UNIT III-MG2452-Engineering Economics and Financial Accounting Notes

Page 1 of 24 Unit-III

UNIT – III

PRODUCTION POSSIBILITY CURVE

The Production Possibility curve is the laws of output combinations which can be obtained from given quantities of factors or inputs. This curve not only shows production possibilities but also the rate of transformation of one product into the other when the economy moves

from one possibility point to the other.

Assumptions:

i. Only two goods X (Consumer goods) and Y (Capital goods) are produced in different

proportions in the economy.

ii. The same resources can be used to produce either or both of the two goods and can be shifted freely between them.

iii. The supplies of factors are fixed. But they can be re-allocated for the production of the tow goods within limits.

iv. The production techniques are given and constant.

v. The economy‟s resources are fully employed and technically efficient.

vi. The time period is short. This is explained with the help of a diagram.

X axis-Product X Y axis- Product Y

PPC-Production Possibility Curve

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Page 2 of 24 UNIT - III

Explanation:

i. The curve production possibility (PP1) depicts the various possible combinations of the two goods, P,B,C,D and P1. This is also known as the transformation curve or production

possibility frontier.

ii. The production possibility curve further shows that when the socie ty moves from the

possibility point B to C or to D, it transfers resources from the production of good X. It is concern as the „optimum product = mix‟ of a society.

iii. Again, all possibility curve combinations lying on the production possibility curve (such as B,

C and D) show the combinations of the tow goods that can be produced by existing resources

and technology of the society. Such combinations are said to be “technologically efficient”.

iv. Any combination lying inside the production possibility curve, such as R implies that the society is not using its existing resources fully. Such a combination is said to be “technologically inefficient”.

v. Any combination lying outside the production possibility frontier, such as K, implies that the

economy does not posses sufficient resources to produce this combination. It is said to be “technologically infeasible or unobtainable”.

THE USES OR APPLICATIONS OF THE PRODUCTION POSSIBILITY CURVE

i. Unemployment: The production possibility curve helps in knowing the level of unemployment of resources in the economy.

ii. Technological Progress: The production possibility curve helps in showing technical progress enables an economy to get more output from the same quantities of resources.

iii. Economic growth: The production possibility curve helps in explaining how an economy

grows.

iv. Present goods vs. Future goods: An economy that allocates more resources in the present to

the production of capital goods than to consumer goods will have more of both kinds of goods in the future. It will there, experience higher economic growth. This is because consumer goods satisfy the present wants while capital goods satisfy future wants.

v. Economic efficiency: The production possibility curve is also used to explain the “three

efficiencies namely efficient selection of the goods to be produced, efficient allocation of resources in the production of these goods and efficient choice of methods of production, efficient allotment of the goods produced among consumers”

vi. Basic fact of human life : The production possibility curve tells us about the basic fact of

human life that the resources available to mankind in terms of factors, goods, money or time are scarce in relation to wants, and the solution lies in economizing these resources.

ISO-QUANT OR EQUAL PRODUCT CURVE

An iso product curve also shows all possible combinations of the two inputs physically capable of producing a given level of output. Since an iso product curve represents those

combinations which will allow the production of an equal quantity of output, the producer

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would be indifferent between them. Iso product curve are therefore, called product indifference curves. They are also known as Iso quants or equal product curve. This is

explained with the help of a diagram.

X axis Units of labor Y Units of capital

IP Iso quant curve (or) Equal product curve

Explanation:

IP represents all those combinations with which the units of the product can be produced. The

shape of the isoquants shows the degree of substitutability between the two factors used in production.

EQUAL PRODUCT MAP (OR) ISO PRODUCT MAP

An iso product map showing various iso product curves, it is possible to say by how much

production is greater or less on one iso product curve than on another. This is explained with the help of a diagram.

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X axis Units of labor Y Units of capital

IP1-IP111 Iso quant curves (or) Equal product curves

Explanation:

An iso product map showing various iso product curves, it is possible to say by how much

production is greater or less on one iso product curve than on another. Higher the iso product curve higher is the level of production & vice versa.

PROPERTIES OF EQUAL PRODUCT CURVES

i. Sloping downwards: Iso product curves slope downwards from left to right. This is so because if the quantity of a factor X is increase, the quantity of factor Y must be decreased so

as to maintain the same level of output.

ii. Convexity: Iso product curves are convex to the origin. This is due to the fact that marginal

rate of technical substitution falls as more and more of X is substituted for Y.

iii. Perfect Substitutes: When the factors of production are perfect substitutes then one factor can completely take the place of the other. They may, in fact, be regarded as on factor. In their case, the marginal rate of technical substitution is constant. Hence, the equal product

curves will be a horizontal straight line instead of being convex to the origin.

iv. Complements: The complementary factors are those which are jointly used in production in a fixed proportion. If one of these factors in increased, the other must also be increased at the same time otherwise no additional output will be obtained, In this case, the equal product

curves will be right angled (i.e. One of the two arms being vertical and the other horizontal) at the combination of the two factors used in fixed proportion.

v. Non-intersecting: Two iso product curves cannot cut each other

APPLICATION OF EQUAL PRODUCT CURVES

i. Applicable to agriculture: The isoquant technique is applicable to agriculture and to all lines of manufacture.

ii. Substitution of some units: The marginal rate of technical substitution guides in the substitution of some units of one input for some units of another input.

iii. Reduction in use of raw materials: In some cases, increased use of labor can help in

making a reduction in the use of raw materials because spoilage and wastage of material may

be cut to the minimum.

iv. Supervisory staff: Similarly, by adding to the supervisory staff, labor may be economized of\r the introduction of machinery may cut down the use of labor.

v. Economical combination: The business man tries various permutations and combinations and the Isoquant technique helps him in reaching the most economical combinations.

MARGINAL RATE OF TECHNICAL SUBSTITUTION

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Marginal rate of technical substitution of X for Y is the number of units of factor Y which can be replaced by one unit of factor X, quantity of output remaining unchanged.

This can be explained with the help of a diagram.

X axis Factor X

Y axis Factor Y IP Iso product curve

Explanation:

i. The marginal rate of technical substitution at point R will be equal to the slope of the tangent DE. Slope of the tangent DE is equal to OD/DE.

ii. Hence, the marginal rate of technical substitution at point R will be equal to OD/DE: Likewise, Marginal rate of technical substitution at point S of the iso product curve will be

OG/OH. THE LAW OF VARIABLE PROPORTIONS

The law states that as the quantity of a variable input is increased by equal doses keeping the quantities of other inputs constant, total product will increase, but after a point at a

diminishing rate. This principle can also be defined thus, when more and more units of the variable factor are use, holding the quantities of fixed factors constant, a point is reached

beyond which the marginal product, then the average and finally the total product will diminish.

Assumptions:

i. It is possible to vary the proportions in which the various factors (inputs) are combined. ii. Only one factor is variable while others are held constant.

iii. All units of the variable factor are homogenous.

iv. There is no change in technology. If the technique of production undergoes a change the product curves will be shifted accordingly but the law will ultimately operate.

v. It assumes a short-run situation, for in the long-run all factors are variable.

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vi. The product is measured in physical units i.e., in quintals, tones etc.

This is explained with the help of a diagram

X axis Units of Variable factor

Y axis TP, AP, MP TP Total Product curve AP Average Product curve

MP Marginal Product curve

Explanation:

Increasing Returns: In this stage, the total product curve also increases rapidly. Thus this

stage relates to increasing average returns. Here land is too much in rela tion to the workers employed. It is, therefore, uneconomical to cultivate land in this stage. The main reason

for increasing returns in the first stage is that in the beginning the fixed factors are large in quantity than the variable factor. When more units of the variable factor are applied to a fixed factor, the fixed factor is used more intensively and production increases rapidly. The TP

curve first rises at an increasing rate up to point A where its slope is the highest. From point A upwards the total product increases at diminishing rate till it reaches its highest point C and

then it starts falling. The marginal product curve (MP) and the average product curve (AP) also rise with TP. The MP curve reaches its maximum point D when the slope of the TP curve is the maximum at point A.

Negative marginal returns: Production cannot take place in Stage III either. For, in this

stage, total product starts declining and the marginal product becomes negative. Here the workers are too many in relation to the available land, making it absolutely impossible to cultivate it. When production takes place to the left of point E the fixed factor is in excess

quality in relation to the variable factor. To the right of point F, the variable input is used excessively.

Diminishing returns: Stage II starts when the AP is at its maximum to the zero point of the marginal product. At the latter point, the total product is the highest. Here land is scarce and

is used intensively. More and more workers are employed in order to have a larger output. Thus the total product increases at a diminishing rate and the average and marginal products

decline. Throughout this stage marginal product is below the average product. “As the proportion of one factor is a combination of factors in a combination of factors is increased, after a point, the average and marginal product of that factor will diminish. Point A where the

tangent touches the TP curve is called the inflection point up to which the total product increases at an increasing rate and from where it starts increasing at a diminishing rate.

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LAWS OF RETURNS TO SCALE

The law of returns to scale describes the relationship between outputs and the scale of inputs in the long-run when all the inputs are increased in the same proportions. To meet a long-run

change in demand the firm increases its scale of production by using more space, more machines and laborers in the factory.

Assumptions:

i. All factors (inputs are variable but enterprises is fixed. ii. A worker works with given tools and implements.

iii. Technological changes are absent

iv. There is perfect competition. v. The product is measured in quantities.

This is explained with the help of a diagram

X axis Scale of production Y axis Marginal Returns

RC Increasing returns DS Decreasing returns CD Constant returns

Explanation:

Increasing Returns to Scale: Returns to scale increases because of the indivisibility of the factors of production. Indivisibility means that machines, management, labor, finance, etc.

cannot be available in very small sizes. They are available only in certain minimum sizes. When a business unit expands the returns to scale increase because the indivisible factors are

employed to their maximum capacity. Increasing returns to scale also result from specialization and division of labor. RS is the returns to scale curve where from R to C returns are increasing.

Constant Returns to scale: Returns increase in the same proportion so that there are

constant returns to scale is horizontal. It means that the increments of each input are constant at all levels of output. The returns to scale are constant when internal diseconomies and economies are neutralized and output increases in the same production. Another reason is the

balancing of external economies and diseconomies. Further, when factors of production are perfectly divisible, substitutable and homogeneous with perfectly elastic supplies at given

prices, returns to scale are constant. From C to D, they are constant Diminishing Returns to scale: Ultimately returns to scale. Indivisible factors may become

inefficient and less productive. Business may become unwidely and produce problems of

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supervision and coordination. Large management creates difficulties of control and rigidities. To these internal diseconomies are added external diseconomies of scale. And from D

onwards they are diminishing.

MANAGERIAL USES OF PRODUCTION FUNCTION

1. Calculate the least cost input combination: It can be used to calculate the least cost input combination for a given output.

2. Calculate the maximum-input-output combination: It can be used to calculate the maximum-input-output combination for a given cost.

3. Deciding on the value of employing a variable input factor: Knowledge of production function is useful in deciding on the value of employing a variable input factor in the

production process. As long as the marginal revenue productivity of a variable input factor exceeds its price, it is worthwhile to increase its usage. When the marginal revenue

productivity just equals the price of input factors then the additional use of input factors must be stopped.

4. Aid in long run decision making: Production functions also aid in long run decision making. If the return to scale is increasing, one can increase production through a

proportionate increase in all the input factors of production. The opposite is true if there is decreasing returns to scale. The producer will be indifferent about increasing or decreasing the production in case of constant returns to scale provided the demand is of no constraint

ISO COST LINE

The combination of factors with which a firm produces the product also depends on the prices of the factors and the amount of money which a firm wants to spend; Iso cost line

represents these two things. The prices of productive factors and the amount of money which a firm wants to spend, Each iso cost line will show various combinations of tow factors

which can be purchased with a given amount of total money. The iso cost line is also known as price line (or) outlay line. This can be explained with the help of a figure below:

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X axis Factor X

Y axis Factor Y Explanation:

The slope of the iso cost line represents the ratio of the price of a unit of input X to the price

of a unit of input Y. In case the price of any one o f them changes, there would be a corresponding change in the slope of the iso cost curve and the equilibrium would shift too.

THE CHOICE OF OPTIMAL FACTOR COMBINATION (OR) LEAST COST

COMBINATION OF FACTORS (OR) PRODUCER EQUILIBRIUM

The choice of optimal expansion path refers to the Combinations of factors of production that

enable the firm to produce various levels of outputs at the least cost while relative factor prices remain constant. Its analysis is done in relation to the short run and the long run.

Assumptions:

i. There are two factors, labor and capital. ii. All units of labor and capital are homogeneous.

iii. The prices of units of labor (W) and that of capital (v) are given and constant. iv. The cost outlay is given v. The firm produces a single product.

vi. The price of the product is given and constant. vii. The firm aims at profit maximization.

viii. There is perfect competition in the factor – market.

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X axis Factor X Y axis Factor Y OS Expansion path

IP Iso product curve Explanation:

i. In order to maximize its profits or to have the least cost combination, the firm combines labor

and capital in such a way that the ratio of their MP is equal to the ratio of their prices, i.e.

MPL/MPC = w/r. This equality occurs at the point of tangency between an iso cost line and an iso quant curve.

ii. The line C2L2 shows higher total outlay than the line C1L1 and C3L3 still higher total

outlay than the line C2L2. They are shown parallel to each other there by reflecting constant

factor prices.

iii. The firm Is in equilibrium at point P where the isoquant IQ1 is tangent to its corresponding iso cost line C1L1 and similarly the other tow iso quants IQ2 and IQ3 are tangent to isocost lines C2L3 and C3L3 respectively at points Q and R.

iv. Each point of tangency implies optimal combination of labor and capital that produces an

optimal output level. The line OS joining these equilibrium point P,Q and R through the origin is the expansion path of the firm.

PRODUCTION FUNCTION

The Production function expresses a functional relationship between quantities of inputs and outputs. It shows how and to what extent output changes with variations inputs during a specified period of time.

ECONOMIES AND DISECONOMIES OF SCALE OR OF LARGE SCALE

PRODUCTION Economies of Scale: An economy of scale exists when larger output is associated with lower

per unit cost.

Diseconomies of Scale: A diseconomy of scale exists when larger output leads to higher per unit cost.

ECONOMIES (OR) ADVANTAGES OF LARGE SCALE PRODUCTION

i. Efficient use of capital equipment: There is a large scope for the use of machinery which results in lower costs.

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ii. Economy of specialized labour: Specialized labour produces a large amount of output and

of better quality.

iii. Better utilization and greater specialization in management: When the scale of production is enlarged, there is fuller use of the manager‟s time and ability. Also, he is able to delegate some of his less important functions to his assistants and increasingly specialize in

the jobs where his ability is most fruitful.

iv. Economics of buying and selling: While purchasing raw material and others accessories, a big business can secure specially favorable terms on account of its large custom.

v. Economics of the overhead charges: The expenses of administration and distribution per unit of output in a big business are much less.

vi. Economy in Rent: A large-scale producer makes a savings in rent too.

vii. Experiments and Research: A large concern can afford to spent liberally on research and experiments.

viii. Advertisement and Salesmanship: A big concern can afford to spend large amounts of money on advertisement and salesmanship.

ix. Utilization of By-products: A big business will not have to throw away any of its by-

products or waste products.

x. Meeting Adversity: A big business can secure credit facilities at cheap rates.

DISECONOMIES (OR) DISADVANTAGES OF LARGE SCALE PRODUCTION

i. Over-Worked management: A large-scale producer cannot pay full attention to every

detail.

ii. Individual tastes ignored: Large-scale production is a mass production or standardized production. This results in a loss of custom.

iii. No personal element: The sympathy and personal touch, which ought to exist between the master, and the men, are missing.

iv. Possibility of depression: Large-scale production may result in over-production. Production may exceed demand and cause depression and unemployment.

v. Dependence on foreign markets: A large-scale producer has generally to depend on foreign

markets. This makes the business risky.

vi. Cut-throat competition: Large-scale producers must fight for the markets. There is

wasteful competition which does no good to society.

vii. International complications and war: When the large-scale produces operate on an international scale, their interests clash either on the score of markets or of materia ls.

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viii. Lack of adaptability: A large-scale producing unit finds it very difficult to switch on from one business to another.

ECONOMIES (OR) ADVANTAGES OF SMALL SCALE PRODUCTION:

i. Prompt decision: The small manufacturer is capable of prompt decision and quick

execution.

ii. Close Supervision: The initiative and sense of responsibility of a small producer have not been sapped by routine.

iii. Personal contact with the employees: Personal contact with the employees, and a kind word thrown now and then, will rule.

iv. Personal contact with the customers: Personal contact with the customers, again, sends them away well satisfied and is productive of good results.

v. Demand is limited: The small-scale producer‟s advantage is the greatest where the demand

is limited and fluctuating.

vi. Self-interest: The small businessman is usually the sole proprietor. Self interest is a strong

spur to his activity.

DISECONOMIES (OR) DISADVANTAGES OF SMALL SCALE PRODUCTION

i. Modern machinery: There is less scope for the use of modern machinery and labour-saving devices. Hence cost per unit is high.

ii. Production is uneconomical: There is little scope for division of labour. The advantages of division of labour are, therefore, lost of him. Hence production is uneconomical.

iii. Pushes up the cost: The small-scale producer is at a disadvantage in the purchase of raw

materials and other accessories. This pushes up the cost.

iv. No innovations: He cannot afford to spend large sums of money on research and

experiments. Hence he cannot make no innovations and thus reduce costs.

v. Higher overhead charges: Cost of rent, interest, advertisement, etc., per unit of output is higher. That is, he has higher overhead changes.

vi. Instability: With his limited resources he cannot meet bad times.

vii. No cheap credit: He cannot secure cheap credit. This means higher costs.

viii. Wastage: By-products have to be thrown away as so much waste.

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TYPES OF ECONOMIES AND DISECONOMIES OF SCALE

TYPES OF ECONOMIES

A. Real Internal Economies: Real internal economies are associated with a reduction in the physical quantity of inputs, raw materials, various types of capital (fixed or circulating) used by a large firm.

i. Labour economies: When a firm expands in size this necessitates division of labour

whereby each worker is assigned one particular job, and the splitting of processes into sub-processes for greater efficiency and productivity.

ii. Technical Economies: Technical economies are associated with all types of machines and equipments used by a large firm. They arise from the use of better machines and techniques

of production which increase output and reduce per unit cost of production. It includes, economies of indivisibility, economies of increased dimensions, economies of linked processes, economies of the use of By-products, economies in power consumption.

iii. Marketing Economies: A large firm also reaps the economies of buying and selling. It buy

its requirements of various inputs in bulk and is, therefore, able to secure them at favorable terms in the form of better quality inputs, prompt delivery, transport concessions, etc.

iv. Managerial Economies: A large firm can afford to put specialists to supervise and manage the various departments. There may be a separate head for manufacturing, assembling,

packing, marketing, general administration, etc.

v. Risk-Bearing Economies: A large firm is in a better position than a small firm in spreading

its risks. It can produce a variety of products, and sell them in different areas.

vi. Economies of Research: A large firm possesses larger resources than a small firm and can establish its own research laboratory and employ trained research workers.

vii. Economies of welfare: All firms have to provide welfare facilities to their workers. But a large firm, with its large resources, can provide better working conditions in and outside the

factory. It may run subsidized canteens, provide crèches for the infants of women workers and recreation rooms for the workers within the factory premises.

B. Pecuniary Internal Economies: Pecuniary or monetary internal economies accrue to a large firm solely through reductions in the market prices of its inputs.

i. It purchases raw materials in bulk at lower prices from its suppliers.

ii. It gets loans from banks and other financial institutions at low interest ra tes because it possesses large assets and good reputation.

iii. It raises capital by floating shares at a premium and debentures at low interest rates in the

capital market.

iv. It advertises at concessional rates on a large scale in different media.

v. It transports large quantities of its commodity at concessional transport rates. Thus pecuniary

economics are realized from paying lower prices for the factors used in the production and

distribution of the product, due to bulk-buying by the firm as its size increases.

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C. Real External Economies: Real external economies accrue to a firm in an industry due to technological influences on its output which reduce its real cost of production.

i. Technical Economies: Technical external economies arise from specialization. When an industry expands in size, firms start specializing in different processes and the industry

benefits on the whole.

ii. Economies of Information: As an industry expands, it specializes in collecting and disseminating market information, in marketing the industry‟s product and in supplying the firms with consultant services.

iii. Economies of By-products: When an industry is localized, it turns out large quantities of

waste materials, such as molasses in sugar industry and iron scrap in steel industry. D. Pecuniary External Economies: Pecuniary external economies arise to firms in an

industry from reductions in factor prices.

TYPES OF DISECONOMIES

A. Real Internal Diseconomy: When a firm expands beyond an optimum level, a number of

problems arise such as factor shortages, lack of coordination and management, marketing and technological difficulties, etc.

i. Managerial Diseconomy: There is a limit beyond which a firm becomes unwidely and hence unmanageable. Supervision becomes less. Workers do not work efficiently, wastages arise,

decision-making becomes difficult, co-ordination between workers and management disappears and per unit cost increases.

ii. Marketing Diseconomy: The expansion of a firm beyond a certain limit may also involve marketing problems. Raw materials may not be available in sufficient quantities due to their

scarcities. The demand for the products of the firm may fall as a result of changes in tastes of the people and the firm may not be in a position to change accordingly in the short period.

iii. Technical Diseconomy: A large scale firm often operates heavy capital equipment which is indivisible. As the firm expands its size beyond the optimum level, there are repeated

breakdowns in plants and equipments and the firm may fail to operate its plant to its maximum capacity. It may have excess capacity or idle capacity. As a result, per unit cost

increases.

iv. Diseconomy of Risk-taking: As the scale of production of a firm expands, risks also

increase with it. An error of judgment on the part of the sales manager or the production manager may adversely affect sales or production which may lead to a great loss.

B. Pecuniary Internal Diseconomy: Pecuniary internal diseconomy arises when the prices of factors used in the production and distribution of the commodity increase.

C. Pecuniary External Diseconomy: Pecuniary external diseconomy arises solely through

increases in the market prices of inputs of an industry.

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COST CONCEPT

i. Money Cost: The cost may be nominal cost or real cost.

ii. Nominal Cost: Nominal Cost is the money cost of production. It is also called expenses of production. These expenses are important from the point of view of the producer. He must

make sure that the price of the product, in the long run, covers these expenses including normal profit, otherwise he cannot afford to carry on the business.

iii. Real Cost: Attempts have been made to “pierce the monetary veil” and to establish cost on a real basis. The real cost of production has been variously interpreted. Adam smith regarded

pains and sacrifices of labour as real cost. Marshall includes under it “real cost of efforts of various qualities” and “real cost of waiting”. This is called the social cost by Marshall.

iv. Opportunity Cost: The Austrian school of economists and their followers gave a new concept of real costs. According to them, the real cost of production of a given commodity is

the next best alternative sacrificed in order to obtain that commodity. It is also called opportunity cost or displacement cost.

v. Economic Cost: By economic costs is meant those payments which must be received by resource owners in order to ensure that they will continue to supply them in the process of

production. This definition is based on the fact that resources are scarce and they have alternative uses. To use them in one process is to deny their use in other processes.

Economic Cost includes normal profit.

vi. Implicit Cost: Implicit costs are costs of self-owned and self-employed resources such as

salary of the proprietor or return on the entrepreneur‟s own investment. These costs are frequently ignored in calculating the expenses of production.

vii. Explicit Cost: Explicit costs are the paid-out costs, i.e., payments made for productive resources purchased or hired by the firm. They consist of the salaries and wages paid to the

employees, prices of raw and semi-finished materials, overhead costs and payments into depreciation and sinking fund accounts. These are firm‟s accounting expenses.

viii. Full Cost: If we add to the money expenses two item, viz., alternative or opportunity costs and normal profits, we get the full costs.

ix. Business Cost: Business costs are synonymous with firm‟s total money expenses as

computed by ordinary accounting methods. The entrepreneur must be sure of normal pro fit if he is to continue in business. In this sense normal profit too is a cost.

x. Social Cost: It is the amount of cost the society bears due to industrialization. Industrialization has certain economic and social merits, but along with the merits, the y bring

about certain demerits also. They are like, development of slums, air-pollution, noise pollution, land pollution, social inequalities, and so on. The amount of cost the society bears due to industrialization is referred as Social Cost.

xi. Entrepreneur’s Cost: In what follows, we shall use the term „cost of production‟ in the

sense of money cost or expenses of production. This is entrepreneur‟s cost. The entrepreneur‟s cost of production includes the following element: (i) Wages of labour; (ii) Interest on capital; (iii) Rent or royalties paid to the owners of land or other property used;

(iv) Cost of raw materials; (v) Replacement and repairing charges of machinery; (vi)

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Depreciation of capital goods; and (vii) Profits if the manufacturer suffic ient to induce him to carry on the production of the commodity.

xii. Classification of Entrepreneur’s Cost: Entrepreneur‟s costs may be classified as:

Production costs, including material costs, wage costs, interest costs, etc., both direct and indirect costs. Selling costs, including costs of advertising and salesmanship, Managerial costs, Other costs, including insurance charges, rates, taxes, etc.

xiii. Short run: Short run is a period of time within which the firms can its output by varying

only the amount of variable factors, such as labour and raw materials. In the short run, fixed factors, such as capital equipment, top management personnel, etc., cannot be varied.

xiv. Long run: Long run is a period of time during which the quantities of all factors, variab le as well as fixed, can be adjusted.

xv. Prime Cost & Overhead Cost: Some costs vary more or less proportionately with the output, while others are fixed and do not vary with the output in the same way. The former

are known as prime costs and the latter as supplementary costs of production or overhead costs.

xvi. Total Cost: Total Cost is the sum of Fixed cost (Factory land, building and machinery…) plus the total variable cost (raw material charges, electricity…)

xvii. Average Cost: Average Cost per unit is the total cost divided by the number of units

produced. It is the sum of average fixed cost and the average variable cost.

xviii. Marginal Cost: Marginal cost is the addition to total cost caused by a small increment in

output. Marginal cost may be defined as the change in total cost resulting from the unit change in the quantity produced. Thus, it can be expressed by the formula:

MC=Change in Q Change in TC

COST-OUTPUT FUNCTION

cost function express the relationship between cost and determinants, like the size of plant, level of output, input prices, technology, etc. in ma mathematical form it can be expressed as,

c=f(S, O,P,T,...), Where

C=refers to cost(unit cost or total cost) S=refers to size of plant

O=means level of output

P=denotes the price of inputs used in production

T=refers to the nature of technology.

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METHODS OF ESTIMATING COST FUNCTIONS

1. Accounting method: this method is used by the cost accountants. Essentially, in this method the data is classified into various cost categories. Observations of cast are then taken

at the extreme and the various intermediate levels of output. By plotting the output levels and the corresponding costs on a graph and joining them by a line the cost functions are estimated. The cost functions, thus found, may be linear or non- linear. It must be noted that

while finding cost functions from basic data in this wat, no attention is generally paid to build up a hypothesis or to find out the changes in conditions which influence cost.

2. Statistical or econometric method: this method uses statistical techniques on economic data to find the nature of cost-output relationship. The economic data may relate to past

records of the firm or to the different firms in the same business at a point of time. If we use the series data we generally get a short-run cost function, while if we take resources to the

cross section data we derive a long-run cost function.

3. Survivorship Method: this method is based on the rationale that overtime competition

tends to eliminate firms of inefficient size and that only the firms with efficient size will survive as these will have lower average cost. The size-group whose share in the industry

grows the most during the specified time period is considered the most efficient size-group. For example, if the share of small firms in the industry increases at the cost of the share of large firms, it implies that the optimum size of a firm in the present case is the small one.

4. Engineering method: In the engineering approach, the cost functions are estimated with

the help of physical relationships, such as weight of supplies and materials used in a process, rated capacity of equipment, etc. emphasis is placed primarily on the physical relationship of production and these are then converted into money terms to arrive at an estimate of costs.

This method may be useful if good historical data is difficult to obtain. But this method requires a sound understanding of engineering and a detailed sampling of the different

process under controlled conditions, which may not always be possible. PROBLEMS IN THE ESTIMATION OF COST

i. Time Period: We must choose an appropriate time period for the analysis of cost. The choice

of such a time period involves the following important considerations:

a. Normality: The time period of study should be normal. A period during which the changes

in technology, plant size, efficiency, other dynamic events are non-existent or are at their minimum.

b. Variety: the length of period should be such that it includes sufficiently wide variation in output, so that enough observation is available for getting a reliable cost function.

c. Recent period: since the results of the cost function are to be used as a guide for future

planning, the period chosen should be recent enough to include data which will be relevant for the future.

d. Units of observation: The value-and-effect relationship between cost and output would be more useful if the data pertains to a shorter length of time. For example, by taking weekly or

monthly data we average out smaller changes in cost and output than by talking yearly data.

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ii. Technical Homogeneity: To eliminate or minimize the impact of technical differences on cost, the plants chosen for the study of the cost-output relationship should be characterized by

homogenous input and output structures. Homogeneity of inputs will ensure that the variations in cost due to different machines and equipment used in production at different

output levels are eliminated. Homogeneity in output reduces the problem of additively that exists in case of heterogeneous product measurement.

iii. Cost Adjustment

a. The choice of a proper data for cost measurement is obviously necessary: Generally, the cost data is not available in the form which can be readily used it needs certain adjustment and precautions, which are the following:

b. Selection of cost data: In order to find cost output relationship, one must select only those

elements of cost that vary with output. Overhead costs and allocated expenses that do not bear any relation to changes in output must be excluded. Further , it is always better to use date on total cost rather than unit cost because(1) the unit cost being a ratio of cost to output,

the impact of the output on cost will not be very revealing and there may be basic problems in interpretation of results. And (2) average and marginal cost functions can be derived from the

total cost functions. No additional purpose is, therefore, served in using unit cost data.

c. Cost deflation: since prices change over time, any money value cost would therefore relate

partly to output changes and partly to price changes. In order to estimate the cost-output relationship, the impact of price change on cost needs to be eliminated by deflating the cost

data by price indices. Wages and equipment price indices are readily available and frequently used to deflate the money cost.

iv. Economic Versus Accounting Cost Data: Accounting data is relatively more easily available and is therefore, used in most of the empirical studies. This data records the actual exp enses

on historical basis.

v. Changes in Accounting Practices: In case we are using time series of accounting data is

necessary that we find out whether accounting methods and procedures have changed or not during that period. These changes may be related to say depreciation method, timing of

recording expenses, etc. if there are any such changes they merit proper adjustment before being used for cost analysis.

PRICING

“Price” is defined as the exchange value of product or a service quantified in monetary terms. OBJECTIVES OF PRICING

i. Satisfactory return on investment.

ii. Maintaining the market share. iii. Meeting a specified profit goal. iv. Attaining largest possible market share.

v. Profit maximization. vi. Meeting competition.

vii. Discouraging entry of the new firms. viii. Flexibility to vary prices to meet change in economic conditions.

ix. Prices set at a high level and then lowered after a certain period has elapsed.

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x. The ultimate objective of the firm is to maximize profits. Hence the firm should strive to blend the different objectives mentioned above to achieve this.

DETERMINANTS OF PRICE

A. Internal Factors

i. Organizational factors: Pricing decisions occur on two level in the organization. Overall price strategy is dealt with by top executives and the actual mechanics of pricing are dealt

with the lower levels in the firm. Usually some combination of production and marketing specialists are involved in choosing the price.

ii. Marketing mix factors: Marketing experts view price as only one of the many important elements of the marketing mix. (product, price, place and promotion). A shift in any one of

the elements has an immediate effect on the otherthree. Thus, all pricing decisions must be viewed in the context of a total marketing strategy and must be coordinated with elements of production, promotions and distribution

iii. Product differentiation: Generally, the more differentiated a product is from competitve

offerings, the more leeways a firm has in setting prices.

iv. Costs: Price are determined solely by costs in that the firm wishes to take its relevant costs

that goes in it. However, in deciding the price of a new product, the firm should think what prices are realistic, considering current demand and competition in the market.

v. Objectives: The variety of possible pricing objectives was discussed earlier in this chapter.

A firm should define its objectives as specifically as possible so that they can be acted upon.

B. External Factors

i. Demand: The market of demand for a product or service obviously has a big impact on

pricing. Demand in turn in affected by the number and size of competitors. What they are

charging for similar products. The most likely buyers. How much they are willing to pay, and what their particular preferences are in deciding upon a price, marketers must study all of

these factors and then gauge the total effect

ii. Competition: Before a firm cam make pricing decisions. It must have a sense of not on the

price of a product. The fluctuations in price of their supplies to firm may have an impact on the prices of finished goods.

iii. Suppliers: Suppliers of raw materials and other goods can have a significant effect on the price of a product. The fluctuations in prices of their supplies to the firm may an impact on the prices of finished goods.

iv. Buyers: The various buyers that buy a firm‟s products and service may have an influence in

the pricing decision.

v. Economic conditions: Inflation, recession, shortage and stagflation all have an impact on

prices in most decision.

vi. Government: The government keeps a close watch on pricing in the private sector. Regulatory pressure effectively discourages private companies from winning too large a share of the market and controlling prices. Also, in many case, special committees or

commissions were appointed by the government to recommend fair selling prices. Tariff

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commission(abolished with effect from august 1, 1976), bureau of industrial costs and prices, essential commodities act, are some of the few instances were a government can intervene in

price fixation.

PRICING UNDER DIFFERENT OBJECTIVES

i. Need based Pricing: Not much managerial thinking has been devoted to this kind of pricing.

However, in a system where economic policy is activity used to promote social goals, need-based pricing is quite important. Four different approaches are available to arrive at a need-

based price:

ii. Ability to pay: The price may be determined according to the ability of consumer to pay.

This method of pricing is used in the pricing of state health service, some of the schooling services, housing provided by government or public sector companies, etc.

iii. Comparative reasonable price: In some case, price is determined by using a comparative

and reasonable open market, price as

iv. Pricing by norm: A norm may be developed. For example, food in an institutional cafeteria

may be priced on the basis of a price per caloric norm.

v. Poorest can afford: Sometimes pricing of an essential commodity or service is done on the

basis that the poorest section of society should be able to afford the product. Rationed sugar or grain and controlled cloth are priced based on such consideration.

vi. Cost-based Pricing: Cost consideration is the fundamental driving force in setting the price.

When other factor which influences pricing, such as government regulations, competitors

pricing strategies, market demand, technology are not dominant, the sole criteria on which the price is set may be costs.

vii. Market-based Pricing: Any pricing policy which takes demand factors into consideration and seeks to maximize revenues or profits is called market-based pricing. Most consumer

packaged goods and many industrial products have market-based prices. Since market-based prices is fraught with uncertainties of demand estimation and market response, the problem is often divided into small, structured manageable steps, each of which the executive into small,

structured manageable steps, each of which the executive can hope to tackle with judgment.

PRICING POLICIES

Pricing policies are the decisions by a company determining prices to be charged for its

products. There are a number of different pricing policies or strategies which a firm may adopt in order to achieve its pricing objectives.

i. Skim pricing: uses high prices to obtain a high profit and quick recovery of the development costs in the early stages of a product‟s life before competition intensities.

ii. Penetration pricing: Is the use of lower than normal prices to increase market share. It is

also used to establish a new product in a market which is expected to have a long-life and

potential for growth.

iii. Mixed pricing: is a policy which initially uses skim pricing and then, as competition increases, price cutting, sometimes even below cost, to penetrate the market, increases market share and eliminate competition.

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iv. Destructive pricing: involves reducing the price of an existing product or selling a new

product at an artificially low price in order to destroy competitor‟s sales.

v. Differential or discrimination pricing: is the use of different prices for the same product when it is sold in different locations or market segments. Large buyers for example. Often receive quantity discounts. Whilst small buyers or those located in remote areas may be

charged a higher price to cover the additional distribution costs. Electricity, gas is sold at different prices to domestic and industrial consumers.

vi. Absorption pricing: involves the use of lower than normal prices ether to launch a new

product or to periodically boost the sales of existing products. Regular special offers by

traders and businesses use loss leaders where everyday goods are sold at less than cost to attract customers.

vii. Marginal cost pricing: is something used when a firm has some spare capacity which it

wishes to use without diverting a way from its regular business. Essentially, a firm incurs

fixed costs such as rent, whether or not it is operating at full capacity. These costs are covered by the firm‟s regular products. Therefore, sometimes a firm is prepared to accept

additional business provided that the marginal (i.e, additional) revenue covers the marginal costs (i.e. materials and labour) involved and makes at least some contribution to the fixed cost which represents the profit.

viii. Negotiable pricing: is common in industrial markers. The price is individually calculated to

take account of costs, demand and any specific customer requirement.

ix. Single pricing: involves a policy of charging one price to everyone. Examples include

standard bus fares, prices of books etc.

x. Market pricing: is determined by the interaction of demand and supply. The seller has little control over the price in this situation which is likely to fluctuate daily. Examples include commodity markets such as gold, silver, wheat and wool and stock exchange.

xi. Sealed-bid pricing: is widely used in government, public sector and other private sector

markets whereby suppliers are invited to tender(offer a fixed price) for the supply of specified goods or services. Tenders must normally be submitted by a specified date in a sealed envelope. The contract is than usually awarded to the lowest bidder. A business will

calculate a tender price based on its own costs and analysis from knowledge and experience of competitor‟s likely bids.

I. COST-ORIENTED PRICING

a. Cost-plus Pricing: In this method the price is determined by adding a fixed mark-up to the cost of acquiring or producing the product.

b. Marginal cost (or direct cost) pricing: The marginal cost pricing implies that the price of the product is based on the incremental cost of production. Unlike the full-cost pricing which

is based on average cost, the incremental or marginal cost pricing is based on variable cost only- the difference between the two being fixed cost only. This makes it apply clear that

whereas the full-cost pricing is a long period phenomenon; the incremental-cost pricing is a short period phenomenon.

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c. Rate of Return (or Target) Pricing: It is a refined version of cost-plus pricing. When, due to certain reasons, the firm has to revise its prices it needs to ensure that the prices so

revised would allow it to maintain either a fixed percentage mark-up over cost; Profit as a fixed percentage of total sales; or a fixed return on existing investments.

II. COMPETITION-ORIENTED PRICING

a. Going-rate pricing: The „going-rate‟ pricing is, in a sense, opposite to „full-cost‟ pricing. In case of the latter the emphasis is on cost of production, while in case of the former it is on

the market situation. The simplest form of the going-rate pricing is where the firm simply examines the general pricing structure in the industry and fixes the price of its own product accordingly.

b. Loss leaders:“A loss leader is an item which produces a less than customary contribution

or a negative contribution to overhead but which is expected to create profits on increased future sales or sales of other items.

c. Trade association pricing: To avoid un certainties of pricing decisions and the downward pressure on prices which competition exerts, firms frequently come to the express or implied

agreements to maintain prices at a similar level. Though express (or, overt) agreements are generally declared as illegal, the firms can easily and safely enter into an implied (or, tacit) collusion.

d. Customary pricing: In case of some commodities the prices get fixed because they have

prevailed over a long period of time. Any change in costs for such products gets reflected in quality or quantity of the product rather than its price.

e. Price leadership: It often happens that in an industry there is one or many big firms whose cost of production is low and they dominate the industry. In such a situation, the small firms

will not like to enter into price war with these big firms. The former may, therefore, follow the price fixed by the leader.

f. Cyclical pricing: We are aware of various methods of pricing employed in various kinds of market structures like perfect and imperfect competition. However, there are considerations

other than market structure that operate to influence the pricing decisions, viz., seasonal and cyclical fluctuations in economic activity. Whereas seasonal factors operate on short-term basis, the cyclical factors influence the economic activity for a long run (up to 3 or more

years).

g. Imitative pricing and suggested prices: This approach is often used in retail business. In oligopolistic market conditions, the firms often follow a price-leader. But in non-oligopoly

situations also, it is many a time considered useful to imitate the price set by other firms. This approach makes decision-making quite easy, as the decision-maker does not have to

undertake the demand and cost analysis.

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PRICING BASED ON OTHER ECONOMIC CONSIDERATIONS

i. Administered prices: These are those prices which are statutorily fixed by the government, taking into account the cost and the stipulated profit per unit. The purpose of introducing

administered prices is to control prices of essential goods and inputs as well as to provide them at economic prices to weaker sections of consumers and producers. The public distribution system, whereby fair price shops sell essential goods to public, is based on

administered prices. Prices of certain goods like steel, fertilizer, coal, etc., are generally statutorily fixed.

ii. Dual pricing: A market, where a commodity is covered simultaneously under the

administered price as well as market price, is said to have dual prices. Here, part of the

output of a firm is subjected to administered price, while the rest of its output is sold in the free market.

iii. Price Discrimination or Differential Pricing: In an open price discrimination situation the

market is sub-divided on some systematic basis, such that it is almost impossible for the

group of buyers to whom a high price is quoted to take advantage by shifting and joining the group to which a lower price is quoted. There are many bases on which the open price

discrimination is practiced. These are discussed below.

a. Time Price Differentials: It is a general practice to use the expression “the demand for a

product or service”, but it is important to note that demand also has a time dimension. The demand may shift in fairly short-time intervals.

b. Clock-time price differentials: When demand elasticities of buyers undergo a change within 24-hour period, the seller can discriminate between the buyers demanding services at

different points of time within the 24-hour time period. These price differentials are called clock-time differentials and its object is to charge higher price for the product or service

during the period of relatively inelastic demand and lower price during the period of relatively elastic demand. The oft quoted example of clock-time differentials is the differences between day and night rates of long-distance telephone calls.

c. Calendar-time price differentials: When price differentials are not based on demand

elasticity differences but simply on time differences like days, weeks, months, etc., we call them calendar-time differentials. These differences are often found in recreational activities.

d. Use-price Differential: Different buyers have different uses of a product or a service. For example, Electricity can, similarly, be used for industrial or residential purposes. Charges for

these different segments according to demand elasticity based on buyers‟ use of the product or service, and then he charges different prices from these different segments.

e. Quality Price Differentials: If the product caters to that group of consumers who are concerned about its quality, then the quality becomes a significant determinant of demand

elasticity. The seller has, therefore, to create differences in quality to sell his product. It must be emphasized here that the differences in quality basically depend upon the buyer‟s understanding of the quality. Sellers use many decides to create quality appearance of the

product, by restricting a particular type of the product to a region or to a sale channel, etc. It is also found that consumers judge quality by the price of the product.

f. Quantity Differentials: When the seller discriminates on the basis of the quantity of purchase, it is known as quantity differentials. In business practice there are three types of

quantity differentials which are of significance.

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PRICING STRATEGIES

a. Stay-out Pricing: When a firm is not certain about the price at which it will be able to sell

its product, it starts with a very high price. If at this high price quotation it is not able to sell, it then lowers the price of its product. It will keep on lowering the price till it is able to sell the targeted amount of the product. This approach helps the firm to ascertain the maximum

possible price it can charge from its customers.

b. Price lining: Here, price of one product in the total range of the products is fixed. Price of rest of the commodities is automatically determined by the relationship between the commodity whose price has been fixed and the rest of the commodities in the range. For

example, if a firm producing shoes or shirts fixes up the price for a particular size, price of rest of the sizes is then fixed simultanelouslyon the basis of the differences in their sizes.

Also, when price of one size of shoes or shirts changes, prices of rest in the line of the product get automatically adjusted.

c. Psychological Pricing(or, Odd number and round number pricing): This is not truly a method of pricing but of price-tagging. Here a firm fixes the price of its product in a manner

which gives the impression of being low. For example, if the price of a product is fixed at Rs. 89.90 rather than Rs. 90, it may have the psychological impact on consumers that price is in 80s rather than in 90s. This may have some impact on sales. For example, the shoe

companies have been following this price policy with some success. On the other hand, some firms round their prices to the next higher rupee so that accounts can be kept easily.

d. Limit Pricing: A firm (or firms) may also try to establish a price that reduces or eliminates the threat of entry of new firms into the industry. This is called „limit pricing‟. For limit

price to be effective some of collusion is necessary among existing firms.

e. Resale Price Maintenance: Resale price maintenance is common in cases of popular or branded products. The manufacturers of such products fix and stipulate the price of the products at which the product is to be resold by the individual retailer. This is done to

maintain a uniform selling price of the branded produces at all the outlets of their sale. Since such a price is handed down from the manufacturer to the retailer, it is kind of vertical price

control.

f. Peak-load pricing: A firm that uses the same facility to supply many markets at different

points of time can increase its profits by the use of peak-load pricing. Peak-load pricing essentially involves charging higher price from consumers wanting to consume the service

during the peak demand period and lower price from those who consume during off-peak period.

g. Multi-product Pricing: Pricing that reflects the inter-relationship among multiple products of a firm that are complements or substitute of each other.

h. Public Utility Rate Regulation: The method of pricing a service owned and operated by the State.

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Documents

UNIT III-MG2452-Engineering Economics and Financial Accounting Notes