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Amity University

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1

Preface
This is an attempt to the integration of economic theory with business practices for the purpose of facilitating Decision Making and Forward Planning by the management. As economics provides as a set of concepts, these concepts furnish us the tools and techniques of analysis. It is in this context economic analysis is an aid to understand business practices in a given environment. As decision making is a basic function of manager, economics is a valuable guide to the manager. In the following we shall be discussing the decision making process of the management and how managerial economics and its various tools and techniques help a manager in this process.

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Index
S.I. Nos. no.
1 2 3 4 5 6

Chapter Title

Page

Managerial Decision Making Business Forecasting Demand Analysis Cost Analysis Production Analysis Objectives of the Firm Pricing Policy of the Firm Market Structure

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1 Brainstorming 1.2 Decision Making Process 1.7 The Steps of Decision Making 1.4 Corporate Decision Making: Ford Introduces the Taurus 1.14 Decision Making Tools 1.3 Management Decision Problems 1.6 Conditions Affecting Decision Making 1.2 The Administrative Model 1.12 Decision Making Techniques 1.3 Delphi Group Technique 1.8 Selecting the Best Alternative 1.13.14.13 Group Decision Techniques 1.14.13.2Inventory Control 4 .1 The Classical Model 1.11.12.1 Linear Programming 1.11.11 Decision Making Model 1.1 Marginal Analysis 1.13.2 Financial Analysis 1.10 Evaluating the Decision 1.5 Types of Decision 1.12.2 Nominal Group Technique 1.Chapter-I Managerial Decision Making Contents: 1.9 Implementing the Decision 1.1 Introduction 1.

Decision is a choice made from alternative courses of action in order to deal with a problem.1 Introduction Managerial Economics is the integration of economic theory with business practices for the purpose of facilitating Decision Making and Forward Planning by the management. A problem is the difference between a desired situation and the actual situation.3 Management Decision Problems • • • • • • Product Price and Output Production Technique Stock Levels Advertising Media and intensity Labor hiring and firing Investment and Financing A practical example can be found in the following: 5 . In the following we shall be discussing the decision making process of the management and how managerial economics and its various tools and techniques help a manager in this process. A decision is optimal if it brings the firm closest to its goals. and choosing one of the particular courses of action. Ascertain solution that may be used in solving the problem Analyze these alternative solutions. Collect and analyze data relevant to the issue. The use of Economic Analysis is to make business decisions involving the best use (allocation) of scarce resources. A second and more detailed method is the following: Identify the problem. As economics provides as a set of concepts. Diagnose the situation.2 Decision Making Process Decision making is commonly defined a choosing from among alternatives. As decision making is a basic function of manager. these concepts furnish us the tools and techniques of analysis. The Decision making process is construed as searching the environment for conditions calling for a decision. economics is a valuable guide to the manager. 1. Economic Theory helps managers to collect the relevant information and process it in order to arrive at the optimal decision given the goals of a firm. decision making is the process of choosing among alternative courses of action to solve a problem. It is in this context economic analysis is an aid to understand business practices in a given environment. Therefore. inventing. developing and analyzing the available courses of action. 1. Select the approach that appears most likely to solve the problem Implement it.1.

The design and efficient production of this car involved not only some impressive engineering advances. then assemble finished cars. The car was a huge success at the time and helped Ford almost to double its profits by 1987. 1. if the government imposed a new tax on gasoline? How should Ford take these uncertainties into account when making its investment decisions? Ford also had to worry about organizational problems. but a lot of economics as well. What would happen if world oil prices doubled or tripled. should Ford charge a low price for the basic stripped-down version of the car but high prices for individual options. How high would production costs be. how were its competitors likely to react? Would GM and Chrystler try to under cut Ford by lowering prices? Might Ford be able to deter GM and Chrysler from lowering prices by threatening to respond with its own price cuts? The Taurus program required a large investment in new capital equipment and Ford had to consider the risks involved and the possible outcomes. How should the managers of the different divisions be rewarded? What price should the assembly division be charged for engines it receives from another division? Should all the parts be obtained from the upstream divisions. such as air conditioning and power steering? Or would it be more comfortable to make these options "Standard" items and charge a high price for the whole package? Whatever prices ford choose. What technique shall be adopted.4 Corporate Decision Making : Ford Introduces the Taurus In late 1985 Ford Introduced the Taurus -a newly designed. Ford had to be concerned with cost of the Car.5 Types of Decision Managers make many decisions.1. For example. Ford is an integrated firm -separate divisions produce engines and parts. aerodynamically styled. Some of this risk was due to uncertainty over the future price of gasoline (Higher gasoline prices would shift demand to smaller cars). had to think carefully about how the public would react to the Taurus design. frontwheel drive automobile. Ford. in order to answer the following questions: What goods shall firm produce? How should firm raise the necessary capital and what shall be its legal form. and what shall be the scale of operations? Where production is located? 6 . how many cars should Ford plan to produce each year? Ford also had to design a pricing strategy for the car and consider how its competitors would react to this strategy. or other firms? All these decision come under managerial decision taking process. how would this depend on the number of cars for produced each year? How would union wage negotiations or the prices of steel and other raw materials effect costs? How much and how fast would costs decline as managers and workers gained experience with the production process? To maximize profits. or. Would consumers be swayed by the styling and performance of the car? How strong would demand depend on the price Ford changed? Understanding consumer preferences and trade-offs and predicting demand and its responsiveness to price were essential parts of the Taurus program.

They involve long-range commitments. each based on different types of decisions. and in order to obtain a clear understanding of the decision making process. Personal decisions are related to the managers as an individual. not as a member of the organizations. important. and unstructured in nature. requiring the support of many people throughout the organizational if they are to be properly implemented.How shall its product be distributed? How shall resources be combined? What shall be the size of output? How shall it deal with its employees? Managers make these decisions. with procedures playing a key role. the setting of objectives and the approval of plans constitute only a few of these. Deciding to retire. Selection of a product line. Organizational decisions are those executives make in their official role as managers. For this reason. being highly novel. Basic and routine decisions Programmed and non-programmed decisions. Organizational and personal decisions. Since some individuals in the organization spend most of their time making routine decisions. and such a degree of importance that a serious mistake might well jeopardize the well being of the company. Programmed decisions correspond roughly to the routine decisions. These two types can be viewed on a continuum. Non programmed decisions are similar to the category of basic decisions. 7 . Such decisions are not delegated to others because their implementation does not require the support of organizational personnel. decision could be classified as computer technology programmed and non-programmed. Such decisions are often delegated to others. Basic decisions can be viewed a much more important than routine ones. The adoption of strategies. having only a minor impact on the firm. taking a job offer from a competitive firm. Taking a cue from computer technology. a classification system is useful. or slipping out and spending the afternoon on the golf course are all personal decisions. Routine decisions are often repetitive in nature. the choice of a new plant site. Three such systems are available. A second approach is to classify decisions into basic and routine categories. most organizations have formulated a host of procedures to guide the manager in handing these matters. The value of viewing decision making in this manner is that it permits a clearer understanding of the methods that accompany each type. or a decision to integrate vertically by purchasing sources of raw materials to complement the current production facilities are all basic decisions. large expenditures of funds. programmed being at one end and non-programmed at the other. these guidelines are very useful to them.

the decision-maker may have so little information that he or she may be unable even to define the problem. In actually. Most business situations however are characterized by incomplete or ambiguous information. managers would have al of the information they need to make decisions with certainty. and their respective outcomes. There are three conditions that affect decision making: Certainty Risk Uncertainty Certainty is the condition that exists when decision makes are fully informed about a problem its alternative solutions. let alone identify alternative solutions and possible outcomes. and their respective outcomes. the decision-maker does not have enough information to determine the probabilities associated with each alternative. Uncertainty is the condition that exists when little or no factual information is available about a problem. and. and Evaluating the decision The first step in the decision-making process is identifying the problem. Under a state of risk. The second step in decision-making process is generating alternative solutions to the problem. the manager has enough information to determine the probabilities associated with each alternative. which affects the level of certainty with which a manager makes a decision.that exists when decision-makers must rely on incomplete. 1.6 Conditions Affecting Decision Making In an ideal business situation. events and their outcomes. the decision-maker does not know with certainty the future outcomes associated with alternative courses of action. for it is what determines the direction that the decision making process takes. risk is the condition . yet reliable information. individuals can anticipate. In the context of decision making. The alternative that has the highest probability of success. In a state of uncertainty. Problem identification is probably the most critical art of the decision making process. the decision that is made. ultimately. and even exercise some control over. He or she can then choose. This step involves identifying items or activities that could reduce or eliminate the difference 8 .7 The Steps of Decision Making Identifying the problem Generating the alternative course of action Evaluating the alternative Selecting the best alternative Implementing the decision. However.1. Under this condition. the results are subjects to chance. its alternative solution.

the arduous task of evaluating each of them begins. including determining the pros and cons of each. managers gather information to determine the effectiveness of their decision. if using weighting. is the company closer to the situation it desired than it was at the beginning of the decision-making process? 1. rational individuals who make decision that are in the best interest of the organization.11 Decision Making Model There are basically two major models of decision-making -the classical model and the administrative model. the sixth and final step in the decision-making process. the decision makers must allot enough time to generate creative alternatives as well as ensure that all individuals involved in the process exercise patience and tolerance of others and their ideas. After generating a list of alternatives. and then multiplying cumulatively to provide a final value for each alternative.9 Implementing the Decision This is the step in the decision making process that transforms the selected alternative from an abstract situation into reality. Also called the rational model.1 The Classical Model The classical model of decision making is a prescriptive approach that outlines how managers should make decisions. the classical model is based on economic assumptions and asserts that managers are logical. 1. and weighting factors important in the decision. the one with the greatest benefits and the lowest costs.11. Implementing the decision involves planning and executing the actions that must take place so that the selected alternative can actually solve the problem. it is time for the fourth step in the decision-making process. The classical model is characterized by the following assumptions: 9 .10 Evaluating the Decision In evaluating the decision. In the Pursuit of ‚quick fix‛ managers too often shortchange this step by failing to consider more than one or two alternatives. which reduces the opportunity to identify effective solutions. For this step to be effective. 1. Has original problem identified in the first step been resolved? If not. The best alternative could be the one with the most "pros" and the fewest "cons".between the actual situation and the desired situation. performing a cost-benefit analysis for each alternative. choosing the best alternative. or the one with the highest cumulative value.8 Selecting the Best Alternative After the decision-makers have evaluated all the alternatives. 1. Numerous methods exist for evaluating the alternatives. the selection process can be fairly straightforward. 1. ranking each alternative relative to its ability to meet each factor. Depending on the evaluation method used.

2 The Administrative Model The Administrative model of decision making is a descriptive approach that outlines how managers actually do make decisions. yet satisfying.satisficing. and the decision-maker has limited knowledge of possible alternatives and their outcomes. while other factors are being held constant. 1. resource. and logic. and their own inability-due to time. or boundaries. 1.bounded rationality and satisfying.one that will resolve the problem situation by offering a good solution to the problem. Labor’s marginal product is the extra output you get when you add one unit of Labor holding all other inputs constant. two of which are marginal analysis and financial analysis.The manager has completed information about the decision situation and operations under a condition of certainty. process. These limits exist because people are bound by their own values and skills.12 Decision Making Techniques It is useful to examine some of the specific technique that has proved valuable in the decision making process. The problem is clearly defined. Also called the organizational. Simon recognized that people do not always make decisions with logic and rationality. The decision-maker satisfies by choosing the first satisfactory alternative. rationality. 10 . and rational decisions. this leads managers often forgo the six steps of decision making in favor of a quicker. Through the use of quantitative techniques.12. the decision-maker evaluates the alternatives and selects the optimum alternative -the one that will maximize the decision situation by offering the best solution to the problem. to their rationality. The Administrative model of decision making also have some basic assumptions: The manager has incomplete information about the decision situation and operates under a condition of risk or uncertainty. Because managers often lack the time of ability to process complete information about complex decisions. and he introduced two concepts that have become hallmarks of the administrative model. The problem is not clearly defined. incomplete information.11. and the decision-maker has knowledge of all possible alternatives and their outcomes. 1. or behavioral model.1 Marginal Analysis The "marginal product" of a productive factor is the extra product or output added by one extra unit of that factor. neoclassical. Bounded rationality means that people have limits. the administrative model is based on the work of economist Herbert A. they usually wind up having to make decisions with only partial knowledge about alternative solutions and their outcomes.

Delphi group participants never meet fact to face.13.Similarly. The manager can use the concept to answer questions such as how much more output will result if one more worker is hired? The answer often called marginal physical product. For this a firm needs to analyze the assets as well as liabilities.2 Nominal Group Technique The Nominal Group Technique involves.making tools are as under: 11 . land's marginal -product is the change in total product resulting from one additional unit of land with all other inputs held constant. 1.1 Brainstorming Brainstorming is a technique in which group members spontaneously suggest keys to solve a problem. 1. in fact. 1.2 Financial Analysis The firms are supposed to safeguard their interest and avert the possibilities of risk or try to minimize it.14 Decision Making Tools The major decision.13. provides a basis for determining whether or not one new man will bring about profitable additional output. choice of project and various vital ratios. efficiency of capital investment. 1. Its primary purpose is to generate a multitude of creative alternatives. The cost benefit analysis ensures the firms to take prudent financial decision.12. 1. they are required to operate independently. the use of highly structured meeting agenda and restricts discussion or interpersonal communication during the decision making process.13 Group Decision Techniques There are several group decision techniques: 1. While the group members are all physically present.3 Delphi Group Technique The Delphi group Technique employs a written survey to gather expert opinions from a number of people without holding a group meeting.13. Unlike in brainstorming and nominal groups. regardless of the likelihood of their being implemented. they may be located in different cities and never see each other.

Second. On the one hand. the manager has to decide if he or she wishes to use what can be labeled a trial-and -error approach. Linear programming can be used in the solution of many kinds of allocation decision problems. the lead time necessary for recording goods is also known with certainty. such as least cost. but its application is certainly limited. All linear programming problems must have two basic characteristics. Nevertheless.14. to be employed effectively the decision problem must be formulated in quantitative terms. It has been described as a technique for specifying how to use limited resources or capacities of a business to obtain a particular objective.2Inventory Control A problem faced by managers is that of maintaining adequate inventories. First. when those resources have alternative uses. There are two types of costs that merit the manager's consideration. and the inventory will be depleted at a constant rate. One way for the manager to solve the inventory problem is to make certain assumptions regarding future demand and then attempt a solution. For example. the approach has many advantages and its application in the area of business decision making is increasing. Three of the most common assumptions made in determining optimal inventory size are: demand is known with certainty. all relationships in the problem must be linear. or least time. highest margin. two or more activities must be competing for limited resources. no one wants to have too many units available because there are costs associated with carrying these customers’s future business. 1.1. Now.14.1 Linear Programming: One of the most widely used techniques is that of linear programming. or if he wants to employ an OR (Operations Research) tool known as the economic order quantity formula which can be given by: OQ = {2DA}½ ⁄ vr 12 . It is a technique that systematizes for certain conditions the process of selecting the most des able course of action from a number of available courses of action. thereby giving management information for making a more effective decision about the resources under its control.

Another important tool in taking one of the most economical decisions is "Decision Trees" Many managers weight alternatives base don their immediate or short-run results. After careful analysis.tree format permits a more dynamic approach because it makes some elements explicit that are generally implicit in other analyses. For example. However. it is only one of many mathematical techniques that lave been developed to help the manager make decisions. assigning payoff corresponding to each act-event combination. but a decision. can employ in identifying the alternative courses of action available to him in solving a problem.Where: D = expected annual demand A = Administrative costs per order V = Value per item r = Estimate for taxes. A decision tree is a graphic method that the manager. insurance and other expenses The EOQ formula is used by many firms in solving inventory control problems. consider the case of a firm that has expansion funds and must decide what to do with them. three alternatives identified: Use the money to buy a new company expand the facilities of the current firm put the money in a saving account 13 .

each of the conditional ROl’s is multiplied by its respective probability and the products are then totaled. which indicates an event and its likelihood such as 0. in figure the conditional ROI (Return on Investment) associated with buying a new firm and having solid economic growth is 15 per cent. such as solid economic growth.5 per solid growth.7 0. In deciding which alternative is best.2 respectively. if the company buys a new firm and there is solid growth in the economy.2 for high inflation.0 Probability 0.0 9.6 14 . buying the firm. This analysis is conducted. In order to determine the expected return associated with buying a new firm. as seen in figure. One is the decision point. represented by a circle. where the return will be 3 percent. are .5 0.0 Probability 0. Having then constructed the tree. represented by a square. which indicates where the decision maker must choose a course of action. and high inflation. second is a chance point. the calculation is as follows: Conditional ROI 15.5 Likewise.0 3. represented by a line flowing from the chance points. the company will start by identifying the three alternatives. analyzing as it goes. In building a decision tree. the firm will roll back it from right to left. the company has gathered all the available information and constructed the decision tree. at the far right is a payoff associated with the each branch.0 3. A third is the branch. it will obtain a 15 per cent ROL However. Finally. where the return will be 9 percent. but this return is conditional on the two preceding factors (buying the firm and having solid growth).And wait for better opportunities. For example.6 10.8 For alternative two. For alternative one. or high inflation. the calculation is: Conditional ROI 10. the probability of such an occurrence is 0.3 Expected Return 5. stagnation. In the figure there are four important components. which indicates where a chance event is expected.02 Expected Return 7. 0. the probabilities associated with stagnant growth.3 . first by taking the conditional ROls at the far right of the tree and multiplying them by the probability of their occurrence.3 and . the probabilities and events associated with each alternative. expanding current facilities.5 0. For example.0 12.5 2.3 for stagnation or 0. It is called a conditional payoff since its occurrence depends on certain conditions. and the amount of return that can be expected from each.

5 6.2 Expected Return 3. because it offers the greatest expected return.4 For alternative three. They can be determined only after the tree has been drawn and the analysis of the branches has been conducted. the calculation is: Conditional ROI 6.In building the tree we moved from left to right but in analyzing we moved from right to left. However.0 0. decision these help the manager identify both what can happen and the likelihood of its occurrence .25 1.3 0. 15 .25 These expected returns are often placed over the chance points on the decision tree. expanding current facilities. The first alternative is the best. In evaluating alternatives.5 0.0 6. In the final analysis the decision tree does not provide any definitive answers. it does allow the manager to allow benefits against costs by assigning probabilities to specific events and then ascertaining the respective payoff.2 0.20 6.0 Probability 0.8 9.80 1.4.

means(a) Technical Feasibility (b) Financial feasibility (c) Commercial feasibility (d) None of the above 16 .3. plant. raw materials and technical know how etc.4 In the context of formulation of an investment decision on a project.2.1. machinery.End Chapter quizzes : Q. Approval of Plans is the best example of (a) Organizational decisions. the availability of land. The Technique that employs a written survey to gather expert opinions from a number of people without holding a group meeting is known as (a) Brainstorming (b) The Delphi group Technique (c) The Nominal Group Technique (d) None of the above Q. Which sort of decision does not require the organizational support(a) Basic decision (b) Routine decision (C) Personal decision (d) Organizational decision Q. (d) Both (a) & (c) Q. (b) Basic decisions (c) Programme decisions.

7. (b) Certainty (c) Uncertainty of probable action. Which out of following is significant threat in front of a manager in his decision making related to technological up gradation? (a) Conflict of Interest (b) Time & Resource constraints (c) Both A & B (d) None of the above Q.8. its possible alternative solutions and their respective outcomes in the decision making process of a manager refers to the condition of – (a) Risky information.9.5. (d) Risk & Uncertainty Q. Knowing the problem. The use of highly structured meeting agenda and restricted discussion or interpersonal communication during the decision making process is known as – 17 . Prescriptive approach that outlines how managers should make decisions is – (a) Administrative Model of decision making (b) Rational Model of decision making (c) Alternative Model of decision making (d) Both (b) & (c) Q.Q.6. the cost of production is calculated on the assumption that the material which was last to enter the inventory of the company was used first is – (a) LIFO (b) FIFO (c) F I LO (d) None of the above Q. The method of inventory valuation & thereupon decision making in which.

(b) Graphical method. In identifying the alternative courses of action available to a manager while solving a problem. 18 . (c) Delphi Group Technique. (b) Brainstorming. (c) Assigns payoff corresponding to each act-event combination. a decision tree is – (a) More dynamic in nature.(a) Nominal Group Technique.10. (d) All of the above. (d) Both (b) & (c) Q.

7.1 Moving average smoothing technique 1.2.2.6.2 Purpose and need of forecasting 1.1 Trend projection method 1.1 Introduction 1.Chapter-II Business Forecasting Contents: 1.2 Opinion pools 1.2 Exponential smoothing technique 1.4 Period of forecasting 1.6.2 Statistical Forecast 1.6.2 Barometric methods 1.9 Risks in Demand Forecasting 19 .6.2.1 Specific purposes of demand forecasting 1.2. Simultaneous equation method (Econometric Models) 1.8.2 Seasonal variation 1.7.6.7 Reasons for fluctuations in time series data 1.4.7.3 Steps Involved in Forecasting 1.1 Cyclical fluctuations 1.6.3 Regression method 1.8.8 Smoothing Techniques 1.5. Input Output Forecasting 1.6.2.2.1.6.5 Levels of Forecasting 1.6.1Qualitative Forecast 1.3 Irregular and random variation 1.6 Methods of Forecasting 1.1.1 Survey techniques 1.

planning long run financial requirements and manpower requirements. Long run forecasts are helpful in proper capital planning. Demand forecast is a must for a firm operating its business as today's market is competitive. In a short run forecast seasonal patters are of prime importance. expansion of the existing units.1.1 Introduction Estimation of demand for a product in a forecast year/ period is termed as Demand forecast. 1.2.3 Steps Involved in Forecasting Identification of objective Determining the nature of goods under consideration. 1. Different set of variables is used in than in short term forecasts. machine time and capacity. Interpretation of results.2 Purpose and need of forecasting Forecasting is done both for long term as well as short term. It helps in saving the wastages in material. Selecting a proper method of forecasting.4 Period of forecasting Short run forecasting: In short run forecasting. Medium run forecasting: In medium run forecasting is done basically for timing of an 20 . 1.1 Specific purposes of demand forecasting Better planning and allocation of resources Appropriate production scheduling Inventory control Determining appropriate pricing policies Setting s les targets and establishing controls and incentives. It helps in arriving at suitable price for the product and necessary modifications in advertising and sales techniques. dynamic and volatile. 1. Such a forecast helps in preparing suitable sales policy and proper scheduling of output in order to avoid over-stocking or costly delay in meeting the orders. The purpose of the two however differs. m -hours. we look for factors which bring fluctuation in demand pattern in the market for example weather conditions like monsoon affecting the demand. Planning a new unit or expanding existing one Planning long term financial requirements Planning Human Resource Development strategies. Long run forecasting is used for new unit planning.

5 Levels of Forecasting Macroeconomic forecasting is concerned with business conditions of the whole economy. consumer durable and Non-durable consumer goods.6 Methods of Forecasting 21 . It is done for decision like diversification. 1. General purpose or specific purpose forecast helps the firm in taking general factors into consideration while forecasting for demand. For each of these categories of goods there is a distinctive pattern of demand.activity like advertising expenditure. Product line forecasting helps the firm to decide which of the product or products should have priority in the allocation of firm's limited resources. Goods can be broadly classified into capital goods. consumer price index. It is used to decide the way the firm should plan for future in relation to the industry. Long run forecasting: It is done to ascertain the validity of trend. Industry demand forecasting gives indication to firm regarding direction in which the whole industry will be moving. 1. Forecast of established product or a new product Types of commodity for which forecast is to be done. Firm demand forecasting is done for planning companies overall operations like sales forecasting etc. It is measured with the help of indices like wholesale price index.

1. Basically compilation of expenditure plans of related industries. plant and equipment. Survey of plans for inventory changes and sales expectations. This could be of two types-Complete enumeration and sample survey.6.6. Then opinion of different people is compiled to get overall demand forecast. Sales force opinion method: In this method people who are closest to the market are asked for their opinion on future demand. However the opinion of the concerned people could be biased or twisted for their own benefit. expenditure plans.1. Survey of consumer expenditure plans.2 Opinion pools Consumer survey: In this method the consumers are contacted personally to disclose their future purchase plans.6. This method has advantage that it is based on first hand knowledge of sales people and also it is cheap and easy.1.1.1 Survey techniques Survey of business executives.1Qualitative Forecast 1. Therefore a final ratification has to be done by the head office. 22 .

A special case in this method is the Delphi Technique. Trend through least squares method: This method uses statistical formulae to find the trend line which best fits the available data. The linear regression model will take the form of Y = a + bX Fitting a trend line by observation: This method involves the plotting of the data on the graph and estimating where the trend line lies.6.1 Trend projection method Under the trend method the time series data on the variable under forecast are used to fit a trend line or curve either graphically or by means of a statistical technique known as the Least Squares method. This method assumes that past data can be used to predict future sales. 1. In this different sets of experts are given the relevant problem without each knowing about the other and their opinions or conclusions are compared. logarithmic or power correlation.2 Statistical Forecast 1.6. Trend projection method can be used when there is some sort of correlation between the two variables. It refers to he values of variable arrange chronologically by days. If the opinion is matching then the opinion is accepted other wise the experts are asked to sit together and arrive at a narrow range. It could be linear. quarters or years. which can be used for forecasting demand by extrapolating the line for future and reading the corresponding values of variables on the graph. The first step in time series analysis is usually to plot past values of the variable that we seek 23 . The line can be extrapolated and the forecast read from the graph. This process is continued till a sufficient range is reached. Time series analysis: This is an extension of linear regression which attempts to build seasonal and cyclical variations into the estimating equation. Then the mean of the upper and lower values is computed to reach a point estimate. Thus the experts giving a very high or a very low value are concerned and the group argues until it comes up with a narrow range of value.2. weeks. This is one of the most frequently used forecasting methods.Experts’ opinion method: In this method opinion of experts' in the related field is solicited and the final forecast based on their opinion. months. The trend line is the estimating equation.

6. It assumption is that the time series will continue to move as in the past. Thirdly the time lag between the indicator and forecast could be so small that it could become useless.2. Lagging indicator: These are indicators which lag the movements in economic activity or business cycle.6. 1.3 Regression method It is one of the statistical tools to fore cast demand. Secondly even if the relevant indicator is found out the changes in factors may render the indicator redundant over time.2 Barometric methods Barometric methods are used to forecast or anticipate short term changes in economic activity by using leading economic indicators. 1. For this reason time series analysis is often referred as "native forecasting‛. In this estimating equations are established and tests can be carried out to observe any statistically significant. It involves following steps Identification of variables which influence the demand for the good whose function is under estimation. There are certain problems associated with this method. Collection of historical data on all relevant variables. 24 . There are only three types of indicators: Leading economic indicator: These indicators tend normally to anticipate turning points in a business cycle. These indicators are time series that tend to precede changes in the level of economic activity.2. The major problem is not choosing the technique but choosing the relevant indicator for the product in question. Coincident indicators: These are indicators which move in step or coincide with movements in general economic activity or business cycle.to forecast on vertical axis and the time on the horizontal axis in order to visually inspect the movement of the time series over time. Choosing an appropriate form of the function. Estimation of the function Regression method is popular because it is prescriptive as well as descriptive.

Simultaneous equation method (Econometric Models) Econometric forecasting incorporates or utilizes the best features of other forecasting techniques such as trend and seasonal variation.78 log y -1.22 log 0 + 2.4 + 1. The first step here is to identify the determinants of the variable to be forecasted. fish and meat price The above equation is a demand forecast equation for groundnut oil 1. Q = a0 + a1P + a2Y +a3N + a4P5 + a5Pc + a6a + e Q = demand P = Price Y = disposable income N = size of population Ps = price of a substitute 25 . A typical demand equation could be : Log d = -12. Single equation models: The simplest form of econometric forecasting is with the single equation model.4.62 log e Y = National income O = groundnut oil price V = Vanaspati price G = ghee price E = egg. smoothing techniques and leading indicators.Also it is not as subjective or objective as other methods. However if the variables chosen are wrong then the forecast will also be wrong.2.8 log g + 1.6. Econometric forecasting models range from single equation models of the demand that the firm faces for tits product to large multiple equation models describing hundreds of sectors and industries of the economy.20 log v + 0.

These are the variables that the model seeks to explain or predict from the solution of the model.Input Output Forecasting Input output analysis was introduced by Prof. It shows the use of the output of each industry as input by other industries and for final consumption. Multiple equation model for GNP Ct = a1+b1GNPt+u1t It =a2+b2IIt-1+U2t GNPt= Ct+ It+Gt C = consumption expenditures GNP = Gross national product in year t I = investment II = Profit G = Government expenditures U = stochastic disturbance (random error term) T = current year t-1 = previous year Variables to the left of the equal sign are called endogenous variable. Leontief.5.6. This is particularly used in forecasting micro variables or the demand and sales of major sectors or industries.2.Pc = price of complement A = level of advertising by the firm Multiple equation model: Sometimes economic relationships may be so complex that a multiple equation model may be required. With this technique the firm can also forecast using Input output tables. Exogenous variables are those determinants outside the model or right of the equal sign of the equation. Input and output analysis allow us to trace through all these inter industry input and outputs flow 26 . 1.

1. labor and capital requirement needed to meet the forecasted change in the demand for their product. They are usually examined separately by qualitative techniques.2.5. It is used by the firm to forecast the raw material.7. Input output tables are usually available with a time lag of many years and while the input output coefficients do not change very rapidly they can become very biased.7.g. A typical cycle could last 15-20 years. a typical factor could be weather and social customs. 27 .1 Uses and shortcomings of input output forecasting Input output analysis and forecasting has many uses and applications. The total variation in the time series is the result of all the above four factors operating together.2 Seasonal variation This refers to regularly recurring fluctuations in economic activity during each year e. long run increase or decrease in data series. 1.7. natural disasters or strikes.though out the economy and to determine the total increase of all the inputs required to meet the increased demand.7 Reasons for fluctuations in time series data Changes occur in secular trend i. 1. 1. In this technique we have two input output matrixes. Direct Requirement Matrix Total Requirement Matrix 1.6.1 Cyclical fluctuations There are the major expansions and contractions in most economic time series data that seem to re-occur every several years.. The shortcomings are that the direct and total coefficients are assumed to be fixed and thus do not allow input substitution.3 Irregular and random variation This is the variations in the data series resulting from unique events like wars.e.

months) in the past. 1.8. The disadvantage of moving average method is that it gives equal weightage to the data related to different periods (i. the value of the forecast of the time series in period t +1l is Ft + 1 = WA1 + (1-w) Ft. and the one that leads to the forecast with smallest root-mean-square error (RMSE) is actually used in forecasting. At) is assigned the weight of 1-w6. Ft + 1) is a weighted average of the actual and forecasted values of the time series in period. Thus.e.1. Here the forecasted value of a time series in a given period is equal to the average value of the time series in a number of previous periods. This method is more useful the more erratic or random is the timeseries data. The value of the time series at period t (i. the greater is the weight given to the value of the time series in period as opposed to previous periods. In general. According to exponential smoothing method more recent the data the more relevant it is for forecasting and therefore it would be more appropriate to give more weightage to recent observations.8. different values of W are tried.e. 1.8 Smoothing Techniques This technique predicts feature value of time series on the basis of some average of its past value only. This method is a refined version of moving average method. The value given to weightage is normally chosen to form a geometric progression. 28 . the forecast for period t +1 (i.1 Moving average smoothing technique The simplest smoothing technique is the moving average. There are two smoothing techniques.e.2 Exponential smoothing technique This technique is used more frequently than simple averages in forecasting. With exponential smoothing. The greater the value of w. This technique is useful when the time series exhibits little trend or seasonal variation but a great deal of random variation.

29 . Forecasting the main driver or user of the product in each segment of the market and projecting how they are likely to change in the future.9 Risks in Demand Forecasting Demand forecasting faces two major risks Overestimation of demand Underestimation of demand One risk arises from entirely unforeseen events such as war. political upheavals and natural disasters. The second risk arises from inadequate analysis of the market.1. Dividing total industry demand into its components and analyzing each component separately. All these forecasting errors could possibly have been avoided through: Carefully defining the market for the product to include all potential users of the market and considering the possibility of product substitution.

(d) Sales People are closely associated with the market. because (a) They cannot deny from providing the information. opinion of sales people is collected to forecast the future demand. Reasons for fluctuations in time series data may occur due to (a) Seasonal variation (b) Cyclical fluctuations (c) Irregular and random variation (d) All of the above 30 . In Sales force opinion method. 4.End Chapter quizzes : 1. short run forecasting is required for (a) Expansion of the existing units (b) New unit planning (c) Sales forecasting (d) capital planning 2 This forecasting technique helps the firm to decide which of the product or products should have priority in the allocation of firm's limited resources. (a) Product line forecasting (b) Industry demand forecasting (c) Firm’s demand forecasting (d) Sales Forecasting 3. (c) They are the only experts of consumer behaviour. Out of the given plannings. (b) They are paid by the company.

months) in the past. The disadvantage of this technique is that it gives equal weightage to the data related to different periods (i. This forecasting technique incorporates or utilizes the best features of other forecasting techniques such as trend and seasonal variation.e. (a) Regression Technique 31 . Which one is not a type of Barometric Indicator? (a) Leading economic indicator (b) Coincident indicators (c) Lagging indicator (d) Climate indicator 6. smoothing techniques and leading indicators. (c) Forecasting the main driver or user of the product in each segment of the market and projecting how they are likely to change in the future. Which of the following step may help in avoiding or minimizing the errors in business forecasting? (a) Carefully defining the market for the product to include all potential users of the market and considering the possibility of product substitution. (b) Dividing total industry demand into its components and analyzing each component separately.5. (d) All of the above 8. (a) Moving average smoothing technique (b) Exponential smoothing technique (c) Input Output Forecasting (d) None of the above 7.

Variation in Data occurring due to regularly recurring fluctuations in economic activity during each year is (a) Cyclical fluctuations (b) Seasonal Variations (c) Random Variation (d) Irregular Variation 10. In this technique two types of matrices i.e. Direct Requirement Matrix and Total Requirement Matrix are used to forecast the demand.(b) Econometric forecasting ( c) Barometric methods (d) None of the above 9. (a) Regression Technique (b) Exponential smoothing technique (c) Input Output Forecasting (d) Econometric forecasting 32 .

1 Individual and Market Demand 1.2.3 Price elasticity and Decision Making 1.8 Shift of Demand Curve v/s Movement along the demand curve 1.2 Types of Demand 1.3 Determinants of Demand 1.1 The Price Elasticity of Demand 1.10.1.10.2.3 Demand for durable and nondurable goods 1.10 Elasticities of Demand 1.11 Classification of Goods 33 .10.2.4 Demand for firm’s product and industry product 1.5 Demand for consumers and producers goods 1.1.2.1 The relationship between marginal revenue and price elasticity 1.2.2 Determinants of Price Elasticity of Demand 1.1 Meaning of Demand 1.4 Demand Function 1.5 Law of Demand 1.9 Effect of a Price Change 1.10.7 Demand Curve 1.1.6 Demand Schedule 1.Chapter-III Demand Analysis Contents: 1.2 Autonomous and derived demand 1.

2The Ordinal Utility Theory 1.2.1The Cardinal Utility Theory 1.14 The consumer surplus 34 .13.1 Equilibrium of Consumer 1.13 Theory of Consumer Behaviour 1.13.1.1Equilibrium of Consumer 1.2.13.12 Exceptions to the Law of Demand – Upward Sloping Demand Curve 1.13.1.2 Properties of Indifference Curve 1.13.

2 Types of Demand The demand for various commodities is generally classified on the basis of the consumers of the product. period of demand and nature of use of the commodity(intermediate or final).1. demand can be defined as the desire for a good backed by the ability and willingness to pay for it.1 Meaning of Demand Conceptually. duration of the consumption of the commodity. Market demand is a multivariate relationship and determined by many factors simultaneously.1 Individual and Market Demand The quantity of a commodity which an individual is willing to buy at a particular price during a specific time period given his money income.2. suppliers of the product. On the other hand market demand of a commodity is the summation of individual demand by all the consumers. The desire without adequate purchasing power and willingness to pay do not become effective demand and only an effective demand matters in economic analysis and business decisions. his taste and prices of other commodities is called individual’s demand for a commodity. interdependence of demand. Individual and Market Demand Autonomous and derived demand Demand for durable and nondurable goods Demand for firm’s product and industry product Demand for consumers and producers goods 1. Some of the most important determinants of the market demand for a particular commodity are 35 . nature of goods. 1.

Commodities like tea and vegetables do come on absolute terms. credit availability. the demand for the product is termed as independent. the demand is termed as derived demand.2. prices of other commodities. 1. consumer’s income. 1. consumer income and is subject to frequent change. past level of income and past level of demand. consumer’s taste. income distribution. The demand for durable goods changes over a relatively longer period.2. On the other hand if the demand for a product is tied to the demand for some parent product.its own price. The demand for nondurable goods depends largely on their prices. Such goods can be used repeatedly over a period of time. 1. Replacement of old products and expansion of existing stock. Government policy. Their demand is of two types.4 Demand for firm’s product and industry product Firm’s demand denotes the demand for the products by a particular company or firm whereas industry demand is the aggregation of demand for the product of 36 . Perishable (non-durable) goods are defined as those which can be used only once. which may be substitute or complementary or on the raw material side or on the product side. consumer’s wealth.2.3 Demand for durable and nondurable goods Durable goods are those whose total utility is not exhausted in a single or short run use. total population. Durable goods may be consumer goods as well as producer goods.2 Autonomous and derived demand The demand for a commodity that arises on its own out of a natural desire to consume or possesses a commodity independent of the demand of other commodities.

It may also be possible that this demand may be accelerated or accentuated in the same proportion as the change in the demand for the final consumer goods. 1.all the firms of an industry as a whole. which are. A small change in the demand for consumer goods may either completely wipes out the demand for the producer goods or may accelerate it. Another distinction is that the demand for producer’s goods is derived demand and it indirectly depends on the demand for the consumer goods which the producer goods is used to produce. Producer's goods on the other hand are used for the production of consumer goods or they are intermediate goods. A Clear understanding of the relation between company and industry demand necessitates the understanding of different market structures. which are further processed upon to convert them into a form to be used by the end user. These structures can be differentiated the basis of product differentiation and number of sellers. meant for the final consumption by the consumers or the end users.5 Demand for consumers and producers goods Consumer goods are those.3 Determinants of Demand        Commodity’s Own Price Prices of related goods → Substitutes and Complements Income level of consumer Tastes & Preferences Expectations Population Other exogenous factors 1. 1.2.4 Demand Function 37 .

A typical demand function can be specified as follows: Dn Where = f( pn. N. Ep. Exp.T. Ey.6 Demand Schedule A demand schedule is one way of showing the relationship between quantity demanded and price. p1. Exp. Price($ per Quantity demanded 38 . other factors remaining constant.……... u) pn = price of n product P1………Pn-1 = Prices of other products Y T Ep Ey Ad.e. ceteris paribus i.The determinants of quantity demanded when summarized in the form of functional notations are called a demand function. N D u = income level of consumers = Taste and preferences of consumers = expected prices = expected income = advertising expenditure = number of consumers = distribution of consumers = other factors 1.5 Law of Demand There is negative relationship between price of a product and quantity demanded of that product. Y. Ad. all other things being held constant. 1.pn-1. p2. D.

50 3.5 2.0 3. The linear demand curve may be written in the form of. Q b0 @b1 P P P Linear Demand Curve Q Non – Linear Demand Curve Q 39 .50 2.dozen) 0.00 2. all other things being held constant.5 1.5 1.0 5.0 1. whereas for a nonlinear or curvilinear curve the slope never remains constant.7 Demand Curve Demand curve is the graphical representation of the relationship between price and quantity demanded of a good.00 (dozen per month) 7.00 1.50 1. A demand curve is said to be linear when its slope is constant all along the curve.

1.8 Shift of Demand Curve v/s Movement along the demand curve A movement along the demand curve is in response to a change in price and leads to expansion or Contraction of Demand.9 Effect of a Price Change   Price Effect Income Effect – A price change causes Real Income to change and therefore consumption of both goods changes 40 . This is called Change in Quantity Demanded. On the other hand Shift in the demand curve either upward or downward is in response to a change in one of the other determinants of demand.1.

10. The most important of these elasticities are: Price elasticity of demand Income elasticity of demand Cross elasticity of demand 1. 1.1 The Price Elasticity of Demand The price elasticity is a measure of the responsiveness of demand to changes in the commodity’s own price. For very small changes in price point elasticity of demand is used as a measure of responsiveness of demand and arc elasticity of demand is the suitable measure for comparatively large changes in price.10 Elasticities of Demand There are as many elasticities of demand as its determinants. ep dQ dP ffffffffff D fffffffff Q P Or ep dQ P ffffffffff fffff A dP Q If the demand curve is linear Q bo @b1 p 41 . Substitution Effect – Price change of one good causes the relative price of the two goods to change and consumers substitute the relatively cheaper good for the more expensive one. Symbolically it is written as. The point elasticity of demand is defined as the proportionate change in the quantity demanded resulting from a very small proportionate change in price.

If e p 1 . 42 . the demand is perfectly inelastic. the demand is unitary elastic. total expenditure remain constant with a change in price.Its slope is dQ/ dP @b1 Asubstituting in the elasticity formula we obtain P fffff e p @b1 A Q Which implies that the elasticity changes at the various points of the linear demand curve? The range of values of the elasticity is 0 ep 1 If e p 0. the demand is perfectly elastic If e p 1.

If 1< e p < 1 the demand is elastic. total expenditure and price change move in the opposite direction.If 0 < e p < 1. the demand is inelastic total expenditure total expenditure and price change move in the same direction. 0 < e p < 1. 1< e p < 1 43 .

1.10.1.1 The relationship between marginal revenue and price elasticity
The marginal revenue is related to the price elasticity with the formula
1 MR p 1 @ fff e
f g

This is a crucial relationship for the theory of pricing Proof The total revenue is
D b cE

TR PQ

f Q Q

The MR is
pQ dQ dP MR d fffffffffff P ffffffffff Q ffffffffff P dQ dQ dQ dP Q ffffffffff dQ

The price elasticity of demand is defined as
dQ e p @ ffffffffff fffffff dP Q

Rearranging we obtain
P fffffffff dP ffffffffff @ eQ dQ

Substituting dP/ dQ in the expression of the MR we have
MR P
f

Q

dP P P ffffffffff fffffffff fffff P @Q P@ dQ eQ e
g

1 MR p 1 @ fff e

We may summarize this relationship as follows:

44

If the demand is inelastic (e < 1) an increase in price leads to an increase in total revenue and vice versa. If the demand is elastic (e>1) an increase in price will lead to a decrease in total revenue and vice versa. If the demand has unitary elasticity (e =1), total revenue is not affected by changes in price.

1.10.1.2 Determinants of Price Elasticity of Demand
     Number and availability of Substitutes The proportion of income spent on the particular commodity Nature of the need that the product satisfies Length of time period under consideration The number of uses to which a commodity can be put

1.10.1.3 Price elasticity and Decision Making
 Information about price elasticities can be extremely useful to managers as they contemplate pricing decisions.  If demand is inelastic at the current price, a price decrease will result in a decrease in total revenue.  Alternatively, reducing the price of a product with elastic demand would cause revenue to increase. Remember TR = P*Q

45

1.10.2 The income elasticity of demand
The income elasticity of demand is defined as the proportionate change in the quantity demanded resulting from a proportionate change in income. The income elasticity is positive for normal goods. Symbolically it may be written as:
ey dQ dY dQ Y ffffffffff fffffffff ffffffffff fffff D A Q Y dY Q

1.10.3 The cross elasticity of demand
The cross elasticity of demand is defined as the proportionate change in the quantity demanded of x commodity resulting from a proportionate change in the price of y commodity. The sign of cross elasticity is negative if x and y are complementary goods and positive if x and y are substitutes. The higher the value of the cross elasticity the stronger will be the degree of substitutability or complementarity of x and y. symbolically we may write it as:

exy

dQx dP y dQx P y ffffffffffff D ffffffffffff ffffffffffffAffffffff Qx Py dP y Qx

1.11 Classification of Goods
Normal Goods – Demand Increases as Income increases Inferior Goods – Demand decreases as consumer Income increases Basic Necessities – Commodities like salt, food grains etc for which demand is relatively inelastic and does not vary with income after a point 46

This is the axiom of utility maximization. 1. 1.12 Exceptions to the Law of Demand – Upward Sloping Demand Curve Giffen Goods – a subclass of Inferior goods for which the income effect outweighs the substitution effect Veblen Products / Snob effect – Goods that have a snob value attached to them for which demand actually increases as price goes up Speculative Effect – In periods of rising prices. In order to attain this objective the consumer must be able to compare the utility of the various ‘baskets of goods’ which he can buy with his income. anticipation of future increases may cause consumers to demand more Bandwagon Effect – Occurs when people demand a commodity only because others are demanding it and in order to be fashionable Emergencies like war.1The Cardinal Utility Theory 47 .13. Given his income and the market prices of the various commodities.1.13 Theory of Consumer Behaviour The consumer is assumed to be rational. There are two basic approaches to compare the utilities. the cardinalist approach and the ordinalist approach. famine etc. he plans the spending of his income so as to attain the highest possible satisfaction or utility.

2The Ordinal Utility Theory The ordinalist school postulated the utility is not measurable. There are certain assumptions of cardinal utility theory. called utils. Under certainty i. the consumer can either buy x or retain his money income y.The cardinal school stated that utility can be measured. Rationality of consumer Constant marginal utility of money Diminishing marginal utility Total utility is additive 1.13.1.1 Equilibrium of Consumer Assuming the simple model of a single commodity x.13. It suffices for the consumer to be able to rank the various baskets of goods according to the satisfaction derived.e. The main ordinal theory is known as the indifference-curve theory is based on certain assumptions. MU x MU y ffffffffffffffff ffffffffffffffff Px Py MU n ffffffffffffffff Pn 1. complete knowledge of market conditions and income levels over the planning period utility can be measured in monetary units.. but is an ordinal magnitude. Under these conditions the consumer is in equilibrium when the marginal utility of x is equated to its market price. the condition for the equilibrium is the equality of the ratios of the marginal utilities of the individual commodities to their prices. Rationality of consumer 48 . MU x Px If there are more commodities.

MRS x . At the point of tangency (point e) the slopes of the budget line ( P x / P y ) and of 49 . given his income and the market prices. This condition is fulfilled by the axiom of diminishing marginal rate of substitution of x for y and vice versa.2.13.1Equilibrium of Consumer The consumer is in equilibrium when he maximizes his utility.y MU x P x ffffffffffffffff ffffffff MU y P y The second condition is that the indifference curve be convex to the origin. This is necessary but not sufficient condition. Two conditions must be fulfilled for the consumer to be in equilibrium.Utility is ordinal Diminishing Marginal rate of substitution Consistency and transitivity of choice Total utility depends on the quantities of the commodities consumed 1. The first condition is that the marginal rate of substitution be equal to the ratio of commodity prices.

2. the higher the utility it denotes Indifference curve do not intersect The indifference curves are convex to the origin 1. 50 .14 The consumer surplus Consumer surplus is equal to the difference between the amount of money that a consumer actually pays to buy a certain quantity of a commodity and the amount that he would be willing to pay for this quantity rather than do without it.y MU x / MU y ) are equal: MRS x .2 Properties of Indifference Curve An indifference curve has a negative slope The further away from the origin an indifference curve lies.the indifference curve ( MRS x . Graphically the consumers’ surplus may be found by his demand curve for commodity and the current market price. which he cannot affect by his purchase of that commodity.13.y MU x P x ffffffffffffffff ffffffff MU y P y 1.

Consumer surplus = PCA End Chapter quizzes : Q.2 What happens to demand when price of the commodity falls 51 . The demand curve of a normal commodity is (a) Upward Sloping (b) Downward sloping (c) Horizontal (d) Vertical Q.1.

5 According to the cardinal approach the marginal utility of money (a) Increases (b) Decreases (c) Remain constant (d) Fluctuates Q.4 At a downward sloping demand curve the price elasticity of demand is (a) Equal to unity (b) Varies at different points (c) Equal to zero (d) Equal to infinity Q.6 The shape of indifference curve is (a) Upward Sloping and concave to the origin (b) Downward sloping and concave to the origin (c) Upward Sloping and convex to the origin 52 .3 In case of substitute goods if the price of commodity x increases the demand of commodity y (a) Remain constant (b) Increases (c) Decreases (d) Fluctuates Q.(a) Demand expands (b) Demand contracts (c) No change (d) Can expand or contract Q.

Q=? (a) Q = 67 (b) Q = 72 (c) Q = 108 (d) Q = 81 53 .9 According to the ordinal approach consumer’s equilibrium is where (a) MU x Px ffffffffffffffff 1 ffffffff MU y Py MU x P x ffffffffffffffff ffffffff < MU y P y MU x P x ffffffffffffffff ffffffff MU y P y MU x P x ffffffffffffffff ffffffff > MU y P y (b) (c) (d) Q.8 The marginal utility from successive consumption of normal good (a) Increases (b) Decreases (c) Remain constant (d) Undefined Q.(d) Downward sloping and convex to the origin Q.10 Given the demand function Q = 90-3p and P = 6.7 The shape of indifference curve implies (a) Diminishing MRSxy (b) Increasing MRSxy (c) Constant MRSxy (d) Infinite MRSxy Q.

Actual Cost 54 .1 Introduction 1.1 Opportunity vs.2.Chapter-IV Cost Analysis: Contents: 1.2 Accounting Cost Concepts 1.

3.3. Incremental cost 1.3 Total.1 Total Cost 1.1.3.2 External economies of scale 1.1 Introduction Cost functions are derived functions from the production function which describes the available efficient methods of production at any one time.2 External diseconomies of scale 1. determination of price and dealers margin.2.7. especially those related to locating the weak points in production management.7.2 Explicit cost vs.5 Short-Run Output Decision 1.2.7.3. finding the optimum level of output. Average and Marginal Costs 1.7.1 Long Run Average Cost Curve 1.6.3.3.6 Long-Run Cost Function 1.2 Fixed and Variable Costs 1.1 Sunk vs.2 Average cost 1.7. The cost of production is an important factor in almost all the business analysis and decisions.3.1 Internal economies of scale 1.1 Economies of Scale 1.2.1. minimizing the cost.3 Analytical Cost Concepts 1. implicit cost 1.1 Internal diseconomies of scale 1.4 Properties of Short Run Cost Curves 1.7.7 Economies and Diseconomies of Scale 1. 55 .3.2 Diseconomies of Scale 1.3 Marginal Cost 1.3.1.

On the other hand actual Cost considers only explicit cost.2 Fixed and Variable Costs 56 . and property rentals. license fee. increased or decreased.estimation of the cost of business operation. A sunk cost is an expenditure that has been made and cannot be recovered since it accord to the prior commitment.2 Accounting Cost Concepts 1. insurance premium. by varying the rate of output. materials. Incremental cost The sunk costs are those which cannot be altered. the out of pocket cost for items such as wages. Implicit cost Explicit costs are cash expenses for the payment of wages.1 Opportunity vs. 1. 1. material. The explicit and implicit costs together make the economic cost. The cost concepts can be grouped under two categories on the basis of their nature and purpose. Actual Cost The opportunity cost may be defined as the expected returns from the second best use of the resources which are foregone due to the scarcity of resources. It is also called alternative cost. 1.2 Explicit cost vs. Opportunity cost is an important example of implicit cost. salaries. depreciation charges and are recorded in normal accounting practices.1 Sunk vs.3.3 Analytical Cost Concepts 1.3. 1.2.2. The concept of economic rent or economic profit is associated with it. salaries. In contrast implicit costs are non cash expenses. Incremental cost is the change in cost tied to a managerial decision associated with expansion of output or addition of new variety of product.

Fixed costs are associated with the short run. depreciation of fixed assets. maintenance of land etc. It include cost of raw material.3. cost of direct labor. The fixed costs include the cost of managerial and administrative staff. b c C f X. It connotes both explicit and implicit money expenditure and include fixed and variable costs. repairs.P f .3. Variable costs are those which vary with the variation in the total output.3.3 Total.K Where C X T Pf total cost output technology prices of factors fixed factors K TC TFC TVC Total Cost Curves 57 . routine maintenance etc.Fixed costs are those which are fixed in volume for a certain given output. Average and Marginal Costs 1. running cost of fixed capital such as fuel. 1. It does not vary with variation in the output for a certain scale.1 Total Cost Total cost is the total expenditure incurred on the production.T.

3.3.1. AC TC ffffffffff Q Average cost further can be categorized as average fixed cost (AFC) and average variable cost (AVC).2 Average cost Average cost is obtained by dividing the total cost by the total output. AFC TFC fffffffffffffff Q TVC fffffffffffffff Q AVC Average cost curves 58 .

3.3 Marginal Cost Marginal cost is the change in the total cost for producing an extra unit of output.1. MC TC/ Q Marginal Cost Curve 1.3.4 Properties of Short Run Cost Curves Short run cost curves get their shape from the marginal productivity of the variable factor 59 .

where MC=MR subject to checking the average condition: If P > ATC. The levels of cost curves are determined by market price of factor along with technology.5 Short-Run Output Decision Firm sets output at Q1.If capital is held constant (short run) then the marginal product of labor gives the short run cost curves their shape. the firm produces Q1 at a profit If ATC > P > AVC. AFC falls continuously MC equals AVC and ATC at their minimum Minimum AVC occurs at a lower output than minimum ATC due to FC 1. the firm produces Q1 at a loss 60 .

and the firm is able to adjust its scale of operations according to demand Therefore. plant size is variable.6 Long-Run Cost Function The long-run total cost curve describes the minimum cost of producing each output level when the firm is free to vary all input levels. The Long Run Average Cost Curve is then an envelope of the different SRACs. 61 . One of the first decisions to be made by the owner/manager of a firm is to decide the scale of operation (size of the firm). 1.6. the firm produces zero output 1. corresponding to each different scale of operation is a relevant Short Run Cost Curve.P < AVC.1 Long Run Average Cost Curve In the Long Run.

1.1Internal economies of scale Internal economies of scale are advantages that a firm gains from increasing the scale of its own operations. Economies of scale are advantages and diseconomies of scale are disadvantages that arise due to the expansion of production scale and lead to a fall and rise in the cost of production respectively. 1.7 Economies and Diseconomies of Scale Economies and diseconomies are associated with long run cost functions. Whereas external economies of scale are advantages that a firm gains from the expansion and size of the industry as whole industrial clusters.7.1.1 Economies of Scale The economies of scale are classified as Internal economies of scale External economies of scale 1.7. It is important to note that internal economies of scale determine the shape of the LRAC 62 .

diseconomies may be internal or external.2.2 External diseconomies of scale Natural constraints especially in agriculture and extractive industries Pressure on inputs market due to increasing demand Pressure on inputs prices due to bulk purchase 63 .1 Internal diseconomies of scale Managerial inefficiency Labor inefficiency 1.7.2 External economies of scale Large scale purchase of raw material Large scale acquisition of external finance Massive advertisement campaign Growth of ancillary industries Change of factor prices in the industry 1.1. 1.7. Technological advantage Advantages of division of labor and specialization Economies in marketing Managerial economies Economies in transport and storage 1.2.2 Diseconomies of Scale Like economies.7.curve while the position of this curve depends on external economies such as change in technology and changes of factor prices in the industry as a whole.7.

End Chapter Quizzes 1. C: Diseconomies of scale D: None of the above 4. Change in the total cost for producing an extra unit of output is know as – A: Incremental Cost B: Marginal Cost C: Variable cost D: Both A & B 2. 5. The shape of SATC necessarily reflects the operation of – A: Law of Variable Proportion. D: None of the above is correct. 7. When MC is rising and is more than AVC – A: The ATC may be rising B: The ATC may be falling C: Either of the two cases mentioned above is possible. Marginal Cost equates with – A: First AVC and then ATC B: First ATC and then AVC C: Never equates with ATC D: Never Equates with AVC 3. Which one of the statement is correct – A: All costs are variable costs in the long run except LMC B: TFC is inverse ‚S‚Shaped reflecting Laws of Returns. Over a range of output. B: Economies of Scale. AFC is Zero. D: Difficult to say as information is inadequate. The nature and shape of AFC is – A: A rectangular Hyperbola B: A horizontal Line C: It is ‚U‛ shaped D: A vertical Line 6. C: Over a very long range of Operation. Explicit cost is also known as – A: Imputed Cost B: Implied Cost C: Accounting Cost 64 .

TCn . The above statement is correct.TCn-1 = ∆ TC/ ∆Output = Marginal Cost { Where ∆ denotes small change} A: B: C: D: 9.D: Opportunity Cost 8. The statement is Vague & irrelevant The above statement is partially true. Gain from the increasing scale of production can be viewed as – A: External economies of scale B: Internal economies of scale C: Externalities D: Internalities 10. An Envelop Curve is drawn from – A: Short run Average Cost Curves B: Long run Average Cost Curves C: Planning Curves D: None of the above 65 . The above statement is incorrect.

2.3.2.2.6 Isocost 1.1 Law of variable proportions 1.7 Isocost Curve and Optimal Combination of L and K 1.1 Constant returns to scale 1.2 Laws of Returns to Scale 1.2 Increasing returns to scale 1.1 Marginal Product of Labor 1.3.2 Short Run Analysis 1.1Production Function 1.Chapter-V Production Analysis Contents: 1.2 Average Product of labor 1.3.4 Isoquant 1.3 Diminishing Returns to Scale 1.5 Equilibrium of the Firm 1.3.3 Laws of Production 1.8 Production with Two (or more) Outputs-Economies of Scope 66 .3.2.2.

1. Capital. Land and Entrepreneurship) Technical Efficiency – Occurs when it is not possible to increase output without increasing inputs Economic Efficiency – Occurs when a given output is being produced at the lowest possible cost. the manager is concerned with efficiency in the use of inputs (Labor. v. y X f L ` a L In the process of production. b c X f L. K. Improvement of Technology is reflected in an upward shift in the Production Function.1Production Function The creation of any good or service that has value to either producers or consumers is termed as production. The production function includes all the technically efficient methods of production. Production function is a technical relation between factor inputs and outputs. S. R. The same amount of input leads to a higher output 67 . It describes the laws of proportion that is the transformation of factor inputs into outputs at any particular time period.

Q f1 L ` a ` a f L L 1.2 Short Run Analysis Short Run is the period of time in which one (or more) of the factors of production employed in a production process is fixed or incapable of being varied. total production is rising If MP < 0. total production is falling Total production is maximum when MP = 0 68 . We usually assume Capital (K) to be fixed and analyze how output varies with changes in Labor (L) X f L ` a 1.1 Marginal Product of Labor The change in output resulting from a very small change in Labor keeping all other factors constant.2. MPL = ∂X ∕ ∂L If MP > 0.

2.1. then AP is rising If MP < AP.2 Average Product of labor APL = X / L If MP > AP. then AP is falling MP = AP when AP is maximum APL MPL L 69 .

1. 1. This is referred to as Law of variable proportions. In the short run output may be increased by using more of the variable factors while keeping other constant. It is also known as the Law of diminishing returns.. Three stages of production APL L Stage I – Capital is Underutilized and Successive units of L add greater Amounts to TP Stage II – Addition to TP due to increase in L continues to be positive but is falling with each unit MPL Stage III – Fixed Input capacity is reached and additional L causes output to decline 70 .3.e. marginal product) starts to diminish.3 Laws of Production The laws of production analyze the technically possible ways of increasing the level of production.1 Law of variable proportions In general if one of the factors of productions (usually capital K) is fixed after a certain range of production additional output (i. The range of output over which the marginal products of the factors are positive but diminishing is considered as equilibrium range of output. Output may increase in various ways. While in long run output expansion may be achieved by varying all factors and it is known as laws of returns to scale. The range of increasing returns to a factor and the range of negative productivity are not suitable for equilibrium.

1.3.1.2. Three types of returns to scale are observed.2. The causes of increasing returns to scale are: Specialization of labor 71 . The laws of returns to scale refer to the effects of scale relationship. it is termed as constant returns to scale. Constant returns to scale Increasing returns to scale Decreasing returns to scale 1.3.3.2 Increasing returns to scale If output increases by a greater proportion in comparison to a change in the scale of inputs it is termed as increasing Returns to Scale.2 Laws of Returns to Scale In the long run expansion of output may be achieved by varying all factors by the same proportion or by different proportions.1 Constant returns to scale If the quantity of all inputs used in the production is increased by a given proportion and we have output increased in the same proportion.

it is described as diminishing returns to scale.2.3 Diminishing Returns to Scale If output increases by a smaller proportion in comparison to the change in the scale of inputs.Inventory Economies Managerial indivisibilities Technical indivisibilities 1.3. The reasons of diminishing returns to scale are: Managerial inefficiency Exhaustible natural resources Increased bureaucratic Labor inefficiency Pressure on inputs market due to increasing demand Pressure on inputs prices due to bulk purchase 72 .

In case the two inputs are imperfectly substitutable. A higher isoquant refers to a larger output. The degree of imperfection in substitutability is measured with marginal rate of technical substitution (MRTS): 73 . C – shaped isoquants are common and imply imperfect substitutability Isoquants may take various shapes depending on the degree of substitutability of inputs. while a lower isoquant refers to a smaller output. The slope of Isoquant shows diminishing marginal rate of input substitution.4 Isoquant An isoquant is the locus of all the technically efficient methods or all the combinations of factors of production for producing a given level of output given the state of technology. However continuous isoquants (an approximation to the realistic form of kinked isoquant) has mostly been adopted because they are mathematically simpler to be handled.1. the optimal combination of inputs depends on the degree of substitutability and on the relative prices of the inputs.

k @ K/ L X/ L D X/ K MRTS l .MRTS l .k MP l fffffffffffffff MP k 1. b c MPl Px MPl Profit Maximization requires w Px CMP l Px Price of final output 74 .5 Equilibrium of the Firm A profit maximizing firm will be using optimal amount of an input at the point at which the monetary value of the input’s marginal product is equal to the additional cost of using that input. Monetary value of the input is.

the total cost or expenditure of the firm can be represented by: C wL rK One can solve Optimization problem for the combination of inputs that either minimizes total cost subject to a given constraint on output OR maximizes output subject to a given total cost constraint.6 Isocost The isocost line is the locus of all combinations of factors the firm can purchase with a given monetary cost outlay. 1.7 Isocost Curve and Optimal Combination of L and K Optimal input Combination Depends on the relative prices of inputs and the degree to which they can be substituted for each other represented by the point of tangency between Isocost and Isoquant. If a firm uses only L & K. 75 .w Wage rate (Cost of input) 1.

producing related products.8 Production with Two(or more) Outputs-Economies of Scope Economies of scope exist when the unit cost of producing two or more products/services jointly is lower than producing them separately. The average total cost of production decreases as a result of increasing the number of different goods produced 76 . and the products that are complementary.MP l w fffffffffffffff fffff MP k r 1.

End Chapter quizzes : Q.4 Returns to scale means (a) Change in output due to change in one variable factor of production (b) Change in output due to change in one constant factor of production (c) Change in output due to change in all variable factors of production (d) Change in output due to change in all constant factor of production Q. Production function states (a) Qualitative relationship between input and output (b) Quantitative relationship between input and output (c) Technical relationship between input and output (d) No relationship between input and output Q.1.5 The slope of isoquant is called (a) Marginal rate of technical substitution 77 .3 The law of variable proportions states that given at least one input constant the marginal product of variable factor (a) Increases (b) Decreases (c) Remain constant (d) Fluctuates Q.2 Total output is maximum where (a) Marginal production is maximum (b) Marginal production is zero (c) Average production is maximum (d) Average production is zero Q.

6 The shape of isoquant curve is (a) Upward Sloping and concave to the origin (b) Downward sloping and concave to the origin (c) Upward Sloping and convex to the origin (d) Downward sloping and convex to the origin Q.8 which of the statements is false (a) At the point of producer’s equilibrium. marginal product also falls and lies below Average product (d) The elasticity of technical substitution is measured by the slope of Isoquant Q. the isoquant is tangent to the Isocost line (b) Constant returns to scale means proportionate change in output due to Proportionate change in inputs (c) When average product falls.7 Economies of scale are related with (a) Size of plant (b) Size of fixed factor (c) Size of variable factor (d) Choice of technique Q.9 Producer’s equilibrium is where 78 .(b) Marginal rate of factor substitution (c) Marginal rate of production substitution (d) Marginal rate of input substitution Q.

(a) MP l w fffffffffffffff fffff > MP k r (b) MP l w fffffffffffffff fffff < MP k r MP l w fffffffffffffff fffff MP k r MP l fffffffffffffff w 1 fffff MP k r (c) (d) Q.10 Which of the statements about the Isocost line is false (a) The budget constraint of the producer (b) The budget constraint of the seller (c) Shows all the combinations of inputs which may be purchased (d) It touches both the axis compulsorily 79 .

2 Growth 1.4 Price Forecasting 1.6.1 Prospective Supply 1.1 Introduction 1.2 Objectives of Pricing Policies 1.1 Skimming Pricing 1.5 Prospective supply and demand 1.3 Maturity 1.6.2 Prospective Demand 1.7.6.6.6.Chapter-VI Pricing Policy of the Firm Contents: 1.3 Factors affecting Pricing Policies 1.7.1 Cost-plus or full-cost pricing: 1.3 Marginal cost pricing 80 .1.6 Pricing Methods 1.1 Introduction 1.4 Saturation 1.2 Penetration Pricing 1.5.2 Rate of Return pricing 1.7.5.7 The various Pricing methods are: 1.1.6.5 Decline 1.6.

down pricing 1.7.8 Peak Load Pricing 81 .7.7.4 Limit Pricing 1.7.1.7 Mark-up and Mark .5 Going Rate Pricing 1.6 Team pricing 1.7.

On the other hand. Price. 82 . so the right choice of the Price fixation would depend on number of factors and wide variety of conditions prevailing in the market.1 Introduction Managerial decision making consists of a number of procedures at each individual stage of the product manufacturing. Available information: The demand supply gap goes a long way in affecting the choice of the pricing policy determination for as company. if the price is set too low the company may not recover its cost. The company should fix the price reasonably because if the price is set too high. establishing and increasing its market share and maintenance of control and finally profit realization. it may lead it to loose its market share. They are related to the product development depending on the market requirement. is the source of revenue which the firm seeks to maximize. All these concepts play an important role in pricing policy formulation. product manufacturing.1. marketing effect. Price sensitivity: Factors like variability in the consumer behavior consumer income level. Competition level: It is important for a company to offer the product which satisfies the wants and desires of the consumer than the one which sells at the lowest price. Also it is the most important device a firm can use to expand its clientele base. nature of product and after sales service among others affect the price sensitivity. Some of the factors which affect the choice of the pricing policies are: Business Objectives: This relates to rate of growth. product distribution and marketing of the same to realize the company's sales targets. Place & Promotion. One of the important factors which assist the company in realizing its profits through targeted sales is the Pricing Policy. As a result the method of the company's Pricing Policy plays an important role in the Managerial decision making. 4P's: Pricing happens to be one of the core concepts of marketing but a firm must consider it together with Product. in fact. it formulates. Moreover the pricing decisions have to be reviewed and formulated from time to time.

Market structure and promotional policies Degree of integration Business Expansion 83 .3 Factors affecting Pricing Policies The company should determine its pricing policies in such a way that depending on the market trends. Few of the factors are enlisted below: Cost involved Demand elasticity Consumer psychology Price changes Type of product Competitors in the market Product segmentation and positioning. which the company should take into consideration.2 Objectives of Pricing Policies Pricing policies form an integral part of the company's overall business strategy. Achieving a satisfactory rate of return 1. Successfully thwart the competitors. 1. Flexibility in pricing to meet the changes in the market. the company is able to adapt itself to the changes occurring in the market. Some of the important objectives.Pricing hence is more a matter of judgment since every pricing situation is different from each other and as such there is no formula existing for the price fixation. are: Profit maximization for the company's products Relation of long term goals of the company.

Individual Firm's Economic 1.e. Related Commodities: The prices of many manufactured goods depend on prices of raw material particularly on the current prices. The price tends to vary for that product where the supply of a product cannot be in accordance with that of demand. a given change in supply will bring a less sever change in price than where the demand is inelastic. supply manufactured product can be altered according to the demand condition. We should have the knowledge of the demand supply conditions. which in turn will depend on the conditions of production e. Demand elasticity: Where the demand is elastic. So that analysis should be made from the supply side and for the manufactured product the rapid demand change can be matched with the supply adjustments.g. i. whose demands remains constant but where the supply may change continuously. at times the prices may change during the period of economic stability also The first step towards successful price forecasting is the understanding of nature of the commodity and its market. c. b.Complementary and substitution products and Other considerations a. these changes may be a part of general economic fluctuations but. The manufacturer while 84 .4 Price Forecasting A Business unit is constantly faced with the risk of a substantial change in the prices of raw materials as 'well as its products. Change in supply of commodity: When the change in demand for commodity takes place price change will depend on the supply conditions. Influence of supply and demand on the price: There are many products particularly agricultural.

1 Prospective Supply The current value of production of commodity should be compared with the total productive capacity in order to ascertain the extent of excessive productive capacity in the market. There will be a tendency among the firms producing a commodity to curtail the production if price decreases over the cost of production. In case of a severe price competition. Type of product: The price of commodity will depend on the other one specially if it is a by product. 1. specially in the buyer's market. On the other hand. resorting to the price cutting would be frequent and uncertain. Supply . an increase in the supply of crude oil will depend on the oil striking capacity. The existing cost -Price relationship may also determine the prospective supply. In that case supply of that by product will depend on the main product and not on its (By-product's) demand conditions.5 Prospective supply and demand In price forecasting a knowledge about the prospective supply and demand conditions is also essential. besides estimating the supply and demand conditions prevailing at the time of the forecast it is imperative to find the probable demand and supply conditions during the next six months. 1.pricing the product will take only this pricing into consideration.g.Controllable and predictable: It may be possible for the supply of a commodity to change substantially but this change may be unpredictable and beyond control e. In fact. 85 . Competitive situations: In case where a dominant producer leads the market. his probable price policy becomes a significant factor in making the price forecast.5. when the price exceeds the variable cost they would enter the industry once again. An excess of capacity creates a persistent tendency towards over production and acts as a restraint upon a rise in the price.

1. price of all commodities would generally record fluctuations. The general business conditions influence the commodity prices through changes in the demand supply relationships in the market for each individual commodity. As a result. when the future date arrives. So it becomes essential to realize this effect on the commodities in different ways. These variations may take place due to seasonal fluctuation in the price of raw materials also. These fluctuations and their relationships are helpful in price forecasting. Some of the fluctuations observed are: Seasonal price variation: These are common in case of number of commodities notably agricultural and food products such variations would take place in markets having seasonal cycles.5. all the producers plan to produce less. When the prices fall.1.2 Prospective Demand The prospective demand is determined by the nature of need for that commodity and the willingness of the buyer to buy the commodity and their purchasing power. An analysis of a price movement of a commodity over a period of time will reveal certain fluctuation.6 Pricing Methods Before we proceed with the various pricing methods. once they have suffered losses on the account of non-materialization of their expected prices. Cyclical price variation: During the business cycle. is so large that the price falls. This time the cumulative effect of smaller output plan leads to the shortage of products which in turn increases the prices. Many products generally have a characteristic known as 86 . they plan independently to producer more. Also new ones enter the field. Cob -Web Cycle: These cycles occur on account of the cumulative effect of the price expectations of the millions of independent producers. it is essential for us to understand the Life cycle concept. the aggregate output. When farmers expect higher prices in future.

1.’ The product cycle begins with the invention of a new product followed by patent protection and further development to make it saleable. There are high promotional costs involved.6. Generally two kinds of pricing policies are suggested. Consumer satisfaction has to be ensured. Then the competitor enters the field with the imitation and the rival products and the distinctiveness of the new product starts diminishing. 1. as soon the product captures the market. The innovation of new product and its degeneration into a common product is termed as Life Cycle of the Product.2 Penetration Pricing: This pricing policy is generally adopted in case of the availability of close substitutes of the new product in the market. setting up a very high price initially and then a subsequent lowering of prices in a series of reduction. 87 .1 Skimming Pricing: This pricing strategy is adopted when close substitutes of a new product are not available in the market. volume of sales is low and there may be heavy losses. To penetrate in the market. The speed of degeneration differs from product to product. High and sharply rising profits may be witnessed. 1.2 Growth Due to the cumulative effects of introduction stage the product begins to make rapid sales gain." There are five distinct stages in the Life Cycle of the product'.1 Introduction Research or engineering skills lead to the product development.1.6. Pricing Policies in Introductory phase largely depend on the close substitutes available in the market. They are as follows: 1.1.'Perishable distinctiveness. price is gradually raised up. To extract the consumer surplus. This is usually followed by a rapid expansion in its sales as the product gains its market acceptance.6.6. initially a lower price is designed.

but at a diminishing rate.7 The various Pricing methods are: Marginal cost pricing. There is a little additional demand to be stimulated. Going rate pricing. therefore. 88 . Profit margin slips despite rise in the sale. Limit pricing Mark-up and Mark-down pricing. must be properly adjusted over the various phases of the life cycle of the product. Full Cost method pricing. because of the declining number of the potential customers who remain unaware of the product or have taken no action.4 Saturation Sales reach and remain on a plate marked by the level of the replacement demand. Rate of Return pricing. Pricing Policy. The life cycle broadly gives the different stages through which a product passes through.6. During Maturity stage.5 Decline Sales begin to diminish absolutely as the customers begin to tire of the product and the product is gradually edged out by better products or the substitutes. firm should move in the direction of Product improvement and market segmentation. 1.6.6. 1. 1.1.3 Maturity Sales growth continue. There are changes taking place in the price and promotional elasticity of demand as also in the production and distribution cost of the product.

Peak load priding. Skimming pricing. This method ignores the demands -there is no necessary relationship between the costs and what the people pay for the product. Mark-ups may be determined by trade associations either by the means of advisory price-list or by actual list of mark ups distributed to members. Exports pricing. differences in cost base. This may reflect differences in competitive intensity. Ordinarily the profits are kept at a margin sensitive to the market conditions. The percentage differs from industry to industry. Under this method.7. Product mix pricing. 1. 1. labour and overhead) and a predetermined percentage for profit. Also it fails to reflect the forces of the competition adequately.7. Value pricing. differences in rate of turnover and risk. Charm pricing. Discrimination pricing. the price is set to cover the costs (materials. Under this method a firm starts with a rate of 89 .1 Cost-plus or full-cost pricing: This is the most common method used for pricing. Penetration pricing. Usually profit margins under price control are so set as to make it possible for even the least efficient firms to survive.. Dual pricing Administered pricing. Position based pricing.Team pricing. Example: All the stationery products are priced in this way.2 Rate of Return pricing It is a refined variant of full cost pricing.

In other words the company determines the standard cost at standard volume and adds the margins necessary to return a target rate of profit over the long run. Unless the manufacturer's products are in direct competition with each other. this objective is achieved by considering each product in isolation and fixing its price at a level which is calculated to maximize its total contribution. Fixing prices to maintain constant percentage mark up over the cost. the prices are based on total cost comprising fixed and variable cost. the firm seeks to fix its prices so as to maximise its total contribution to fixed cost and profit. This can be broadly grouped under the following: 1. and 3. The firm's prices will be rendered un. This method also helps the manufacturer to develop a far more aggressive pricing policy than the full cost pricing. firm's using marginal cost pricing may lower prices in order retain its market share. With marginal cost pricing. the prices are never rendered up-competitively because of a higher fixed cost are higher than those of the competitor.throat competition. 2.7. 1. Example: Most products are priced I this way for instance Philips audio systems are currently priced based on what the manufacturers estimate the returns to be. In a period of business recession. the fixed costs are ignored and prices determined on the basis of marginal cost. 90 . With marginal cost pricing. and these are controllable in short run marginal cost more accurately reflects future as distinct from present cost level and relationship.competitive by high variable cost. Fixing prices to maintain a constant return on the investment capital.3 Marginal cost pricing Both under the full cost pricing and rate of return pricing.return they consider satisfactory and then set a price that allows them to earn that return when there plant utilization is at some standard rat. Under marginal cost pricing. This may lead other firms to reduce their prices leading to cut. The price cut may be up to such an extent that the fixed cost is not covered and thus a fair return on the investment is not obtained. The firm uses only those costs that are directly attributable to the output of a specific product. Fixing prices to maintain the profit as constant percentage of sale.

Traditional theory was concerned only with actual entry of the firms and not the potential entry. i. shape and level of LAC. market elasticity of demand. The level at which limit will be set depends on the estimation of the costs of the potential entrant. they did not charge the price which would maximize their revenue. Bain argued that in the long run because of the existence of barrier to entry the price do not fall to the level of LAC. size of the market and number of firms in the industry. the highest price that the established firms believe they can charge without inducing entry. 91 . 1.4 Limit Pricing Bain explained why firms over a long period of time were keeping their price at a level of demand where the elasticity was below unity..e.7. that is. This behaviour can be explained by assuming that there are barriers to entry and the existing firms do not set the monopoly price but the limit price.Example: Nestle Tea is priced based on this method.

92 . The firm adjusts its own price policy to general pricing structure in the industry. hence every manufacturer wanting to enter this segment has to be Nescafe's line.7. Where price leadership is well established.5 Going Rate Pricing Here instead of cost. charging according to what competitors are charging. Many cases of this type are situations of price leadership. the emphasis is on the market. This may seem to be a rational pricing policy when the costs are difficult to measure.1. is the only safe policy. Example: Since Nescafe is the market leader in the instant coffee segment. It must be noted that this pricing is not quiet the same as accepting the price impersonally set by a near perfect market. Whether it would seem that the firm has some power to set its own price and could be a price maker if it chooses to face all the consequences.

1. Example: During Diwali as the day approaches the firecracker prices increase and on the diwali afternoon the prices are significantly marked down. called peak-load price is charged during the peak-load period and a lower price is charged during the off-peak period. the demand falls.down pricing When a retailer follows the practice of fixing the price over the one at which he has obtained the product. 93 . 1. 1. Example: Several retailers give free items with certain items. "marks down" the product price. restaurants face peak demand and during day time. Allen Solly & Van Heusen are examples.g.e. A higher price. Some items may be used as promotional items which are priced and advertised with prime purpose of attracting the customers and other may be intended to make up for the low margin obtained on the promotional items. the retailer pulls the price down i. During evening hours.7 Mark-up and Mark . for instance with a Van Heusen Blazer you can choose Van Heusen tie for free.7.7. Pantaloon. a double pricing system is adopted. In case certain goods are not sold within a reasonable time. the companies sometimes assign special roles to the various products they sell. such that it covers the cost and leaves a reasonable profit margin he is said to follow the mark-up policy.8 Peak Load Pricing There are certain perishable products which are being demanded in varying quantities at different point of time. E.6 Team pricing According to this method.7. For these kinds of products.

Under marginal cost pricing.End Chapter quizzes : 1. which cost is ignored (a) Variable Cost (b) Fixed Cost (c) Marginal cost (d) Opportunity Cost 2 Cost.Plus pricing methods ignores (a) Labor cost (b) Percentage for profit (c) Demand for the product (d) Supply price of Raw materials 3. Setting up higher prices initially to extract the consumer surplus is known as (a) Penetration Pricing (b) Limit Pricing (c) Skimming Pricing (d) Team Pricing 4. In which Pricing method. Increase in Sales along with gain in profits is witnessed during (a) Introductory Stage 94 . the firm adjusts its own price policy to general pricing structure in the industry: (a) Team Pricing (b) Going Rate Pricing (c) Penetration Pricing (d) Mark-up Pricing 5.

(d) the product has no close substitutes. Peak Load pricing strategy involves fixing higher price when (a) The product is launched in the market. Which factor affects the determination of Price for a product (a) Demand elasticity (b) Consumer psychology ( c) Price changes (d) all of the above 9. it is known as (a) Adjustment pricing (b) Administered pricing 95 . the retailer pulls the price down. (b) the demand is reaching at its highest point. (c) The product is in decline stage.(b) Growth Stage (c) Maturity stage (d) Decline Stage 6. 7. the company determines the standard cost at standard volume and adds the margins necessary to return a target rate of profit over the long run: (a) Rate of Return pricing (b) Cost plus Pricing (c) Marginal cost Pricing (d) Mark up Pricing 8. In this Pricing strategy. In case certain goods are not sold within a reasonable time.

(c) Mark-down pricing (d) Mark-up pricing 10. This pricing strategy acts as a barrier to entry to new firms (a) Limit Pricing (b) Administered Pricing (c) Peak –Load Pricing (d) Skimming Pricing 96 .

Chapter-VII Objectives of the Firm Contents: 1.2 Baumol’s Sales Revenue Maximization Theory 1.4 Williamson Model of Managerial Discretion 1.3 Marris’s model of the managerial enterprise 1.1 Introduction 1.5 Satisficing Behavior Theory of the Firm 97 .

growth and diversification and managers may aim at Salary. In this wake several objectives were identified and proved to be true in real business practices. Firms aim to maximize Sales Revenue. Profit constraint is exogenously determined by the demand and expectations of the shareholders. Promotion. 1. A Sales Revenue Maximizing firm. banks and other financial institutions. produces a greater output than a Profit Maximizing Firm and sells at a price lower than the profit maximizer. If the profit constraint is operative the sales revenue maximizer will operate in the area where price elasticity is greater than unity. 98 .1 Introduction Traditional theories of the firm advocated that profit maximization is the goal of the firms. Job Security and Career. Perks.1. net worth. This development has led to the separation of ownership and management.2 Baumol’s Sales Revenue Maximisation Theory Manager’s rewards are more closely linked to Sales rather than Profits. in general. Further with this division the utility functions of both parties faced confrontation in certain areas and profit maximization did not remain the single objective of the firm. This objective was based on the single entity of ownership and management. With the course of development simple business activities turned into complex organizations dealing with specialized and classified activities. but subject to a Profit Constraint. The maximum sales revenue will be where e = 1 (and hence MR = 0) and will be earned only if the profit constraint is not operative. Coordination and compromise between organizational parameters of concern and their managerial counterparts is necessary. Organization could aim at profits.

QΠ QS QRS Π

= = = =

Profit Maximizing Output Sales Maximizing Output Constrained Sales Maximizing Output Profit Curve

1.3 Marris’s model of the managerial enterprise
The growth of an organization depends on the separate but interdependent Utility functions of both owners and managers Utility of Owners → Profits, market Share, Public Esteem etc. Utility of Managers → Salaries, Status, Job Security etc. Long Term goal of an organization is assumed to be ‚Balanced Rate of Growth‛

99

Job Security is important for Managers which imposes a constraint on the diversification and growth of the firm On the other hand, there is a trade off between retained profits (reinvested for growth) and profits declared as dividends.

1.4 Williamson Model of Managerial Discretion
Managers have discretion in pursuing policies which maximize their own utility rather than attempting the maximization of profits which maximizes the utility of owners. This is attained by the expense preference such as staff expenditure on emoluments, funds available for discretionary investment. It gives managers a positive satisfaction because these expenditures are a source of security and reflect the power, status, prestige and professional achievement of managers. It emphasizes the ability of managers to maximize their own Utility function (Owner’s Utility acts as a constraint).

100

b

c

U m f S, M, I d
Where

S→

staff expenditure

M → managerial emoluments
Id→
discretionary investment

An important aspect is the non – pecuniary components of the Managers’ Utility – reflected in Emoluments and Managerial Slack in the form of expense accounts, luxurious offices etc. Also important are the funds available to managers for ‚Discretionary Investment‛

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Employees b.. profit goal etc. Maximizing behavior may be replaced by ‚Satisficing‛. i. decision makers seek an acceptable or satisfactory outcome.1. inventory goal. sales goal. People possess limited cognitive ability and so can exercise only ‚Bounded Rationality‛ when making decisions in complex uncertain situations. Shareholders d. 102 . Decisions are taken in conditions of uncertainty and ignorance.e.5 Satisficing Behaviour Theory of the Firm Behavioral economists argue that any corporation is composed of various groups a. setting minimum acceptable levels of achievement. Customers Each group has different goals such as production goal. Rather than an exhaustive search for the best or ideal solution. Managers c.

2 The equilibrium of the traditional firm is where (a) MR > MC (b) MR = MC (c) MR < MC (d) MR ≠ MC Q.1.3 Sales revenue maximizer is successful when a) Profit constraint is too high b) Profit constraint is non operative c) Profit constraint is zero d) Profit constraint is too low Q. Traditionally the objective of the firm was a) Sales maximization b) Profit maximization c) Barriers to new entrants d) Maximization of managers utility function Q.5 According to Marris the utility functions of manager and owner are a) Always same b) Always separate 103 .End Chapter quizzes : Q.4 Which of the statements is false about sales revenue maximisation a) Output is more than profit maximiser b) Prices are lower than profit maximizer c) Sales revenue is maximum where elasticity = 1 d) Prices are higher than profit maximizer Q.

7 The relationship between discretionary investment and managers utility maximization is a) Positively high b) Positively low c) Negatively high d) Negatively low Q.6 Maximisation of balanced rate of growth means a) (a) g < gd < gc b) (b) g gd gc c) (c) g > gd > gc d) (d) g a gd a gc 6 6 Q.9 Satisficing behavior theory states that a) Firm is a coalition of harmonized interest groups b) Firm is a coalition of conflicting interest groups c) Firm is not a coalition of interest groups d) Firm is a single goal entity Q.c) Interdependent d) Separate but interdependent Q.8 Owners utility maximization is determined by a) Revenue maximization b) Profit maximization c) Investment maximization d) Prices maximization Q.10 Satisficing behavior theory focuses on 104 .

a) Decision making process of small single product firms under imperfect market conditions b) Decision making process of large multiproduct firms under imperfect market conditions c) Decision making process of large multiproduct firms under perfect market conditions d) Decision making process of small single product firms under perfect market conditions 105 .

3.1 Structure 1.4.3.3.6 Long Run Equilibrium 1.2.1.4 Oligopoly Market 1.3.3.6 Price Stability with a Kinked Demand Curve 106 .Chapter-VIII Market Structure Contents: 1.5 Sweezey’s Model of Kinked Demand Curve 1.3.1 Why do Monopolies exist? 1.2 Mutual Interdependence 1.1 Price Output Determination Under Perfect Competition 1.3.5 Perfect Competition and the LR Supply Curve 1.3.2 Equilibrium in Short Run 1.3 Long Run Equilibrium 1.3.3.3.3 Monopolistic Competition 1.1.1 Structure 1.2 Meaning of market 1.3.3.1 Perfect Competition 1.4.3.3 Perfect Competition in the Long Run 1.2.3.3.3.3.4.4 Explicit Collusion – Cartels 1.3.1.3.1.2 Monopoly Market 1.4 Perfect Competition and Plant Size 1.2.4.3.3 Classification of Market Structure 1.3.3.2 Short Run Equilibrium 1.3.4.4 Efficiency under Monopolistic Competition 1.3.3 Price Discrimination 1.3.3.2 Equilibrium of the Firm 1.4.3 Collusion is difficult if 1.1.1 Introduction 1.1.

1.3.4.7 Tacit Collusion: Price Leadership 1.3.4.7.1 Dominant Firm Price Leadership 1.3.4.7.2 Barometric Price Leadership

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1.1 Introduction
Maximization of output or optimization of cost or optimization of resource allocation is only one aspect of the profit maximizing behavior of the firm. Another and equally important aspect of Profit Maximization is to find the price from the set of prices revealed by the demand schedule that is in agreement with the profit maximization objective of the firm.

The profit maximizing price does not necessarily coincide with minimum cost of production. Besides, the level of profit-maximizing price also depends on the nature of competition prevailing in the market. Therefore, while determining the price for its product, a firm has to take into account the degree of competition.

1.2 Meaning of market
A market is a group of people and firms which are in contact with one another for the purpose of buying and selling some product. It is not necessary that every member of the market be in contact with each other. Market structure refers to the number and size distribution of buyers and sellers in the market for a good or service. The market structure for a product not includes firms and individuals currently engaged in Buying and selling but also the potential entrants.

1.3 Classification of Market Structure
On the basis of the degree of competition, Markets are traditionally classified as: Perfect Competition Imperfect Competition

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1.3.1 Perfect Competition
Characteristics of Perfect Competition: Large number of small sellers and buyers: The number of buyer as well as seller is so large that the share of each buyer in total market demand and the share of each seller in total market supply is insignificant and hence no individual buyer or seller can influence the market price. Homogeneous products: Products supplied by the firms are identical and are regarded as perfect substitute to each other. Perfect mobility of factors of production: For a market to be perfectly competitive, the factors of production must be in the position of moving freely into or out of the industry and from one firm to another. Free entry and free exit of the firms: No legal or otherwise restrictions on the entry and exit of the firms. Perfect dissemination of the information: to the buyers and sellers. No government intervention and Absence of collusion. Examples: Agricultural commodities and Stock market

1.3.1.1 Price Output Determination Under Perfect Competition
In a perfectly competitive market, where large number of sellers selling homogeneous product, no single seller can influence the market price. Similarly, each buyer has too small share in total market demand to influence the price. Market Price is therefore determined by the market demand and market supply for the industry and is given for each individual firm and for each buyer. Thus, a seller in a perfectly competitive market is a ‘price-taker’ not a ‘price maker’. This means the individual firm will face a horizontal demand curve. It will be horizontal at the market price, established by supply and demand on the market as a whole.

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2 Equilibrium in Short Run A Short run is a period in which firms can neither change their size nor quit. 4.1(a) and adjustment of output by the firms to the market price and firm’s equilibrium are shown in Fig.1. Given the Price OP. Firms can increase (or decrease) the supply of the product by increasing (or decreasing) the variable inputs. nor can new firms enter the industry. The process of firm’s output determination and its equilibrium are shown in the Fig 4.1. Fig. This price is fixed for all the firms in the industry. 4. Since price is fixed at OP. firm’s average revenue AR= OP and also if AR is given.3.1. firm’s cost curves are required to be studied. The determination of market price in the short run is illustrated in the Fig. an individual firm can produce and sell any quantity at this price.2(b).3 Perfect Competition in the Long Run 110 . MR=AR. supply curve is elastic in short run. Therefore.3.2(b). Firm’s upward sloping MC curve intersects MR 1.1(a) shows the price determination for the industry by the demand curve D and supply curve S at the price OP. 4. Profit maximizing condition for a firm is MR=MC. To determine the profit maximizing output.

thereby reducing the profits of each firm. entry and exit become possible. the market supply curve must shift to the right.In the long run. As a result the total market supply will increase and. This must continue until there are no economic profits. Here is a diagram of the final. The profits are an incentive to enter. It drives down the price on the market. Now the firms are making profits. therefore. But if there are still economic profits being made. more firms will enter. Firms will choose to enter the industry if the existing firms in the industry are making economic profits. Why? Because potential firms can buy fixed inputs and become actual firms. long-run equilibrium under perfect competition: 111 . but smaller profits than before. And existing firms can sell off or stop renting their fixed inputs and go out of business. What has to be true when profits equal zero? TR = TC p*×q = q×ATC p* = ATC So entry finally stops when firms are producing at their lowest average total cost.

causing a left shift of market supply. Firms will exit the market. so that no resources are being wasted in its production. Long Run competitive equilibrium consists of two conditions: • p* = MC • p* = minimum ATC The first condition is caused purely by profit maximization. is caused by entry and exit in the LR. given the profits that many firms earn in reality. causing a reduction of losses. and to that extent 112 . They will only buy the good if the value to them is greater than the price. Thus. These two conditions have important efficiency implications. This continues until losses are zero. Marginal-cost pricing (p*= MC) means that consumers who buy the product face the true opportunity cost of their choices. What could explain the difference between theory and reality? (1) Reality may differ from the perfectly competitive model. however. and it’s true in both the SR and the LR. Minimum average cost pricing (p* = minimum ATC) means that the product is being made at the lowest average cost possible. which represents the value of the resources that went into making the product. causing a rise in market price. The second condition.What if typical firm is making losses? Then the reverse process will take place. The conclusion that firms make zero profit in the LR may seem odd. It won’t necessarily be true in the SR.

(2) the profits we generally hear about are accounting profits. not just the SRATC.economic profits can be made.5 Perfect Competition and the LR Supply Curve As we have seen. Finally. we’d need more information about their implicit costs. But also. We want to use this information to derive a LR supply curve. Start with an initial (short-run) supply and 113 . 1. Now we’re going to use the same basic technique to trace out the LR supply curve. (3) we may be observing short-run profits. If you look at three different demand curves.4 Perfect Competition and Plant Size It turns out that the perfectly competitive firm produces not just at the minimum of its SRATC. this has no effect on the supply curve. A LR supply curve. changes in demand in a PC market create profits and losses for firms. We can do this by changing demand. but unlike the SR supply curve. it shows the quantity supplied after all long-term changes. and then mark the equilibrium point on each one.3. In the basic supply-and-demand framework. shows the total quantity that will be supplied in a market at different prices. not economic profits.1. So by the same arguments as before. you can connect the equilibrium points to find where the supply curve must be.1. those profits will attract entrants into the industry in the usual fashion. firms enter for profits and leave to escape losses. 1. and then finding the equilibrium points after allowing LR adjustments. but in the LR. The price must be at the bottom of the LRATC. change its input combination to take advantage of lower average costs. not long-run profits. but also its LRATC. In the SR. including entry and exit. including entry and exit of firms. in the LR.3. have been taken into account. profits will eventually dissipate to zero. just like a SR supply curve. To find out whether these ‚profitable‛ firms are really making economic profits. Why? Because any PC firm not at its minimum LRATC will. If firms are able to make positive profits by moving outward on the LRATC curve. leading to supply curve shifts. notice that we can use demand curves and equilibrium points to ‚trace out‛ the supply curve.

but potential firms as well. Once profits are back to zero again. In the short-run.demand. and then connect the dots to get the long-run supply curve. you’re in a new long-run equilibrium. since the LR supply curve takes into account the quantity responses of all firms. profits are zero. price rises a lot. So eventually supply shifts to the right as well. Now. Why? 114 . But the higher price creates profits. let demand shift to the right. Do this all again to find a third long run equilibrium. Notice that the LR supply curve is flatter than the SR supply curve. The interpretation of the LR supply curve is pretty much the same as the SR supply curve: it shows the willingness of producers to sell at each price. and profits attract entry in the long run. This must be so. If we are in long-run equilibrium. But the LR supply curve measures this willingness in the broadest sense. including all firms that might potentially supply this product. pushing price back down (though possibly not as low as it was before). It is even possible that the LR supply curve can be downward-sloping. not just the ones currently in the market.

Consider what must happen if entry and exit do not affect the cost curves of individual firms. If the industry in question has a large impact on the markets for its inputs. then the LR supply curve may slope upward or downward. This is most likely to be the case when the industry in question constitutes only a small portion of the demand for its inputs. They face a perfectly elastic demand curve Market prices change only if demand and supply change 1. the LR supply curve is downward-sloping.6 Long Run Equilibrium 115 . On the other hand. which is exactly where it was before. so that a firm’s cost curves rise as a result of the entry of new firms. So in this case. if entry into the industry creates a greater demand for inputs that allows those inputs to be produced through mass production techniques (i. the market price must have returned to the lowest point on the LRATC. In this case. then the market price after adjustment will be higher than it was before.1.3. which results from external economies. If the effect of entry into the industry is to bid up the price of inputs. then the industry can benefit from lower costs of production. at lower average cost). In this case. We call this a constant--cost industry. which results from external diseconomies. the LR supply curve must be horizontal. this is called an increasing-cost industry. the LR supply curve must be upward-sloping as in the picture above.e. Then after all adjustment to a change in demand has taken place.. This is called a decreasing-cost industry.

7 Supply Curve under Perfect Competition Short Run Firm Supply – MC curve is the SR supply curve so long as P > AVC Long Run firm Supply – LMC curve is the LR supply curve so long as P > ATC In the LR.1 Why do Monopolies exist? Barriers to Entry a) Control of scarce resources or input b) Economies of scale natural monopolies 116 . the firm must cover all necessary costs of production and earn a normal profit 1.2.1.3. Only one firm produces the product Low cross elasticity of demand between the monopolist’s product and any other product. 1. P = MC = AC = MR 1. The firm has substantial control over the price.3. if product is differentiated and if there are no threats of new firms entering the same business.2 Monopoly Market A monopoly market is one in which there is only one seller of a product having no close substitutes. a monopoly firm can manage to earn excessive profits over a long period. Substantial barriers to entry that prevents competition from entering the industry. that is no close substitute products.Normal profit is necessary to attract and maintain capital investment Marginal Analysis MR = MC => Normal Profits Output will settle at the point where. Further.3.

2 Equilibrium of the Firm Monopoly firms’ ability to set price is limited by the demand elasticity Supernormal profits may be earned in the Long Run since there is no entry P > competitive price Q < competitive quantity The monopolist will always try to operate on the elastic portion of the demand curve 1.2.3.3 Price Discrimination 117 .c) Technological superiority d) Govt.2. created barriers e) Patents 1.3.

3. Firms in such a market structure have some control over price. Second degree of price discrimination – Charging more than two different prices from each customer’s block Third degree of price discrimination – Charging different prices from each consumer.Price discrimination means selling the same or slightly differentiated product to different sections of consumers at different prices. trade mark. shape.3.3 Monopolistic Competition It implies a market structure with a large number of firms selling differentiated products. Two brands of shampoos may just be identical but perceived by customers as different on some fancy dimension like freshness. The differentiation may be real like brand name. 1. credit terms etc. packaging. The necessary conditions for price discrimination are: Different markets must be separable The elasticity of demand must be different in different markets There must be imperfect competition in the market Profit maximizing output is much larger than the quantity demanded in a single market Price discrimination can be categorized into three types: First degree of price discrimination – Charging two different prices in different markets having demand curves with different elasticities.1 Structure 118 . or is perceived so by the customers like product image.3. design. The demand curve becomes the marginal revenue curve of the seller. colour . 1.

3.3.2 Short Run Equilibrium The firm under Monopolistic Competition acts just as a monopolist in the Short Run 1.3. ‚Free‛ entry and exit. Full and symmetric information.Several firms in the market.3 Long Run Equilibrium Free Entry and Exit drive Long Run Profits to the level of Normal profits Firm demand will be tangent to its LR Average Cost Curve 119 . Consumers have ‚brand preference‛ but can be induced to change brands Advertising often plays a big role in monopolistically competitive markets 1. Producing differentiated products.3.

3.4 Oligopoly Market It is a market structure in which a small number of firms account for the whole industry's output.4 Efficiency under Monopolistic Competition Excess Capacity under Monopolistic Competition Compared to perfect competition: less will be sold at a higher price firms will not be producing at the least-cost point (i. 1.3. The product may or may not be differentiated.3. min AC) => firms have excess capacity On the other hand it is often argued that these wastes are insignificant and perhaps well compensated to the consumer by the greater variety of products to choose. For example only 5 or 6 firms in India constitute 100% of the integrated steel industry's output.e. All of them market almost identical products.1. On the other hand. passenger car industry with only 120 .

No generalization can be made about profitability scenarios.3 Collusion is difficult if There are many firms in the industry The product is not standardized Demand and cost conditions are changing rapidly There are no barriers to entry Firms have surplus capacity 121 .2 Mutual Interdependence The essence of an oligopolistic industry is the need for each firm to consider how its own actions affect the decisions of its relatively few competitors To predict the outcome in such a market. Homogenous product → Pure Oligopoly Entry is often limited by legal restrictions (e. Oligopoly is characterized by vigorous competition where firms manipulate both prices and volumes in an attempt to outsmart their rivals.three firms is characterized by marked differentiation in products The nature of products is such that very often one finds entry of new firms difficult.4.1 Structure In an oligopoly there are very few sellers of the good. economists need to model the interaction between firms.3. automobiles) or homogeneous (e. 1.g. Oligopoly may be characterized by Collusion Cartels Or Non .g.4. banking in most of the world) by a very large minimum efficient scale by strategic behavior. 1. The product may be differentiated among the sellers (e.4.3. petrol).g.3.Cooperation 1.

4.3.3.4.4.6 Price Stability with a Kinked Demand Curve For any MC between a and b. lowest possible equilibrium price that could prevail is the competitive price and output 1. the profit maximizing price and output remain unchanged. 122 . rivals are less likely to react. demand in response to a price reduction is likely to be relatively inelastic For a price rise.4 Explicit Collusion – Cartels A Cartel is a formal organization of sellers that seeks to restrict competition Maximum possible profits that can accrue as a result of a cartel is the amount that would prevail under Monopoly If the firms compete vigorously on the basis of price.3. so demand may be relatively elastic 1.5 Sweezey’s Model of Kinked Demand Curve Explains Price Rigidity under Oligopoly Starts with a predetermined Price – Output Demand Curve is kinked at current price: The firm may expect rivals to respond if it reduces its price – so.1.

1.1 Dominant Firm Price Leadership Dominant Firm sets the price for the industry but lets followers sell all they want at that price The Dominant firm will provide the rest of the market demand Followers.4. accept the price as given 1.3.3.4.7. like in Perfect Competition.7.7 Tacit Collusion : Price Leadership One firm sets the price and others follow three types of leaders: Dominant firm price leadership Barometric Price Leadership Price Leadership by a low – cost firm 1.3.2 Barometric Price Leadership 123 .4.

There is no one dominant firm Price changes are in response to changes in some underlying market conditions. obvious to all the firms The critical requirement for being a leader is the ability to interpret market conditions and propose price changes that other firms are willing to follow 124 .

Sweezey’s Model of Kinked Demand Curve determines (a) Price Rigidity in Oligopoly market (b) Price discrimination in Monopoly market 125 .2 Which is not the characteristic of a perfect market (a) Large number of small buyers and sellers (b) Restricted entry and exit (c) Homogeneous Products (d) Free mobility of factors of production Q.3. Banking Sector is an example of (a) Perfect Market (b) Monopolistic Market (c) Oligopoly Market (d) Monopoly Market Q. (b) MR>MC (c) MR<MC (d) MC = AC Q.End Chapter quizzes Q.1.4. In a Monopoly market. Barriers to Entry may be existing due to (a) Control of scarce resources or input (b) Technological superiority (c) Patents (d) All of the above Q.5. Profit maximizing condition for a firm is (a) MR=MC.

(b) Elasticity of demand is same in different markets. Q.9. in long run.8. A formal organization of sellers that seeks to restrict competition is known as (a) Sellers Association (b) Cartel (c) Trade Union (d) Trade Association Q. Which condition is false in case of a monopoly firm to earn excessive profits over a long period (a) Only one firm produces the product (b) Low cross elasticity of demand between the monopolist’s product and any other product. ( c) Market is imperfect. firm earns (a) Abnormal Profits (b) Supernormal Profits (c) Normal Profits (d) Economic Profits 126 .6.(c) Profit maximizing Output in Oligopoly market (d) Profit maximizing Output in Monopoly market Q. that is no close substitute products. (c) Free entry of new firms (d) Substantial barriers to entry that prevents competition from entering the industry. Q. Price Discrimination under Monopoly is not possible if (a) Different markets are separable. In a Perfectly competitive market.7. (d) Elasticity of demand is different in different markets.

Q.10. Demand curve of a firm in perfect competitive market is (a) Upward sloping (b) Downward sloping (c) Horizontal (d) Vertical 127 .

4(a ). 3(a ). 6(c ). 9(b ). 9(b ). 5(a ). 8(d ). 5(a ). 9(c ). 4(b ). 5(a ). 4(d ). 2(a ). 10(a ) Chapter –VII Objectives of the firm 1 (b ). 7(d ). 3(b ). 7(a ). 9(a ). 8(b ). 7(c ). 6(a ). 7(a ). 5(d ). 9(c ). 10(d ) Chapter –II Business Forecasting 1 (c ). 3(c ). 6(d ). 6(d ). 2(b ). 2(c ). 9(b ). 10(b ) Chapter –IV Cost Analysis 1 (b ). 10(b ) Chapter –VI Pricing Policy of the Firm 1 (b ). 2(a ). 3(d ). 6(b ). 5(d ). 2(a ). 10(c ) 128 . 10(c ) Chapter –III Demand Analysis 1 (b ). 7(a ). 8(b ). 4(b ). 6(b ). 2(b ). 8(b ). 5(a ). 10(a ) Chapter –V Production Analysis 1 (c ). 5(c ). 8(a ). 3(c ). 5(b ).Key to End Chapter Quizzes Chapter –I Managerial Decision Making 1 (b ). 7(c ). 4(c ). 8(d ). 6(b ). 2(a ). 3(a ). 7(b ). 2(b ). 3(b ). 7(a ). 9(c ). 4(d ). 9(c ). 8(b ). 4(b ). 3(b ). 8(b ). 10(b ) Chapter –VIII Market Structure 1 (c ). 4(d ). 6(b ).

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