This action might not be possible to undo. Are you sure you want to continue?
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
The chief contribution of macro-economics is in the area of forecasting. therefore. As the prospects of an individual firm often depend greatly on general business conditions. 5. To illustrate various micro-economic concepts such as elasticity of demand. individual firm forecasts depend on general business forecasts.K. various market forms. 2. 3. 8. 9. etc. marginal cost. The modern theory of income and employment has direct implications for forecasting general business conditions. Economics has two main divisions: microeconomics and macroeconomics. conclude the subject-matter of Managerial Economic consists of applying economic cripples and concepts towards adjusting with various uncertainties faced by a ness firm. Managerial Economics and Economics Managerial Economics has been described as economics applied to decisionmaking. 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. 4. on the other hand. Economics. We can. Macroeconomics.) Is the main source of concepts and analytical tools for managerial economics. 7. are all of great significance to managerial economics. 5/87 9/18/2007 1:31 PM . Microeconomics. and capital uncertainty. has shown that business economists have found the following economic concepts quite useful and of frequent application: 1.DHARMENDRA MISHRA uncertainty. A survey in the U. 10. It may be viewed as a special branch of economics bridging the gulf between pure economic theory and managerial practice. 6. statistics. Microeconomics has been defined as that branch where the unit of study is an individual or a firm. is aggregate in character and has the entire economy as a unit of study. 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. In this connection. Mathematics and Accounting deserve special mention. also known as price theory (or Marshallian economics. the short and the long runs.
First. which is concerned with recording the financial operations of a business firm. it culls from economic theory the concepts.. 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. Secondly. the accounting data are also to be provided in a form so as to fit easily into the concepts and analysis of managerial economics. 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. principles and techniques of analysis which have a bearing on the decision making process. it presents those aspects of traditional economics. 8. Demand theory Theory of the firm-price. Thus. 3. sociology. 4. For the purpose. For instance. 6. Of course. Indeed. Managerial Economics and Accounting Managerial Economics is also closely related to accounting. adapted or modified with a view to enable the manager take better decisions. Recasting and adjustment before they can be used safely and effectively. accounting data call for careful interpretation. 5. It is in this context that the growing link between management accounting and managerial economics deserves special mention.DHARMENDRA MISHRA Business economics have also found the following main areas of economi9cs as useful in their work 1. 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. These are. if necessary. which are relevant for business decision making it real life. accounting information is one of the principal sources of data required by a managerial economist for his decision-making purpose. if they are found relevant for decision making. 2. managerial economics accomplishes the objective of building suitable tool kit from traditional economics. it also incorporates useful ideas from other disciplines such a psychology. 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. etc. USES OF MANAGERIAL ECONOMICS Managerial economics accomplishes several objectives. 6/87 9/18/2007 1:31 PM . 7.
it serves as an instrument in rehiring the economic welfare of the society through socially oriented business decisions. where for various functional areas functional specialists or functional departments exist. at the level of the firm. personal production. and there are frequent advertisements for such positions. in business concerns.. also keeps an economist. Managerial economics focuses attention on these social obligations as constraints subject to which business decisions are to be taken. his importance is being growingly recognized..DHARMENDRA MISHRA Thirdly. DCM and Hindustan Lever employ economists. In this connection. the significance of which lies in the fact that the functional departments or specialists often enjoy considerable autonomy and achieve conflicting coals. 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. marketing. Indian Petrochemicals Corporation Ltd. That is why. In advanced countries like the U. It thus enables business decisionmaking not in watertight compartments but in an integrated perspective. big industrial houses have come to recognize the need for managerial economists. Let us examine in specific terms how a managerial economist can contribute to decision-making in business. e. etc. (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.. Tatas.S. Thus he can capture the essential relationships which characterize a situation while leaving out the cluttering details and peripheral relationships. It has come to be realized that business part from its obligations to shareholders has certain social obligations. two important questions need be considered: 7/87 9/18/2007 1:31 PM . large companies employ one or more economists.. Fifthly. Finally. 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.g. finance. 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. In so doing.A. managerial economics helps in reaching a variety of business decisions. managerial economics makes a manager a more competent model guilder. In our country too. a Government of India undertaking.
In general. 6. that is. the actions of its competitors and the like. Certain important relevant questions in this connection are as follows: 1. 8. etc. 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. 7. To illustrate. What role does he play in business. The internal factors he within the scope and operations of a firm and hence within the control of management.DHARMENDRA MISHRA 1. 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. prices. 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. What is the outlook for the national economy? What are the most important local. 5. where to invest.. how much labour to employ and what to pay for it. and they are known as business operations. 3. Environmental Studies An analysis and forecast of external factors constituting general business conditions. national income and output. are of great significance since every business from is affected by them. 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. what particular management problems lend themselves to solution through economic analysis? How can the managerial economist best serve management.. a business firm is free to take decisions about what to invest.g. e. volume of trade. 8/87 9/18/2007 1:31 PM . these factors can be divided into two-category (i) external and (ii) internal. 4. The external factors lie outside the control management because they are external to the firm and are said to constitute business environment. that is. 2. 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.
Kemp: 1.J. 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. 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. can be had from the following specific functions performed by them as revealed by a survey pertaining to Britain conducted by K. Certain relevant questions in this context would be as follows: 1. 11. Alexander and Alexander G. 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. expansion or contraction. Sales forecasting 9/87 9/18/2007 1:31 PM . business-like practical notes. rate of operations. In a mixed economy like India. In fact. government policies charge out of the performance of industry. the managerial economist pragmatically interprets the intentions of controls and evaluates their impact. credit. investment. 2. And it is these questions which present some of the areas where a managerial economist can make effective contribution. 3. He has to digest the ever-growing economic literature and advise top management by means of short. translating the government’s intentions and transmitting the reactions of the industry. 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. tax rates. What are the main components of the five-year plan? What are the areas where outlays have been increased? What are the segments. 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.DHARMENDRA MISHRA 9. the expectations of the people and political expediency. He acts as a bridge between the government and the industry. Specific Functions A further idea of the role managerial economists can play. 4. 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.W.
carry our analysis of these records and report on trends in demand. 8. managerial economist may also provide general intelligence service supplying management with economic information of general interest such as competitors prices and products. 11. In the case of industries prone to rapid technological advances. has been the most important. profit and market potentialities. In fact. 9. However. and the relative efficiency of their retail outlets. a good deal of published material is already available and it would be useful for a firm to have someone who understands it. tariff rates. Participating in Public Debates 10/87 9/18/2007 1:31 PM . their market shares. Production programs. Economic analysis of competing companies. they may have to undertake detailed statistical analysis. The managerial economist has to gather economic data. For this purpose. Environmental forecasting. Advice on primary commodities. of course. 4. marketing functions. Economic analysis of agriculture. The managerial economist can do the job with competence. Security/investment analysis and forecasts. etc. But there is no doubt that the job of a managerial economist requires alertness and the ability to work under pressure. Pricing problems of industry. he may have to prepare speeches for the corporate executives. analyze all pertinent information about the business environment and prepare position papers on issues facing the firm and the industry. Advice on foreign exchange.e. Industrial market research. 12. It is thus clear that in practice managerial economists perform many and varied functions.DHARMENDRA MISHRA 2. 6. 3. i. 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. he may have to make a continuous assessment of the impact of changing technology. There are. He may have to evaluate the capital budget in the light of short and long-range financial. Capital projects. Thus while carrying out their functions. they may compile statistical records of the sales performance of their own business and those relating to their rivals. Advice on trade and public relations. Very often. 10. tax rates. of these. 5. 13. 7. sales forecasting and industrial market research. Economic Intelligence Besides these functions involving sophisticated analysis.. Analysis of underdeveloped economics.
In fact. Their advice and views are being sought by the government and society alike. Conferences. 4. speeches.DHARMENDRA MISHRA May well-known business economists participate in public debates.. etc. Economic feasibility of new production lines/processes and projects. 3. Economics of various productions lines. 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. a managerial economist is expected to perform the following functions: 1. Macro-forecasting for demand and supply. Production planning at macro and micro levels. Their practical experience in business and industry ads stature to their views. He has to constantly gauge the possibilities of translating the rapidly changing economic scenario into viable business opportunities. 9. Capacity planning and product-mix determination. Indian Context In the Indian context. to make a profit on its invested capital. 6. For this. he cannot expect to succeed in serving management unless he has a strong personal conviction that 8. he must thoroughly recognize his responsibilities and obligations. 11/87 9/18/2007 1:31 PM . future growth opportunities. With the adoption of the New Economic Policy. A managerial economist can serve management best only if he always keeps in mind the main objective of his business. Preparation of periodical economic reports bearing on various matters such as the company’s product-lines. his effectiveness is almost sure to be lost. let us next examine how he can best serve the management. And these changes have tremendous implications for business. Their public recognition enhances their stature in the organization itself. RESPONSIBILITIES OF A MANAGERIAL ECONOMIST Having examined the significant opportunities before a managerial economist to contribute to managerial decision-making. Once management notices this. Assistance in preparation of overall development plans. the macro-economic \ Environment is changing fast at a pace that has been rarely witnessed before. 7. and various national/international factors affecting industry and business. articles and papers for top management for various Chambers. Committees. 5. market pricing situation. Preparing briefs. Seminars. viz. 2. 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. As India marches towards globalization. Keeping management informed o various national and international developments on economic/industrial matters. The managerial economist has to play a much more significant role. general business.
he has a major responsibility to alert ‘management at the earliest possible moment in case he discovers an error in his forecast. For. he must establish and maintain many contacts with individuals and data sources. he must be willing to make considered but fairly positive statements about impending economic developments. so that the management can follow a more orderly course of business planning. a managerial economist can only function effectively in an atmosphere where his success or failure can be traced not only to his basic ability. Nothing will build management confidence in a managerial economist more quickly and thoroughly than a record of successful forecasts. which would not be immediately available to the other members of the management. A few corollaries to the above proposition need also be emphasized here. Again. By making best possible forecasts and through constant efforts to improve upon them. It is. Most management decisions necessarily concern the future. he should join professional associations and take active part in them. For. By promptly drawing attention to changes in forecasting conditions. in other cases. 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. if a managerial economist is to be really helpful to the management in successful decision-making and forward planning. First. In any case. 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. which is rather uncertain. Secondly. it will almost automatically 12/87 9/18/2007 1:31 PM . he must be able to earn full status on the business team. training and experience. well documented in advance and modestly evaluated when the actual results become available. the risks involved in uncertainties. In fact. Extensive familiarity with reference sources and material is essential. be that in study teams. he will have to reassure the management that an important trend will continue. absolutely essential that a managerial economist recognizes his responsibility to make successful forecasts. he should aim at minimizing. based upon the best possible information and analysis and stake his reputation upon his judgment. it is well known that hat management does not understand.DHARMENDRA MISHRA profits are essential and that his chief obligation is to help enhance the ability of the firm to make profits. therefore. 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. he may have to point out the probabilities of a turning point in some activity of importance to management. but also to his personality and capacity to win continuing support for himself and his professional ideas. Within any business. For this purpose. committees or special projects. 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. At times. but it is still more important that he knows individuals who are specialists in particular fields having a bearing on his work. Of course. if not completely eliminating. He should be ready and even offer himself to take up special assignments.
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 .DHARMENDRA MISHRA reject. 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. Further.
Thus the demand schedule reveals the inverse price-demand relationship. It is interpreted as a want backed up by thepurchasing power”.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.00 1. moreover it is meaningless to mention demand without reference to price.00 1. this is indicated in the following table. i.DHARMENDRA MISHRA Demand Demand In economic terminology the term demand conveys a wider and definite meaning than in the ordinary usage.25 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.” Law of Demand This law explains the functional relationship between price of a commodity and the quantity demanded of the same. per unit of time. the law of demand.5 0. An increase in the price leads to a fall in the demand and vice versa. In case of an increase in price the situation will be reserved.50 0.75 1. which is bought. “Demand for anything means the quantity of that commodity.5 1.e. 24 22 20 18 Individual Demand Schedule (Quantity in liter Demand by Different Individuals) (Daily Demand) 1.50 0.75 1.75 1. at a given price. Considering all these aspects the term demand can be defined in the following words. 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. per week etc. The demand schedule is a schedule or a table which contains various possible prices of a commodity and different quantities demanded at them. Ordinarily demand means a desire. Further demand is per unit of time such as per day.00 0. 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. Price per Liter in Rs.75 0. whereas in economic sense it is something more than a mere desire.25 0. 14/87 9/18/2007 1:31 PM . This relationship can be stated as “Other things being equal.25 1.
e. these can be expressed as follows. These are termed as the exceptions to the law. A demand curve can be obtained by plotting a demand schedule on a graph and joining the points so obtained. The following diagram shows the two types of demand curves. Exceptions of the Law In case of major bulk of the commodities the validity of the law is experienced. figure A shows an individual demand curve-of the consumer A in the above schedule-while figure B indicates the total market demand. i. These Assumptions are expressed in the phrase “other things remaining equal”.DHARMENDRA MISHRA Demand Curve It is a geometrical device to express the inverse price-demand relationship.e. a market or a total demand curve. 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. the quantity demanded rises to OM thus a demand curve diagrammatically explains the law of demand. No change in the size and composition of population. No change in tastes. Such a curve shows the inverse relationship between the two variables. It can be noticed that both the curves are negatively sloping or downwards sloping from left to right. It may be noted that at a higher price OP the quantity demanded is OM while at a lower price say OP. 15/87 9/18/2007 1:31 PM . preference. The former shows the demand curve of an individual buyer while the latter shows the sum total of all the individual curves i. Constancy of the price of other goods. habits etc. In the above diagram. like the demand schedule we can derive an individual demand curve as well as a market demand curve. the law of demand. In this case the two variable are price on Y axis and the quantity demanded on X axis. However there are certain situations and commodities which do not follow the law.
without any change in price. When the price of an inferior commodity declines. population. (3) Conspicuous Consumption refers to the consumption of those commodities which are bought as a matter of prestige.g. the demand curve becomes an upwards rising one as shown in the alongside diagram.e. buys less of that commodity and switches on to a superior commodity. It means the demand changes in the same direction as the income. of the consumer have a profound effect on the demand for a commodity. likes. habits. If the price of a complimentary commodity rises. The relationship is a direct one. the higher is the demand and vice versa. do not remain constant and keep on affecting the demand. a consumer buys less at a low price and awaits a further in price. habits.DHARMENDRA MISHRA (1) Continuous changes in the price lead to the exceptional behavior. 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. the demand curve is positively sloping one due to which more is demanded at a high price and less at a low price. Hence the exception. As a result the demand declines with a fall in the price of such prestige goods. the demand for petrol will decline due to rise in the price of cars and the consequent decline in their demand. (4) Ignorance Effect implies a situation in which a consumer buys more of a commodity at a higher price only due to ignorance. (2) Giffens’s Paradox describes a peculiar experience in case of inferior goods.. the consumer. In the exceptional situations quoted above. (4) Other Prices: This is another important determinant of demand for a commodity. instead of purchasing more. In the alongside figure. he will not buy it despite a fall in price. prejudices and preference etc. Naturally with a fall in the price of such goods. The higher the size of population. these factors such as income. Opposite effect will be experienced incase of substitutes. tastes. The effects depends upon the relationship between the commodities in question. In reality however. dislikes. (2) Population: The size of population also affects the demand. preferences etc. while explaining the price-demand relationship assumes other factors to be constant. rises or falls. there is no distinction in buying the same. On the other hand a very high price also may not stop him from buying a good if he likes it very much. (1) Income: The relationship between income and the demand is a direct one. An increase in income leads to rise in demand and vice versa. Determinants of Demand The law of demand. As a result the demand changes i. (3) Tastes and Habits: The tastes. E. As against it when the price starts falling continuously. the demand for the commodity in reference falls. 16/87 9/18/2007 1:31 PM . If a consumers dislikes a commodity.
DHARMENDRA MISHRA (5) Advertisement: This factor has gained tremendous importance in the modern days. cause the rise or fall in demand without any change in the price. (1) Increase in Demand: This refers to higher demand at the same price and results from rise in income. extension and contraction in demand due to price and (b) Changes i.. It is shown by a downwards movement on a given demand curve. increase and decrease in demand due to other factors. population etc. the consumers buy the advertised commodity even at a high price and many times even if they don’t need it. 17/87 9/18/2007 1:31 PM . income. (2) Decrease in demand: It means less quantity demanded at the same price. This is the result of factors like fall in income.. It means they occur without any change in price. under the assumption of constancy of other determinants. price. Changes in Demand The law of demand explains the effect of only-one factor viz. When a product is aggressively advertised through all the possible media. (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) 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.e. due to which the low income groups imitate the consumption patterns of the rich ones. In economic theory a distinction is made between (a) variations i.e. They are termed as changes in demand in contrast to variations in demand which occur due to changes in the price of a commodity. (7) Imitation: This tendency is commonly experienced everywhere. (a) Variations in demand refer to those which occur due to changes in the price of a commodity. This operates even at international levels when the poor countries try to copy the consumption patterns of rich countries. (1) Extension of Demand: This refers to rise in demand due to a fall in price of the commodity. They are of two types. This factor has a great impact on the demand. These effects are different from the law of demand. this is shown on a new demand curve lying above the original one. population etc. population etc. on the demand for a commodity. These are two types. This is known as the demonstration effects. (b) Changes in demand imply the rise and fall due to factors other than price. other factors such as. In practice. this is shown on a new demand lying below the original one.
the demand for a commodity depends not only on the price of a commodity but also on other factors such as income. the demand extends from OQ to OQ2. 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. it fails to explain the extent or magnitude of a change in demand with a given change in price. On D1 more is demand (OQ1) at the same price while on D2 less is demanded (OQ2) at the same price OP. the inverse pricedemand relationship holds good in case of the goods that are bought and sold in the market. Some commodities are more responsive or sensitive to change in price while some others are less. but does not throw any light on the amount by which the demand will change in response to a given change in price. such response varies from commodity to commodity. The concept of 18/87 9/18/2007 1:31 PM . Barring certain exceptions. B an increase in demand is shown by a new demand curve. In other words. the law of demand explains the qualitative but not the quantitative aspect of pricedemand relationship. the original price is OP and the Quantity demanded is OQ. In figure. 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. Elasticity of Demand The law of demand explains the functional relationship between price and demand. However. population. the law of demand merely shows the direction in which the demand changes as a result of a change in price. D1 while the decrease in demand is expressed by the new demand curve D2. The law of demand assumes these factors to be constant and states the inverse price-demand relationship.DHARMENDRA MISHRA Fig (A) Extension/Contraction of Demand Fig (B) Increase/Decrease in Demand In figure A. Thus. tastes and preferences of the consumer. In fact. lying above and below the original demand curve D respectively. Although it is true that demand responds to change in price of a commodity.
perfectly inelastic demand. whatever be the price the quantity demanded remains the same. 19/87 9/18/2007 1:31 PM . This describes a situation in which demand shows no response to a change in price. It thus elaborates the price-demand relationship. the demand for a good is said to be inelastic when a change in price fails to bring about significant change in demand. “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. In other words. Hence. 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. The elasticity of demand thus means the sensitiveness or responsiveness of demand to a change in price. (5) Perfectly elastic demand (e = x) (1) Perfectly Inelastic Demand (ep = o). Demand for some commodities is more elastic while that for certain others is less elastic. 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.” From the above discussion. it possible to mention following different types of price elasticity: (1) Perfectly inelastic demand (ep = o). it will be clear that thought different commodities react to a change in price in the same direction. The alongside figure shows this type. Using the formula of elasticity. The demand is said to be elastic when a small change in price brings about considerable change in demand.DHARMENDRA MISHRA the elasticity of demand has great significance as it explains the degree of responsiveness of demand to a change in price. Elasticity of demand is a measure of relative changes in the amount demanded in response to a small change in price. demand does not at all respond to a change in price. Thus. Demand for some commodities is more sensitive or responsive to a change in price. According to Marshall. (2) Inelastic (less elastic) demand (e< 1) (3) Unitary elasticity (e = 1). while it is less responsive for some others. (4) Elastic (more elastic) demand (e> 1). the degree of their response differs. Thus ep = O. Certain goods are said to have an elastic demand while others have an inelastic demand. Fig a (2) Inelastic (less elastic) Demand (e < 1): In this case the proportionate change in demand is smaller than in price. On the other hand. It can be depicted by means of the alongside diagram.
In this case an insignificant change in price produces tremendous change in demand. This can be understood by means of the alongside figure. demand. Fig c (4) Elastic Demand (e> 1): > In case of certain commodities the demand is relatively more responsive to the change in price. From the above analysis it can be concluded that theoretically five different types of price elasticity can be mentioned. This is referred to as an inelastic demand. Fig b It can be noticed that at a given price an infinite quantity is demanded. In practice. In this case percentage change in demand is equal to percentage change in price. 20/87 9/18/2007 1:31 PM . 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 the demand is relatively c less responsive to the change in price. It means a small change in price induces a significant change in. Fig e (3) Unitary Elasticity (e = 1): When the percentage change in price produces equivalent percentage change in demand. however two extreme cases i. Hence. we have a case of unit elasticity. The rectangular hyperbola as shown in the figure demonstrates this type of elasticity.DHARMENDRA MISHRA In the alongside figure percentage change in demand is smaller than that in price. A small change in price produces infinite change in demand. perfectly elastic and perfectly inelastic demand.e. hence e = 1. are rarely experienced. A perfectly competitive firm faces this type of demand. It can be noticed that in the above example the percentage change in demand is greater than that in price. The demand curve showing perfectly elastic demand is a horizontal straight line. The unitary elasticity is a dividing line between these two cases.
e. its consumption will be restricted only to more important uses and when the price falls the consumption may be extended to less urgent uses. the demand will be elastic.e. the higher is the elastic. (1) Nature of the Commodity: Humans wants. the demand will be more elastic. i. (2) Number of Substitutes Available: The availability of substitutes is a major determinant of the elasticity of demand. 21/87 9/18/2007 1:31 PM . The large the number of substitutes.e. coal electricity. whether the demand is elastic or inelastic depends upon many factors. As against this in the absence of substitutes. (3) Number Of Uses: If a commodity can be put to a variety of uses. i. The demand for necessities is inelastic and for comforts and luxuries it is elastic. It means if a commodity has many substitutes. 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.DHARMENDRA MISHRA Determinants of Elasticity The nature of demand for a commodity.g. Though it is difficult to state precisely the nature of demand for a particular commodity. 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. The nature of demand for a commodity depends upon this classification. When the price of such commodity rises. water etc. the commodities satisfying them can be classified broadly into necessaries on the one hand and comforts and luxuries on the other hand.
(9) The nature of demand for a commodity is also influenced by the complementarities of goods. three values of ‘ep’ can be obtained. unequal distribution of income and wealth makes the demand in general. A rise or fall in the price will not have significant effect in the demand. ep = 1. By doing so. If the consumption of a commodity can be postponed. ep >1. Similarly. (5) Range of prices: The demand for very low-priced as well as very high-price commodity is generally inelastic.e. say newspaper. ep <1. it is clear that no precise conclusion about the nature of demand for any specific commodity can be drawn. e 1.. it is essential to measure the exact elasticity of demand. the demand will tend to be inelastic. e = 1. (8) In addition. Measurement of Elasticity For practical purposes. If only a small fraction of income is being spent on a particular commodity. By measuring the elasticity we can know the extent to which the demand is elastic or inelastic. (c) If percentage change in demand is less than that in price. likes customs etc. a rise or fall in the price. ep = Percentage change in demand / Percentage change in price In this method. when the price is so low that the commodity can be brought by all those who wish to buy. (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. (7) According to Taussig. i. the percentage change in demand and percentage change in price are compared. a change. (b) If percentage change in demand is greater than percentage change in price. i.e. the demand will be elastic.DHARMENDRA MISHRA (4) Possibility of Postponement of Consumption: This factor also greatly influences the nature of demand for a commodity. (1) Percentage Method: In this method. the commodity is consumed only by the rich people. it means the demand is elastic. Different methods are used for measuring the elasticity of demand. Viz. tastes. The conclusion regarding the nature of demand should. From the above analysis of the determinants of elasticity of demand. percentage change in demand is equal to percentage change in price . will hardly have any effect on the demand. the influence of changes in habits. meaning thereby the demand is inelastic. is usually elastic... 22/87 9/18/2007 1:31 PM . and the psychology of the consumers. it is a case of unit elasticity . e> 1. (a) If 5% change in price leads to exactly 5% change in demand. can be ignored. It depends upon the range of price. elastic. When the price is very high. it is observed that demand for durable goods. 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. therefore be restricted to small changes in prices during short period. (6) Proportion of Income Spent: Income of the consumer significantly influences the nature of demand.
a greater portion of income is being spent on a commodity with an increase in income. demand is said to be elastic or e 1. i. In fact. Thus. price is not the only determinant of demand. it is the case of unit elasticity. It means if the total revenue (price x Quantity bought) remains the same in spite of a change in price. if total revenue falls with rise in price or rises with fall in price. In other words. ‘ep’ is said to be equal to 1. DD1 is a straight line demand curve meeting the two axes at D and D1. (3) Point Method: Another suggested by Marshall is to measure elasticity at a point on a straight line. e = o and point at which it meets Y axis. at a point where the curve intersects X axis. income elasticity of demand means the responsiveness of demand to changes in income.DHARMENDRA MISHRA (a) If a given change in price fails to bring about any change in the total outlay. (3) Income Elasticity Less Than One (EY< 1): This occurs when the percentage < change in demand is less than the percentage change in income. 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. The income effect suggests the effect of change in income on demand. above the mid-point e I and below the I-point e<1. Thus. (c) When price and total revenue are directly related. (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. Demand for a commodity changes in response to a change in income of the consumer. 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. However. The income elasticity of demand explains the extent of change in demand as a result of change in income.e. at mid-point e=1. i. 23/87 9/18/2007 1:31 PM .. as already explained. EY = 1 or the income elasticity is unitary. that at different points on the demand curve the elasticity will be different.income elasticity is said to be greater than one. This method can be better understood with the help of a diagram as given below: In the Fig. A is any point on the demand curve at which the elasticity is to be measured. the demand is said to be inelastic pr e <1.e. 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. income effect is a constituent of the price effect. (b) If price and total revenue are inversely related. if total revenue rises with a rise in price and falls with a fall in price.
If on the other hand. The income elasticity of demand in such cases will be negative. the demand for a commodity X depends not only on the price of X but also on the prices of other commodities Y. (2) The Pricing policy of the producer is greatly influenced by the nature of demand for his product. Z…. instead of buying more of a commodity. are unrelated there will be no change i. In case of complementary commodities. Cross elasticity in cad of such unrelated goods will then be zero. 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. a result of change in price of Y. This implies that as the income increases the consumer.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. Demand for X as a result of change in price of Y. In short. buys less and switches on to a superior commodity. 24/87 9/18/2007 1:31 PM . (2) Positive cross elasticity – Substitutes. The goods X and Y can be complementary goods (such as pen and ink) or substitutes (such as pen and ball pen). low price will be advantageous to the producer. its importance lies in the fact that it deeply analyses the price-demand relationship. the demand is elastic. Thus.N etc. cross elasticity will be of three types: (1) Negative cross elasticity – Complementary commodities. 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. (1) Theoretically. 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). (5) Negative Income Elasticity of Demand (EY< o): It is well known that income < effect for most of the commodities is positive. But in case of inferior goods. 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 income effect beyond a certain level of income becomes negative. The law of demand merely explains the qualitative relationship while the concept of elasticity of demand analyses the quantitative price-demand relationship. The concept of cross elasticity explains the degree of change in demand for X as. The concept of elasticity helps the monopolist while practicing the price discrimination. he will be benefited by charging a high price. Cross Elasticity of Demand While discussing the determinants of demand for a commodity. If the demand is inelastic. say X and Y. If two commodities. (3) Zero cross elasticity – Unrelated goods. Importance of elasticity The concept of elasticity is of great importance both in economic theory and in practice. the cross elasticity will be negative.
It helps in solving some of the problems of international trade such as gains from trade. policy of tariff also depends upon the nature of demand for a commodity. Protection and subsidy is granted to the industries which face an elastic demand. has been widely accepted. 3 Define price elasticity of demand ad distinguish between its various types. He should tax such commodities which have inelastic demand so that the Government can raise handsome revenue. Its usefulness in branches of economic such as production. such as wool and mutton.) (4) The concept of elasticity of demand is helpful to the Government in fixing the prices of public utilities. international trade etc. distribution. Write a short note on (i) Law of demand 2 Explain briefly how the demand for a commodity is affected by changes in price. (a) The concept of elasticity of demand guides the finance minister in imposing the commodity taxes.DHARMENDRA MISHRA (3) The price of joint products can be fixed on the basis of elasticity of demand. In case of such joint products.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 . wages. cotton and cotton seeds. international trade etc. advertisement ad population.. separate costs of production are not known. public finance. (6) The concept of elasticity of demand is useful to Government in formulation of economic policy in various fields such as taxation. price of substitute.. In nutshell. (7) The concept of elasticity of demand is very important in the field international trade. (b) The concept of elasticity of demand helps the Government in formulating commercial policy. (5) The Elasticity of demand is important not only in pricing the commodities but also in fixing the price of labour viz. Discuss the role of price elasticity of demand in business decision 4 Define elasticity of demand . In come. Question bank 1. 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. it can be concluded that the concept of elasticity of demand has great significance in economic analysis. balance of payments etc.
Distinction between Stock and Supply In ordinary languages the two terms viz. is a function of price. Thus. Law of Supply Supply.” 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. stock and supply are used interchangeably. the quantity of any goods which people are ready to offer for sale generally varies directly with the price. or during any one period of time. This means that a particular quantity of a good will be offered at a certain price at a particular point of time. 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. a month and so on. (iv) The supplier is able and willing to supply the good at a given price. This law may also be stated in the following words: “Other things remaining the same..DHARMENDRA MISHRA Supply The term “Supply” is one of the important terms in economic. as the price of a commodity rises. for example. (iii) During the given period of time. It implies various amounts or quantities of a good offered for sale at various prices. it will show that: (i) Price and supply vary or change in the same direction. (ii) The amount of a good is offered for sale at a given time. supply thereof will contact. (ii) The supply position holds good at a particular time. It means a change in price brings about a change in supply. a week. 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. (3) Supply refers to the actual Quantity offered for sale at the prevailing price while stock means the potential supply. The distinction between the two can be explained as follows: (1) Stock is a reservoir while supply is a flow.” If this statement of law of supply is analyzed. This means that if price of a good rises. strictly in economic sense the two terms convey different meaning. the conditions of supply remain unchanged. The law is stated in the following words: “In a given market at any given time. like demand. its supply will increase and if its price falls. in which the conditions of supply remain the same. its supply is extended and as the price falls its supply is contracted. which may be a day.” 26/87 9/18/2007 1:31 PM . a week and so on. However. (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. a day. The law of supply explains the functional relationship between price and supply.
The following schedule makes the point clear: Price per kg 2. likewise there can be many other supplier in the market. It can be noticed that the reaction of an individual supplier to the change in price is similar. Such curves can be obtained for every firm separately as well as for the entire 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. 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. we get individual supply curve as also the market supply curve. The last column shows the market supply which is obtained by summing up the individual supplies of different firms at different prices. S2. it is obvious that it changes in the same direction. Thus.00 3.00 6. 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 . S3.00 5. Supply curve is thus.00 4. Supply Schedule: It is a table or schedule that shows different quantities of a commodity that are offered for sale at a particular time. 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. a graphical presentation of the law of supply. Hence as the price rises the supply increases. It implies that as the price rises every individual seller offers a larger quantity for sale. the supply schedules explain the direct relationship between price and quantity supplied. (ii) Market supply schedule. Supply Curve: Supply curve is a geometrical device to express the price-supply relationship. Supply schedule can be (i) individual supply schedule. Accordingly. etc.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. Since the market supply is nothing but the sum total of the individual supplies.
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. The law of supply. can thus be expressed by means of supply schedule and supply curve. S3 are the three individual supply curves while the last figure shows the market supply (SM). S1. It can be observed that as the price rises more is supplied. which states that price and supply are directly related. Such curve indicates price supply relationship. Different positions showing price and the corresponding quantity supplied are joined to get the supply curve. at a certain price it will supply the quantity at which the profits are 28/87 9/18/2007 1:31 PM . S2. Obviously. Hence the supply curve is rising upwards to the right or positively sloping. Explanation of the law Individual Supply: An individual firm is interested in securing maximum profits from its supply.
every commodity has a reservation price which means the minimum price expected by the producer. position may also change. the supply. (iii) Factors of production: If the price of factors of production changes. similarly. Price. During the war 29/87 9/18/2007 1:31 PM . the supply will be reduced. If price rises. higher price offers an inducement to firm for offering larger quantity. more will be supplied at a high price and less at a low price. Expansion of Market Supply occurs at a high price. a firm will not be able and willing to supply more quantity unless the price is higher. 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. it is observed that as the production and supply increase the per unit cost goes on increasing. thus. production may be curtailed and hence. (ii) Production cost: If production-cost changes. there would be change in the volume of production and with that there would be a change in the supply position. both the individual as well as the market supply change in the same direction as the price. Contraction of market supply occurs due to (i) Reduction in supply by some firms. the supply position may change. (ii) Exit from the market of certain other firms who cannot supply any quantity at the new low price. If these means are not adequate. Naturally. the direct relationship. (iv) Transport facilities etc. If the actual price is less than the reservation price no supply will be forthcoming. Hence. Thus. the same will decrease. is not the only determinant of supply. Determinants of Supply The law of supply explains the functional relationship between price and supply. In other words. develop. it will behave in the same way as the individual supply in response to change in price. There are many factors along with price which cause changes in supply. (v) Future trends in prices: if future trends in prices indicate the possibility of rise in the price. the present supply will decrease and vice versa. As the price rises more will be supplied. If cost of production rises. (ii) New suppliers enter the market. if natural calamities occur. because (i) The Existing suppliers supply larger quantity. (i) Price: A change in price of a given good may bring about a change in the supply position. Market Supply: As mentioned earlier market supply is the sum total of individual supply. the situation will be just opposite. Generally. efficient or economical. supply can be increased. the supply may decrease. supply will increase and in case of unfavorable weather conditions. Naturally. like war etc. It means if communications and transport are improved. though important. the supply may be reduced and if the cost of production declines. (vii) Abnormal circumstances: It may be pointed out that if some abnormal circumstances. supply will increase and vice versa. (vi) Nature factors: If weather conditions are favorable.DHARMENDRA MISHRA maximum. Moreover. generally.
If liberal monetary policy is adopted by the Government. Supply rises to ‘OQ1’ thus ‘QQ1’ is the extension of supply. the supply may also increase. it may be pointed out that the monetary policy of the Government may also change the supply position. the Government adopts tight monetary policy. But if hostilities are over. It assumes other factors to be constant. 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. QQ2’ therefore. it is possible that production may increase and as such. shows contraction of supply. opposite may happen. at price ‘OP’ the quantity supplied is OQ. In 30/87 9/18/2007 1:31 PM . (2) As the price falls to ‘OP2’ the supply falls to ‘OQ2’. 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.DHARMENDRA MISHRA time supply may be reduced. If however. 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. The variations in supply i. (viii) Monetary policy of the Government: Lastly. (b) Increase/Decrease in Supply: The law of supply expresses the changes in supply due to changes in the price of a commodity. Thus.e. rise or fall in it. there can be increase in the supply. brought about due to changes in the price are called extension and contraction of supply respectively. Originally. (1) As the price rises to ‘OP1’ the.
Elasticity of Supply The supply. Such change.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. be seen that new supply curves have to be drawn to show increase and decrease in supply. It 31/87 9/18/2007 1:31 PM . at the same price ‘OP’ the quantity supplied is ‘OQ2’. Increase and decrease in supply can be shown by means of the following diagram: Alongside diagram shows three supply curves ‘S1’ S1’ and ‘S2’.e. the price remains same i.DHARMENDRA MISHRA reality the supply changes without any change in the price. (1) Increase in supply means more quantity supplied at the same price. are termed as increase and decrease in supply respectively. This happens due to various factors other than price. All these factors bring about rise or fall in the supply of a commodity. the responsiveness of the supply of a commodity to the changes in price. The law of supply expresses the price supply relationship. which means that more is supplied at a high price and less at a low price. (2) ‘S2’ shows decrease in supply. (1) ‘S1’ shows increase in the supply. thus. (2) Decrease in supply means less quantity supplied at the same price. Let us assume that ‘S’ is the original supply curve. (3) Change in the techniques of production etc. OP but quantity supplied rises to OQ1. It is usually observed that the price and supply are directly related. QQ2’ is thus. On this curve. It can. The elasticity of supply means. decrease in supply. (2) Change in the prices of factors of production. like the demand. QQ1’ is thus increase in supply. i. is a function of price. On this supply curve ‘OQ’ quantity is supplied at price ‘OP’. while the new supply curve (S2) which lies to the left of original curve (S) shows decrease in supply. On this curve. rise or fall in supply due to effect of other factors. These factors are: (1) Rise or fall in the cost.
the elasticity of supply is zero. (d) When the percentage change in supply is greater than that of the price. Accordingly. (b) Certain commodities may have perfectly or infinitely elastic supply. we come across commodities having more elastic supply and those having less elastic supply. the elasticity of supply is greater than one. This can be represented with the help of a horizontal straight line supply curve as in figure b. This means. we have a case of perfectly inelastic supply. This is represented in diagram e. This is shown in figure d. In this case. the degree of response varies from commodity to commodity. 32/87 9/18/2007 1:31 PM . remains constant. Some commodities are more responsive to a change in price. (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. while certain others are less responsive. (c) When the percentage change in supply is the same. “e” is less than 1. In this case. i. as the percentage change in demand a case of unit elasticity is experienced. whatever be the change in price.DHARMENDRA MISHRA may be noticed that though most of the commodities follow the law of supply. This can be shown by means of a vertical straight line supply curve as in figure a.e. The case of unitary elasticity is shown in figure c. 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. This is the case of elastic supply. which means that the supply is fully sensitive to even a smallest possible change in price.
DHARMENDRA MISHRA Measurement of Elasticity of Supply The elasticity of supply. (3) If the tangent meets the ‘X’ axis to the right of origin. SS is the supply curve and the elasticity of supply is to be measured at any point. can be measured by drawing a tangent to the curve at the point. ‘e’ is greater than 1. the elasticity at point ‘A’ is measured as: Es = NM / OM (1) If the tangent drawn to supply curve passes through the origin. i. 33/87 9/18/2007 1:31 PM . at a point on a supply curve. elasticity is less than 1. a case of unit elasticity. This can be better understood with help of a diagram. (2) If the tangent cuts ‘Y’ axis. “(o)” the elasticity is equal to one. say ‘A’ on this curve. 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’.e. In the alongside diagram.e. i.
as a result of which. (i) The time element: The most important factor. etc. it can be concluded that the elasticity of supply is the result of a variety of factors. If the techniques are rigid and cannot be changed. influencing the elasticity of supply. influenced by the cost of attracting the productive resources. the supply can be slightly adjusted to the changes in price and hence. If the techniques of production are improved. which makes the supply fairly elastic. During the short period. the full adjustments in the supply can be made and hence.DHARMENDRA MISHRA Determinants of Elasticity The elasticity of supply depends upon a variety of factors. which means the supply will be less elastic. which means it will be elastic. in response to the changes in price and hence. nature of production technique. If the rise in the cost is sharp and rapid. the supply becomes much more elastic. Question bank 1. the more elastic is the supply. If the fixed factors are intensively utilized. making the supply inelastic. On the other hand. the production and supply can be easily adjusted to the changes in price. However. (vi) In addition to the above factors. however. In short. There is very little scope for expanding the supply. the longer the period. The lower the cost of attracting the resources. the supply is more or less inelastic. 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 . (v) The elasticity of supply is. Thus. the fixed factor is not much utilized. the higher will be the degree of elasticity. it will be difficult to expand the supply. the supply during very short period or market period is perfectly inelastic. The higher the cost of attracting the resources lower will be the elasticity. utilization of fixed factors. (iv) The elasticity of supply also depends on the Availability of the variable inputs. (iii) The degree of elasticity of supply also depends on the extent to which the fixed factors are being utilized. If . is the time at the disposal of a firm to adjust the supply to the changes in prices. the supply will be fairly elastic. if the factors are not available. During long period. the supply will be fairly elastic. (ii) The elasticity of supply also depends on the possibilities of changes in the production techniques. In case of the perishable goods. (vii) The availability of markets also determines the degree of elasticity. If such factors are abundantly available. there will be much rigidity in the supply. behavior of cost. the supply can be easily increased. During the short period. if the cost rises gradually. the supply will become inelastic or less elastic. more can be produced and supplied. to a great extent. the behavior of the cost also determines the nature of supply. availability of variable inputs. the supply is elastic. such as time element. it becomes fairly elastic.
in economic sense there is relevance to a place but to a commodity. one dollar to a millions. In ordinary languages. and the structure i. The best way to know the meaning of the term in economic sense is to refer to the following features. while for a businessman it suggest advertising and sales promotion for an industrialist it may mean discovery of foreign outlets for his products. direct or indirect. Thus the term basically implies trading i. • Existence of buyers and sellers. buying and selling. the term market refers to a place i. • Identical commodity. Classification of market Markets can be viewed from different criteria such as extent or coverage. As mentioned above. a geographical location where the buying and selling of the commodities takes place e. From this angle the 35/87 9/18/2007 1:31 PM . Whatever the interpretation. extent of competition etc. It is rightly pointed out that “the infinite variety of meanings involving anywhere from two people to thousands.e. It means a market can exist even without the buyers and sellers meeting each other.e.e. Thus from the economic point a market implies a contact.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. time element. • Existence of price. Calcutta market etc. truly what the economic meaning of the term implies is the contact between the buyers and the sellers. Such a contact may be direct or an indirect one. It means shopping to a housewife. is what makes a market hard to define”. this can be explained by the following points. (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. it is certain that the term is related to buying and selling activities. and for a farmer it stands for the sale of his products.g. between the buyers and sellers of an identical product for which there exists a price. • Contact between buyers and sellers. Bombay market. the term market means different things to different people. From this angle one speaks of textile market. The original of the term can be tracked back to a Latin word “Marcatus or marcart which means to trade’. food grains market etc. It conveys a variety of meanings when viewed from different angles.
usually the perishable commodities such as vegetables. fish. As a result. just like a drop of water in the ocean. National. oligopoly. monopolistic competition etc. As shown in the chart above. particularly oligopoly. can be included in this category. Electronic goods. etc. Similarly. indicate deviations from the perfectly competitive market in different ways such as.DHARMENDRA MISHRA markets can be classified as Local. there may be basic changes in the techniques of production. have a national market. In the very long period there may occur structural changes on demand as well as supply sides. and International etc. sugar. A town etc. begins to play an active role in the price determination. hence during the very period everything becomes flexible and both the sides can have full impact on the price. on the basic degree of competition. 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. Perfect competition is the most ideal. cotton etc. habits. milk etc. The adjustability of supply depends on the availability of time. Finally certain commodities are such that their buyers and sellers are spread over the entire world. along with demand. As a result of this an individual becomes only a price taker but not a price maker. with latter having different varieties. Flowers. the markets. Long period refers to that period during which full adjustments in supply are possible. This classification is neither scientific nor rigid. even the perishable commodities can conquer international market. the imperfect markets. (B) Classification according to time: it was Alfred Marshall who introduced this important approach. (C) Structural Classification: In the context of the process of price determination and the equilibrium of the firm this classification is of great significance. undergo fundamental changes. This is because the contribution of an individual either as a consumer or a producer is negligible. quality and the quantity of inputs etc. It is useful to get acquainted with the characteristic features of different markets forms. supply. nature of product. enjoy only local market. can be broadly divided into two categories viz. The extent of competition is the basic of his classification. A local market is said to exist when the buyers and the sellers are confined to a small area like a village. the perfect market and the imperfect markets. In comparison with perfect competition. The imperfect markets such as monopoly. In the short period some marginal adjustments on the supply side are possible through the changes in the employment of the variable inputs. The factors affecting demand such as size and the composition of population. have a greater empirical validity. The time element the determination of price. fashions etc. the greater is the elasticity of supply. the number of firms. vehicles. 36/87 9/18/2007 1:31 PM . monopolistic competition etc. With the development of the means of communications and transport. particularly from the supply side. 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. chemicals. The longer the period. but the least practicable form of market. Hence they enjoy an international or a global market. medicines etc. Non-perishable consumption goods like wheat.
Even if he charges a high price there is no fear of losing the customer because there is no substitute available. the cross elasticity of demand between the monopoly product and any other product is “zero” or very small. is rarely experienced in its pure form. In other words. Naturally. monopoly is characterized by restrictions which prevent other firms from entering the monopoly 37/87 9/18/2007 1:31 PM . Firm cannot charge a higher price and a firm does not charge a lower price than one that rules the market. 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. In fact it represents another theoretical extreme which like perfect competition. The demand for the product of a monopolist is perfectly inelastic. the consumers as well as the firms have perfect knowledge about the market conditions. No doubt there may exist remote substitute. Such an absence of close substitutes helps the monopolist to control prices. This feature of perfect competition. particularly about the prevailing price of the product. The chief features can be mentioned as follows: (1) A single Firm: In contrast to infinite number of firms under perfect competition. No consumer pays a higher price and no firm charges a lower one than that prevailing in the market. (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. (4) Perfect Knowledge: Another important condition of perfect competition is that both. Maximizes the welfare of the consumers. A monopoly market is characterized by the existence of a single producer who rules the entire market for the said product. This ensures a uniform factor reward. 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. (3) Barriers to Entry of New Firms: Unlike under perfect competition. 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. Monopoly: This form of market is diagonally opposite to perfect competition. (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. (6) perfect Mobility: The factors of production are assumed to be fully mobile under the conditions of perfect competition.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. (3) Freedom of Entry and Exit: Perfect competition allows the existing firms to leave the industry if they so desire. As a result a uniform price rules the perfectly competitive market. This enables the monopolist to charge an exorbitant price and enjoy super normal profits permanently.
In case they also follow the price reduction policy. the firm in question will hardly be in a position to expand its market share. Thus the entire picture is uncertain to all the firms. on the expected behavior of a few close rivals. With the close substitutes offered by the small number of rivals. the AR curve of a firm. in a part. etc. The above features reveal the fact that monopolist has a complete control over the price and the output of a commodity. Limited competition.” Stigler. Nobody can derive a precise demand schedule and a demand curve because of the unpredictable reaction of the market. 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. 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. steel. a firm bases its market policy. “Oligopoly is that situation in which. In this case whether the firm will succeed or not depends upon the reaction of the rivals. etc. 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. Obviously every move of the rival firms has to be closely watched by every other firm. The decisions to raise or lower the price or the output receives a sharp reaction from other firms. cement.DHARMENDRA MISHRA market. Naturally every individual firm in this type of market makes a sizeable contribution to the total supply. ‘Oligos’ which means a few. That he produces and sells.e. (2) Interdependence: A distinct feature of oligopoly is the existence of extreme interdependence among the firms. These barriers are artificial. legal or institutional. The barriers are strong enough to block completely all the potential competitors. There is hardly any interdependence under perfect or monopolistic competition as a number of firms is very large. economic. which means no effect on the demand. incomplete monopoly. multiple monopoly. such as automobiles. 38/87 9/18/2007 1:31 PM . is supplied by the oligopolistic firms. he does not know what and how strong that reaction will be. oligopoly is characterized by the existences of a limited number of firms. It is rightly described as ‘A competition among a few’. In real world a large number of products. This market form which consists of a few firms selling either identical or a differentiated product is known by many names such as. 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 almost impossible to precisely derive the demand curve i. to sell. electronics goods. (1) Few Sellers: In contrast to perfect competition with infinite number of firms and the monopoly with a single firm. and ‘Pollen’ meaning. 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. His price output policy is not affected by that of the other firms. the cross elasticity of demand of different products is very high. Oligopoly: The term oligopoly is derived from two Greek words. (3) Indeterminate Demand Curve: Under oligopoly.
This leads to a ‘kinky demand curve. “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. (5) Conflicting Behavior: An element of uncertainty is witnessed even in respect of attitude of the firms. Hence the price-rigidity. By contrast it is held that most economic situations are composites of both monopoly and perfect competition. Sometimes they adopt the attitude of co-operation so as to prevent the fall in sales and profits. As a result each individual brand enjoys certain amount of monopoly among a small group of buyers who are attached to that particular brand. An oligopoly situation exhibits a composition of small. (6) A Monopoly Element: As a result of the existence of only a few firms under the oligopoly market form. It means if one is present the other cannot exist. on certain occasions they pick up the fight among them especially in respect of distribution of profits or sharing of markets. 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. Hence the term Monopolistic Competition. Thus no oligopolistic firm will either lower or raise the price. The monopoly power is further strengthened because of an attachment of some buyers to a particular product. soaps. medium and large sized firms. (7) Lack Of Uniformity: Finally an oligopoly market is characterized by an absence of uniformity. Thus there can be a situation of war or peace among the oligopolistic firms depending upon their attitude or the behavior. With a differentiated product. Thus there exists a competition among the monopolists. it is but natural that there prevails a strong monopoly element. He argues. detergents etc. Thus it is clear that oligopoly exhibits some unique features which distinguish it from other market forms. This is the result of quick reaction of the rivals.DHARMENDRA MISHRA (4) Price Rigidity: This is a unique feature of oligopoly. 39/87 9/18/2007 1:31 PM . Chamberlin who introduced the concept of monopolistic competition. A variety of tooth pastes. In the wider circle however. Monopolistic Competition: It was Prof. In other words. hair oils. This implies that the price is fixed rigid or stuck-up at certain level. these products are exposed to competition to similar but not identical brands. The firms widely differ in respect of size. He emphasized the fact that real market situation exhibits a simultaneous existence of both the pure forms which are mixed up. Thus there can be collusion among the firms. are available in the market with different brand names. To a certain extent it is possible for an oligopolist to follow it own independent price-output policy. at least among a small group of buyers. Thus there is no departure from the existing price. every firm enjoys a monopoly power. In contrast. though these products belong to a similar category of the commodity. He disagreed with the traditional view which regarded monopoly and perfect competition to be mutually exclusive market forms. the price neither rises nor falls from a given level but remains rigid at that point.” 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.
Selling costs can take a variety of forms such as free sampling lucky draws. It means the products are not perfect substitutes as under perfect competition.DHARMENDRA MISHRA Features of Monopolistic Competition: (1) Large Number of Seller: Like under perfect competition. Television serial. discount and above all advertisement. (2) product Differentiation: This is most vital feature of monopolistic competition. Popular personalities from politics. there exists a sizeable number of firms under monopolistic competitions also. packing. may be in respect of colour. there are no restrictions of any type on the entry of new firms. quality. In other words. monopoly there exists no close substitutes. TV. (3) Selling Cost: This is yet another unique feature of monopolistic competition. firms. This is because the number of firms under monopolistic competition is not as large as that under perfect competition. Thus the market undet the monopolistic competition is constituted of ‘Too Many Too Small’ firms. This is achieved through the practice of product differentiation. Such expenditure is not necessary either under perfect competition or monopoly because under the former the products are homogenous while under the latter i. Repeated advertising has a profound impact on the psychology of the buyers which tremendously benefits the concerned product. 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. the firms produce a differentiated product which is similar but not identical. thus the individual product is similar but not identical to that of the rival firms. Propaganda and sales promotion drives through various media such as radio. It is only under monopolistic competition with differentiated product that a firm is required to create demand for the same. (4) Freedom of Entry: In this respect monopolistic competition is similar to perfect competition and opposite to monopoly. Sports etc. free sale. due to which an individual firm has no significant control over the market situation. Moreover. The individual firms trade in a product which belongs to the broad category of the commodity being produced by the rival firms. is the key to capture the new markets and to strengthen the existing one. workmanship etc.e. are made to advertise the product to catch the attention and the demand of the consumers. Every firm tries to impress upon the minds of the buyers that its product is distinct from that of the others. 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. As under perfect competition. 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. The only peculiarity is that 40/87 9/18/2007 1:31 PM . newspaper. However each individual product has its own identity and dissimilarity in comparison with the products of other firms. 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. Magazines etc. In other words. However the firm under this form of market is not as passive as that under the perfect competition. They are only remote or the distant substitutes. as a result the small firms have some control or monopoly over a part of the market which is attached to that particular product.
Alfred Marshall rightly emphasized the role of both the forces of demand and supply in the determination of price. In this context the monopoly element due to the product differentiation as also the selling costs. is that it is both. finally that price rules the market at which a 41/87 9/18/2007 1:31 PM . none is able to influence the price. Some economists like Adam Smith and Ricardo attached great importance to supply and argued that price is determined by the cost of production. One thing is certain that a market is dependent upon two forces viz. It may happen that at any particular time demand may be active and the supply passive. while under monopolistic competition the new entrant has to introduce a different variety of the concerned product. The actual formation of price for the industry as a whole can be determined by the equality between demand and supply.DHARMENDRA MISHRA under perfect competition the new firms have to produce the existing product. “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.” From the above analysis it is clear that price is determined by demand and supply. Since the contribution of our individual seller in the total supply and of individual buyer in the total demand. Stonier and Hague rightly remark.” Above statement rightly emphasizes that price is the result of both demand as well as supply. is insignificant. demand and supply which are represented by the buyers and sellers respectively. (5) Independence: In contrast to oligopoly. there is high independence among the firms operating under monopolistic competition. But both are essential. This is due to large number of buyers and sellers with a homogeneous product. Another important aspect to be noticed is that under perfect competition. Neither is more or less important than the other in determining price. no individual buyer or seller can determine the price. Price Determination under perfect Competition In economic analysis there has always been a controversy as to what determines the price of a commodity. it is obvious that an individual firm can have its independent price output policy without relying on other rivals. Certain others though that demand is the real determinant of price. 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. “The only really accurate answer to the question whether it is supply or demand which determines the price. It means the price under competitive conditions is the result of total demand for the total supply of the industry. It is determined by the combined action of the entire seller and the entire buyer taken together. Thus this market claims many distinct and realistic features . In his words.
300. hence OP (Rs. It is shown in the following diagram: In the above figure. the supply curve of the industry intersects its total demand curve at point ‘E’. 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. This is because it has a large number of perfect substitutes. It means it can sell any quantity at the ruling price. 300) is the price which will rule the market.e. Hence the demand curve facing an individual firm is a horizontal straight line. This can be explained with the help of following schedule and diagram. in the above figure an individual firm produces ‘QQ’ output and sells it at the given price ‘OP’. 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. If its cost cannot be covered by the given price it will suffer losses and will be forced to leave the industry. Hence it is the price that uniformly exists in the market. The demand for individual firm is perfectly elastic. However it has no power to charge a higher price. 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. How much it will produce will be governed by its cost conditions. 42/87 9/18/2007 1:31 PM . An individual firm cannot fix the price but only adjust its supply to the given price.
He thus has to make a choice between large quantity (Low price) and small quantity (high price). Naturally the demand becomes fairly inelastic. cost conditions while determining the price. It must be remembered that a monopolist faces a down ward sloping demand curve. The monopoly firm however has an advantage because there is no close substitute for its product.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. It means if he produces and sells a small quantity he can charge a high price. as a result the monopolist can charge a high price. But if he is interested in selling a large quantity he can do so only at alower proce. His 43/87 9/18/2007 1:31 PM .e.
A monopolist also follows the same rule that he produces that quantity at which MR=MC. A monopolist will fix up that price at which his profits are maximum. 44/87 9/18/2007 1:31 PM .e. This is course is possible but not practicable. finally he sells that quantity which fetches with maximum profit.e. Generally it is believed that a monopolist charges extremely high price. • Reaction for the Gov. 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. Once he decides upon the price he ahs to produce that amount of output which is demanded at that price. A monopolist follows a trial and error method for determining the price and output. Once this is decided he ahs to compare the revenue per unit i. Within these limits the monopolist charges such a price which enables him to get maximum profit. average revenue (AR) and the cost per unit i. Generally any product considers two things what is the cost of producing one more unit. nationalization etc. which is known as marginal cost (MC) and what revenue or income he gets by selling that unit which is called marginal revenue (MR). • Substitutes available. 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. While fixing the price output. • Reaction of factor owner – demand for higher rewards. the monopolist has to take into account various factors such as • Nature of demand (elasticity) for his product. • Cost conditions.DHARMENDRA MISHRA motive obviously is the maximization of total profits. • Reaction for rival – Introduction of a substitute. The are ‘APRS’ shows the total profit enjoyed by the monopolist Lastly one point has to be cleared. He has to fix one and accept the other. average cost (AC). A monopolist has to be careful about the following: • Reaction of the customers – Boycotting the product. – Control over price.
which produce a homogeneous commodity. constitute an industry. equilibrium of a firm implies the fixation of profit maximizing output. the price remains fixed and given for a competitive firm. On the other hand. 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. 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.DHARMENDRA MISHRA Equilibrium under Perfect Competition Perfect competition is a form of market in which various firms. a firm will not lower the price because it knows that any quantity it produces can be sold at the prevailing price. This implies that a competitive firm has only to accept the price which is determined by the industry as a whole. Short run equilibrium: 45/87 9/18/2007 1:31 PM . AR with its cost situations. 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. If it thinks of raising the price. Hence. As a result of two characteristics an individual firm does not have any grip over the price of the product. it will never operate will losses. a firm will compare the given price i. Under the profit maximization principle. The only decision left to an individual firm is whether to produce or not and how much to produce. the firm may operate in spite of losses but in the long run. the short run considerations widely differ from the long run ones. For this purpose. Thus. It has no capacity to alter this price in any direction.e. a firm will produce and sell that output which offers it is maximum profits. It may be noticed that in the short run.
price i. price. figure (a) shows profits while (b) losses. AR is equal to marginal cost. If AR>AC there are abnormal profits. The industry. In order to maximize the profits. The abnormal profits enjoyed by the firm during the short period attached the other firms to enter the industry. will try to leave the industry. during short period. neither entry nor exit is possible in the short run.e. it means for all the output that the firm produces. in the short run. 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). it is only the variable cost which is relevant from the point of view of equilibrium output.e. therefore. No doubt. On the other hand. when AR is less than AC. the firm will continue to produce. If it is less than AC. The fixed cost has to be incurred even if no production is undertaken. a firm cannot leave the industry. the firm incurring losses during short period. the firms intends to equal MR with MC. However. is not in equilibrium. why should a firm continue to produce when it faces losses i. Since the price is given and constant. Thus in short run. At this level.e. It is observed that in spite of losses. the firms continue to produce. Since MR is always equal to AR i. AR is equal to MR. there may be abnormal profits ((AR>AC) or losses (AR<AC). It means. but can certainly stop the operation.DHARMENDRA MISHRA Short run is a period during which certain factors and costs remain fixed or constant while certain others can be varied. it follows that at equilibrium. AR<AC is shown in the following diagrams: In the above diagram. The quality between the total demand and total supply suggests that the industry is only in temporary or indeterminate equilibrium. However. Such a decision can be explained with reference to the 46/87 9/18/2007 1:31 PM . Under any of these conditions. greater than or less than the average cost.e. The decision of the firm to produce if the existing price renders abnormal profits can be easily understood. there are losses to the firm and when AR is equal to AC there are only normal profits. The equilibrium with profits i. the demand curve faced by an individual firm is horizontal straight line and the MR curve coincides with it is all levels of output.e. But this price may be equal to. firm is equilibrium at the level of output where MC is equal to MR. AR>AC and that with losses i.
So long as price is greater than average variable costs i. a firm continues to produce. Losses by closing down can be restricted only to the fixed cost in this case. the decision regarding production or otherwise is a matter of indifference. and (2) there are losses (AR<AC). if the price falls below OP1 say to OP2. even then. Thus. 47/87 9/18/2007 1:31 PM . Thus. It is an attempt to minimize the losses. Since the prevailing price is covering at least a part of fixed cost. If the firm stops the production. (ii) Losses minimization and (iii) close down position. no rational producer will operate because this price does not even cover the AVC. therefore.e. the total cost (OLNQ) exceeds the total revenue (OPEQ) by LPEN which means the firm faces losses. 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. It means such costs have to be incurred even if the firm does not produce any output. the equilibrium will be reached at point “E1” at which the level of output is “OQ”. This is known as the close down position of a firm. Now. Lastly. AVC.e. if any price falls below OP1 the firm will not operate. i. AVC (average variable cost) is also shown. the losses by producing some are less than by not producing at all. This decision by the firm reduces losses. if the price is less than AVC. the firm will stop the production. Thus. the MC intersects the MR curve at point “E” and the equilibrium output is “OQ” at this level of output. it will have to bear the losses worth the entire amount of fixed cost. A firm under perfect competition will operate if (1) there are abnormal profits (AR>AC). short run marginal cost and short run average cost respectively. losses to the extent of fixed costs have to be borne by the firm.DHARMENDRA MISHRA distinction between fixed costs and the variable costs. If the prevailing price is OP1. At this point. In short. the short run equilibrium of a firm indicates three possibilities namely (i) Profit maximization. A firm. (AR = MR) is OP. continue to produce because the price “OP” covers not only AVC (QA) but a part of fixed cost (AE). cover any portion of the fixed cost. if the price i. However. the firm will continue to operate. Hence. At this point of output. It will. Hence. but AR>AVC. 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. 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. Fixed costs are those costs which have no relation with the output produced.e.
it may be stated at the given price a firm may be in – (1) Profit maximization Position (if AR > AC0. The supply in the long run can be adjusted through a change not only in variable factors but also in fixed factors. a firm may operate in spite of losses in the short run but it can not do so in the long run. the price equates not only marginal cost but also the average cost. 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. (i) Increase in supply and therefore a fall in price. by expanding the plant size. if they face losses. the changes in output can be brought about through the changes in the scale of production i. the equilibrium of a firm will be reached at the quality between MC and MR i. On the other hand. The existing firms can expand output. The entry of new firms in the context of supernormal profits will produce a twofold effect. incase of which AR is less than AC will leave the industry. 48/87 9/18/2007 1:31 PM . because if price is greater than AC. Thus. size of the firm. (ii) Increase in demand for productive resources and hence increase in the cost. In this diagram.DHARMENDRA MISHRA Thus the short run equilibrium of a competition firm exhibits all of the possibilities. at OP1 there normal profits and at price OP2 losses. (2) Loss minimization position when (AR < AC > AVC). In the long run. the abnormal profits will attract new firms into the market. the long run price must necessarily be equal to the average cost. full adjustments are possible in the long run.e. It may be earning supernormal profits (if AR>AC) only normal profits (if AR=AC) or losses (if AR<AC). however. at price OP there are supernormal profits. Similarly. it means in the long run. MC and price. (3) Shut down position (AR < AVC). In other words. the new firms can also enter the market or the old firms can leave the industry. Such firms. The entry of new firms will wipe out such supernormal profits. In other words. To conclude the discussion regarding the short run equilibrium of a competitive firm. The distinction between fixed and variable costs no more exists because all costs are variable costs. In the long run.e. price can neither exceed the average cost nor can be less than it.
in the long run. 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. it is concluded that perfect competition is an ideal market situation which produces most efficiently and sells at the lowest price. (ii) Industry is in equilibrium because of quality between AR and AC. (ii) Fall in demand for productive resources and consequent rise in cost.DHARMENDRA MISHRA Similarly. 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. (3) AR = MR = MC. Thus in the long run under perfect competition. From this. AC and MC is obtained at price OP. not only an individual firms but the entire industry reaches a determine equilibrium because of the quality between AR and AC. MR. the long run equilibrium exhibits the following: (1) MR = MC. Moreover. (4) AR = AC = MC=MR. (i) Decrease in supply and rise in price. (iv) Abnormal profits are absent due to equality between AR and AC. (2) AR = AC. Thus. the exit of the existing firms will also affect the cost and revenue positions in two ways. 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. Equilibrium under Monopoly 49/87 9/18/2007 1:31 PM . (iii) All firms tend to be optimum since they operate at lowest AC. a grand equilibrium is obtained.
e. The price i. the MR curve is always below the former. Long run Equilibrium: In the long run. Now. at equilibrium is less than AC. The price in the long run is necessarily higher than cost implying abnormal profits.e.e. QL) Hence there are abnormal profits. in short run monopolist will be in equilibrium when MR=MC. i. AR>MR. 50/87 9/18/2007 1:31 PM . AR curve facing a monopolist is downwards sloping which implies that a monopolist can sell more only at a lower price. there are abnormal profits worth the area PNLM. In the short period if AR<AC. Such profits can continue even in the long run because there is no fear of new firm entering and competing away the profits.DHARMENDRA MISHRA Short run Equilibrium: like any other producer.e. though higher than MC. AR>MR but MR = MC ∴AR> MC. Since the AR>AC. Since the AR curve is downwards sloping. AR. Firm is in equilibrium at point E producing OQ output. can be higher or lower than AC. price is always greater than marginal cost. firm suffers losses. In figure (a) at equilibrium output AR (i. Since a monopoly firm itself means the entire industry. It can make full adjustments in supply according to the change in demand. it means the firm earns abnormal profits. a firm cannot afford to face the losses. this price in the short run can be greater than or less than AC. But a monopolist will continue to produce so long as the price covers the average variable cost. a firm is in equilibrium at point ‘E’ at which MR=MC. under monopoly. a demand curve i. a monopolist aims at maximizing the profits. Thus. In figure (b) since the price i. This can seen from the alongside diagram. implying profits or losses respectively. under monopoly. Is greater than Ac 9i. This can be observed in the following diagram: In both (a) and (b) above. If the price is greater than AC.e. QM). He produces that output at which MR = MC. in the short run there can be profits or losses under monopoly. But it will continue to produce.e. In short. The output is OQ. Thus. there will be losses. In other words.
or diminishing cost conditions. (2) Price under monopoly is always greater than MC. e>1. (1) Monopoly equilibrium can occur in any phase i. monopoly price is a function of MC and elasticity of demand.R. Thus. when e<1. A=M (e / (e-1)) where A = A. (3) In the short run the price may be greater than AC implying abnormal profits or less than AC indicating losses. = M. It is known that. This is seen in the following diagram: in the above diagrams. Since MC is positive.e. increasing.R. AR curve at midpoint e=1 and below midpoint e<1. If MC is zero.R (e / (e-1)) but in equilibrium M. (2) Monopoly price is a function of marginal cost and elasticity of demand.e. (b) shows equilibrium under constant cost and (c) the equilibrium under increasing cost.e. Producer equates MR with MC can never be negative no producer will produce when MR is negative i.R Price = MC (e / (e-1)) Thus.e.DHARMENDRA MISHRA Certain important features of monopoly equilibrium should be noted. the equilibrium may occur at midpoint at which MR is zero. e<1. 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. equilibrium under monopoly can be summed up as follows: (1) A monopoly firm like any other firm is in equilibrium when MR=MC.e. On a straight line demand i. Under any case a monopolist can permanently enjoy abnormal profits. e = elasticity of demand Price = M. i. constant. price M=M. figure (a) shows equilibrium under diminishing cost. Thus.C. MR is negative. 51/87 9/18/2007 1:31 PM . the equilibrium must occur at that level of output at which MR is positive i. it means producers will not be in equilibrium if the elasticity of demand is less than one.
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. In practice. In the words of Mrs. diminishing increasing or constant. i.e. in railways and airways. Under perfect competition with large number of producers. refers to the act of selling the same commodity at different prices in different markets whenever it is possible and profitable. Price discrimination. e>1. As the monopolist is a single producer in the market. commodities or services are slightly differentiated. For example. at different price to different buyers is known as price discrimination. PRICE DISCRIMINATION Meaning of price discrimination: So far we have discussed the price output determination under simple monopoly. price discrimination is practiced. under a situation in which the monopolist charges uniform price for the same product to different consumers. i. It means monopolist can permanently enjoy the abnormal profits.” 52/87 9/18/2007 1:31 PM .e. (5) Monopoly equilibrium may occur under any cost conditions i. the individual firm has no control over the market-supply. Joan Robinson. therefore. He can sell the commodity at different prices to different consumer. it is rather difficult to offer the identical commodity at different prices.e.DHARMENDRA MISHRA (4) The long run price under monopoly will always be greater than AC. “the act of selling the same article produced under single control. to widen the scope of price discrimination. It should be noted that generally price discrimination in confined to simple price discrimination. However. i. Hence it is not possible to practice price discrimination in a competitive market. (7) A monopolist may produce output corresponding to unit elasticity if MC is zero. he has control over the supply of the product. charging different prices for the same product from different consumers.e. Therefore. (6) Monopoly equilibrium will necessarily be at that level of output which corresponds to elastic demand.
Age discrimination and sex discrimination is also practiced. (consumer’s illusion) 53/87 9/18/2007 1:31 PM . Similarly. (2) Local Discrimination: in local discrimination. two important conditions are essential for the price discrimination to become possible. 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. For instance. a deluxe edition of a book is sold at a higher price than its paper-back edition. a monopoly can be a simple monopoly when a uniform price is charged by the monopoly firm.DHARMENDRA MISHRA Thus. (Ignorance of consumers) (ii) The consumer has irrational feeling that he is paying a higher price for a better quality. railways charge different rates for different classes of travel. etc. or it can be a discriminating monopoly when he discriminates between users or persons and charges different prices for the same product. cinema houses charge different admission rates. it should be impossible to transfer the commodity from the cheaper market to the dearer market. (6) Time Discrimination: Different prices for the same commodity or services are charged at different times. Similarly. Second. other professionals like lawyers. Other important conditions of price discrimination are as follows: (1) Price discrimination often occurs due to consumer’s peculiarities. in dumping. When is price discrimination possible? Broadly speaking. (3) Trade discrimination: this form of price discrimination is based on the use of the product. For example. may also discriminate between rich and poor. From the above. there are different tariffs in the supply of electricity for home consumption. teachers. For example. For instance. the monopolist charges higher price at home and lower price in a foreign market. Forms of price discrimination: price discrimination by a monopolist may take many forms. First. it follow that price discrimination will be possible when the monopolist is able to keep his two markets separate. consultants. the monopolist charges a lower price at one place and a higher price at other places. (4) Quality discrimination: Price discrimination may also take place on the basis of qualitative differences of the same product. there are different rates for trunk calls. there should be no possibility for the consumers to transfer themselves to the cheaper market. In this case there are three possibilities. industrial and agricultural uses. trunk call charges are higher during day time and lower during night time. Similarly. For example. a doctor may charge higher fees to the rich and lower fees to the poor. For example. (5) Special service discrimination: In this situation price discrimination takes place on the basis of special services provided to the consumers. (i) The consumers are very often unaware that prices have changed.
if different prices are charged by transferring the output discrimination will not be profitable: 54/87 9/18/2007 1:31 PM . the electricity company has different tariffs for domestic and industrial consumers. Sometimes different services are rendered or different goods are offered at different prices. Since he is serving two markets the marginal revenue (Combined MR) obtained in both the markets must be equal to MC. (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. the most fundamental factor of profitability is the nature of elasticity of demand at the single monopoly price in these markets. the resales are impossible. For example. the monopolist may serve two different markets. Likewise in railways it is an offence for one to travel in other class without a proper ticket. He will sell at different prices till the MR obtained in one market is equal to the MR obtained in another market.” Thus. When is Price Discrimination Profitable? We have so far analyzed the conditions in which price discrimination is possible. This enables the monopolist to earn maximum profit However. it also depends on his power to ensure that no one else sells his products at a lower price. (Let go attitude) (2) Price difference also occurs due to legal sanction where customers are divided into different groups. it is largely prohibited to transfer the use of commodity from a particular purpose. the facilities provided in the first class hardly are in proportion to the high fare charged. 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. Most common example is provided by railways where the first and second class fares widely differ. It should be noted that the monopolist seeks maximum profits when he fixes his output so as to equal marginal revenue with marginal cost. it is clear that all these forms of price discrimination depend on his ability to retain his customers. In this case price discrimination refers mostly to direct services which can not be resold. In this case the basic condition is that the elasticity of demand should be different in different market. Namely a home market with tariff and a world market without tariff. It follows from the formula M That MR in two markets is the same and therefore. Above are the circumstances under which price discrimination is possible.DHARMENDRA MISHRA (iii) Price difference are marginal and the consumers simply do not bother about the changes in price. Price discrimination does not necessarily imply that different prices are charged for the same product. 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. but the differences in the quality are not so high as to justify the price difference. These services are directly given to the consumers and therefore. However. “price discrimination as the sales of technically similar products at prices no which are or proportional to marginal costs. It will be possible when the monopolist is serving separate markets. (3) Price discrimination will be possible due to the nature of the commodity. Hence this also is a way of price discrimination. But it may not be always profitable for him to practice price discrimination. Further. Similarly.
as he withdraws some quantity from other market. The principle of profit maximization is extended to different markets. Technique of price discrimination Price-output determination under discriminating monopoly. On the other hand. The monopolist practices price discrimination for maximizing his total profits. When more is supplied in the market with higher MR. It is evident from the above formula that MR in the two markets will be different and the monopolist. MR in that market will rise. The discriminating monopolist is required to take two decisions. The same principle is equally applicable to discriminating monopoly. 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. thus. The monopolist will equate his MC with each MR. the price. and therefore. We are acquainted with the basic principle of profit maximization viz. the price i. If follows from the above analysis that price discrimination will be profitable only when the elasticity of demand is different in each market. condition of equilibrium of discriminating monopoly can be stated as MC=MR1 MR2=MR3…. the seller will be benefited by transferring some quantity from the latter to the former market.MR This condition means that given the different demand schedules corresponding to different markets.e. If the MR in one market is higher than that in the other market. by transferring the commodity. price discrimination will be profitable. Once such equality is achieved any further shifting will be unprofitable. there are different AR and MR curves corresponding to different markets.. and hence.DHARMENDRA MISHRA If elasticties of demand in two markets at a single. Under discriminating monopoly. Thus. The monopolist will. AR. MR in that market will decline. the monopolist will sell that much output in each market at which MR in each market is equal to the MC. (a) How much to produce? (b) How to distribute the total output among the different markets? 55/87 9/18/2007 1:31 PM . the equality between MR and MC. The process of shifting will continue till the MRs in the different markets become equal. monopoly price are different. equalize the marginal revenue in the different markets.
e. Thus. again he is helped by the marginal principle. The discriminating monopolist will be in equilibrium at point E in fig. In solving this problem. In the above diagrams Fig.. However. he will produce at the level of output at which MC=AMR=MR1+MR2…+MRn. next problem facing the firm is the distribution of this output among different markets so as to acquire maximum profits. The monopolist will. After the equilibrium i. In the above diagrams. Thus. As them are large numbers of (a) 56/87 9/18/2007 1:31 PM . The total output produced by the monopolist is. we may attempt a comparison between monopoly and perfect competition with reference to their characteristics. as explained above. therefore. © at which the MC curve intersects the AMR curve. (a) And Fig. equality between MC and AMR provides answer to the first question faced by the discriminating monopolist viz. (a) depicts a higher market with less degree of elasticity while Fig. there are significant dissimilarities between the two market situations. Thus. how much to produce. (c) above.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. It can be easily noticed that he charges higher price in less elastic market and lower in more elastic market (OP1 >OP2). The aggregate marginal revenue curve (AMR) obtained by lateral summation of MR1 and MR2 drawn in Fig. and Oq1 at price OP2 in the second market. Monopoly and Perfect Competition – A Comparison We have so far analysed the market situations under perfect competition and monopoly. (b) portrays a lower market with higher elastic demand. a parallel line drawn from the point of equilibrium ‘E’ intersects MR1 and MR2 at E1 and E2 respectively. 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. Market structure: Perfect competition is a market situation is which there is a large number of buyers nad sellers. the monopolist will sell that much output in each market at which MR in each market equates the MC. The price in the market of the entire industry is determined by the forces of demand and supply. The following figure clarifies the point. It may be observed that fig. price and output determination. E1 and E2 are the equilibrium positions in the two markets. profit maximizing output has been fixed. the size of profit etc. each one selling a small proportion of the total output. 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. Thus. AR1 and AR2 are the demand curves and MR1 and MR2 are their corresponding marginal revenue curves in higher and lower markets respectively. Hence. therefore. OQ. (b) Show two different markets with different degrees of elasticity. All competing firms have to accept this price. sell OQ1 quantity at price OP1 in the first market.
In such a situation a firm may acquire control over 57/87 9/18/2007 1:31 PM . under monopoly. monopoly may emerge when a single firm has control over the supply of strategic raw materials. But there are differences between the prices – marginal cost relationship. Accordingly. the firm accepts the price as given and adjusts its output at the level which ensures maximum profit it is clear. (c) Price-marginal cost relationship: As pointed out. Thus. as individual firms can sell any amount depending upon its size.” (1) Control over raw materials: It may be possible for single firm to acquire ownership or control of essential raw materials required for production. When the price is reduced. Thus. therefore. Robinson “ a monopoly firm can exist only so long as it is able to bar the entry of its potential competitors or rivals. thus. Thus. once the price in the market is established. In fact. selling homogeneous products. there is only one firm selling a particular commodity or service. already there is similarity between the equilibrium conditions of the firms under perfect competition and monopoly. it has no incentive to lower it. the total output produced by an industry is quite large.DHARMENDRA MISHRA firms. a price taker and output adjuster in the market. It implies that if the product has close substitutes. industry cannot sell more at the same price. He may charge either a single uniform price or different prices to the consumers. and the entry of new firms is restricted. The monopoly firm itself fixes the price for its product unlike perfect competition. But the demand curve faced by the industry consisting of a large number of firms slopes downward from left to right. A monopoly firm may emerge when there are restrictions to the entry of new firms into the organization. at ruling price. for the same product. the absence of competition is the essence of monopoly. the demand curve (AR) of an industry will have a negative slope. According to Prof. The demand curve (AR) of a firm is perfectly elastic and the marginal revenue coincides with it. there are two important points: (a) the firm emerging as a monopoly power. Every firm is. the total demand for the commodity rises. Hence there is no distinction between the firm and industry under this type of market situation. (2) Nature monopolies: Monopoly may emerge due to one single firm’s control of raw materials. It would be an effective barrier to the entry of other firms into the monopoly industry. the monopoly firm will continue to enjoy the privileged position even in the long run. Since it can sell as much as it likes at the prevailing price. the geographical distribution of natural and mineral resources is very uneven. (b) Nature of demand curve-and industry: Under perfect competition. There is a clear distinction between the firm and industry. for instance. Sources of Monopoly Power There are many factors or circumstances responsible for the emergence of monopoly. A monopoly firm may also acquire raw materials in big quantities at lower prices. On the other hand. This is characterized as natural monopoly. Thus. especially those the supply of which depends on natural forces. Since. and (b) to retain that power in the long run. the demand curve or the average revenue curve (AR) faced by the firm and industry will be different. the monopoly firm is a price maker. In this context. that under perfect competition there can be only one price in the market at a point of time because the products are homogeneous.
In this case. These tend to become natural monopolies and competition in such services is avoided. In other words. operate on a large scale and enjoy economies of large scale production. railway etc. Further. (3) Legal barriers: This is most important factor to confer the monopoly right and prevent the entry of the potential competitors. trade marks. anti-trust and anticartel legislation have been passed in the USA. Similarly. chemicals. singers. In order to eliminate monopoly power. some surgeons. output and sharing of the market it will also prevent the entry of new potential competitors. As a result. They do not confer permanent monopoly power. the firm is protected by law against imitation by rival producers. capital equipment. motor cars etc. (4) Business combinations: It is possible for a number of big business companies to acquire a degree of monopoly power through voluntary agreement. The liberalization of licensing policy. law may confer patent. innovations. socially least desirable. E. the existence of giant firms enjoying economies of large scale production etc. may not be permanent.DHARMENDRA MISHRA natural resources. Again the Government may reserve certain products and services for itself in order to provide better services to the community. such combinations exploit the consumers and therefore. 58/87 9/18/2007 1:31 PM . (5) Existence of goodwill or reputation: A well established firm possesses a degree of monopoly power. etc. for instance. These economies of scale reduce the cost of production and thus enable the firms to supply goods at low prices. (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. monopoly is preferred. copy right etc. These business combinations are variously called as pools. Natural monopolies. liberal bank credit may result in the emergence of new competitors. monopoly may emerge as a result of certain legal provisions of the government. From the above discussion of the sources of monopoly power. can charge higher fees than others in the same profession. lawyers. It is prohibitively risky for the new firms to compete with the existing firms. it is impossible for the new firms to enter the industry. it should be noted that different sources are more or less temporary in nature. This will help them to eliminate competition among the groups in terms of price. a firm gets an absolute monopoly power in the production of a particular commodity. Monopoly power can also be acquired if a firm has control over professional services. For instance. existence of economies of large scale production may not always mean the possibility of only a few giant firms. But the Government subjects such services to certain regulations in the interest of the consumers. syndicates. Similarly in public utility services like water supply. Similarly. the firms manufacturing types. It is a protected from the threat of competition from new firms making identical products. transport. tariffs on imports of certain goods will restrict foreign competition in the domestic market. On the privileged firms. cartels. Such a firm will have considerable goodwill and it is virtually impossible for potential competitor to enter the industry. telephone services etc. trade associations etc. This will tend to create a monopolistic position for the domestic producers. trusts. labour etc.g. 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. posts and telegraph.
the scale of production. During short period. economics of scale due to which the increasing returns to scale are experienced. the technical economies occur due to application of superior technique. 59/87 9/18/2007 1:31 PM . • In between the balances between economies and diseconomies brings about constant returns to scale. since all factors are variable.e. These benefits can be termed as internal economies. (b) External economies: These are associated with the entire industry. however.e. With the expansion of the scale of production a firm derives certain benefits i. (a) Internal economies: this refers to those advantages which are enjoyed by an individual firm which expands its scale. Thus • Initially expansion of the firm renders advantages and the firms enjoys increasing returns. there is a tendency to continue as a monopoly. A larger firm is able to employ such machinery and equipments. a firm cannot alter the scale of production. Such benefits are shared by all the firms in the expanding industry. 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. which lead to diminishing returns to scale. Such benefits are not shared by all but accrue only to that firm which grows in size. Such monopolies are socially more desirable.e. Economies of Scale Economies of scale refer to the advantage enjoyed by affirm due to expansion of its size i.e. (b) Another type of technical economies enjoyed by the large firm are the advantages of division of labour. Thus. Here economies of scale are associated with long run production function i. Experts can be appointed by a large firm to perform specialized functions. the expansion leads to occurrence of diseconomies of scale and the firm suffers the diminishing returns to scale. it is possible a form to expand or contract its size as per the requirement.. A small firm is unable to install specialized and advanced machinery. In the long run. Different individual restaurants are the firms that constitute that industry. the expansion of size causes disadvantages or diseconomies. (a)Internal Economies The term refers to those advantages which are enjoyed by an individual firm in an industry. These are the economies of specialization. expands the sale it alone will enjoy certain advantages. Now if an individual restaurant grows in size i. since some factors of production are fixed.DHARMENDRA MISHRA However. Take for example hotel industry. • Beyond desirable limit. The economies of scale are classified into two broad categories viz. Beyond certain limit. in the case of social monopoly or public utility. The firm enjoys a reduction in cost per unit or increase in output as a result of such specialized capital equipments. returns to scale.
Business fluctuations and the risks associated with them bring the every the very existence of such small firm into danger. risk-bearing or survival economies are enjoyed by an expanding firm. Such an advantage cannot be enjoyed by a small firm. Similarly. (d) Similarly. A large firm can afford to have its own marketing department through which the services of experts can be obtained. on the other hand. whereas large firms are in a position to bear such risks and overcome the same. These economies are essentially associated with the large firm. large firm may be able to enjoy certain advantages which are absent in the case of a small firm. Thus. Thus. It means as the size of the firm 60/87 9/18/2007 1:31 PM . In a small firm. A small firm finds it difficult to sell shares and debentures. (4) Financial Economies: A large and reputed firm enjoys certain gain in the matter of raising funds. Thus. a large firm can reduce the expenses in the purchase of raw materials. Such firm spreads the risk by diversification of products. Thus.DHARMENDRA MISHRA (c) A large firm can make a proper use of wastes for producing by-products. 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. (e) Dimensional economies are also enjoyed by the use of large sized capital equipment. the owner has to look after different processes. certain risk-bearing economies are enjoyed by a large firm. a large firm can enjoy many advantages in the marketing of their product through advertising. fall in demand etc. A small firm finds it difficult to face the general and particular risks arising out of economic depression. The large firm buys the raw materials in big quantities because of which it is assured of regular supply at a cheap rate. Experts and qualified persons can be appointed only by a large firm. (5) Risk-Bearing Economies (survival Economies): Lastly. diversification of markets and minimizes the risks. various financial economies accrue to an expanding firm. a large firm with sizable resources can effectively face such risks and can survive. (3) Marketing Economies: These economies emerge from the bulk buying. An expanding firm is also in comfortable position in respect of obtaining credit from banks and other financial institutions. Marketing economies may also arise from specialization. (2) Managerial Economies (Administrative Economies): These economies result from the managerial division of labour. A large firm also enjoys concession in transport charges. It can raise the loans easily and at cheaper rates. Thus. These are known as the economies of by-products. When the different processes are linked together under one control the dependence and inconvenience is avoided. These economies or advantage are called the advantage of functional specialization. a large firm may be able to avail of the economies of linked processes. A large firm can do as very smoothly as the public in general is willing to subscribe to their capital needs.
Restaurants and hotels in that area can naturally get number of advantages. 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. a particular place becomes a favorite tourist attraction. Thus.DHARMENDRA MISHRA expands. Similarly. it receives the following advantages: (a) Provision of efficient transport system. It means the increasing returns can be attributed to the external economies along with the 61/87 9/18/2007 1:31 PM . When an industry gets concentrated in a particular area. Increasing returns imply diminishing costs. The external economies emerge particularly from the localization of industry. it gains certain benefits or advantage known as external economies which help the firm in increasing the production or reducing the cost. These gains thus accrue to all the firms in the industry.g. raising the average and marginal returns. Technical information may also be made available. the industry can establish its own research center which will benefit the different firms. it gets more than proportionate returns. any further expansion will lead to diseconomies of scale and the firm will face the diminishing returns. this phase of increasing returns or diminishing costs can not occur indefinitely. Surveys can be undertaken which help the firm in obtaining the statistical and market information. As a result of growth of a particular industry many benefits are shared by all the constituent firms. If we consider again the hotel industry. However. when the industry grows. (d) Supply of adequate sources of power. 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. They are termed as external economies. A limit to the expansion of the firm is reached at a point where average returns are maximum and average costs are minimum. (2) Economies of Disintegration: With the growth of the industry. Various such economies can be discussed as follows: (1) Economies of Concentration: Certain benefits occur as a result of concentration of localization of industry. Beyond this point. (3) Economies of information: The industry may publish certain trade journals which are useful to the firms.e. It is possible to visualize such external economies e. (c) Better and cheap credit facilities through the development of banks and other financial institutions. (b) External Economies There are certain advantages which are enjoyed by all the firms in an industry. Such economies help in reducing the cost of production i. Development of such firms helps in reducing the cost of the main industry. These advantages can not be secured by the firms if they are not localized. (b) Availability of skilled and trained labour.
Thus. which bring about increasing returns initially. Some economists are of the opinion that since entrepreneur is always a fixed factor. Managerial Diseconomies: Beyond certain limit the growth of the firm creates many managerial problems and difficulties. When the firm expands. all other inputs except the entrepreneur are variable. This results in growing labour problems. This result in delay and red-tapism reducing the efficiency which causes the diminishing returns. The large size of the firm reduces the initiative. 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. diminishing return to scale is nothing but a special case of the law of variable proportions.burdened & hence inefficient. Diseconomies of Scale (1) Internal diseconomies: As the firm expands in size. 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. The various economies such as technical. these equipments become over. Technical Diseconomies: As the size of the firm expands beyond the optimum limit. develop into internal diseconomies. they have to depend upon second hand information. 62/87 9/18/2007 1:31 PM . etc. In the long run. Hence. Moreover. There is a separation between those who take decisions and those who execute the same. Similarly the indivisible equipments have a maximum capacity up to which such equipment work more and more sufficiently but once these limit is crossed . the economies arising from specialization and indivisibilities change in diseconomies Division of labour and specialization beyond certain limits prove to be in efficient. But as already stated. diminishing returns creep in due to problems and complexities of the management. when decision-making is done by different groups there can be disharmony.DHARMENDRA MISHRA internal economies. The problems faced are mainly of coordination and supervision. it experiences certain economies or advantages as mentioned above. the advantages turn into disadvantages and result in diminishing returns or increasing costs. Thus. the decision-makers are not directly concerned with productive. 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. managerial. with the growth of the firm beyond the optimum limit. 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. Thus increasing returns occur due to internal as well as external economies. it becomes unwieldy and uncontrollable. In addition to this. Any expansion of the firm beyond this optimum limit will lead to diseconomies of scale. The personal contact between management and workers is lost in a large firm.
explain ad illustrate the condition for the establishment of firm’s equilibrium under perfect competition 4 In short run cost analysis.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 . 6 Writes a short note on causes ad disadvantages of monopoly 7Explain the main features of monopolistic competition . How is price determined in a discriminating monopoly? 3 Distinguish between the perfect and monopolistic competition . 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.
Thus. however instead of the demand. petroleum companies. Demand forecasting is very popular in industrially advanced countries where demand conditions are always more uncertain than the supply conditions. India had to spend in 1978 Rs.How far ahead? The problem is solved by having both short-run forecasting. the becomes so uncertain that the projection becomes rather dubious. demand forecasting is bound to become important in India also. the very high capital costs 64/87 9/18/2007 1:31 PM . in a country like India supply forecasting seems to be more important than demand forecasting. Forecasting helps a firm to assess the probable demand for its products and plan its production accordingly. firms produce in anticipation of future demand.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. High prices and black markets point to supply bottlenecks. machine accessories. For example. In such areas. in view of the long life of the fixed assets. viz. because of the close link with capital expenditure forecasting. 10 or even 20 years. It can also help management in reducing its dependence on chance. It may be necessary to look 20 years ahead in case of certain industries. and long-run forecasting covering a period of 5. forecasting is an important aid in effective and efficient planning. The national Council of applied Economic Research has made demand forecasts for a number of products (consumer as well as industrial) on a macrolevel. In developing countries. However.000 cores on imports of even essential goods.. raw materials. However. buildings. depends upon the nature of the industry but. supply is often the limiting factor. shipping companies and paper mills. 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. supply as far in excess of demand and the producers have begun to battle for the market place. Naturally. beyond ten years. usually defined as covering any period up to one year. some firms may as a policy produce to order but generally. etc. How far ahead can the long-term forecast go. In fact. FACTORS INVOLVED IN DEMAND FORECASTING There are at least six factors involved in demand forecasting: 1. 1. equipment. Competition has spread to most areas except those where massive investment is required. Demand forecasting is also helpful in better planning and allocation of national resources. These forecasts can be helpful in determining industry demand. labour. Because of unrealistic estimate of projected demand and production.
Thus the time period involved will be ten years. 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. 3 Problems and methods of forecasting are usually different for new products from those for products already well established in the market. this may be preferable to a fluctuating level of production. it is concerned with extending or reducing the limits of resources. depending upon the nature of the business. equip and bring it into operation will be five years. (b) Industry-level prepared by different trade associations. therefore. if it is intended to establish a factory. the period chosen will depend upon the expected life of the plant or machinery. for which sales trends are known and the competitive characteristics of the product well understood. Such external data constitute the basic assumptions on which the business must base its forecasts. then the forecast of the demand for the products to be made in the factory must start five years ahead. Accordingly. When it is intended to replace plant or to buy new or improved machines. 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. do have to forecast well deep into the future. Which period is chosen depends upon the nature of business. which provides information for major decisions. If stocks can be built up in the slack sales period. The latter may cause problems of labour and machine utilization. However. when demand fluctuates from one month to another. Short-term forecasting may cover a period of three months six months or one year. and may be projected for a further five-year period in order to establish the viability of the project. but it usually needs to be broken down into commodity productwise forecasts and forecasts by areas of sale. short-term forecast is one which provided information for tactical decisions. 65/87 9/18/2007 1:31 PM . It is.DHARMENDRA MISHRA involved and the possibility of profit only in the distant future. national income or expenditure. and it is thought that the time required to build. the time required to purchase and to bring it into use. 2 For example. concerned with day-today operations within the limits of resources currently available. the last being the most usual. and the time required for the capital outlay to be recovered. a very short period should be taken.© Firm-level. which could be avoided if production is continued during the slack period. A long-term forecast is one. 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.
Forecasting short-term financial requirements.g. If targets are set too high. Setting sales targets and establishing controls and incentives. 5 Finally in every forecast special factor peculiar to the product and the market must be taken into account. Sociological factors are of great importance in some markets e. they will be discouraging salesmen who fall to achieve them: if set too low. in the case of women’s dresses likewise the role of psychology in demand can hardly be understated. but also the (ii) (iii) (iv) (v) 66/87 9/18/2007 1:31 PM . It requires an analysis of the long-term demand potential of the products in question. therefore. Moreover. Political developments such as general elections are also important. their own personal prospects and about products and brands are vital factors for firms and industries. it takes time to arrange for funds on reasonable terms.. Purposes of Long-term Forecasting (i) Planning of a new unit or expansion of an existing unit. 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. Sales forecasts will. For this purpose production schedules have to be geared to expected sales. the targets will be achieved easily and hence incentives will prove meaningless. What people think about the future. Cash requirements depend on sales level and production operations. consumer durables or consumer goods and services. Purposes of Short-term Forecasting (i) Appropriate production scheduling so as to avoid the problem of over production and the problem of short supply. PURPOSES OF FORECASTING The purposes of forecasting differ according to types of forecasting: shortterm forecasting and long-term forecasting.DHARMENDRA MISHRA 4 It is important to classify products as producer goods. 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. Economic analysis indicates distinctive patterns of demand for each of these different categories. Helping the firm in reducing costs of purchasing raw materials and controlling inventory by determining its future resource requirements. enable arrangement of sufficient funds on reasonable terms well in advance. A multiproduct firm must ascertain not only the total demand situation.
They can be started well in advance only on the basis of estimates of manpower requirements assessed according to long-term sales forecasts. For example. Discretionary income can be estimated by subtracting three items from disposable income vtz. major fixed outlay payments such as mortgage debt payment. long-term sales forecasts are quite essential to assess long-term financial requirements. One may also consider the price differences between products concerned and its substitutes and complements. 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.DHARMENDRA MISHRA demand of different items separately. There are three basic factors influencing the demand for these goods: Purchasing power. Insurance premium payments and rent and essential expenditures such as food and clothing and transport expenses based upon consumption in a normal year. Data on aggregate personal income and personal disposable income are published by the Central Statistical Organization (C. Some people suggest the use of discretionary income in place of disposable income. dyestuff industry as also for ready made garments industry. As planning for raising funds requires considerable advance notice. one has to consider the prices of the product and also its substitutes and complements.O.S. imputed income and income in kind. Discretionary income can be quite an important determinant in case of consumer non-durables. Here. 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 . Planning man-power requirements. Training and personnel development are long-term propositions. The demand forecasts of particular products may also provide a guideline for demand forecasts for related industries. Price. The price factor is another important variable to be included in demand analysis. the demand forecast for cotton textiles may provide an idea of the likely demand for the textile machinery industry. Non-durable consumer goods.). 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. (ii) Planning long-term financial requirements. This is determined by disposable personal income (personal income direct taxes and other deductions). taking considerable time to complete. which are luxuries. Thus. DETERMINANTS OF DEMAND 1. demand forecasts are useful to the industry as also to the government. its competitive position would be much better. or in devising appropriate export promotion policies if there is a surplus.
social status. In fact. it involves distinguishing between the total market demand and market segments. using the product concerned. etc. © Demography. over a period of time a change may take place in some or all of these factors. Direct price elasticity can be expected to be more important with respect to those consumer non-durables. human as well as non-human. Thus food prices exert a negative influence on the demand for cloth. This involves the characteristics of the population. For example. or on economic factors like income and obsolescence. 2. educational level. The various determinate of the demand for cotton textiles can provide a good illustration. when quantified.DHARMENDRA MISHRA than it is directly in terms of rice elasticity. prestige etc. Such segments may be derived in terms of income. geographic location. male female ratios. urban-rural ratios. there is no alternative but to continue using the old product. The demand for cotton cloth is a function of the price of cotton cloth. D is demography and P is price. 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. Durable consumer goods. It bears a negative relationship with the price of cotton cloth and with the prices of complementary commodities. P) Where d is demand. D. age. prices of substitute commodities and the income of consumers. For example. Demand can be forecast by employing the following formula: D = J (Y. However. If necessary or (b) disposing it of and replacing it with a new one. the segment.. This icads to a cut in the demand for cloth. 68/87 9/18/2007 1:31 PM . prices of food grains constitute an important determinant of the demand for cloth. Which are capable of storage and are free from risks of changes in styles. on the other hand a positive relationship exists with the prices of substitute commodities and with income. 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. Y is disposable income. can be used as an independent variable affecting the demand for the product in question. In periods of shortage. For example. 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. population may increase and fashions and consumer preferences may undergo a change. But in a developing country like India. 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. The choice may depend upon non-economic factors like social status. sex.
the number of families and some other factors depending on the product concerned. Western countries have had this facility as a matter of routine. It is the level towards which the actual volume of consumer stock tends to gravitate. The ratio of price to the average like of the product should be considered. (D) As consumer durables are used by more than one person. (F) Price and credit conditions. and electricity for refrigerators and TVs. Again. extension of credit is used as a sales promotion measure. When purchasing power increases. e. income and other considerations. the decision to purchase may be influenced by family characteristics. the scrap page rate tends to be high and vice versa again. In fact. Among the manufacturers. For certain well-established products.. life expectancy tables have been prepared in advanced countries in order to estimate the average replacement rates. This facility has now been extended in India as well. But as production catches up. If the average life is high. The total demand is symbolically stated as d = N + R. (C) To the extent that the consumer durable is used by “household” rather than on an individual basis. The difference between optimum and the actual stock shows the growth potential of the demand for durable goods. and (b) a replacement demand. Once a person gets used to a thing he is unlikely to give it up at some future date. Each of these independent variables may be forecast separately. Disintegration of joint Hindu family has led to an increase in the number of households. scrap page rate is lower. The names of Zarapkars of Bombay and V G Pancreas of Madras need a special mention in this respect.g. Many firms specialize in selling goods on hire purchase. the 69/87 9/18/2007 1:31 PM . Such as the size of families and the age distribution of adults and children as well as price. The few consumer durables (for example. This makes replacement demand regular and predictable. The replacement demand tends to grow with the growth in the total stock with the consumers. The existence and growth of such facilities is an important variable for determining their demand. when demand exceeds production.DHARMENDRA MISHRA (B) These goods require special facilities for their use. The availability of hire purchase facility tends to push up the demand for consumer durables. roads for automobiles. The purchasing power. set an upper limit to the maximum or the optimum level. 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 household figures are more important than total population figures (and changes therein). electric shavers) that are used individually could be expected to depend more on population than on households. the principal effect would be dampen the influence of price. the scrap page tends to increase. where N is New owner Demand and R is the Replacement Demand. (E) The total demand consists of (a) a new owner demand.
Moreover. and the level of wage rates. Again. When wage rates rise in relation to other costs. the demand for refrigerators in India is mainly a function of income while in the U. Hawkins Pressure Cookers are also available on hire-purchase basis. The intensified competition between car and two-wheeler manufacturers has led to many firms extending credit for their purchase. 3. (iv) availability of bank finance to the prospective customers and (v) growth pattern of the economy. New demand as well as replacement demand will have to be considered. These deliberations very often involve choice among many competing consumer durables. The demand for textile machinery will for example. the ratio of production to capacity in the user industries. be determined by the expansion of textile industry in terms of new units and replacement of existing machinery. Purchases of consumer durables are rather discretionary. For example. the management will seriously consider further investment in labour-saving equipment. 70/87 9/18/2007 1:31 PM . So also. it will depend upon the profitability of industries using the capital goods (called user industries). As the demand for capital goods is a derived one. the discretionary purchases may be postponed if there are reports of impending product improvements. They are very often made at unevenly spaced intervals of time. For estimating the demand for aero planes. The demand for cable extruders would depend primarily on the demand for cables which in turn would be linked to electrification programmes. there is no compelling need to make these discretionary purchases at any given time. these purchases may be speeded up or else they may be postponed. The demand for commercial vehicles depends upon (i) The scrap page rate. (iii) economics of movement by road vis-à-vis rall. Thus durables are bought sporadically. the manufactures of Singer.DHARMENDRA MISHRA Indian Sewing Machine Company. (ii) The availability of vehicles. Capital goods are used for further production. it is a function of new houses built. If there are expectations of prices going up.A. demand will depend upon the specific markets they serve and the end uses of which they are bought. usually several months elapse between the formation of the idea and the culmination of the purchase decision. Which is particularly the case in automobiles in foreign countries. the points to be considered are expected passenger demand and traffic growth. In the case of particular capital goods. Capital Goods. Forecasting demand for consumer durables presents some difficult problems. (A particular commodity may be a producer good for one but consumer good for the other).S. They are not made on the spur of the moment but after considerable deliberations among members of the family. The relative importance of these various factors will vary from country to country. Government spending etc. claim to have pioneered hire purchase in India..
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. also known as Opinion Surveys. Though statistical techniques are essential in clarifying relationships and providing techniques of analysis. too much emphasis should not be placed on mathematical or statistical techniques of forecasting. Here the burden of forecasting is shifted to the customer. This method is not very useful in the case of household customers for several reasons 71/87 9/18/2007 1:31 PM . mild steel may be in use in place of construction steels which are more suitable. customers may tend to exaggerate their requirements. If shortages are expected. operating costs per seat mile and the nature and extent of competition (for an individual firm). is most useful when bulk of the sales is made to industrial producers. The velocity of their use. Moreover. air and noise pollution. norms of consumption would also change. 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). For construction of bridges. for example.DHARMENDRA MISHRA airport congestion and landing fees. The more commonly used methods of demand forecasting are discussed below. 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. It is assumed that norms of consumption would remain stable. i. However. as the pattern of availability changes. because of the latter’s non-availability of high costs. in some cases the present norms may reflect shortages (for instance. METHODS OF FORECASTING It should first of all the emphasized that there is no easy method or simple formula. 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. First. they are not substitutes for judgment. A number of biases may creep into the surveys. What is needed is some commonsense mean between pure guessing and too much mathematics. In such cases. This method. 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. two dangers must be guarded against. which enables an individual or a business to predict the future with certainty or to escape the hard process of thinking. in the case of imported spares subject to import controls).
about 620 experts with different backgrounds such as policymakers. possess wide knowledge and experience of the subject and have an aptitude and earnest disposition towards the participants. Most often. 72/87 9/18/2007 1:31 PM . scientists. A basic limitation of this method is that it is passive and “does not expose and measure the variables under management’s control”.S. the Delphi method presumes the following two conditions. technologists. possess ample abilities to conceptualise the problems for discussion. stimulate dialogue among panelists and make inferential analysis of the multitudinal views of the participants. However. and the possibility that the buyers plans may not be real but only wishful thinking. the complexity of the subject under debate determines the degree of these qualities on the part of the conductors. Secondly. Delphi method was originally developed at Rand Corporation of the U. bandwagon effects” and ‘ego involvements’ associated with publicity expressed opinions. genera tic considerable thinking. The Delphi method has some exclusive advantages. This enables the respondent to be candid and forthright in his/her view. First the panelists must be rich in their expertise. Delphi Method. In one case for example. the Delphi presupposes that its conductors are objective in their job. Thus.DHARMENDRA MISHRA viz irregularity in customers buying intentions. The leader provides each expert with the responses of the others including their reasons. A variant of the opinion poll and survey method is Delphi method. 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.A. 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”. The participants are supplied the responses to previous questions from others in the group by a coordinator or leader of some sort. predicting technical changes. their inability to foresee their choice when faced with multiple alternatives. Delphi renders it possible to pose the problem to the experts at one time and have their response.e. Again. First it facilitates the maintenance of anonymity of the respondent’s identity throughout the course. It has proved more popular in forecasting non-economic rather than economic variables. I. This is nearly as good as the panelists physically pooled together for the exercise. household customers numerous making this method rather impracticable and costly. economists. administrators and advisers were solicited. Secondly. in the late 1940s by Olaf Helmer. this technique saves time and other resources in approaching a large number of experts for their views. I.
The rationale of this method is that salesmen. Advantages (1) The method is simple and does not involve the use of statistical techniques. here salesmen will have to depend more on their judgment than in the case of existing products. changes in secular forces like purchasing power. managerial economist. 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 . being the closest to the customers. Disadvantages (1) it is almost completely subjective as personal opinions can possibly influence the forecast. (3) Salesmen may be unaware of the broader economic changes likely to have an impact on the future demand. for a period of about one year. and the top executives. III. customer reaction to the products of the firm and their sales trends. These forecasts may not be useful for long-term production planning. income distribution. which has been in existence for some time. They are then reviewed to eliminate the bias of optimism on the part of some salesmen and pessimism on the part of others. marketing manager. I. Such data can be presented either in a tabular form or graphically for further analysis.DHARMENDRA MISHRA II. are likely to have the most intimate feel of the market. (3) The method may prove quite useful in forecasting sales of new products. In many cases. will have accumulated considerable data on sales pertaining to different time periods. Such data when arranged chronologically yield ‘time series’. Analysis of Time Series and Trend Projections A firm. the sales forecast would emerge after these factors have been taken into account. say five years ahead or more. Salesmen may even understate the forecast of their sales quotas are to be based on it. (2) The usefulness of this method is restricted to short-term forecasting. etc. Collective Opinion Under this method also called sales force polling salesmen are required to estimate expected sales in their respective territories and sections.e. Of course. product designs and advertisement programmes. (2) The forecasts are based on first-hand knowledge of salesmen and others directly connected with sales. Their jobs usually require full-time attention to the present so that they do not get time to think about the future. etc. The time series relating to sales represent the past pattern of effective demand for a particular product. sales manager. This method is known as the collective opinion method as it takes advantage of the collective wisdom of salesmen departmental heads like production manager. population. These revised estimates are further examined in the light of factors like proposed changes in selling prices. they may lack the necessary breadth of vision for looking into the future. expected changes in competition. i.e. The estimates of individual salesmen are consolidated to find out the total estimated sales. employment.
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 trend values are then eliminated from observed data (TSCI/T). The analyst chooses a plausible algebraic relation (linear. Nevertheless. cyclical fluctuations and irregular or random forces. quadratic. This method is popular because it is simple and inexpensive and partly because time series data often exhibit a persistent growth trend. but the prediction of cycles is hazardous for the simple reason that there is no regularity in the cyclical behavior. there are two assumptions underlying this approach: (1) The analysis of movements would be in the order of trend. seasonal variations and 74/87 9/18/2007 1:31 PM . it is of limited value in actual business forecasting. The problem in forecasting is to separate and measure each of these four factors. A cycle is then fitted to the remainder. 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. However. the trend projection breaks down. logarithmic etc) between sales and the independent variable time. given much thought to the turning points. 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 real challenge of forecasting is in the prediction of turning points rather than in the projection of trends. The next step is to calculate the seasonal index.DHARMENDRA MISHRA series. Whenever a turning point occurs. The trend and the seasonal factor can be forecast. The foregoing approach to the decomposition of time series data is a useful analytical device for understanding that nature of business fluctuations. It is when turning points occur that management will have to alter and revise its sales and production strategies most drastically. which is used to remove the seasonal effect (SCI/S). therefore. This technique yields acceptable results so long as the time series shows a persistent tendency to move in the same direction. Many analyses have. The trend line is then projected into the future by extrapolation. however. which also contains the irregular effect. 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. However.
the value of Y. Past relationships may not recur. There can be curvilinear relationships as well. say.e.O. Personal income for the demand of consumer goods. demand can be estimated for any given value of x.i. New factors may also have to be taken into consideration. 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. It is inappropriate. Construction contracts sanctioned for the demand of building materials. e..S.DHARMENDRA MISHRA cyclical changes: and (2) The effects of each component are independent of each other. For example construction contracts will result in a demand for building materials but with a certain amount of time lag. the utility is limited because may have to be based on projected economic index itself which may not come true. For new products.g. Hence the need for value judgment as well. Finding an appropriate economic indicator may be difficult. • • • • 2. Once regression equation is derived. the equation will be of the form Y = a + ax.. For the use of economic indicators. 3. This method of forecasting works best where the relationship of demand with a particular indicator is characterized by a time lag. fertilizers etc. IV. Use of Economic Indicators The use of this approach bases demand forecasting on certain economic indicators. 75/87 9/18/2007 1:31 PM . which publishes national income estimates. 1. These economic indicators are published by specialized organization like the C. Assuming the relationship to be linear. petrol etc. where the demand does not lag behind the particular economic index. However. Limitations 1. as no past data exist. d Automobile registration for the demand of accessories. 2. cement. implements. Establish the relationship through the method of least squares and derive the regression equation. 3.
etc. Controlled Experiments Under this method. on sales can be assessed by either varying them over different markets or by varying them over different time periods in the same markets. 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. etc. for example. consumers and competitors. Controlled experiments have often been conducted in the U. Even when statistical methods are used. 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. and conduct the experiments assuming that the other factors remain constant. (c) Statistical forecasts are more reliable for larger levels of aggregations. e. Thus. an effort is made vary separately certain determinates of demand which can be manipulated. sizes and models. 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.DHARMENDRA MISHRA V. First such experiments are expensive as well as time-consuming. used this method to find out the effect of a price rise on the demand for Quink Ink. product design..g. advertisement. packaging etc. etc. controlled experiments have sufficient potentialities to become a major method for business research and analysis in future. the effect of demand determinates like price. The method of controlled experiments is still relatively new and less tried. a major technological breakthrough in product or process design. price advertising. In 76/87 9/18/2007 1:31 PM . Despite these limitations. for example the Parker Pen Co. Thirdly.S. This is due to several reasons. For example. It must be noted that the market divisions here must be homogeneous with regard to income tastes. 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. Fourthly. It may be more difficult to accurately forecast demand by sales territory. it is difficult to satisfy the condition of homogeneity of markets. It would be taken into account only through the judgmental approach.A. (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. Thus while it may be possible to forecast the total national demand more or less accurately. VI. 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. to gauge the effect of a change in some demand determinates like price. advertising. Secondly they are risky too because they may lead to unfavorable reactions on dealers.
These are sometimes known as rolling forecasts. Identify the variables affecting the demand for the product and express them in appropriate forms. market share or industry as a whole. Product group may 77/87 9/18/2007 1:31 PM . 3. For forecasting the company’s share in the demand. Gather relevant data for approximations to relevant data to represent the variables. 2. If would. 6. 9. APPROACH TO FORECASTING 1. As forecasts are based on certain assumptions. 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. They are more meaningful than a single forecast. the projections may be revised every year. Forecasts may be made in terms of product groups and then broken for individual products on the basis of past percentages. 4. Identify and clearly state the objectives of forecasting-short-term or longterm. however. be useful to prepare alternative forecasts.DHARMENDRA MISHRA such cases. forecasts must be revised when improved information is available. 5. Through the use of statistical techniques. the company may assume a market share different from that of the past. Select appropriate method of forecasting. Interpretation is more important to the management. Prepare the forecast and interpret the results. In long-term forecasts. 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. The latter may be converted into physical units by dividing it by the expected selling price. (b) On the basis of an analysis of likely competition and industry trends. there is no alternative but to depend upon judgment for developing more detailed forecasts. 7.
production schedules. schedule of operations and budgetary control over expenses. raw material requirements and the size and scope of R & D programs. etc. will provide a barrier to continuous growth. either by increased promotion activity. For determining the month-wise break-up of the forecast sales of a new product. brands. involving a period from on to two years. new product development or by discontinuing the brand. either. are useful for determining the rate of maintenance. Long-term demand forecasts. (i) use may be made of other firms data. if available. the more uncertain is the future. Medium term forecasts. personnel requirements.. LENGTH OF FORECASTS 1. judge ting and planning cash flows. 3. labels. colours. Analyze the raw product as a substitute for some existing product or service. etc. 78/87 9/18/2007 1:31 PM . FORECASTING DEMAND FOR NEW PRODUCTS Joel Dean has suggested a number of possible approaches to the problem of forecasting demand for new products: 1. This is so for two reasons: (1) in the long-term market forces such as competition.DHARMENDRA MISHRA be divided into individual products in terms of sizes. (See illustration below. are useful for determining capital expenditures. involving a period up to twelve months. the longer the forecast period. the long-term trend will tend towards the horizontal. financial requirements. or (ii) some survey may be necessary. are useful for determining sales quotas. involving a period of three to ten years. (2) No company will allow a product to decline indefinitely without taking some action. market situation. Inventory control. Project the demand for the new product as an outgrowth of an existing old product. In the absence of any other evidence. 2. Short-term forecasts. Forecasts may be made on annual basis and then divided month-wise or week-wise on the basis of past records. Similar will be the situation when the forecast sales of a product line have to be divided product wise. However.) 10. 2. 11.
To some extent. either by the used of samples or on a full scale. 2.DHARMENDRA MISHRA 3. A question may arise. Estimate the demand by making direct enquiries from the ultimate purchasers. 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. The techniques employed should be able to produce meaningful results quickly. 4. Accuracy. Understanding is also needed for a proper interpretation of the results. This has three aspects. 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. The accuracy of the forecast is measured by: (a) the degree of deviations between forecasts and actual. and (b) the extent of success in forecasting directional changes. 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. Maintenance of Timeliness. 5. by direct mall or through one multiple shop organization 6. Economy. Offer the new product for sale in a sample market. 3. CRITERIA OF A GOOD FORECASTING METHOD 1. Availability. Costs must be weighed against the importance of the forecast to the operations of the business. These methods are not mutually exclusive and it would be desirable to try to combine several of them so that crosschecking is possible. the methods of forecasting demand for an established product may also be applied or adapted for new products.g. 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. The forecast should be capable of being maintained on an up-to-date basis. 4. e. techniques which take a long time to work out may produce useful information too late for effective management decisions. 79/87 9/18/2007 1:31 PM . Some comparisons of the model with what actually happens and of the assumptions with what is borne out in practice are more desirable. Simplicity and Ease of Comprehension. Management must be able to understand and have confidence in the techniques used. It is necessary to check the accuracy of past forecasts against present performance and of present forecasts against future of performance. 5.
aggregate savings. if the level of national savings is projected to rise fast. An increase in investment would raise demand for intermediate goods or vice versa. Investment. Further this in turn would depress investment in these (ii) (iii) (iv) (v) (vi) 80/87 9/18/2007 1:31 PM . For example. aggregate demand and the level of spending in general. provide the boundaries within which projections of demand for an industry. etc. Population Growth. Government expenditure.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. Taxation can also influence demand pattern. rising population indicates that the market for various commodities is in general expanding. The future demand for all types of goods would rise with population growth. Various macro-parameters found useful for demand forecasting are as under: (i) National income and per capita income. etc. if the level of savings is high. per capita income. a firm or a product fit in. In the context of Indian economy. Taxation. The forecasting procedure should permit changes to be made in the relationships as they occur. Savings. Thus savings parameter has a bearing on future demand for consumer goods. Population growth. air-conditioners. Increase in these parameters indicates rising market potential consumer goods. this would dampen consumer goods demand. Certain taxes would depress the demand of commodities taxed. High level of public expenditure would stimulate investment in the private sector. the disposable consumer expenditure on products will in all probability decline. (b) (c) ROLE OF MACRO-LEVEL FORECASTING IN DEMAND FORECASTS Macro-level forecasting precedes micro-level demand forecasting for a firm or an industry. The macro-parameters such as Gross National Product (GNP). Likewise. the increase in public expenditure has a decisive role in stimulating private investment. high level of excise duties on semi-luxury and luxury goods such as electrical appliances refrigerators. level of investment. especially durable consumer goods. for instance. would depress the demand for these goods.
Credit policies affect holding capacities of all business sections-producers. The data pertaining to national income. present a reasonable basis for good forecasts.DHARMENDRA MISHRA industries and as such demand for capital goods employed in these industries. 4. 5. per capita income. In India. RECENT TRENDS IN DEMAND FORECASTING 1. There is a greater emphasis on sophisticated techniques such as using computers. Forecasts are usually broken down in monthly forecasts. Such policies influence cost of credit. Better kind of data and improved forecasting techniques have been developed. dealers and retailers. prices. demand forecasts are still not too accurate. a team spirit has developed. 81/87 9/18/2007 1:31 PM . etc. Top down approach starts by analyzing national economy. in spite of the application of newer and modern techniques. credit availability and company finance. 7. National Council of Applied Economic Research and Central Statistical Organization. 8.. taxes. It should thus be clear how forecasts regarding national parameters would influence and determine firm’s demand projections. More firms are giving importance of demand forecasting than a decade ago. 9. (vii) Credit policy. The usefulness of personal feel or subjective touch has been accepted. New products forecasting is still in infancy. inventories are largely affected by credit policies through their effects on carrying costs of inventors. then the industry and finally the individual firm. 2. 6. production. Since forecasting requires closer co-operation and consultation with many specialists. However. A good crop forecast and higher rural incomes would lower cost of materials and boost demand for various products. 3. information and data about macro parameters are mostly available in various publications of Government organizations. Top down approach is more popular than bottom up approach. The time pattern of investment is largely affected by credit policies again.
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.
BEP= Fixed cost / contribution = (1200000-200000-100000) / (80-60) = 45000 Units P/Vratio = (s-v)/s = (80-60) / 80 = 0.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. A cost which cannot be influenced by the action of the specified member of na organisationis referred as uncontrollable cost. 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 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. Selling price Rs 10 Variable cost per unit Rs 6 Fixed cost 100000 86/87 9/18/2007 1:31 PM . It is also known as unavoidable cost. The benefit lost is usually the net earnings or profits that might have been earned from rejecting alternative Sunk 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. 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 1200000.25 25 % 3 for the particular product following information is given. Selling price of good is Rs 80 per unit and variable cost is Rs 60 find BEP and p/v ratio. write off of goodwill 100000.
Opportunity cost incremental cost. 87/87 9/18/2007 1:31 PM . Find out the break even point for the company . 70000 Revised sales price = 270000/ 25000 = 10.DHARMENDRA MISHRA Due to inflation variable cost increases by 10% while fixed cost increases by 5%. 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. actual cost.8/10 . The budgeted fixed cost and sales are 250000 and 993000 resp. BEP. Sunk cost.6 + 105000 = 2. 70000 so Sales = 2. 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. 4 From the following calculate P/V.80 Increase in sales price to maintain same BEP = 10. Variable costs.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.6 New fixed cost = Rs 105000 At BEP sales = total cost Total cost = 25000* 6.