MGT – 102 Managerial Economics(Module – I) Introduction to Managerial Economics& Demand and Supply Analysis

Debasis PaniFaculty, GIACR

1. Introduction to Managerial Economics (Meaning)

What is Economics?The science of economics is concerned with the allocation of resources to alternative uses so

as to achieve maximum possible satisfaction of the people. To Adam Smith “Economics is a science of wealth”To Marshall “Economics is a science of material welfare”To Robbins “Economics is a science of scarcity”“Economics is the study of the behaviour of human beings in producing, distributing and

consuming material goods and services in a world of scare resources”

The Logic of Studying EconomicsEconomics is the study of how societies use scare resources to produce valuable commodities and distribute them among different people. Behind this definition are two key ideas in economics: those goods are scare and that society must use its resources efficiently. Indeed, economics is an important subject because of the fact of scarcity and the desire for efficiency.

But no society has reached a utopia of limitless possibilities. Ours is a world of scarcity, full of economic goods. A situation of scarcity is one in which goods are limited relative to desires. Efficiency denotes the most effective use of a society’s resources in satisfying people’s wants and needs.

The essence of economics is to acknowledge the reality of scarcity and then figure out how to organize societies in a way which produces the most efficient use of resources. That is where economics makes its unique contribution.

So economics is the study of behaviour of individual in production, consumption and distribution in the world of scare resources at individual level (micro) as well as at aggregate level (macro). The ultimate goal of economic science is to improve the living conditions of people in their everyday lives.

What is Management?To Koontz and O’Donell, “management as the creation and maintenance of an internal

environment in an enterprise where individuals, working together in groups, can perform efficiently and effectively towards the attainment of group goals.”

“Management is the discipline of organizing and allocating a firm’s scarce resources to achieve its desired objectives” These two definitions clearly points, a close relationship between management and economics has led to the development of managerial economics.

What is Managerial Economics?In simple terms, managerial economics is an application of that part of micro-economics and

macro-economics, which is directly related to decision making by a manager. To Mansfield, “Managerial economics is concerned with the application of economics concept

and economics to the problems of formulating rational decision making” To Spencer and Seigelman, “Managerial economics is the integration of economic theory and

practices for the purpose of facilitating decision making and forward planning by management”

Managerial economics refers to the application of economic theory and methods of decision sciences to arrive at the optimal solution to the various decision-making problems faced by managers of business firms.

Difference between Managerial Economics and Economics

Managerial Economics EconomicsManagerial economics involves application of economic principles to the problem of the firm

Economics deals with the body of principles itself

Managerial economics deals with micro economics at large

Economics deals with both micro economics and macro economics

Managerial economics, though micro in character deals only with the firm and has nothing to do with an individuals economic problem

Micro economics as a branch of economics deals with both economics of the individual as well as economics of firm.

The scope of managerial economics is narrow in comparison to economics

The scope of economics is wider then managerial economics

Managerial economics adopts modifies and reformulates economic models to suit the specific conditions and serves the specific problem solving processes.

Economic theory hypothesizes economic relationships and builds simplified economic models

Managerial economics introduces certain feedbacks such as objectives of the firm, environmental aspects and legal constraints.

Economic theory makes certain assumptions.

2. Nature of Managerial Economics, [A]Various Business Decision-Making Problems

(1) Choice of product, i.e., the products a firm has to produce - A manager has to allocate the available resources, so as to maximize the profit of the firm.(2) Choice of inputs – After determining the profit maximising level of output, the manager has to identify the input-mix which would produce the profit maximizing level of output at minimum cost.(3) Distribution of the firms’

revenue – The revenue received by the firm through sales has to be distributed in a just and fair manner by the manager. Workers, owner of factory building, bankers, and all those who have

contributed their materials and services in the process of production, storage and transportation, have to be paid remunerations, according to the terms and conditions already agreed upon. The residual after such payments constitutes the firm’s profit which has to be distributed among the owners of the firm after tax payment.(4) Rationing - This constitutes an important function of a manager. He/she should utilize the scarce resources optimally, which involves expenditure. As the manager has to often look after several plants simultaneously, he/she must prioritize not only the allocation of resources but also the time.(5) Maintenance and expansion – In addition, the manager has to plan strategies to ensure that the level of output is maintained, the efficiency of the firm is retained over time, and also to plan the future expansion of the firm. Expansion of the firm involves making adequate provisions for mobilizing additional capital from the market and/or borrowing money from banks. A dynamic manager always aspires to expand the firm’s scale of operation, so as to increase the profits.

[B] Managerial economics and Economic theoryManagerial economics uses economic theory to solve business decision-making problems.

Economics can be broadly divided into two categories: micro economics and macroeconomics. Macroeconomics studies the economic system in aggregate, while micro-economics studies the behaviour of an individual decision-making economic unit like a firm, a consumer, or an individual supplier of some factor of production. Macro-economics relates to issues such as determination of national income, savings, investment, employment at aggregate levels, tax collection, government expenditure, foreign trade, money supply, price level, etc.

[C] Managerial economics and Decision sciencesManagerial economics depends on economic theory for theoretical framework for analyzing the problems of business decision-making. On the other hand decision science provides tools and techniques for constructing decision models and for evaluating the results of alternative courses of action. Business economies use optimization techniques including differential calculus, linear programming, statistical tools and forecasting techniques.

3. Scope of Managerial Economics

In general the scope of Managerial Economics comprehends all those economic concepts, theories and tools of analysis which can be used to analyze the business environment and to find solution to practical business problems. In other words Managerial Economics is the economics applied to the analysis of business problems and decision-making. Broadly speaking it is applied economics. The areas of business issues to which economic theories can be directly applied may be broadly divided into two categories A) Operational or internal issues and B) Environment or external issues.(1) Demand Analysis and Forecasting: a business firm is an economic organism which transforms productive resources into goods that are to be sold in a market. A major part of managerial decision making depends on accurate estimates of demand. Before production schedules can be prepared and resources employed, a forecast future sales is essential. Demand analysis helps to identify the various factors influencing the demand for a firm’s product and thus provides guidelines to manipulating demand. Demand analysis and forecasting therefore is essential for business planning and occupies a strategic place in managerial economics. It mainly consists of discovering the force determining sales and their measurement. The chief topics covered are demand determinants, demand forecasting(2) Cost Analysis: a study of economic costs, combined with the data drawn from the firms accounting records, can yield significant cost estimates that are useful for managerial decisions. The factors causing variations in costs must be recognized and allowed for if management is to arrive at cost estimates which are significant for planning purposes. The chief topics covered under cost concepts are: cost concept and classifications, cost-output relationships, economics and diseconomies of scale, and cost control and cost reduction.(3) Production and Supply Analysis: production analysis is narrower in scope than cost analysis. Production analysis frequently proceeds in physical terms while cost analysis proceeds in monetary terms. Production analysis mainly deals with different production functions and their managerial uses.Supply analysis deals with various aspects of supply of a commodity. Certain important aspects of supply analysis are: supply schedule, curve and function, law of supply and its limitations. Elasticity of supply and factors influencing supply.(4) Pricing Decisions, Policies and Practices: pricing is a very important area of managerial economics. In fact, price is the genesis of the revenue of a firm and as such the success of a business firm largely depends on the correctiveness of price decisions taken by it. The important aspects dealt with under this area are: price determination in various market forms, pricing methods, differential pricing, product line pricing and price forecasting.(5) Profit Management: business firms are generally organized for the purpose of marking profit and, in the long-run; profits provide the chief measure of success. However, in a world of uncertainty, expectations are not always realized so that profit planning and measurement

constitute the difficult area of managerial economics. The important aspects covered under this area are: nature and measurement of profit, profit policies and techniques of profit planning like break-even-analysis. (6) Capital Management: the most complex problem is related to the firm’s capital investment. Briefly capital management implies planning and control of capital expenditure. The main topics dealt with are: cost of capital, rate of return and selection of projects

4. Significance of Managerial Economics,

1. It presents those aspects of traditional economics which are relevant for business decision-making in real life.

2. It also incorporates useful ideas from other disciplines such as psychology, sociology etc.3. Managerial economics helps in reaching a variety of business decisions in a complicated

environment.4. Managerial Economics makes a manager a more competent model builder.5. Managerial Economics serves as an integrating agent by coordinating the different

functional areas such as finance, marketing, HR, production and bringing to bear on the decisions of each department or specialist the implications pertaining to other functional areas.

6. Managerial Economics takes cognizance of the interaction between the firms and society and accomplishes the key role of business as an agent in the attainment of social and economic welfare.

Role of a Managerial Economist

A managerial economist can play a very important role by assisting the management in using the increasingly specialized skills and sophisticated techniques which are required to solve the difficult problems of successful decision-making and forward planning. So most of big business houses have the need of managerial economist and their roles are as follows.

1. Environmental studies2. Business operations3. Specific functions4. Economic intelligences5. Participating in the Public Debate

5. Relationship to the Functional areas of Business Administration studies like- Marketing, Finance, Statistics, Accounting, OR etc.

Managerial Economics and Marketing Product research Pricing decisions Packaging research Buying behaviour Design of distribution channel Sales and market research

Managerial Economics and Finance Forecasting Capital Budgeting Ratio analysis

Portfolio management Risk management Derivative future and options Mergers and acquisitions

Managerial Economics and Statistics Statistics provides the detailed data about the firm, which is useful for empirical testing. The probability theory of statistics offers the logic for dealing with uncertainty of future

events. Statistics also provides the knowledge about the different variables, which affect the

decisions taken in a firm.

Managerial Economics and Accounting Managerial economics draws heavily on the accounting records, which provides an authentic

source of information Accounting records can provide information relating to uses of funds over a long period for

managerial decision making

Managerial Economics and Operation Research OR is an activity oriented analysis of a business situation to find an optimal solution. The various decision making problems like allocation of space, utilisation of transport

facilities, choice of inventory can be answered through OR Linear programming is very useful in making the best use of scare resources.

6. Theory of the Firm:-Firm& Industry,

A firm in economics is the smallest unit of a production outfit. A business firm therefore is any production entity that carries out activities for money e.g. poultry farm, bakery, tannery, an accounting firm etc. The firm is an organisation that produces a good or service for sale and it plays a central role in theory and practice of Managerial Economics.

The function of firms, therefore to purchase resources or inputs of labour services capital and raw materials in order to transform them into goods and services for sale.

Industry is an aggregation of firms. Industry composed of various firms producing homogeneous, undifferentiated products. Firms are visible but industry is not visible. The firms have to follow industry norms.

7. Forms of ownership, {Study Material}

8. Basic & Alternate objectives of Firm.

The traditional objective of the firm has been profit maximisation. It is still regarded as the most common and theoretically the most plausible objective of business firms.

1. Profit Maximisation: the rationality on the part of producer implies that he tries to maximize his profit. We define profits as revenues less costs.

The surplus of total revenue over total cost is called his residual income. The residual income is the profits of entrepreneur. It is always residual income which is his true or net profits that the entrepreneur is assumed to maximise.

Although, profit maximisation is a dominant objective of the firm, other important objectives of the firm, other than profit maximisation are considered as alternative objective of firm:1. Maximisation of sales revenue.2. Maximisation of firm’s growth rate3. Maximisation of manager’s own utility or satisfaction4. Making a satisfactory rate of profit.5. Long-run survival of the firm6. Entry-prevention and risk avoidance.

9. Demand Analysis:- Demand& Demand Function,

Demand condition for a firm’s product has profound influence on its financial decisions, HR decisions, and marketing and operation decisions. If the demand for a product is quite large, then it may cause a large number of firms producing a product which may ensure a high level of competition in the industry.

What is Demand?Quantities of goods and services that people are ready to buy at various prices with in some

given time period, other factors besides price remains constant. Conceptually demand means desire for a commodity backed by the ability and willingness to pay for it.

Why people demand goods and services?People demand goods because they satisfy they want of the people. The utility means the

amount of satisfaction which an individual derives from consuming a commodity. It also defined as want satisfying power of a commodity.

Utility is a subjective entity resides in the mind of the consumer. Being it subjective it varies with different persons derive different amount of utility from a given a good. People know it by introspection. Thus in economics the concept of utility is ethically neutral.

Demand analysis and Management (Decision Making)Objective of business firm may differ but the basic objective is to produce and sell the goods

or services which is demanded by the customers. As necessity is the mother of invention, demand is the mother of production. If the demand for a particular product increases, then there is good prospect of business in future.

Demand analysis is a necessary informational input into the business decision process since, in a sense, demand fundamentally determines what is to be produced and at what price. Accordingly, business economists use demand analysis to discover the various factors determining the demand for a given product or service.

E.g. increasing demand for computers and mobile phone in India has enlarged the business prospect for both home countries and foreign countries. On the other hand declining demand for B&W TV is forcing the companies to switch over modern substitutes or to go out of business. So every manager should have the knowledge regarding the following aspect of demand.

Who will demand what much In which price Time period over which the product is demanded Market is in which the commodity is demanded.

So for a business decision both quantities demanded statement with specific price at a particular period in a particular market is relevant. e.g. the annual demand of Hero Honda Glamour in Delhi at an average price of Rs 50,000 and Piece is 20,000.

Demand function

The demand function for a commodity describes the relationship between the quantity demanded of it and the factors that influences it. Individual demand for a commodities depend on its own price, his income, price of related commodities, his taste and preferences, and advertising expenditure made by the producers for the commodity in question. With this we write the demand function as Qd = f (Px, I, Pr, T, A) ………..(1)Where Px = Own price of the commodity X, I = Income of the individual, Pr = Price of related commodities, T = Taste and preferences of the individual consumer, A = Advertising expenditure made by the producers of the commodity. For many purpose in economics, it is useful to focus on the relationship between price of a commodity and its quantity demanded of a good and its own price while keeping other determining factor constant. With this we write the demand function as

Qd = f ( Px ) ………..(2)This implies that quantity demanded of a good X is function of its own price, other determinants remain constant. As has been explained above, there is inverse relationship between price of a commodity and its quantity demanded.The individual’s demand function in (2) above is in general function form and does not show how much quantity demanded of a consumer will change following a unit change in price (Px). For the purpose of actually estimating demand for a commodity we need a specific form of the demand function. Generally, demand function is considered to be of a linear form. The specific demand function of a linear form is written as Qd = a – bPx ……….. (3)

Where a is a constant intercept term on the X-axis and b is the coefficient showing the slope of the demand curve. The coefficient of price P that is b being negative implies that there is a negative relationship between price and quantity demanded of a commodity. Factors Determining Demand (1) The Price of a Product: it is one of the most important determinants. The price of a product and its quantity demand are inversely related. Law of demand states that quantity demand of a product states that quantity demand of a product increases when its price falls and decreases when its price increases other factor remains constant. These other factors are income of consumer, prices of substitute and complementary good, consumer taste preference etc.(2) Income of the People: Purchasing powers of the consumer also determine the demand of the product. People with higher income spend larger amount on consumer goods then those with lower income. It means if income increases, consumption demand increases, if income falls, consumption decline at a lower proportion. Qd = f(I), ∆Qd / ∆I > 0But the impact of income on demand of the product differs according to the nature of product, i.e.

Essential Consumer Goods: it is otherwise called basic needs e.g. food grains, salts, fuel, cloth& housing. In this type of goods as income increases the quantity demand increases up to a certain limit after that the proportion of income in demand become slow or remain constant.

Inferior Goods: in case of inferior goods demand for these good decreases with increase in consumers income beyond a certain level e.g. millet is inferior than wheat and rice, bidi is inferior than cigarette, kerosene is inferior than cooking gas and so on.

Luxury and Prestige Goods: beyond a certain level of consumer’s income, consumption enters in to the area of luxury goods. Producer of such item should consider the income changes in richer section of the society e.g. AC car, diamond jewellery

(3) Price of the Related Goods: demand for a commodity is also affected by the demand in the price of related goods. These related good may be substitute goods or complementary goods.

Substitute Goods: if change in price of one commodity affect the demand of other commodity in the same direction, then both the commodity are substitute to each other. It shows that there is positive relationship between demand and price of two substitute product e.g. tea & coffee, alcohol & drugs.

Complementary Goods: when the use of two goods goes together so that their demand changes simultaneously is called complement goods. Its means if the demand of one commodity increases, the demand for its complement goods will decrease even if at lower price. There is inverse relationship between the demand for goods and price of its complement. e.g. petrol & car, ink & pen, butter & bread, milk & tea. An increase in the price of milk causes in the decreases of demand of tea other thing remain same.

(4) Taste and Preferences of Consumer: taste and preference generally depend on life-style, social customers, religious values attached to a commodity, habit of the people age & sex of the consumer etc. change in these factors change consumers taste & preference as a result demand for

goods or commodity increases or decreases. E.g. following the change in fashion people switch their consumption pattern. The change in demand for various goods occur due to the change in fashion and also due to the pressure of advertisements by the manufacturers and sellers of different products.(5) Advertisement Expenditure: it increases the demand for the product in four ways.

Informing consumer about availability Superiority of the product Influencing consumers Setting new fashion

With increases in the advertisement sales volume increases S = f (Ad)(6) Number of Consumer in the Market: the greater the number of consumers of a good, the greater the market demand for it. Another cause for the growth of number of consumer is the growth of population in India the demand for many essential goods, especially food grains, has increased because of the increase in the population of the country.(7) Consumers Expectation: consumers expectation regarding the future prices, income and supply position of goods etc play an important role in determining demand. If the consumer expects the high rise in price, the consumer current demand increases even at high price and vice-versa. Similarly, with expectation of increases in income or scarcity of product in future leads increases in quantity demand in current period.(8) Demonstration Effect: some of the people purchase commodity not because of necessity but because their neighbours have bought these goods. It is otherwise called as Band-Wagon effect. These effects have positive effect on demand. On the contrary, when the commodities are commonly used rich class people decrease the consumption. Or there are also consumers who like to behave differently from the others. This is known as Snob effect and it has negative effect on demand.(9) Credit Facility: availability of credit to the consumers from the sellers, banks, friends encourages the consumer to buy more. It mostly affects the demand of durable commodity. So manager of durable commodity should provide easy instalment facilities to sell his product.(10) Distribution of National Income: if the national income is equitably distributed, demand for necessity goods increases but demand for luxury goods decreases.

10. Law of demand and the reasons for it,

The demand schedule shows the quantity of goods that a consumer would be willing and able to buy at specific prices under the existing circumstances. Some of the more important factors affecting demand are the price of the good, the price of related goods, tastes and preferences, income, and consumer expectations. Economists record demand on a demand schedule and plot it on a graph as a demand curve that is usually downward sloping. The downward slope reflects the relationship between price and quantity demanded: as price decreases, quantity demanded increases. This behaviour of the consumer is governed by a law as the law of demand

The law of demand explains the behaviour of consumers, either a single consumer/household or all the consumers collectively. The law of demand states that other things remaining the same (ceteris paribus), the quantity demanded of a commodity is inversely related to its price. In other words, as price falls, the consumers buy more. Or, the demand for a commodity falls when its price rises. Thus:(1) The concept of demand generally refers to the quantity demanded at a given time, which may be a point of time, a day or a week.(2) The law of demand is based on the assumption that within the given time frame, there would be no change in the quality of the good in question. To put it differently, among the various determinants of demand, the price of the commodity is only variable.(3) The term ceteris paribus associated with the law of demand implies that taste and preference, income, the prices of related goods and social status, all remain constant over the period in which the impact of price variation on the quantity demanded is being analyzed.

(4) The law of demand is a partial analysis of the relationship between demand and price, in the sense that it relates to the demand for only one commodity, say X, at a time or over a period of time.

The demand schedule of an individual The demand curve of an individual Qd = 70-5pConsumer Here a = 70, b =∆Q/∆P = 10/2 = 5 So Qd = 70-5p It will be seen from both demand schedule and the demand curve that as the price of a commodity falls, more quantity of it is purchased or demanded. Since more is demanded at a lower price and less is demanded at a higher price, the demand curve is in accordance with the law of demand which, as stated above, describes inverse price demand relationship.

Reason for the Law of Demand: why does demand curve slope downwards?(1) Income effect: - as a result of the fall in the price of a commodity, consumers real income or purchasing power increases. This increase in real income induces the consumer to buy more of that commodity. This is one reason why a consumer buys more of a commodity whose price falls.(2) Substitution effect: - when the price of a commodity falls, it becomes relative cheaper than other commodities. This induces the consumer to substitute the commodity whose price has fallen for other commodities which have now become relatively dearer. As a result of substitution effect, the quantity demanded of the commodity, whose price has fallen, rises. This substitution effect is more important than the income effect. (3) New consumers:- when the price of commodity falls, many new consumer who were not consuming that commodity will start consuming the commodity.(4) Several Uses:- some commodity can be put to several uses which leads to downward slope of the demand curve as prices falls(5) Psychological effects:- when the price of a commodity falls people favour to buy more which is psychological.(6) Law of Diminishing Marginal Utility:- It is the basic cause of the law of demand. The law of diminishing marginal utility states that as an individual consumes more and more units of a commodity, the utility derived from it goes on decreasing. So as to get maximum satisfaction, an individual purchases in such a manner that the marginal utility of the commodity is equal to the price of the commodity. When the price of commodity falls, a rational consumer purchases more so as to equate the marginal utility and the price level. Thus, if a consumer wants to purchase larger quantities, then the price must be lowered. This is what the law of demand also states.

Exception to the Law of Demand (1) Goods having Prestige value: Veblen Effect. One exception to the law of demand is associated with the name of the economist, Thorstein Veblen who propounded the doctorine of conspicuous consumption. To Veblen, some consumers measure the utility of a commodity entirely by its price i.e., for them, greater the price of commodity, the greater it’s utility. E.g. Diamond, Luxury cars. (2) Giffen goods: - another exception to the law of demand was pointed out by Sir Robert Giffen who observed that when price of bread increases, the low paid British workers in the early 19 th

century purchased more bread and not less of it and this is contrary to the law of demand described above. The reason given for this is that these British workers consumed a diet of mainly bread and when the price of bread went up they were compelled to spend more on given quantity on bread. Therefore they could not afford to purchase as much meat as before. Thus they substituted even bread for meat in order to maintain their intake of food. It is important to note that with the rise in the price of giffen goods, its quantity demanded increases and with the fall in its price its quantity demanded decreases, the demand curve will slope upward to the right and not downward.

11. Relationship between demand function and demand curve

Demand Function

Demand function is a mathematical function showing relationship between the quantity demanded of a commodity and the factors influencing demand.

Dx = f (Px, Py, T, Y, A, Pp, Ep, U)

In the above equation,Dx = Quantity demanded of a commodityPx = Price of the commodityPy = Price of related goodsT = Tastes and preferences of consumerY = Income levelA = Advertising and promotional activitiesPp = Population (Size of the market)Ep = Consumer’s expectations about future pricesU = Specific factors affecting demand for a commodity such as seasonal changes, taxation policy, availability of credit facilities, etc.

Market Demand Function

Market demand is the combined response of individual demand. Manager of a firm is more interested in the size of total market demand for the commodity and firm’s share in it. This is because it will provide a basis of his pricing and output decision. Apart from the factors affecting individuals demand, market demand for a product depends on an additional factor namely number of consumers which in turns depend on the population of a region or a city or country. With this we write the market demand function as Qd = f (Px, I, Pr, T, A, N)

Where the additional factor is N which stands for the number of consumers or population.

Suppose there are two individual buyers of a good in the market. In the above diagram the fist consumer and second consumer shows the demand curve of the two independent individual buyers. Now the market demand curve can be obtained by adding together the amounts of the good which individuals wish to buy at each price (4+2=6 and 5+8=13).

Elasticity of Demand

Price Elasticity (ep) Income Elasticity (ei) Cross Elasticity (ec)

The market demand curve slopes downward to the right since the individual demand curve whose lateral summation gives us the market curve, normally slopes downward to the right. Besides, as the price of the goods falls, it is very likely that the new buyers will enter the market and will further raise the quantity demanded of the good. This is another reason why the market demand curve slopes downward to the right.

12. Bandwagon Effect & Snob Effect;

Bandwagon Effect:- The bandwagon effect is a well documented form of groupthink in behavioral science and has many applications. Some of the people purchase commodity not because of necessity but because their neighbours have bought these goods. It is otherwise called as Band-Wagon effect. These effects have positive effect on demand. The tendency to follow the actions or beliefs of others can occur because individuals directly prefer to conform, or because individuals derive information from others. In layman’s term the bandwagon effect refers to people doing certain things because other people are doing them, regardless of their own beliefs, which they may ignore or override.

Snob Effect:- when the commodities are commonly used rich class people decrease the consumption. Or there are also consumers who like to behave differently from the others. This is known as Snob effect and it has negative effect on demand. This situation is derived by the desire to own unusual, expensive or unique goods.

13. Elasticity of demand and its uses for Managerial decision-making,

The law of demand shows the direction of change in quantity demanded due to change in its price. But it does not state the extent or degree of change in quantity demanded due to change in price. The elasticity of demand shows the degree or extent of commodity with reference to change in its price, What is Elasticity of Demand?

The elasticity of demand refers to the degree of responsiveness of quantity demanded due to change in its price, consumer’s income and price of related goods.

Price Elasticity (ep) is the degree of responsiveness of quantity demanded due to change in its price

Income Elasticity (ei) is the degree of responsiveness of quantity demanded due to change in consumers income

Cross Elasticity (es) is the degree of responsiveness of quantity demanded due to change in price of related goods which may either a substitute for it or a complementary with it.

{I} Price Elasticity of Demand (ep)

Price elasticity is a measure used in economics to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price. More precisely, it gives the percentage change in quantity demanded in

response to a percent change in price (holding constant all the other determinants of demand, such as income). It was devised by Alfred Marshall. More often the price elasticity is commonly known as elasticity of demand.

To A.K. Cairnchash,” The elasticity of demand for a commodity is the rate at which quantity demanded bought changes as the price changes.”

In general price elasticity of demand is the ratio of percentage change in quantity demanded due to percentage change in priceep = Percentage change in quantity demanded / Percentage change in price

Measurement of Price Elasticity of DemandThe elasticity of demand can be measured with the following methods: - Gradient method,

Percentage method, Total outlay method, Point method, Arc method.

[1] Gradient MethodIn gradient method elasticity of demand is measured with the gradient or slope of a demand

curve. A flat curve shows elastic demand and steep curve less elastic demand. A curve in the nature of 45degree line from y axis shows unity elasticity. The gradient or slope of a curve is represented by Q/P

(1) Unity Elastic: in diagram B, the elasticity of demand is unity because the percentage change in quantity demanded is equal to percentage change in price. So this is called unity elasticity of demand. |ep| or |Ep| =∆Q/∆P = 1 , demand is unitarily elastic(2) More Elastic: the diagram A, represents more elastic of demand. Here the change in quantity demanded ∆Q is greater than change in price ∆P. so elasticity of demand is more elastic |ep| or |Ep| = ∆Q/∆P (where ∆Q>∆P)

|ep| or |Ep |> 1, demand is elastic(3) Less Elastic: in the figure C the elasticity of demand is less elastic because the change in quantity demanded is less than of the change in price; the ratio of change in quantity demanded to price is less then one |ep| or |Ep| = ∆Q/∆P (where ∆Q<∆P)

|ep| or |Ep| < 1, demand is inelastic

(4) Perfect Elastic: in figure D the demand curve is horizontal. It represents perfect elastic demand because here an insignificant change in price brings about a large change in quantity demanded of a good. |ep| or |Ep| = ∆Q/∆P = ∞(5) Perfect Inelastic: in figure E, the demand curve is vertical which represent perfectly inelastic demand. Because here a large change in price brings no change in quantity demanded.|ep| or |Ep| = ∆Q/∆P = 0

[2] Percentage MethodThis is an important method of measurement of elasticity of demand. In this method elasticity

of demand is measured as the ratio of the percentage changes in quantity demanded (%ΔQd) to the

percentage change in price (%ΔP). of the commodity

Ep = ∆Q/Q x P/∆P = ∆Q/∆P x P/QThe above formula usually yields a negative value, due to the inverse nature of the

relationship between price and quantity demanded, as described by the "law of demand". For example, if the price increases by 5% and quantity demanded decreases by 5%, then the elasticity at the initial price and quantity = −5%/5% = −1. However it may be noted that a convention has been adopted in economics that price elasticity is expressed with a positive sign .

[3] Total Outlay Method or Total Expenditure MethodIn this method elasticity of demand is measured from the changes in the expenditure of the consumer on the commodity as a result of change in its price. This method was developed by Marshall. If total expenditure remains the same after a change in price then elasticity of demand is said to be equal to one or unity elastic. If total expenditure increases as a result of a fall in price then elasticity of demand is said to be more than one or more elastic.

If total expenditure decline even after a fall in price of a commodity then elasticity of demand is called less elastic or less then one. In the above table when price falls the total expenditure increases up to a certain point but after that it remain constant for some time and again it falls. So total expenditure increases up to the forth unit of quantity demanded. Hence

it is called more elastic. When fifth and the sixth units of quantity demanded the total expenditure remains constant. So it is called unity elastic when a quantity demanded increases from seventh unit the total expenditure decreases so it is called less elastic. In the side diagram LA portion shows less then unity elastic because the total expenditure increases with rise in price. Hence it is inelastic. The AB portion shows unity elastic because here total expenditure remains same or constant, when price is rising. In BC portion to the total expenditure falls as price raises so elasticity of demand is greater then one or more elastic.

Price Quantity Demanded

Total Expenditure

10987

1234

1018 More Elastic ep>12428

65

56

30 Unity Elastic ep=130

4321

78910

2824 Less Elastic ep<11810

[4] Point MethodPoint method measures the elasticity of demand at a point on the demand curve. It measures elasticity of demand in case of infinite change in price. So point method is used to measure the elasticity of demand at a point on demand curve. Here elasticity of demand is

Ep = Lower segment of the demand curve / Upper segment of the demand curve

Derivation of the Formula

Ep = Proportionate change in quantity demanded ∆Q / Proportionate change in price ∆P

Ep = ∆Q/Q x P/∆P = ∆Q/∆P x P/Q

Ep = ∆Q/∆P x P/Q(After substituting the values in the above formula)Ep = (QQ’ / PP’) x (OP / OQ) …………….. Equation 1

In the figure QQ’ = MR’ and PP’ = MR and OP = QR thereforeEp = (MR’ / RM) x (QR / OQ) …………….. Equation 2

Now in triangle ∆RMR’ and ∆RQD’ m< MR’R = m< QD’R

m< RMR’ = m< RQD’m< MRR’ is common to both Therefore ∆RMR’ ≡ ∆RQD’

therefore ∆RMR’ and ∆RQD’ are similar to each other and corresponding sides are parallel to each other Hence MR’ / MR = QD’ / QRNow replace the value in Equation 2Ep = QD’ / OQNow triangle QD’R and PDR are similar because their corresponding angles are equally. Therefore we have QD’ / PR = RD’ / RDThus we conclude that price elasticity at on a straight line demand curve is = RD’ / RD

Or Lower segment of the demand curve / Upper segment of the demand curve

If R point lies exactly at the middle of the straight line demand curve DD’ the lower segment RD’ is equal to upper segment RD. Hence Ep = RD’ / RD = 1 (Unity elastic)

At the point S the lower segment SD’ is greter than upper segment SD hence Ep = SD’ / SD > 1 (More elastic)

At the point T the lower segment TD’ is smaller then the upper segment TD. Therefore price elasticity at T is Ep = TD’ / TD < 1 (More inelastic)

[5] Arc Method (Mid-point Method)Arc method is used to measure the elasticity of demand in

case of large changes in price. In this method the average or original price and changed price is used in place of original price and average of original quantity and changed quantity is used in place original quantity where elasticity of demand is measured between two points on the demand curve. It is called arc elasticity.

Ep = (∆Q / Q1 + Q2 ) / (∆P / P1 + P2) = (∆Q / Q1 + Q2 ) x ( P1 + P2 / ∆P )Ep = ∆Q (P1 + P2) / ∆P (Q1 + Q2)

In this diagram the area between R and M on demand curve DD’ is an Arc which measures elasticity over a situation range of price and quantity. Therefore the arc elasticity formula should be used when the change in price is somewhat large but not very large on the other hand when the two points on demand curve are very close.

Importance of the Concept of Demand Analysis1. The concept of elasticity of demand plays a crucial role in the pricing decisions of the

business firms and the govt when it regulates prices.2. The concept of elasticity is also important in judging the effect of devaluation of a currency on

its export earnings.3. It has also a great use in fiscal policy because the finance minister has to keep in view the

elasticity of demand when he considers imposing taxes on various commodities.4. Elasticity of demand also influences the determination of wages as well as the price of other

factor of production.

Determinants of Price Elasticity of Demand1. availability of substitutes 2. Nature of commodities – demand for luxury good is more elastic than the demand for

necessity and comforts because consumption of luxury goods can be postponed when the prices rise.

3. Weightage in the total consumption.4. The time factor in adjustment of consumption pattern.5. Range of commodity use.6. Proportion of market supplied

{2} Income Elasticity (ei)

Income elasticity of demand shows the degree of responsiveness of quantity demanded of a good to a small change in income of consumers. Thus more precisely the income elasticity of demand may be defined as the ratio of the proportionate change in the quantity purchased of a good to the proportionate change in income which includes the former.

Income Elasticity (ei) = Proportionate change in purchase of a good / proportionate change in incomeIncome Elasticity (ei) of demand as per percentage method is

ei = (∆Q / ∆M) x (M / Q)Midpoint formula for measuring income elasticity of demand when changes in income are quite large can be written as

ei = (∆Q / ∆M) x (M1 + M2 / Q1 + Q2)

For superior goods income elasticity is positive, whereas for inferior good it is negative. Positive income elasticity can assume three forms: greater than unity (one) elasticity, unity elasticity and less than unity elasticity.

1. When a change in income results in a direct and more than proportionate change in the quantity demanded, the income elasticity is said to be positive and more than unity. Luxury goods are its example.

2. When a change in income leads to a direct and proportionate change in the quantity demanded, then it is known as positive and unit income elasticity. Its examples include semi-luxury and comfort goods.

3. When an increase in income results in a less than proportionate increase in quantity demanded, then the elasticity is positive and less than unity. Necessary goods falls under this category.

4. The income elasticity is negative when an increase in income leads to a decrease in quantity demanded. Inferior quality goods came under this category. Knowledge of income elasticity of

demand for various commodities is useful in determining the effects of changes in business activity on various industries.

{3} Cross Elasticity (ec)

The sales volume of one product may be influenced by the price of either substitute or complementary products. Cross-price elasticity of demand provides a means to quantify that type of influence. Therefore, the degree of responsiveness of changers in the demand for one goods in response to change in price of another goods represents the cross elasticity of demand of one goods for the other.

Now suppose that the price of goods Y fall from OP1 to OP2, while price of goods X remains constant at OP. as a consequence of fall in price of goods y from OP1 to OP2, its quantity demanded rises from OQ1 to OQ2. In drawing the demand curve Dx for Goods X, it is assumed that the price of other goods including Goods Y remains the same. Now that the price of Goods Y has fallen and the as Goods Y is a substitute for goods, then as a result of the fall in price of Goods Y from OP1 to OP2 the demand curve of Goods X will shift to the left, i.e. demand for Goods X will decrease. This is because the marginal utility curve of the substitute goods shifts to the left. As a result of fall in price of goods Y the demand curve of goods X shift from Dx to Dx’. So that now at price OP less quantity OM2 of goods X is demanded. M1M2 of goods X has been substituted by Q1Q2 quantity of goods Y Cross Elasticity of demand of X for Y (ec) = Proportionate change in quantity demand of Goods X / Proportionate change in the price of Goods Y

ec = (∆Qx / ∆Py) x (Py / Qx)When the change in price is large, we should use midpoint method for estimating cross elasticity of demand. We can write the midpoint formula for measuring cross elasticity of demand as

ec = (∆Qx / ∆Py) x (Py1 + Py2 / Qx1 + Qx2)

If two goods are unrelated, a change in the price of one will not affect the sales of the other. The numerator of the cross-price elasticity ratio would be 0, and thus the coefficient of cross-price elasticity would be 0. In this case, the two commodities would be defined as independent. For example, consider the expected effect that a 10% increase in the price of eggs would have on the quantity of electronic calculator sales.

These relationships can be summarized as follows:If ec or Ec > 0, goods are substitutesIf ec or Ec < 0, goods are complementaryIf ec or Ec = 0, goods are independent

Cross price elasticises may not always be symmetrical. For example, consider two dailies, Times of India and the Hindustan Times competing in the Delhi market. Most analysts will agree that the two products are substitutes i.e. the cross price elasticity is positive. However, there is no reason to

believe that the change in demand for the Times of India following a one percent change in the price of Hindustan times will be equal to the change in demand for Hindustan Times following a one per cent change in the price of the Times of India. Many large corporations produce several related products. Maruti produces many varieties of automobiles, Hindustan Lever produces many brands of soap and Gillette produces much type of razors. If Maruti reduces the price of its Alto model, sales of its old warhorse the Maruti 800 may decline. When a company sells related products, knowledge of cross elasticity can aid decision makers in assessing such impacts.

14. Demand Forecasting

Demand forecasting is predicting future demand for a product. The information regarding future demand is essential for planning and scheduling production, purchase of raw materials, acquisition of finance and advertising. The information regarding future demand is also essential for existing firms to be able to avoid under or over production.

Various methods to demand forecasting have been divided into two types they are qualitative methods and quantitative methods. The techniques of forecasting are many but the choice of a suitable method is a matter of purpose, experience and expertise. To a large extent it also depends on the nature of the data available for the purpose.

[I] Qualitative Methods of Demand Forecasting

(1) Jury Method/Executive Opinion Method: the jury method is one of the commonly employed methods of sales forecasting. It is also known as executive opinion method. Judgment is the basis in this method. This is true for both the jury method and the percolated jury method. The difference that in the former the participants are limited to the top executives and in the latter, a large number of marketing and sales executive participate. In both, the participants exercise their judgment and give their opinions. The final forecast is arrived at by averaging these opinions. Evidently for the forecasts arrived at by this method is reliable, the executives participating must have versatile experience and sound knowledge of the business.(2) Survey of Experts Opinion: this is yet another judgment based method of sales forecasting but is some what different from the jury method. In this jury method, opinion of executives gives rise to the forecast. In survey of expert opinions, experts I the concerned field, inside or outside the organizations are approached for their estimates. This method is used more in developing total industry forecast than company sales forecast.(3) The Delphi Method: is a kind of survey of expert opinion method. It is used more for working out broad-based, futuristic estimates, rather than sales forecasts. In this method a panel of experts in the field is interrogated by a sequence of questionnaires. Any information that is available with any one member of the panel is passed on to others as well as enabling all members to have access to all the available information. The panel members are asked to react to a checklist of questions, which are significant to the forecast that is attempted. Their opinions are reactions are analyzed and where there is a sharp difference on an issue, interchanges are permitted and the final forecasts are presented.(4) Sales Force Composite Method: here the sales forecasting is done by the sales force. It is also judgment based method. Each salesman develops the forecast for his respective territory, the territory wise forecasts are consolidated at branch/area/region level; and the aggregate of all these forecasts is taken as the corporate forecast. Composite method seeks to aggregate the judgment of entire sales force. It is a grassroot method; the forecasting originates at the grassroot level people who are close to the market place from the basis for the forecast.(5) Survey of Buyer Intensions: forecasting is the art of anticipating what buyers are likely to do under a given set of condition. The various surveys also inquire into a consumers present and future personal finances and their expectation about the company. Buyer intension surveys are particularly

useful in estimating demand for industrial products, consumer durables, product purchases where advanced planning is required and new products.(6) Market Test: it is a essentially a risk control method or it is experiential marketing at minimum cost and risk. When firm decides on full scale manufacturing and marketing of the product on the basis of results of experiment, it helps avoid costly business errors. This method is useful for new product, with the support of the chosen marketing mix, is actually launched and marketed in a few selected cities/ towns/ other territories. The selected test markets will be representative of the final market

[II] Quantities Methods of Demand Forecasting

(1) Simple Projection Method: the simple projection method is the one in which the current year’s forecast is arrived at by simply adding an assumed growth rate to last years sales; same firms go by the industry growth rate and project the sales; some others take the growth rate achieved by the No1 firm in the industry. Another formula, as shown below is also used by same firmsNext years sales = (This year’s sales)2 / Last years salesOnly where the year-by-year sales are stable and show an increasing trend, this formula will provide a reasonably reliable estimate(2) Extrapolation Method: extrapolation is a projection method, but is a bit more complex compared to the simple projection method. It involves the plotting of the sales figure for the past several years and stretching of the line or the curve as the case may be. The extrapolation will give the figures for the coming years. Extrapolation basically assumes that the variable well follow their previously established pattern. In other words, the assumption is that the past will show the future.(3) Moving Average Method: this method helps eliminate the effects of seasonality and other irregular trends in sales while forecasting future sales. The method delivers a time series of moving averages. Each point of the time series is the arithmetical or weighted average of a number of preceding consecutive points of the series. If seasonal effects are present in the demand pattern of the product, a minimum of two years sales history is needed for applying this model.(4) Exponential Smoothing: is yet another projection method used for sales forecasting. It is similar to moving averages and is used fairly extensively. It too represents the weighted sums of all past numbers in a time series, with the heaviest weight placed on the most recent data or information. This method involves estimating the value of the ‘smoothing constant’ usually designated by symbol alphaAnd then using it to smooth the raw sales data. This assumption is this method is that actual sales are a function of environmental factors and the method helps to smothout these factors. This can be represented symbolically as

St = α Xt-1 + ( 1 – α ) St-1

St Refers to smoothed sales in period tα Is smoothing constant with a value between 0 to 1Xt-1 is actual sales in period t-1St-1 is smoothed sales in period t-1

This method is particularly useful when forecasts of a large number of items are made. It is not necessary here to keep a long history of past data. (5) Time Series Analysis: is also known as trend cycle analysis. A time series is a set of chronologically ordered raw data, for example, the monthly sales of given product for several continue years. Time series analysis helps to identify and explain:

Systematic variation or seasonal variation, which arises due to seasonality in the series of data.

Cyclical pattern that repeat themselves every two or every three years and soon. Trend in the data Growth rates of these trends

The main assumption in time series analysis is that the factors influencing sales will not changes very much over a period of time and that the future will reflect the past. In this sense this method is basically a projection method. Projections of future sales are made by studying the interaction of the basic and significant influence of sales. A through and systematic analysis of data is carried out. All the basic factors underlying the sales fluctuations are analyzed. The four main types of sales variations are as follows.

1. Long-term growth trends (Secular trends)2. Cyclical changes3. Seasonal variations4. Irregular or random fluctuations -

Are isolated and measured using the statistical procedure. The trend lines for each type of variations are studied and sales estimates are made. (6) Regression Analysis: it is another analytical technique used for demand forecasting. This technique combines economic theory and statistical technique of estimation. Economic theory is employed to specify the determinants of demand (Demand function) and to determine the nature of relationship between the demand for a product and its determinants. Statistical techniques are employed to estimate the values of parameters in the estimated equation.

In regression technique of demand forecasting, the analysts estimate the demand function for a product. In the demand function, the quantity to be forecast is a ‘dependent variable’ and the variables that affect or determine the demands are ‘independent variable’ or ‘explanatory variables’.

The simple regression technique is based on the assumptions (i) that independent variable will continue to grow at its past growth rate, and (ii) that the relationship between the dependent and independent variables will continue to remain the same in the future as in the past. The regression method, in general will give more accurate forecasts than the trend method since regression takes into account causal factor.(7) Econometric Models: this models basically attempts to express economic theories in mathematical terms so that they can be verified by statistical methods and used to measure the impact of one economic variable upon another predicting future event. The econometric model is constituted by a set of interdependent equations that describe and simulate the total demand situation. The forecast is derived through this set of equations.

Econometric model are quite complex and expensive to develop. But they predict the turning points more accurately. Econometric model are used more in forecasting the demand of durable goods, industrial as well as consumer durables, where replacement demand is significant factor to be projected.

Significance of Demand ForecastingEstimating and forecasting demand are crucial to the following types of decision-makers for knowing the present level of demand and the expected increase in demand over time.(i) Producers: A producer allocates various factors of production for maximization of profit, for which knowledge of both the present and future demands are important. Future demand estimates helps the producer to plan the extent of expansion in scale of operations, so as to deal with the increased demand and earn higher profits.(ii) Policy makers and planners: It helps government to formulate economic policies through the planning boards or planning commissions to allocate resources for economic development through production in the public, private and export sectors to achieve the targets set for a given time period. It also ensures adequate supply of inputs for achieving the objectives of industrial policy, import-export policies, credit policy, public distribution system, and other related policies, which involves forecasting of future demand.(iii) Other groups of the society: Demand forecasts are also useful to researchers, social workers and others with futuristic approach, to understand the levels of future demand or supply, the gaps, and their expected impact on prices or the economy.

15. Demand Estimation;

Why Demand Estimation?When running a small business, it is important to have an idea of what you should expect in

the way of sales. To estimate how many sales a company will make, demand estimation is a process

that is commonly used. With demand estimation, a company can gauge how much to produce and make other important decisions.

What is Demand Estimation?Demand estimation is a process that involves coming up with an estimate of the amount of

demand for a product or service. The estimate of demand is typically confined to a particular period of time, such as a month, quarter or year.

Various Methods for Demand Estimation

There are a variety of ways that can be used to estimate demand, each of which has certain advantages and disadvantages1. Consumer Survey: survey is a method for collecting quantitative information about items in a population. Firms can obtain information regarding their demand functions by using interviews and questionnaires, asking questions about buying habits, motives and intention. Advantages

They give up-to-date information reflecting the current business environment. Much useful information can be obtained that would be difficult to uncover in other ways.

Disadvantages Validity. Consumers often find it difficult to answer hypothetical questions, and sometimes

they will deliberately mislead the interviewer to give the answer they think the interviewer wants.

Reliability. It is difficult to collect precise quantitative data by such means. Sample bias. Those responding to questions may not be typical consumers

2. Market Experiments: market experiments seek to test consumer reactions to changes in variables in the demand function in a controlled environment. For example, consumers are normally given small amounts of money and allowed to choose how to spend this on different goods at prices that are varied by the investigator. However, such experiments have to be set up very carefully to obtain valid and reliable results. Advantages

Direct observation of consumers’ actual spending behaviour is possibleDisadvantages

There is less control in this case, and greater cost. The number of variations in the variables is limited because of the limited number of market

segments available. Experiments may have to be long-lasting in order to reveal reliable indications of consumer

behaviour. 3. Regression Analysis: Statistical techniques, especially regression analysis, provide the most powerful means of estimating demand functions. This is a statistical technique by which demand is estimated with the help of certain independent variable. Moreover multiple regression analysis is used to estimate demand as a function of two or more independent variables that vary simultaneously. Advantages

Regression techniques have become the most popular method of demand estimation software packages are available to use regression techniques

Disadvantages They require a lot of data in order to be performed. They necessitate a large amount of computation.

16. Supply and its elasticity,

The supply of a product refers to the various quantities of the product, which a seller is willing and able to sell at different prices in a given period of time.

Factors affecting Supply

(a) Cost of production: Variations in cost of production occur due to changes in cost of labor , raw materials, capital, technological advancements, etc. An increase in the cost of production leads to adecrease in supply . If due to technological advancement and large-scale production, the cost of production decreases in the long run, there would be an increase in supply .(b) Availability of other products: The supplier can switch over their production to any of their complementary or substitute product if their cost of production is less. (c) Climatic changes: Climatic conditions also affect the supply of products. When the climatic condition is favourable, production is usually more, which may lead to fall in prices. For example, agricultural production is largely dependent on climatic conditions.(d) Changes in government policies: A rise in direct or indirect taxes has an immediate effect on the prices of commodities. If a new tax is imposed or existing tax rates are increased, price of the product will go up resulting in decline of supply of the product.

The Law of SupplyThe law of supply states that other factors remaining constant, higher the price, greater the

quantity supplied and lower the price, lower the quantity supplied. Hence, the price and quantities supplied are positively related. This explains the reason why the supply curve slopes upwards.The law of supply takes into account only the most important determinant of supply i.e. the price of

the product. Supply Schedule: The supply schedule refers to the quantity of products a producer or seller

wishes to sell at a given price level. It explains the behaviour of sellers at various price levels. The supply schedule can be represented in a tabular form where it depicts the quantity supplied and price of the product at a given period of time.Supply Curve: When we represent the supply schedule in the form of a graph we get the supply curve. The graphical representation of supply schedule is known as supply curve.

Price of chocolate

Quantity supplied of chocolates

1 102 203 304 405 50

When we represent the supply schedule in the form of a graph we get the supply curve. In Figure the above figure, we have plotted the data given in the table in the form of a supply curve. Here, it is a typical upward-sloping supply curve. At a very low price, the chocolate manufacturer supplies smaller quantity of chocolates. But as the price of chocolates increases the manufacturers find it more profitable to shift to chocolates. Thus, higher the price of chocolates, the greater the amount of chocolates supplied.

Elasticity of Supply Elasticity of supply refers to the percentage change in quantity supplied of a product due to one percent change in its price. This can be denoted in an equation form:

Es = % change in the quantity supplied of a product / % change in its price

When the change in the quantity supplied changes more than proportionate to the change in price, the supply is elastic. On the other hand, if the change in the price leads to a less than proportionate change in quantity demanded, the supply is in elastic. When change in the quantity supplied is proportionate to the changes in the price, the product is said to be of unitary elastic supply .

When elasticity of supply is Known asEqual to Infinity More than one but less than infinity Equal to one Less than one but more than zero

Perfectly elastic supplyRelatively elastic supplyUnitary elastic supplyRelatively inelastic supply

Equal to zero Perfectly inelastic supplyAs a thumb rule, we should remember that flatter the supply curve, higher the elasticity and steeper the supply curve, lower is the elasticity.

17. Market Equilibrium.

The market for a particular good or service consists of all buyers and sellers of that good or service. In economics, the word market always implies bringing together of demand and supply in relation to goods or services. The interaction of potential buyers and potential sellers establishes a market.

A market is an arrangement as well as an institution, where both buyers and sellers come closer for a predefined transaction.

Market equilibrium refers to a situation where quantity demanded for a commodity is equals to its price. We have seen that the demand and supply of any product depend on its price. The equilibrium price is that price at which the total demand for any product in the market is equal to the total supply of that product.

The market demand curve gives us an idea of the total quantity demanded by all the buyers in the market at different price levels. In the same way, each seller takes the price as given and decides to offer a certain quantity for sale in the market. Thus, each seller has an individual supply curve and by summing up the individual supply curves of all the sellers in the market, we get the market supply curve. From the market supply curve we get to know the total supply by all sellers at different prices.

Demand and supply shifts Effect on price and quantityIf demand rises… The demand curve shifts to the right Both price and quantity increasesIf demand falls… The demand curve shifts to the left Both price and quantity fallsIf supply rises… The supply curve shifts to the right Price falls but quantity increasesIf supply falls… The supply curve shifts to the left Price increases and quantity decreases

MGT – 102 Managerial Economics(Module – II) Production and Cost Analysis

Debasis Pani

Faculty, GIACR

1. The Organization of Production

What is Production?The relationship between input and resulting in output is called production. The word

production in economics is not merely confined to physical transformation in the matter, it is creation and addition of value, therefore production in economics also covers the rendering of services. The theory of production provides a formal framework to help the managers of firms in deciding how to combine various factors or inputs most efficiently to produce the desired output of a product or service.

What is Production Function? A production function expresses the technological or engineering relationship between the

output of a commodity and its factor inputs. Traditionally, economic theory considers four factors of production, namely, land, labour, capital and organisation or management. Now, technology is also considered as an important determinant, as it contributes to output growth. Therefore, output is a positive function of the quantities of land, labour, capital, the quality of management, and the level of technology employed in its production. During this process every entrepreneur wants to maximize his profit as profit maximization is his prime motto. This relationship may be expressed as follows:-

Q = f (A, L , K, M, T)Where, f1,f2, f3, f4, f5 > 0

Q = quantity of output, A = land employed in the production of X, L = labour employed, K = capital employed, M = management employed, T = technology used, f = unspecified function, and f1 = partial derivative of f with respect to the ‘i’th independent variable.

This function describes a general production function. For the production of different commodities, one or all the factor inputs may not be equally important for all commodities. The importance of a factor of production varies from product to product. For instance, while land is the most important factor in the case of an agricultural product, its importance is relatively lower in the case of a manufacturing product. Meanwhile, the significance of management and technology may be greater in the case of an industrial product, rather than for an agricultural product. Therefore, researchers modify the production function according to the product and the specific objectives analysed.

Generally for the analysis of production decision problems, labour and capital are the only two factor inputs considered for convenience. Then, the production function reduces to:- Q = f (L.K)For a given level of output Q, various combinations of L and K may be used, which is known as production process or technology. Further, these combinations would also vary with variations in the level of output Q. Usually for production, both labour and capital are necessary and they substitute each other. When an entrepreneur employs more of labour than capital, then the production process is known as labour intensive production technique. Whereas, if more of capital is used in relation to labour, the production technique becomes capital intensive.

Production function carries the input and output relationship and according to economics the relationship is of two kinds when some inputs are fixed and some inputs are varied we call it short run period production function. When all inputs are varied and resulting output is called long run production function. The short run production function is also known as Law of Variable Proportion and the long run production function is known as Law of Returns to Scale.

2. Production Function with one variable inputs (Law of variable proportions)

The law of variable proportion is one of the fundamental law in economics. Thus law deals with the behaviour of production function in the short run. This kind of input-output relation forms

the subject matter of the law of diminishing marginal returns which is also called law of variable proportions and describes returns to a factor. To S.J. Stigler, “as equal increments of one input are added; the input of other productive services being held constant, beyond a certain point the resulting increments of product will decrease, i.e., the marginal products will diminish.”To Samuelson, “an increase in some inputs relative to other fixed inputs will, in a given state of technology, causes output to increase; but after a point the extra output resulting from the same additions of extra inputs will become less and less.”

In the short run factors of production are two types they are fixed factors and variable factors. In the short-run the volume of production can be changed by varying the variable factor only. This is because fixed factor like plant size, machinery etc can’t be changed in short period when the production function with one factor variable where other factors production are kept constant. Thus the short-run two factor production function can be written as Q = f (L, K‾)Where Q stands for output, L for labour and K for capital which is held constant in the short run

The ratio of variable factor to fixed factor in the production function increases. E.g. suppose in production function two factors are assumed that is land and labour. It also assumed that 10acres of land is available. Suppose the labour is engaged the ratio would 1:10, if the same labour is increased to 15 the ratio would be 15:10 this variation in the ratio of various factors causes the change in the size of output. At first there will be increasing in returns there after there will be diminishing returns and finally there will be negative return.

Assumption of the Law 1. Constant technology: - this law assumes that the techniques of production are constant.

Because if there are any technological changes instead of diminishing of marginal and average product it goes on increasing.

2. Short run: - this law specially operated in short run only because here some factor are fixed and some factor are variable. More over if it is a long run there is a chance that all the factors are variable.

3. Homogeneous factors: - this law is based on the assumption that the variable resources are applied unit by unit and each factor unit is homogeneous or very much identical to each other both in quantity and quality.

4. Changeable input ratio: - the law suppose the possibility of the ratio of fixed factor to variable factor being changed in other words it is possible to use various amounts of a variable factor with fixed factor of production.

Explanation of the LawThe production function shows the maximum quantity of the output that can be produced per unit of time for each set of alternative inputs, given the best available production technology available. In the short-run, at least one factor of production remains fixed. For instance, in the case of an agricultural production function, various alternative commodities of labour or capital per unit of time may be used in relation a fixed amount of land the law can be explained with the help of diagram and table. Suppose a firm has 10 acres of land the variable input is labour. In order to increase his firm out put the farmer the farmer can vary the labour on its cultivation change inputs. There will be changes in the output or response of the output is shown on the table. AP = TP/ Units of labour MP = ∆Q/∆L

Number of Men Total Product in Quantities (TP)

Marginal Product (MP)

Average Product (AP)

Stages

012

038

035

034

Stage – I

345

121414

420

43.52.8

Stage - II

6 12 -2 2 Stage – III

According the above table when the labour is increased from the one to two the MP as well as AP increases that is called Stage- I. But as more men are employed first the MP starts to fall and then AP starts to fall this stage we call it Stage – II. As we increase more and more labour MP goes negative that is stage-II. TP increases at a diminishing rate where as the stage-III TP starts to diminishing because here MP is negative these stages can be shown on diagram.

Stage – I In this diagram x-axis shows the units of labour is employed or the variable factor on the y-axis AP and MP has been shown. Stage – I ends where AP is maximum and MP intersects the AP from above. It is clear from the diagram in Stage – I, MP is higher than AP and TP increases at a increasing rate to the point F where MP is maximum after point F it increases at a diminishing rate so that point is known as point of inflation stage-I is called by some economist as stage of increasing returns because AP of the variable factors through out this stage. Stage – II starts where both the AP and MP are falling and TP increases at a diminishing rate. Stage – II ends at the point where MP is zero and TP is the maximumStage – III begins where the TP is maximum at the point k and MP touches the ox axis at the point B in the diagram with OA of variable inputs where getting AM of total product at a increasing returns. Similarly OB of variable output total product increases at a diminishing rate and reaches at the maximum point at K. this stage is called the stage of negative returns since the MP of the variable factor is negative during this stage.

Ideal Stage of Operation : it is note worthy that Marshall assumes only two laws of production that is Law of increasing and law of diminishing return, though the concept of constant return to scale occur even in the short period for negligible time. Practically in the stage –I the entrepreneur experiences increasing return. In Stage – II diminishing return at Stage – III is negative return. As it is well aware of the fact that the entrepreneur never restricts his production function. In the Stage – I that is increasing return because of profit maximization is the main motto of our entrepreneur. When he is getting increasing return that does ultimately mean that the entrepreneur is experiencing diminishing cost thus he never operates in Stage – I. similarly in the Stage – III also no entrepreneur operates. Therefore it is clear that the entrepreneur operates in the Stage – II only. He steps to take more variable inputs where TP is the maximum and profit is also the maximum. It is possible at the point where MP is zero. Thus Stage – II is the normal operation when the law of diminishing return operates

Cause of Diminishing Marginal ReturnsImperfect substitute:- the factor of production are imperfect substitute for one another. In other words one variable factor may be substituted for one another but that may not work with the same efficiency e.g. capital can be substituted for labour but imperfectly. If these factors were perfect substitutes there would no point in distinguishing between them. The greater the imperfection in substitutes of one factor for another the faster shall be the marginal return fall as the ratio of one factor is changed relatively to the other.Factor are not perfectly divisible:- the factor of production are not perfectly divisible in nature. In other words attaining the increasing return in the initial stage. We can’t increases the variable factor in the same proportion. So as to achieve the constant returns and avoid diminishing returns because the factors are not divisible. Fixity of some factors: - in the short period as some factors are given or fixed because their supply can’t be increased. E.g. for the farmers land is the fixed factor or when variable factors are mixed with it in increasing proportion. This fixed factor is spread thinly with the units of variable factor. As a result the variable factor gets diminishing returns.Optimum proportion of factors:- in many production process factors are to be combined in a proportion. Which is the given best proportion in other words this combination would be the best and the most efficient to operate. If this proportion is disturbed the efficiency of factor uses fall leading to diminishing returns.General Applicability of the Law of Diminishing Returns:- This law applies as much to industries as to agriculture. Whenever some factors are fixed and the amount of other increases, then the technology remaining the same, diminishing returns to a factor are bound to occur eventually both in agriculture and industries.

3. Production Function with two variable inputs (Law of Returns to scale

Another important attribute of production function is how output responds in the long run to changes in the scale of the firm i.e. when all inputs are increased in the same proportion, how does output change. Clearly, there are 3 possibilities. If output increases by more than an increase in inputs, then the situation is one of increasing returns to scale (IRS). If output increases by less than the increase in inputs, then it is a case of decreasing returns to scale (DRS). Lastly, output may increase by exactly the same proportion as inputs. For example a doubling of inputs may lead to a doubling of output. This is a case of constant returns to scale (CRS).

Constant returns to scale: When an increase in all inputs leads to proportional increase in output or vice-versa, it is called constant returns to scale. For example, there are two factors of production land and labor and they are doubled, the output will also double in case of constant returns to scale.Increasing returns to scale: When an increase in all inputs leads to more than proportional increase in output or vice-versa, it is called increasing returns to scale. In a small scale chemical plant, let us assume that labour, material, capital - all factors of production – are increased by 10%. Output will increase more than 10% in case of increasing returns to scale. The various causes of increasing returns to scale are

Indivisibility of factors Greater possiblility of specialisation Dimentional economies Internal economies External economies

Decreasing returns to scale: It occurs when an increase in all inputs leads to less than proportional increase in output. When processes are scaled up, they reach a point beyond which inefficiencies set in. It may happen due to either costs of management or ineffective control. The various causes of decreasing returns to scale are

Ineffective management Technical difficulties Limit of specialisation Imperfect substitution of factors

There is no universal answer to which industries will show what kind of returns to scale. Some industries like public utilities (Telecom and Electricity generation) show increasing returns over large ranges of output, whereas other industries exhibit constant or even decreasing returns to scale over the relevant output range. Therefore, whether an industry has constant, increasing or decreasing returns to scale is largely an empirical issue.

4. Optimal input combination for minimizing costs or maximizing outputs,

Production IsoquantsIn Greek the word ‘iso’ means ‘equal’ or ’same’. A production isoquant (equal output curve) is the locus of all those combinations of two inputs which yields a given level of output. With two variable inputs, capital and labour, the isoquant gives the different combinations of capital and labour, that produces the same level of output.

For example, 5 units of output can be produced using either 15 units of capital (K) or 2 units of labour (L) or K=10 and L=3 or K=5 and L=5 or K=3 and L=7. These four combinations of capital

and labour are four points on the isoquant associated with 5 units of output as shown in below figure

Each capital labour combination can be on only one isoquant. That is, isoquants cannot intersect. These isoquants are only three of an infinite number of isoquants that could be drawn. A group of isoquants is called an isoquant map. In an isoquant map, all isoquants lying above and to the right of a given isoquant indicate higher levels of output. Thus, in above figure isoquant II indicates a higher level of output than isoquant I, and isoquant III indicates a higher level of output than isoquant II. Figure shows an Isoquant Map: These isoquants shows various combinations of capital and labour inputs that can produce 10, 15, and 20 units of output. Capital Input Labour Input

In general, isoquants are determined in the following way. First, a rate of output, say Q0, is specified. Hence the production function can be written as Q0 = f ( K, L ) Those combinations of K and L that satisfy this equation define the isoquant for output rate Q0.

Marginal Rate of Technical Substitution (MRTS)As we have seen above, generally there are a number of ways (combinations of inputs) that a particular output can be produced. The rate, at which one input can be substituted for another input, if output remains constant, is called the marginal rate of technical substitution (MRTS). It is defined in case of two inputs, capital and labour, as the amount of capital that can be replaced by an extra unit of labour, without affecting total output.

MRTS L for K = (∆K / ∆L)

Isocost Lines

Recall that a universally accepted objective of any firm is to maximise profit. If the firm maximises profit, it will necessarily minimise cost for producing a given level of output or maximise output for a given level of cost. Suppose there are 2 inputs: capital (K) and labour (L) that are variable in the relevant time period. What combination of (K,L) should the firm choose in order to maximise output for a given level of cost? If there are 2 inputs, K,L, then given the price of capital (Pk) and the price of labour (PL), it is possible to determine the alternative combinations of (K,L) that can be purchased for a given level of expenditure. Suppose C is total expenditure, thenC= ( PL x L + Pk x K ) This linear function can be plotted on a graph to get isocost line.

Optimal Combination of InputsThe Long Run When both capital and labour are variable, determining the optimal input rates

of capital and labour requires the technical information from the production function i.e. the isoquants be combined with market data on input prices i.e. the isocost function. If we superimpose the relevant isocost curve on the firm’s isoquant map, we can readily determine graphically as to which combination of inputs maximise the output for a given level of expenditure.

Consider the problem of minimising the cost of a given rate of output. Specifically if the firm wants to produce 50 units of output at minimum cost. Two production isoquants have been drawn in figure. Three possible combinations (amongst a number of more combinations) are indicated by points A, Z and B in figure. Obviously, the firm should pick the point on the lower isocost i.e point Z. In fact, Z is the minimum cost combination of capital and labour. At Z the isocost is tangent to the 50 unit isoquant. Alternatively, consider the problem of maximising output subject to a given cost amount. You should satisfy yourself that among all possible output levels, the maximum amount will be represented by the isoquant that is tangent to the relevant isocost line. Suppose the budget of the firm increases to the amount shown by the higher of the two isocost lines in figure, point Q or 100 units of output is the maximum attainable given the new cost constraint in figure.

Regardless of the production objective, efficient production requires that the isoquant be tangent to the isocost function. If the problem is to maximise output, subject to a cost constraint or to minimise cost for a given level of output, the same efficiency condition holds true in both situations. Intuitively, if it is possible to substitute one input for another to keep output constant while reducing total cost, the firm is not using the least cost combination of inputs. In such a situation, the firm should substitute one input for another.

5. Technological Progress and its Implications.

Technological change means developments in the processes and methods of producing goods or services. It also includes changes in the old products or the introduction of new products.

For example, with technological developments in the aviation industry, large jet planes have increased the number of passenger miles per unit of input ( by almost fifty percent).

With the development of the optical fibre technology, the cost of telephony has come down drastically.

There are many such technological innovations which have improved productivity and reduced costs. There are other subtle technological changes which help reduce wastages in production process and increase output. Innovations can be divided into process innovations and product innovations.

Product innovation takes place when a new product with extra features is introduced in the market.

Process innovation takes place with the improvement in the production techniques for existing products. Process innovation allows firms to produce more output with the same inputs or to produce the same output with fewer inputs. In other words, process innovation is

equivalent to a shift in the production function. The side figure shows the shift in the total product curve because of the impact of technology in the form of process innovation. The lower curve indicates the possible output or the production function in the year 2000. If the productivity or output increases by 4 percent annually , the output per unit of input will increase by [(1.04)10 = 1.48] 50 percent after 10 years, because of the advancement in technology .

It is difficult to quantify product innovation, as compared to process innovation. However, product innovation is of more importance as it helps in increasing the standard of living in the long run. For example, a few decades ago the concept of cellular telephony would have seemed like science fiction. Inferior technologies become obsolete in a market economy, while superior technologies with higher productivity will increase the profits of innovating firms.

6. Cost Analysis: Meaning of Cost in Economic Analysis and its relevance in Managerial decision making;

Meaning of cost In general cost means input price. Cost can be defined as the price or money for expenses on input and process along with

value of time in a production process. Cost of production means input multiplied by their respective prices and added together to

give the money value of inputs.

Cost concepts On the basis of business operation and decision, the total cost concept are grouped under two

categories that is A) Accounting Cost Concepts B) Analytical Cost Concepts

[A] Accounting Cost Concepts(1) Opportunity Cost: opportunity cost is otherwise called as Alternative cost or Transfer cost. It is defined as the expected income which is foregone from the next best alternative use of resources, e.g. a man has a piece of land either he cultivate it or give it on rent. If he cultivates it, he will get 10,000 per annum and if he gives it on rent he expects to get 8,000 per annum. So as a rational man he cultivates the land and forego to expected income from rent. So the opportunity cost

of cultivation of the land is the expected income from the rent i.e. 8000 on the basis of opportunity cost business decision can be taken. (2) Social Cost (Real Cost) and Private Cost: is expressed in term of all efforts, services and sacrifices made in the process of production of a commodity. They are not expressed in terms of monetary form. Social cost of producing a commodity refers to the opportunities of producing other commodities foregone, given the scarce resources. In simple terms, it is the cost of alternative good sacrificed by a community in producing a certain amount of one good. Private costs, on the other hand, include the costs incurred by an individual firm to obtain the resources used for the production of commodity. The reduction in private cost of a product would result in the reduction in of social cost.(3) Explicit Costs : Production of a commodity generally requires different kinds of labour and capital in many forms. Modern economists call the direct production expenses as the explicit costs of production. This cost is actually entered in the books of account. These are recorded in normal accounting practices. It includes the expenses incurred by a producer on buying the productive services owned by others. Like payment for wages, salary, materials, license fee, insurance premium, depreciation charges etc. (4) Implicit costs: implicit costs are not appeared in the accounting system, nor that is paid in the form of cash. Implicit costs include the evaluation of a producer’s efforts and sacrifices incurred in production process. In other words, it refers to the reward a producer would like to pay self for self-owned and self-employed resources. They include a normal return on own investment, and the opportunity cost (alternative earnings) of own labour. E.g. wages to owner if he acts as manger him self, rent to owner’s building, interest to his own capital etc. these costs are not taken while calculating loss or gains of the business.(5) Economic vs Accounting costs/Historical cost: Accounting cost includes the expenses incurred on production process, in addition to the wear and tear of machines and equipments, which can be translated into monetary terms. The accountant records all the explicit costs in the account book, so as to compare them with the sale proceeds in order to compute profits. Whereas, economic cost includes all the implicit and explicit costs of production. It involves the estimation of opportunity cost, which is the price a factor of production can receive in any alternative use, including the implicit costs of the factors owned by the entrepreneur.Economic cost = Explicit cost + Implicit cost

[B] Analytical Cost Concepts(1) Total Cost: total expenditure incurred on the production of goods and servicesTotal Cost = Fixed Costs + Variable Costs (2) Average Cost: it is obtained by dividing total cost with total output AC = TC / Q(3) Marginal Cost: it he the addition to total cost on account of producing one additional unit of the product. It is the cost of marginal unit produced.MC = TCn – TCn-1 n=number of unit produced MC = ∂TC / ∂Q

(4)Incremental Cost: it refers to the total additional cost associated with the discussions to expand the output or to add a new variety of product etc. it arises also owing to the charge in product lines, addition or introduction of a new product, replacement of old techniques of production with a new one etc.(5) Sunk costs: They are the costs which cannot be recovered, and therefore, are not included in the decision making process. They include the costs of highly specialized resources or inputs, which once installed, cannot be put to any alternative use. For e.g., a big plant or machine installed by a firm which has become obsolete or inoperative due to non-availability of some parts, then the money spent on it is known as a sunk cost. It is sunk because neither can the firm uses it, nor sell it, or put it to any alternative use. Hence, sunk costs have no relevance in decision making.(6) Fixed costs: In production process, some factors are constant in the short run, while others are variable. Fixed costs are costs which do not vary with a change in output. The examples are interest on capital, rent on building, salaries to the staff, etc., which must be incurred, regardless of the level of output. (7) Variable costs: variable costs change with the variations in the level of output. They include the payments made to the variable factors, such as wages paid to workers, raw materials, electricity, transportation cost, etc., Total cost is the sum total of fixed and variable costs.(8) Controllable cost: the cost which can be controlled by the executive of the company is called controllable cost. i.e. direct labour cost, material cost etc.(9) Uncontrollable cost: which is controlled by external environment e.g. tax, tariff rate, custom duty etc.

Cost Functions – Short-run Cost Functions and its Empirical Estimation

Shot-run Cost Functions

A cost function expresses the relationship between the cost of production and levels of output. Before starting the cost function we should know about the short-run cost output relationship. The short-run cost are those costs which are incurred by firm during a period in which some factors especially capital equipment, building, land and management are held constant. The short-run costs are incurred on the purchase of labour, raw materials, chemicals, fuel etc. so in short-run and long-run cost functions we study the relation between the cost and level of output i.e., C = f (Q), the difference lies in factors that are varied to expand or contract output.

Total Fixed and Variable Costs in the Short-runTotal Fixed Cost: Fixed costs are those which are independent of output that is they do not change with the change in output. These costs are fixed amount which must incurred by a firm in the short-run, where the output is small or large. Even if some firm closes down for some time in the short-run but remains in business, these costs have to be borne by it. Fixed costs are also known as overhead costs and include changes such as contractual rent, insurance fee, maintenance costs, property taxes, interest on the borrowed funds, minimum administrative expenses such as managers salary, watchman’s wages etc. thus fixed costs are those which are incurred in hiring fixed factors of production whose amount cannot by altered in the short-run.

Total Variable Cost: variable costs are those costs which are incurred on the employment of variable factors of production whose amount can be altered in the short-run. Thus the total variable cost change with changes in output in the short-run, that is they increase or decrease when the output rises or falls. These costs include the payments made to the variable factors, such as wages paid to workers, price of raw materials, electricity, transportation cost, fuel cost etc. if a firm shutdowns for sometime it will not use the variable factors of production and therefore will not incur any variable cost. Variable costs are called prime costs or direct costs.

Total Cost: it is the actual cost that must be incurred to produce a given quantity of output. So in short-run. It should be noted that total cost TC is function of the total output Q; the greater the output, the greater will be the total cost in symbol we can write: TC = f (Q) Total Cost = Total Fixed Costs + Total Variable Costs or TC = TFC + TVC

Quantity of Output

Total Fixed Costs (TFC)

Total Variable Costs (TVC)

short-run Total cost(TC = TFC + TVC)

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The diagram shows that both total variable cost (TVC) and total cost (TC) curves are increasing functions of the level of output. TVC initially increases at a decreasing rate and then at an increasing rate. However, the total fixed cost curve remains constant at all output levels. The shape of total cost curve (TC) reflects that at each level of output, total cost exceeds the variable cost. The vertical distance between TC and TVC represents total fixed cost. Initially, the distance between TC and TVC is relatively high when the proportion of fixed to total cost is high. But, as the level of output increases, fixed cost constitutes a small fraction of total cost and hence the TC converges towards TVC. This is because, with the rise in the level of output produced, the fixed cost gets distributed across larger units of output. This reduces the fixed cost per unit of output.

Total Cost = Total Fixed Costs + Total Variable Costs or TC = TFC + TVC

Average and Marginal Cost Curves in the Short-runAverage Fixed Cost :- Average fixed cost is the total fixed costs divided by the number of units of output produced. Therefore,

AFC = TFC / Q Where Q represents the number of units of output produced. As output increases the TFC spreads over more and more units and therefore AFC becomes less and less. It will be seen from the table that AFC is the fixed cost per unit of output. Since TFC is a constant quantity Rs.60, AFC steadily falls as output increases. Therefore, AFC slopes downward throughout its length but it does not touch the. X-axis How the AFC is derived from the TFC is shown above.

shows the derivation of AFC from TFC. Choice of certain points on TFC and dividing the vertical distance by the corresponding quantity of output would give the slopes of different rays starting from origin and extending to the TFC. The slopes of OA1, OA2, OA3, OA4 and OA5 indicate average fixed cost at different output levels.

Quantity of Output (Q)

Total Variable

Costs (TVC)

AVC= (TVC / Q)

Total fixed cost

(TFC)

AFC = (TFC / Q)

ATC = AVC + AFC

MC = (∆TVC /

∆Q)

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Average Variable Cost:- is the total variable cost divided by the number of units of output produced therefore, AVC = TVC / Q

It is also possible to derive average variable cost (AVC) by measuring the slopes of different rays from the origin to the corresponding points on the TVC curve. However, analyzing the pattern of variation in AVC is more complicated as compared to the AFC, because both of these elements determine its change. Since AVC = TVC, both the numerator (TVC) and the denominator (output) increase together, but not necessarily in the same proportion. The AVC curve is ‘U’ shaped due to the operation of law of variable proportions. Decreasing costs arise due to economies of scale reaped by firms, whereas increasing costs occur due to diseconomies of scale. Above shows TVC at different levels of output. The change in slope indicates that TVC increases at different rates at different

quantities of output. For instance, for producing OQ1 units of output, the AVC is OC1, which is nothing but the slope of the ray OC at A on the TVC curve

Average Total Cost or Average Cost: - or simply called as Average Cost (AC) is the total cost divided by the number of units of output produced, thusAverage Total Cost or Average Cost = Total Cost / Output AC = TC / QSince the total cost is the sum total of the TFC and TVC. The AC is also the sum of AVC and AFC AC = TC / Q = TFC + TVC / QAFC = TFC / Q AVC = TVC / QAC = AFC + AVCIt needs to emphasize that the behavior of the AC curve will depend upon the behaviour of AFC and AVC. In the beginning, both AFC and AVC curve fall, the AC therefore fall sharply in

the beginning. When AVC begins rising, but AFC is falling steeply, the AC curve continue to fall. This is because during this stage the fall in AFC curve weighs more than the rise in the AVC curve. But as output increases further, there is a sharp rise in AVC which is more than offsets the fall in AFC. Therefore the AC curve rises after a point. Therefore, the AC like the AVC curve first falls, reaches its minimum value and then rises. The AC curve is therefore almost ‘U’ – shape

Marginal Cost:- is the addition to the total cost caused by producing one more unit of output. In other words, MC is the addition to the TC of producing n units instead of n-1 units that is one less, where n is any given number. In symbols. MCn = TCn – TCn-1Since MC is a change in TC as a result of a unit change in output, it can also be written as:For a given quantity of output and other costs are MC = ΔTC / ΔQ = ∂TC / ∂QBut ∆TC = ∆TFC + ∆TVC In short-run the MC is independent of fixed costs. Since fixed costs do not change with the change in output, there are no marginal fixed costs when output is increased in the short-run. So the MC are in fact due to change in variable costs.In short-run ∆TFC = 0 so ∆TC = ∆TVCSo MC = ∆TVC / ∆Q , if ∆Q = 1 Then MC = ∆TVC The MC curve declines as output increases in the beginning. Further according to law of variable proportion, marginal product declines after a certain level of output this cause the MC to rise after a certain level of output. Thus, the fact that marginal product rises first, reaches a maximum and declines, ensures that the MC curve of a firm declines first, reaches a minimum level and then rises. In other words, MC curve of a firm has a ‘U’-shape.

Relation between AC and MC: the relation between the MC and AC is the same as that between marginal average quantities. When MC is less than AC, AC falls and when MC is greater than AC, AC rises. For better understanding let us take an example of a cricket player’s batting average is 50, if in the next innings he scores 45, then his average score fall because his

AC

MC

MC

MC

Marginal score is less than his average score. If instead of 45, he scores 55 in his next innings, then his average score will increase because his marginal score is greater than average score. His present average is 50. Suppose if he will score 50 than his average score remains 50, because the marginal score is equal to average score.

Example: A biscuit producing company has the following variable cost function: TVC= 200Q+9Q2+0.25Q3 if the company’s fixed costs are equal to Rs.150 lakhs find outTotal cost function, MC function, AVC function, AC function and at what output levels AVC and MC will be minimum.Solution: since the TC is the sum of TFC and TVC, we get the TC function as under:TC = 150 + 200Q + 9Q2 + 0.25Q3

To determine MC we take the first derivative of the TVC function with respect to output Q thusMC = ∂TC / ∂Q = 200 - 18Q + 0.75Q2

To derive the AC and AVC we derive the respective TC by the output level.AC = TC/Q = (150 + 200Q + 9Q2 + 0.25Q3) / Q

= 150/Q + 200 – 9Q + 0.25Q2

And AVC = TVC/Q = 200 – 9Q + 0.25Q2

It is also useful to know at what level of output, AVC takes on its minimum value. To determine the level of output at which AVC is minimum, we have to take first the derivative of AVC function and set this derivative equal to zero. Thus, taking the first derivative of AVC function AVC =200 – 9Q + 0.25Q2 ∂ (AVC)/ ∂Q = -9 + 0.50QSetting it equal to zero we have

-9 + 0.50Q = 0 0.50Q = 9 ½ Q = 9 Q = 18

Thus at output equal to 18, where AVC will be minimum.To find the output level at which MC is minimum, we have to set the first derivative of MC function is MC = 200 - 18Q + 0.75Q2

∂ (MC)/ ∂Q = -18 + 1.50Qsetting ∂ (MC)/ ∂Q equals to zero, we have:

-18 + 1.50Q = 0 1.50Q = 18 Q = (18 x 10)/15 Q = 12

Thus, at output level 12, MC is minimumIt is thus clear from above that MC takes on the minimum value at an output level smaller than that at which AVC is minimum.

Application in business: every business firm want to minimize its cost and maximize its output. It means it produce that amount of output where AC become minimum. So to minimize AC, the derivative of AC should equal to zero.

Suppose TC = 10+6Q-0.9Q2+0.05Q3

AC = TC/Q = 10/Q + 6 – 0.9Q + 0.05Q2 = 10Q-1 + 6 – 0.9Q + 0.05Q2

∂ (AC)/ ∂Q = -10Q-2 – 0.9 + 0.1Q -10Q-2 – 0.9 + 0.1Q = 0 -10/Q2 – 0.9 + 0.1Q = 0 -10 -0.9Q2 + 0.1Q3 = 0 (when both sides are multiplied by Q2) -100 - 9Q2 + Q3 = 0 (when both sides are multiplied by 10) Q3 - 9Q2 -100 = 0 (Q - 10) (Q2 + Q +10) = 0

One of the terms must equal to zero, so we have Q2 + Q +10 = 10Then Q – 10 = 0 and Q= 10

For equilibrium MC must cuts AC at the lowest point from the below, which represent optimum output level at minimum cost. So the optimum output can be achieved where AC = MC at minimum point of ACExample: suppose short-run cost function is given find out the optimum level of output. If TC = 200 + 5Q + 2Q2

AC = TC/Q = 200/Q + 5 +2QMC = ∂ (TC)/ ∂Q = 5 + 4QTo get optimum output, AC=MC

200/Q + 5 +2Q = 5 + 4Q 200/Q = 2Q 2Q2 = 200 Q2 = 100 Q = 10 So at 10unit of output the AC is minimum.

Long run Cost Function

Long-run is defined as the period in which all factors of production are variable. While, in the short-run some costs are fixed and others vary (variable costs), in the long-run all the costs are variable. Hence, the long run cost reflects the returns to scale. When a manager decides to increase all the factors of production, it is known as a change in the scale of a firm’s operation. Inresponse to the change in the scale, the firm may experience increasing, constant and/or diminishing returns to scale. These changes in returns may be expressed in terms of cost conditions as decreasing costs, and constant costs and/or increasing costs. Long-run is a composed of series of short-run. So Long-run curves are composed of short-run curves

Derivation of LAC from SAC: in every short-run Total cost curve there is one short-run average cost curve i.e. SAC1, SAC2, SAC3 every SAC has its minimum point the LAC curve are derived from the SAC curves by joining the minimum point, or diminishing point or increasing point, depending upon STCs.

The relation between LTC & LAC is at the initial stage, LTC increases at diminishing rate and later it increases at an increasing rate. So the LAC in first instances it declines then it increases.

At the initial short-run average cost SAC1, the firm produces OQ1 units of output at the per unit cost OC1. When the manager plans to increase output to OQ2 units, the average cost would be OC3 on the rising part of the SAC1 cost curve if the same plant is used. On the other hand, if an additional plant is installed, the cost would fall to OC2 (OC2 < OC1). Thus, the installation of a new plant decreases the cost per unit of output. The diagram shows that average cost will successively fall till the installation of the fourth plant. The lowest AC level is reached at output level OQ3. This level is known as the optimum level of output, at which the long run average cost (LAC) is minimum and the LMC cuts it from below. Here, the long run equilibrium condition of LAC = LMC and LMC cutting LAC from below have been reached. If output increases beyond OQ3, the LAC would rise for every additional plants installed. No rational manager would install new plant beyond it, as they wish to make at least normal profits in the long run. The long run average cost curve (LAC) is also known as envelope curve as it envelopes several average cost curves corresponding to different plant size. Further, it is also known as a planning curve, as it guides the manager in planning the future expansion of plant and output.

Derivation of LMC from SMC: LMC curve can also be derived from the LAC in the same way as the LMC curve is related to the LAC in the same way as the SMC is related to SACTo derive LMC we have to consider the point of tangency between SACs and LAC i.e. PQR. If we draw perpendicular the corresponding output at different short period are OA, OB, OC. The perpendicular PA, intersects SMC1 at point N, it means at OA output the LMC=NA, if output increases LMC rises to QB or RC. A curve draw through N,Q,R is LMC Optimum level of output: At OB output optimum production can be achieved at minimum cost because it is the minimum point of LAC i.e. Q before point Q, there is chance of further decrease in LAC. So the

production continues. But after point B, the LAC rises. So the production process stops at that point. So OB is the optimum level of output at minimum cost.So the condition for optimizing output and minimizing cost in Long-run are

1. The LMC = LAC2. LMC must cuts LAC at minimum point form below3. SAC = SMC = LMC = LAC

7. Economies of scale,

An economy of scale, in microeconomics, refers to the cost advantages that a business obtains due to expansion. There are factors that cause a producer’s average cost per unit to fall as the scale of output is increased. "Economies of scale" is a long run concept and refers to reductions in unit cost as the size of a facility and the usage levels of

other inputs increase. When an increase in output causes LRATC or LRAC (Long Run Average Total Cost Curve) to decrease, we say that the firm is enjoying economies of scale: the more output produced, the lower the cost per unit. Diseconomies of scale are the opposite. The common sources of economies of scale are

Purchasing (bulk buying of materials through long-term contracts),

Managerial (increasing the specialization of managers),

Financial (obtaining lower-interest charges when borrowing from banks and having access to a greater range of financial instruments),

Marketing (spreading the cost of advertising over a greater range of output in media markets), and

Technological (taking advantage of returns to scale in the production function). Each of these factors reduces the long run average costs (LRAC) of production by shifting the short-run average total cost (SRATC) curve down and to the right. Economies of scale are also derived partially from learning by doing.

Economies of scale is a practical concept that is important for explaining real world phenomena such as patterns of international trade, the number of firms in a market, and how firms get "too big to fail". The exploitation of economies of scale helps explain why companies grow large in some industries. Economies of scale also play a role in a "natural monopoly."

Long-run average total cost increases as output increases. While economies of scale are more likely at low levels of output, diseconomies of scale are more likely at higher output levels. In Figure, you can see that the firm does not experience diseconomies of scale until its output reaches more than 185 units.

8. Economies of Scope,

Economies of scope are conceptually similar to economies of scale. Whereas economies of scale primarily refer to efficiencies associated with supply-side changes, such as increasing or decreasing the scale of production, of a single product type, economies of scope refer to efficiencies primarily associated with demand-side changes, such as increasing or decreasing the scope of marketing and distribution, of different types of products. Economies of scope are one of the main reasons for such marketing strategies as product bundling, product lining, and family branding.

Panzar and Willig coined the term "economies of scope" in 1975 in their paper "Economies of Scale and Economies of Scope in Multi-Output Production."

The economies of scope is an extension of economies of scale to the multi product case. Economies of scope can be measured where C(Q1Q2) is the cost of jointly producing goods 1 and 2 in respective quantities C(Q1) is the cost of producing good 1 and similarly for C(Q2) is the cost of producing good2.

SC = C(Q1) + C(Q2) - C(Q1Q2) / C(Q1) + C(Q2)

Economies of scope arise from complementarities in the production of or distribution of distinct goods and services.

Economies of scope can be reached when additional advertising expenditure will results in more effective sales.

If a sales force is selling several products more efficiently that improves cost efficiency. There can also be synergies between products such that offering a complete range of

products gives the consumer a more desirable product offering than a single product would. Economies of scope can also operate through high distribution efficiencies e.g. HUL. Further economies of scope occur when there are cost-savings arising from by-products in the

production process. A by-product is a secondary or incidental product deriving from a manufacturing process. A by-product can be useful and marketable, or it can be considered waste.

A company which sells many product lines, sells the same product in many countries, or sells many product lines in many countries will benefit from reduced risk levels as a result of its economies of scope. If one of its product lines falls out of fashion or one country has an economic slowdown, the company will, most likely, be able to continue trading

9. Linkage between Cost, Revenue and Output through Optimization. (Numerical examples to be used to explain the concepts)

Profit is defined as the firm’s sales revenue minus its costs of production. But there are two different conceptions of the firm’s costs, and each of them leads to a different definition of profit.

Accounting profit = Total revenue - Accounting costs.Economic profit = Total revenue - All costs of production

= Total revenue - (Explicit costs - Implicit costs)

Profit Maximisation Output Level 1. In the total revenue and total cost approach, the firm calculates Profit =TR - TC at each

output level and selects the output level where profit is greatest. To maximize profit, the firm should produce the quantity of output where the vertical distance between the TR and TC curves is greatest and the TR curve lies above the TC curve.

2. There is another way to find the profit-maximizing level of output. This approach, which uses marginal concepts, gives us some powerful insights into the firm’s decision making process. Recall that marginal cost is the change in total cost from producing one more unit of output. Now, let’s consider a similar concept for revenue. Marginal revenue-The change in total revenue from producing one more unit of output. To maximize profit, the firm should produce the level of output closest to the point where MC = MR—that is, the level of output at which the MC and MR curves intersect.

Total revenue is the product of the number of units sold and the price per unit. If the firm is able to sell more units by reducing the price, the total revenue (TR) curve will be concave. The total cost (TC) function is a short run function, which shows the relationship between costs and output for a production process in which one or more of the factors of production are fixed. Short run cost

comprises of both fixed and variable cost components. When costs are deducted from revenue, what remains is the firm’s profit:

Total Profit (π) = Total Revenue – Total Costs.

the vertical distance between the curves of total revenue (TR) and total cost (TC) determines total profits at any level of production. The point where the total cost equals the total revenue is known as the break-even point. In the above diagram at q2 level of output the firm is attaining break-even point. Break-even analysis is an important practical application of the cost function. In business planning, many decisions are taken on the basis of an anticipated level of output. Break even analysis studies the inter-relationships between the firm's revenues, costs and operating profit at various levels of

production. It is used to measure the effects of changes in selling prices, fixed costs, and variable costs on the output level that is to be achieved before the firm starts earning operating profits.

MGT – 102 Managerial Economics(Module – III) Market Structure and Pricing Practices

Debasis PaniFaculty, GIACR

1. Market Morphology

Market refers to an arrangement as well an institution, where both buyer and seller get interacted through a medium for a pre-defined transaction.

In a simple sense market can be defined as the interaction between seller and buyers of a good or service at a mutually agreed upon price

Market morphology is otherwise called market structure refers to the competitive environment in which buyer and seller co-exist in an economy.

Knowledge of market structure is very important to study the behaviour of firms in an economy. The type of decisions a firm makes and the potential of the firm to earn profits in the short run and long run, depends on the type of market structure in which the firm operates.

Market structure can be broadly categorised in to three types as perfect competition, monopoly and imperfect competition.

Type of Market Number of Firm

Nature of product

Number of buyers

Freedom of entry and exit

Examples

Perfect competition

Very large Homogeneous Very large Unrestricted Agricultural commodities, share market

Monopoly Single Unique Large Restricted Indian railway, Microsoft, Intel Processor

Monopolistic competition

Many Differentiated Large Unrestricted Retail Stores

Oligopoly Few Differentiated unique

Large Restricted Cars, Telecom Service provider

Duopoly Two Differentiated unique

Large Restricted Pepsi Vs Coke

2. Price and Output Determination under Different Markets

3. Perfect Competition

In perfect competition, firm is the part of the whole industry and industry is the aggregation of many firm. In such market the price is determined by the decided by the industry and the firms are price takers again there is free entry and free exit of the firm.

Perfect competition is that sort of market structure, where there is large number of buyer and large number of seller, buying and selling homogeneous product. Where the price is determined by the industry and all the firms have to follow the price.

Mrs Jhon Robinson “Perfect competition prevails when the demand for output of each producer is perfectly elastic”

To Marshall “the price in perfect competition is determined by the interaction of demand and supply” he compared the demand and supply with two blades of a scissor, but it is uncertain to say which blade actually works. Therefore in short we can say price is that point where both demand curve and supply curve interact to each other.

Characteristics of perfect competition (a) Large number of buyers and sellers: - A perfectly competitive market is basically formed by a large number of buyers and sellers. Their number is sufficiently large and the size of each seller and buyer is relatively small in terms of market. So, the individual seller’s buyer’s and supply and demand are negligible in terms of market supply and demand. Hence, individual seller and buyer do not have a control over supply and demand of the market.

(b) Homogeneous Product: - The commodity supplied by each firm in a perfectly competitive market is homogeneous. It means all firms in the industry produce identical products. The products are identical in terms of quality , variety , colour , design, packing and other selling conditions of the product. (c) Free entry and exit of firms: - New firms are not having any legal, technological, economic, and financial or any other barrier to their entry in the industry. Similarly, existing firms are free to quit the market. There are no barriers to entry or exit of firms. Entry or exit may take time, but firms have the freedom to move in or move out of the industry . (d) Perfect knowledge of market conditions: - Perfect competition requires that all the buyers and sellers must possess perfect knowledge about the existing market conditions such as market price, quantities and sources of supply and demand. The perfect knowledge ensures transactions in a perfectly competitive market at a uniform price.(e) Non-intervention of the Government: - A perfect competition also implies that there is no government intervention in the working of market economy. This means that there are no tariffs, subsidies, rationing of goods, control on supply raw materials and licensing policy. (f) Absence of transport costs element:-It is essential that competitive position of no firm is adversely affected by the transport cost differences. Hence, it is assumed that there is absence ofTransport cost as all firms are closer to the markets.(g) Perfect mobility of factors of production:- it implies that various factors of production should be free to move in to any use which they consider profitable for themselves. Similarly they are also free to come out from the industry whenever they consider their remuneration is inadequate.

Example of Perfect competition market Share market Securities and bond market Agricultural products like Local vegetable market

Condition for equilibrium As explained earlier, under perfect competition the firm is a price taker and it any way can’t

influence the price by its individual action. Thus the demand curve or average revenue curve of the firm is a horizontal straight line or perfectly elastic at the level of prevailing price. It implies a perfectly competitive firm sells additional units of output at the same price, MR curve coincides with the AR curve. That the MR of a perfectly competitive firm equals price or AR can be mathematically shown as under

MR = ∆TR / ∆Q Now ∆TR = ∆(P x Q)Since price of the product P for a perfectly competitive firm is a given datum and is independent of its level of output Q, therefore,∆TR = P x ∆Q thus MR = ∆TR / ∆Q = P x ∆Q / ∆Q = P

Price for an individual firm under perfect competition is given. It cannot influence the price by its own action. Hence, the demand curve or average revenue curve facing a firm under perfect competition is perfectly elastic at the ruling price. Perfectly competitive firm can sell as much as it wishes without affecting the price, and the marginal

revenue is equal to the price (average revenue) of the commodity. So, the average revenue (or demand) curve, (AR) and marginal revenue curve (MR) must coincide with each other for a firm under perfect competition.If price prevailing in the market is OP, then PA is both the average and marginal revenue curve. MC is the marginal cost curve. It may be noted that under perfect competition, a firm’s upwards rising position of MC curve is also its supply curve. Given the price OP, the firm will fix its output where its profits are maximum. Profits are the greatest at the level of output for which marginal cost is equal to marginal revenue and marginal cost curve cuts the marginal revenue curve from below. In point B

MC is equal to MR but MC is cutting MR from above rather than from below. Therefore, B cannot be a position of equilibrium. At point C or output OX1, the marginal cost equals MR and marginal cost curve is also cutting MR curve from below. Hence, at the output OX1, the profits would be maximum and the firm would be in equilibrium position. Thus, the conditions of firm’s equilibrium under perfect competition are: -

(i) MC =MR = Price(ii) MC must cut MR from below.

Equilibrium of firms and industry in Short periodThe short run has been defined as a period of time sufficient to allow the firm to adjust its

output by increasing or decreasing the amount of variable input and fixed factors of production remains constant. Thus, in the short run, the size and kind of plant cannot be changed, nor can new firms enter the industry. The industry would be in equilibrium where there will be equilibrium in all the firms. The equilibrium of the firm and industry can be discussed under two conditions

Some times the cost conditions of the firm with in the industry are different. We may find that some firms are producing their output at lower cost of production then other firms it is due to differences in the efficiency of entrepreneurship. So when factors of production are heterogeneous. That leads to cost curves of the different firms takes different shape. In the above diagram-A where the price of the industry has been determined and that is similar to all. At that price firm –B is making super normal profit as its cost curve is below the price. Firm-C is making normal profit as its cost curve is tangent or equal to price. Firm-D is incurring losses since its cost curve is above then the price of the industry. Firm-E where the firm is going to stop its business because incurring loss a firm can continue its operation so long as it is covering the AVC. Once it is not recovering the AVC, then immediately it will stop its operation.

Equilibrium of firms and industry in Long periodThe long run is a period which is long enough to permit changes in the variable as well as in the fixed factors of input. Hence, firms can change their output by increasing their fixed equipment. They can enlarge the old plants or replace them by new plants or add new plants. Moreover, in the long run, new firms can also enter the industry. On the contrary, if the situation so demands, in the long run, the existing firms can leave the industry. So, it is the long run average and marginal cost curves are relevant for making output decisions. For a perfectly competitive firm to be in equilibrium in the long run, in addition to marginal cost equal to price, price must also be equal to average cost. If the price is greater than the average cost, the firms will be making supernormal profits. Lured by these supernormal profits, new firms will enter the industry and these extra profits will be competed away. When the new firms enter the industry, the supply of output of the industry will increase and hence the price of the output will be reduced

As studied earlier price under perfect competition is determined by the industry and firms are price takers at a given price on that same market price firms can earn supernormal profit or normal profits depending upon the level of cost curves of the firm. That is why it is said that the firms can earn

supernormal profit by lowering their cost with their efficient management this can be shown with the help of a diagram

in the diagram the demand and supply curve of industry both they interacts at point E where OP is the price and OM is the output. OP price is carried on to firm-A and firm-B. in the firm-A LMC intersect the MR at the point E1 where the firm enjoying PRQE1 of supernormal profit because of efficient management. Similarly the firm-B where the equilibrium point is E2. the firm is enjoying normal profit. Hence the firm-A is called intra-marginal firm where as firm-B is called marginal firm. In the longrun if any firm enjoys the losses cant sustained. Hence in the longrun no firm enjoy losses.

Relevance of Pure CompetitionPerfect competition is practically non-existence in the real world. Pure competition is more

realistic then perfect competition. Professor Chamberlin has propounded the concept of pure competition. If we exclude perfect knowledge and perfect mobility from the feature of perfect competition then it becomes pure competition. However, the main importance of pure competition is:-(i) The study of the purely competitive is a rare phenomenon. But, there are at any time in existence certain industries which resemble a competitive model. The best example in this regard is of a garment industry, agriculture, steel, aluminium.(ii) From the purely competitive model, we will be able to know how outside forces affect an industry. Agriculture is a purely competitive industry which is vitally affected by external factors.(iii) The study of the purely competitive market structure is helpful in understanding the imperfectly competitive model.(iv) Purely competitive model is a very useful starting point for economic analysis in the real world conditions.(v) An understanding of a purely competitive model can enable us to study the beneficial effects of increased production. We will be able to know, for instance how competition lowers prices, costs and profit margins under the impact of increased production. This is highly beneficial to the general public. Besides, we can grasp the force of anti-trust or anti-monopoly arguments and arguments for lowering the tariff barriers, reduce import quotas and have freer international trade.

4. Monopoly

Meaning of MonopolyMonopoly is a word derived from the Latin word mono and poly. Mono means single and poly means seller. Therefore monopoly is form of market organization where only seller of the commodity available moreover there is no close substitute for the commodity. Since the seller being the only seller. He has full control over the supply of commodity. In such situation the seller dictates the price to the consumer. Thus monopolist is the price maker. Under the monopoly form of market there is no much difference between the firm and industry.

Main Features of Monopoly: (1) One seller and large number of buyers:- There is only one seller of a particular good or service. The monopolist may be a single person or a partnership firm or a corporate body. Again in monopoly the number of buyers is large and the demand for the monopolist is the market demand. As there is no difference between industry and firm in monopoly.(2) No close substitute: - Rivalry from the producers of substitutes insignificant. This implies that the cross-elasticity of demand between the monopolists’ product and any other product is small or zero(3) The monopolist is price maker:- The monopolist is in a position to set the price himself. The strength of a monopolist lies in his power to raise his prices without frightening away all his customers. How much he can raise them depends on the elasticity of demand for his particular product. This, in turn, depends on the extent to which substitutes for his products are available. And in most cases, there is rather an infinite series of closely competing substitutes. Even exclusive monopolies like railways or telephones must take account of potential competition by alternative services. An undue increase in rates may lead to substitution of railways by motor transport and of telephone calls by telegrams. The closer the substitute and the greater the elasticity, therefore, of the demand for a given manufacturing’s product, the less he can raise his price without frightening away his customers. In fact, two conditions are necessary to make a monopolist strong: (i) A gap in the chain of substitutes, and (ii) Possibility of securing control over all the close substitutes. In fact, it is very difficult to draw a line between what is and what is not a monopoly. (4) Restriction on the entry of new firm:- in simple monopoly there is a strict barrier on the entry of new firms hence monopolist faces no competition.(5) Nature of demand curve:- in monopoly, as there is one firm the aggregate demand for all buyers is the demand curve for the monopolist. It slopes downward from left to right. According to this demand curve it is clear that monopolist can sale more of his output at lower price and vice-versa. The downward sloping demand curve also tells that the AR curve or the price goes on falling as sales are increased. Therefore both AR and MR curve slopes downward from left to right. It is also note worthy that AR remains higher then MR.

Causes of Monopoly(i) The Government may grant a license to any particular person or persons for operating public utilities like a gas company or an electricity undertaking. (ii) A producer may possess certain scarce raw materials, patent rights, secret methods of production, or specialized skill which might give him monopoly power. For example, Hoechst held a monopoly for some time in oral medicines for diabetes because they were the first to find out the methods of reducing blood sugar by an oral dose. (iii) The necessity of having large resources, as is the case where the minimum efficient scale of operations is very large, may often create monopoly. For example, it is so for making some chemicals.(iv) Ignorance, laziness and prejudice of the buyers may create monopoly in favour of a particular producer.

The Nature of Demand and Marginal Revenue Curve Average Revenue. If a monopolist raises his price slightly, he will sell less, but there will still be some buyers of his product. He can increase his sales only by reducing his price. His average revenue (demand) curve will slopes downwards to the right. It shows that larger quantities can be sold at lower prices, whereas smaller quantities can be sold at higher prices.

it is important to know the relationship between MR and price under monopoly which faces a downward sloping demand curve. To explain this relationship MR = ∆TR / ∆Q = ∆(PQ) / ∆QWhere ∆TR stands for change in total revenue, P for price and Q for quantity of output sold. In the above figure DD is the demand curve and when price falls from OP to OP` the quantity demand increases to OQ to OQ` to change in TR is equals to ∆(P.Q) is equal to the gain in evenue from extra unit sold (i.e. P. ∆Q) following the decline in price and the loss in revenue incurred on all the previous intramarginal units due to fall in price equals to (i.e Q. ∆P)thus, for small values of ∆P and ∆Q, the change in TR can be obtained as under∆TR = P. ∆Q + Q. ∆P∆TR / ∆Q = P + Q. ∆P/∆Q (Dividing both side by ∆Q)MR = P + Q. ∆P/∆Q Since demand curve facing the monopolist is downward sloping, ∆P is negative where as ∆Q is positive, the term Q. ∆P/∆Q will be negative. It therefore follows from the above expression that MR will be less than price (P)MR = P + 1.Q. ∆P/∆Q

= P + P/P.Q. ∆P/∆Q= P + P.Q/P. ∆P/∆Q= P + P. ∆P/∆Q.Q/PThe price elasticity of demand is e=∆Q/∆P.P/Q therefore, ∆P/∆Q.Q/P = 1/e

MR = P + P.1/eMR= P(1 + 1/e)Since the demand curve facing the monopolist has a negative slope, elasticity e will be negative therefore. MR = P (1 - 1/e)

Price and Output determination under Monopoly

(1) Price and output determination in short-run:- short period is a time period in which there are two types of factors of production namely fixed factors and variable factors. Hence in the short-run production can be changed only by changing the variable factors of production i.e. existing machine and plants and new factories can’t be installed. The aim of the monopolist is to earn maximum profit or suffer minimum losses. Since monopolist is the single seller he can fix up his price equal to or above or less then AC. Thus in the short-run he may earn normal profit or super normal profit or even losses. This depends upon the nature of the demand for his product and the consumer surplus of the society because a monopolist has to fix up the price with in the consumer surplus otherwise he may loose the market. In order to maximize profit and minimize losses the monopolist obviously compares his MR and MC. If MR exceeds the MC the monopolist can minimize his profit by increasing his output.

In the first figure the monopolist is in equilibrium at the point E because at this point MC intersects MR from its below at that point the output is OM. In such situation he is earring supernormal profit as shown in the shaded area PQRS. In the second figure E is the point of equilibrium where MR=MC. At this point price = SAC hence the firm is earning normal profit. The last figure shows the firm is incurring losses where is AC is higher than the AR and the monopolist firm is incurring losses in the shaded area of PQRS

(2) Price and output determination in Long-run: - The long run is a period which is long enough to permit changes in the variable as well as in the fixed factors of input. Hence, firms can change their output by increasing their fixed equipment. They can enlarge the old plants or replace them by new plants or add new plants.

In the Long-run the monopolist firm is in equilibrium where MC=MR and MC intersects from below. The long run equilibrium of firm under monopoly can be explained in the side diagram the firm is in equilibrium at the point E where the LMC intersects MR from below. At this point OM is the output firm is earning super normal profit equal to PQRS as AR is higher then AC by PQ. In the long run monopolist firm always enjoys supernormal profit thus they are called monopoly profit.

In the Long-run monopoly prices affected by the laws of returns to scale. The law of returns to scale refers to the behavior of AC and MC

Price Discrimination or Discriminating MonopolySometimes monopolist charges different prices for the same product from different buyers. It is possible on his part when market condition do permit and if it is profitable for him to do so in such cases a monopoly is called discriminating monopoly.

Conditions for Price Discrimination.The main conditions of Price discriminations are:-(i) Multiple Demand Elasticity’s:- There must be difference in demand elasticties among buyers due to differences in income, location, available alternatives, tastes or other factors.

(ii) Market Segmentation:- The seller must be able to partition (segment) the total market by segregating buyers into groups according to elasticity.(iii) Market sealing:- The seller must be able to prevent, or natural circumstances must exist which will prevent any significant resale of goods from the lower to the higher price sub-market.(iv) Legal sanction: - some time the Government gives legal sanction to go for price discrimination such sanctions we can see in Indian Railway which charges different price from different persons

Objectives of Price Discrimination(i) To appropriate the consumer’s surplus so that it accrues to the producer rather than to the consumer.(ii) To dispose of occasional surplus.(iii) To develop a new market.(iv) To make the maximum use of the unutilized capacity.(v) To earn monopoly profits.(vi) To enter into or retain export markets.(vii) To destroy or to forestall competition or to make the competitors amenable to the wishes of the seller adopting price discrimination. It may be called predatory or discriminatory competition.(viii) To raise future sales. This is done by quoting lower rates in the present so that people develop in future a taste for the allied commodities produced by the same manufacturer.

Degree of Discrimination The degree of discrimination depend upon the elasticity of demand. More the inelasticity higher would be the degree of discrimination.

Ist Degree Discrimination: here the monopoly is suppose to know the maximum amount of money each consumer will pay for any quantity. He then sets his price in such a way that he can extract the whole consumer surplus. Such a monopoly is known as perfect discrimination because it is an extreme limiting case. In practical only few of the monopolists can go for first degree of discrimination. In this diagram the consumer is purchasing OM units of output in the absence of discrimination by spending OPBM. The monopolist would able to extract the total revenue ABMO. Thus a perfectly discriminating monopolist is in a position to extract the whole of consumer surplus of APB.

IInd Degree Discrimination: it occurs where a monopolist said different prices for different customers. But doesn’t fully exploit the potential demand prices so that the monopolist can capture only a part of consumer surplus. E.g. scheduled rate charges by Indian Railway. In this diagram it is assumed that the monopoly charges the price OP1 for OM1 units of output. A lower price OP2 for OM2 units of output and still a lower price OP3 for more then OM3 units of output. Suppose a typical consumer purchases OM3 of output in the absence of price discrimination. The monopolist obtain P3CM3O of revenue. With the monopolist will extract a part of the consumer surplus shown in shaded area of the

triangle.

IIIrd Degree of Discrimination: here the monopolist divides his customers into two or more classes on the basis of elasticity and the demand for the product and charges different prices to each class of buyers. In third degree discrimination the monopolist take the advantage of differentiation of

elasticity in demand. The seller segregate buyers according to income, geographic location, individual tastes, kinds of uses for the product, and charges different prices to each group or market despite equivalent costs in serving them. As long as the demand elasticity’s among different buyers are unequal, it will be profitable for the seller to group the buyers into separates classes according to elasticity, and charge each class a separate price.

Disadvantages of Monopoly (i) When a monopolist exercises the market power by restricting supplies, he will become richer and he will do so at the expense of those who consume his producer.(ii) Consumer choice is restricted because in monopoly there is only one producer.(iii) The absence of competition means that there will be no pressure on the monopolist firms to be as economical as feasible. Wasteful costs tend to be reflected in higher prices.(iv) The exercise of monopoly power causes resources to be misallocated from society’s point of view. As the monopolist restricts output, his output is too small. He employs too little of society’s resources. As a result, too much of these resources may go into the production of goods with low consumer preferences. Thus resources are misallocated.(v) A firm enjoying monopoly position in a strategic sector may provide too big a risk for the economy. For example, it has been pointed out that putting all the power engineering facilities in one company, i.e., BHEL, is full of risks, as an natural or man-made causes of slow-down or stoppage of production would give severe setback to the economy.

5. Monopolistic Competition

Meaning of Monopolistic competitionMonopolistic competition is mostly found in the present world. Monopolistic competition refers to a market situation in which there are many producers producing goods which are close substitutes of one another.

The distinguishing features of monopolistic competition which makes it as a blending of competition and monopoly is the differentiation of the product. This means that the products of

various firms are not homogeneous but differentiation though they are closely related to each other. As defined by Joe S.Bain ‘Monopolistic competition is found in the industry where there are a large

number of sellers, selling differentiated but close substitute products’. Monopolistic competition is said to be the combination of perfect competition as well as

monopoly because it has the features of both perfect competition and monopoly.

Characteristics of Monopolistic competition(1) Large number of sellers:- the number of sellers in monopolistic competition market structure is sufficiently large and each firms acts independently without caring others.(2) Product differentiation:- there is large number of buyers in monopolistic competition who are offered differentiated products and consequently have preference for the product of particular seller. To initiate preferences different seller resort different method of advertisement for their’ own product may be real or fancied. Moreover differentiation of product may be linked with the condition of the sale that means location of his soap the courteous and smiling disposition of its salesman. E.g there is various manufacturer of toothpaste which produces different brands such as Colgate, Binaca, Forhans, Pepsodent, Signals, Neem etc.(3) Unrestricted entry:- entry to the industry is unrestricted. New firms are able to commence production of very close substitute for the existing brands of the products.(4) Selling cost:- every firm tries to promote its own product through different types of expenditure on advertisement. The effect of this advertisement expenditure or the selling cost may be attached to the consumer. In this way the selling cost of the different product differ from each other.(5) Price policy of firm:- in Monopolistic competition the firm takes the decision of price policy where as in perfect competition a firm is only a price taker.

Problems of equilibrium of the firm

(1) Three type of adjustment:- the firm in Monopolistic competition basically make three types of adjustment namely price, product, selling effort. As regard to the price to maximize the profit the firm reviews its price policy as regard to product the producer has to produce the best quality of product at a cheaper cost. As regard to the quality of the product at a cheaper cost. As regard to the selling effort the producer has to win over the consumer with advertisement and other techniques.(2) Non-use of MR and MC approach:- there should be MR and MC approach, but for the first time an analysis of product variation and selling cost introduced in the economic literature by chamberlain. He tried to analyze the equilibrium without the help of MR and MC curve. Because in monopolistic competition the MR and MC curves differ from each other.(3) Primarily a short period analysis:- another important point is that in monopolistic competition we should go for short period analysis of the firm only. Because of the reason that the cost and revenue curve of the firms take diversity in the long run.(4) Difficulty in identifying the industry:- in monopolistic competition, firms produce different product which are not close substitute to each other. As such it is not possible to identify the industry. Hence it is difficult to draw a supply curve for the industry. To avoid this difficulty Professor chamberlain introduce the concept of group equilibrium to him “Monopolistic competition concerns itself not only with the problem of an individual equilibrium, but also with that of group equilibrium. In this it differs both from the theory of competition and from the theory of monopoly” Therefore the term industry losses its significance under monopolistic competition. Prof. Chamberlin has used the word group; by group he means a number of producers whose goods are fairly close substitutes. And each producer with in the group is a monopolist, yet his market is interwoven with those of his competitors, and he is no longer to be isolated from them.

The Nature of Demand and MR Curve under Monopolistic Competition Under monopolistic competition raises the price of its product, it will find some of its customers going away to buy other products as a result the quantity demand of a products fall and vice versa. It therefore falls that the demand curve facing an individual firm under monopolistic competition slopes downward.

If a firm working under monopolistic competition wants to increase the sales of its product, it must lower the price. In the above left diagram DD is the demand curve facing an individual firm under monopolistic competition. At price OP the quantity demanded is OM. If it wants to sell greater quantity ON, then it has to reduce its price to OL. If it restricts its quantity to OG, price will rise to OH. In the above right diagram AR curve of the firm under monopolistic competition and MR of the firm slopes downward. MR lies below the AR curve. At quantity OM, AR or Price is OP and MR is MQ which is less than OP.

MR = AR (1 – 1/e) where e stands for absolute value of price elasticity of demand.

Price-output Determination under Monopolistic CompetitionUnder monopolistic competition, different firms, produce different varieties of the product. Therefore, different prices for them will be determined in the market depending upon their respective demand and cost conditions. Each firm under monopolistic competitions seeks to achieve equilibrium or

profit-maximizing position as regards (1) price and output, (2) product adjustment and (3) adjustment of selling costs. In other words, the producer, under monopolistic competition, must make optimal adjustments not only in the price charged and as regards the quantity of output sold but also in the design of the product and the way in which he promotes the sales.

Short-run EquilibriumIn the short run, the firm will be in equilibrium when it is maximizing its profit, i.e., (i) Marginal Revenue = Marginal Cost, and(ii) Slope of marginal cost > Slope of marginal revenue.

In this, AR is average revenue curve, MR is marginal revenue curve, SAC is the short-run average cost curve, and SMC is the shortrun marginal cost curve. In these figures, marginal revenue curve (MR) and marginal cost curve (SMC) intersects each other at the output OM at which price is OP’.the firms is earning supernormal profits. Supernormal profit per unit of output is the difference between average revenue and average cost at the equilibrium point. In this case, in equilibrium, the average revenue is MP and average cost is MT’. Therefore, PT is the supernormal profit per unit of output. Total supernormal profit will be measured by the area of the rectangle PTT’P’, i.e., output multiplied by supernormal profit per unit of output. However, if the demand and cost situation are less favorable, then the monopolistically competitive firm will be realizing losses in the short run as illustrated infig-7 Here, the price is OP’ (=MP) which is less than the average cost MT. TP is the loss per unit of the output OM (=PP’). Hence, the total loss is represented by the shaded area TPP’T’. Thus, in the short run, the monopolistically competitive firm may either realize profits or suffer losses, or neither profit nor loss. Besides, the conditions for equilibrium under monopolistic competition are:-(i) MC = MR(ii) Slope of MC > Slope of MR

Long-run Equilibrium of Firm and Group Equilibrium.The firms under monopolistic competition can earn only normal profits in the long run. This is because we assume that entry is free and new firms will enter the industry, if the existing firms are making supernormal profits. As new firms enter and start production, supply will increase and the price will fall, i.e., average revenue curve faced by the firm will shift to the left, and therefore, the supernormal profits will be competed away and the firms will be earning only normal profits. In, the long run, firms which are realizing losses, will leave the industry so that the remaining firms will be earning normal profits. Another point which is to be noted in this context is that average revenue curve in the long run will be more elastic, due to large number of available substitutes. Hence, in the long run, equilibrium is established when firms are earning only normal profits. Therefore, the equilibrium in the long run under monopolistic competition is when MC equals with MR and MC intersects the MR from its below. But the firm under monopolistic competition in longrun only enjoys normal profit. So another distinguishing feature is AR = AC or Price = AC.Average Revenue = Average Cost.

In Fig. 8, average revenue curve (AR) is a tangent to the average cost curve (LAC) at P. Hence, the equilibrium output in the long run is OM and the corresponding price is MP. At this point, average cost and average revenue is MP. Therefore, there are only the normal profits which form part of the cost of production. Thus in the long run, the firm is in equilibrium when output is OM, and the price is MP.

6. Oligopoly

Market in which the number of seller is small but greater then one present new problem. A market with two sellers is a duopoly, and a market with a small number greater than two is an oligopoly.

In oligopoly we are dealing with a market structure where there few firms in the industry producing either homogeneous good or differentiated goods. Or it is market from where there exist two or more firms.

However it is not the number of firms which is important but the nature of interdependence in decision making. In an oligopoly industry the firms are ‘strategically interdependent’ in decision making. This implies that no firm can take any policy decision or action be it pricing, quality, advertising etc. without taking into account how the rival firms would respond or react and what kind of decisions or actions they in turn take to its own decisions and actions. It is interdependence in decision making which is the main characteristic of an oligopoly situation.

Why oligopolyHighest investment, Economies of scale, Legal restriction, Controll over certain raw material, Merger and takeover

Characteristics of Oligopoly Few firms:- Oligopoly is a market situation in which there are few firms selling homogeneous

or differentiated products. Imperfect oligopoly(differentiated product):- Automobiles, soaps, TVs, detergents……. Perfect oligopoly (homogeneous):- Aluminum, cement, copper, steel, zinc..

Interdependence :- there is a complete interdependence among the sellers with regard to their price output policies.

Advertisement :- Boumol says under oligopoly advertisement can become a life-and-death matter.

Competition :- each seller is always on the alert and keeps a close watch over the moves of its rivals in order to have a countermove.

Barriers to entry of firms :- as there is keen competition, there will be no barriers to entry or exit. However in the longrun there may be resistant on new firms because of economies of scale enjoyed by a few large firms, control over special and specialized inputs, high capital requirements, exclusive patents and license and existence of unused capacity which makes the industry unattractive.

Lack of uniformity:- firms differ considerably in size.

Oligopoly Models

In oligopoly the rival firm indulge in an action, reaction and counter action showing a variety of behavioural pattern. In oligopoly rivals may decide to get together and cooperate in the pursuit of their objectives, or at the other extreme may try to fight each other to the death. Even if they enter in an agreement it may last or it may breakdown.So in oligopoly it is very difficult to study the behavior of firm. So different economist view different models these models are;1. Cournot’s duopoly model, 2. Sweezy’s Kinked demand curve model, 3. Price leadership model, 4. Collusive model, 5. The game model.

1. Cournal’s Model of Duopoly: this model is called duopoly model because it is a limited case of oligopoly and propounded by Augustine Cournet a French economist. Assumption-> Two firm ->Zero marginal cost -> One will not react with other

According to this model as there is two firm each produce 1/3 of the product and rest 1/3 product remain unsupplied. As supply is 2/3rd and demand is 1, it means supply is less than demand. So price is above zero i.e. cost.

In the diagram, by assumption MC=0, if there is only one firm-A, firm A’s MR curve cuts MC curve at point Q. so output is OQ and price is OP2. suppose firm-B enters in the market. The market remains to firm-B in OM. But the firm will only produce QN as MRb cuts MC at point N. so the firm B’s price =OP and output = QN.When B’s price is less, A will reduce its price by reducing its output from OQ to less than OQ. This adjustment will continue till both produce equal number of output i.e. 1/3rd

each and rest 1/3 can’t be supplied. The formula for determining the share of each seller in an oligopolistic market is Q / (n + 1)

where Q is market size and n is the number of seller. Determinants of market sharePeriod Seller A Seller B I ½ ½(1/2)=1/4II ½(1-1/4)=3/8 ½(1-3/8)=5/16III ½(1-5/16)=11/32 ½(1-11/32)=21/64

IV ½(1-21/64)=43/128 ½(1-43/128)=85/256… …. …….… …. ……N ½(1-1/3)=1/3 ½(1-1/3)=1/3

In the above analysis, it is conclude that the firm A will reduce its quantity and firm B will increase its quantity till both will produce 1/3 of total output.

2. Price Leadership Model:-Price leadership may arise out of technical reason or out of process efficiency or due to explicit agreement for leaders etc. in price leadership model the leading role played by the dominant firm. The large firm will make the price and other will follow that

the price leadership may be barometric in this leadership any one of the firm lead to announce any change in price. The price leadership arises out of two reasons

A) Price leadership by low cost firm suppose all the firm faces identical revenue curve i.e. AR and MR, but they have different cost curve. Suppose large firm has the cost curve is AC1 and MC1 and all other small firm faces the cost curve is AC2 and MC2.It is because large firm enjoy economies of scale given the cost and revenue condition, the low cost firm will maximize its profit at OP2 price and OQ2 quantity. But the high cost firm will maximize their profit at OP3 price and OQ1 quantity. But if they charge higher price they will loose some customer. So large firm forced to accept price OP2. it the low cost firm charge OP1 price, it will

eliminate small firm and enjoy only normal profit. But due to fear of anti-monopoly laws the low cost firm charge OP2 price and other firm will follow that price.B) Price Leadership by dominant firm: Dominant firm are those firm which enjoys large market share. The dominant firm can cut its price to eliminate its entire rival firm. The firm may enjoy monopoly power. But legal problem may arise. To avoid this problem the dominant firm will compromise with small firm. The small firm just like complete market accepts the price set by the dominant firm.

in the figure let market demand is DDm and Ss is the supply curve of small firm. As per the diagram if the firm set the price at OP3 the total quantity P3E can be supplied by small firm, as at higher price small firm can supply more. But large firm enjoy profit maximization at OQd of output and OP’ price. So at OP’ price the large firm will produce AB portion of the market and P’A portion is produced by small firm. Even if the dominant price reduces its price to OP2 it eliminate some small firm so the

quantity supply by large firm increases from P’A to P2C. if the firm reduce its price to OP1 it become monopoly firm and capture 100% market share. But for profit maximization the large firm set OP’ price. So the small firm will produce P’A and large firm will produce AB

C) Barometric Price Leadership:- Under this type of price leadership, an old, experienced and the largest firm assumes the role of a leader. Besides, it protect the interests of all firms instead of merely promoting its own interest. In a way it acts as the custodian of firms operating in the industry. It fixes a price which is found to be suitable for all the firms in the industry. This price is fixed by taking into consideration the market conditions with regard to the demand for the product, cost of production, competition from the rival producers, etc.

D) Exploitative or Aggressive Price Leadership:- Under this category, one big firm comes to establish its supremacy in the market by following aggressive price policies. This firm compels other firms to follow it and accept the price fixed by it. In case the other firms show any independence, this firm threatens them and coerces them to follow its leadership with the result that the prices set by this firm comes to be accepted.

3. Collusion Model (Cartel):- cartel is an association of business firm formed by an explicit agreement between them under this the firm jointly decide -> Price and output -> Production quota-> Supervision of market activities.The main objective of cartel group are

To reduce competition and resulting monopoly profit. Eliminating uncertainty surrounding in the market.

Cartle function under a board, it decide the market share of its member through MC and MR of industry. Once the industry output is determined that output is allocated among its member on the basis of their own MCLet there are two firms A and B. so in the diagram OQ and PQ is industries output and price respectively. The share of each firm is determined on the output where individual MC equates industry MC. The industry’s MC is CQ. So if we down the product line from C with X axis, the point

where it touches MC2 and MC1 i.e. output produced by firm B and A. so the share of firm A = OQ1 and firm B = OQ2. total output OQ1+OQ2. Profit = (Price - AC)x Firms output. As each firm enjoy maximum profit, there is no motivation for the firm to charge the price.

4. Sweezy’s Model (Kinked Demand Curve):- It is impossible to find a single generalized solution to the problem of oligopoly pricing. This is because of the difficulty of knowing the exact position of the demand curve facing a firm under oligopoly. This is turn is due to the fact that the effect of a given price changes by a seller on the demand for his product depends very much on the reactions of his rivals and, as we explained earlier, rival consciousness is a basic characteristic of oligopolistic situations.

The kinked demand curve is drawn on the assumption that the kink in the curve is always at the ruling price. Taking the ruling price as given, it assumes that a rise in price beyond the ruling price on the part of a given firm under oligopoly will invite retaliation from the rivals. Otherwise, they

will allow him to raise his price and lose customers to his rivals. The rival firm react with change in price in three following ways

Rival firm follow the price changes, both cut and hike It don’t follow the price change It follow the price change but not price hike

in the figure dd’ is the market demand curve for a product and that the initial price is fixed at PQ. When the firm increases its price, he expects that he will move on dP segment, but he will shift to DP segment of demand curve as other firm will not follow him. Suppose an oligopoly firm reduces its price then the rival firm will also cut their price otherwise they would lose their customer. Thus the revelant segment of ht edemand cuuve for price cut is PD’. Thus the two parts of the demand curve put together give the relevant demand curve for the firm as DPd’ which is Kink at point P.

Hence, the upper part of the curve is more elastic than the lower part of the curve lying below the kink. This is because a reduction of price below the ruling price will invite immediate

retaliation from the rivals who wish to protect their own sales. The result will be that it cannot push up its sales due to the fact that the rival firms also follow suit with a price cut. So, the lower part of the demand curve is less elastic than the upper one.5. The Game Theory: it is a mathematical technique to show how a oligopoly firm play their game of business. Game theory is concerned with how individuals make decisions when they are aware that their actions affect each other and when each individuals take into account. They are many different types of games each characterized by a unique set of assumptions concerning such conditions as the number of players, the state involved, whether there must be a winner or loser and whether the decision taken are simultaneous or sequential. But regardless of conditions the essential idea of game theory is to apply the logic of mathematics to arrive at a solution or in economic term equilibrium.

7. Product Pricing:-Cost Based Pricing {Study Material}

8. Pricing Based on Firm’s Objectives {Study Material}

9. Competition Based Pricing {Study Material}

10. Product Life-cycle Based Pricing {Study Material}

11. Cyclical Pricing {Study Material}

12. Multi-product Pricing {Study Material}

13. Peak-load Pricing {Study Material}

14. Retail Pricing {Study Material}

MGT – 102 Managerial Economics(Module – IV) Macro Economic Aspects of Managerial Decisions

Debasis PaniFaculty, GIACR

1. Basic Macroeconomic Concepts

Nature of Macro EconomicsMacroeconomics is the study of aggregates or averages covering the entire economy, such as

total employment, national income, national output, total investment, total consumption, total savings, aggregate supply, aggregate demand and general price level, wage level and cost structures.

Professor Ackley “Macroeconomics deals with economic affairs in the large” Macro economics is also known as the theory of income and employment or simply income analysis. It is concerned with the problems of unemployment, economic fluctuations, inflation and deflation, international trade or economic growth. It is the study of the cause of unemployment and the various determinants of employment.

Micro Economics Vs Macro EconomicsFor understanding we can say Macro economics studies the character of the forest separately

of the trees which compose it. It means in the forest is compose of trees. Studying about the individual trees is known as micro economies and studying about the forest is known as macro economics. What is not important for micro economics is important for macro economics e.g. giving an additional tax of 1 paisa will not matters in micro sense but in macro sense it is a big difference.

Micro economics is the study of the economic actions of individuals and small groups on individuals e.g. study of particular firms, particular households, individual prices, wages, incomes, individual industries, particular commodities’. But Macro economics deals with aggregates of these quantities not with individual income but with national income, not with individual price but with price levels, not with individual output but with national output.

Both Micro economics and Macro economics involve the study of aggregates. But aggregates in micro economics are different from that in macroeconomics. Thus micro economics uses aggregates relating to individual households, firms and industries, while macroeconomics uses aggregates which relate them to the economy-wide-total.

Scope and Importance of Macroeconomics1. To Understand the Working of the Economy:- the study of macro economic variable is

important for understanding the working of economy. Those variables are income, output, employment, and general price level of the economy.

2. In Economic Policies:- macro economics is extremely useful for the point of view of formulating economic policy relating to various macro problem like overpopulation, inflation, general price, general volume of trade, general outputs etc.

3. In General Unemployment:-unemployment is thus caused by deficiency of effective demand. In order to eliminate it, effective demand should be raised by increasing to total investment, total output, total income and total consumption. Thus macro economics has special significance in studying the causes, effect and remedies of general unemployment.

4. In National Income:- the study of macro economics is very important for evaluating the overall performance of the economy in terms of national income.

5. In Economic Growth:- plan for the overall increases in national income, output, employment are framed and implemented so as to raise the level of economic development of the economy as a whole.

6. In Monetary Problems:- frequent changes in the value of money inflation or deflation affect the economy adversity. They can be neutralize by adopting monetary, fiscal and direct control measures for the economy as a whole.

7. Business Cycles:- it is important to analyze the causes of economic fluctuations and macro economics helps in providing remedies.

8. For Understanding the Behaviour of Individual Units:- understanding the behaviour of individual units is the study of macro economics and demand for individual products depends upon aggregate demand in the economy.

Limitations of Macroeconomics1. Fallacy of composition2. To regard the aggregates as homogeneous3. Aggregate variables may not be important necessarily4. Indiscriminate use of macro economics misleading5. Statistics and conceptual difference

2. Open and Closed Economies,

{Close Economy} Closed economy is an economy, which does not have any sort of economic relation with rest of the world but is confined to itself only. A closed economy does not enter into any one of the following activities.

It neither exports goods and services to the foreign countries nor imports goods and services from the foreign countries.

It neither buys shares, debentures, bonds etc. from foreign countries nor sells shares, debentures, bonds etc. to foreign countries.

It neither borrows from the foreign countries nor lends to the foreign countries. It neither receives gifts from foreigners nor sends gifts to foreigners. Normal residents of a closed economy cannot go to other countries to work in their domestic

territory. No foreigner is allowed to work in the domestic territory of a closed economy.Due to all these seasons, Gross Domestic Product and Gross National Product are the same in a closed economy.{Open Economy} On the other hand, an open economy is one, which is not only involved in the process of production within its domestic territory but also can participate in production anywhere in the rest of the world. An open economy involves itself in the following activities.

It buys shares, debentures, bonds etc. from foreign countries and sells shares, debentures, bonds etc. to foreign countries.

It borrows from foreign countries and lends to foreign countries. It can send gifts and remittances to foreigners and can receive the same from them. Normal residents of an open economy can move or be employed and are allowed to work in

the domestic territory of other economies.Due to these reasons, Gross Domestic Product and Gross National Product are not same in an open economy. It is to be noted that at present all economies of the world are open economies.

Three Sector Economy (Close Economy) :- This model is based on the following assumptions. All production takes place in the firms and all factors of production are owned by the households i.e. Land Labour and capital. Finally, all income is spent. The diagram shows the real and money income flow in a two-sector model. The firms produce goods, for which the services of factors of production are required. The factors of production (Factor market) are supplied by households, for which they receive income. With the income earned, they purchase the finished products (Product Market) from the firms. This provides income to the firms, which is used for purchasing factors of production from the households. Thus, the sales value of net production must be equal to the sum total of payments made by the firms to the factors of production (i.e., wages, rents, interest and profits). These incomes in turn become the sources of expenditure of the households.

The Circular Flow with Saving and Investment Added In an economy the ‘inflows’ and ‘linkages’ occur in the expenditure and income flows. Such linkages are saving and inflows or injection are investment which equal to each other. Expenditure has now two alternative paths from household and product market i) directly via consumption expenditure ii) indirectly via investment expenditure

There is a capital or credit market in between saving and investment flows from household to business firms. The capital market refers to a number of financial institutions such as commercial

banks, saving banks, loan institutions, the stock and bond markets etc. the capital market coordinates the saving and investment activities of the households and the business firms. The households supply saving to the capital market and the firms in turn obtain investment funds from the capital market.

here we add Government sector so as to make it three sector closed model of circular flow of income and expenditure. For this we added taxation and government purchases. Taxation is a leakage from the circular flow and government purchases are injection to the circular flow. First take the circular flow between the household sector and the Govt. sector. Taxes in the form of personal income tax and commodity taxes paid by the household sector are outflow or leakages from the circular flow. But the Govt. purchases the service of the households, makes transfer payments in the form of old age pensions, unemployment relief, sickness benefit etc and also spends on them to provide certain social services like education, health, housing, water, parks, and other facilities. All such expenditures by the government are injection to the circular flow.

Next circular flow between the business sector and the Govt sector. All types of taxes paid by the business sector to the Govt are leakages from the circular flow. On the other hand the govt purchases all its requirements of goods of all types from the business sector, gives subsidies and make transfer payments to firms in order to encourage their production. These govt expenditures are injection into the circular flow.

Four Sector Economy (Open Economy) :- it is an open economy where the foreign sector is added. In real world most of the economies are open economy where foreign trade plays an important role. Exports are an injection or inflow to the economy. They create income for the domestic firms. When foreigner buys goods and services produced by the domestic firms. They are exports in the circular flow of income. On the other hand imports are leakages from the circular flow. They are expenditures incurred by the household sector to purchase goods from foreign countries.

Take the inflow and outflow of ht household, business and govt sector. The household sector buys goods imported from abroad and makes payment for them which is a leakage from the circular flow. The household may receive transit payment from the foreign sector for the services.

On the other hand, the business sector exports goods to foreign countries and its receipts are an injection in the circular flow. Similarly there are many services rendered by business firms to foreign countries such as shipping, insurance, banking etc. for which they receive payments from abroad. They also receive royalties, interests, dividends, profits etc. for investments made in foreign countries. On the other hand the business sector makes payments to the foreign sector for imports of capital goods machinery, raw materials to the foreign sector for imports of capital goods, machinery, raw materials, consumer goods, and services form abroad. These are leakages from the circular flow.

Like the business sector, modern governments also exports and imports goods and services and lend to and borrow from foreign countries. For exports of goods the government received payments from abroad. The Govt. receives payments from foreigners for various services that are injection into the circular flow. On the other hand the leakages are payments made for the purchase of goods and services to foreigners. The outflow and inflow pass through the foreign sector which is also called the ‘Balance of Payments Sectors’.

3. Primary, Secondary and Tertiary sectors and their contributions to the Economy.

Primary Sector and its Contribution to the Indian Economy When the economic activity depends mainly on exploitation of natural resources then that

activity comes under the primary sector. Agriculture and agriculture related activities are the primary sectors of economy.

The primary sector of the economy is the sector of an economy making direct use of natural resources. This includes agriculture, forestry, fishing, mining, and extraction of oil and gas

The share of primary sector has decreased from the past four decades. In 1970 the share of the sector was 50% which has reduced to 29% in 1995 and is now further reduced to 25%.

The economic survey 2010-11 says that the agricultural sector GDP has increased by only 3.46 percent during 2004-05 to 2010-11 and it accounts for 58 % of employment in the country. About 43% of the country’s total geographical area is used for agricultural purpose.

Agriculture in India is the responsibility of the states rather than the central government. The central government formulates policy and provides financial assistance to the states. States like Punjab, Haryana, Uttar Pradesh, Andhra Pradesh, Tamil Nadu, Karnataka and West Bengal are major producers of food grains in India.

Secondary Sector and its Contribution to the Indian Economy When the main activity involves manufacturing then it is the secondary sector. All

industrial production where physical goods are produced come under the secondary sector.

The secondary sector of the economy or industrial sector includes those economic sectors that create a finished, tangible product: production and construction.

India’s industrial sector accounts for 27.6% of the GDP and gives employment of 17% of the total workforce.

Today India holds some key industries in the sectors like steel, engineering and machine tools, electronics, petrochemicals, textiles and software. Importance has also been give to improve the infrastructure of the country.

The government has liberalized its industrial policy thereby attracting huge foreign direct investment. If on one hand several multinational companies opened their offices in India, on the other hand many Indian companies started their operations in foreign countries.

Tertiary Sector and its Contribution to the Indian Economy When the activity involves providing intangible goods like services then this is part of the

tertiary sector. Financial services, management consultancy, telephony and IT are good examples of service sector.

The services sector is a vital cog in the wheel of the Indian economy. The sector, accounting for 60 per cent of the gross domestic product (GDP), grew 5 per cent in the year 2012-13

The Indian service industry has emerged as one of the largest and fastest-growing sectors on the global landscape and hence has made substantial contribution towards global output and employment.

Growing at faster pace as compared to agriculture and manufacturing sectors, Indian service segment comprises of wide range of activities, such as trading, transportation and communication, financial, real estate and business services, as well as community, social and personal services

4. SWOT Analysis for the Indian economy;

The economy of India is the tenth-largest in the world by nominal GDP and the third-largest by purchasing power parity (PPP). The country is one of the G-20 major economies and a member of BRICS. On a per-capita-income basis, India ranked 141st by nominal GDP and 130th by GDP (PPP) in 2012, according to the IMF.  India is the 19th-largest exporter and the 10th-largest importer in the world. The economy slowed to around 5.0% for the 2012–13 fiscal year compared with 6.2% in the previous fiscal.  On 28 August 2013 the Indian rupee hit an all time low of 68.80 against the US dollar. In order to control the fall in rupee, the government introduced capital controls

on outward investment by both corporates and individuals. India's GDP grew by 9.3% in 2010–11; thus, the growth rate has nearly halved in just three years. GDP growth rose marginally to 4.8% during the quarter through March 2013, from about 4.7% in the previous quarter. The government has forecast a growth rate of 6.1%-6.7% for the year 2013–14, whilst the RBI expects the same to be at 5.7%. Besides this, India suffered a very high fiscal deficit of US$ 88 billion (4.8% of GDP) in the year 2012–13. The Indian Government aims to cut the fiscal deficit to US$ 70 billion or 3.7% of GDP by 2013–14.

Introduction to Indian Economy• India is the 10th largest economy in world in terms of GDP 3rd largest by PPP.• Population: 1.22 billion• Yearly increase: 18 million• Major group: 50% - 0 – 25 years• More than 1.53 billion people by the end of 2030. • Average life expectancy: 68.6 years• Economic growth rate slowed to around 5.3% for the 2012–13 fiscal year.

Strength of Indian Economy Agriculture High percentage of cultivable land 56.78% Huge English speaking population Availability of skilled manpower Extensive Higher Education (4.4 million PG & UG Joined annually) Diversified nature of the economy System Third largest reservoir of engineers High growth rate of economy Rapid growth of IT and BPO sector brining valuable foreign exchange Abundance of natural resources

Weakness of Indian Economy Very High percentage of workforce involved in agriculture which involves only 17.2% of GDP Rural poverty leads horrible wave of suicides by indebted farmers In rural India, about 34 percent of the population lives on less than $1.25 a day Coal Mines Corruption – Illegal allotment and Kick Backs Time zone difference with the US Inequality in prevailing socio economic conditions Poor infrastructural facilities Huge population leading to scarcity of resources Low literacy rate Unequal distribution of wealth Rural urban divide, leading to inequality of high standards

Opportunity of Indian Economy• Scope for entry of private firms in various sectors for business• Inflow of Foreign Direct Investment• Huge foreign exchange earnings• Area of biotechnology• Area of Infrastructure• Huge Domestic Market• Huge natural gas deposits found in India, • Huge agricultural resources, fishing, plantation crops, livestock• Investment in R & D, engineering design• Huge population of India in foreign countries .• Vast forest area and diverse wildlife

Threat of Indian Economy

Global economy recession/slowdown  High fiscal deficit  Volatility in crude oil prices across the world  Growing Import bill -$461.4 billion Population explosion, rate of growth of population still high  Inflation: 6.87 per cent in July of 2012 Agriculture excessively dependent on monsoons .• Rising operating costs in tier-I cities (salary increase and rise in rentals)• Competition from new offshoring locations such as China and the Philippines

5. Components of GDP, Measuring GDP and GDP growth rate {Study Material}

6. National income, Problems in Measuring National income {Study Material}

7. Inflation:-Types, Measurement, Kinds of Price indices

What is Inflation? Inflation is defined as a sustained increase in the price level or a sustained fall in the value of

money. While inflation means a rise in the general price level, the rate of inflation is the rate of

change of the general price level.

Kind of Prices of Indices(A) GNP Deflator: An economic metric that accounts for the effects of inflation in the current year's gross national product by converting its output to a level relative to a base period. The GNP deflator

is calculated with the following formula: Since the GNP deflator is based on a calculation involving all the goods produced in the economy, it is a widely based price index that is frequently used to

measure inflation. Thus the calculation of real GNP gives us a useful measure of inflation – the GNPdeflator.(B) Consumer Price Index: consumer price index,  measure of living costs based on changes in retail prices. Such indexes are generally based on a survey of a sample of the population in question to determine which goods and services compose the typical “market basket.” These goods and services are then priced periodically, and their prices are combined in proportion to the relative importance of the goods. This set of prices is compared with the initial set of prices (collected in the base year) to determine the percentage increase or decrease.

Consumer price indexes are widely used to measure changes in the cost of maintaining a given standard of living. The consumption basket data come from family budget surveys which are carried out from time to time. These surveys yield estimates of commodity composition of consumption expenditures of a typical family in a specified population group. Price data are obtainedfrom retail outlets by a large staff of field investigators. The base year is changed every few years so that account can be taken of changes in tastes, appearance of new items in the consumption baskets, etc. Without such updating the index would lose its usefulness as an approximate measure of cost of living.

CPIs for various population groups are calculated and published by the Bureau of Labour. They are reproduced in a variety of government and non-government publications

(C) Wholesale Price Index:- The principles of construction of WPI are quite analogous to those behind CPI. The differences between the two are:

The items included in WPI are quite different. They include items like fertilizers, minerals, industrial raw materials and semi-finished goods, machinery and equipment, etc., apart from items in the food group and in the fuel, light and power group. The WPI can be interpreted as an index of prices paid by producers for their inputs.

Wholesale prices rather than retail prices are used. Thus for minerals ex-mine prices, for manufactured products ex-factory prices, for agricultural commodities the first wholesaler's prices, etc., are used.

Weights are based on value of transaction in the various items in the base year. For manufactured products it is the value of production, for agricultural products the value of

marketable surplus, etc. The main groups of items are:

Primary articles which include food (rice, wheat, etc.), non-food (raw cotton, jute, etc.), minerals (iron ore, manganese ore, etc). In all 80 primary articles are covered.

Manufactured articles include 270 items. Fuel, power, light and lubricants include 10 items.

Wholesale price indices for individual commodities, commodity groups and the overall WPI are published monthly by the Office of the Economic Adviser to the Government of India. They are reported in a number of other publications.

8. Business cycle:-Features and Phases, Effects and Control.