output resulting from the efforts of given production function at a given time
Total product (TP):
• Total product per unit of given input factor.
Average product(AP):
• The change in total product per unit change in given input factor or the quantity of variable factor.
Marginal product(MP):
Three Stages of Production in Short Run
AP,MP
X
Stage I Stage II Stage III
APX
MPXFixed input grossly underutilized; specialization and teamwork cause AP to increase when additional X is used
Specialization and teamwork continue to result in greater output when additional X is used; fixed input being properly utilized
Fixed input capacity is reached; additional X causes output to fall
-3-2-1012345
0 1 2 3 4 5 6 7
02468
10121416
1 2 3 4 5 6 76
’
TotalProduct
Marginal& AverageProduct
Labor
Labor
THE LAW OF DIMINISHING RETURNS & STAGES OF PRODUCTION
Stage I Stage II Stage III
TP
MP
AP
Three stages of production
• Increasing Returns – TP increases at increasing rate, indicated by increasing MP. • There is intermediary constant stage between stage I & stage II. TP increases at a constant rate indicated by constant MP
Stage I:
• Diminishing Returns – TP continues to increase but at diminishing rates, indicated by declining MP
Stage II:
• Negative Returns – TP begins to decline, indicated by negative MP
Stage III:
RELATIONSHIP BETWEEN TP & MP
1. When TP increases at increasing rate, MP also increases.
2. When TP starts increasing at decreasing rate, MP decreases but remains positive
3. When TP is maximum & constant MP is O (zero)
4. When TP begins to fall, MP is negative• If MP is positive then TP is increasing. • If MP is negative then TP is decreasing.• TP reaches a maximum when MP=0 (Maximization Condition!)
Marginal and Average ProductWhen marginal product is greater than the
average product, the average product is increasing
When marginal product is less than the average product, the average product is decreasing
When marginal product is zero, total product (output) is at its maximum
Marginal product crosses average product at its maximum
• If MP > AP then AP is rising. • If MP < AP then AP is falling.• MP=AP when AP is maximum
Three stages of production
Total Product Marginal Product Average Product
STAGE IIncreases at an increasing
rateIncreases and reaches its
maximumIncreases (but slower
than MP)
STAGE II Increases at a diminishing
rate and becomes maximum
Starts diminishing and becomes equal to zero
Starts diminishing
STAGE IIIReaches its maximum, becomes constant and then starts declining
Keeps on declining and becomes negative
Continues to diminish (but must always be greater than zero)
1. Increasing return to a factor:-
(i) Fuller utilization of fixed factor :
• In the initial stages Fixed factor remain under utilized its fuller utilization starts with the more application of variable factor, hence, initially additional unit of variable factors add more to the total output
(ii) Specialization of Labour :-
• Additional application of Variable factor causes process based division of Labour that raises the efficiency of factors. Accordingly marginal productivity tends to rise.
2. Diminishing return to a factor:-
(i) Imperfect factor substitutability :-
• Factors of production are imperfect substitutes of each other. • More & more of Labour, for eg. Cannot be continuously used in place of additional
capital. Accordingly diminishing returns to variable factor becomes inevitable.
(ii) Disturbing the optimum proportion :-
• Continuous increase in application of variable factor along with fixed factors beyond a point crosses the limit of ideal factor ratio.
• This results in poor co-ordination between the fixed & variable factors which causes diminishing return to a factor.
3. Negative returns to a factor :-
(i) Overcrowding :-
• When more & more variable factors are added to a given quantity of fixed factor it will lead to over crowding & due to this MP of the Labours decreases & it goes into negative
(ii) Management Problems :-
• When there are too many workers they may shift the responsibility to others & it becomes difficult for the management to coordinate with them.
• The Labours avoid doing work. All these things lead to decrease in efficiency of Labours. • Thus the output also decreases.
CONCLUSIONProduction should be stopped at the point where Marginal Product is equal to Marginal Cost
Here there is maximum utilization of resources
MP=MC= max utilization of resources.
Ideally it should be MP ≥ MC
Production Function in Long Run
Laws of Returns to Scale
• The percentage increase in output when all inputs vary in the same proportion is known as returns to scale. It obviously relates to greater use of inputs maintaining the same technique of production.
Three Situations of Returns To Scale
• Increasing Returns to Scale• Constant Returns to Scale• Decreasing Returns to Scale
LAW OF INCREASING RETURNS This law states that with
an increase in the quantity of variable factor, average and marginal products show a tendency to rise (i.e. total product increases with an increasing rate)
No of men
Total Product
Average Product
Marginal Product
0 0 0 01 20 20 202 50 25 303 90 30 404 160 40 70
5 250 50 90
Returns to ScaleIncreasing returns to scale: output more than doubles when all inputs are doubled
• Larger output associated with lower cost (cars)• One firm is more efficient than many (utilities)
The causes of increasing returns to scale:
Higher degree of specialization• Certain inputs cannot be divided into parts to suit small scale
production.Technical and managerial indivisibilities
• Use of specialized labour and modern machinery increases productivity for variety of inputs.Dimensional relations
• Length and Breadth• 15*10=150 sqft• 30*20=600 sqft
LAW OF CONSTANT RETURNS This law explains that if the
quantity of a variable factor is changed then the average and marginal products will not change i.e. total output will increase only at a constant rate
This law is the intermediate stage between the initial stage of the increasing return and the ultimate stage of the diminishing returns.
Constant returns to scale: output doubles when all inputs are doubled Size does not affect productivity May have a large number of
producers
No of men
Total Product
Average Product
Marginal Product
0 0 0 --
1 100 100 100
2 200 100 100
3 300 100 100
4 400 100 100
5 500 100 100
LAW OF DIMINISHING RETURNS It is the ultimate stage of
production. Beyond the optimum stage increase
in the variable factors only disrupts the existing organization and leads to inefficiency.
At this stage the average and marginal products continuously fall.
Output less than doubles when all inputs are doubled
Causes: Decrease in managerial efficiency Exhaustibility of natural resources Reduction of entrepreneurial
abilities
No of men
Total Product
Average Product
Marginal Product
0 0 0 01 10 10 102 18 9 83 25 8.3 74 30 7.5 5
5 32 5.4 2
SUPPLY & LAW OF SUPPLYSupply analysis is related to the behaviour of the producer – supply of a commodity influenced by price of commodity.
In the ordinary language supply mean the stock of goods in existence.
It is also mean the amount of good offered for sale per unit of time.Supply of a commodity may be defined as the amount of the commodity which the sellers are able & willing to offer for sale at a particular period a given period of time.
These factors can be written in the form of an equation known as the supply function
(supply function)Sq = f (pq, Pa, Pb…..F1, F2 … G,
T)Sq = Supply of commodity qf = Functional relationship between
price of commodity & quantity supply
Pq = Price of commodity q Pa Pb = Prices of other commodities F1 , F2 = Prices of factors of production G = Goal of producers T = State of technology
Supply Schedule
Individual Supply Schedule
Market Supply Schedule
Assumptions of the Law of the Supply
• The number of firms in the market remains the same.• The scale of production do not change.• Market prices of related goods remains constant over a period of time.• Cost of Production does not change.• Climatic conditions remains constant.• Taste and preferences of consumers remains constant.• Government polices such as taxation policy, trade policy should be unchanged.• No changes in transport costs• No. other inputs are available in the market.
Factors Determining Supply
Price TimePrices of related commodities
Cost of Production Technology
NaturalFactors Govt Policy &
ActionFuture
Expectations
ELASTICITY OF SUPPLYEs = Percentage Change in Quantity Supply
Percentage Change in Price
= Change in Quantity Supply
Change in price Initially÷ Change in Price
Initial supply
=∆Qs
Qs*∆P
P
Where ∆Qs = Change in Quantity Supply
∆P = Change in Price
TABLE - TYPES OF PRICE ELASTICITY OF SUPPLY
Sl No. Types of ES
Numerical Expression
Description Shape of Curves
1. Perfectly Elastic
∞ Infinite Horizontal
2. Perfectly Inelastic
0 Zero Vertical
3. Unit Elastic 1 One Rectangular Hyperbola
4. Relatively Elastic
> 1 More than One
Flat
5. Relatively Inelastic
< 1 Less than One
Steep
COST CONCEPTS PDF File
Meaning of Market
A place / region where Sellers and buyers are interacted with goods and service by selling and purchasing at a given price. It is considered as a Process
• Goods and service • Buyers and sellers • A place or region • Given price
Perfect Competition Market
Classification of Market
Markets Form Perfect
Competition Imperfect
Competition Monopolistic
Competition
Oligopoly
Duopoly
Monopoly
Meaning of Perfect Competition Market
“A Market situation in which a large number of producers or sellers producing and selling homogeneous product.”
Main features of Perfect Competition Market
• Each sellers sell a small portion total
• Single sellers has no influence on market
• Sellers are price taker
Large no. of buyers and sellers
• Identical product • Same price and cost
Homogeneous product
• There is no government or other controlFree entry and exit
Main features of Perfect Competition Market
• Perfect knowledge about the prevailing price.
Perfect knowledge about market
• Large no. of firm, so no transport or selling cost
• Homogeneous product, so no advt. needed
Absents of selling cost and Advt. cost
• Price is determined in the industry .
A single price of product
Example: Agricultural products
PRICE DETERMINATION UNDER PC
Equilibrium of the Industry:
• When the total output of the industry is equal to the total demand• Price prevailing is the equilibrium price• No buyer goes dissatisfied who wanted to buy at that price and
none of the sellers is dissatisfied that he could not sell his goods at that price
• If price changes or the quantity changes the firm wont remain in equilibrium
Meaning of Perfect Competition Market
Price determination in the industry
Price
Output
Demand Curve
Supply Curve
Excess supply
Excess Demand
PRICE DETERMINATION UNDER PC
Equilibrium of the Firm:
• When it maximizes its profit• The output which gives maximum profit is called equilibrium output• In equilibrium state the firm has no incentive to increase or decrease
its output.• Firms are price takers because of presence of large no of firms in the
market with identical or homogeneous products• They have to accept the price fixed by the industry as a whole
Meaning of Perfect Competition Market
Nature of demand and AR, MR Curve of a firm
Out put
Price TR AR MR
1 102 103 104 105 106 107 108 10
Price
Output
Price=AR=MR
Demand and AR, MR Curve of a firm Out put
Price TR AR MR
1 10 10 10 102 10 20 10 103 10 30 10 104 10 40 10 105 10 50 10 106 10 60 10 107 10 70 10 108 10 80 10 10
Meaning of Perfect Competition Market
Price determination in the industry
Price
Output
Price=AR=MR
Firm ( is a Price Taker)
Price
Output
Industry
Demand Curve
Supply Curve
First Condition for maximization of profit > MR= MC
Second Condition for maximization of profit > MC curve cut MR curve from below
Meaning of Perfect Competition Market
The firms equilibrium(Out put determination)
Price
Output
Price=AR=MR
Firm ( is a Price Taker)
Price
Output
Industry
Demand Curve
Supply CurveMC
O M
MC=MR
EE0
First Condition for maximization of profit is MR= MC
Second Condition for maximization of profit is MC curve cut MR curve from bellow
Meaning of Perfect Competition Market
Short run equilibrium of a firm with abnormal /super normal profit
Profit
Price
Output
Price=AR=MR
Firm with Profit
MC
O M
MC=MR
E
AC
Meaning of Perfect Competition Market
Short run equilibrium of a firm with No profit No Losses
Price
Output
Price=AR=MR
Firm with Profit
MC
O M
MC=MR
E
AC
Meaning of Perfect Competition Market
Short run equilibrium of a firm with Losses
Losses
Price
Output
Price=AR=MR
Firm with Profit
MC
O M
MC=MR E
AC
Meaning of Perfect Competition Market
Long run equilibrium of a firm with Normal Profit
Price
Output
Price=AR=MR
Firm with Profit
LMC
O M
MC=MR
E
LAC
MONOPOLY, MONOPOLISTIC, OLIGOPOLY PDF File
PRICE DISCRIMINATION
TYPES OF PRICE DISCRIMINATION
First-degree price discrimination occurs when the seller charges each individual consumer his reservation price; thus, she obtains the maximum possible revenue from each consumer. For this reason, first-degree price discrimination is often called perfect price discrimination.
In this case the seller must possess information on each consumer's maximum willingness to pay; obviously, this is a nontrivial proposition that is impossible to satisfy in practice.
Practical markets which come the closest to perfect price discrimination are the markets for unique art pieces and online auctions.
Second-degree price discrimination involves the seller charging different marginal prices depending on the quantity of goods purchased. The schedule of prices offered to each consumer is the same, however.
• Classic examples of second-degree price discrimination are quantity discounts. The seller does not need to exogenously divide the consumers into classes. The schedule of prices is designed so that each consumer reveals his type by self-selecting a quantity to purchase with corresponding marginal price.
Third-degree price discrimination requires that the seller divide the customers into exogenous groups according to specific characteristics and then offer a constant marginal price to each customer class.
• These characteristics should separate consumers with different price sensitivities (demand elasticities). There are countless examples of this form of price discrimination including student discounts, matinee prices, and hardcover vs. paperback books.
INTRODUCTION
Pricing policies are policies involving long term decisions
regarding prices of the products of the firm taking various factors
into consideration - economic, social and political.
It is a crucial problem and there is no short - cut formula. Again, prices once fixed need review
and revision from time to time to make them suitable according to
the changed conditions.
OBJECTIVES OF PRICING POLICIESI. To maximize profits-
• Exploiting consumers will not pay - The firm should take a long time view.
II. Price Stability -
• To generate confidence and goodwill among consumers.
III. Facing Competitive Situation
• Should avoid potential competitors.
IV. Capturing the Market -• In price-sensitive markets, a producer may fix a comparatively lower
price while introducing his product - to capture a lion's share of the market (Market Penetration).
V. Achieving a Target-return -• Prices of products so calculated as to earn the target return on cost of production/sale/investment.
• Different target - returns may be fixed for different products/brands/markets, but such returns should be related to a single over - all rate of return target.
VI. Ability to Pay -
• Price decisions often hinge on the customer's ability to pay eg lawyers, doctors, Governments.
VII. Long run Welfare of the Firm -
• Keeping the best interests of the firm in the long run.
Factors affecting Price Policy - There are external and internal factors.
• External factors are elasticity of demand/supply, goodwill of the firm, purchasing power of consumers, trend of the market etc.
• Internal Factors include cost considerations and management policy.
COST PLUS PRICINGUnder this method, (Mark up Pricing) the price is set to cover all costs (material, labour and overhead) and a predetermined percentage for profit. • This percentage is never alike among various units within the
industry and even products of the same concern. This is due to difference in competitive intensity, cost base, turn - over rate with risk. It shows some vague idea of just profit.
Limitations: (i) Demand is ignored :• there is no reciprocity between cost and demand for goods. It
ignores demand totally. (ii) Failure to show the forces of competition
(ill) Exaggeration of the precision of allocated costs
(iv) Based on cost concept - This may not be relevant for the decision of the price.
SUITABLE IN THE FOLLOWING CASES:(I) Ideal Method:
• It is an ideal, fair and just method of pricing. Prices can be fixed very easily and with speed. Prices are defensible on moral grounds.
(II) Uncertainty of Demand :• Firms are often uncertain of their demand and probable response
to any price change.• This method is fool-proof that way.
(III) Stability :• In cases where costs of getting information on market situations
are high with process of trial and error, they stick to it so that the cost of decision making is reduced to the minimum.
(IV) Managements
• tend to know more about product costs than other factors relevant to pricing.
(V) Major Uncertainty in Cost Setting:
• Rival's prices could not be known. Hence, it is difficult to set the price accordingly.
(VI) Product Tailoring:• When the selling price is determined, the product design
can be determined easily.(VII) Pricing of Products :
• When they are manufactured on the orders of a single buyer as per specifications.(VIII) Monopoly Buying:
• Buyers know of the supplier's costs - if price charged is high they will prepare the product themselves.(IX) Public Utility Pricing.
(X) Useful in Times of Depression.
MARGINAL COST PRICINGUnder Marginal Pricing method, the price of a product is determined on the basis of the marginal or variable costs.
• In this method, fixed costs are totally ignored and only variable costs are taken into account.
This is done on the assumption that fixed costs are caused by outlays which are historical and sunk.
• Their relevance to pricing decision is limited, as pricing decision requires planning the future.
Under marginal cost pricing, the objective of the firm is to maximize its total contribution to fixed costs and profit.
ADVANTAGES OF MARGINAL COST PRICINGI. Marginal cost pricing method is highly useful for public utility undertakings.
• It helps them in maximising out-put or better capacity utilisation and helps in maximising social welfare.
• This is possible only when lowest possible price is charged . The lowest limit is set by marginal cost of the product.
II. This method enables the firms to face competition.
• This is the reason why export prices are based on marginal costs since international market is highly competitive.
III. This method helps in optimum allocation of resources and as such it is the most efficient and effective pricing technique.
• It is useful when demand conditions are slack.
IV. Marginal cost pricing is suitable for pricing over the life-cycle of a product.
• Each stage of the life- cycle has separate fixed cost and short-run marginal cost.
LIMITATIONS OF MARGINAL COST PRICING:
(i) Firms may find it difficult to cover up costs and earn a fair return on capital employed when they follow marginal cost principle in times of recession when demand is slack and price reduction becomes inevitable to retain business.
• (ii) When production takes place under decreasing costs, marginal cost pricing is unsuitable since MC curve will be below the AC curve and marginal cost pricing is bound to lead to deficits.
(iii) Marginal cost pricing requires a better understanding of marginal cost technique. Some accountants are not fully conversant with the marginal techniques themselves. Therefore, they are not capable of explaining their use to the management.
• In spite of its advantages, marginal pricing has not been adopted extensively, due to its inherent weakness of not ensuring the coverage of fixed costs. It is confined to cases of special orders only.
CONCEPT OF PROFITProfit means the compensation received by a firm for its managerial functions. It is called normal profit which is a minimum sum essential to induce the firm to continue the business.
• Profit is a reward for true entrepreneurial function. It is a reward earned by the entrepreneur for bearing the risk. It is termed as supernormal profit.
Profit may also imply monopoly profit. It is earned by the firm through extortion because of its degree of monopoly power enjoyed in the market. It may not be related to any useful or specific function. Monopoly profit is not a functional reward.• Profit may also refer to windfall profit. It is an unexpected
reward earned by a firm just by mere chance. It is also an undeserved reward, as it is not earned for any specific function.
FEATURES OF PROFITProfit is the return to entrepreneurial ability
It is not a contractual payment
It is not a fixed remuneration
It is a residual surplus
It is uncertain
It may be positive or negative. A negative net profit means a loss.It is widely fluctuating, while other factor incomes are more stable over time.
Profit = Total Revenue – Total Cost
GROSS PROFITGross profit is surplus of total money
expenditure incurred by a firm after the production process.
Gross Profit = Net Profit + Implicit rent + Implicit Wages+ Implicit Interest +
normal profit + depreciation & maintenance charges + non-enterprenerial profit
NET PROFIT Net Profit is pure economic profit earned by
entrepreneur for his services & efficiency.
Net Profit = Gross Profit – (Implicit rent + Implicit Wages+ Implicit Interest +
normal profit + depreciation & maintenance charges + non-entrepreneurial profit)
Net Profit = Economic Profit or Pure Business Profit
HAWLEY’S RISK THEORY OF PROFIT
“The riskier the industry the higher its profit rate”
• Since entrepreneur take the risks of business, he is entitled to receive profit as his rewards.
Profit is commensurate with risk.
Criticisms:
• There are no functional relationship between risk and profit.• Profit is not based on entrepreneur's ability to undertake risks, but rather as his capability of risk avoidance.• The theory disregards many other factors attributable to profit and just concentrate on risks.
KNIGHT’S THEORY OF RISK UNCERTAINTY AND PROFIT
Knight defines pure profit as “the difference between the returns actually realized by entrepreneur and competitive rate of Interest in high class gilt-edged securities”• Insurable risk• Non insurable risk
Acc. To him, Risks are of two type:
• For instance, fire, theft, floods, accidents, etc
Some risks are predictable because they are certain and hence are insurable.• Such risks are not the real risk attributed to entrepreneurial
functions.Business losses arising out of such risks are compensated by the insurance company.• Unforeseeable risks are non-insurable.
A true entrepreneurship lies in bearing non-insurable risk and uncertainties.
Examples of Non-insurable Risks
• Demand Fluctuation• Trade Cycle• Technological changes• Outbreak of war• Changes in Govt. policies• Competition
Criticisms:
• Uncertainty-bearing is not sole determinant of profit.• It is business ability rather than atmosphere of uncertainty which a leads to high
reward of profits.• Theory does not suit to monopoly business phenomenon.• The uncertainty element can’t be quantified to impute profit.
DYNAMIC THEORY OF PROFITClark defines profit as the difference between selling price and the cost resulting in the changes in demand and supply conditions.
Profit is the surplus over cost.
Changes that causes profit to emerge:• Increase in population• Changes in tastes and preferences• Multiplication of wants• Capital formation• Technological advancementCriticism:• It gives an artificial dichotomy of ‘profit’ and ‘wages of
management’• All dynamic changes lead to profit, but only unpredictable
changes gives rise to the profit.• Clarks theory not stress the element of the risk involved in the
business due to dynamic changes.
Theory of Innovation
The theory propounded by Schumpeter – it is more or less similar to Clark’s dynamic theory of profit.
• Instead of five changes mentioned by Clark’s Schumpeter explains the change caused by innovation in the productive process.
According to this theory, profit is the reward for innovations.
• The term innovation has been used in a broader sense than that of Clark’s attributes to dynamism.
Innovations refers to all those changes in the production process with a objective aims of reducing the cost of production.
• The gap between the existing price of the commodity and its new cost.
Innovation in form of• Introduction of a new technique or new plant• Changes in the internal structure or organization as
set up.• Changes in the quality of raw-material• New sources of energy.• Better method of salesmanship.
Innovation always reducing cost of production
Marginal Productivity Theory of Profit
• This theory was developed by Prof. Chapman – profit are equal to the marginal worth of the entrepreneur and are determined by the marginal productivity of the entrepreneur.
When the marginal productivity is high, profits will also be high and vice-versa.
• But it is difficult to measure marginal productivity of entrepreneur.
In case of other factors such as land, labour and capital – marginal productivity can be measurable either increasing or decreasing the units of factors.
KEYNESIAN THEORY OF PROFITRelates money supply variability and uncertainty to inflation and deflation.
Variability of prices is a major cause of business cycles.
Wages and other costs of production adjust more slowly than prices.
Therefore price variability affects profits and therefore investment.
Investment cycles cause business cycles.
BREAK EVEN ANALYSISIt relates revenue, costs and total profits of the firm at various levels of output
BEP point is that volume of sales where the firm the total costs will be equal to total revenue.
It is the point of 0 profit
BEP = Fixed Costs/(Selling Price – Variable Costs)
ASSUMPTIONSPerfect distinction of costs into fixed and variable costs
Whatever is produced is sold (Production = Sales)
Revenue is perfectly variable with production (Straight Line)
Stable Product Mix
BE CHARThttp:/ / www.bized.ac.uk
Copyright 2004 – Biz/ ed
Break-Even AnalysisCosts/Revenue
Output/Sales
FC
VCTCTR TR
Q1
Implications
Both cost and revenue curve are linear curve. (Constant variable costs and constant MR)
• Effect of change in Price• Effect of change in VC• Effect of change in FC
Contribution Margin
• Total Contribution Profit : Difference between total revenues and total variable costs.• On a per unit basis , it is equal to difference between the price and average variable
costs.
Advantages
• To determine optimum level of output• To decide the ideal production level (capacity)• To choose projects from alternatives• To know the impact of changes in price and costs on profits. • To know the pricing policy• Situations like hire or purchase, add or drop, expand or divert.
Thank You
