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INTRODUCTION TO MANAGERIAL ECONOMICS
NATURE OF MANAGERAL ECONOMICS
MANAGERIAL Economics and Business economics are the two terms, which, at times have been used interchangeably. Of late, however, the term Managerial Economics has become more popular and seems to displace progressively the term Business Economics. Decision-making and Forward Planning
The prime function of a management executive in a business organization is decision-making and forward planning. Decision-making means the process of selecting one action from two or more alternative courses of action whereas forward planning means establishing plans for the future. The question of choice arises because resources such as capital, land, labour and management are limited and can be employed in alternative uses. The decision-making function thus becomes one of making choices or decisions that will provide the most efficient means of attaining a desired end, say, profit maximization. Once decision is made about the particular goal to be achieved, plans as to production, pricing, capital, raw materials, labour, etc., are prepared. Forward planning thus goes hand in hand with decision-making. A significant characteristic of the conditions, in which business organizations work and take decisions, is uncertainty. And this fact of uncertainty not only makes the function of decision-making and forward planning complicated but adds a different dimension to it. If knowledge of the future were perfect, plans could be formulated without error and hence without any need for subsequent revision. In the real world, however, the business manager rarely has complete information and the estimates about future predicted as best as possible. As plans are implemented over time, more facts become known so that in their light, plans may have to be revised, and a different course of action adopted. Managers are thus engaged in a continuous process of decision-making through an uncertain future and the overall problem confronting them is one of adjusting to uncertainty. In fulfilling the function of decision-making in an uncertainty framework, economic theory can be pressed into service with considerable advantage. Economic theory deals with a number of concepts and principles relating, for example, to profit, demand, cost, pricing production, competition, business cycles, national income, etc., which aided by allied disciplines like Accounting. Statistics and Mathematics can be used to solve or at least throw some light upon the problems of business management. The way economic analysis can be used towards solving business problems. Constitutes the subject-matte of Managerial Economics. Definition: According to McNair and Meriam, Managerial Economics consists of the use of economic modes of thought to analyse business situation Spencer and Siegelman have defined Managerial Economics as “the integration of economic theory with business practice for the purpose of facilitating decision-making and forward planning by management”. We may, therefore define Managerial Economics as the discipline which deals with the application of economic theory to business management. Managerial 1/87 9/18/2007 1:31 PM
DHARMENDRA MISHRA Economics thus lies on the borderline between economics and business management and serves as abridge between economics and business management and serves as a bridge between the two disciplines. (See Chart 1) Chart 1 – Economics, Business Management and Managerial Economics.
Economics -Theory and Methodology
Business Management -Decision Problems Managerial Economics -Application of Economics to solving business problems
To business problems
Aspects of Application The application of economics to business management or the integration of economic theory with business practice, as Spencer and Siegelman have put it, has the following aspects: 1. Reconciling traditional theoretical concepts of economics in relation to the actual business behavior and conditions. In economic theory, the technique of analysis is one of model building whereby certain assumptions are made and on that basis, conclusions as to the behavior of the firms are drown. The assumptions, however, make the theory of the firm unrealistic since it fails to provide a satisfactory explanation of that what the firms actually do. Hence the need to reconcile the theoretical principles based on simplified assumptions with actual business practice and develops appropriate extensions and reformulation of economic theory, if necessary. Estimating economic relationships, viz., measurement of various types of elasticities of demand such as price elasticity, income elasticity, cross-elasticity,
DHARMENDRA MISHRA promotional elasticity, cost-output relationships, etc. the estimates of these economic relation-ships are to be used for purposes of forecasting. 3. Predicting relevant economic quantities, eg., profit, demand, production, costs, pricing, capital, etc., in numerical terms together with their probabilities. As the business manager has to work in an environment of uncertainty, future is to be predicted so that in the light of the predicted estimates, decision-making and forward planning may be possible. Using economic quantities in decision-making and forward planning, that is, formulating business policies and, on that basis, establishing business plans for the future pertaining to profit, prices, costs, capital, etc. The nature of economic forecasting is such that it indicates the degree of probability of various possible outcomes, i.e. losses or gains as a result of following each one of the strategies available. Hence, before a business manager there exists a quantified picture indicating the number o courses open, their possible outcomes and the quantified probability of each outcome. Keeping this picture in view, he decides about the strategy to be chosen. Understanding significant external forces constituting the environment in which the business is operating and to which it must adjust, e.g., business cycles, fluctuations in national income and government policies pertaining to public finance, fiscal policy and taxation, international economics and foreign trade, monetary economics, labour relations, anti-monopoly measures, industrial licensing, price controls, etc. The business manager has to appraise the relevance and impact of these external forces in relation to the particular business unit and its business policies.
Chief Characteristics It would be useful to point out certain chief characteristics of Managerial Economics, inasmuch it’s they throw further light on the nature of the subject matter and help in a clearer understanding thereof. 1 Managerial Economics micro-economic in character. 2 Managerial Economics largely uses that body of economic concepts and principles, which is known as ‘Theory of the firm’ or ‘Economics of the firm’. In addition, it also seeks to apply Profit Theory, which forms part of Distribution Theories in Economics. 3 Managerial Economics is pragmatic. It avoids difficult abstract issues of economic theory but involves complications ignored in economic theory to face the overall situation in which decisions are made. Economic theory appropriately ignores the variety of backgrounds and training found in individual firms but Managerial Economics considers the particular environment of decision-making. 4 Managerial Economics belongs to normative economics rather than positive economics (also sometimes known as descriptive economics). In other words, it is prescriptive rather than descriptive. The main body of economic theory confines itself to descriptive hypothesis, attempting to generalize about the relations among different
DHARMENDRA MISHRA variables without judgment about what is desirable or undesirable. For instance, the law of demand states that as price increases. Demand goes down or vice-versa but this statement does not tell whether the outcome is good or bad. Managerial Economics, however, is concerned with what decisions ought to be made and hence involves value judgments. Production and Supply Analysis Production analysis is narrower in scope than cost analysis. Production analysis frequently proceeds in physical terms while cost analysis proceeds in monetary terms. Production analysis mainly deals with different production functions and their managerial uses. Supply analysis deals with various aspects of supply of a commodity. Certain important aspects of supply analysis are supply schedule, curves and function, law of supply and its limitations. Elasticity of supply and Factors influencing supply. Pricing Decisions, Policies and Practices Pricing is a very important area of Managerial Economics. In fact, price is the ness of the revenue of a firm and as such the success of a business firm largely depends on the correctness of the pries decisions taken by it. The important aspects alt with under this area is: Price Determination in various Market Forms, Pricing methods, Differential Pricing, Product-line Pricing and Price Forecasting. Profit Management Business firms are generally organized for the purpose of making profits and, in long run, profits provide the chief measure of success. In this connection, an important point worth considering is the element of uncertainty exiting about profits because of variations in costs and revenues which, in turn, are caused by torso both internal and external to the firm. If knowledge about the future were fact, profit analysis would have been a very easy task. However, in a world of certainty, expectations are not always realized so that profit planning and measurement constitute the difficult are Of Managerial Economics. The important acts covered under this area are: Nature and Measurement of Profit. Profit iciest and Techniques of Profit Planning like Break-Even Analysis. Capital Management Of the various types and classes of business problems, the most complex and able some for the business manager are likely to be those relating to the firm’s investments. Relatively large sums are involved, and the problems are so complex that their disposal not only requires considerable time and labour but is a term for top-level decision. Briefly, capital management implies planning and trolls of capital expenditure. The main topics dealt with are: Cost of Capital. Rate return and Selection of Project. The various aspects outlined above represent the major uncertainties which a ness firm has to reckon with, viz., demand uncertainty, cost uncertainty, price certainty, profit 4/87 9/18/2007 1:31 PM
Microeconomics has been defined as that branch where the unit of study is an individual or a firm. The chief contribution of macro-economics is in the area of forecasting. therefore. Mathematics and Accounting deserve special mention. marginal cost. Price elasticity of demand Income elasticity of demand Opportunity cost The multiplier Propensity to consume Marginal revenue product Speculative motive Production function Balanced growth Liquidity preference. 10. and capital uncertainty. 4.) Is the main source of concepts and analytical tools for managerial economics. A survey in the U.DHARMENDRA MISHRA uncertainty. conclude the subject-matter of Managerial Economic consists of applying economic cripples and concepts towards adjusting with various uncertainties faced by a ness firm. individual firm forecasts depend on general business forecasts. To illustrate various micro-economic concepts such as elasticity of demand. 5/87 9/18/2007 1:31 PM . are all of great significance to managerial economics. 7. In this connection. statistics. Economics. the short and the long runs. is aggregate in character and has the entire economy as a unit of study. has shown that business economists have found the following economic concepts quite useful and of frequent application: 1. various market forms. MANAGERIAL ECONOMICS AND OTHER SUBJECTS Yet another useful method of throwing light upon the nature and scope of managerial Economics is to examine is relationship with other subjects. also known as price theory (or Marshallian economics. The modern theory of income and employment has direct implications for forecasting general business conditions. 3. Economics has two main divisions: microeconomics and macroeconomics. etc. on the other hand. Microeconomics. As the prospects of an individual firm often depend greatly on general business conditions. 2. Macroeconomics. 9. 6. 8. It may be viewed as a special branch of economics bridging the gulf between pure economic theory and managerial practice. 5. Managerial Economics and Economics Managerial Economics has been described as economics applied to decisionmaking. We can.K.
For the purpose. if they are found relevant for decision making. if necessary. 7. It is in this context that the growing link between management accounting and managerial economics deserves special mention. it culls from economic theory the concepts.. the accounting data are also to be provided in a form so as to fit easily into the concepts and analysis of managerial economics. 5. 6. which are relevant for business decision making it real life. accounting data call for careful interpretation. which is concerned with recording the financial operations of a business firm. Recasting and adjustment before they can be used safely and effectively. 8. output and investment decisions Business financing Public finance and fiscal policy Money and banking National income and social accounting Theory of international trade Economics of developing countries. Thus. 6/87 9/18/2007 1:31 PM . First. 2. Indeed. accounting information is one of the principal sources of data required by a managerial economist for his decision-making purpose. managerial economics accomplishes the objective of building suitable tool kit from traditional economics. Secondly. it presents those aspects of traditional economics. 4. adapted or modified with a view to enable the manager take better decisions. 3. In face managerial economics takes the aid of other academic disciplines having a bearing upon the business decisions of a manager in view of the carious explicit and implicit constraints subject to which resource allocation is to be optimized.DHARMENDRA MISHRA Business economics have also found the following main areas of economi9cs as useful in their work 1. The main task of management accounting is now seen as being to provide the sort of data which managers need if they are to apply the ideas of managerial economics to solve business problems correctly. Demand theory Theory of the firm-price. etc. USES OF MANAGERIAL ECONOMICS Managerial economics accomplishes several objectives. Of course. Managerial Economics and Accounting Managerial Economics is also closely related to accounting. These are. For instance. the profit and loss statement of a firm tells how well the firm has done and the information it contains can be used by managerial economist to throw significant light on the future course of action-whether it should improve or close down. it also incorporates useful ideas from other disciplines such a psychology. principles and techniques of analysis which have a bearing on the decision making process. sociology.
in business concerns. finance. and there are frequent advertisements for such positions. Let us examine in specific terms how a managerial economist can contribute to decision-making in business. etc.S. large companies employ one or more economists. it serves as an instrument in rehiring the economic welfare of the society through socially oriented business decisions. at the level of the firm. That is why. In our country too. marketing. a Government of India undertaking.. It has come to be realized that business part from its obligations to shareholders has certain social obligations. MANAGERIAL ECONOMIST ROLE AND RESPONSIBILITIES A managerial economist can play a very important role by assisting the Management in using the increasingly specialized skills and sophisticated techniques which are required to solve the difficult problems of successful decision-making and forward planning. Finally.g. It thus enables business decisionmaking not in watertight compartments but in an integrated perspective. where for various functional areas functional specialists or functional departments exist. also keeps an economist. managerial economics serves as an integrating agent by co-coordinating the different areas and bringing to bear on the decisions of each department or specialist the implications pertaining to other functional areas.. managerial economics makes a manager a more competent model guilder. Indian Petrochemicals Corporation Ltd. Tatas. In so doing..A. Managerial economics focuses attention on these social obligations as constraints subject to which business decisions are to be taken. managerial economics takes cognizance of the interaction between the firm and society and accomplishes the key role of business as an agent in the attainment of social and economic welfare. (i) (ii) (iii) (iv) (v) What products and services should be produced? What inputs and production techniques should be used? How much output should be produced and at what prices it should be sold? What are the best sizes and locations of new plants? How should the available capital be allocated? Fourthly. Fifthly. e. the significance of which lies in the fact that the functional departments or specialists often enjoy considerable autonomy and achieve conflicting coals. DCM and Hindustan Lever employ economists. big industrial houses have come to recognize the need for managerial economists. In advanced countries like the U. managerial economics helps in reaching a variety of business decisions. two important questions need be considered: 7/87 9/18/2007 1:31 PM . personal production. his importance is being growingly recognized. In this connection. Thus he can capture the essential relationships which characterize a situation while leaving out the cluttering details and peripheral relationships..DHARMENDRA MISHRA Thirdly.
2. 6. prices. a business firm is free to take decisions about what to invest. what are the responsibilities of a successful managerial economist? ROLE OF A MANAGERIAL ECONOMIST One of the principal objectives of any management in its decision-making process is to determine the key factors which will influence the business over the period ahead. e. The internal factors he within the scope and operations of a firm and hence within the control of management. regional or worldwide economic trends? What phase of the business cycle lies immediately ahead? What about population shifts and the resultant ups and downs in regional purchasing power? What are the demands prospects in new as well as established markets? Will changes in social behavior and fashions tend to expand or limit the sales of a company’s products. where to invest. The external factors lie outside the control management because they are external to the firm and are said to constitute business environment.. 8. that is. What role does he play in business.. 3. that is. and they are known as business operations. 7. 8/87 9/18/2007 1:31 PM . To illustrate. how to price its products and so on but all these decisions are taken within the framework of a particular business environment and the firm’s degree of freedom depends on such factors as the government’s economic policy. and how will new foreign government legislation’s affect operation of the overseas plants? Will the availability and cost of credit tend to increase or decrease buying? Are money or credit conditions ahead likely to be easy or tight? What the prices of raw materials and finished products are likely to be? Is competition likely to increase or decrease? 2. Environmental Studies An analysis and forecast of external factors constituting general business conditions. What is the outlook for the national economy? What are the most important local. national income and output. or possibly make the products obsolete? Where are the market and customer opportunities likely to expand or contract most rapidly? Will overseas markets expand or contract. these factors can be divided into two-category (i) external and (ii) internal.DHARMENDRA MISHRA 1. etc. volume of trade.g. what particular management problems lend themselves to solution through economic analysis? How can the managerial economist best serve management. 4. how much labour to employ and what to pay for it. In general. Certain important relevant questions in this connection are as follows: 1. are of great significance since every business from is affected by them. the actions of its competitors and the like. 5.
Kemp: 1. rate of operations.W. the expectations of the people and political expediency. Business Operations A managerial economist can also be helpful to the management in making decisions relating to the internal operations of a firm in respect of such problems as price. can be had from the following specific functions performed by them as revealed by a survey pertaining to Britain conducted by K.DHARMENDRA MISHRA 9. business-like practical notes. He acts as a bridge between the government and the industry. 4. credit.J. Alexander and Alexander G. which have suffered a cut in their outlay? What is the outlook regarding government’s economic policies and regulations? What about changes in defense expenditure. 3. 11. What are the main components of the five-year plan? What are the areas where outlays have been increased? What are the segments. What will be a reasonable sales and profit budget for the next year? What will be the most appropriate production Schedules and inventory policies for the next six months? What changes in wage and price policies should be made now? How much cash will be available next month and how should it be invested? 10. the managerial economist pragmatically interprets the intentions of controls and evaluates their impact. Specific Functions A further idea of the role managerial economists can play. And it is these questions which present some of the areas where a managerial economist can make effective contribution. translating the government’s intentions and transmitting the reactions of the industry. Sales forecasting 9/87 9/18/2007 1:31 PM . Certain relevant questions in this context would be as follows: 1. sales and profits? Reasonably accurate answers to these and similar questions can Enable management’s to chalk out more wisely the scope and direction of their own business plans and to determine the timing of their specific actions. expansion or contraction. In a mixed economy like India. 2. He has to digest the ever-growing economic literature and advise top management by means of short. tax rates. In fact. The managerial economist has not only to study the economic trends at the macro-level but must also interpret their relevance to the particular industry/firm where he works. investment. government policies charge out of the performance of industry. tariffs and import restrictions? Will Reserve Bank’s decisions stimulate or depress industrial production and consumer spending? How will these decisions affect the company’s cost.
5. analyze all pertinent information about the business environment and prepare position papers on issues facing the firm and the industry. profit and market potentialities. Economic Intelligence Besides these functions involving sophisticated analysis. However. In the case of industries prone to rapid technological advances. 7. 4.DHARMENDRA MISHRA 2. differences in the relative importance of the various functions performed from firm to firm and in the degree of sophistication of the methods used in carrying them out. they may have to undertake detailed statistical analysis. The managerial economist has to gather economic data. etc. Participating in Public Debates 10/87 9/18/2007 1:31 PM . 6. and the relative efficiency of their retail outlets. 9. 11. tax rates. Advice on foreign exchange. 10. Advice on primary commodities. sales forecasting and industrial market research. they may compile statistical records of the sales performance of their own business and those relating to their rivals. 3. It is thus clear that in practice managerial economists perform many and varied functions. managerial economist may also provide general intelligence service supplying management with economic information of general interest such as competitors prices and products. tariff rates. he may have to make a continuous assessment of the impact of changing technology. Environmental forecasting. of these. i. In fact. Security/investment analysis and forecasts. He may have to evaluate the capital budget in the light of short and long-range financial. a good deal of published material is already available and it would be useful for a firm to have someone who understands it. Economic analysis of competing companies. their market shares. But there is no doubt that the job of a managerial economist requires alertness and the ability to work under pressure. There are.. Industrial market research. of course. The managerial economist can do the job with competence. Analysis of underdeveloped economics. Capital projects.e. Very often. Pricing problems of industry. Economic analysis of agriculture. For this purpose. 12. has been the most important. 8. 13. carry our analysis of these records and report on trends in demand. Advice on trade and public relations. Production programs. marketing functions. he may have to prepare speeches for the corporate executives. Thus while carrying out their functions.
he must thoroughly recognize his responsibilities and obligations. 9. A managerial economist can serve management best only if he always keeps in mind the main objective of his business. As India marches towards globalization. The managerial economist has to play a much more significant role. Conferences. For this. In fact.DHARMENDRA MISHRA May well-known business economists participate in public debates. Preparation of periodical economic reports bearing on various matters such as the company’s product-lines. With the adoption of the New Economic Policy. Seminars. Economic feasibility of new production lines/processes and projects. Capacity planning and product-mix determination. 11/87 9/18/2007 1:31 PM . Their advice and views are being sought by the government and society alike. His academic training and the critical comments from people outside the business may lead a managerial economist to adopt an apologetic or defensive attitude towards profits. a managerial economist is expected to perform the following functions: 1. 7. Assistance in preparation of overall development plans. Macro-forecasting for demand and supply. And these changes have tremendous implications for business. RESPONSIBILITIES OF A MANAGERIAL ECONOMIST Having examined the significant opportunities before a managerial economist to contribute to managerial decision-making. general business. viz. 3. 6. his effectiveness is almost sure to be lost.. speeches. he cannot expect to succeed in serving management unless he has a strong personal conviction that 8. Committees. market pricing situation. Indian Context In the Indian context. Preparing briefs. the macro-economic \ Environment is changing fast at a pace that has been rarely witnessed before. 2. Their practical experience in business and industry ads stature to their views. Keeping management informed o various national and international developments on economic/industrial matters. He has to constantly gauge the possibilities of translating the rapidly changing economic scenario into viable business opportunities. Economics of various productions lines. 5. Once management notices this. etc. Production planning at macro and micro levels. let us next examine how he can best serve the management. and various national/international factors affecting industry and business. Their public recognition enhances their stature in the organization itself. 4. future growth opportunities. articles and papers for top management for various Chambers. to make a profit on its invested capital. he will have to interpret the global economic events and find out how his firm can avail itself of the carious export opportunities or of establishing plants abroad either wholly owned or in association with local partners.
Nothing will build management confidence in a managerial economist more quickly and thoroughly than a record of successful forecasts. he should be able to express himself clearly and simply and must always try to minimize the use of technical terminology in communicating with his management executives. he has a major responsibility to alert ‘management at the earliest possible moment in case he discovers an error in his forecast. A few corollaries to the above proposition need also be emphasized here. if not completely eliminating. committees or special projects. well documented in advance and modestly evaluated when the actual results become available. First.DHARMENDRA MISHRA profits are essential and that his chief obligation is to help enhance the ability of the firm to make profits. therefore. He should be ready and even offer himself to take up special assignments. be that in study teams. absolutely essential that a managerial economist recognizes his responsibility to make successful forecasts. It is. but also to his personality and capacity to win continuing support for himself and his professional ideas. Extensive familiarity with reference sources and material is essential. a managerial economist can only function effectively in an atmosphere where his success or failure can be traced not only to his basic ability. In any case. in other cases. there may be a wealth of knowledge and experience but the managerial economist would be really useful if he can supplement the existing know-how with additional information and in the quickest possible manner. Again. it will almost automatically 12/87 9/18/2007 1:31 PM . he may have to point out the probabilities of a turning point in some activity of importance to management. By promptly drawing attention to changes in forecasting conditions. For. based upon the best possible information and analysis and stake his reputation upon his judgment. At times. which would not be immediately available to the other members of the management. one of the best means of determining the caliber of a managerial economist is to evaluate his ability to obtain information quickly by personal contacts rather than by lengthy research from either readily available or obscure reference sources. which is rather uncertain. By making best possible forecasts and through constant efforts to improve upon them. Secondly. the risks involved in uncertainties. if a managerial economist is to be really helpful to the management in successful decision-making and forward planning. so that the management can follow a more orderly course of business planning. he must establish and maintain many contacts with individuals and data sources. training and experience. he should aim at minimizing. In fact. Most management decisions necessarily concern the future. he must be willing to make considered but fairly positive statements about impending economic developments. For. he will have to reassure the management that an important trend will continue. Of course. he will not only assist management in making appropriate adjustment in policies and programs but will also be able to strengthen his own position as a member of the management team by keeping his fingers on the economic pulse of the business. For this purpose. but it is still more important that he knows individuals who are specialists in particular fields having a bearing on his work. Within any business. it is well known that hat management does not understand. he should join professional associations and take active part in them. he must be able to earn full status on the business team.
Further.DHARMENDRA MISHRA reject. Question Bank 1 Define managerial economics with definition 2 How does managerial economics differ from economics? 3 Write a short note on managerial economist 4 Explain the scope of managerial economics 13/87 9/18/2007 1:31 PM . while intellectually he must be in tune with industry’s thinking the wider national perspective should not be absents from his advice to top management.
“Demand for anything means the quantity of that commodity.00 1. which is bought.25 1. moreover it is meaningless to mention demand without reference to price.50 0.75 0.00 Market Demand Schedule (Daily Demand 75 100 125 150 It can be observed that with a fall in price every individual consumer buys a larger quantity than before as a result of which the total market demand also rises. 24 22 20 18 Individual Demand Schedule (Quantity in liter Demand by Different Individuals) (Daily Demand) 1. per week etc. In case of an increase in price the situation will be reserved. at a given price. An increase in the price leads to a fall in the demand and vice versa. whereas in economic sense it is something more than a mere desire. the demand for a commodity varies inversely as the price” OR “The demand for a commodity at a given price is more than what it would be at a higher price and less than what it would be at a lower price” Demand Schedule and Demand Curve These are the two devices to present the law. This relationship can be stated as “Other things being equal.00 1. 14/87 9/18/2007 1:31 PM . per unit of time. i.75 1.” Law of Demand This law explains the functional relationship between price of a commodity and the quantity demanded of the same.75 1. It is observed that the price and the demand are inversely related which means that the two move in the opposite direction.00 1.00 0.25 0. It is interpreted as a want backed up by thepurchasing power”.75 1.50 0. The demand schedule is a schedule or a table which contains various possible prices of a commodity and different quantities demanded at them.5 1.DHARMENDRA MISHRA Demand Demand In economic terminology the term demand conveys a wider and definite meaning than in the ordinary usage. the law of demand.5 0.e. Price per Liter in Rs. It can be an individual demand schedule representing the demand of an individual consumer or can be the market demand schedule showing the total demand of all the consumers taken together.25 1. Considering all these aspects the term demand can be defined in the following words. Thus the demand schedule reveals the inverse price-demand relationship. Further demand is per unit of time such as per day. this is indicated in the following table. Ordinarily demand means a desire.
The following diagram shows the two types of demand curves. like the demand schedule we can derive an individual demand curve as well as a market demand curve. In this case the two variable are price on Y axis and the quantity demanded on X axis. the quantity demanded rises to OM thus a demand curve diagrammatically explains the law of demand. No change in tastes. No change in the size and composition of population. a market or a total demand curve.DHARMENDRA MISHRA Demand Curve It is a geometrical device to express the inverse price-demand relationship. Assumptions of Law The law of demand in order to establish the price-demand relationship makes a number of assumptions as follows: Income of the consumer is given and constant. These Assumptions are expressed in the phrase “other things remaining equal”. However there are certain situations and commodities which do not follow the law. Such a curve shows the inverse relationship between the two variables. 15/87 9/18/2007 1:31 PM . These are termed as the exceptions to the law.e. It may be noted that at a higher price OP the quantity demanded is OM while at a lower price say OP. preference. the law of demand. habits etc. these can be expressed as follows. i. figure A shows an individual demand curve-of the consumer A in the above schedule-while figure B indicates the total market demand. A demand curve can be obtained by plotting a demand schedule on a graph and joining the points so obtained. The former shows the demand curve of an individual buyer while the latter shows the sum total of all the individual curves i. Exceptions of the Law In case of major bulk of the commodities the validity of the law is experienced. In the above diagram.e. It can be noticed that both the curves are negatively sloping or downwards sloping from left to right. Constancy of the price of other goods.
the demand curve becomes an upwards rising one as shown in the alongside diagram. these factors such as income. prejudices and preference etc. preferences etc. a consumer buys less at a low price and awaits a further in price. buys less of that commodity and switches on to a superior commodity. If the price shows a rising trend a buyer is likely to buy more at a high price for protecting himself against a further rise. do not remain constant and keep on affecting the demand. E. The relationship is a direct one. (1) Income: The relationship between income and the demand is a direct one. The higher the size of population. the higher is the demand and vice versa. (2) Population: The size of population also affects the demand. likes. Determinants of Demand The law of demand. rises or falls. In the alongside figure. It means the demand changes in the same direction as the income. while explaining the price-demand relationship assumes other factors to be constant. instead of purchasing more. As a result the demand declines with a fall in the price of such prestige goods. An increase in income leads to rise in demand and vice versa. If a consumers dislikes a commodity. As against it when the price starts falling continuously..DHARMENDRA MISHRA (1) Continuous changes in the price lead to the exceptional behavior. the demand curve is positively sloping one due to which more is demanded at a high price and less at a low price. If the price of a complimentary commodity rises. In the exceptional situations quoted above. 16/87 9/18/2007 1:31 PM . On the other hand a very high price also may not stop him from buying a good if he likes it very much. habits.g. Naturally with a fall in the price of such goods. tastes. the demand for the commodity in reference falls. without any change in price. the consumer. population. When the price of an inferior commodity declines. dislikes. The effects depends upon the relationship between the commodities in question. of the consumer have a profound effect on the demand for a commodity. (2) Giffens’s Paradox describes a peculiar experience in case of inferior goods. he will not buy it despite a fall in price. the demand for petrol will decline due to rise in the price of cars and the consequent decline in their demand. habits. As a result the demand changes i. there is no distinction in buying the same. Opposite effect will be experienced incase of substitutes. (3) Tastes and Habits: The tastes.e. Hence the exception. (3) Conspicuous Consumption refers to the consumption of those commodities which are bought as a matter of prestige. (4) Other Prices: This is another important determinant of demand for a commodity. In reality however. (4) Ignorance Effect implies a situation in which a consumer buys more of a commodity at a higher price only due to ignorance.
extension and contraction in demand due to price and (b) Changes i. This factor has a great impact on the demand. income.. This is known as the demonstration effects. (1) Increase in Demand: This refers to higher demand at the same price and results from rise in income. It means they occur without any change in price. other factors such as. (7) Imitation: This tendency is commonly experienced everywhere. 17/87 9/18/2007 1:31 PM . (1) Extension of Demand: This refers to rise in demand due to a fall in price of the commodity. this is shown on a new demand curve lying above the original one.e.DHARMENDRA MISHRA (5) Advertisement: This factor has gained tremendous importance in the modern days. They are termed as changes in demand in contrast to variations in demand which occur due to changes in the price of a commodity. (2) Contraction of Demand: This means fall in demand due to increase in price and can be shown by an upwards movement on a given demand curve. They are of two types. This operates even at international levels when the poor countries try to copy the consumption patterns of rich countries. When a product is aggressively advertised through all the possible media. These effects are different from the law of demand. population etc. population etc. on the demand for a commodity. population etc. price. due to which the low income groups imitate the consumption patterns of the rich ones. In practice. this is shown on a new demand lying below the original one. (6) Fashions: Hardly anyone has the courage and the desire to go against the prevailing fashions as well as social customs and the traditions.. (2) Decrease in demand: It means less quantity demanded at the same price. Changes in Demand The law of demand explains the effect of only-one factor viz. the consumers buy the advertised commodity even at a high price and many times even if they don’t need it. (b) Changes in demand imply the rise and fall due to factors other than price. These are two types. It is shown by a downwards movement on a given demand curve.e. This is the result of factors like fall in income. In economic theory a distinction is made between (a) variations i. increase and decrease in demand due to other factors. (a) Variations in demand refer to those which occur due to changes in the price of a commodity. cause the rise or fall in demand without any change in the price. under the assumption of constancy of other determinants.
The law of demand assumes these factors to be constant and states the inverse price-demand relationship. The concept of 18/87 9/18/2007 1:31 PM . lying above and below the original demand curve D respectively. the inverse pricedemand relationship holds good in case of the goods that are bought and sold in the market. the demand extends from OQ to OQ2. In figure. Some commodities are more responsive or sensitive to change in price while some others are less. the demand for a commodity depends not only on the price of a commodity but also on other factors such as income. the law of demand merely shows the direction in which the demand changes as a result of a change in price. population. the law of demand explains the qualitative but not the quantitative aspect of pricedemand relationship. but does not throw any light on the amount by which the demand will change in response to a given change in price. Elasticity of Demand The law of demand explains the functional relationship between price and demand. it fails to explain the extent or magnitude of a change in demand with a given change in price. The law of demand explains the direction of a change as it states that with a rise in price the demand contracts and with a fall in price it expands. such response varies from commodity to commodity. Barring certain exceptions.DHARMENDRA MISHRA Fig (A) Extension/Contraction of Demand Fig (B) Increase/Decrease in Demand In figure A. Although it is true that demand responds to change in price of a commodity. tastes and preferences of the consumer. However. On D1 more is demand (OQ1) at the same price while on D2 less is demanded (OQ2) at the same price OP. In fact. D1 while the decrease in demand is expressed by the new demand curve D2. B an increase in demand is shown by a new demand curve. In other words. the original price is OP and the Quantity demanded is OQ. Thus. With a rise in price from OP to Op1 the demand contracts from OQ to Oq1 and as a result of fall in price from OP to OP2.
DHARMENDRA MISHRA the elasticity of demand has great significance as it explains the degree of responsiveness of demand to a change in price. Using the formula of elasticity. Certain goods are said to have an elastic demand while others have an inelastic demand. The elasticity of demand thus means the sensitiveness or responsiveness of demand to a change in price. (2) Inelastic (less elastic) demand (e< 1) (3) Unitary elasticity (e = 1). (5) Perfectly elastic demand (e = x) (1) Perfectly Inelastic Demand (ep = o). (4) Elastic (more elastic) demand (e> 1). Thus ep = O. The vertical straight line demand curve as shown alongside reveals that with a change in price (from OP to Op1) the demand remains same at OQ. Fig a (2) Inelastic (less elastic) Demand (e < 1): In this case the proportionate change in demand is smaller than in price. The alongside figure shows this type. In other words. whatever be the price the quantity demanded remains the same. Demand for some commodities is more sensitive or responsive to a change in price. According to Marshall. Thus.” From the above discussion. perfectly inelastic demand. the demand for a good is said to be inelastic when a change in price fails to bring about significant change in demand. It thus elaborates the price-demand relationship. it will be clear that thought different commodities react to a change in price in the same direction. Demand for some commodities is more elastic while that for certain others is less elastic. it possible to mention following different types of price elasticity: (1) Perfectly inelastic demand (ep = o). On the other hand. This describes a situation in which demand shows no response to a change in price. The concept of elasticity can be expressed in the form of an equation as: Ep = Percentage change in quantity demanded/Percentage change in the price Types of Price Elasticity The concept of price elasticity reveals that the degree of responsiveness of demand to the change in price differs from commodity to commodity. demand does not at all respond to a change in price. 19/87 9/18/2007 1:31 PM . Hence. “the elasticity (or responsiveness) of demand in a market is great or small accordingly as the demand changes (rises or falls) much or little for a given change (rise or fall) in price. It can be depicted by means of the alongside diagram. the degree of their response differs. Elasticity of demand is a measure of relative changes in the amount demanded in response to a small change in price. The demand is said to be elastic when a small change in price brings about considerable change in demand. while it is less responsive for some others.
The rectangular hyperbola as shown in the figure demonstrates this type of elasticity. In practice. A perfectly competitive firm faces this type of demand. From the above analysis it can be concluded that theoretically five different types of price elasticity can be mentioned. The unitary elasticity is a dividing line between these two cases. however two extreme cases i.DHARMENDRA MISHRA In the alongside figure percentage change in demand is smaller than that in price. are rarely experienced. This is referred to as an inelastic demand. The demand curve showing perfectly elastic demand is a horizontal straight line. demand. Fig e (3) Unitary Elasticity (e = 1): When the percentage change in price produces equivalent percentage change in demand. It can be noticed that in the above example the percentage change in demand is greater than that in price. This can be understood by means of the alongside figure. hence e = 1. Fig c (4) Elastic Demand (e> 1): > In case of certain commodities the demand is relatively more responsive to the change in price. It means a small change in price induces a significant change in.e. In this case percentage change in demand is equal to percentage change in price. 20/87 9/18/2007 1:31 PM . perfectly elastic and perfectly inelastic demand. A small change in price produces infinite change in demand. In this case an insignificant change in price produces tremendous change in demand. Hence. Fig b It can be noticed that at a given price an infinite quantity is demanded. It means the demand is relatively c less responsive to the change in price. we have a case of unit elasticity. What we really have is more elastic (e 1) or less elastic (e 1 ) demand. the elastic demand (e>1) Fig d (5) Perfectly Elastic Demand (e = x): This is experienced when the demand is extremely sensitive to the changes in price.
It means if a commodity has many substitutes.e. the commodities satisfying them can be classified broadly into necessaries on the one hand and comforts and luxuries on the other hand. When the price of such commodity rises. coal electricity. water etc. The demand for necessities is inelastic and for comforts and luxuries it is elastic. the demand becomes relatively inelastic because the consumers have no other alternative but to buy the same product irrespective of whether the price rises or falls. The nature of demand for a commodity depends upon this classification. the demand will be elastic. whether the demand is elastic or inelastic depends upon many factors. Though it is difficult to state precisely the nature of demand for a particular commodity. i. The large the number of substitutes. (2) Number of Substitutes Available: The availability of substitutes is a major determinant of the elasticity of demand. it is possible to classify the commodities under broad categories and make certain generalizations regarding whether the demand for commodities belonging to a certain group is elastic or inelastic.e. the demand will be more elastic. (3) Number Of Uses: If a commodity can be put to a variety of uses.DHARMENDRA MISHRA Determinants of Elasticity The nature of demand for a commodity. As against this in the absence of substitutes. (1) Nature of the Commodity: Humans wants. its consumption will be restricted only to more important uses and when the price falls the consumption may be extended to less urgent uses. e. the higher is the elastic. i. 21/87 9/18/2007 1:31 PM .g.
(1) Percentage Method: In this method. and the psychology of the consumers.DHARMENDRA MISHRA (4) Possibility of Postponement of Consumption: This factor also greatly influences the nature of demand for a commodity.e. ep <1. Measurement of Elasticity For practical purposes. a rise or fall in the price. ep = 1. will hardly have any effect on the demand. elastic. If the consumption of a commodity can be postponed. percentage change in demand is equal to percentage change in price . (c) If percentage change in demand is less than that in price. a change. three values of ‘ep’ can be obtained. (8) In addition. 22/87 9/18/2007 1:31 PM . e 1.. The conclusion regarding the nature of demand should. is usually elastic. Different methods are used for measuring the elasticity of demand. (a) If 5% change in price leads to exactly 5% change in demand. the influence of changes in habits. it is a case of unit elasticity . e> 1. ep >1. (7) According to Taussig. tastes. therefore be restricted to small changes in prices during short period. can be ignored. (9) The nature of demand for a commodity is also influenced by the complementarities of goods. From the above analysis of the determinants of elasticity of demand. Similarly. it is clear that no precise conclusion about the nature of demand for any specific commodity can be drawn. unequal distribution of income and wealth makes the demand in general. Viz. likes customs etc. By doing so. ep = Percentage change in demand / Percentage change in price In this method.. (b) If percentage change in demand is greater than percentage change in price. it means the demand is elastic. it is essential to measure the exact elasticity of demand. when the price is so low that the commodity can be brought by all those who wish to buy. the demand will be elastic. It depends upon the range of price. say newspaper. the demand will tend to be inelastic. (6) Proportion of Income Spent: Income of the consumer significantly influences the nature of demand. When the price is very high. If only a small fraction of income is being spent on a particular commodity.e. The change in price changes the demand for a commodity which in turn changes the total expenditure of the consumer or total revenue of the seller. the commodity is consumed only by the rich people.. it is observed that demand for durable goods. meaning thereby the demand is inelastic. (5) Range of prices: The demand for very low-priced as well as very high-price commodity is generally inelastic. i. A rise or fall in the price will not have significant effect in the demand. i. the percentage change in demand and percentage change in price are compared. By measuring the elasticity we can know the extent to which the demand is elastic or inelastic. e = 1. (2) Total Outlay Method: The elasticity of demand can be measured by considering the changes in price and the consequent changes in demand causing changes in the total amount spent on the goods.
. e = o and point at which it meets Y axis. (3) Point Method: Another suggested by Marshall is to measure elasticity at a point on a straight line.e. if total revenue rises with a rise in price and falls with a fall in price. (3) Income Elasticity Less Than One (EY< 1): This occurs when the percentage < change in demand is less than the percentage change in income. (2) Income Elasticity is unitary: When the proportion of income spent on a commodity remains the same or when the percentage change in income is equal to the percentage change in demand. income effect is a constituent of the price effect. However. i. income elasticity of demand means the responsiveness of demand to changes in income. the demand is said to be inelastic pr e <1.income elasticity is said to be greater than one.DHARMENDRA MISHRA (a) If a given change in price fails to bring about any change in the total outlay. A is any point on the demand curve at which the elasticity is to be measured. 23/87 9/18/2007 1:31 PM . a greater portion of income is being spent on a commodity with an increase in income. Thus. at a point where the curve intersects X axis. ‘ep’ is said to be equal to 1. In other words. it is the case of unit elasticity. income elasticity of demand can be expressed as: EY =Percentage change in demand /Percentage change in income The following types of income elasticity can be observed: (1) Income Elasticity of Demand Greater than One: When the percentage change in demand is greater than the percentage change in income. It means if the total revenue (price x Quantity bought) remains the same in spite of a change in price. (b) If price and total revenue are inversely related. Demand for a commodity changes in response to a change in income of the consumer. that at different points on the demand curve the elasticity will be different. The income elasticity of demand explains the extent of change in demand as a result of change in income. The income effect suggests the effect of change in income on demand. at mid-point e=1. above the mid-point e I and below the I-point e<1. as already explained. (c) When price and total revenue are directly related. e = Income Elasticity of Demand The discussion of price elasticity of demand reveals that extent of change in demand as a result of change in price. price is not the only determinant of demand. DD1 is a straight line demand curve meeting the two axes at D and D1. if total revenue falls with rise in price or rises with fall in price. Thus. EY = 1 or the income elasticity is unitary. The formula for measuring the same at a point say ‘A’ isep = Lower segment of the demand curve AD1/ Upper segment of the demand curve =AD It will be observed from Fig. i. This method can be better understood with the help of a diagram as given below: In the Fig.e. demand is said to be elastic or e 1. In fact.
(3) Zero cross elasticity – Unrelated goods. The law of demand merely explains the qualitative relationship while the concept of elasticity of demand analyses the quantitative price-demand relationship. Importance of elasticity The concept of elasticity is of great importance both in economic theory and in practice. If two commodities. In short. this can be expressed asEC =Percentage Change in demand for X / Percentage change in price of Y The relationship between any two goods is of two types. the cross elasticity will be negative. The income elasticity of demand in such cases will be negative. the income effect beyond a certain level of income becomes negative. 24/87 9/18/2007 1:31 PM . Z…. (1) Theoretically. Thus. Cross elasticity in cad of such unrelated goods will then be zero. buys less and switches on to a superior commodity. (2) Positive cross elasticity – Substitutes. the demand is elastic. say X and Y. But in case of inferior goods. If the demand is inelastic.DHARMENDRA MISHRA (4) Zero Income Elasticity of Demand (EY=o): This is the case when change in income of the consumer does not bring about any change in the demand for a commodity. instead of buying more of a commodity. The concept of elasticity helps the monopolist while practicing the price discrimination. the cross elasticity for substitutes is positive which means a fall in price of X (pen) results in rise in demand for X and fall in demand for Y (ball pen).N etc. (5) Negative Income Elasticity of Demand (EY< o): It is well known that income < effect for most of the commodities is positive. Demand for X as a result of change in price of Y. Cross Elasticity of Demand While discussing the determinants of demand for a commodity. he will be benefited by charging a high price. In case of complementary commodities. a result of change in price of Y. (2) The Pricing policy of the producer is greatly influenced by the nature of demand for his product. The goods X and Y can be complementary goods (such as pen and ink) or substitutes (such as pen and ball pen). the demand for a commodity X depends not only on the price of X but also on the prices of other commodities Y. low price will be advantageous to the producer. The concept of cross elasticity explains the degree of change in demand for X as. we have observed that demand for a commodity depends not only on the price of that commodity but also on the prices of other related goods. This means that fall in price of X (pen) leads to rise in its demand so also rise in t) demand for Y (ink) On the other hand. This implies that as the income increases the consumer. If on the other hand. are unrelated there will be no change i. its importance lies in the fact that it deeply analyses the price-demand relationship. cross elasticity will be of three types: (1) Negative cross elasticity – Complementary commodities.
distribution. In come. (b) The concept of elasticity of demand helps the Government in formulating commercial policy. separate costs of production are not known. He should tax such commodities which have inelastic demand so that the Government can raise handsome revenue.explain with diagrams the cases where the absolutely value of elasticity is (i) zero (ii) infinity (iii) one (iv) less than one (v) more than one 25/87 9/18/2007 1:31 PM .. advertisement ad population. price of substitute.. international trade etc. has been widely accepted. Discuss the role of price elasticity of demand in business decision 4 Define elasticity of demand . (6) The concept of elasticity of demand is useful to Government in formulation of economic policy in various fields such as taxation. wages. In nutshell. 3 Define price elasticity of demand ad distinguish between its various types. (a) The concept of elasticity of demand guides the finance minister in imposing the commodity taxes. It helps in solving some of the problems of international trade such as gains from trade. international trade etc. such as wool and mutton. (5) The Elasticity of demand is important not only in pricing the commodities but also in fixing the price of labour viz. Write a short note on (i) Law of demand 2 Explain briefly how the demand for a commodity is affected by changes in price. Question bank 1. public finance.) (4) The concept of elasticity of demand is helpful to the Government in fixing the prices of public utilities. In case of such joint products. it can be concluded that the concept of elasticity of demand has great significance in economic analysis. Its usefulness in branches of economic such as production. (7) The concept of elasticity of demand is very important in the field international trade. policy of tariff also depends upon the nature of demand for a commodity. High price is charged for a product having inelastic demand (say cotton) and low price for its joint product having elastic demand (say cotton seeds.DHARMENDRA MISHRA (3) The price of joint products can be fixed on the basis of elasticity of demand. cotton and cotton seeds. Protection and subsidy is granted to the industries which face an elastic demand. balance of payments etc.
strictly in economic sense the two terms convey different meaning. (ii) The supply position holds good at a particular time. which may be a day. the quantity of any goods which people are ready to offer for sale generally varies directly with the price. (3) Supply refers to the actual Quantity offered for sale at the prevailing price while stock means the potential supply. a day. This law may also be stated in the following words: “Other things remaining the same.. It implies various amounts or quantities of a good offered for sale at various prices. supply thereof will contact. Mayers has defined this term in the following words: “We may define ‘supply’ as a schedule of the amount of a good that would be offered for sale at all possible prices at any one instant of time. stock and supply are used interchangeably. like demand. for example. It means a change in price brings about a change in supply. (ii) The amount of a good is offered for sale at a given time. Thus. (iv) The supplier is able and willing to supply the good at a given price. in which the conditions of supply remain the same. supply implies the willingness and ability on the part of a person (supplier) to sell a good in different quantities at a certain price and time. This means that if price of a good rises. The law of supply explains the functional relationship between price and supply. (2) At any time Stock is bigger than supply because supply represents only a part of total stock. (4) Supply is more elastic than stock. or during any one period of time. Law of Supply Supply. is a function of price. The distinction between the two can be explained as follows: (1) Stock is a reservoir while supply is a flow. a month and so on. as the price of a commodity rises.DHARMENDRA MISHRA Supply The term “Supply” is one of the important terms in economic. (iii) During the given period of time. the conditions of supply remain unchanged. a week. it will show that: (i) Price and supply vary or change in the same direction. The law is stated in the following words: “In a given market at any given time. its supply will increase and if its price falls. its supply is extended and as the price falls its supply is contracted. Distinction between Stock and Supply In ordinary languages the two terms viz. a week and so on.” If this statement of law of supply is analyzed.” Analysis of the above definition implies that: (i) It is a schedule of the amount of a good which is offered for sale at all possible prices. However. This means that a particular quantity of a good will be offered at a certain price at a particular point of time.” 26/87 9/18/2007 1:31 PM .
If the points in the above schedule are plotted and the positions so obtained are joined we get a supply curve as shown in the following diagrams: 27/87 9/18/2007 1:31 PM . it is obvious that it changes in the same direction.00 3. Thus. Hence as the price rises the supply increases. (ii) Market supply schedule. Supply Schedule: It is a table or schedule that shows different quantities of a commodity that are offered for sale at a particular time.00 S1 20 30 40 45 50 S2 35 45 50 55 60 S3 40 50 55 60 65 S4 Total supply 500 700 1000 1200 1500 market In the above schedule supply of different individual firms is shown as S1. Accordingly. The following schedule makes the point clear: Price per kg 2. etc.00 5. It can be noticed that the reaction of an individual supplier to the change in price is similar. the supply schedules explain the direct relationship between price and quantity supplied.00 4. It implies that as the price rises every individual seller offers a larger quantity for sale. S3. likewise there can be many other supplier in the market.DHARMENDRA MISHRA Supply Schedule and Supply Curve: The law of supply can be explained by means of a supply schedule and a supply curve. Supply schedule can be (i) individual supply schedule. The former relates to the quantity that an individual firm or producer or supplier is willing and able to offer for sale at different prices. a graphical presentation of the law of supply. The last column shows the market supply which is obtained by summing up the individual supplies of different firms at different prices. we get individual supply curve as also the market supply curve. Such curves can be obtained for every firm separately as well as for the entire market.00 6. S2. The market supply refers to the sum total of the quantities of a commodity offered for sale by different individual suppliers at different prices per unit of time. Since the market supply is nothing but the sum total of the individual supplies. Supply curve is thus. Supply Curve: Supply curve is a geometrical device to express the price-supply relationship.
S1. Obviously. The law of supply. S3 are the three individual supply curves while the last figure shows the market supply (SM).DHARMENDRA MISHRA In the above diagrams price is measured along the vertical Y axis while the quantity supplied is measured along the horizontal ‘X’ axis. Different positions showing price and the corresponding quantity supplied are joined to get the supply curve. Hence the supply curve is rising upwards to the right or positively sloping. can thus be expressed by means of supply schedule and supply curve. Such curve indicates price supply relationship. which states that price and supply are directly related. Explanation of the law Individual Supply: An individual firm is interested in securing maximum profits from its supply. at a certain price it will supply the quantity at which the profits are 28/87 9/18/2007 1:31 PM . It can be observed that as the price rises more is supplied. S2.
supply will increase and vice versa. there would be change in the volume of production and with that there would be a change in the supply position. Determinants of Supply The law of supply explains the functional relationship between price and supply. the supply position may change. efficient or economical. it is observed that as the production and supply increase the per unit cost goes on increasing. Moreover. the direct relationship. Naturally. the supply may be reduced and if the cost of production declines. develop. If the actual price is less than the reservation price no supply will be forthcoming. (iii) Factors of production: If the price of factors of production changes. If these means are not adequate. though important. Generally. Contraction of market supply occurs due to (i) Reduction in supply by some firms. There are many factors along with price which cause changes in supply. (vi) Nature factors: If weather conditions are favorable. Price. (vii) Abnormal circumstances: It may be pointed out that if some abnormal circumstances. (v) Future trends in prices: if future trends in prices indicate the possibility of rise in the price. It means if communications and transport are improved. Market Supply: As mentioned earlier market supply is the sum total of individual supply.DHARMENDRA MISHRA maximum. the supply. (i) Price: A change in price of a given good may bring about a change in the supply position. position may also change. Thus. supply can be increased. more will be supplied at a high price and less at a low price. the same will decrease. higher price offers an inducement to firm for offering larger quantity. it will behave in the same way as the individual supply in response to change in price. In other words. if natural calamities occur. the supply may decrease. During the war 29/87 9/18/2007 1:31 PM . similarly. a firm will not be able and willing to supply more quantity unless the price is higher. both the individual as well as the market supply change in the same direction as the price. generally. If price rises. the present supply will decrease and vice versa. supply will increase and in case of unfavorable weather conditions. If cost of production rises. (ii) New suppliers enter the market. Naturally. In order to derive the profits an individual seller has to take into account the cost of production and compare the same with price to calculate his profits. is not the only determinant of supply. (ii) Production cost: If production-cost changes. Expansion of Market Supply occurs at a high price. like war etc. thus. production may be curtailed and hence. the supply will be reduced. (ii) Exit from the market of certain other firms who cannot supply any quantity at the new low price. Hence. (iv) Transport facilities etc. the situation will be just opposite. every commodity has a reservation price which means the minimum price expected by the producer. because (i) The Existing suppliers supply larger quantity. As the price rises more will be supplied.
But if hostilities are over. (2) As the price falls to ‘OP2’ the supply falls to ‘OQ2’. Supply rises to ‘OQ1’ thus ‘QQ1’ is the extension of supply. The variations in supply i. it is possible that production may increase and as such. the Government adopts tight monetary policy. Thus. Extension of supply means higher quantity supplied at a high price while Contraction of supply refers to fall in supply due to a fall in the price of a commodity. (1) As the price rises to ‘OP1’ the. (viii) Monetary policy of the Government: Lastly.DHARMENDRA MISHRA time supply may be reduced. Originally. If however. (b) Increase/Decrease in Supply: The law of supply expresses the changes in supply due to changes in the price of a commodity. It assumes other factors to be constant. at price ‘OP’ the quantity supplied is OQ. the supply may also increase. Increase/Decrease and Extension/Contraction of Supply (a) Extension and Contraction of Supply: The law of supply expresses the functional relationship between price and supply and states that the two are directly related. opposite may happen. In 30/87 9/18/2007 1:31 PM . Such changes can be shown by means of the following In the alongside diagram price of good is measured along Y axis while quantity supplied along ‘X’ axis. brought about due to changes in the price are called extension and contraction of supply respectively. If liberal monetary policy is adopted by the Government. there can be increase in the supply. QQ2’ therefore.e. shows contraction of supply. it may be pointed out that the monetary policy of the Government may also change the supply position. rise or fall in it.
(3) Change in the techniques of production etc. Let us assume that ‘S’ is the original supply curve. QQ2’ is thus. (1) Increase in supply means more quantity supplied at the same price. at the same price ‘OP’ the quantity supplied is ‘OQ2’. the price remains same i. On this curve. i. It 31/87 9/18/2007 1:31 PM . OP but quantity supplied rises to OQ1. This happens due to various factors other than price. Elasticity of Supply The supply. decrease in supply. Increase and decrease in supply can be shown by means of the following diagram: Alongside diagram shows three supply curves ‘S1’ S1’ and ‘S2’. be seen that new supply curves have to be drawn to show increase and decrease in supply. rise or fall in supply due to effect of other factors. The law of supply expresses the price supply relationship. It is usually observed that the price and supply are directly related. The elasticity of supply means. (2) Decrease in supply means less quantity supplied at the same price. On this supply curve ‘OQ’ quantity is supplied at price ‘OP’. (2) Change in the prices of factors of production.e. An increase in supply can be shown by means of a new supply curve (S1) which lies to the right of the original one. It can. like the demand. are termed as increase and decrease in supply respectively.DHARMENDRA MISHRA reality the supply changes without any change in the price. the responsiveness of the supply of a commodity to the changes in price.e. (2) ‘S2’ shows decrease in supply. while the new supply curve (S2) which lies to the left of original curve (S) shows decrease in supply. These factors are: (1) Rise or fall in the cost. All these factors bring about rise or fall in the supply of a commodity. On this curve. Such change. thus. which means that more is supplied at a high price and less at a low price. (1) ‘S1’ shows increase in the supply. is a function of price. QQ1’ is thus increase in supply.
whatever be the change in price. This is shown in figure d. i. This means. the degree of response varies from commodity to commodity. This can be shown by means of a vertical straight line supply curve as in figure a. (e) The supply is said to be inelastic or less elastic when the proportionate change in supply is lesser than that in the price. “e” = 1. the elasticity of supply is greater than one. which means that the supply is fully sensitive to even a smallest possible change in price. (d) When the percentage change in supply is greater than that of the price. while certain others are less responsive. This can be represented with the help of a horizontal straight line supply curve as in figure b. This is the case of elastic supply. remains constant. we have a case of perfectly inelastic supply. 32/87 9/18/2007 1:31 PM . “e” is less than 1. as the percentage change in demand a case of unit elasticity is experienced. Accordingly. Some commodities are more responsive to a change in price. This is represented in diagram e. In this case.e. (c) When the percentage change in supply is the same.DHARMENDRA MISHRA may be noticed that though most of the commodities follow the law of supply. we come across commodities having more elastic supply and those having less elastic supply. In this case. The elasticity of supply can be expressed in the form of a formula as follows: Es= Percentage change in supply / = Change in ‘S’ / Original ‘S’ percentage change in price / Change in ‘P’ / Original ‘P’ Various types of elasticity of supply can be mentioned: (a) If the supply does not at all change. The case of unitary elasticity is shown in figure c. (b) Certain commodities may have perfectly or infinitely elastic supply. the elasticity of supply is zero.
SS is the supply curve and the elasticity of supply is to be measured at any point. ‘e’ is greater than 1. i. This can be better understood with help of a diagram. at a point on a supply curve. the elasticity at point ‘A’ is measured as: Es = NM / OM (1) If the tangent drawn to supply curve passes through the origin. can be measured by drawing a tangent to the curve at the point. (3) If the tangent meets the ‘X’ axis to the right of origin.e. i. “(o)” the elasticity is equal to one. 33/87 9/18/2007 1:31 PM . say ‘A’ on this curve. In the alongside diagram. (2) If the tangent cuts ‘Y’ axis.e. elasticity is less than 1. a case of unit elasticity.DHARMENDRA MISHRA Measurement of Elasticity of Supply The elasticity of supply. A tangent to supply curve is drawn at point ‘A’ to meet the ‘X’ axis at point the perpendicular drawn from point ‘A’ meets ‘X’ axis at ‘M’.
which makes the supply fairly elastic. the supply is more or less inelastic. influencing the elasticity of supply.DHARMENDRA MISHRA Determinants of Elasticity The elasticity of supply depends upon a variety of factors. The lower the cost of attracting the resources. making the supply inelastic. In case of the perishable goods. If the fixed factors are intensively utilized. Write a short note on (i) Law of supply 2 Explain the concept of 34/87 (i) elasticity of supply (ii) cross elasticity of supply 9/18/2007 1:31 PM . There is very little scope for expanding the supply. During long period. the behavior of the cost also determines the nature of supply. If the techniques are rigid and cannot be changed. Question bank 1. the higher will be the degree of elasticity. the supply can be easily increased. the supply is elastic. there will be much rigidity in the supply. the supply will become inelastic or less elastic. availability of variable inputs. During the short period. if the factors are not available. In short. behavior of cost. if the cost rises gradually. If . in response to the changes in price and hence. the fixed factor is not much utilized. the longer the period. the supply becomes much more elastic. however. the supply during very short period or market period is perfectly inelastic. On the other hand. (vii) The availability of markets also determines the degree of elasticity. If the rise in the cost is sharp and rapid. which means it will be elastic. the supply will be fairly elastic. utilization of fixed factors. During the short period. (iv) The elasticity of supply also depends on the Availability of the variable inputs. The higher the cost of attracting the resources lower will be the elasticity. such as time element. the supply can be slightly adjusted to the changes in price and hence. etc. (i) The time element: The most important factor. However. influenced by the cost of attracting the productive resources. If such factors are abundantly available. it can be concluded that the elasticity of supply is the result of a variety of factors. it becomes fairly elastic. nature of production technique. as a result of which. more can be produced and supplied. the more elastic is the supply. the supply will be fairly elastic. which means the supply will be less elastic. the full adjustments in the supply can be made and hence. is the time at the disposal of a firm to adjust the supply to the changes in prices. (vi) In addition to the above factors. to a great extent. If the techniques of production are improved. Thus. (v) The elasticity of supply is. (ii) The elasticity of supply also depends on the possibilities of changes in the production techniques. it will be difficult to expand the supply. the production and supply can be easily adjusted to the changes in price. (iii) The degree of elasticity of supply also depends on the extent to which the fixed factors are being utilized.
It is rightly pointed out that “the infinite variety of meanings involving anywhere from two people to thousands. Thus from the economic point a market implies a contact. The best way to know the meaning of the term in economic sense is to refer to the following features. a geographical location where the buying and selling of the commodities takes place e. The original of the term can be tracked back to a Latin word “Marcatus or marcart which means to trade’. Thus the term basically implies trading i. Whatever the interpretation. From this angle one speaks of textile market. Classification of market Markets can be viewed from different criteria such as extent or coverage. in economic sense there is relevance to a place but to a commodity.DHARMENDRA MISHRA 3 Explain the determinants of supply 4 Distinction between Stock and Supply Market structures What is a Market? Introduction The term Market is so familiar and commonly used one that it is difficult to offer a precise definition of the same. Such a contact may be direct or an indirect one. • Contact between buyers and sellers. • Existence of buyers and sellers.e. In ordinary languages. and the structure i. Bombay market. Calcutta market etc. It means shopping to a housewife. one dollar to a millions. food grains market etc. the term market means different things to different people. It means a market can exist even without the buyers and sellers meeting each other. • Identical commodity.e. this can be explained by the following points. From this angle the 35/87 9/18/2007 1:31 PM . is what makes a market hard to define”. It conveys a variety of meanings when viewed from different angles. time element. extent of competition etc. • Existence of price. (A) Classification according to size: One simple way of classifying the markets is to take into account their size or the area covered by a product. direct or indirect. As mentioned above. the term market refers to a place i. buying and selling. and for a farmer it stands for the sale of his products. it is certain that the term is related to buying and selling activities.e. between the buyers and sellers of an identical product for which there exists a price. truly what the economic meaning of the term implies is the contact between the buyers and the sellers. while for a businessman it suggest advertising and sales promotion for an industrialist it may mean discovery of foreign outlets for his products.g.
undergo fundamental changes. National. chemicals. Similarly. (C) Structural Classification: In the context of the process of price determination and the equilibrium of the firm this classification is of great significance. It is useful to get acquainted with the characteristic features of different markets forms. cotton etc. A town etc. the imperfect markets. and International etc. along with demand. As a result of this an individual becomes only a price taker but not a price maker. 36/87 9/18/2007 1:31 PM . milk etc. Hence in the very short period the supply is rigid or inelastic and cannot exert any influence on the price which is dominated by the demand. The extent of competition is the basic of his classification. oligopoly. The longer the period. can be included in this category. The time element the determination of price. there may be basic changes in the techniques of production. In the very long period there may occur structural changes on demand as well as supply sides. have a greater empirical validity. even the perishable commodities can conquer international market. habits. vehicles. This is because the contribution of an individual either as a consumer or a producer is negligible. fashions etc. usually the perishable commodities such as vegetables. monopolistic competition etc. With the development of the means of communications and transport. nature of product. Hence they enjoy an international or a global market. enjoy only local market. just like a drop of water in the ocean. supply. Perfect Competition: (1) Large Number Of buyer and sellers: This feature implies that an individual producer or an individual consumer cannot have any influence on the price. on the basic degree of competition. hence during the very period everything becomes flexible and both the sides can have full impact on the price. etc. The adjustability of supply depends on the availability of time. A local market is said to exist when the buyers and the sellers are confined to a small area like a village. Non-perishable consumption goods like wheat. the greater is the elasticity of supply. particularly from the supply side. begins to play an active role in the price determination. can be broadly divided into two categories viz. The factors affecting demand such as size and the composition of population. fish. As a result. with latter having different varieties. As shown in the chart above. The imperfect markets such as monopoly. This classification is neither scientific nor rigid. (B) Classification according to time: it was Alfred Marshall who introduced this important approach. Flowers. the markets. quality and the quantity of inputs etc. In the short period some marginal adjustments on the supply side are possible through the changes in the employment of the variable inputs. have a national market. the number of firms. sugar. Electronic goods. monopolistic competition etc. medicines etc. the perfect market and the imperfect markets. Perfect competition is the most ideal. Long period refers to that period during which full adjustments in supply are possible. but the least practicable form of market. Finally certain commodities are such that their buyers and sellers are spread over the entire world. indicate deviations from the perfectly competitive market in different ways such as. In comparison with perfect competition.DHARMENDRA MISHRA markets can be classified as Local. particularly oligopoly.
As a result a uniform price rules the perfectly competitive market. (3) Freedom of Entry and Exit: Perfect competition allows the existing firms to leave the industry if they so desire. Firm cannot charge a higher price and a firm does not charge a lower price than one that rules the market. This feature of perfect competition. This ensures a uniform factor reward. In other words. The chief features can be mentioned as follows: (1) A single Firm: In contrast to infinite number of firms under perfect competition. Even if he charges a high price there is no fear of losing the customer because there is no substitute available. This makes the demand for the product of an individual firm perfectly elastic and hence the demand curve is a horizontal straight line this feature further loosens the control of an individual firm on the price of the product. monopoly is characterized by restrictions which prevent other firms from entering the monopoly 37/87 9/18/2007 1:31 PM . No doubt there may exist remote substitute. the consumers as well as the firms have perfect knowledge about the market conditions. the cross elasticity of demand between the monopoly product and any other product is “zero” or very small. A monopoly market is characterized by the existence of a single producer who rules the entire market for the said product. (5) Absence of Transport Cost: This feature implies that the price of the competitive product differs in different places only by the amount of transport cost. Monopoly: This form of market is diagonally opposite to perfect competition. (2) Absence of Close Substitute: Another important feature of monopoly market is that there is no close substitute available for the product of the monopolist. (3) Barriers to Entry of New Firms: Unlike under perfect competition. (6) perfect Mobility: The factors of production are assumed to be fully mobile under the conditions of perfect competition. particularly about the prevailing price of the product. This enables the monopolist to charge an exorbitant price and enjoy super normal profits permanently. The demand for the product of a monopolist is perfectly inelastic. Such an absence of close substitutes helps the monopolist to control prices. Similarly there are no obstacles to the entry of new firms as a result of which the abnormal profits are eliminated from the competitive market. Naturally. Generally the firms which suffer the losses even in the long period are anxious to leave the industry and only the efficient ones can survive. (4) Perfect Knowledge: Another important condition of perfect competition is that both. is rarely experienced in its pure form.DHARMENDRA MISHRA (2) Homogenous product: under perfectly competitive market the products of all the firms are identical or homogenous which means there is no difference whatsoever among them. No consumer pays a higher price and no firm charges a lower one than that prevailing in the market. Maximizes the welfare of the consumers. In fact it represents another theoretical extreme which like perfect competition.
steel. the cross elasticity of demand of different products is very high. to sell. (3) Indeterminate Demand Curve: Under oligopoly.” Stigler. These barriers are artificial. 38/87 9/18/2007 1:31 PM . The barriers are strong enough to block completely all the potential competitors. multiple monopoly. oligopoly is characterized by the existences of a limited number of firms. With the close substitutes offered by the small number of rivals. An oligopolist is thus caught in a strange situation of an indeterminate demand curve for through he knows that his decision is bound to cause a reaction. etc. is supplied by the oligopolistic firms. Nobody can derive a precise demand schedule and a demand curve because of the unpredictable reaction of the market. economic. The above features reveal the fact that monopolist has a complete control over the price and the output of a commodity. That he produces and sells. Suppose an individual firm decides to lower the price to command a larger market share. As a result the price-output policy of a firm influences and is influenced by that of other rivals. This market form which consists of a few firms selling either identical or a differentiated product is known by many names such as. etc. legal or institutional. In real world a large number of products. (1) Few Sellers: In contrast to perfect competition with infinite number of firms and the monopoly with a single firm. The extreme interdependence among the firms creates uncertainty about the possible response of the rivals and of the consumers to a change in the price output policy. electronics goods. ‘Oligos’ which means a few. The decisions to raise or lower the price or the output receives a sharp reaction from other firms. the interdependence is so strong that every firm has to properly predict and analyze the possible reaction of the rivals before taking any important decision. the firm in question will hardly be in a position to expand its market share.e. Limited competition. and ‘Pollen’ meaning. “Oligopoly is that situation in which. In case they also follow the price reduction policy. His price output policy is not affected by that of the other firms. he does not know what and how strong that reaction will be. the AR curve of a firm. There is hardly any interdependence under perfect or monopolistic competition as a number of firms is very large. In the words of Stonier and Hague “Pure monopoly occurs when a producer is so strong that he is able to take the whole of the consumer’s incomes whatever the level of his output”. It is rightly described as ‘A competition among a few’. Thus the entire picture is uncertain to all the firms. (2) Interdependence: A distinct feature of oligopoly is the existence of extreme interdependence among the firms.DHARMENDRA MISHRA market. incomplete monopoly. a firm bases its market policy. cement. it is almost impossible to precisely derive the demand curve i. on the expected behavior of a few close rivals. In this case whether the firm will succeed or not depends upon the reaction of the rivals. Naturally every individual firm in this type of market makes a sizeable contribution to the total supply. such as automobiles. Oligopoly: The term oligopoly is derived from two Greek words. which means no effect on the demand. Obviously every move of the rival firms has to be closely watched by every other firm. in a part.
soaps. Thus there can be a situation of war or peace among the oligopolistic firms depending upon their attitude or the behavior. detergents etc. The firms widely differ in respect of size. (5) Conflicting Behavior: An element of uncertainty is witnessed even in respect of attitude of the firms. With a differentiated product. As a result each individual brand enjoys certain amount of monopoly among a small group of buyers who are attached to that particular brand. hair oils. Chamberlin who introduced the concept of monopolistic competition. By contrast it is held that most economic situations are composites of both monopoly and perfect competition. it is but natural that there prevails a strong monopoly element. are available in the market with different brand names. on certain occasions they pick up the fight among them especially in respect of distribution of profits or sharing of markets. at least among a small group of buyers. Monopolistic Competition: It was Prof.” In practice we come across a number of small firms which produce and sell a commodity which has its own identity and stands distinguished from other similar products. Thus it is clear that oligopoly exhibits some unique features which distinguish it from other market forms. Thus there is no departure from the existing price. An individual firm will not raise the price because of fear of losing the customers to rivals neither can it lower the price as this decision will be immediately followed by the other firms and the firms in question cannot reap the benefits of wider market. In contrast. Thus there can be collusion among the firms. The monopoly power is further strengthened because of an attachment of some buyers to a particular product. Thus no oligopolistic firm will either lower or raise the price. This implies that the price is fixed rigid or stuck-up at certain level. (7) Lack Of Uniformity: Finally an oligopoly market is characterized by an absence of uniformity. To a certain extent it is possible for an oligopolist to follow it own independent price-output policy. In the wider circle however. This leads to a ‘kinky demand curve. (6) A Monopoly Element: As a result of the existence of only a few firms under the oligopoly market form. Hence the price-rigidity. “Monopolistic Competition is a challenge to the traditional viewpoint of economists that competition and monopoly are alternatives and that individual prices are to be explained in terms or either one or the other. He argues. Hence the term Monopolistic Competition. 39/87 9/18/2007 1:31 PM . It means if one is present the other cannot exist. Thus there exists a competition among the monopolists. A variety of tooth pastes. In other words. Sometimes they adopt the attitude of co-operation so as to prevent the fall in sales and profits. these products are exposed to competition to similar but not identical brands. every firm enjoys a monopoly power. He disagreed with the traditional view which regarded monopoly and perfect competition to be mutually exclusive market forms. medium and large sized firms. An oligopoly situation exhibits a composition of small.DHARMENDRA MISHRA (4) Price Rigidity: This is a unique feature of oligopoly. though these products belong to a similar category of the commodity. This is the result of quick reaction of the rivals. He emphasized the fact that real market situation exhibits a simultaneous existence of both the pure forms which are mixed up. the price neither rises nor falls from a given level but remains rigid at that point.
newspaper. Selling costs can take a variety of forms such as free sampling lucky draws. free sale. is the key to capture the new markets and to strengthen the existing one. Selling costs have become so persuasive and aggressive that on any occasions the buyers are made to purchase a commodity which is of hardly any use to them. Selling costs have become so inevitable in the modern highly competitive market that usually the expenditure of selling costs far exceeds that on production cost. Repeated advertising has a profound impact on the psychology of the buyers which tremendously benefits the concerned product. packing. workmanship etc. Television serial. However each individual product has its own identity and dissimilarity in comparison with the products of other firms. It means the products are not perfect substitutes as under perfect competition. due to which an individual firm has no significant control over the market situation. (3) Selling Cost: This is yet another unique feature of monopolistic competition. there exists a sizeable number of firms under monopolistic competitions also. In other words. discount and above all advertisement. Propaganda and sales promotion drives through various media such as radio. there are no restrictions of any type on the entry of new firms. (2) product Differentiation: This is most vital feature of monopolistic competition. Such expenditure is not necessary either under perfect competition or monopoly because under the former the products are homogenous while under the latter i. as a result the small firms have some control or monopoly over a part of the market which is attached to that particular product.e. firms. It is only under monopolistic competition with differentiated product that a firm is required to create demand for the same. This is because the number of firms under monopolistic competition is not as large as that under perfect competition. They are only remote or the distant substitutes. The individual firms trade in a product which belongs to the broad category of the commodity being produced by the rival firms. This is achieved through the practice of product differentiation. The only peculiarity is that 40/87 9/18/2007 1:31 PM . Moreover. (4) Freedom of Entry: In this respect monopolistic competition is similar to perfect competition and opposite to monopoly. However the firm under this form of market is not as passive as that under the perfect competition. In other words. The products of different firms under monopolistic competition are only remote but not the perfect substitutes. there is freedom of entry to the new firms in the monopolistically competitive market. thus the individual product is similar but not identical to that of the rival firms. Popular personalities from politics. Thus the market undet the monopolistic competition is constituted of ‘Too Many Too Small’ firms.DHARMENDRA MISHRA Features of Monopolistic Competition: (1) Large Number of Seller: Like under perfect competition. Every firm tries to impress upon the minds of the buyers that its product is distinct from that of the others. are made to advertise the product to catch the attention and the demand of the consumers. the firms produce a differentiated product which is similar but not identical. Magazines etc. Sports etc. monopoly there exists no close substitutes. TV. As under perfect competition. may be in respect of colour. Selling cost refers to those expenses which are incurred in order to create the market or the demand for the differentiated product of the individual firm. quality.
“We might as reasonably dispute whether it is the upper or the lower blade of a pair of scissors that cuts a piece of paper as whether value is governed by utility or cost of production. demand and supply which are represented by the buyers and sellers respectively. there is high independence among the firms operating under monopolistic competition. no individual buyer or seller can determine the price. The actual formation of price for the industry as a whole can be determined by the equality between demand and supply. Stonier and Hague rightly remark. is insignificant. The differentiated product and the reliance on selling costs render the firms under monopolistic to plan and execute their own independence policy in respect of price and output. none is able to influence the price. But both are essential. It means the price under competitive conditions is the result of total demand for the total supply of the industry. (5) Independence: In contrast to oligopoly. In his words. This is due to large number of buyers and sellers with a homogeneous product. Since the contribution of our individual seller in the total supply and of individual buyer in the total demand. it is obvious that an individual firm can have its independent price output policy without relying on other rivals.” Above statement rightly emphasizes that price is the result of both demand as well as supply. while under monopolistic competition the new entrant has to introduce a different variety of the concerned product. Thus this market claims many distinct and realistic features . Neither is more or less important than the other in determining price. It may happen that at any particular time demand may be active and the supply passive. Some economists like Adam Smith and Ricardo attached great importance to supply and argued that price is determined by the cost of production. Certain others though that demand is the real determinant of price. “The only really accurate answer to the question whether it is supply or demand which determines the price. It is determined by the combined action of the entire seller and the entire buyer taken together.DHARMENDRA MISHRA under perfect competition the new firms have to produce the existing product. In this context the monopoly element due to the product differentiation as also the selling costs. finally that price rules the market at which a 41/87 9/18/2007 1:31 PM . Price Determination under perfect Competition In economic analysis there has always been a controversy as to what determines the price of a commodity.” From the above analysis it is clear that price is determined by demand and supply. One thing is certain that a market is dependent upon two forces viz. Another important aspect to be noticed is that under perfect competition. Alfred Marshall rightly emphasized the role of both the forces of demand and supply in the determination of price. is that it is both.
Hence it is the price that uniformly exists in the market. It means it can sell any quantity at the ruling price. the supply curve of the industry intersects its total demand curve at point ‘E’. 42/87 9/18/2007 1:31 PM . in the above figure an individual firm produces ‘QQ’ output and sells it at the given price ‘OP’. hence OP (Rs. 300. Equilibrium Price of Footwear Demand 1000 800 600 300 100 Price 100 200 300 400 500 Supply 100 300 600 800 1000 The total demand for the product (Footwear) of the industry is equal to the total supply when the price is Rs.e. If its cost cannot be covered by the given price it will suffer losses and will be forced to leave the industry. How much it will produce will be governed by its cost conditions. Hence the demand curve facing an individual firm is a horizontal straight line. An important point that needs to be mentioned here is that every individual firm has to adjust its output at the given price.DHARMENDRA MISHRA quantity demanded is equal to quantity supplied. At any other price either the demand will exceed the supply or vice versa. 300) is the price which will rule the market. It is shown in the following diagram: In the above figure. This can be explained with the help of following schedule and diagram. However it has no power to charge a higher price. This is because it has a large number of perfect substitutes. The firm at a given price produces that output at which its marginal cost (MC) is equal to marginal revenue (MR) and average revenue (AR) i. The demand for individual firm is perfectly elastic. An individual firm cannot fix the price but only adjust its supply to the given price.
It means if he produces and sells a small quantity he can charge a high price. The monopoly firm however has an advantage because there is no close substitute for its product. It must be remembered that a monopolist faces a down ward sloping demand curve. But if he is interested in selling a large quantity he can do so only at alower proce.DHARMENDRA MISHRA Price Determination under Monopoly Like any other producer the monopolist also has to consider the demand for his product as well as the supply conditions i. Naturally the demand becomes fairly inelastic. as a result the monopolist can charge a high price. His 43/87 9/18/2007 1:31 PM . cost conditions while determining the price.e. He thus has to make a choice between large quantity (Low price) and small quantity (high price).
• Substitutes available. 44/87 9/18/2007 1:31 PM . A monopolist has to be careful about the following: • Reaction of the customers – Boycotting the product. This is shown in the following diagram: The equilibrium point is ‘E’ at which MR curve intersects ‘MR’ the output produced is OQ which is sold at price OA or PQ. Generally it is believed that a monopolist charges extremely high price. This is course is possible but not practicable. A monopolist follows a trial and error method for determining the price and output. the monopolist has to take into account various factors such as • Nature of demand (elasticity) for his product.e. Generally any product considers two things what is the cost of producing one more unit. nationalization etc. • Reaction of factor owner – demand for higher rewards.DHARMENDRA MISHRA motive obviously is the maximization of total profits. Within these limits the monopolist charges such a price which enables him to get maximum profit. a point to be noted is that though monopoly producer has a firm grip over the market he cannot dictate both the price and the output. average cost (AC). finally he sells that quantity which fetches with maximum profit. The are ‘APRS’ shows the total profit enjoyed by the monopolist Lastly one point has to be cleared. – Control over price. • Reaction for the Gov. Once this is decided he ahs to compare the revenue per unit i. While fixing the price output. • Cost conditions. which is known as marginal cost (MC) and what revenue or income he gets by selling that unit which is called marginal revenue (MR). He has to fix one and accept the other. A monopolist will fix up that price at which his profits are maximum. Once he decides upon the price he ahs to produce that amount of output which is demanded at that price.e. average revenue (AR) and the cost per unit i. • Reaction for rival – Introduction of a substitute. A monopolist also follows the same rule that he produces that quantity at which MR=MC.
It is in this sense that a remark is passed that the firm under perfect competition is only a price taker and not a price market. a firm will produce and sell that output which offers it is maximum profits. It has no capacity to alter this price in any direction. a firm will compare the given price i. AR with its cost situations. Short run equilibrium: 45/87 9/18/2007 1:31 PM . The existence of large number of firms selling and identical product implies that the product of an individual firm faces a large number of perfect substitutes in the market. the short run considerations widely differ from the long run ones. the price remains fixed and given for a competitive firm. which produce a homogeneous commodity. constitute an industry. If it thinks of raising the price. the consumers will switch on to various alternatives available in the market and hence there will be no demand for the product of the firm which raises the price. it will never operate will losses. the firm may operate in spite of losses but in the long run. Thus. On the other hand. Under the profit maximization principle. Hence. The only decision left to an individual firm is whether to produce or not and how much to produce.DHARMENDRA MISHRA Equilibrium under Perfect Competition Perfect competition is a form of market in which various firms.e. As a result of two characteristics an individual firm does not have any grip over the price of the product. equilibrium of a firm implies the fixation of profit maximizing output. It may be noticed that in the short run. This implies that a competitive firm has only to accept the price which is determined by the industry as a whole. For this purpose. a firm will not lower the price because it knows that any quantity it produces can be sold at the prevailing price.
greater than or less than the average cost. when AR is less than AC.e. it means for all the output that the firm produces. Since the price is given and constant. In order to maximize the profits. The quality between the total demand and total supply suggests that the industry is only in temporary or indeterminate equilibrium. during short period. price. there are losses to the firm and when AR is equal to AC there are only normal profits. is not in equilibrium.e. Under any of these conditions. figure (a) shows profits while (b) losses. If AR>AC there are abnormal profits. AR<AC is shown in the following diagrams: In the above diagram. At this level. why should a firm continue to produce when it faces losses i. It means. will try to leave the industry. in the short run. Such a decision can be explained with reference to the 46/87 9/18/2007 1:31 PM . neither entry nor exit is possible in the short run. it follows that at equilibrium. But this price may be equal to. price i. Since MR is always equal to AR i. The decision of the firm to produce if the existing price renders abnormal profits can be easily understood. However. the firms intends to equal MR with MC. Thus in short run. the firm incurring losses during short period. the firms continue to produce. It is observed that in spite of losses. firm is equilibrium at the level of output where MC is equal to MR. However.e. If it is less than AC. there may be abnormal profits ((AR>AC) or losses (AR<AC). therefore. AR>AC and that with losses i. AR is equal to marginal cost. The abnormal profits enjoyed by the firm during the short period attached the other firms to enter the industry.e.e. the demand curve faced by an individual firm is horizontal straight line and the MR curve coincides with it is all levels of output. On the other hand. the firm will continue to produce. a firm cannot leave the industry.DHARMENDRA MISHRA Short run is a period during which certain factors and costs remain fixed or constant while certain others can be varied. No doubt. The industry. The equilibrium with profits i. it is only the variable cost which is relevant from the point of view of equilibrium output. but can certainly stop the operation. In figure (a) at equilibrium output AR is greater than AC while in Figure (b) at equilibrium output “OQ” AR is less than AC There NEPL shows the total profits in figure (a) and total losses in figure (b). The fixed cost has to be incurred even if no production is undertaken. AR is equal to MR.
weather the firm produces or not does not make any difference because the loss in both the cases will be equal to the fixed cost. However. This is known as the close down position of a firm. cover any portion of the fixed cost. the prevailing price “OP1” just covers the AVC since the AR – MR curve is tangent to the AVC curve at “E1” price OP1 does not therefore. Losses by closing down can be restricted only to the fixed cost in this case. the losses by producing some are less than by not producing at all. the firm will continue to operate. i. 47/87 9/18/2007 1:31 PM . short run marginal cost and short run average cost respectively. no rational producer will operate because this price does not even cover the AVC. In short. it will have to bear the losses worth the entire amount of fixed cost. It will. if the price falls below OP1 say to OP2. the decision regarding production or otherwise is a matter of indifference. therefore. At this point. even then. if any price falls below OP1 the firm will not operate. A firm under perfect competition will operate if (1) there are abnormal profits (AR>AC). the total cost (OLNQ) exceeds the total revenue (OPEQ) by LPEN which means the firm faces losses. (ii) Losses minimization and (iii) close down position. AVC. but AR>AVC. Fixed costs are those costs which have no relation with the output produced. This decision by the firm reduces losses. the equilibrium will be reached at point “E1” at which the level of output is “OQ”. a firm continues to produce. Hence. continue to produce because the price “OP” covers not only AVC (QA) but a part of fixed cost (AE). It is an attempt to minimize the losses.e. Lastly. if the price is less than AVC. the short run equilibrium of a firm indicates three possibilities namely (i) Profit maximization. and (2) there are losses (AR<AC).e. Thus. Thus. if the price i.e.DHARMENDRA MISHRA distinction between fixed costs and the variable costs. the firm will stop the production. If the firm stops the production. At this point of output. If the prevailing price is OP1. A firm. Since the prevailing price is covering at least a part of fixed cost. in the short run concentrates upon the variable costs. All these positions are explained in the following diagram: In the alongside diagram along with the SMC and SAC. (AR = MR) is OP. the MC intersects the MR curve at point “E” and the equilibrium output is “OQ” at this level of output. losses to the extent of fixed costs have to be borne by the firm. It means such costs have to be incurred even if the firm does not produce any output. Hence. So long as price is greater than average variable costs i. Now. AVC (average variable cost) is also shown. Thus.
the abnormal profits will attract new firms into the market. price can neither exceed the average cost nor can be less than it. In this diagram. incase of which AR is less than AC will leave the industry. however. In the long run. the long run price must necessarily be equal to the average cost. In other words. (3) Shut down position (AR < AVC). the changes in output can be brought about through the changes in the scale of production i. the price equates not only marginal cost but also the average cost. (ii) Increase in demand for productive resources and hence increase in the cost. To conclude the discussion regarding the short run equilibrium of a competitive firm. at price OP there are supernormal profits. In the long run. at OP1 there normal profits and at price OP2 losses.e. In other words. Similarly. MC and price. (i) Increase in supply and therefore a fall in price. The distinction between fixed and variable costs no more exists because all costs are variable costs.e. the new firms can also enter the market or the old firms can leave the industry. it may be stated at the given price a firm may be in – (1) Profit maximization Position (if AR > AC0. full adjustments are possible in the long run. On the other hand. The entry of new firms will wipe out such supernormal profits. by expanding the plant size. The entry of new firms in the context of supernormal profits will produce a twofold effect. Long run equilibrium: long run is defined as the period during which all factors are variable because of which the firms have sufficient time at their disposal to bring about full adjustment on the supply side. a firm may operate in spite of losses in the short run but it can not do so in the long run. it means in the long run. size of the firm. It may be earning supernormal profits (if AR>AC) only normal profits (if AR=AC) or losses (if AR<AC). if they face losses. 48/87 9/18/2007 1:31 PM . because if price is greater than AC. Thus. Such firms. The supply in the long run can be adjusted through a change not only in variable factors but also in fixed factors. The existing firms can expand output. (2) Loss minimization position when (AR < AC > AVC). the equilibrium of a firm will be reached at the quality between MC and MR i.DHARMENDRA MISHRA Thus the short run equilibrium of a competition firm exhibits all of the possibilities.
Thus. Equilibrium under Monopoly 49/87 9/18/2007 1:31 PM . (ii) Industry is in equilibrium because of quality between AR and AC. (2) AR = AC. a grand equilibrium is obtained.DHARMENDRA MISHRA Similarly. (iii) All firms tend to be optimum since they operate at lowest AC. (3) AR = MR = MC. From this. (4) AR = AC = MC=MR. (i) Decrease in supply and rise in price. (ii) Fall in demand for productive resources and consequent rise in cost. Thus. Hence it maximizes welfare. the long run equilibrium of a firm and industry exhibits the following remarkable features: (i) Firms are in equilibrium because MR = MC. AC and MC is obtained at price OP. MR. the exit of the existing firms will also affect the cost and revenue positions in two ways. This is shown in the diagram below: It may be noticed in the alongside diagram that corresponding to the output OQ2 the grand equilibrium between AR. no other price can prevail in the market because at a price higher than OP there will be supernormal profits inviting new firms while at any price below OP the losses will force the firms to leave the industry. the long run equilibrium exhibits the following: (1) MR = MC. not only an individual firms but the entire industry reaches a determine equilibrium because of the quality between AR and AC. Moreover. Thus in the long run under perfect competition. in the long run. (iv) Abnormal profits are absent due to equality between AR and AC. it is concluded that perfect competition is an ideal market situation which produces most efficiently and sells at the lowest price.
50/87 9/18/2007 1:31 PM . Since the AR curve is downwards sloping. This can be observed in the following diagram: In both (a) and (b) above.e. a demand curve i. Now. In the short period if AR<AC.e. firm suffers losses. in the short run there can be profits or losses under monopoly. implying profits or losses respectively. a monopolist aims at maximizing the profits. a firm cannot afford to face the losses. Long run Equilibrium: In the long run. Such profits can continue even in the long run because there is no fear of new firm entering and competing away the profits. The price i. In other words. In figure (a) at equilibrium output AR (i. it means the firm earns abnormal profits. AR. Thus.DHARMENDRA MISHRA Short run Equilibrium: like any other producer. If the price is greater than AC. QL) Hence there are abnormal profits. It can make full adjustments in supply according to the change in demand. though higher than MC.e. He produces that output at which MR = MC. AR curve facing a monopolist is downwards sloping which implies that a monopolist can sell more only at a lower price. can be higher or lower than AC. at equilibrium is less than AC. AR>MR. The output is OQ. there are abnormal profits worth the area PNLM. Thus. under monopoly. i.e. this price in the short run can be greater than or less than AC. In figure (b) since the price i. Since the AR>AC. Is greater than Ac 9i. in short run monopolist will be in equilibrium when MR=MC. the MR curve is always below the former. In short.e. But a monopolist will continue to produce so long as the price covers the average variable cost. Since a monopoly firm itself means the entire industry. But it will continue to produce. price is always greater than marginal cost.e. The price in the long run is necessarily higher than cost implying abnormal profits. there will be losses. QM). Firm is in equilibrium at point E producing OQ output. This can seen from the alongside diagram. under monopoly. AR>MR but MR = MC ∴AR> MC. a firm is in equilibrium at point ‘E’ at which MR=MC.
51/87 9/18/2007 1:31 PM . figure (a) shows equilibrium under diminishing cost. Thus. (1) Monopoly equilibrium can occur in any phase i. e>1. = M. (b) shows equilibrium under constant cost and (c) the equilibrium under increasing cost. AR curve at midpoint e=1 and below midpoint e<1. equilibrium under monopoly can be summed up as follows: (1) A monopoly firm like any other firm is in equilibrium when MR=MC. increasing. Thus.R Price = MC (e / (e-1)) Thus. i. price M=M. MR is negative. when e<1. the equilibrium must occur at that level of output at which MR is positive i.e.e. On a straight line demand i. e<1.R (e / (e-1)) but in equilibrium M. constant. (3) In the short run the price may be greater than AC implying abnormal profits or less than AC indicating losses.e. Since MC is positive. or diminishing cost conditions. Under any case a monopolist can permanently enjoy abnormal profits. it means producers will not be in equilibrium if the elasticity of demand is less than one.e. e = elasticity of demand Price = M.e. This is seen in the following diagram: in the above diagrams. (2) Monopoly price is a function of marginal cost and elasticity of demand.R.R. the equilibrium may occur at midpoint at which MR is zero. Producer equates MR with MC can never be negative no producer will produce when MR is negative i. If MC is zero.DHARMENDRA MISHRA Certain important features of monopoly equilibrium should be noted.C. (2) Price under monopoly is always greater than MC. equilibrium of the monopolist will necessarily occur at the level of output at which on the corresponding AR curve the elasticity is greater than one. A=M (e / (e-1)) where A = A. It is known that. monopoly price is a function of MC and elasticity of demand.
he has control over the supply of the product. It should be noted that generally price discrimination in confined to simple price discrimination. e>1. in railways and airways. it is rather difficult to offer the identical commodity at different prices. refers to the act of selling the same commodity at different prices in different markets whenever it is possible and profitable. “the act of selling the same article produced under single control. In practice. Joan Robinson. there are many cases in which a monopolist charges different price for the same product such a practice of charging different prices from different prices from different groups of consumers is known as price discrimination. (7) A monopolist may produce output corresponding to unit elasticity if MC is zero. Price discrimination. He can sell the commodity at different prices to different consumer. In the words of Mrs. (5) Monopoly equilibrium may occur under any cost conditions i.e. i. at different price to different buyers is known as price discrimination. price discrimination is practiced.e. (6) Monopoly equilibrium will necessarily be at that level of output which corresponds to elastic demand. therefore. i.e. Under perfect competition with large number of producers.e. commodities or services are slightly differentiated. diminishing increasing or constant. Therefore. It means monopolist can permanently enjoy the abnormal profits. to widen the scope of price discrimination. i. For example. the individual firm has no control over the market-supply.DHARMENDRA MISHRA (4) The long run price under monopoly will always be greater than AC. PRICE DISCRIMINATION Meaning of price discrimination: So far we have discussed the price output determination under simple monopoly. under a situation in which the monopolist charges uniform price for the same product to different consumers. As the monopolist is a single producer in the market.” 52/87 9/18/2007 1:31 PM . charging different prices for the same product from different consumers. Hence it is not possible to practice price discrimination in a competitive market. However.
(consumer’s illusion) 53/87 9/18/2007 1:31 PM . etc. the monopolist charges a lower price at one place and a higher price at other places. it follow that price discrimination will be possible when the monopolist is able to keep his two markets separate. Age discrimination and sex discrimination is also practiced. industrial and agricultural uses. Similarly. a deluxe edition of a book is sold at a higher price than its paper-back edition. From the above. other professionals like lawyers. there are different tariffs in the supply of electricity for home consumption. For instance. a doctor may charge higher fees to the rich and lower fees to the poor. Similarly. For example. there are different rates for trunk calls. there should be no possibility for the consumers to transfer themselves to the cheaper market. First. When is price discrimination possible? Broadly speaking. (4) Quality discrimination: Price discrimination may also take place on the basis of qualitative differences of the same product. (Ignorance of consumers) (ii) The consumer has irrational feeling that he is paying a higher price for a better quality. consultants. (2) Local Discrimination: in local discrimination. Other important conditions of price discrimination are as follows: (1) Price discrimination often occurs due to consumer’s peculiarities. The important forms of price discrimination are discussed as under: (1) Personal discrimination: Personal discrimination occurs when different prices are charged from different consumers depending upon their incomes. In this case there are three possibilities. it should be impossible to transfer the commodity from the cheaper market to the dearer market.DHARMENDRA MISHRA Thus. For example. Similarly. in dumping. (3) Trade discrimination: this form of price discrimination is based on the use of the product. or it can be a discriminating monopoly when he discriminates between users or persons and charges different prices for the same product. trunk call charges are higher during day time and lower during night time. For example. Second. (i) The consumers are very often unaware that prices have changed. cinema houses charge different admission rates. For instance. two important conditions are essential for the price discrimination to become possible. railways charge different rates for different classes of travel. For example. a monopoly can be a simple monopoly when a uniform price is charged by the monopoly firm. (5) Special service discrimination: In this situation price discrimination takes place on the basis of special services provided to the consumers. (6) Time Discrimination: Different prices for the same commodity or services are charged at different times. Forms of price discrimination: price discrimination by a monopolist may take many forms. the monopolist charges higher price at home and lower price in a foreign market. may also discriminate between rich and poor. teachers.
Above are the circumstances under which price discrimination is possible. Similarly. Most common example is provided by railways where the first and second class fares widely differ. the facilities provided in the first class hardly are in proportion to the high fare charged. (4) Discrimination often occurs when the market are situated at large distance and makes it very expensive to transfer goods from a cheaper market to the dearer market. When is Price Discrimination Profitable? We have so far analyzed the conditions in which price discrimination is possible. it is largely prohibited to transfer the use of commodity from a particular purpose. (Let go attitude) (2) Price difference also occurs due to legal sanction where customers are divided into different groups. However. the most fundamental factor of profitability is the nature of elasticity of demand at the single monopoly price in these markets. Hence this also is a way of price discrimination. In this case the basic condition is that the elasticity of demand should be different in different market. But it may not be always profitable for him to practice price discrimination. For example. Since he is serving two markets the marginal revenue (Combined MR) obtained in both the markets must be equal to MC. the electricity company has different tariffs for domestic and industrial consumers. Sometimes different services are rendered or different goods are offered at different prices. In this case price discrimination refers mostly to direct services which can not be resold. (3) Price discrimination will be possible due to the nature of the commodity. This enables the monopolist to earn maximum profit However. Namely a home market with tariff and a world market without tariff. Price discrimination does not necessarily imply that different prices are charged for the same product. It should be noted that the monopolist seeks maximum profits when he fixes his output so as to equal marginal revenue with marginal cost. Likewise in railways it is an offence for one to travel in other class without a proper ticket. Further. but the differences in the quality are not so high as to justify the price difference. It follows from the formula M That MR in two markets is the same and therefore. the monopolist may serve two different markets. If the elasticity of demand in each market is the same at each price the monopolist will not resort to price discrimination because marginal revenues are equal. it also depends on his power to ensure that no one else sells his products at a lower price. if different prices are charged by transferring the output discrimination will not be profitable: 54/87 9/18/2007 1:31 PM .” Thus. It will be possible when the monopolist is serving separate markets. These services are directly given to the consumers and therefore. the resales are impossible.DHARMENDRA MISHRA (iii) Price difference are marginal and the consumers simply do not bother about the changes in price. “price discrimination as the sales of technically similar products at prices no which are or proportional to marginal costs. it is clear that all these forms of price discrimination depend on his ability to retain his customers. He can take advantages of tariff barrier to sell the commodity at a higher price in the home market and at a lower price in the world market. He will sell at different prices till the MR obtained in one market is equal to the MR obtained in another market.
Technique of price discrimination Price-output determination under discriminating monopoly. MR in that market will decline.. the equality between MR and MC. We are acquainted with the basic principle of profit maximization viz. the seller will be benefited by transferring some quantity from the latter to the former market. (a) How much to produce? (b) How to distribute the total output among the different markets? 55/87 9/18/2007 1:31 PM . by transferring the commodity. price discrimination will be profitable. as he withdraws some quantity from other market. The monopolist practices price discrimination for maximizing his total profits. can charge different prices at which the gain in MR will be greater than the loss in MR> he will continue transferring units of the good until marginal revenue in two markets are equal. The same principle is equally applicable to discriminating monopoly. monopoly price are different.DHARMENDRA MISHRA If elasticties of demand in two markets at a single. Under discriminating monopoly. When more is supplied in the market with higher MR. and therefore. If follows from the above analysis that price discrimination will be profitable only when the elasticity of demand is different in each market. On the other hand.e. AR. MR in that market will rise. there are different AR and MR curves corresponding to different markets. The process of shifting will continue till the MRs in the different markets become equal. Thus. The principle of profit maximization is extended to different markets. condition of equilibrium of discriminating monopoly can be stated as MC=MR1 MR2=MR3…. Once such equality is achieved any further shifting will be unprofitable. and hence. The monopolist will equate his MC with each MR. The monopolist will. the monopolist will sell that much output in each market at which MR in each market is equal to the MC. thus. If the MR in one market is higher than that in the other market. the price i.MR This condition means that given the different demand schedules corresponding to different markets. equalize the marginal revenue in the different markets. It is evident from the above formula that MR in the two markets will be different and the monopolist. the price. The discriminating monopolist is required to take two decisions.
as explained above. (b) Show two different markets with different degrees of elasticity. each one selling a small proportion of the total output. Market structure: Perfect competition is a market situation is which there is a large number of buyers nad sellers. © at which the MC curve intersects the AMR curve. AR1 and AR2 are the demand curves and MR1 and MR2 are their corresponding marginal revenue curves in higher and lower markets respectively. The monopolist will. the technique of price discrimination lies in equating the marginal cost of total output with the aggregate marginal revenue to determine the total output produced and to marginal revenue in each market to distribute the total output in different markets. In the above diagrams Fig. Monopoly and Perfect Competition – A Comparison We have so far analysed the market situations under perfect competition and monopoly. The discriminating monopolist will be in equilibrium at point E in fig. (a) depicts a higher market with less degree of elasticity while Fig. E1 and E2 are the equilibrium positions in the two markets. However.DHARMENDRA MISHRA The answers to the two questions above are found by equating MC of the total output to the aggregate marginal revenue (AMR) which is obtained by adding up the marginal revenues in the different markets. price and output determination. a parallel line drawn from the point of equilibrium ‘E’ intersects MR1 and MR2 at E1 and E2 respectively. OQ. Hence. The following figure clarifies the point. It can be easily noticed that he charges higher price in less elastic market and lower in more elastic market (OP1 >OP2). therefore. equality between MC and AMR provides answer to the first question faced by the discriminating monopolist viz. therefore. the size of profit etc. All competing firms have to accept this price. (a) And Fig. again he is helped by the marginal principle. how much to produce. we may attempt a comparison between monopoly and perfect competition with reference to their characteristics.e. The aggregate marginal revenue curve (AMR) obtained by lateral summation of MR1 and MR2 drawn in Fig.. sell OQ1 quantity at price OP1 in the first market. Thus. The price in the market of the entire industry is determined by the forces of demand and supply. (b) portrays a lower market with higher elastic demand. profit maximizing output has been fixed. It may be observed that fig. Thus. The total output produced by the monopolist is. One of the common features of these market situations is that the firms aim at maximizing profits at the equilibrium output where: marginal cost equal marginal revenue. In the above diagrams. the monopolist will sell that much output in each market at which MR in each market equates the MC. Thus. After the equilibrium i. he will produce at the level of output at which MC=AMR=MR1+MR2…+MRn. (c) above. Thus. As them are large numbers of (a) 56/87 9/18/2007 1:31 PM . and Oq1 at price OP2 in the second market. there are significant dissimilarities between the two market situations. next problem facing the firm is the distribution of this output among different markets so as to acquire maximum profits. In solving this problem.
Robinson “ a monopoly firm can exist only so long as it is able to bar the entry of its potential competitors or rivals. In this context. the total demand for the commodity rises. as individual firms can sell any amount depending upon its size. Hence there is no distinction between the firm and industry under this type of market situation. Sources of Monopoly Power There are many factors or circumstances responsible for the emergence of monopoly. Thus. (c) Price-marginal cost relationship: As pointed out. under monopoly. industry cannot sell more at the same price. There is a clear distinction between the firm and industry. A monopoly firm may also acquire raw materials in big quantities at lower prices.DHARMENDRA MISHRA firms. for the same product. Thus. Thus. The monopoly firm itself fixes the price for its product unlike perfect competition. the demand curve (AR) of an industry will have a negative slope. the monopoly firm is a price maker. especially those the supply of which depends on natural forces. the firm accepts the price as given and adjusts its output at the level which ensures maximum profit it is clear. (b) Nature of demand curve-and industry: Under perfect competition. A monopoly firm may emerge when there are restrictions to the entry of new firms into the organization. It would be an effective barrier to the entry of other firms into the monopoly industry. The demand curve (AR) of a firm is perfectly elastic and the marginal revenue coincides with it. the geographical distribution of natural and mineral resources is very uneven. This is characterized as natural monopoly. Since it can sell as much as it likes at the prevailing price. In fact. In such a situation a firm may acquire control over 57/87 9/18/2007 1:31 PM . But the demand curve faced by the industry consisting of a large number of firms slopes downward from left to right. there are two important points: (a) the firm emerging as a monopoly power. It implies that if the product has close substitutes. But there are differences between the prices – marginal cost relationship. Every firm is. the demand curve or the average revenue curve (AR) faced by the firm and industry will be different. selling homogeneous products. therefore. (2) Nature monopolies: Monopoly may emerge due to one single firm’s control of raw materials. for instance. On the other hand. the total output produced by an industry is quite large. thus. at ruling price. once the price in the market is established. and the entry of new firms is restricted. the monopoly firm will continue to enjoy the privileged position even in the long run. Accordingly. According to Prof. and (b) to retain that power in the long run. monopoly may emerge when a single firm has control over the supply of strategic raw materials. Since. Thus. that under perfect competition there can be only one price in the market at a point of time because the products are homogeneous. it has no incentive to lower it. When the price is reduced. He may charge either a single uniform price or different prices to the consumers. there is only one firm selling a particular commodity or service. a price taker and output adjuster in the market. already there is similarity between the equilibrium conditions of the firms under perfect competition and monopoly. the absence of competition is the essence of monopoly.” (1) Control over raw materials: It may be possible for single firm to acquire ownership or control of essential raw materials required for production.
singers. These economies of scale reduce the cost of production and thus enable the firms to supply goods at low prices. operate on a large scale and enjoy economies of large scale production. Monopoly power can also be acquired if a firm has control over professional services. As a result. In other words. E. cartels. In this case. labour etc.DHARMENDRA MISHRA natural resources. These business combinations are variously called as pools. Similarly. The liberalization of licensing policy. It is a protected from the threat of competition from new firms making identical products. trade associations etc. tariffs on imports of certain goods will restrict foreign competition in the domestic market.g. transport. may not be permanent. monopoly is preferred. such combinations exploit the consumers and therefore. innovations. motor cars etc. It is possible for new firms to enter the industry at one stage or the other because of discovery of a new source of raw materials. telephone services etc. chemicals. etc. For instance. Similarly in public utility services like water supply. In order to eliminate monopoly power. copy right etc. the firms manufacturing types. a firm gets an absolute monopoly power in the production of a particular commodity. capital equipment. (6) Technical economies of scale: There are a number of industries which are dominated by a few giant firms with great technical economies of scale. Similarly. (3) Legal barriers: This is most important factor to confer the monopoly right and prevent the entry of the potential competitors. the firm is protected by law against imitation by rival producers. syndicates. some surgeons. anti-trust and anticartel legislation have been passed in the USA. it should be noted that different sources are more or less temporary in nature. From the above discussion of the sources of monopoly power. trade marks. (5) Existence of goodwill or reputation: A well established firm possesses a degree of monopoly power. But the Government subjects such services to certain regulations in the interest of the consumers. socially least desirable. 58/87 9/18/2007 1:31 PM . Natural monopolies. posts and telegraph. It is prohibitively risky for the new firms to compete with the existing firms. output and sharing of the market it will also prevent the entry of new potential competitors. law may confer patent. They do not confer permanent monopoly power. trusts. This will tend to create a monopolistic position for the domestic producers. Such a firm will have considerable goodwill and it is virtually impossible for potential competitor to enter the industry. monopoly may emerge as a result of certain legal provisions of the government. it is impossible for the new firms to enter the industry. existence of economies of large scale production may not always mean the possibility of only a few giant firms. liberal bank credit may result in the emergence of new competitors. This will help them to eliminate competition among the groups in terms of price. the existence of giant firms enjoying economies of large scale production etc. Again the Government may reserve certain products and services for itself in order to provide better services to the community. On the privileged firms. railway etc. can charge higher fees than others in the same profession. Further. lawyers. for instance. These tend to become natural monopolies and competition in such services is avoided. (4) Business combinations: It is possible for a number of big business companies to acquire a degree of monopoly power through voluntary agreement.
(b) External economies: These are associated with the entire industry. Experts can be appointed by a large firm to perform specialized functions. Thus. During short period. Such benefits are shared by all the firms in the expanding industry. A larger firm is able to employ such machinery and equipments. Now if an individual restaurant grows in size i. • Beyond desirable limit. With the expansion of the scale of production a firm derives certain benefits i. Beyond certain limit. the technical economies occur due to application of superior technique. (b) Another type of technical economies enjoyed by the large firm are the advantages of division of labour. The economies of scale are classified into two broad categories viz.e. (a)Internal Economies The term refers to those advantages which are enjoyed by an individual firm in an industry. it is possible a form to expand or contract its size as per the requirement. In the long run. Thus • Initially expansion of the firm renders advantages and the firms enjoys increasing returns. which lead to diminishing returns to scale. returns to scale. since some factors of production are fixed. the scale of production. Take for example hotel industry. These benefits can be termed as internal economies. there is a tendency to continue as a monopoly. Different individual restaurants are the firms that constitute that industry. • In between the balances between economies and diseconomies brings about constant returns to scale. 59/87 9/18/2007 1:31 PM .e. Such monopolies are socially more desirable. These are the economies of specialization. Economies of Scale Economies of scale refer to the advantage enjoyed by affirm due to expansion of its size i. Internal economies enjoyed by an individual firm can be discussed under different categories as follows: (1) Technical Economies: (a) Technical economies are those advantages enjoyed by the firm which emerge due to greater efficiency of capital equipments. the expansion leads to occurrence of diseconomies of scale and the firm suffers the diminishing returns to scale. a firm cannot alter the scale of production. since all factors are variable.DHARMENDRA MISHRA However. Such benefits are not shared by all but accrue only to that firm which grows in size. The firm enjoys a reduction in cost per unit or increase in output as a result of such specialized capital equipments. in the case of social monopoly or public utility. economics of scale due to which the increasing returns to scale are experienced. the expansion of size causes disadvantages or diseconomies.. Here economies of scale are associated with long run production function i. expands the sale it alone will enjoy certain advantages.e. however.e. (a) Internal economies: this refers to those advantages which are enjoyed by an individual firm which expands its scale. A small firm is unable to install specialized and advanced machinery.
a large firm can enjoy many advantages in the marketing of their product through advertising. the owner has to look after different processes. These economies or advantage are called the advantage of functional specialization. Thus. risk-bearing or survival economies are enjoyed by an expanding firm. fall in demand etc. (e) Dimensional economies are also enjoyed by the use of large sized capital equipment. (5) Risk-Bearing Economies (survival Economies): Lastly. large firm may be able to enjoy certain advantages which are absent in the case of a small firm. When the different processes are linked together under one control the dependence and inconvenience is avoided. diversification of markets and minimizes the risks. In a small firm. a large firm with sizable resources can effectively face such risks and can survive. (d) Similarly. it can be concluded at a large firm enjoys various internal economies because of which a firm is in a position to enjoy increasing returns. (2) Managerial Economies (Administrative Economies): These economies result from the managerial division of labour. Experts and qualified persons can be appointed only by a large firm. Thus. whereas large firms are in a position to bear such risks and overcome the same. (4) Financial Economies: A large and reputed firm enjoys certain gain in the matter of raising funds. These are known as the economies of by-products. a large firm may be able to avail of the economies of linked processes. certain risk-bearing economies are enjoyed by a large firm. It means as the size of the firm 60/87 9/18/2007 1:31 PM . Thus. The large firm buys the raw materials in big quantities because of which it is assured of regular supply at a cheap rate. Thus. Marketing economies may also arise from specialization. These economies are essentially associated with the large firm. A large firm can do as very smoothly as the public in general is willing to subscribe to their capital needs. A small firm finds it difficult to sell shares and debentures. An expanding firm is also in comfortable position in respect of obtaining credit from banks and other financial institutions. on the other hand. Thus. Such firm spreads the risk by diversification of products. various financial economies accrue to an expanding firm. a large firm can reduce the expenses in the purchase of raw materials. Similarly. (3) Marketing Economies: These economies emerge from the bulk buying. Such an advantage cannot be enjoyed by a small firm.DHARMENDRA MISHRA (c) A large firm can make a proper use of wastes for producing by-products. A large firm also enjoys concession in transport charges. Business fluctuations and the risks associated with them bring the every the very existence of such small firm into danger. A large firm can afford to have its own marketing department through which the services of experts can be obtained. It can raise the loans easily and at cheaper rates. A small firm finds it difficult to face the general and particular risks arising out of economic depression.
(d) Supply of adequate sources of power. Such economies help in reducing the cost of production i. It means the increasing returns can be attributed to the external economies along with the 61/87 9/18/2007 1:31 PM . (b) Availability of skilled and trained labour. Various such economies can be discussed as follows: (1) Economies of Concentration: Certain benefits occur as a result of concentration of localization of industry. any further expansion will lead to diseconomies of scale and the firm will face the diminishing returns. it receives the following advantages: (a) Provision of efficient transport system. raising the average and marginal returns. The external economies emerge particularly from the localization of industry. (3) Economies of information: The industry may publish certain trade journals which are useful to the firms. Technical information may also be made available. The expenditure on advertisement and such other sales promotion drive may be borne by the industry as a whole and to that extent the expenditure of an individual firm can be reduced. Development of such firms helps in reducing the cost of the main industry. Beyond this point.e. These gains thus accrue to all the firms in the industry. (2) Economies of Disintegration: With the growth of the industry. If we consider again the hotel industry. Thus. a particular place becomes a favorite tourist attraction. it gets more than proportionate returns. Restaurants and hotels in that area can naturally get number of advantages. Similarly. However. When an industry gets concentrated in a particular area.g. (b) External Economies There are certain advantages which are enjoyed by all the firms in an industry.DHARMENDRA MISHRA expands. (c) Better and cheap credit facilities through the development of banks and other financial institutions. They are termed as external economies. Increasing returns imply diminishing costs. this phase of increasing returns or diminishing costs can not occur indefinitely. the industry can establish its own research center which will benefit the different firms. It is possible to visualize such external economies e. A limit to the expansion of the firm is reached at a point where average returns are maximum and average costs are minimum. it gains certain benefits or advantage known as external economies which help the firm in increasing the production or reducing the cost. Surveys can be undertaken which help the firm in obtaining the statistical and market information. These advantages can not be secured by the firms if they are not localized. various other firms come up in the area and these firms supply raw materials to the main industry and also make use of the wastes of the industry for producing the by-products. when the industry grows. As a result of growth of a particular industry many benefits are shared by all the constituent firms.
etc. Thus. with the growth of the firm many important and responsible functions have to be delegated to lower level officials who are inexperienced and lack the necessary knowledge to perform such decision-making functions. When the firm expands. This results in growing labour problems. The problems faced are mainly of coordination and supervision. diminishing returns creep in due to problems and complexities of the management. they have to depend upon second hand information. Managerial Diseconomies: Beyond certain limit the growth of the firm creates many managerial problems and difficulties. In the long run. the decision-makers are not directly concerned with productive. diminishing return to scale is nothing but a special case of the law of variable proportions. The various economies such as technical. Some economists are of the opinion that since entrepreneur is always a fixed factor. 62/87 9/18/2007 1:31 PM . Hence. This result in delay and red-tapism reducing the efficiency which causes the diminishing returns.burdened & hence inefficient. Diseconomies of Scale (1) Internal diseconomies: As the firm expands in size. The large size of the firm reduces the initiative. But as already stated. It means what really happens is that the proportion between fixed (entrepreneur) and variable (other inputs) factors go on varying and the diminishing returns to scale occur. it becomes unwieldy and uncontrollable. The personal contact between management and workers is lost in a large firm. which bring about increasing returns initially. Moreover. the advantages turn into disadvantages and result in diminishing returns or increasing costs. Those who do not admit diminishing returns to scale to be special case of the law of variable proportions attribute the occurrence of diminishing returns to the various managerial and technical diseconomies which result from expansion of the firm beyond the optimum size. it experiences certain economies or advantages as mentioned above. when decision-making is done by different groups there can be disharmony. these equipments become over. In addition to this. Any expansion of the firm beyond this optimum limit will lead to diseconomies of scale. all other inputs except the entrepreneur are variable. Technical Diseconomies: As the size of the firm expands beyond the optimum limit. with the growth of the firm beyond the optimum limit. these advantages can be enjoyed only up to a certain limit upto which the average returns go on increasing or average costs go on diminishing. There is a separation between those who take decisions and those who execute the same. the economies arising from specialization and indivisibilities change in diseconomies Division of labour and specialization beyond certain limits prove to be in efficient. Thus.DHARMENDRA MISHRA internal economies. Similarly the indivisible equipments have a maximum capacity up to which such equipment work more and more sufficiently but once these limit is crossed . Thus increasing returns occur due to internal as well as external economies. managerial. develop into internal diseconomies.
6 Writes a short note on causes ad disadvantages of monopoly 7Explain the main features of monopolistic competition .explain ad illustrate the condition for the establishment of firm’s equilibrium under perfect competition 4 In short run cost analysis. explain with diagram giving reasons the following statement “the MC curve intersects both the AVC curve ad ATC curve at their minimum points” 5 Explain the main features of oligopoly market.DHARMENDRA MISHRA External Diseconomies: the external economics which benefit the firm’s initially change into diseconomies and result in raising the cost of production the diseconomies are of different types Transport bottlenecks causing delay in obtaining raw materials and marketing finished products High rent which is inevitable result of localization Wage rates increase as a result of increasing demand from number of firm’s The firm’s have to use less and less efficient units of input Question bank 1 Writes a short note on economics of scale 2 Explain the term price discrimination.How does it differs from perfect competition 8 Describe the short and long run equilibrium under monopoly 9 Writes a short note on imperfect competition 10 name & explain the different types of market 63/87 9/18/2007 1:31 PM . How is price determined in a discriminating monopoly? 3 Distinguish between the perfect and monopolistic competition .
Thus. because of the close link with capital expenditure forecasting. Competition has spread to most areas except those where massive investment is required. with the relaxation of industrial licensing regulations and economic liberalization in general in recent years increasing competition has already begun to change the situation in India as well. The national Council of applied Economic Research has made demand forecasts for a number of products (consumer as well as industrial) on a macrolevel. supply is often the limiting factor. In fact. buildings. depends upon the nature of the industry but. and long-run forecasting covering a period of 5. Because of unrealistic estimate of projected demand and production. machine accessories. These forecasts can be helpful in determining industry demand.000 cores on imports of even essential goods. etc. forecasting is an important aid in effective and efficient planning. labour. the very high capital costs 64/87 9/18/2007 1:31 PM .. Forecasting helps a firm to assess the probable demand for its products and plan its production accordingly. supply as far in excess of demand and the producers have begun to battle for the market place. In such areas. However. 10 or even 20 years. demand forecasting is bound to become important in India also. some firms may as a policy produce to order but generally. For example. beyond ten years. It may be necessary to look 20 years ahead in case of certain industries. however instead of the demand. shipping companies and paper mills. Demand forecasting is very popular in industrially advanced countries where demand conditions are always more uncertain than the supply conditions. However. usually defined as covering any period up to one year. How far ahead can the long-term forecast go. petroleum companies. In developing countries. Demand forecasting is also helpful in better planning and allocation of national resources. Naturally.How far ahead? The problem is solved by having both short-run forecasting. firms produce in anticipation of future demand. It can also help management in reducing its dependence on chance. viz. in view of the long life of the fixed assets. equipment. in a country like India supply forecasting seems to be more important than demand forecasting. raw materials. High prices and black markets point to supply bottlenecks. India had to spend in 1978 Rs.DHARMENDRA MISHRA Demand Forecasting Accurate demand forecasting is essential for a firm to enable it to produce the required quantities at the right time and arrange well in advance for the various factors of production. 1. the becomes so uncertain that the projection becomes rather dubious. FACTORS INVOLVED IN DEMAND FORECASTING There are at least six factors involved in demand forecasting: 1.
here too. which is the most important from managerial viewpoint 2 Should the forecast be general or specific? The firm may find a general forecast useful. do have to forecast well deep into the future. Accordingly. which could be avoided if production is continued during the slack period. If stocks can be built up in the slack sales period. It is. short-term forecast is one which provided information for tactical decisions. it is concerned with extending or reducing the limits of resources. but it usually needs to be broken down into commodity productwise forecasts and forecasts by areas of sale. However. Such external data constitute the basic assumptions on which the business must base its forecasts. concerned with day-today operations within the limits of resources currently available. When it is intended to replace plant or to buy new or improved machines. 2 For example. 65/87 9/18/2007 1:31 PM . (b) Industry-level prepared by different trade associations. the time required to purchase and to bring it into use. a very short period should be taken. depending upon the nature of the business. equip and bring it into operation will be five years. if it is intended to establish a factory.© Firm-level. Thus the time period involved will be ten years. the period chosen will depend upon the expected life of the plant or machinery. and it is thought that the time required to build. for which sales trends are known and the competitive characteristics of the product well understood. The latter may cause problems of labour and machine utilization. then the forecast of the demand for the products to be made in the factory must start five years ahead. Short-term forecasting may cover a period of three months six months or one year.DHARMENDRA MISHRA involved and the possibility of profit only in the distant future. and may be projected for a further five-year period in order to establish the viability of the project. Which period is chosen depends upon the nature of business. therefore. the last being the most usual. national income or expenditure. Instead of defining short-term and long-term forecasting in terms of different periods of time1 an alternative method is to associate them with certain types of decisions or objectives to be met. A long-term forecast is one. this may be preferable to a fluctuating level of production. 1 Demand forecasting may be undertaken at three different levels (a) Macrolevel concerned with business conditions over the whole economy measured by an appropriate index of industrial production. when demand fluctuates from one month to another. and the time required for the capital outlay to be recovered. 3 Problems and methods of forecasting are usually different for new products from those for products already well established in the market. which provides information for major decisions.
consumer durables or consumer goods and services. Setting sales targets and establishing controls and incentives. enable arrangement of sufficient funds on reasonable terms well in advance. Purposes of Long-term Forecasting (i) Planning of a new unit or expansion of an existing unit. they will be discouraging salesmen who fall to achieve them: if set too low. The nature of the competition in the market how far the situation is complicated by uncertainty or non-measurable risk and the possibility of error of inaccuracy in the forecast must be seriously considered. Helping the firm in reducing costs of purchasing raw materials and controlling inventory by determining its future resource requirements.g. Sales forecasts will. Cash requirements depend on sales level and production operations. Economic analysis indicates distinctive patterns of demand for each of these different categories. 5 Finally in every forecast special factor peculiar to the product and the market must be taken into account. it takes time to arrange for funds on reasonable terms. Purposes of Short-term Forecasting (i) Appropriate production scheduling so as to avoid the problem of over production and the problem of short supply. A multiproduct firm must ascertain not only the total demand situation. but also the (ii) (iii) (iv) (v) 66/87 9/18/2007 1:31 PM . For this purpose production schedules have to be geared to expected sales. Sociological factors are of great importance in some markets e. therefore. their own personal prospects and about products and brands are vital factors for firms and industries. If targets are set too high. Determining appropriate price policy so as to avoid an increase when the market conditions are expected to be weak and a reduction when the market is going to be strong. Political developments such as general elections are also important. the targets will be achieved easily and hence incentives will prove meaningless.. Forecasting short-term financial requirements. in the case of women’s dresses likewise the role of psychology in demand can hardly be understated. Moreover. PURPOSES OF FORECASTING The purposes of forecasting differ according to types of forecasting: shortterm forecasting and long-term forecasting. It requires an analysis of the long-term demand potential of the products in question.DHARMENDRA MISHRA 4 It is important to classify products as producer goods. What people think about the future.
which are luxuries. demand forecasts are useful to the industry as also to the government. At the macro level demand forecasts may also help the government in determining whether imports are necessary to meet any possible deficit in the domestic supply. Training and personnel development are long-term propositions. As planning for raising funds requires considerable advance notice. Price as a determinant of the volume of sales of consumer non-durables is sometimes more important through cross-elasticity (involving substitute products) (iii) (A) (B) 67/87 9/18/2007 1:31 PM . The price factor is another important variable to be included in demand analysis. Thus. Here. the demand forecast for cotton textiles may provide an idea of the likely demand for the textile machinery industry.S. dyestuff industry as also for ready made garments industry. (ii) Planning long-term financial requirements. Discretionary income can be quite an important determinant in case of consumer non-durables. Some people suggest the use of discretionary income in place of disposable income.O. This is determined by disposable personal income (personal income direct taxes and other deductions). its competitive position would be much better. one has to consider the prices of the product and also its substitutes and complements. Non-durable consumer goods. Price. Data on aggregate personal income and personal disposable income are published by the Central Statistical Organization (C. imputed income and income in kind.). One may also consider the price differences between products concerned and its substitutes and complements. DETERMINANTS OF DEMAND 1. major fixed outlay payments such as mortgage debt payment. long-term sales forecasts are quite essential to assess long-term financial requirements. There are three basic factors influencing the demand for these goods: Purchasing power. Planning man-power requirements. For example. or in devising appropriate export promotion policies if there is a surplus. taking considerable time to complete. Insurance premium payments and rent and essential expenditures such as food and clothing and transport expenses based upon consumption in a normal year.DHARMENDRA MISHRA demand of different items separately. Discretionary income can be estimated by subtracting three items from disposable income vtz. If a company has better knowledge than its rivals of the growth trends of the aggregate demand and of the distribution of the demand over various products. They can be started well in advance only on the basis of estimates of manpower requirements assessed according to long-term sales forecasts. The demand forecasts of particular products may also provide a guideline for demand forecasts for related industries.
DHARMENDRA MISHRA than it is directly in terms of rice elasticity. Which are capable of storage and are free from risks of changes in styles. 2. However. geographic location. prestige etc. P) Where d is demand. This involves the characteristics of the population. But in a developing country like India. In fact. Direct price elasticity can be expected to be more important with respect to those consumer non-durables. there is no alternative but to continue using the old product. Such segments may be derived in terms of income. Y is disposable income. In periods of shortage. For example. If necessary or (b) disposing it of and replacing it with a new one. Durable consumer goods.. For example. can be used as an independent variable affecting the demand for the product in question. human as well as non-human. Thus food prices exert a negative influence on the demand for cloth. or on economic factors like income and obsolescence. It bears a negative relationship with the price of cotton cloth and with the prices of complementary commodities. urban-rural ratios. prices of food grains constitute an important determinant of the demand for cloth. the segment. D is demography and P is price. The various determinate of the demand for cotton textiles can provide a good illustration. it may pertain to the number and characteristics of children in a study of the demand for toys or the number and characteristics of automobiles in a study of the demand for tyres or petrol. © Demography. population may increase and fashions and consumer preferences may undergo a change. etc. social status. The choice may depend upon non-economic factors like social status. over a period of time a change may take place in some or all of these factors. age. prices of substitute commodities and the income of consumers. male female ratios. D. For example. sex. Demand can be forecast by employing the following formula: D = J (Y. educational level. it involves distinguishing between the total market demand and market segments. using the product concerned. The demand for cotton cloth is a function of the price of cotton cloth. 68/87 9/18/2007 1:31 PM . Since the demand for food is inelastic any increase in the food prices leads to a corresponding increase in the expenditure on food reducing the part of income available for purchasing other goods including cotton cloth. The important considerations in the forecasting of demand for durable consumer goods are as under: (A) The consumer has to make a choice between: (a) using the goods longer by repairing it. This icads to a cut in the demand for cloth. a person may replace his black and white TV by selling it or just exchanging it for a colour TV after paying the difference in prices. when quantified. on the other hand a positive relationship exists with the prices of substitute commodities and with income.
This facility has now been extended in India as well. the principal effect would be dampen the influence of price. Once a person gets used to a thing he is unlikely to give it up at some future date. the decision to purchase may be influenced by family characteristics. the total household figures are more important than total population figures (and changes therein). Each of these independent variables may be forecast separately. Many firms specialize in selling goods on hire purchase. The difference between optimum and the actual stock shows the growth potential of the demand for durable goods. (F) Price and credit conditions. Such as the size of families and the age distribution of adults and children as well as price. When purchasing power increases. The replacement demand tends to grow with the growth in the total stock with the consumers. roads for automobiles. where N is New owner Demand and R is the Replacement Demand. In fact.DHARMENDRA MISHRA (B) These goods require special facilities for their use. electric shavers) that are used individually could be expected to depend more on population than on households. when demand exceeds production. changes in credit terms can offset a price increase: lowering the cash down payment or extending the credit period or reducing the rate of interest. The total demand is symbolically stated as d = N + R. e. The ratio of price to the average like of the product should be considered. (E) The total demand consists of (a) a new owner demand. and (b) a replacement demand. The names of Zarapkars of Bombay and V G Pancreas of Madras need a special mention in this respect. and electricity for refrigerators and TVs. It is the level towards which the actual volume of consumer stock tends to gravitate.g. Disintegration of joint Hindu family has led to an increase in the number of households. (D) As consumer durables are used by more than one person. life expectancy tables have been prepared in advanced countries in order to estimate the average replacement rates. The existence and growth of such facilities is an important variable for determining their demand. The availability of hire purchase facility tends to push up the demand for consumer durables. The few consumer durables (for example. The purchasing power. (C) To the extent that the consumer durable is used by “household” rather than on an individual basis. the number of families and some other factors depending on the product concerned. Among the manufacturers. scrap page rate is lower. For certain well-established products. extension of credit is used as a sales promotion measure. set an upper limit to the maximum or the optimum level. the scrap page tends to increase. If the average life is high. the 69/87 9/18/2007 1:31 PM . income and other considerations. Western countries have had this facility as a matter of routine. Again. But as production catches up. This makes replacement demand regular and predictable. the scrap page rate tends to be high and vice versa again..
the discretionary purchases may be postponed if there are reports of impending product improvements. the manufactures of Singer. demand will depend upon the specific markets they serve and the end uses of which they are bought. there is no compelling need to make these discretionary purchases at any given time. and the level of wage rates. Again. (A particular commodity may be a producer good for one but consumer good for the other). 70/87 9/18/2007 1:31 PM . They are very often made at unevenly spaced intervals of time. 3. These deliberations very often involve choice among many competing consumer durables. For estimating the demand for aero planes. Capital goods are used for further production. (ii) The availability of vehicles. the ratio of production to capacity in the user industries.. usually several months elapse between the formation of the idea and the culmination of the purchase decision. Purchases of consumer durables are rather discretionary.S. the management will seriously consider further investment in labour-saving equipment. The relative importance of these various factors will vary from country to country. The demand for cable extruders would depend primarily on the demand for cables which in turn would be linked to electrification programmes. The demand for textile machinery will for example. Capital Goods. New demand as well as replacement demand will have to be considered. it is a function of new houses built. the demand for refrigerators in India is mainly a function of income while in the U. The demand for commercial vehicles depends upon (i) The scrap page rate.A. it will depend upon the profitability of industries using the capital goods (called user industries). For example. Thus durables are bought sporadically. So also. Government spending etc. the points to be considered are expected passenger demand and traffic growth. The intensified competition between car and two-wheeler manufacturers has led to many firms extending credit for their purchase. be determined by the expansion of textile industry in terms of new units and replacement of existing machinery. Moreover. (iii) economics of movement by road vis-à-vis rall. As the demand for capital goods is a derived one.DHARMENDRA MISHRA Indian Sewing Machine Company. When wage rates rise in relation to other costs. these purchases may be speeded up or else they may be postponed. (iv) availability of bank finance to the prospective customers and (v) growth pattern of the economy. Forecasting demand for consumer durables presents some difficult problems. Which is particularly the case in automobiles in foreign countries. If there are expectations of prices going up. Hawkins Pressure Cookers are also available on hire-purchase basis. claim to have pioneered hire purchase in India. They are not made on the spur of the moment but after considerable deliberations among members of the family. In the case of particular capital goods.
What is needed is some commonsense mean between pure guessing and too much mathematics. First. also known as Opinion Surveys. The data required for estimating the demand for capital goods are: (a) The growth prospects of the user industries (demand estimates for the enduse products in the case of intermediate goods) The norm of consumption of capital goods per unit of installed capacity (per unit of each end use product in the case of intermediate products). Yet it would be wise to depend wholly on the buyer’s estimates and they should be used cautiously in the light of the seller’s own judgment.DHARMENDRA MISHRA airport congestion and landing fees. The other danger is that we may go to the opposite extreme and regard forecasting as something to be left to the judgment of the so-called experts. Here the burden of forecasting is shifted to the customer. is most useful when bulk of the sales is made to industrial producers. For construction of bridges. air and noise pollution. Though statistical techniques are essential in clarifying relationships and providing techniques of analysis. A number of biases may creep into the surveys. The velocity of their use. The customers may know what their total requirements are but they may misjudge or mislead or may be uncertain about the quantity they intend to purchase from a particular firm. they are not substitutes for judgment. because of the latter’s non-availability of high costs. operating costs per seat mile and the nature and extent of competition (for an individual firm). It is assumed that norms of consumption would remain stable. If shortages are expected. two dangers must be guarded against. in some cases the present norms may reflect shortages (for instance. In such cases. which enables an individual or a business to predict the future with certainty or to escape the hard process of thinking. This method. Survey of Buyers Intentions (b) (c) The most direct method of estimating demand in the short run is to ask customers what they are planning to buy for the forthcoming time period-usually a year. mild steel may be in use in place of construction steels which are more suitable. for example. Moreover. METHODS OF FORECASTING It should first of all the emphasized that there is no easy method or simple formula. The more commonly used methods of demand forecasting are discussed below. in the case of imported spares subject to import controls). norms of consumption would also change. However. i. too much emphasis should not be placed on mathematical or statistical techniques of forecasting. as the pattern of availability changes. customers may tend to exaggerate their requirements. This method is not very useful in the case of household customers for several reasons 71/87 9/18/2007 1:31 PM .
This enables the respondent to be candid and forthright in his/her view. Dalkey and Gordon and has been successfully used in the area of technological forecasting. It consists of an attempt to arrive at a consensus in an uncertain area by questioning a group of experts repeatedly until the responses appear to converge along a single line or the issues causing disagreement are clearly defined. It has proved more popular in forecasting non-economic rather than economic variables. and the possibility that the buyers plans may not be real but only wishful thinking. A variant of the opinion poll and survey method is Delphi method.A. genera tic considerable thinking. However. economists. First it facilitates the maintenance of anonymity of the respondent’s identity throughout the course. the Delphi method presumes the following two conditions. This is nearly as good as the panelists physically pooled together for the exercise. this technique saves time and other resources in approaching a large number of experts for their views. First the panelists must be rich in their expertise. predicting technical changes. stimulate dialogue among panelists and make inferential analysis of the multitudinal views of the participants. I. Delphi Method.e. 72/87 9/18/2007 1:31 PM . Secondly. scientists. The leader provides each expert with the responses of the others including their reasons.S. Thus. in the late 1940s by Olaf Helmer. bandwagon effects” and ‘ego involvements’ associated with publicity expressed opinions. Secondly. the Delphi presupposes that its conductors are objective in their job. Again. possess ample abilities to conceptualise the problems for discussion.DHARMENDRA MISHRA viz irregularity in customers buying intentions. Delphi renders it possible to pose the problem to the experts at one time and have their response. The participants are supplied the responses to previous questions from others in the group by a coordinator or leader of some sort. about 620 experts with different backgrounds such as policymakers. their inability to foresee their choice when faced with multiple alternatives. Most often. Delphi method was originally developed at Rand Corporation of the U. I. household customers numerous making this method rather impracticable and costly. The Delphi method has some exclusive advantages. A basic limitation of this method is that it is passive and “does not expose and measure the variables under management’s control”. Each expert is given the opportunity to react to the information or consideration advanced others but interchange is anonymous so as to avoid or reduce the “halo effect”. technologists. possess wide knowledge and experience of the subject and have an aptitude and earnest disposition towards the participants. In one case for example. administrators and advisers were solicited. the complexity of the subject under debate determines the degree of these qualities on the part of the conductors.
They are then reviewed to eliminate the bias of optimism on the part of some salesmen and pessimism on the part of others. (2) The usefulness of this method is restricted to short-term forecasting. In many cases. population. The most popular method of analysis of time series is to project the trend of the time 73/87 9/18/2007 1:31 PM . Advantages (1) The method is simple and does not involve the use of statistical techniques.e. managerial economist. etc. I. This method is known as the collective opinion method as it takes advantage of the collective wisdom of salesmen departmental heads like production manager. etc. they may lack the necessary breadth of vision for looking into the future. will have accumulated considerable data on sales pertaining to different time periods. Of course. say five years ahead or more. These revised estimates are further examined in the light of factors like proposed changes in selling prices. (3) The method may prove quite useful in forecasting sales of new products. The estimates of individual salesmen are consolidated to find out the total estimated sales. Salesmen may even understate the forecast of their sales quotas are to be based on it. Such data when arranged chronologically yield ‘time series’. Collective Opinion Under this method also called sales force polling salesmen are required to estimate expected sales in their respective territories and sections. and the top executives. These forecasts may not be useful for long-term production planning. employment. III. being the closest to the customers. the sales forecast would emerge after these factors have been taken into account. are likely to have the most intimate feel of the market. (2) The forecasts are based on first-hand knowledge of salesmen and others directly connected with sales. Analysis of Time Series and Trend Projections A firm. customer reaction to the products of the firm and their sales trends. which has been in existence for some time. The time series relating to sales represent the past pattern of effective demand for a particular product. for a period of about one year. sales manager. expected changes in competition. Such data can be presented either in a tabular form or graphically for further analysis.e. income distribution. Their jobs usually require full-time attention to the present so that they do not get time to think about the future.DHARMENDRA MISHRA II. marketing manager. The rationale of this method is that salesmen. (3) Salesmen may be unaware of the broader economic changes likely to have an impact on the future demand. product designs and advertisement programmes. Disadvantages (1) it is almost completely subjective as personal opinions can possibly influence the forecast. i. changes in secular forces like purchasing power. here salesmen will have to depend more on their judgment than in the case of existing products.
seasonal variations and 74/87 9/18/2007 1:31 PM . The real challenge of forecasting is in the prediction of turning points rather than in the projection of trends. it is of limited value in actual business forecasting. The analyst chooses a plausible algebraic relation (linear. cyclical fluctuations and irregular or random forces.DHARMENDRA MISHRA series. The next step is to calculate the seasonal index. the trend projection breaks down. A cycle is then fitted to the remainder. which also contains the irregular effect. The trend and the seasonal factor can be forecast. However. A trend line can be fitted through a series either visually or by means of statistical techniques such as the method of least squares. The basic approach is to treat the original time series data (O or observed data) as composed of four parts a secular trend (T) a seasonal factor (S) a cyclical element © and an irregular movement (I) It is generally assumed that these elements are bound together in a multiplicative relationship expressed by the equation O = TSCI The usual practice is to first compute the trend from the original data. a forecaster could normally expect to be right in most forecasts especially if the turning points are few and spaced at long intervals from each other. The problem in forecasting is to separate and measure each of these four factors. The trend values are then eliminated from observed data (TSCI/T). This method is popular because it is simple and inexpensive and partly because time series data often exhibit a persistent growth trend. therefore. Many analyses have. It is when turning points occur that management will have to alter and revise its sales and production strategies most drastically. This technique yields acceptable results so long as the time series shows a persistent tendency to move in the same direction. however. but the prediction of cycles is hazardous for the simple reason that there is no regularity in the cyclical behavior. There are primarily four sets of factors which are responsible for the characterization of time series by fluctuations and turning points in a time series: trend seasonal variations. there are two assumptions underlying this approach: (1) The analysis of movements would be in the order of trend. Whenever a turning point occurs. The trend line is then projected into the future by extrapolation. However. given much thought to the turning points. quadratic. which is used to remove the seasonal effect (SCI/S). The basic assumption of the trend method is that the past rate of change of the variable under study will continue in the future. The foregoing approach to the decomposition of time series data is a useful analytical device for understanding that nature of business fluctuations. Nevertheless. logarithmic etc) between sales and the independent variable time.
Once regression equation is derived. implements. e. 3. 3. which publishes national income estimates. It is inappropriate. cement. Personal income for the demand of consumer goods.g. as no past data exist. the value of Y.. Use of Economic Indicators The use of this approach bases demand forecasting on certain economic indicators. the following steps have to be taken See whether a relationship exists between the demand for a product and certain economic indicators. Agricultural income for the demand of agricultural inputs. There can be curvilinear relationships as well.DHARMENDRA MISHRA cyclical changes: and (2) The effects of each component are independent of each other.i. where the demand does not lag behind the particular economic index. For the use of economic indicators. However. Limitations 1.O.e. Assuming the relationship to be linear.S. For example construction contracts will result in a demand for building materials but with a certain amount of time lag. say. fertilizers etc. For new products. 2. New factors may also have to be taken into consideration. IV. Hence the need for value judgment as well. Finding an appropriate economic indicator may be difficult. 75/87 9/18/2007 1:31 PM .. petrol etc. the equation will be of the form Y = a + ax. Past relationships may not recur. Establish the relationship through the method of least squares and derive the regression equation. the utility is limited because may have to be based on projected economic index itself which may not come true. This method of forecasting works best where the relationship of demand with a particular indicator is characterized by a time lag. 1. These economic indicators are published by specialized organization like the C. Construction contracts sanctioned for the demand of building materials. demand can be estimated for any given value of x. d Automobile registration for the demand of accessories. • • • • 2.
Controlled Experiments Under this method. Secondly they are risky too because they may lead to unfavorable reactions on dealers. the effect of demand determinates like price. In 76/87 9/18/2007 1:31 PM .g. sizes and models.. It may be more difficult to accurately forecast demand by sales territory. This is due to several reasons. packaging etc. It would be taken into account only through the judgmental approach. Despite these limitations. Thus while it may be possible to forecast the total national demand more or less accurately. It might be desirable to supplement them by use of judgment for the following reasons (a) Even the most sophisticated statistical methods cannot incorporate all the potential factors affecting demand as. controlled experiments have sufficient potentialities to become a major method for business research and analysis in future. and (ii) use of regression method is not possible because of lack of historical data or because of managements is inability to predict or even identify causal factors. to gauge the effect of a change in some demand determinates like price. an effort is made vary separately certain determinates of demand which can be manipulated. consumers and competitors. Thirdly. For example. The method of controlled experiments is still relatively new and less tried. Controlled experiments have often been conducted in the U. Fourthly. (b) For industrial products demand may be concentrated in a small number of buyers if the management anticipates loss or addition of a few such large buyers. price advertising. used this method to find out the effect of a price rise on the demand for Quink Ink.DHARMENDRA MISHRA V. etc. for example. e. a major technological breakthrough in product or process design.A. VI. it is difficult to satisfy the condition of homogeneity of markets. Judge mental Approach Management may have to use its own judgment when: (i) analysis of time series and trend projections is not feasible because of wide fluctuations in sales or because of anticipated changes in trends. for example the Parker Pen Co. there is a great difficulty in planning the study inasmuch as it is not always easy to determine what conditions should be taken as constant and what factors should be regarded as variable so as to segregate and measure their influence on demand. First such experiments are expensive as well as time-consuming. on sales can be assessed by either varying them over different markets or by varying them over different time periods in the same markets. and conduct the experiments assuming that the other factors remain constant. (c) Statistical forecasts are more reliable for larger levels of aggregations. Thus. Even when statistical methods are used.S. It must be noted that the market divisions here must be homogeneous with regard to income tastes. etc. advertising. advertisement. product design. etc. different prices would be associated with different sales and on that basis the price quantity relationship is estimated in the form of regression equation and used for forecasting purposes.
9. In long-term forecasts. Identify the variables affecting the demand for the product and express them in appropriate forms. forecasts must be revised when improved information is available. Through the use of statistical techniques. As forecasts are based on certain assumptions. Gather relevant data for approximations to relevant data to represent the variables. 2. Forecast may be made either in terms of physical units or in terms of rupees of sales volume. determine the most probable relationship between the dependent and the independent variables. If would. however. market share or industry as a whole. (b) On the basis of an analysis of likely competition and industry trends. Prepare the forecast and interpret the results. They are more meaningful than a single forecast. the company may assume a market share different from that of the past. Product group may 77/87 9/18/2007 1:31 PM . the projections may be revised every year. 3. Interpretation is more important to the management. 5. be useful to prepare alternative forecasts.DHARMENDRA MISHRA such cases. For forecasting the company’s share in the demand. 8. two different assumptions may be made: (a) The ratio of the company sales to the total industry sales will continue as in the past. Identify and clearly state the objectives of forecasting-short-term or longterm. APPROACH TO FORECASTING 1. 4. 6. there is no alternative but to depend upon judgment for developing more detailed forecasts. Select appropriate method of forecasting. These are sometimes known as rolling forecasts. 7. The latter may be converted into physical units by dividing it by the expected selling price. Forecasts may be made in terms of product groups and then broken for individual products on the basis of past percentages.
2. market situation. production schedules. either. involving a period from on to two years. (2) No company will allow a product to decline indefinitely without taking some action. Project the demand for the new product as an outgrowth of an existing old product.. will provide a barrier to continuous growth. Similar will be the situation when the forecast sales of a product line have to be divided product wise. brands. Long-term demand forecasts. etc. are useful for determining capital expenditures.DHARMENDRA MISHRA be divided into individual products in terms of sizes. 2. However. or (ii) some survey may be necessary. the long-term trend will tend towards the horizontal. raw material requirements and the size and scope of R & D programs. Medium term forecasts. etc. involving a period of three to ten years. For determining the month-wise break-up of the forecast sales of a new product. Short-term forecasts. labels. are useful for determining sales quotas. (i) use may be made of other firms data. Forecasts may be made on annual basis and then divided month-wise or week-wise on the basis of past records. colours. financial requirements. LENGTH OF FORECASTS 1. the more uncertain is the future. In the absence of any other evidence. FORECASTING DEMAND FOR NEW PRODUCTS Joel Dean has suggested a number of possible approaches to the problem of forecasting demand for new products: 1. if available.) 10. either by increased promotion activity. Analyze the raw product as a substitute for some existing product or service. 3. involving a period up to twelve months. are useful for determining the rate of maintenance. This is so for two reasons: (1) in the long-term market forces such as competition. the longer the forecast period. schedule of operations and budgetary control over expenses. 11. 78/87 9/18/2007 1:31 PM . personnel requirements. new product development or by discontinuing the brand. (See illustration below. judge ting and planning cash flows. Inventory control.
The accuracy of the forecast is measured by: (a) the degree of deviations between forecasts and actual. 4. The forecast should be capable of being maintained on an up-to-date basis. Estimate the demand by making direct enquiries from the ultimate purchasers. Maintenance of Timeliness.g. These methods are not mutually exclusive and it would be desirable to try to combine several of them so that crosschecking is possible. Simplicity and Ease of Comprehension. 5. either by the used of samples or on a full scale. This has three aspects. A question may arise. Availability. by direct mall or through one multiple shop organization 6. Understanding is also needed for a proper interpretation of the results. Elaborate mathematical and econometric procedures may be judged less desirable if management does not really understand what the forecaster is doing and falls to understand the procedure. CRITERIA OF A GOOD FORECASTING METHOD 1. 5. 2. The techniques employed should be able to produce meaningful results quickly. the methods of forecasting demand for an established product may also be applied or adapted for new products. Management must be able to understand and have confidence in the techniques used. Economy. Survey consumer’s reactions to a new product indirectly through the eyes of specialized dealers who are supposed to be informed about consumers need and alternative opportunities. 3. Accuracy. e. 4. Estimate the rate of growth and the ultimate level of demand for the new product on the basis of the pattern of growth of established products. techniques which take a long time to work out may produce useful information too late for effective management decisions. Costs must be weighed against the importance of the forecast to the operations of the business. how much money and managerial effort should be allocated to obtain a high level of forecasting accuracy? The criterion here is the economic consideration of balancing the benefits from increased accuracy against the extra cost of providing the improved forecasting. Some comparisons of the model with what actually happens and of the assumptions with what is borne out in practice are more desirable.DHARMENDRA MISHRA 3. and (b) the extent of success in forecasting directional changes. Offer the new product for sale in a sample market. To some extent. It is necessary to check the accuracy of past forecasts against present performance and of present forecasts against future of performance. 79/87 9/18/2007 1:31 PM .
rising population indicates that the market for various commodities is in general expanding. (b) (c) ROLE OF MACRO-LEVEL FORECASTING IN DEMAND FORECASTS Macro-level forecasting precedes micro-level demand forecasting for a firm or an industry. Taxation. Further this in turn would depress investment in these (ii) (iii) (iv) (v) (vi) 80/87 9/18/2007 1:31 PM . High level of public expenditure would stimulate investment in the private sector. Thus savings parameter has a bearing on future demand for consumer goods. aggregate demand and the level of spending in general. if the level of savings is high. Population Growth. aggregate savings. etc. etc. An increase in investment would raise demand for intermediate goods or vice versa. per capita income. the increase in public expenditure has a decisive role in stimulating private investment. for instance. For example. Taxation can also influence demand pattern. high level of excise duties on semi-luxury and luxury goods such as electrical appliances refrigerators. Increase in these parameters indicates rising market potential consumer goods. Population growth. a firm or a product fit in. if the level of national savings is projected to rise fast. Various macro-parameters found useful for demand forecasting are as under: (i) National income and per capita income. Savings. provide the boundaries within which projections of demand for an industry. Certain taxes would depress the demand of commodities taxed. Government expenditure. Investment. The future demand for all types of goods would rise with population growth. Likewise. level of investment. air-conditioners. would depress the demand for these goods.DHARMENDRA MISHRA (a) The relationships underlying the procedure should be stable so that they will carry into the future for a significant amount of time Current data required to use these underlying relationships should be available on timely basis. The forecasting procedure should permit changes to be made in the relationships as they occur. this would dampen consumer goods demand. In the context of Indian economy. especially durable consumer goods. the disposable consumer expenditure on products will in all probability decline. The macro-parameters such as Gross National Product (GNP).
81/87 9/18/2007 1:31 PM .. a team spirit has developed. information and data about macro parameters are mostly available in various publications of Government organizations. Better kind of data and improved forecasting techniques have been developed. inventories are largely affected by credit policies through their effects on carrying costs of inventors. The data pertaining to national income. Credit policies affect holding capacities of all business sections-producers. 7. Since forecasting requires closer co-operation and consultation with many specialists. production. It should thus be clear how forecasts regarding national parameters would influence and determine firm’s demand projections. The time pattern of investment is largely affected by credit policies again. taxes. present a reasonable basis for good forecasts. 8. RECENT TRENDS IN DEMAND FORECASTING 1. A good crop forecast and higher rural incomes would lower cost of materials and boost demand for various products. Top down approach is more popular than bottom up approach. then the industry and finally the individual firm.DHARMENDRA MISHRA industries and as such demand for capital goods employed in these industries. 2. However. demand forecasts are still not too accurate. New products forecasting is still in infancy. 4. 9. 3. The usefulness of personal feel or subjective touch has been accepted. per capita income. 6. There is a greater emphasis on sophisticated techniques such as using computers. (vii) Credit policy. Top down approach starts by analyzing national economy. 5. Such policies influence cost of credit. in spite of the application of newer and modern techniques. etc. Forecasts are usually broken down in monthly forecasts. credit availability and company finance. prices. National Council of Applied Economic Research and Central Statistical Organization. More firms are giving importance of demand forecasting than a decade ago. dealers and retailers. In India.
Bottom up approach is preferred by small firms because (i) they are closer to the customers. (ii) They cannot afford more sophisticated techniques, and (iii) very often; the small firms manufacture a single product. Question Bank 1 What is demand forecasting? Explain in brief the various methods of forecasting demand 2 Explain Delphi method .what the advantages ad disadvantages of this method 3 Write a short note on survey method of demand forecasting 4 Write short note statistical methods of demand forecasting 5 Write short note sample survey of consumer’s intention demand forecasting 6 What is demand forecasting? How do you estimate demand for a new product
BREAK EVEN ANALYSIS
The fundamental objective of any business is to earn more and more profit. Profit mainly depends on three factors namely cost of production, amount of output and revenue. The value of these components depends on the level of various activities performed in the organization. There is need to analyze fixed costs, variable costs and costs and revenues at different levels of output to determine optimum profit. Cost of production is composed of two components viz. fixed costs and Variable costs. Fixed costs are assumed to constant at all levels of output e.g. expenditure on permanent labour and overheads, But with the increase in output fixed cost per unit of output decreases ,variable costs tend to vary with output e.g. material costs etc. Cost of production can be minimized by (i) increase in output (ii) using alternative cheaper material without affecting the quality (iii) Maintaining optimum inventory levels (iv) standardization and mass production (v) Developing human resources by training and incentive schemes and .One of the techniques to study the total cost, total revenue and output relationship is break even analysis.. It is also termed as cost volume pro/it analysis. The break-even analysis is the study of Cost-volume-profit (CVP) relationship. Break-even analysis can be carried out in two ways:(a) Algebraic method(b} Graphical method usually, a break-even Analysis is presented graphically, as this method of visual presentation well-suited to the need of managers to appraise the situation at a glance. ASSUMPTIONS IN BREAK-EVEN ANALYSIS: The following assumptions arc
DHARMENDRA MISHRA made while plotting a break-even chart: 1The total cost of production can be divided into two categories- (a) Fixed cost, (b) Variable cost 2. Fixed cost remains constant i.e. it is independent of the quantity produced and include executive salaries, rent of building, depreciation of plant and equipment etc 3 The variable cost varies directly and proportionately with the volume of production If V =variable cost per unit and Q is the quantity produced, variable cost = V X Q. 4 The selling price does not change with change in the volume of sales. If P is the selling price total sales income = P X Q 5 The firm deals with only one product, or the sales mix remains unchanged 6 There is a perfect synchronization between production and sales. This assumes that everything produced is sold and there is no change in the inventory of finished goods 7 The productivity per worker and efficiency of plant. etc., remains mostly unchanged.
PLOTTING BREAK-EVEN CHART 1 The cost and the sales income (revenue) in rupees are plotted along the vertical axis 2 the quantity (volume of production) is plotted along the horizontal axis 3 the fixed cost are represented by a straight line parallel to the horizontal axis 4 variable costs are superimposed upon the horizontal line representing the fixed cost. This top line represents the total cost line 5 the sales income line passes through the origin 6 the point of intersection of the sales income line and the total cost line represents the break even point 7 the shaded area between the total cost line and the sales income line on the left hand side of B.E.P .indicates loss whereas the shaded area on the right hand side of B.E.P. shows profit.
DHARMENDRA MISHRA Margin of safety it is a distance between the break even point and the out put being produced margin of safety is generally expressed as 1 Ratio of budgeted sales to sales at BEP 2 Ratio of actual sales to sales at BEP 3 Percentage of budget to BEP 4 Percentage of budget to actual sales at BEP In case of unsatisfactory Margin of safety the following measures can be taken Increase in sales price Reduction in fixed cost Reduction in variable costs Increase in output
Margin of safety = sales – sales at BEP x100 Sales = x sales Sales – variable cost Angle of Incidence: The angle between the sales income line and the total cost line is called as angle of Angle of Incidence .A large angle of Incidence indicates large profit and extremely favorable business position .A narrow angle shows that even though overheads are recovered, the profit accrued shows a low rate of return. This indicates a large part of variable costs in total costs Profit Volume (P/V Ratio): Profit volume ratio measures the profitability in relation to sales. The contribution at given output is defined as difference between total sales and total variable costs. The P/V ratio is the ratio of contribution to sales. It represents the relationship between contribution and turn-over. So, it is a measure to compare profitability of different products. Higher the P/V ratio the high yielding is the product P/V ratio = Contribution ----------------Sales = Increase in profit --------------------Increase In sales profit
Total sales – Total variable costs
Total sales 84/87 9/18/2007 1:31 PM
= Uses of P/V ratio
Price unit- Cost per unit ---------------------Price per unit
The P/V ratio can be used to study a variety of problems viz 1. Determination of B.E.P. 2. To know profit for given sales volume. 3. To now sales volume for achieving some desired profit. P/V ratio can be increased by 1. Increasing the selling price. 2. Changing the mix of sales. 3. Reduction In variable costs.
COST Cost is the amount of resources sacrificed or given up to achieve a specific objective which may be the acquisition of goods or services. Costs are always expressed in money terms. Types of cost include Direct material cost direct material refers to the cost of materials which become a major part of finished product. e.g. raw cotton in textiles, steel for automobile parts Direct labour. Direct labour is defined as the labour associated with workers who are engaged in the production process. It is the labour costs for specific work performed on products that is traceable to end products.e.g. Labour of machine operators, assembly operators. Factory overheads these are also called as manufacturing costs. These include the cost of indirect materials, indirect labour and indirect expenses. e.g. foreman, shop clerks, material handlers, cutting oils Fixed cost The cost which don’t change for a given period in spite of change in volume of production. This cost is independent of volume of production. E.g. fixed costs are rent, taxes, insurance etc. Variable costs These vary directly and proportionality with output. There is constant ratio between the change in the cost and change in level of output. Direct material cost and direct labour cost are generally variable cost.
The variable cost accounts Rs 8 per unit and selling price is Rs 13. Controllable and non controllable cost a controllable cost is the cost over which a manager has direct and complete decision authority. It as expenditure for equipment or productive resources which has no economic relevance to the present decision making process. This includes depreciation of Rs 200000. The benefit lost is usually the net earnings or profits that might have been earned from rejecting alternative Sunk cost. It is also known as unavoidable cost. It is the cost that has either already been incurred or is yet be incurred but will be same no matter which alternative course of action is selected. A cost which cannot be influenced by the action of the specified member of na organisationis referred as uncontrollable cost. Selling price Rs 10 Variable cost per unit Rs 6 Fixed cost 100000 86/87 9/18/2007 1:31 PM .25 25 % 3 for the particular product following information is given.DHARMENDRA MISHRA Opportunity cost opportunity cost is defined as the benefits lost by rejecting the best competing alternative to the one chosen. Numerical 1 A manufacturing firm incurs a fixed cost of Rs 18000. write off of goodwill 100000. Find the number of pieces to be produced to brake even Solution Fixed cost = 18000 Variable cost =8 Selling price = 13 BEP = Fixed cost / contribution = 18000 / ( 13-8) = 3600 2Total fixed cost for the year is Rs 1200000. Selling price of good is Rs 80 per unit and variable cost is Rs 60 find BEP and p/v ratio. BEP= Fixed cost / contribution = (1200000-200000-100000) / (80-60) = 45000 Units P/Vratio = (s-v)/s = (80-60) / 80 = 0.
80 Increase in sales price to maintain same BEP = 10. 87/87 9/18/2007 1:31 PM . Find out the break even point for the company .8/10 .6 New fixed cost = Rs 105000 At BEP sales = total cost Total cost = 25000* 6.DHARMENDRA MISHRA Due to inflation variable cost increases by 10% while fixed cost increases by 5%. The budgeted fixed cost and sales are 250000 and 993000 resp. 4 From the following calculate P/V. BEP. Opportunity cost incremental cost. actual cost.6 + 105000 = 2.10 =8 % QUESTION BANK 1 Write a short note on Break even analysis 2 what is BEP? What is its significance? 3 Explain fixed cost. 70000 so Sales = 2. Variable costs. 70000 Revised sales price = 270000/ 25000 = 10. if the break even quantity is remain constant by what percentage should the sales price to be raised Solution BEP= Fixed cost / contribution = 100000/( 10-6) = 25000 New variable cost = Rs 6. and Margin of safety Sales 100000 Fixed cost 20000 Variable cost 60000 5 A company estimates that next year it will earn a profit of Rs 50000. Sunk cost.
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