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MANAGERIAL ECONOMICS

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MBA

First Semester

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VINOBA BHAVE UNIVERSITY


HAZARIBAG, JHARKHAND
BOARD OF STUDIES

Prof. (Dr.) Gurdeep Singh Vice Chancellor


Vice Chancellor,
Vinoba Bhave University
Hazaribag
Prof. (Dr.) K.K. Srivastava Director - DDE
Professor
Department of Chemistry
Vinoba Bhave University

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Hazaribag
Dr. Saroj Ranjan Subject Expert
Associate Professor

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University Department of Management Studies
Vinoba Bhave University

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Hazaribag

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Author: D.N. Dwivedi, Prof. of Economics, Maharaja Agrasen Institute of Management Studies, Delhi
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Copyright © Author, 2016


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SYLLABI-BOOK MAPPING TABLE
Managerial Economics

Syllabi Mapping in Book

Unit - I
Unit 1: Introduction to Managerial
Nature, scope and application of Managerial Economics.
Economics
Theory of the firm and business objectives. Economic, Behavioural (Pages: 3-40)
and Managerial theories.

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Unit - II Unit 2: Analysis of Demand
DemandAnalysis. Law of Demand. Determinants of Demand. (Pages: 41-89)

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Elasticity of Demand. Demand forecasting.

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Unit - III
Unit 3: Theory of Consumer
Consumer Behaviour, Cardinal and ordinal approaches: Demand
Consumer’s equilibrium; the revealed preference. (Pages: 91-121)

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Unit - IV Unit 4: Input-Output Decisions
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Input-Output decisions. Law of supply; Elasticity of supply.
Production function; short-run analysis; Long-run function. Short-
(Pages: 123-162)

run and long-run cost functions.


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Unit - V Unit 5: Price and Output
Determination
Price-Output Decisions. Market structures. Price determination (Pages: 163-222)
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under perfect, imperfect, monopoly and duopoly. Pricing practices


and strategies.
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Unit - VI Unit 6: Measurement of Profit


Measurement of profit and profit policy. and Profit Policy
(Pages: 223-234)
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Unit - VII
Unit 7: Macroeconomic Concept
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Micro-economic concepts: National Income: Marginal propensity (Pages: 235-263)


of consume; Multiplier effect; Effective demand.
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CONTENTS
INTRODUCTION 1

UNIT 1 INTRODUCTION TO MANAGERIAL ECONOMICS 3-40


1.0 Introduction
1.1 Unit Objectives
1.2 Nature, Scope and Application of Managerial Economics

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1.2.1 What is Economics?
1.2.2 What is Managerial Economics?
1.2.3 Why do Managers Need to Know Economics?
1.2.4 Application of Economics to Business Decisions: An Example

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1.2.5 The Scope of Managerial Economics
1.2.6 Gap between Theory and Practice and the Role of Managerial Economics

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1.2.7 How Managerial Economics Fills the Gap
1.3 Theory of the Firm and Business Objectives
1.3.1 Profit as Business Objective
1.3.2 Problems in Profit Measurement
1.3.3 Profit Maximization as Business Objective

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1.3.4 Controversy Over Profit Maximization Objective: Theory vs. Practice
1.3.5 Alternative Objectives of Business Firms
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1.3.6 Making a Reasonable Profit — a Practical Approach
1.3.7 Profit as Control Measure
1.4 Summary
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1.5 Key Terms
1.6 Answers to ‘Check Your Progress’
1.7 Questions and Exercises
1.8 Further Reading
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UNIT 2 ANALYSIS OF DEMAND 41-89


2.0 Introduction
2.1 Unit Objectives
2.2 Law of Demand
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2.3 Determinants of Demand


2.4 Elasticity of Demand
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2.4.1 Price Elasticity of Demand


2.4.2 Measuring Price Elasticity from a Demand Function
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2.4.3 Price Elasticity and Total Revenue


2.4.4 Price Elasticity and Marginal Revenue
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2.4.5 Determinants of Price Elasticity of Demand


2.4.6 Cross-Elasticity of Demand
2.4.7 Income-Elasticity of Demand
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2.4.8 Advertisement or Promotional Elasticity of Sales


2.4.9 Elasticity of Price Expectations
2.5 Demand Forecasting
2.5.1 Why Demand Forecasting
2.5.2 Steps in Demand Forecasting
2.6 Techniques of Demand Forecasting
2.6.1 Survey Methods
2.6.2 Statistical Methods
2.7 Summary
2.8 Key Terms
2.9 Answers to ‘Check Your Progress’
2.10 Questions and Exercises
2.11 Further Reading

UNIT 3 THEORY OF CONSUMER DEMAND 91-121


3.0 Introduction
3.1 Unit Objectives
3.2 Consumer Behaviour

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3.3 Cardinal Utility Approach
3.3.1 Meaning and Measurability of Utility
3.3.2 Total and Marginal Utility

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3.3.3 Law of Diminishing Marginal Utility
3.3.4 Consumer’s Equilibrium

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3.4 Ordinal Utility Approach
3.4.1 Meaning and Nature of Indifference Curve and Indifference Map
3.4.2 Diminishing Marginal Rate of Substitution (MRS)
3.4.3 Properties of Indifference Curves
3.4.4 Consumer’s Equilibrium
3.4.5 Income and Substitution Effects

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3.5 Revealed Preference Approach
3.6 Summary
3.7 Key Terms
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3.8 Answers to ‘Check Your Progress’
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3.9 Questions and Exercises
3.10 Further Reading

UNIT 4 INPUT-OUTPUT DECISIONS 123-162


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4.0 Introduction
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4.1 Unit Objectives


4.2 Law of Supply
4.3 Elasticity of Supply
4.4 Production Function
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4.5 Short-run and Long-run Production Function


4.6 Short-run and Long-run Cost Functions
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4.6.1 Short-run Cost-Output Relations


4.6.2 Short-run Cost Functions and Cost Curves
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4.6.3 Cost Curves and the Law of Diminishing Returns


4.6.4 Some Important Cost Relationships
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4.6.5 Output Optimization in the Short-run


4.6.6 Long-run Cost-Output Relations
4.7 Summary
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4.8 Key Terms


4.9 Answers to ‘Check Your Progress’
4.10 Questions and Exercises
4.11 Further Reading

UNIT 5 PRICE AND OUTPUT DETERMINATION 163-222


5.0 Introduction
5.1 Unit Objectives
5.2 Competition and Market Structures
5.2.1 Features of Perfect Competition
5.2.2 Price and Output Determination under Perfect Competition
5.3 Monopoly
5.3.1 Demand and Revenue Curves under Monopoly
5.3.2 Cost and Supply Curves under Monopoly
5.3.3 Profit Maximization under Monopoly
5.3.4 Absence of Supply Curve in a Monopoly
5.3.5 Price Discrimination in a Monopoly
5.3.6 Measures of Monopoly Power
5.4 Oligopoly, Non-Price Competition
5.4.1 Oligopoly: Meaning and Characteristics

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5.4.2 Duopoly Models
5.4.3 Oligopoly Models
5.4.4 Game Theory Approach to Oligopoly

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5.5 Summary
5.6 Key Terms

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5.7 Answers to ‘Check Your Progress’
5.8 Questions and Exercises
5.9 Further Reading

UNIT 6 MEASUREMENT OF PROFIT AND PROFIT POLICY 223-234

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6.0 Introduction . L in
6.1 Unit Objectives
6.2 The Meaning of Pure Profit
6.3 Theories of Profit
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6.3.1 Walker’s Theory of Profit: Profit as Rent of Ability
6.3.2 Clark’s Theory of Profit: Profit as Reward for Dynamic Entrepreneurship
6.3.3 Hawley’s Risk Theory of Profit: Profit as Reward for Risk-Bearing
6.3.4 Knight’s Theory of Profit: Profit as a Return to Uncertainty Bearing
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6.3.5 Schumpeter’s Innovation Theory of Profit: Profit as Reward for Innovations


6.4 Summary
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6.5 Key Terms


6.6 Answers to ‘Check Your Progress’
6.7 Questions and Exercises
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6.8 Further Reading

UNIT 7 MACROECONOMIC CONCEPT 235-263


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7.0 Introduction
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7.1 Unit Objectives


7.2 National Income
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7.2.1 Measures of National Income


7.2.2 Choice of Methods
7.2.3 Theory of National Income Determination
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7.2.4 Aggregate Supply and Aggregate Demand


7.3 Consumption Function
7.4 Shift in Aggregate Demand Function and the Multiplier
7.5 Summary
7.6 Key Terms
7.7 Answers to ‘Check Your Progress’
7.8 Questions and Exercises
7.9 Further Reading
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Introduction
INTRODUCTION
The natural curiosity of a student who begins to study a subject is to know its nature and NOTES
scope. Such as it is, a student of economics would like to know ‘What is economics’ and
‘What is its subject matter’. Surprisingly, there is no precise answer to these questions.
Attempts made by economists over the past 300 years to define economics have
not yielded a precise and universally acceptable definition of economics. Economists
right from Adam Smith—the ‘father of economics’—down to modern economists have

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defined economics differently, depending on their own perception of the subject matter
of economics of their era. Thus, economics is fundamentally the study of choice-making
behaviour of the people. The choice-making behaviour of the people is studied in a

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systematic or scientific manner. This gives economics the status of a social science.
However, the scope of economics, as it is known today, has expanded vastly in the post-

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World War II period. Modern economics is now divided into two major branches:
Microeconomics and Macroeconomics.
Microeconomics is concerned with the microscopic study of the various elements
of the economic system and not with the system as a whole. As Lerner has put it,

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‘Microeconomics consists of looking at the economy through a microscope, as it were,
to see how the millions of cells in body economic—the individuals or households as
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consumers and the individuals or firms as producers—play their part in the working of
the whole economic organism.’ Macroeconomics is a relatively new branch of economics.
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Macroeconomics is the study of the nature, relationship and behaviour of aggregates
and averages of economic variables. Therefore, the technique and process of business
decision-making has of late changed tremendously.
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The basic functions of business managers is to take appropriate decisions on


business matters, to manage and organize resources, and to make optimum use of available
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resources with the objective of achieving the business goals. In today’s world, business
decision-making has become an extremely complex task due to the ever-growing
complexity of the business world and the business environment. It is in this context that
modern economics—howsoever defined—contributes a great deal towards business
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decision-making and performance of managerial duties and responsibilities. Just as biology


contributes to the medical profession and physics to engineering, economics contributes
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to the managerial profession.


This book, Managerial Economics, aims at equipping management students with
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economic concepts, economic theories, tools and techniques of economic analysis as


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applied to business decision-making.


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Self-Instructional
Material 1
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Introduction to

UNIT 1 INTRODUCTION TO Managerial Economics

MANAGERIAL ECONOMICS
NOTES
Structure
1.0 Introduction
1.1 Unit Objectives
1.2 Nature, Scope and Application of Managerial Economics

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1.2.1 What is Economics?
1.2.2 What is Managerial Economics?
1.2.3 Why do Managers Need to Know Economics?
1.2.4 Application of Economics to Business Decisions: An Example

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1.2.5 The Scope of Managerial Economics
1.2.6 Gap between Theory and Practice and the Role of Managerial Economics

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1.2.7 How Managerial Economics Fills the Gap
1.3 Theory of the Firm and Business Objectives
1.3.1 Profit as Business Objective
1.3.2 Problems in Profit Measurement
1.3.3 Profit Maximization as Business Objective

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1.3.4 Controversy Over Profit Maximization Objective: Theory vs. Practice
1.3.5 Alternative Objectives of Business Firms
1.3.6
1.3.7
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Making a Reasonable Profit — a Practical Approach
Profit as Control Measure
1.4 Summary
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1.5 Key Terms
1.6 Answers to ‘Check Your Progress’
1.7 Questions and Exercises
1.8 Further Reading
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1.0 INTRODUCTION
In this unit, you will learn about the nature, scope and application of managerial economics
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and the theory of the firm.


Emergence of managerial economics as a separate course of management studies
can be attributed to at least three factors: (a) growing complexity of business decision-
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making process due to changing market conditions and business environment,


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(b) consequent upon, the increasing use of economic logic, concepts, theories and tools
of economic analysis in the process of business decision-making, and (c) rapid increase
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in demand for professionally trained managerial manpower. Let us have a glance at how
these factors have contributed to the creation of ‘managerial economics’ as a separate
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branch of study.

1.1 UNIT OBJECTIVES


After going through this unit, you will be able to:
 Describe the nature, scope and application of managerial economics
 Discuss the theory of firm and business objectives

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Material 3
Introduction to
Managerial Economics 1.2 NATURE, SCOPE AND APPLICATION OF
MANAGERIAL ECONOMICS
NOTES It is a widely accepted fact that business decision-making process has become increasingly
complicated due to ever growing complexities in the business world. There was a time
when business units (shops, firms, factories, mills, etc.) were set up, owned and managed
by individuals or business families. In India, there were 22 top business families like
Tatas, Birlas, Singhanias, Ambanis and Premjis, etc. Big industries were few and scale

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of business operation was relatively small. The managerial skills acquired through
traditional family training and experience were sufficient to manage small and medium
scale businesses. Although a large part of private business is still run on a small scale

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and managed in the traditional style of business management, the industrial business
world has changed drastically in size, nature and content. The growing complexity of the

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business world can be attributed to the growth of large scale industries, growth of a
large variety of industries, diversification of industrial products, expansion and diversification
of business activities of corporate firms, growth of multinational corporations, and mergers
and takeovers, especially after the Second World War. These factors have contributed a
great deal to the recent increase in inter-firm, inter-industry and international rivalry,

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competition, risk and uncertainty. Business decision-making in this kind of business
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environment is a very complex affair. The family training and experience is no longer
sufficient to meet the managerial challenges.
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The growing complexity of business decision-making has inevitably increased the
application of economic concepts, theories and tools of economic analysis in this area.
The reason is that making an appropriate business decision requires a clear understanding
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of market conditions, the nature and degree of competition, market fundamentals and
the business environment. This requires an intensive and extensive analysis of the market
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conditions in the product market, input market and financial market. On the other hand,
economic theories, logic and tools of analysis have been developed to analyse and predict
market behaviour. The application of economic concepts, theories, logic and analytical
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tools in the assessment and prediction of market conditions and business environment
has proved to be of great help in business decision-making. The contribution of economics
to business decision-making has come to be widely recognized. Consequently, economic
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theories and analytical tools, which are widely used in business decision-making have
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crystallized into a separate branch of management studies, called managerial economics


or business economics.
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Let us begin our study of managerial economics by learning:


(i) What economics is
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(ii) About managerial decision-making problems, and


(iii) How economics contributes to business decision-making?

1.2.1 What Is Economics?


Managerial economics essentially constitutes of economic theories and analytical
tools that are widely applied to business decision-making. It is therefore useful to
know, ‘what is economics’1. Economics is a social science. Its basic function is to

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study how people—individuals, households, firms and nations—maximize their gains Introduction to
Managerial Economics
from their limited resources and opportunities. In economic terminology, this is called
maximizing behaviour or, more appropriately, optimizing behaviour. Optimizing
behaviour is, selecting the best out of available options with the objective of
maximizing gains from the given resources. Economics is thus a social science, NOTES
which studies human behaviour in relation to optimizing allocation of available
resources to achieve the given ends. For example, economics studies how households
allocate their limited resources (income) between the various goods and services they
consume so that they are able to maximize their total satisfaction. It analyzes how

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households with limited income decide ‘what to consume’ and ‘how much to consume’
with the aim of maximizing total utility.
Consider the case of firms, the producers of goods and services. Economics

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studies how producers—the firms—make the choice of the commodity to produce, the
production technology, location of the firm, market or market segment to cater to, price

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of the product, the amount to spend on advertising (if necessary) and the strategy for
facing competition, etc.
At macro level, economics studies how nations allocate their resources, men and
material, between competing needs of the society so that economic welfare of the society

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can be maximized. Also, economics studies how government formulates its economic
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policies—taxation policy, expenditure policy, price policy, fiscal policy, monetary policy,
employment policy, foreign trade (export-import policy), tariff policy, etc. – and, the
effects of these policies.
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Economics is obviously a study of the choice-making behaviour of the people. In
reality, however, choice-making is not as simple as it looks because the economic world is
very complex and most economic decisions have to be taken under the condition of imperfect
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knowledge, risk and uncertainty. Therefore, taking an appropriate decision or making an


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appropriate choice in an extremely complex situation is a very difficult task. In their


endeavour to study the complex decision-making process, economists have developed a
large kit of analytical tools and techniques with the aid of mathematics and statistics and
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have developed a large corpus of economic theories with a fairly high predictive power.
Analytical tools and techniques, economic laws and theories constitute the body of
economics.
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1.2.2 What is Managerial Economics?


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The subject matter of economic science consists of the logic, tools and techniques
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of analyzing economic phenomena as well as, evaluating economic options,


optimization techniques and economic theories. The application of economic science
in business decision-making is all pervasive. More specifically, economic laws and tools
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of economic analysis are now applied a great deal in the process of business decision-
making. This has led, as mentioned earlier, to the emergence of a separate branch of
study called managerial economics. The application of economic concepts and theories
in combination with quantitative methods is illustrated in Fig. 1.1.

Self-Instructional
Material 5
Introduction to
Managerial Decision Areas
Managerial Economics
• Assessment of Investible Funds
• Selecting Business Area
• Choice of Product
• Determining Optimum Output
NOTES • Determining Price of the Product
• Determining Input-Combination and Technology
• Sales Promotion

Application of
Economic Concepts

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and Theories in • Mathematical Tools
Decision-Making • Statistical Tools
• Econometrics

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Managerial Economics
Application of Economic Concepts, Theories and Analytical

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Tools to find Optimum Solution to Business Problems.

Fig. 1.1 Application of Economics to Managerial Decision-Making

Managerial economics can be broadly defined as the study of economic

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theories, logic and tools of economic analysis that are used in the process of
business decision-making. Economic theories and techniques of economic analysis
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are applied to analyse business problems, evaluate business options and
opportunities with a view to arriving at an appropriate business decision. Managerial
economics is thus constituted of that part of economic knowledge, logic, theories and
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analytical tools that are used for rational business decision-making.

Some Definitions of Managerial Economics


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Let us look at some definitions of managerial economics offered by a few eminent


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economists.
“Managerial economics is concerned with the application of economic concepts
and economics to the problems of formulating rational decision making” 2.—
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Mansfield
“Managerial economics ... is the integration of economic theory with business
practice for the purpose of facilitating decision making and forward planning by
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management”3.
—Spencer and Seigelman
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“Managerial economics is concerned with the application of economic


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principles and methodologies to the decision-making process within the firm or


organization. It seeks to establish rules and principles to facilitate the attainment
of the desired economic goals of management”4.
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—Douglas
“Managerial economics applies the principles and methods of economics to
analyze problems faced by management of a business, or other types of
organizations and to help find solutions that advance the best interests of such
organizations”5. —Davis and Chang
These definitions of managerial economics together reveal the nature of the
discipline even though they do not provide its perfect definition.

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1.2.3 Why do Managers Need to Know Economics? Introduction to
Managerial Economics
Economics contributes a great deal towards the performance of managerial duties and
responsibilities. Just as biology contributes to the medical profession and physics to
engineering, economics contributes to the managerial profession. All other professional NOTES
qualifications being the same, managers with a working knowledge of economics can
perform their functions more efficiently than those without it. The basic function of the
managers of a business firm is to achieve the objective of the firm to the maximum possible
extent with the limited resources placed at their disposal. The emphasis here is on the
maximization of the objective and limitedness of the resources. Had the resources been

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unlimited, the problem of economizing on resources or resource management would have
never arisen. But resources at the disposal of a firm, be it finance, men or material, are by
all means limited. Therefore, the basic task of the management is to optimize their use.

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How Economics Contributes to Managerial Functions

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We have noted above why managers need to know economics. Let us now see how
economics contributes to the managerial task of decision-making. As mentioned above,
economics, though variously defined, is essentially the study of logic, tools and
techniques of making optimum use of the available resources to achieve the given

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ends. Economics thus provides analytical tools and techniques that managers need to
achieve the goals of the organization they manage. Therefore, a working knowledge of
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economics, not necessarily a formal degree, is essential for managers. In other words,
managers are essentially practicing economists.
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In performing their functions, managers have to take a number of decisions in
conformity with the goals of the firm. Many business decisions are taken under conditions
of uncertainty and risk. These arise mainly due to uncertain behaviour of the market
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forces, changing business environment, emergence of competitors with highly competitive


products, government policy, international factors impacting the domestic market due
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mainly to increasing globalization as well as social and political changes in the country.
The complexity of the modern business world adds complexity to business decision-
making. However, the degree of uncertainty and risk can be greatly reduced if market
conditions are predicted with a high degree of reliability. Economics offers models, tools
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and techniques to predict the future course of market conditions and business prospects.
The prediction of the future course of business environment alone is not sufficient.
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What is equally important is to take appropriate business decisions and to formulate a


business strategy in conformity with the goals of the firm. Taking a rational business
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decision requires a clear understanding of the technical and environmental conditions


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related to the business issues for which decisions are taken. Application of economic
theories to explain and analyse the technical conditions and the business environment
contributes a good deal to rational decision-making. Economic theories have, therefore,
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gained a wide range of application in the analysis of practical problems of business. With
the growing complexity of business environment, the usefulness of economic theory as
a tool of analysis and its contribution to the process of decision-making has been widely
recognized.
Baumol6 has pointed out three main contributions of economic theory to
business ecomomics.
First, ‘one of the most important things which the economic [theories] can
contribute to the management science’ is building analytical models, which help to
Self-Instructional
Material 7
Introduction to recognize the structure of managerial problems, eliminate the minor details that might
Managerial Economics
obstruct decision-making, and help to concentrate on the main issue.
Secondly, economic theory contributes to the business analysis ‘a set of analytical
methods’, which may not be applied directly to specific business problems, but they do
NOTES enhance the analytical capabilities of the business analyst.
Thirdly, economic theories offer clarity to the various concepts used in business
analysis, which enables the managers to avoid conceptual pitfalls.

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1.2.4 Application of Economics to Business Decisions:
An Example
We have discussed above – in general terms, of course – how economics can contribute

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to business decision-making. In this section, we show this application in some hypothetical

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business issues.
Business decision-making is essentially a process of selecting the best out of
alternative opportunities open to the firm. The process of decision-making7 comprises
four main phases:

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(i) determining and defining the objective to be achieved;
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economic, social, political and technological environment and foreseeing the
necessity and occasion for decision;
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(iii) inventing, developing and analysing possible courses of action; and
(iv) selecting a particular course of action, from the available alternatives.
This process of decision-making is, however, not as simple as it appears to be.
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Steps (ii) and (iii) are crucial in business decision-making. These steps put managers’
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analytical ability to test and determine the appropriateness and validity of decisions in the
modern business world. Modern business conditions are changing so fast and becoming
so competitive and complex that personal business sense, intuition and experience alone
may not prove sufficient to make appropriate business decisions. Personal intelligence,
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experience, intuition and business acumen of the decision-makers need to be supplemented


with quantitative analysis of business data on market conditions and business environment.
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It is in this area of decision-making that economic theories and tools of economic analysis
contribute a great deal.
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For instance, suppose a firm plans to launch a new product for which close
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substitutes are available in the market. One method of deciding whether or not to launch
the product is to obtain the services of business consultants or to seek expert opinion. If
the matter has to be decided by the managers of the firm themselves, the two areas
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which they will need to investigate and analyse thoroughly are:


(i) production related issues, and
(ii) sales prospects and problems.

In regard to production related issues, managers will be required to collect and analyse
data on:
(a) available techniques of production,
(b) cost of production associated with each production technique,
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(c) supply position of inputs required to produce the planned commodity, Introduction to
Managerial Economics
(d) price structure of inputs,
(e) cost structure of competitive products, and
( f ) availability of foreign exchange if inputs are to be imported. NOTES
In order to assess the sales prospects, managers are required to collect and analyse data
on:
(a) market size, general market trends and demand prospects for the product,
(b) trends in the industry to which the planned product belongs,

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(c) major existing and potential competitors and their respective market shares,
(d) prices of the competing products,

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(e) pricing strategy of the prospective competitors,
( f ) market structure and degree of competition, and

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(g) supply position of complementary goods.
It is in this kind of analysis of input and output markets that the application of
economic theories and tools of economic analysis helps significantly in the process of
decision-making.

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Economic theories state the functional relationship between two or more economic
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variables, under certain given conditions. Application of relevant economic theories to the
problems of business facilitates decision-making in at least three ways.
First, it gives a clear understanding of various economic concepts (e.g., cost,
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price, demand, etc.) used in business analysis. For example, the concept of ‘cost’ includes
‘total’, ‘average’, ‘marginal’, ‘fixed’, ‘variable’, ‘actual’, and ‘opportunity’. Economics
clarifies which cost concepts are relevant and in what context.
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Second, it helps in ascertaining the relevant variables and specifying the relevant
ub

data. For example, it helps in deciding what variables need to be considered in estimating
the demand for two different sources of energy—petrol and electricity.
Third, economic theories state the general relationship between two or more
economic variables and also events. Application of the relevant economic theory provides
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consistency to business analysis and helps in arriving at right conclusions. Thus, application
of economic theories to the problems of business not only guides, assists and streamlines
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the process of decision-making but also contributes a good deal to the validity of the
decisions.
a

1.2.5 The Scope of Managerial Economics


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Economics has two major branches: (i) Microeconomics, and (ii) Macroeconomics.
Both micro and macro-economics are applied to business analysis and decision-making—
V

directly or indirectly. Managerial economics comprises, therefore, both micro and macro
economic theories. The parts of microeconomics and macroeconomics that constitute
managerial economics depend on the purpose of analysis.
In general, the scope of managerial economics comprises all those economic
concepts, theories and tools of analysis which can be used to analyze issues related to
demand prospects, production and cost, market structure, level of competition and general
business environment and to find solutions to practical business problems. In other words,
managerial economics is economics applied to the analysis of business problems and
decision-making. Broadly speaking, it is applied economics.
Self-Instructional
Material 9
Introduction to The areas of business issues to which economic theories can be directly applied
Managerial Economics
may be broadly divided into two categories: (a) microeconomics applied to operational or
internal issues, and (b) macroeconomics applied to environmental or external issues.

NOTES Microeconomics Applied to Operational Issues


Operational issues are of internal nature. Internal issues include all those problems which
arise within the business organization and fall within the purview and control of the
management. Some of the basic internal issues are: (i) choice of business and the nature
of product, i.e., what to produce; (ii) choice of size of the firm, i.e., how much to

se
produce; (iii) choice of technology, i.e., choosing the factor-combination; (iv) choice of
price, i.e., how to price the commodity; (v) how to promote sales;
(vi) how to face price competition; (vii) how to decide on new investments;
(viii) how to manage profit and capital; (ix) how to manage an inventory, i.e., stock of

u
both finished goods and raw materials. These problems may also figure in forward

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planning. Microeconomics deals with such questions confronted by managers of business
enterprises. The following microeconomic theories deal with most of these questions.
Theory of Demand
Demand theory deals with consumers’ behaviour. It answers such questions as: How do

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the consumers decide whether or not to buy a commodity? How do they decide on the
quantity of a commodity to be purchased? When do they stop consuming a commodity?
. L in
How do the consumers behave when price of the commodity, their income and tastes
and fashions, etc., change? At what level of demand, does changing price become
vt sh
inconsequential in terms of total revenue? The knowledge of demand theory can, therefore,
be helpful in making the choice of commodities, finding the optimum level of production
and in determining the price of the product.
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Theory of Production and Production Decisions


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Production theory explains the relationship between inputs and output. It also explains
under what conditions costs increase or decrease; how total output behaves when units
of one factor (input) are increased keeping other factors constant, or when all factors
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are simultaneously increased; how can output be maximized from a given quantity of
resources; and how can the optimum size of output be determined? Production theory,
thus, helps in determining the size of the firm, size of the total output and the amount of
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capital and labour to be employed, given the objective of the firm.


a

Analysis of Market-Structure and Pricing Theory


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Price theory explains how price is determined under different kinds of market conditions;
when price discrimination is desirable, feasible and profitable; and to what extent advertising
can be helpful in expanding sales in a competitive market. Thus, price theory can be
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helpful in determining the price policy of the firm. Price and production theories together,
in fact, help in determining the optimum size of the firm.
Profit Analysis and Profit Management
Profit making is the most common objective of all business undertakings. But, making a
satisfactory profit is not always guaranteed because a firm has to carry out its activities
under conditions of uncertainty with regard to (i) demand for the product, (ii) input prices
in the factor market, (iii) nature and degree of competition in the product market, and (iv)
Self-Instructional
10 Material
price behaviour under changing conditions in the product market, etc. Therefore, an element Introduction to
Managerial Economics
of risk is always there even if the most efficient techniques are used for predicting the
future and even if business activities are meticulously planned. The firms are, therefore,
supposed to safeguard their interest and avert or minimize the possibilities of risk. Profit
theory guides firms in the measurement and management of profit, in making allowances NOTES
for the risk premium, in calculating the pure return on capital and pure profit and also for
future profit planning.
Theory of Capital and Investment Decisions

se
Capital like all other inputs, is a scarce and expensive factor. Capital is the foundation of
business. Its efficient allocation and management is one of the most important tasks of
the managers and a determinant of the success level of the firm. The major issues
related to capital are (i) choice of investment project, (ii) assessing the efficiency of

u
capital, and (iii) most efficient allocation of capital. Knowledge of capital theory can

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contribute a great deal in investment-decision making, choice of projects, maintaining
the capital, capital budgeting, etc.
Macro-economics Applied to Business Environment
Environmental issues pertain to the general business environment in which a business

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operates. They are related to the overall economic, social and political atmosphere of
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the country. The factors which constitute economic environment of a country include
the following:
vt sh
(i) The type of economic system in the country,
(ii) General trends in national income, employment, prices, saving and investment,
etc.,
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(iii) Structure of and trends in the working of financial institutions, e.g., banks, financial
corporations, insurance companies, etc.,
ub

(iv) Magnitude of and trends in foreign trade,


(v) Trend in labour supply and strength of the capital market,
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(vi) Government’s economic policies, e.g., industrial policy, monetary, fiscal, price and
foreign trade,
(vii) Social factors like value system of the society, property rights, customs and habits,
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(viii) Socio-economic organizations like trade unions, consumers’ associations, consumer


a

cooperatives and producers’ unions,


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(ix) Political environment, which is constituted of such factors as political system—


democratic, authoritarian, socialist, or otherwise, State’s attitude towards private
business, size and working of the public sector and political stability,
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(x) The degree of globalization of the economy and the influence of MNCs on the
domestic markets.
It is far beyond the powers of a single business firm, howsoever large it may be,
to determine and guide the course of economic, social and political factors of the nation.
However, all the firms together or giant business houses can jointly influence the economic
and political environment of the country.8 For the business community in general, however,
the economic, social and political factors are to be treated as business parameters.

Self-Instructional
Material 11
Introduction to The environmental factors have a far-reaching bearing upon the functioning
Managerial Economics
and performance of the firms. Therefore, business decision-makers have to take into
account the present and future economic, political and social conditions in the country
and give due consideration to the environmental factors in the process of decision-
NOTES making. This is essential because business decisions taken in isolation of environmental
factors may not only prove infructuous, but may also lead to heavy losses as has happened
in case of establishing SEZ in Nandigram and Tata’s small care project in Singur district
of West Bengal. Consider also, for example, the following kinds of business decisions—
l A decision to set up a new alcohol manufacturing unit or to expand the existing

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ones ignoring the impending prohibition—a political factor—would be suicidal for
the firm;
l A decision to expand the business beyond the paid-up capital permissible under

u
Monopolies and Restrictive Trade Practices Act (MRTP Act) amounts to inviting
legal shackles;

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l A decision to employ a highly sophisticated, labour-saving technology ignoring the
prevalence of mass open unemployment—an economic factor—may prove to be
self-defeating;
l A decision to expand the business on a large scale, in a society having a low per

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capita income and hence a low purchasing power stagnant over a long period
. L in may lead to wastage of resources.
The managers of business firms are, therefore, supposed to be fully aware of the
economic, social and political conditions prevailing in the country while taking decisions
vt sh
on business issues of wider implications.
Managerial economics is, however, concerned with only the economic
environment, and in particular with those economic factors which form the business
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climate. The study of political and social factors falls out of the purview of managerial
economics. It should, however, be borne in mind that economic, social and political
ub

behaviour of the people are interdependent and interactive. For example, growth of
monopolistic tendencies in the industrial sector of India led to the enactment of the
Monopolies and Restrictive Trade Practices Act (1961), which restricts the proliferation
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of large business houses. Similarly, various industrial policy resolutions formulated until
1990 in the light of the socio-political ideology of the government restricted the scope
and area of private business and had restrained the expansion of private business in
s

India. Some of the major areas in which politics influences economic affairs of the
a

country are concentration of economic power, growth of monopoly, state of technology,


existence of mass poverty and unemployment, foreign trade, taxation policy, labour
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relations, distribution system of essential goods, etc.


In this book, we will concentrate on only some basic aspects of macroeconomics,
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including meaning and measurement of national income and its determination; theories
of business cycles, economic growth, and economic factors; content and logic of some
relevant state policies which form the business environment.
Macroeconomic Issues
The major macroeconomic or environmental issues that figure in business decision-
making, particularly with regard to forward planning and formulation of the future strategy,
may be described under the following three categories.

Self-Instructional
12 Material
1. Issues Related to Macroeconomic Trends in the Economy. Macroeconomic trends Introduction to
Managerial Economics
are indicated by the trends in macro variables, e.g., the general trend in the economic
activities of the country, the level of GDP, investment climate, trends in national output
(measured by GNP or GDP) and employment, as well as price trends. These factors not
only determine the prospects of private business, but also greatly influence the functioning NOTES
of individual firms. Therefore, a firm planning to set up a new unit or expand its existing
size would like to ask itself ‘What is the general trend in the economy? What would be
the consumption level and pattern of the society? Will it be profitable to expand the
business?’ Answers to these questions and the like are sought through macroeconomic
studies.

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2. Issues Related to Foreign Trade. Most countries have trade and financial relations
with other countries. The sectors and firms dealing in exports and imports are affected

u
directly and more than the rest of the economy. Fluctuations in the international market,
exchange rate and inflows and outflows of capital in an open economy have a serious

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bearing on its economic environment and, thereby, on the functioning of its business
undertakings. The managers of a firm would, therefore, be interested in knowing the
trends in international trade, prices, exchange rates and prospects in the international
market. Answers to such problems are obtained through the study of international trade
and monetary mechanism. These aspects constitute a part of macroeconomic studies.

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3. Issues Related to Government Policies. Government policies designed to control
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and regulate economic activities of the private business affect the functioning of the
private business undertakings. Besides, firms’ activities as producers and their attempt
to maximize their private gains or profits leads to considerable social costs, in terms of
vt sh
environment pollution, traffic congestion in the cities, creation of slums, etc. Such social
costs not only bring a firm’s interests in conflict with those of the society, but also impose
a social responsibility on the firms. The government’s policies and its regulatory measures
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are designed, by and large, to minimize such social costs and conflicts. The managers
should, therefore, be fully aware of the aspirations of the people and give such factors a
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due consideration in their decisions. The forced closure of polluting industrial units set up
in the residential areas of Delhi and the consequent loss of business worth billion of
rupees in 2000 is an example of the result of ignoring the public laws and the social
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responsibility by the businessmen. The economic concepts and tools of analysis help in
determining such costs and benefits.
s

Concluding Remarks
a

Economic theories, both micro and macro, have a wide range of applications in the
process of business decision-making. Some of the major theories which are widely
ik

applied to business analysis have been mentioned above. It must, however, be borne in
mind that economic theories, models and tools of analysis do not offer readymade answers
to the practical problems of individual firms. They provide only the logic and methods to
V

find answers, not the answers as such. It depends on the managers’ own understanding,
experience, intelligence, training and their competence to use the tools of economic
analysis to find reasonably appropriate answers to the practical problems of business.
Briefly speaking, microeconomic theories including those of demand, production,
price determination, profit and capital budgeting, andmacroeconomic theories including
of national income, those economic growth and fluctuations, international trade and
monetary mechanism, and the study of state policies and their repercussions on the
private business activities, by and large, constitute the scope of managerial economics.
Self-Instructional
Material 13
Introduction to This should, however, not mean that only these economic theories form the subject-
Managerial Economics
matter of managerial economics. Nor does the knowledge of these theories fulfill wholly
the requirement of economic logic in decision-making. An overall study of economics
and a wider understanding of economic behaviour of the society, individuals, firms and
NOTES state would always be desirable and more helpful.
Some Other Topics in Managerial Economics
As mentioned earlier, managerial economics is essentially the study of economic analysis
applied to find solutions to the problems of business undertakings. There are, however,

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certain other disciplines which provide enormous aid to the economic analysis. The
study of managerial economics, therefore, includes also the study of certain topics from
other disciplines from which economic analysis borrows. The most important disciplines
on which economic analysis draws heavily are mathematics, statistics and operations

u
analysis. Other important disciplines associated with managerial economics are

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management theory and accounting.
Mathematical Tools
Businessmen deal primarily with concepts that are essentially quantitative in nature,
e.g., demand, price, cost, product, capital, wages, interest rate, inventories, etc. These

td g
variables are interrelated, directly or indirectly. What is needed in economic analysis is
to have clarity of these concepts in order to have, as far as possible, accurate estimates
. L in
of these economic variables. The use of mathematical tools in the analysis of economic
variables provides not only clarity of concepts, but also a logical and systematic framework
vt sh
within which quantitative relationships can be measured. More importantly, mathematical
tools are widely used in ‘model’ building, for exploring the relationship between related
economic variables. Mathematical logic and tools are, therefore, a great aid to economic
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analysis.
Furthermore, a major problem that managers face is how to minimize cost,
ub

maximize profit or optimize sales under certain constraints. Mathematical concepts and
techniques are extensively used in economic analysis with a view to finding answers to
these questions. Besides, certain mathematical tools and optimization techniques, relatively
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more sophisticated and advanced, designed during and after World War II have found
wide ranging application to business management, viz., linear programming, inventory
models and game theory. A working knowledge of these techniques and other mathematical
s

tools is essential for managers. These topics, therefore, fall very much within the scope
a

of managerial economics.
Statistics
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Similarly, statistical tools provide a great aid in business decision-making. Statistical


techniques are used in collecting, processing and analyzing business data, testing the
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validity of economic laws with the real life economic data before they are applied to
business analysis. A good deal of business decisions are based on probable economic
events. The statistical tools, e.g., theory of probability, forecasting techniques and
regression analysis help the decision-makers in predicting the future course of economic
events and probable outcome of their business decisions. Thus, the scope of business
economics includes also the study of statistical tools and techniques that are applied to
analyse the business data and to forecast economic variables. The mathematical and
statistical techniques are the tools in the armoury of decision-makers that solve the
complex problems of business.
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14 Material
Operations Research (OR) Introduction to
Managerial Economics
Operations Research (OR) is an inter-disciplinary technique of finding solutions to
managerial problems. It combines economics, mathematics and statistics to build models
for solving specific business problems and to find a quantitative solution thereto. Linear NOTES
programming and goal programming are two widely used OR techniques in business
decision-making.
Management Theory and Accountancy
Management theory and accounting are the other disciplines that are closely associated

se
with managerial economics. Management theories bring out the behaviour of the firm in
their efforts to achieve certain predetermined objectives. With a change in conditions,
both the objectives of firms and managerial behaviour change. An adequate knowledge

u
of management theory is, therefore, essential for a managerial economist. Accounting,
on the other hand, is the main source of data reflecting the functioning and performance

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of the firm. Besides, certain concepts used in business accounting are different from
those used in pure economic logic. It is the task of the managerial economist to seek and
provide clarity and synthesis between the two kinds of concepts to be used in business
decisions, thus preventing ambiguity and incoherence.

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The scope of managerial economics is, thus, very wide. It is difficult to do justice
to the entire subject matter of managerial economics in one volume. In this book, we
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have covered only that part of microeconomic theory which has direct application to
business decisions, as mentioned above. In addition, some broad aspects of
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macroeconomic theory, international trade and government policies, which often figure
in business decision-making have also been covered.

1.2.6 Gap between Theory and Practice and The Role of


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Managerial Economics
ub

We have noted above that application of theories to the process of business decision-
making contributes a great deal in arriving at appropriate business decisions. In this
section, we highlight the gap between the theoretical world and the real world and see
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how managerial economics bridges this gap.

Theory vs. Practice


s

It is widely known that there exists a gap between theory and practice in all walks of life,
a

more so in the world of economic thinking and behaviour. A theory which appears logically
sound may not be directly applicable in practice. For example, when there are economies
ik

of scale, it seems theoretically sound that if inputs are doubled, output will be, more or
less, doubled and if inputs are trebled, output will be, more or less, trebled. This theoretical
V

conclusion may not hold good in practice. This gap between theory and practice has
been very well illustrated in the form of a story by a classical economist, J.M. Clark.9 He
writes:
‘There is a story of a man who thought of getting the economy of large scale
production in plowing, and built a plow three times as long, three times as wide, and three
times as deep as an ordinary plow and harnessed six horses [three times the usual
number] to pull it, instead of two. To his surprise, the plow refused to budge, and to his
greater surprise it finally took fifty horses to move the refractory machine… [and] the
fifty could not pull together as well as two’.
Self-Instructional
Material 15
Introduction to The gist of the story is that managers—assuming they have abundant resources—
Managerial Economics
may increase the size of their capital and labour, but may not obtain the expected results.
Most probably the man in Clark’s story did not get the expected result because he was
either not aware of or he ignored or could not measure the resistance of the soil to a huge
NOTES plow. This incident clearly shows the gap between theory and practice.
In fact, the real economic world is extremely complex. The reason is that in an
economy, everything is inter-linked. Economic decisions and economic activities of
economic entities—individuals, households, firms, and the government are, therefore,
interconnected and interdependent. Change in one important economic variable generates

se
a wave of changes, beginning with a change in the directly related areas, which create
counter-changes. In economic terminology, a change in one economic variable causes
change in a large number of related variables. As a result, the entire economic
environment changes. An alterning economic environment changes people’s economic

u
goals, motivations and aspirations which, in turn, change managers’ decisions. In fact,

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decision-making becomes a continuous process. The entire system looks ‘hopelessly
chaotic’. Under the condition of changing environment and economic decisions, it is
extremely difficult to predict human behaviour.
On the contrary, economic theories are rather simplistic because they are
propounded on the basis of economic models built on simplifying assumptions—most

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economic models assume away the interdependence of economic variables. In fact,
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through these models, economists create a simplified world with its restrictive boundaries.
It is from such models that they derive their own conclusions and formulate their theories.
It is another thing that some economic, rather econometric, models are more complex
vt sh
than the real world itself. Although economic models are said to be an extraction from
the real world, how close it is to reality depends on how realistic are the assumptions of
the model.
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The assumptions of economic models are often claimed to be unrealistic. The


most common assumption of the economic models is the ceteris paribus assumption,
ub

i.e., other things remain constant. For example, consider the law of demand. It states
that demand for a commodity changes in reverse direction of the change in its price,
other things remaining constant. The ‘other things’ include consumers’ income, prices
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of substitute and complementary goods, consumer’s tastes and preferences, advertisement,


consumer’s expectations about the commodity’s future price, ‘demonstration effect’,
and ‘snob effect’, etc. In reality, however, these factors do not remain constant. Since
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‘other things’ do not remain constant, the ceteris paribus assumption is alleged to be the
a

most unrealistic assumption. Nevertheless, the law of demand does state the nature of
relationship between the demand for a product and its price, in isolation of the factors
ik

determining the demand for that product.


Economic theories are, no doubt, hypothetical in nature but not away from
V

reality. Economic theories are, in fact, a caricature of reality. In their abstract form,
however, they do look divorced from reality. Besides, abstract economic theories cannot
be straightaway applied to real life problems. This should, however, not mean that
economic models and theories do not serve any useful purpose. ‘Microeconomic theory
facilitates the understanding of what would be a hopelessly complicated confusion of
billions of facts by constructing simplified models of behaviour, which are sufficiently
similar to the actual phenomenon and thereby help in understanding them’.10 Nevertheless,
it cannot be denied that there is apparently a gap between economic theory and
practice. This gap arises mainly due to the inevitable gap between the abstract world of
Self-Instructional economic models and the real world.
16 Material
1.2.7 How Managerial Economics Fills the Gap Introduction to
Managerial Economics
There is undeniably a gap between economic theory and the real economic world. But,
at the same time, it is also a mistaken view that economic theories can be directly
applied to business decision-making. As already mentioned, economic theories do not NOTES
offer a custom-made or readymade solution to business problems but what they actually
do is to provide a framework for logical economic thinking and analysis. The need for
such a framework arises because the real economic world is too complex to permit
considering every bit of relevant facts that influence economic decisions. In the words
of Keynes, ‘The objective of [economic] analysis is not to provide a machine, or method

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of blind manipulation, which will furnish an infallible answer, but to provide ourselves
with an organized and orderly method of thinking out particular problem…’. 11 In the
opinion of Boulding, the objective of economic analysis is to present the ‘map’ of reality

u
rather than a perfect picture of it.12 In fact, economic analysis presents us with a road
map; it guides us to the destination, but does not carry us there.

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Here, as mentioned earlier, managerial economics can also be compared with
medical science. Just as the knowledge of medical science helps in diagnosing the disease
and prescribing an appropriate medicine, managerial economics helps in analyzing the
business problems and in arriving at an appropriate decision.

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Let us now see how managerial economics bridges this gap. On one side, there is the
complex business world and, on the other, are abstract economic theories. ‘The big gap
. L in
between the problems of logic that intrigue economic theorists and the problems of
policy that plague practical management needs to be bridged in order to give executive
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access to the practical contributions that economic thinking can make to top management
policies’.13 Managerial decision-makers deal with the complex, rather chaotic, business
conditions of the real world and have to find the way to their destination, i.e., achieving
Check Your Progress
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the goal that they set for themselves. Managerial economics applies economic logic and
analytical tools to sift wheat from the chaff. The economic logic and tools of analysis 1. Define optimizing
ub

guide them in behaviour in the


context of
(i) Identifying their problems in achieving their goal economics.
2. How does
(ii) Collecting the relevant data and related facts
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economics
(iii) Processing and analysing the facts contribute to
managerial
(iv) Drawing relevant conclusions economics?
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(v) Determining and evaluating the alternative means to achieve the goal 3. How do economic
a

theories facilitate
(vi) Taking a decision business decision-
making?
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Without application of economic logic and tools of analysis, business decisions


4. What are the
are most likely to be irrational and arbitrary, which are often counter-productive. market-related
factors which
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determine if a
1.3 THEORY OF THE FIRM AND BUSINESS company would
OBJECTIVES make a profit?
5. Point out how there
is a difference
The first and most important responsibility of a business manager is to achieve the between the theory
objective of the firm he manages. However, as we will see below, the objectives of and practice of
business firms can be varied and also conflicting. Therefore, we begin our study of managerial
economics.
managerial economics with a discussion on the various objectives of business firms. The
primary objective of a business firm is to make profit. That is why the conventional
Self-Instructional
Material 17
Introduction to theory of firm assumes profit maximization—not just making any profit—as the sole
Managerial Economics
objective of business firms. Baumol, a Nobel laureate in Economics and an authority on
business economics, has, however, argued, “There is no reason to believe that all
businessmen pursue the same objective”.14 Recent researches on this issue reveal that
NOTES the objectives that business firms pursue are more than one. Some important objectives,
other than profit maximization, are: (a) maximization of sales revenue, (b) maximization
of firm’s growth rate, (c) maximization of manager’s utility function, (d) making a
satisfactory rate of profit, (e) long-run survival of the firm, and (f) entry-prevention and
risk-avoidance.

se
The question that arises from business analysis point of view is ‘What is the most
common objective of business firms?’ There is no definite answer to this question. Perhaps
the best way to find out the common objective of business firms is to ask the business

u
owners and managers themselves. However, Baumol, has remarked that firms and their
executives are often not clear about the objectives they pursue. “In fact, it is common

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experience when interviewing executives to find that they will agree to every plausible
goal about which they are asked.”15 However, profit maximization is regarded as the
most common and theoretically most plausible objective of business firms.
In this section, we discuss briefly the various objectives of business firms suggested
by economists. The various objectives that are found to be pursued by the business firms

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are discussed under two heads: (i) profit maximization, and (ii) alternative objectives.
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We will first discuss the meaning of profit, theory of profit and problems in measuring
profit. This will be followed by a detailed discussion onprofit maximization asthe objective
of business firms. Finally, we will discuss briefly the alternative objectives of business
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firms.
1.3.1 Profit as Business Objective
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Meaning of Profit
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Profit means different things to different people. “The word ‘profit’ has different meaning
to businessmen, accountants, tax collectors, workers and economists and it is often used
in a loose polemical sense that buries its real significance…” 16 In a general sense,
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‘profit’ is regarded as income accruing to the equity holders, in the same sense as wages
accrue to the labour; rent accrues to the owners of rentable assets; and interest accrues
to the moneylenders. To a layman, profit means all income that flows to the investors. To
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an accountant, ‘profit’ means the excess of revenue over all paid-out costs including
a

both manufacturing and overhead expenses. It is more or less the same as ‘net profit’.
For all practical purposes, profit (or business income) means profit in accountancy sense
ik

plus non-allowable expenses.17 Profit figures published by the business firms are profits
conforming to accounting concept of profit. Economist’s concept of profit is of ‘pure
profit’, also called ‘economic profit’ or ‘just profit’. Pure profit is a return over and
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above the opportunity cost, i.e., the income which a businessman might expect from the
second best alternative use of his resources. You will learn more about this in Unit 6.
1.3.2 Problems in Profit Measurement
As mentioned above, accounting profit equals revenue minus all explicit costs, and
economic profit equals revenue minus both explicit and implicit costs. Once profit is
defined, it should not be difficult to measure the profit of a firm for a given period. But
two questions complicate the task of measuring profit: (i) which of the two concepts of
Self-Instructional
18 Material
profit should be used for measuring profit? and (ii) what costs should be or should not be Introduction to
Managerial Economics
included in the implicit and explicit costs?
The answer to the first question is that the use of a profit concept depends on the
purpose of measuring profit. Accounting concept of profit is used when the purpose is to
produce a profit figure for (i) the shareholders to inform them of progress of the firm, NOTES
(ii) financiers and creditors who would be interested in the firm’s creditworthiness, (iii)
the managers to assess their own performance, and (iv) for computation of tax-liability.
For measuring accounting profit for these purposes, necessary revenue and cost data
are, in general, obtained from the firm’s books of account. It must, however, be noted

se
that accounting profit may present an exaggeration of actual profit (or loss) if it is based
on arbitrary allocation of revenues and costs to a given accounting period.
On the other hand, if the objective is to measure ‘true profit’, the concept of

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economic profit should be used. However, ‘true profitability of any investment or business
cannot be determined until the ownership of that investment or business has been fully

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terminated.’18 But then life of a corporation is eternal. Therefore, true profit can be
measured only in terms of “maximum amount that can be distributed in dividends
(theoretically from now to the identifinite future) without impairing the companies’ earning
power. Hence, the concept aims at preservation of stockholders’ real capital. To estimate
income then a forecast of all future changes in demand, changes in production process,

td g
cash outlays to operate the business, cash revenues and price changes. [is needed].” 19
. L in
This concept of business income is, however, an ‘unattainable ideal’ and hence is of little
practical use. Nevertheless, it serves as a guide to income measurement even from
businessmen’s point of view.
vt sh
If follows from the above discussion that, for all practical purposes, profits have to
be measured on the basis of accounting concept. But, measuring even the accounting
profit is not an easy task. The main problem is to decide as to what should be and what
P li

should not be included in the cost. One might feel that profit and loss accounts and balance
sheet of the firms provide all the necessary data for measuring accounting profit. In fact,
ub

profit figures published by the joint stock companies are taken to be their actual accounting
profit and are used for analysing firms’ performance. There are, however, three specific
items of cost and revenue which pose conceptual problems. These items are: (i) depreciation,
P

(ii) capital gains and losses, and (iii) current vs. historical costs. Measurement problems
arise for two reasons: (a) economists’ view on these items differs from that of accountants,
and (b) there is more than one accepted method of treating these items. We discuss below
s

the problems related to these items in detail.


a

Problem in Measuring Depreciation


ik

Economists view depreciation as capital consumption. From their point of view, there
are two distinct ways of charging for depreciation: (i) the depreciation of an equipment
V

must equal its opportunity cost, or alternatively, (ii) the replacement cost that will
produce comparable earning.
Opportunity cost of an equipment is ‘the most profitable alternative use of it that is
foregone by putting it to its present use’. The problem is then of measuring the opportunity
cost. One method of estimating opportunity cost, suggested by Joel Dean, is to measure
the fall in value during a year. Going by this method, one assumes selling of the equipment
as an alternative use. This method, however, cannot be applied when a capital equipment
has no alternative use, like a harvester, a printing machine and a hydro-power project, etc.
In such cases, replacement cost is the appropriate measure of depreciation.
Self-Instructional
Material 19
Introduction to To accountants, depreciation is an allocation of capital expenditure over time.
Managerial Economics
Such allocation of historical cost of capital over time, i.e., charging depreciation, is made
under unrealistic assumptions of (a) stable prices, and (b) a given rate of obsolescence.
What is more important in this regard is that there are different methods of charging
NOTES depreciation over the lifetime of an equipment. The use of different methods of charging
depreciation results in different levels of profit reported by the accountants.
For example, suppose a firm purchases a machine for ` 10,000 having an estimated life
of 10 years. The firm can apply any of the following four methods of charging
depreciation:

se
(1) straightline method
(2) reducing balance method
(3) annuity method

u
(4) sum-of-the-year’s digit approach

. Ho
Under the straightline method, the following formula is used for measuring
depreciation.
Cost of Capital
Annual Depreciation =
Years of Capital life

td g
. L in Using this method for our example, we get
` 10,000
Annual Depreciation =  ` 1,000 . Thus, ` 1,000 would be charged as
10 years
vt sh
depreciation each year.
Under reducing balance method, depreciation is charged at a constant (per
P li

cent) rate of annually written down values of the machine. Assuming a depreciation rate
of 20 per cent, ` 2000 in the first year, ` 1600 in the second year, ` 1280 in the third year,
ub

and so on, shall be charged as depreciation.


Under annuity method, the annual depreciation (d) is measured by using the
following formula.
P

d = (C + Cr)/n

where C = total cost, n is the number of active years of capital, and r is the interest rate.
s

By applying annuity method to our example, we get d as follows.


a

10, 000  10, 000  0.20 12, 000


d=  ` 1200
ik

10 10

Finally, under the sum-of-the-year’s digits approach (i.e., a variant of the reducing
V

balance method) the years of equipment’s life are aggregated to give an unvarying
denominator. Depreciation is then charged at the rate of the ratio of the last year’s digits
to the total of the years. In our example, the aggregated years of capital’s life equals
1 + 2 + 3 + … + 10 = 55.
Depreciation in the first year will be 10,000  10/55 = ` 1818.18,
in the second year it will be 1,000  9/55 = ` 1636.36 and
in third year it will be 10,000  8/55 = ` 1454.54, and so on.

Self-Instructional
20 Material
Note that the four methods yield four different measures of annual depreciation Introduction to
Managerial Economics
and, hence, the different levels of profit.

Treatment of Capital Gains and Losses


Capital gains and losses are regarded as ‘windfalls’. Fluctuation in the stock market NOTES
prices is one of the most common sources of ‘windfalls’. In a progressive society,
according to Dean, capital losses are, on balance, greater than capital gains. Many of
the capital losses are of insurable nature, and when a businessman over-insures, the
excess insurance premium becomes eventually a capital gain.

se
Profit is also affected by the way capital gains and losses are treated in accounting.
As Dean suggests, “A sound accounting policy to follow concerning windfalls is never to
record them until they are turned into cash by a purchase or sale of assets, since it is

u
never clear until then exactly how large they are …”20 But, in practice, some companies
do not record capital gains until it is realized in money terms, but they do write off capital

. Ho
losses from the current profit. If ‘sound accounting policy’ is followed, there will be one
profit, and if the other method is followed, there will be another figure of profit. That is
the problem.
An economist is not concerned with what accounting practice or principle is

td g
followed in recording the past events. He is concerned mainly with what happens in
future. Therefore, the economist would suggest that the management should be aware
. L in
of the approximate magnitude of such ‘windfalls’ long before they become precise enough
to be acceptable to accountants. This would be helpful in taking the right decision in
respect of affected assets.
vt sh
Current vs. Historical Costs
Accountants prepare income statements typically in terms of historical costs, i.e., in terms
P li

of purchase price, rather than in terms of current price. The reasons given for this practice
ub

are: (i) historical costs produce more accurate measurement of income, (ii) historical costs
are less debatable and more objective than the calculated present replacement value, and
(iii) accountants’ job is to record historical costs whether or not they have relevance for
future decision-making. The accountant’s approach ignores certain important changes in
P

earnings and losses of the firms, e.g., (i) the value of assets presented in the books of
accounts is understated in times of inflation and overstated at the time of deflation and
s

(ii) depreciation is understated during deflation. Historical cost recording does not reflect
such changes in values of assets and profits. This problem assumes a critical importance in
a

case of inventories and material stocks. The problem is how to evaluate the inventory and
the goods in the pipeline.
ik

There are three popular methods of inventory valuation: (i) first-in-first-out (FIFO),
(ii) last-in-first-out (LIFO) and (iii) weighted average cost (WAC).
V

Under FIFO method, material is taken out of stock for further processing in the
order in which they are acquired. The material stocks, therefore, appear in the firm’s
balance sheet at their actual cost price. This method is suitable when price has a secular
trend. However, this system exaggerates profits at the time of rising prices.
The LIFO method assumes that stocks purchased most recently become the
costs of the raw material in the current production. If inventory levels are stable, the
cost of raw materials used at any point in the calculation of profits is always close to
market or replacement value. But, when inventory levels fluctuate, this method loses its
advantages. Self-Instructional
Material 21
Introduction to The WAC method takes the weighted average of the costs of materials purchased
Managerial Economics
at different prices and different points of time to evaluate the inventory.
All these methods have their own weaknesses and, therefore, they do not reflect
the ‘true profit’ of business. So the problem of evaluating inventories so as to yield a true
NOTES profit figure remains.
1.3.3 Profit Maximization as Business Objective
As mentioned earlier, profit maximization has been the most important assumption on
which economists have built price and production theories. This assumption has, however,

se
been strongly questioned and alternative hypotheses suggested. This issue will be discussed
in the forthcoming sections. Let us first look into the importance of the profit maximization
assumption and theoretical conditions of profit maximization.

u
The conventional economic theory assumes profit maximization as the only
objective of business firms. Profit maximization as the objective of business firms has a

. Ho
long history in economic literature. It forms the basis of conventional price theory. Profit
maximization is regarded as the most reasonable and analytically the most ‘productive’
business objective. The strength of this assumption lies in the fact that this assumption
‘has never been unambiguously disproved’.

td g
Besides, profit maximization assumption has a greater predictive power. It helps
in predicting the behaviour of business firms in the real world and also the behaviour of
. L in
price and output under different market conditions. No alternative hypothesis explains
and predicts the behaviour of firms better than the profit maximization assumption. Let
vt sh
us now discuss the theoretical conditions for profit maximization.
Profit Maximizing Conditions
P li

Total profit () is defined as


 = TR – TC …(1.1)
ub

where TR = total revenue, and TC = total cost.


There are two conditions that must be fulfilled for TR – TC to be maximum.
These conditions are called (i) necessary or the first order condition, and
P

(ii) secondary or supplementary condition.


The necessary or the first-order condition requires that marginal revenue (MR)
s

must be equal to marginal cost (MC). By definition, marginal revenue is the revenue
a

obtained from the production and sale of one additional unit of output and marginal cost
is the cost arising due to the production of one additional unit of output.
ik

The secondary or the second-order condition requires that the necessary or first-
order condition must be satisfied under the stipulation of decreasing MR and rising MC.
V

The fulfilment of the two conditions makes it the sufficient condition.


The profit maximizing conditions can also be presented algebraically as follows.
We know that a profit maximizing firm seeks to maximize
 = TR – TC
Let us suppose that the total revenue (TR) and total cost (TC) functions are,
respectively, given as
TR = f(Q) andTC = f(Q)
where Q = quantity produced and sold.
Self-Instructional
22 Material
By substituting total revenue and total cost functions in Eq. (2.1), the profit function Introduction to
Managerial Economics
may be written as
 = f(Q)TR – f(Q)TC ...(1.2)
Equation (1.2) can now be manipulated to illustrate the first and second order NOTES
conditions of profit maximization as follows.
First-order condition The first-order condition of maximizing a function is that its
first derivative must be equal to zero. Thus, the first-order condition of profit maximization
is that the first derivative of the profit function Eq. (1.2) must be equal to zero.

se
Differentiating the total profit function and setting it equal to zero, we get
 TR TC
  0 ...(1.3)
Q Q Q

u
This condition holds only when
TR TC

. Ho

Q Q

In Eq. (1.3), the term TR/Q gives the slope of the TR curve which in turn gives
the marginal revenue (MR). Similarly, the term TC/Q gives the slope of the total cost
curve which is the same as marginal cost (MC). Thus, the first-order condition for profit

td g
maximization can be stated as
. L in MR = MC
The first-order condition is generally known as necessary condition. A necessary
vt sh
condition is one that must be satisfied for an event to take place. In other words, the
condition that MR = MC must be satisfied for profit to be maximum.
Second-order Condition As already mentioned, in non-technical terms, the second-
P li

order condition of profit maximization requires that the first order condition is satisfied
under rising MC and decreasing MR. This condition is illustrated in Fig. 1.2. The MC
ub

and MR curves are the usual marginal cost and marginal revenue curves respectively.
Incidentally, MC and MR curves are derived from TC and TR functions respectively.
MC and MR curves intersect at two points, P1 and P2. Thus, the firstorder condition is
P

satisfied at both the points, but the second order condition of profit maximization is
satisfied only at point P2. Technically, the second-order condition requires that the second
derivative of the profit function is negative. The second derivative of the total profit
s

function is given as
a
ik
V

Fig. 1.2 Marginal Conditions of Profit Maximization


Self-Instructional
Material 23
Introduction to
Managerial Economics  2   2TR  2TC
  ...(1.4)
Q 2 Q 2 Q 2

The second-order condition requires that


NOTES
 2TR  2TC
 0
Q 2 Q 2

 2TR  2TC

se
or ...(1.5)
Q 2 Q 2

Since 2TR/ Q2 gives the slope of MR and 2


TC/ Q2 gives the slope of MC, the
second-order condition may also be written as

u
Slope of MR < Slope of MC

. Ho
It implies that MC must have a steeper slope than MR or MC must intersect the
MR from below.
To conclude, profit is maximized where both the first and second order conditions
are satisfied.

td g
Algebra of Profit Maximization
. L in
We may now apply the profit maximization conditions to a hypothetical example and
compute profit maximizing output.
vt sh
We know that TR = P.Q
Suppose demand function for a product is given as Q = 50 – 0.5P. Given the
demand function, price (P) function can be derived as
P li

P = 100 – 2Q …(1.6)
ub

By substituting price function for P in TR equation, we get


TR = (100 – 2Q)Q
P

or TR = 100Q – 2Q2 …(1.7)


s

Let us also suppose that the total cost function is given as


a

TC = 10 + 0.5 Q2 …(1.8)
ik

Given the TR function (1.7) and TC function (1.8), we can now apply the first
order condition of profit maximization and find profit maximizing output. We have noted
that profit is maximum where
V

MR = MC
TR TC
or 
Q Q

Given the total TR function in Eq. (1.7) and TC function in Eq. (1.8),
TR
MR = = 100 – 4Q ...(1.9)
Q
Self-Instructional
24 Material
Introduction to
TC Managerial Economics
and MC = =Q ...(1.10)
Q

Thus, profit is maximum where


MR = MC NOTES

or 100 – 4Q = Q
5Q = 100
Q = 20

se
The output 20 satisfies the second-order condition also. The second-order
condition requires that

u
 2TR  2TC
 0
Q 2 Q 2

. Ho
In other words, the second-order condition requires that

MR MC
 0
Q Q

td g
 (100  4Q)  (Q)
or
. L in Q

Q
0
vt sh
That is, –4–1<0
Thus, the second-order condition is also satisfied at output 20.
P li

1.3.4 Controversy Over Profit Maximization Objective:


Theory vs. Practice
ub

Arguments Against Profit Maximization Objective


As noted above, traditional theory assumes profit maximization as the sole objective of a
P

business firm. In practice, however, firms have been found to be pursuing many objectives
other than profit maximization. It is argued, in the first place, that the reason for the
firms, especially the large corporations, pursuing goals other than profit maximization is
s

the dichotomy between the ownership and the management. The separation of
a

management from ownership gives managers an opportunity and also discretion to set
goals other than profit maximization. It is argued that large firms pursue such goals as
ik

sales maximization, maximization of managerial utility function, maximization of firm’s


growth rate, making a target profit, retaining market share, building up the net worth of
the firm, and so on.
V

Secondly, traditional theory assumes full and perfect knowledge about current
market conditions and the future developments in the business environment of the firm.
The firm is thus supposed to be fully aware of its demand and cost conditions in both
short and long runs. Briefly speaking, a complete certainty about the market conditions
is assumed. Some modern economists question the validity of this assumption. They
argue that the firms do not possess the perfect knowledge of their costs, revenue and
future business environment. They operate in the world of uncertainty. Most price and
output decisions are based on probabilities.
Self-Instructional
Material 25
Introduction to Finally, the equi-marginal principle of profit maximization, i.e., equalizingMC and
Managerial Economics
MR, has been claimed to be absent in the decision-making process of the firms. Empirical
studies of the pricing behaviour of the firms have shown that the marginal rule of pricing
does not stand the test of empirical verification. Hall and Hitch21 have found, in their
NOTES study of pricing practices of 38 UK firms, that the firms do not pursue the objective of
profit maximization and that they do not use the marginal principle of equalizingMR and
MC in their price and output decisions. Most firms aim at long-run profit maximization.
In the short-run, they set the price of their product on the basis of average cost principle,
so as to cover AC = AVC + AFC (AC = Average cost, AVC = Average variable cost,
AFC = Average fixed cost) and a normal margin of profit (usually 10 per cent). In a

se
similar study, Gordon22 has found (i) that there is a marked deviation in the real business
conditions from the assumptions of the traditional theory and (ii) that pricing practices
were notably different from the marginal theory of pricing. Gordon has concluded that the

u
real business world is much more complex than the one postulated by the theorists. Because
of the extreme complexity of the real business world and ever-changing conditions, the

. Ho
past experience of the business firms is of little use in forecasting demand, price and costs.
The firms are not aware of their MR and MC. The average-cost-principle of pricing is
widely used by the firms. Findings of many other studies of the pricing practices lend
support to the view that there is little link between pricing theory and pricing practices.

td g
The Defence of Profit Maximization
. L in
The arguments against profit-maximization assumption, however, should not mean that
pricing theory has no relevance to the actual pricing policy of the business firms. A
vt sh
section of economists has strongly defended the profit maximization objective and
‘marginal principle’ of pricing and output decisions. The empirical and theoretical support
put forward by them in defence of the profit maximization objective and marginal rule of
pricing may be summed as follows.
P li

In two empirical studies of 110 ‘excellently managed companies’, J.S. Earley23


ub

has concluded that the firms do apply the marginal rules in their pricing and output
decisions. Fritz Maclup24 has argued in abstract theoretical terms that empirical studies
by Hall and Hitch and by Lester do not provide conclusive evidence against the marginal
P

rule and these studies have their own weaknesses. He argues further that there has
been a misunderstanding regarding the purpose of traditional theory of value. The
traditional theory seeks to explain market mechanism, resource allocation through price
s

mechanism and has a predictive value, rather than deal with specific pricing practices of
certain firms. The relevance of marginal rules in actual pricing system of firms could not
a

be established for lack of communication between the businessmen and the researchers
ik

as they use different terminology like MR, MC and elasticities. Besides, businessmen,
even if they do understand economic concepts, would not admit that they are making
abnormal profits on the basis of marginal rules of pricing. They would instead talk of a
V

‘fair profit’. Also, Maclup is of the opinion that the practices of setting price equal to
average variable cost plus a profit margin is not incompatible with the marginal rule of
pricing and that the assumptions of traditional theory are plausible.
While the controversy on profit maximization objective remains unresolved, the
conventional theorists, the marginalists, continue to defend the profit maximization objective
and its marginal rules.
Other Arguments in Defence of Profit Maximization Hypothesis The conventional
economic theorists defend the profit maximization hypothesis on the following grounds also.
Self-Instructional
26 Material
1. Profit is indispensable for firm’s survival. The survival of all the profit-oriented Introduction to
Managerial Economics
firms in the long run depends on their ability to make a reasonable profit depending on
the business conditions and the level of competition. What profit is reasonable may be a
matter of opinion. But, making profit is a necessary condition for the survival of the firm.
Once the firms are able to make profit, they try to make it as large as possible, i.e., they NOTES
tend to maximize it.
2. Achieving other objectives depends on firm’s ability to make profit. Many other
objectives of business firms have been cited in economic literature, e.g., maximization of
managerial utility function, maximization of long-run growth, maximization of sales revenue,

se
satisfying all the concerned parties, increasing and retaining market share, etc. The
achievement of such alternative objectives depends wholly or partly on the primary
objective of making profit.

u
3. Evidence against profit maximization objective is not conclusive. Profit
maximization is a time-honoured objective of business firms. Although this objective has

. Ho
been questioned by many researchers, some economists have argued that the evidence
against it is not conclusive or unambiguous.
4. Profit maximization objective has a greater predicting power. Compared to
other business objectives, profit maximization assumption has been found to provide a

td g
much more powerful basis for predicting certain aspects of firms’ behaviour. As Friedman
has argued, the validity of the profit maximization objective cannot be judged by a priori
. L in
logic or by asking business executives, as some economists have done. The ultimate test
of its validity lies in its ability to predict the business behaviour and the business trends.
vt sh
5. Profit is a more reliable measure of a firm’s efficiency. Though not perfect, profit
is the most efficient and reliable measure of the efficiency of a firm. It is also the source
of internal finance. Profit as a source of internal finance assumes a much greater
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significance when financial market is highly volatile. The recent trend shows a growing
dependence on the internal finance in the industrially advanced countries. In fact, in
ub

developed countries, internal sources of finance contribute more than three-fourths


of the total finance.
6. Finally, according to Milton Friedman, whatever one may say about firms’ motivations,
P

if one judges their motivations by their acts, profit maximization appears to be a more
valid business objective.25
s

1.3.5 Alternative Objectives of Business Firms


a

While postulating the objectives of business firms, the conventional theory of firm does
not distinguish between owners’ and managers’ interests. The recent theories of firm,
ik

called ‘managerial’ and ‘behavioural’ theories of firm, however, assume owners and
managers to be separate entities in large corporations with different goals and motivations.
V

Berle and Means26 were the first to point out the dichotomy between the ownership and
the management and its role in managerial behaviour and in setting the goal(s) for the
firm that they manage. Later on Galbraith27 wrote extensively on this issue which is
known as Berle-Means-Galbraith (B-M-G) hypothesis. The B-M-G hypothesis states
(i) that owner controlled firms have higher profit rates than manager controlled firms;
and (ii) that managers have no incentive for profit maximization. The managers of large
corporations, instead of maximizing profits, set goals for themselves that can keep the
owners quiet so that managers can take care of their own interest in the corporation. In
this section, we will discuss very briefly some important alternative objectives of business
firms, especially of large business corporations. Self-Instructional
Material 27
Introduction to Baumol’s Hypothesis of Sales Revenue Maximization
Managerial Economics
Baumol28 has postulated maximization of sales revenue as an alternative to profit-
maximization objective. He attributes this objective to the dichotomy between ownership
NOTES and management in large business corporations. This dichotomy gives managers an
opportunity to set their goals other than profit maximization goal which most owners and
businessmen pursue. Given the opportunity, managers choose to maximize their own
utility function. According to Baumol, the most plausible factor in managers’ utility
functions is maximization of the sales revenue.
According to Baumol, the factors which explain the pursuance of sales

se
maximization by the managers are following.
First, salary and other earnings of managers are more closely related to sales revenue
than to profits.

u
Secondly, banks and financial corporations look at and lay a great emphasis on sales

. Ho
revenue while financing a corporation.
Thirdly, trend in sales revenue is a readily available indicator of the performance of the
firm. It helps also in handling the employee’s problem of awarding efficiency and penalizing
inefficiency.

td g
Fourthly, increasing sales revenue enchances the prestige, reputation and perks of
managers while profits go to the owners.
. L in
Fifthly, managers find profit maximization a difficult objective to fulfill consistently over
time and at the same level. Profits may fluctuate with changing conditions.
vt sh
Finally, growing sales strengthen competitive spirit of the firm in the market whereas
decreasing sales put the survivial of the firm at risk.
P li

However, Baumol’s sales maximization hypothesis has also been questioned on


the following grounds.
ub

First, so far as empirical validity of sales revenue maximization objective is concerned,


factual evidences are inconclusive.29 Most empirical works are, in fact, based on
inadequate data simply because requisite data is mostly not available. Secondly, even
P

theoretically, if total cost function (TC) intersects the total revenue function (TR) before
it reaches its climax, Baumol’s theory collapses.
Finally, it is also argued that, in the long run, sales maximization and profit maximization
s

objective converge into one. For, in the long run, sales maximization tends to yield only
a

normal levels of profit which turns out to be the maximum under competitive conditions.
Thus, profit maximization is not incompatible with sales maximization.
ik

Marris’s Hypothesis of Maximization of Firm’s Growth Rate


V

According to Robin Marris,30 managers maximize firm’s balanced growth rate subject
to managerial and financial constraints. He defines firm’s balanced growth rate (G) as
G = GD = GC
where GD = growth rate of demand for firm’s product and GC = growth rate of capital
supply to the firm.
In simple words, a firm’s growth rate is balanced when demand for its product
and supply of capital to the firm increase at the same rate. Marris translates the two

Self-Instructional
28 Material
growth rates into two utility functions: (i) manager’s utility function and (ii) owner’s Introduction to
Managerial Economics
utility function.
The manager’s utility function (Um) and owner’s utility function (Uo) may be
specified as follows.
NOTES
Um = f (salary, power, job security, prestige, status),
and Uo = f (output, capital, market-share, profit, public esteem).
Owners’ utility function (Uo) implies growth of demand for firm’s product and
supply of capital to the firm. Therefore, maximization of Uo means maximization of

se
‘demand for firm’s product’ or ‘growth of capital supply’. According to Marris, by
maximizing these variables, managers maximise both their own utility function and that
of the owners. The managers can do so because most of the variables (e.g., salaries,
status, job security, power, etc.) appearing in their own utility function and those appearing

u
in the utility function of the owners (e.g., profit, capital market, share, etc.) are positively

. Ho
and strongly correlated with a single variable, i.e., size of the firm. Therefore, managers
seek to maximize the size of the firm. Maximization of size of the firm depends on the
maximization of its growth rate. The managers, therefore, seek to maximize a steady
growth rate.
Marris’s theory, though more rigorous and sophisticated than Baumol’s sales

td g
revenue maximization, has its own weaknesses. It fails to deal satisfactorily with
. L in
oligopolistic interdependence. Another serious shortcoming of his model is that it ignores
price determination which is the main concern of profit maximization hypothesis. In the
opinion of many economists, Marris’s model too, does not seriously challenge the profit
vt sh
maximization hypothesis.
Williamson’s Hypothesis of Maximization of Managerial Utility Function
P li

As mentioned above, in modern corporations, owners (or stockholders) and managers


(paid salary for their managerial services) are two separate entities with different
ub

objectives. The relationship between owners and managers is of principal and agent
nature. The problem of determining firm’s objective is generally known also as Principal-
Agent Problem. Like Baumol and Marris, Williamson31 argues that managers have
P

discretion to pursue objectives other than profit maximization. Instead of maximizing


profit, the managers of modern corporations seek to maximize their own utility function
subject to a minimum level of profit. Managers’ utility function(U) is expressed as
s

U = f(S, M, ID)
a

where S = additional expenditure on staff,


ik

M = managerial emoluments,
I D = discretionary investments.
V

According to Williamson’s hypothesis, managers maximize their utility function


subject to a satisfactory profit. A minimum profit is necessary to satisfy the shareholders
or else manager’s job security is endangered.
The utility functions which managers seek to maximize include both quantifiable
variables like salary and slack earnings, and non-quantitative variables such as prestige,
power, status, job security, professional excellence, etc. The non-quantifiable variables
are expressed, in order to make them operational, in terms of expense preference

Self-Instructional
Material 29
Introduction to defined as ‘satisfaction derived out of certain types of expenditures’ (such as slack
Managerial Economics
payments), and ready availability of funds for discretionary investment.
Like other alternative hypotheses, Williamson’s theory too suffers from certain
weaknesses. His model fails to deal with the problem of oligopolistic interdependence.
NOTES Williamson’s theory is said to hold only where rivalry between firms is not strong. In
case of strong rivalry, profit maximization is claimed to be a more appropriate hypothesis.
Thus, Williamson’s managerial utility function too does not offer a more satisfactory
hypothesis than profit maximization.
Cyert-March Hypothesis of Satisficing Behaviour

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Cyert-March32 hypothesis is an extension of Simon’s hypothesis of firms’ ‘satisficing
behaviour’ or satisfying behaviour. Simon had argued that the real business world is full

u
of uncertainty; accurate and adequate data are not readily available; where data are
available, managers have little time and ability to process them; and managers work

. Ho
under a number of constraints. Under such conditions it is not possible for the firms to
act in terms of rationality postulated under profit maximization hypothesis. Nor do the
firms seeks to maximize sales, growth or anything else. Instead they seek to achieve a
‘satisfactory profit’ a ‘satisfactory growth’, and so on. This behaviour of firms is termed
as ‘Satisfaction Behaviour’.

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. L in Cyert and March added that, apart from dealing with an uncertain business world,
managers have to satisfy a variety of groups of people—managerial staff, labour,
shareholders, customers, financiers, input suppliers, accountants, lawyers, authorities,
etc. All these groups have their interest in the firms. Their interests are often conflicting.
vt sh
The manager’s responsibility is to ‘satisfy’ them all. Thus, according to the Cyert-March
hypothesis, firm’s behaviour is ‘satisficing behaviour’. The ‘satisficing behaviour’ implies
satisfying various interest groups by sacrificing firm’s interest or objective. The underlying
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assumption of ‘Satisficing Behaviour’ is that a firm is a coalition of different groups


connected with various activities of the firm, e.g., shareholders, managers, workers,
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input suppliers, customers, bankers, tax authorities, and so on. All these groups have
some kind of expectations–high and low–from the firm, and the firm seeks to satisfy all
of them in one way or another by sacrificing some of its interest.
P

In order to reconcile between the conflicting interests and goals, managers form
an aspiration level of the firm combining the following goals: (a) Production goal,
s

(b) Sales and market share goals, (c) Inventory goal, and (d ) Profit goal.
These goals and ‘aspiration level’ are set on the basis of the managers’ past
a

experience and their assessment of the future market conditions. The ‘aspiration levels’
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are modified and revised on the basis of achievements and changing business environment.
The behavioural theory has, however, been criticised on the following grounds.
First, though the behavioural theory deals realistically with the firm’s activity, it does not
V

explain the firm’s behaviour under dynamic conditions in the long run. Secondly, it cannot
be used to predict exactly the future course of firm’s activities, Thirdly, this theory does
not deal with the equilibrium of the firm or the industry. Fourthly, like other alternative
hypotheses, this theory too fails to deal with interdependence of the firms and its impact
on firms’ behaviour.
Rothschild’s Hypothesis of Long-Run Survival and Market Share Goals
Another alternative objective of a firm–as an alternative to profit maximization—was
suggested by Rothschild.33 According to him, the primary goal of the firm is long-run
Self-Instructional
30 Material
survival. Some other economists have suggested that attainment and retention of a Introduction to
Managerial Economics
constant market share is an additional objective of the firms. The managers, therefore,
seek to secure their market share and long-run survival. The firms may seek to maximize
their profit in the long-run though it is not certain.
NOTES
Entry-prevention and Risk-avoidance
Yet another alternative objective of the firms suggested by some economists is to prevent
entry of new firms into the industry. The motive behind entry-prevention may be (a)
profit maximization in the long run, (b) securing a constant market share, and (c) avoidance

se
of risk caused by unpredictable behaviour of new firms. The evidence of whether firms
maximize profits in the long-run is not conclusive. Some economists argue, however,
that where management is divorced from ownership, the possibility of profit maximization
is reduced.

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The advocates of profit maximization argue, however, that only profit-maximizing

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firms can survive in the long-run. They can achieve all other subsidiary goals easily if
they can maximize their profits.
It is further argued that, no doubt, prevention of entry may be the major objective
in the pricing policy of the firm, particularly in case of limit pricing. But then, the motive

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behind entry-prevention is to secure a constant share in the market. Securing constant
market share is compatible with profit maximization.
. L in
1.3.6 Making A Reasonable Profit—A Practical Approach
vt sh
As noted above, objectives of business firms can be various. There is no unanimity
among the economists and researchers on the objectives of business firms. One thing is,
however, certain that the survival of a firm depends on the profit it can make. So whatever
the goal of the firm—sales revenue maximization, maximization of firm’s growth,
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maximization of managers’ utility function, long-run survival, market share, or entry-


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prevention—it has to be a profitable organization. The firms, therefore, adopt a more


practical approach. Maximization of profit in technical sense of the term may not be
practicable, but making profit has to be there in the objective function of the firms. The
firms may differ on ‘how much profit’ but they do set a profit target for themselves.
P

Some firms set their objective of a ‘standard profit’, some of a ‘target profit’ and some
of a ‘reasonable profit’. A ‘reasonable profit’ is the most common objective.
s

Let us now look into the policy questions related to setting standard or criteria for
a reasonable profit. The important policy questions are:
a

(i) Why do modern corporations aim at a “reasonable profit” rather than attempting
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to maximize profit?
(ii) What are the criteria for a reasonable profit?
V

(iii) How is the “reasonable profit” determined?


Let us now briefly examine the policy implications of these questions.
Reasons for Aiming at “Reasonable Profits”
For a variety of reasons, modern large corporations aim at making a reasonable profit
rather than maximizing the profit. Joel Dean34 has listed the following reasons.
1. Preventing entry of competitors. Profit maximization under imperfect market
conditions generally leads to a high ‘pure profit’ which is bound to attract competitors,
Self-Instructional
Material 31
Introduction to particularly in case of a weak monopoly.35 The firms, therefore, adopt a pricing and a
Managerial Economics
profit policy that assure them a reasonable profit and, at the same time, keep potential
competitors away.
2. Projecting a favourable public image. It becomes often necessary for large
NOTES corporations to project and maintain a good public image, because if public opinion turns
against the firm, its sales begin to fall and if profits are high, government officials start
raising their eyebrows on profit figures. Corporations may find it difficult under such
conditions to sail smoothly. So most firms set prices lower than those conforming to the
maximum profit but high enough to ensure a “reasonable profit”.

se
3. Restraining trade union demands. High profits make trade unions feel that they
have a share in the high profit and therefore they raise demands for wage-hike. Wage-
hike may lead to wage-price spiral and frustrate the firm’s objective of maximizing

u
profit. Therefore, profit restrain is sometimes used as a weapon against trade union
activities.

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4. Maintaining customer goodwill. Customer’s goodwill plays a significant role in
maintaining and promoting demand for the product of a firm. Customer’s goodwill depends
largely on the quality of the product and its ‘fair price’. What consumers view as fair
price may not be commensurate with profit maximization. Firms aiming at better profit

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prospects in the long-run, sacrifice their short-run profit maximization objective in favour
of a “reasonable profit”.
. L in
5. Other factors. Some other factors that put restraint on profit maximization include
(a) managerial utility function being preferable to profits maximization for executives,
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(b) congenial relation between executive levels within the firm, (c) maintaining internal
control over management by restricting firm’s size and profit, and (d) forestalling the
anti-trust suits.
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Standards of Reasonable Profits


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When firms voluntarily exercise restraint on profit maximization and choose to make
only a ‘reasonable profit’, the questions that arise are:
(i) What form of profit standards should be used?
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(ii) How should reasonable profits be determined?


(i) Forms of Profit Standard Profit standards may be determined in terms of
s

(a) aggregate money terms, (b) percentage of sales, or (c) percentage return on
a

investment. These standards may be determined with respect to the whole product line
or for each product separately. Of all the forms of profit standards, the total net profit of
ik

the enterprise is more common than other standards. But when purpose is to discourage
the potential competitors, then a target rate of return on investment is the appropriate
profit standard, provided competitors’ cost curves are similar. The profit standard in
V

terms of ‘ratio to sales is an eccentric standard’ because this ratio varies widely from
firm to firm, even if they all have the ‘same return on capital invested’. This is particularly
so when there are differences in (a) vertical integration of production process, (b) intensity
of mechanization, (c) capital structure, and (d) turnover.
(ii) Setting the Profit Standard The following are the important criteria that are taken
into account while setting the standards for a ‘reasonable profit’.
(a) Capital-attracting standard. An important criterion used in setting standard
profit is that it must be high enough to attract external (debt and equity) capital. For
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32 Material
example, if a firm’s stocks are being sold in the market at five times their current earnings, Introduction to
Managerial Economics
it is necessary that the firm earns a profit of one-fifth or 20 per cent of the book
investment.
There are however certain problems associated with this criterion: (i) capital
structure of the firm (i.e., the proportions of bonds, equity and perference shares) affects NOTES
the cost of capital and thereby the rate of profit, and (ii) whether profit standard has to
be based on current or long-run average cost of capital as it varies widely from company
to company and may at times prove treacherous.
(b) ‘Plough-back’ standard. In case a company intends to rely on its own sources

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for financing its growth, then the most relevant standard is the aggregate profit that
provides for an adequate ‘plough-back’ for financing a desired growth of the company
without resorting to the capital market. This standard of profit is used especially by those

u
firms for whom maintaining liquidity and avoiding debt are main considerations in profit
policy.

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Plough-back standard is, however, socially less acceptable compared to capital-
attracting standard. From society’s point of view, it is more desirable that all earnings are
distributed to stockholders and they should decide the further investment pattern. This is
based on a belief that market forces allocate funds more efficiently and an individual is

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the best judge of his resource use. On the other hand, retained earnings which are under
the exclusive control of the management are likely to be wasted on low-earning projects
. L in
within the company. But one cannot be sure as to which of the two allocating agencies—
market or management—is generally superior. It depends on ‘the relative abilities of
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management and outside investors to estimate earnings prospects.’
(c) Normal earnings standard. Another important criterion for setting standard
of reasonable profit is the ‘normal’ earnings of firms of an industry over a normal period.
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Company’s own normal earnings over a period of time often serve as a valid criterion of
reasonable profit, provided it succeeds in (i) attracting external capital,
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(ii) discouraging growth of competition, and (iii) keeping stockholders satisfied. When
average of ‘normal’ earnings of a group of firms is used, then only comparable firms and
normal periods are chosen.
P

However, none of these standards of profits is perfect. A standard is, therefore,


chosen after giving due consideration to the prevailing market conditions and public
attitudes. In fact, different standards are used for different purposes because no single
s

criterion satisfies all conditions and all the people concerned.


a

1.3.7 Profit as Control Measure


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An important managerial aspect of profit is its use in measuring and controlling


performance of the executives of the large business undertakings. Researches have
revealed that business executives of middle and high ranks often deviate from profit
V

objective and try to maximize their own utility functions.36 They think in terms of job
security, personal ambitions for promotions, larger perks, etc., which often conflict with
firms’ profit-making objective. Keith Powlson37 has pointed out three common deviationist
tendencies:
(i) more energy is spent in expanding sales volume and product lines than in raising
profitability;
(ii) subordinates spend too much time and money doing jobs to perfection regardless
of its cost and usefulness and
Self-Instructional
Material 33
Introduction to (iii) executives cater more to the needs of job security in the absence of any reward
Managerial Economics
for imaginative ventures.
In order to control these deviationist tendencies and orienting managerial functions
towards the profit objective, the top management uses ‘managerial decentralization and
NOTES control-by-profit techniques’. These techniques have distinct advantage for a big business
corporation. Managerial decentralization is achieved by changing over from functional
division of business activities (e.g., production branch, sales division, purchase department,
etc.) to a system of product-wise division. Managerial responsibilities are then fixed in
terms of profit. Managers enjoy autonomy in their operations under the general policy

se
framework. They are allotted a certain amount of money to spend and a profit target to
be achieved by the particular division. Profit is then the measure of executive performance,
not the sales or quality. This kind of reorganization of management helps in assessing
profit-performance of various product lines in a multi-product organization. It serves as

u
a useful guide in reorganization of the product lines.

. Ho
The use of this technique, however, raises many interesting technical issues that
complicate its application. These issues centre around the method of measuring divisional
profits and profit standards to be set. The two important problems that arise are:
(i) should profit goals be set in terms of total net profit for the divisions or should they be
confined to their share in the total net profit? and (ii) how should divisional profits be

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determined when there is a long ladder of vertical integration?
. L in In respect to question (i), the most appropriate profit standard of divisional
performance is revenue minus current expenses. In respect to allocating different costs,
however, some arbitrariness is bound to be there. However, where a long vertical
vt sh
integration is involved, relative profitability of a division can be fixed in terms of a lower
‘transfer price’ compared to the market price. But, control measures are not all that
simple to apply. It is difficult to set a general formula. It has to be settled differently
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under varying conditions.


ub

Conclusion
Although profit maximization continues to remain the most popular hypothesis in economic
analysis, there is no reason to believe that profit maximization is the only objective that
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Check Your Progress firms pursue. Modern corporations, in fact, pursue multiple objectives. Through their
study of business firms, the economists have postulated a number of alternative objectives
6. What was Walker’s
s

theory of profit? pursued by them. The main factor behind the multiplicity of the objectives, particularly in
7. Give a few case of large corporations, is the dichotomy between the management and the ownership.
a

examples of Moreover, profit maximization hypothesis is a time-tested one. It is more easy to


innovation.
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handle. The empirical evidence against this hypothesis is not conclusive and unambiguous.
8. Which are the three
specific items of Nor are the alternative hypotheses strong enough to replace this hypothesis. More
cost and revenue importantly, profit maximization hypothesis has a greater explanatory and predictive
V

that pose power than any of the alternative hypotheses. Therefore, it still forms the basis of firms’
conceptual
problems in profit
behaviour.
measurement?
9. Name the three
popular methods of
1.4 SUMMARY
inventory valuation.
10. What is satisficing  The growing complexity of business decision-making has inevitably increased the
behaviour? application of economic concepts, theories and tools of economic analysis in this
area. The reason is that making an appropriate business decision requires a clear
Self-Instructional
34 Material
understanding of market conditions, the nature and degree of competition, market Introduction to
Managerial Economics
fundamentals and the business environment.
 Economics is obviously a study of the choice-making behaviour of the people. In
reality, however, choice-making is not as simple as it looks because the economic
world is very complex and most economic decisions have to be taken under the NOTES
condition of imperfect knowledge, risk and uncertainty.
 Many business decisions are taken under conditions of uncertainty and risk. These
arise mainly due to uncertain behaviour of the market forces, changing business
environment, emergence of competitors with highly competitive products,

se
government policy, and international factors impacting the domestic market due
mainly to increasing globalization as well as social and political changes in the
country.

u
 Economics has two major branches: (i) Microeconomics, and (ii) Macroeconomics.
Both micro and macro-economics are applied to business analysis and decision-

. Ho
making—directly or indirectly.
 It is far beyond the powers of a single business firm, howsoever large it may be,
to determine and guide the course of economic, social and political factors of the
nation. However, all the firms together or giant business houses can jointly influence

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the economic and political environment of the country.
 Microeconomic theories including those of demand, production, price determination,
. L in
profit and capital budgeting, and macroeconomic theories including of national
income, those economic growth and fluctuations, international trade and monetary
vt sh
mechanism, and the study of state policies and their repercussions on the private
business activities, by and large, constitute the scope of managerial economics.
 The primary objective of a business firm is to make profit. That is why the
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conventional theory of firm assumes profit maximization—not just making any


profit—as the sole objective of business firms.
ub

 To a layman, profit means all income that flows to the investors. To an accountant,
‘profit’ means the excess of revenue over all paid-out costs including both
manufacturing and overhead expenses. It is more or less the same as ‘net profit’.
P

 Opportunity cost of an equipment is ‘the most profitable alternative use of it that


is foregone by putting it to its present use’. The problem is then of measuring the
s

opportunity cost. One method of estimating opportunity cost, suggested by Joel


Dean, is to measure the fall in value during a year.
a

 The conventional economic theory assumes profit maximization as the only


ik

objective of business firms. Profit maximization as the objective of business firms


has a long history in economic literature. It forms the basis of conventional price
theory. Profit maximization is regarded as the most reasonable and analytically
V

the most ‘productive’ business objective. The strength of this assumption lies in
the fact that this assumption ‘has never been unambiguously disproved’.
 While postulating the objectives of business firms, the conventional theory of firm
does not distinguish between owners’ and managers’ interests. The recent theories
of firm, called ‘managerial’ and ‘behavioural’ theories of firm, however, assume
owners and managers to be separate entities in large corporations with different
goals and motivations.

Self-Instructional
Material 35
Introduction to
Managerial Economics 1.5 KEY TERMS
 Managerial economics: can be broadly defined as the study of economic theories,
NOTES logic and tools of economic analysis that are used in the process of business
decision-making.
 Economics: It is a social science and its basic function is to study how people—
individuals, households, firms and nations—maximize their gains from their limited
resources and opportunities.

se
 Accounting profit: To an accountant, profit means the excess of revenue over
all paid-out costs including both manufacturing and overhead expenses.
 Opportunity cost: It is defined as the payment that would be necessary to draw

u
forth the factors of production from their most remunerative alternative
employment.

. Ho
 Innovation theory of profit: As per the theory, factors like emergence of interest
and profits, recurrence of trade cycles and such other changes are only incidental
to a distinct process of economic development and the principles which could
explain the process of economic development would also explain these economic

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variables.
. L in
1.6 ANSWERS TO ‘CHECK YOUR PROGRESS’
vt sh
1. Optimizing behaviour is, selecting the best out of available options with the objective
of maximizing gains from the given resources. Economics is thus a social science,
which studies human behaviour in relation to optimizing allocation of available
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resources to achieve the given ends.


2. Economics, though variously defined, is essentially the study of logic, tools and
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techniques of making optimum use of the available resources to achieve the given
ends. Economics thus provides analytical tools and techniques that managers
need to achieve the goals of the organization they manage. Therefore, a working
P

knowledge of economics, not necessarily a formal degree, is essential for managers.


In other words, managers are essentially practicing economists.
3. Application of relevant economic theories to the problems of business facilitates
s

decision-making in at least three ways:


a

(i) It gives a clear understanding of various economic concepts (e.g., cost,


price, demand, etc.) used in business analysis.
ik

(ii) It helps in ascertaining the relevant variables and specifying the relevant
data.
V

(iii) Economic theories state the general relationship between two or more
economic variables and also events.
4. Making a satisfactory profit is not always guaranteed because a firm has to carry
out its activities under conditions of uncertainty with regard to (i) demand for the
product, (ii) input prices in the factor market, (iii) nature and degree of competition
in the product market, and (iv) price behaviour under changing conditions in the
product market, and so on.

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36 Material
5. A theory which appears logically sound may not be directly applicable in practice. Introduction to
Managerial Economics
For example, when there are economies of scale, it seems theoretically sound
that if inputs are doubled, output will be, more or less, doubled and if inputs are
trebled, output will be, more or less, trebled. This theoretical conclusion may not
hold good in practice. NOTES
6. According to Walker, profit is the rent of “exceptional abilities that an entrepreneur
may possess” over others. Just as land rent is the difference between the yields
of the least and the most fertile lands, profit is the difference between the earnings
of the least and the most efficient entrepreneurs. In formulating his profit theory,

se
Walker assumed a state of perfect competition in which all firms are presumed to
possess equal managerial ability.
7. Innovations may include:

u
 Introduction of a new commodity or a new quality of goods;
 The introduction of a new method of production;

. Ho
 The emergence or opening of a new market;
 Finding new sources of raw material;
 Organizing the industry in an innovative manner with new techniques.

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8. These items are: (i) depreciation, (ii) capital gains and losses, and (iii) current
vs. historical costs.
. L in
9. There are three popular methods of inventory valuation: (i) first-in-first-out (FIFO),
(ii) last-in-first-out (LIFO) and (iii) weighted average cost (WAC).
vt sh
10. The ‘satisficing behaviour’ implies satisfying various interest groups by sacrificing
firm’s interest or objective. The underlying assumption of ‘Satisficing Behaviour’
is that a firm is a coalition of different groups connected with various activities of
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the firm, e.g., shareholders, managers, workers, input suppliers, customers, bankers,
tax authorities, and so on. All these groups have some kind of expectations–high
ub

and low–from the firm, and the firm seeks to satisfy all of them in one way or
another by sacrificing some of its interest.
P

1.7 QUESTIONS AND EXERCISES


s

Short-Answer Questions
a

1. Managerial economics is the discipline which deals with the application of


‘economic theory to business management’. Comment.
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2. What are the major areas of business decision-making? How does economic
theory contribute to managerial decisions?
V

3. “Managerial economics bridges the gap between economic theory and business
practice”. How?
4. What are the related topics other than microeconomic theories in managerial
economics? How do they contribute to managerial economics?
5. What are the basic functions of a manager? How does managerial economics
contribute to business decision making?
6. Write a note on the nature and scope of managerial economics.
Self-Instructional
Material 37
Introduction to 7. What are the operational issues in business management? How does
Managerial Economics
microeconomics contribute to decision making in the operational issues?
8. What is macroeconomics? In what way is macroeconomics applicable to business
decision-making?
NOTES
9. What macroeconomic issues figure in business decision-making? How does
macroeconomics help in understanding the implications of macroeconomic issues?
10. What is meant by business environment? What branch of economics is related to
the environmental issues of private business?

se
11. What are the basic functions of business managers? How does economics help
business managers in performing their functions?
Long-Answer Questions

u
1. Discuss the nature and scope of managerial economics. What are the other related

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disciplines?
2. Managerial economics is essentially the application of microeconomic theory of
business decision-making. Discuss the statement.
3. “Managerial economics is applied microeconomics”. Elucidate.

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4. “Managerial economics is the integration of economic theory with business practice
. L in for the purpose of facilitating decision-making and forward planning by the
management.” Explain.
5. How does the study of managerial economics help a business manager in decision-
vt sh
making? Illustrate your answer with examples from production and pricing issues.
6. What are the major macroeconomic issues related directly to business decision-
making? What is their significance in business decisions?
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7. Distinguish between the following concepts of profit:


ub

(a) Accounting profit and economic profit; (b) Normal profit and monopoly
profit;
(c) Pure profit and opportunity cost.
P

8. Explain the following statements:


(i) Profit is the rent for exceptional ability of an entrepreneur (Walker).
(ii) Profits arise only in a dynamic world (J.B. Clark).
s

(iii) Profit is a reward for risk bearing (F.B. Hawley).


a

(iv) Profit is a return to uncertainty bearing (F.H. Knight).


(v) Profit is reward for innovations (J.A. Schumpeter).
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9. What is the most plausible objective of business firms? What is the controversy
on profit maximization hypothesis? How will you react to the debate?
V

10. What problems do the depreciation and capital gains cause in measuring profit?
What are the methods of resolving the problems?
11. Examine critically profit maximization as the objective of business firms. What
are the alternative objectives of business firms?
12. Explain the first and second-order conditions of profit maximization.
13. Explain how profit is used as a control measure. What problems are associated
with the use of profit figure as a control measure?
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38 Material
Introduction to
1.8 FURTHER READING Managerial Economics

Dwivedi, D. N. 2008. Managerial Economics, Seventh Edition. New Delhi: Vikas


Publishing. NOTES
Keat, Paul G. and Philip, K. Y. Young. 2003. Managerial Economics: Economics
Tools for Today’s Decision Makers, Fourth Edition. Singapore: Pearson
Education.
Keating, B. and J. H. Wilson. 2003. Managerial Economics: An Economic Foundation

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for Business Decisions, Second Edition. New Delhi: Biztantra.
Mansfield, E., W. B. Allen, N. A. Doherty, and K. Weigelt. 2002. Managerial
Economics: Theory, Applications and Cases, Fifth Edition. NY: W. Orton

u
& Co.
Peterson, H. C. and W. C. Lewis. 1999. Managerial Economics, Fourth Edition.

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Singapore: Pearson Education.
Salvatore, Dominick. 2001. Managerial Economics in a Global Economy, Fourth
Edition. Australia: Thomson-South Western.
Thomas, Christopher R. and Maurice S. Charles. 2005. Managerial Economics:

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Concepts and Applications, Eighth Edition. New Delhi: Tata McGraw-Hill.
Endnotes
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1. It may be surprising that there is no final answer to this question. It is surprising because
vt sh
economics is the oldest social science and it has grown over the past two and a quarter
centuries much faster than any other social science in terms of literature and application
and yet could not be defined precisely. Economics has been defined differently at different
stages of its growth. As yet, there is no universal definition of economics, perhaps,
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because ‘economics is [still] an unfinished science’ (Zeuthen) and also because


“Economics is still a young science” (Schultz).
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2. Mansfield, E. (ed.), Managerial Economics and Operations Research, (W.W. Norton and
Co., Inc., New York, 1966)., p. 11.
3. Spencer, M.H., and Seigelman, L., Managerial Economics, (Irwin Illinois, 1969), p. 1.
P

4. Douglas, Evan J. Managerial Economics: Analysis and Strategy, (Prentice-Hall, N.J.,


1987), p. 1.
5. Davis Ronnie and Semoon Chang, Principles of Managerial Economics, (Prentice-Hall,
s

N.J., 1986), p. 3.
a

6. Baumol, W.J. ‘What Can Economic Theory Contribute to Managerial Economics’ in AER,
Vol. 51, No. 2, May 1961.
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7. See also Simon, Herbert A. “The Decision-Making Process” in Mansfield (ed.), op. cit.
8. For example, Federation of Indian Chambers of Commerce and Industries (FICCI) has
been influencing the government’s economic policies, especially in regard to foreign
V

investment, customs, oil prices, monetary (interest rate) policy and taxation policy.
9. Studies in the Economics of Overhead Costs, University of Chicago, 1923, p. 116, quoted
in K.K. Seo, Managerial Economics, Text, Problems, and Short Cases, (Richard, D. Irwin,
Inc., Homewood, Ill, 1984), p. 325.
10. Lerner, A.P. “Microeconomic Theory” in Perspective in Economics—Economists Looks
at Their Field of Study by A.A. Brown, E. Neuberger, and M. Pakmastier (eds.), (McGraw-
Hill, NY), p. 36.
11. Keynes, J.M. The General Theory of Employment Interest and Money, (Harcourt Brace,
New York, 1936), p. 297.
Self-Instructional
Material 39
Introduction to 12. Boulding, K.E. Economic Analysis, (Harper and Bros., New York, 1948), p. 14.
Managerial Economics
13. Dean, Joel Managerial Economics, (Prentice Hall of India, New Delhi, 1977), p. vii..
14. Baumol, J. William, Economic Theory and Operations Analysis, (Prentice-Hall of India
Pvt. Ltd., New Delhi), 1980, Fourth Edn., pp. 377–79.
NOTES 15. Ibid., p. 378.
16. Dean, Joel, Managerial Economics, (Asia Publishing House, Bombay), 1960, p. 3.
17. For example, Indian Income Tax Act makes only partial allowance for expenses on
‘entertainment and advertisement’.
18. Reekie, W.D. and J.N. Crook, Managerial Economics, (Phillip Allan, 1982), p. 381.

se
19. Dean, Joel, op. cit., p. 14.
20. Dean, Joel, op. cit., p. 19.
21. Hall, R.L., and C.J. Hitch, “Price Theory and Business Behaviour”, Oxford Economics

u
Papers (1939), reprinted in ‘Studies in the Price Mechanism’ (ed.) by Wilson, T. and
Andrews, P.W.S. (Oxford University Press, 1952).

. Ho
22. Gordon, R.A., “Short Period Price Determination in Theory and Practice”, Am. Eco. Rev.,
1948.
23. In his ‘Recent Developments in Cost Accounting and the Marginal Analysis’, Journal of
Political Economy, 1955, and ‘Marginal Policies of Excellently Managed Companies’, Am.
Eco. Rev., 1956.

td g
24. Maclup, Fritz ‘Marginal Analysis and Empirical Research’, Am. Eco. Rev., 1946, and
. L in ‘Theories of the Firm: Marginalist, Managerialist, Behavioural’, Am. Eco. Rev. (1967).
25. Friedman, Milton, Essays in Positive Economics (Chicago University Press, Chicago,
1953), pp. 3–43.
vt sh
26. Berle, A.A., and G.C. Means, The Modern Corporation and Private Property (Commerce
Clearing House, New York, 1932).
27. Galbraith, J.K., Amercian Capitalism: The Concept of Countervailing Power, 1952; The
Affluent Society, 1958; The New Industrial State, 1967, all by Houghton Mifflin, Boston.
P li

28. Baumol, W.J., Business Behaviour, Value and Growth (Macmillan, New York, 1959).
Revised edition published by Harcourt, (Brace & World Inc., 1967).
ub

29. Koutsoyiannis, A., Modern Microeconomics (Macmillan, 1979), pp. 346–51.


30. Marris, Robin, “A Model of the Managerial Enterprise”, Q.J.E., 1963 and Theory of
Managerial Capitalism (N.Y., Macmillan, 1963).
P

31. Williamson, O.E., “Managerial Discretion and Business Behaviour”, Am. Eco. Rev., 1963
and The Economics of Discretionary Behaviour: Managerial Objectives the Theory of
Firm (Markhamm, Chicago, 1967).
s

32. Cyert, Richard M., and March James, G. A Behavioural Theory of the Firm (Prentice-Hall,
1963), Earlier this theme was developed by H.A. Simon, in his “A Behavioural Model of
a

Rational Choice”, Q.J.E., 1955, pp. 99–118.


ik

33. Rothschild, K.W., “Price Theory and Oligopoly”, E.J., 1947, pp., 297–320.
34. Dean, Joel, op. cit., pp. 29–33.
35. A weak monopoly is one that has no strong barriers to protect its strategic material
V

markets, patent rights, etc., and where production of a close substitute is technically a
near possibility.
36. Managerial utility functions have already been discussed above under ‘Alternative
Objectives of Business Firms’.
37. Quoted in Joel Dean, Managerial Economics, pp. 39–40.

Self-Instructional
40 Material
Analysis of Demand

UNIT 2 ANALYSIS OF DEMAND


Structure
NOTES
2.0 Introduction
2.1 Unit Objectives
2.2 Law of Demand
2.3 Determinants of Demand
2.4 Elasticity of Demand

se
2.4.1 Price Elasticity of Demand
2.4.2 Measuring Price Elasticity from a Demand Function
2.4.3 Price Elasticity and Total Revenue
2.4.4 Price Elasticity and Marginal Revenue

u
2.4.5 Determinants of Price Elasticity of Demand
2.4.6 Cross-Elasticity of Demand

. Ho
2.4.7 Income-Elasticity of Demand
2.4.8 Advertisement or Promotional Elasticity of Sales
2.4.9 Elasticity of Price Expectations
2.5 Demand Forecasting
2.5.1 Why Demand Forecasting

td g
2.5.2 Steps in Demand Forecasting
2.6 Techniques of Demand Forecasting
. L in
2.6.1 Survey Methods
2.6.2 Statistical Methods
2.7 Summary
vt sh
2.8 Key Terms
2.9 Answers to ‘Check Your Progress’
2.10 Questions and Exercises
2.11 Further Reading
P li
ub

2.0 INTRODUCTION
The demand side of the market for a product refers to all its consumers and the price
P

they are willing to pay for buying a certain quantity of the product during a period of
time. The quantity that consumers buy at a given price determines the market size. It is
the size of the market that determines the business prospects of a firm and an industry.
s

The demand side of the market is governed by the law of demand, which governs the
a

market such that when the prices go up, demand goes down and size of the market is
reduced, all other things remaining the same. Similarly, when prices decrease, demand
ik

increases, causing a rise in sales and market size tends to increase.


In this unit, you will learn about the law and determinants of demand, the elasticity
V

of demand and demand forecasting.

2.1 UNIT OBJECTIVES


After going through this unit, you will be able to:
 Define the law of demand
 Examine determinants of demand
 Analyse the concept of elasticity of demand
Self-Instructional
Material 41
Analysis of Demand  Discuss demand forecasting
 Identify techniques of demand forecasting

NOTES 2.2 LAW OF DEMAND


The law of demand states the nature of relationship between the quantity demanded of
a product and the price of the product. Although quantity demanded of a commodity
depends also on many other factors, e.g., consumer’s income, price of the substitutes
and complementary goods, consumer’s taste and preferences, advertisement, etc., the

se
current price is the most important and the only determinant of demand in the short run.
The law of demand can be stated as all other things remaining constant, the
quantity demanded of a commodity increases when its price decreases and

u
decreases when its price increases. This law implies that demand and price are inversely

. Ho
related. Marshall, the originator of the law, has stated the law of demand as “the amount
demanded increases with a fall in price and diminishes with a rise in price”. This law
holds under ceteris paribus assumption, that is, all other things remain unchanged.

2.3 DETERMINANTS OF DEMAND

td g
. L in
The market demand for a product is determined by a number of factors, viz. price of the
product, price and availability of the substitutes, consumer’s income, his own preference
for a commodity, utility derived from the commodity, ‘demonstration effect’,
vt sh
advertisement, credit facility by the sellers and banks, off-season discounts, number of
the uses of the commodity, population of the country, consumer’s expectations regarding
the future trend in the price of the product, consumers’ wealth, past levels of demand,
P li

past levels of income, government policy, etc. But all these factors are not equally
important. Besides, some of these factors are not quantifiable, e.g., consumer’s
ub

preferences, utility, demonstration effect, and expectations, and hence are not usable in
the demand estimation. Nevertheless, we will discuss here how some important
quantifiable and non-quantifiable determinants determine the market demand for a product.
P

1. Price of the Commodity


As stated above, price is the most important determinant of the quantity demanded of a
s

commodity. The price–quantity relationship is the central theme of demand theory. The
a

nature of relationship between price of a commodity and its quantity demanded has
already been discussed under the ‘Law of Demand’.
ik

2. Price of Substitutes and Complementary Goods


V

The demand for a commodity depends also on the prices of its substitutes and
complementary goods. Two commodities are deemed to be substitutes for each other
if change in the price of one affects the demand for the other in the same direction. For
instance, commodities X and Y are, in an economic sense, substitutes for each other if a
rise in the price of X increases the demand for Y, and vice versa. Tea and coffee,
hamburger and hot-dog, alcohol and drugs are some common examples of substitutes.
By definition, the relationship between demand of a product (say, tea) and the
price of its substitute (say, coffee) is positive in nature. When price of the substitute
(coffee) of a product (tea) falls (or increases), demand for the product falls (or increases).
Self-Instructional The relationship of this nature is given in Figure 2.1(a).
42 Material
A commodity is deemed to be a complement of another when it complements the Analysis of Demand
use of the other. In other words, when the use of any two goods goes together so that
their demand changes (increases or decreases) simultaneously, they are treated as
complements. For example, petrol is a complement of motor vehicles; butter and jam are
complements of bread; milk and sugar are complements of tea and coffee. Technically, NOTES
two goods are complements of one another if an increase in the price of one causes a
decrease in the demand for another. By definition, there is an inverse relationship between
the demand for a good and the price of its complement. For instance, an increase (or
decrease) in the price of petrol causes a decrease (or an increase) in the demand for
car, other things remaining the same. The nature of relationship between the demand for

se
a product and the price of its complement is given in Figure 2.1(b).

u
. Ho
td g
. L in
vt sh
(a) (b)

Fig. 2.1 Demand for Substitutes and Complements


P li
ub

3. Consumer’s Income
Income is the basic determinant of the quantity demanded of a product as it determines
the purchasing power of the consumer. That is why the people with higher current
P

disposable income spend a larger amount on normal goods and services than those with
lower incomes. Income–demand relationship is of a more varied nature than that between
demand and its other determinants.
s

For the purpose of income–demand analysis, goods and services may be grouped
a

under four broad categories, viz. (a) essential consumer goods; (b) inferior goods; (c)
normal goods; and (d) prestige or luxury goods. The relationship between income and the
ik

different kinds of consumer goods is presented through the Engel Curves in Figure 2.2.
(a) Essential Consumer Goods (ECG): The goods and services which fall in
V

this category are consumed, as a matter of necessity, by almost all persons of a


society, e.g., foodgrains, salt, vegetable oils, matches, cooking fuel, a minimum
clothing and housing. Quantity demanded of such goods increases with increase
in consumer’s income only upto a certain limit, other factors remaining the same.
The relation between demand of this category and consumer’s income is shown
by curve ECG in Figure 2.2. As the curve shows, consumer’s demand for essential
goods increases until his income rises to OY2 and beyond this level of income, it
does not.

Self-Instructional
Material 43
Analysis of Demand (b) Inferior goods: Inferior and superior goods are generally known to the consumers
by and large. For instance, every consumer knows that bajra is inferior to wheat
and rice; bidi (an indigenous cigarette) is inferior to cigarette, cars without AC
are inferior to AC cars, kerosene-stove is inferior to gas-stove; travelling by bus
NOTES is inferior to travelling by taxi, and so on. In economic terminology, however, a
commodity is deemed to be inferior if its demand decreases with the increase in
consumers’ income. The relation between income and demand for an inferior
good is shown by curve IG in Figure 2.2 under the assumption that other
determinants of demand remain the same. Demand for such goods may initially
increase with increase in income (say, upto Y1) but it decreases when income

se
increases beyond a certain level.
(c) Normal goods: Technically, normal goods are those which are demanded in
increasing quantities as consumers’ income rises. Clothing is the most important

u
example of this category of goods. The nature of relation between income and

. Ho
demand for the normal goods is shown by curve NG in Figure 2.2. As the curve
shows, demand for such goods increases with the increase in income of the
consumer, but at different rates at different levels of income. Demand for normal
goods initially increases rapidly, and later, at a lower rate. With the increase in the
consumers’ income, its income-elasticity decreases.

td g
. L in
vt sh
P li
ub
P
s

Fig. 2.2 Income–Demand Curves


a

It may be noted from Figure 2.2 that upto a certain level of income (Y1) the
relation between income and demand for all types of goods is positive. While
ik

demand for some NGs increases at a faster rate, for others, it increase at a low
rate. The difference is of degree only. The income–demand relationship becomes
V

distinctly different beyond the level of income Y1.


(d) Prestige or luxury goods: Prestige goods are those which are consumed mostly
by the rich section of the society, e.g., luxury cars, stone-studded jewellery, costly
cosmetics, decoration items (like antiques) etc. Demand for such goods arises
only beyond a certain level of consumer’s income. The income–demand relationship
of this category of goods is shown by the curve LG in Figure 2.2.

Self-Instructional
44 Material
4. Consumers’ Tastes and Preferences Analysis of Demand

Consumers’ tastes and preferences play an important role in determining the demand
for a product. Tastes and preferences depend, generally, on the social customs, religious
values attached to a commodity, habits of the people, the general lifestyle of the society, NOTES
and also the age and sex of the consumers. Changes in these factors change consumers’
taste and preferences. As a result, consumers reduce or give up the consumption of
some goods and include some others in their consumption basket. Generally, if consumers’
liking, taste and preference for certain goods and services change following the change
in fashion, people switch their consumption pattern from cheaper, old-fashioned goods

se
over to costlier ‘mod’ goods, so long as the price differentials commensurate with their
preference. Consumers are prepared to pay higher prices for ‘mod’ goods even if their
virtual utility is the same as that of old-fashioned goods. This fact reveals that tastes and

u
preferences also influence the demand for goods and services.

. Ho
5. Consumers’ Expectations
Consumers’ expectations regarding the future course of economic events, particularly
regarding changes in prices, income, and supply position of goods, play an important role
in determining the demand for goods and service in the short-run. As mentioned above,

td g
if consumers expect a rise in the price of a commodity, they tend to buy more of it at its
current price with a view to avoiding the pinch of price–rise in future. For example,
. L in
when the automobile owners expect or Government of India announces a rise in petrol
and diesel prices from a future date, automobile owners buy more of petrol and diesel at
their current prices. On the contrary, if consumers expect a fall in the price of certain
vt sh
goods, they postpone their purchase of such goods with a view to taking advantage of
lower prices in future, mainly in the case of non-essential goods. This behaviour of
consumers reduces the current demand for the goods whose prices are expected to
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decrease in future.
ub

Similarly, an expected increase in income on account of announcement of revision


of pay scales, dearness allowance, bonus, etc., induces increase in current purchase,
and vice versa. Besides, if consumers or users expect scarcity of certain goods in future
on account of a reported fall in future production, labour strikes on a large scale, diversion
P

of civil supplies towards the military use, etc., the current demand for such goods would
increase, more so if their prices show an upward trend. Consumers demand more for
s

future consumption; profiteers demand more to make money out of expected scarcity.
In simple words, expectation regarding the shortage of a commodity in future increases
a

its current demand at the prevailing price.


ik

6. Demonstration Effect
When new commodities or new models of existing ones appear in the market, rich
V

people buy them first. Some people buy new goods or new models of goods because
they have a genuine need for them while others buy because they want to exhibit their
affluence. Fashion goods make the most common case for this category of goods. But
once new commodities come in vogue, many households buy them not because they
have a genuine need for them but because others or neighbours have bought these
goods. The purchases by the latter category of the buyers are made out of such feelings
as jealousy, competition, equality in the peer group, social inferiority and the desire to
raise their social status. Purchases made on account of these factors are the result of
‘Demonstration Effect’ or the ‘Bandwagon Effect’. These effects have a positive effect
Self-Instructional
Material 45
Analysis of Demand on the demand. On the contrary, when a commodity becomes a thing of common use,
some people, mostly the rich, decrease or give up the consumption of such goods. This
is known as ‘Snob Effect’. It has a negative effect on the demand for the related goods.

NOTES 7. Consumer-Credit Facility


Availability of credit to the consumers from the sellers, banks, relations and friends or
from any other source encourages the consumers to buy more than what they would
buy in the absence of credit facility. That is why the consumers who can borrow more
can consume more than those who can borrow less. Credit facility affects mostly the

se
demand for consumer durables, particularly those which require bulk payment at the
time of purchase.
8. Population of the Country

u
The total domestic demand for a product depends also on the size of the population.

. Ho
Given the price, per capita income, taste, preferences, etc., the larger the population, the
larger the demand for a product. With an increase (or decrease) in the size of population,
employment percentage remaining the same, demand for the product will increase (or
decrease). The relation between market demand for essential and normal goods and the
size of population is similar to the income–demand relation.

td g
9. Distribution of National Income
. L in
Apart from the level of individual incomes, the distribution pattern of national income
also affects the demand for a commodity. If national income is evenly distributed, market
vt sh
demand for normal goods will be the largest. If national income is unevenly distributed,
i.e., if majority of population belongs to the lower income groups, market demand for
essential goods (including inferior ones) will be the largest whereas the same for other
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kinds of goods will be relatively low. Furthermore, given a distribution of national income
and a market demand for various types of goods, if national income gets distributed in
ub

favour of the rich so that this section becomes smaller, the demand for essential goods
will increase and the same for other kinds of goods will decrease and vice versa.
P

2.4 ELASTICITY OF DEMAND


s

We have earlier discussed the nature of relationship between demand and its
determinants. From managerial point of view, however, the knowledge of nature of
a

relationship alone is not sufficient. What is more important is the extent of relationship or
the degree of responsiveness of demand to the changes in its determinants. The degree
ik

of responsiveness of demand to the change in its determinants is called elasticity of


Check Your Progress
demand.
V

1. What is a ceteris
paribus The concept of elasticity of demand plays a crucial role in business-decisions
assumption? regarding manoeuvring of prices with a view to making larger profits. For instance,
2. What are prestige/ when cost of production is increasing, the firm would want to pass the rising cost on to
luxury goods? the consumer by raising the price. Firms may decide to change the price even without
3. What is the any change in the cost of production. But whether raising price following the rise in cost
consumer-credit
facility and how or otherwise proves beneficial depends on:
does it affect (a) the price-elasticity of demand for the product, i.e., how high or low is the
demand?
proportionate change in its demand in response to a certain percentage change in
its price; and
Self-Instructional
46 Material
(b) price-elasticity of demand for its substitute, because when the price of a product Analysis of Demand
increases, the demand for its substitutes increases automatically even if their
prices remain unchanged.
Raising the price will be beneficial only if (i) demand for a product is less elastic;
and (ii) demand for its substitute is much less elastic. Although most businessmen are NOTES
intuitively aware of the elasticity of demand of the goods they make,1 the use of precise
estimates of elasticity of demand will add precision to their business decisions.
In this section, we will discuss various methods of measuring elasticities of
demand. The concepts of demand elasticities used in business decisions are:

se
(i) Price elasticity, (ii) Cross-elasticity; (iii) Income elasticity; and (iv) Advertisement
elasticity, and (v) Elasticity of price expectation.
2.4.1 Price Elasticity of Demand

u
Price elasticity of demand is generally defined as the responsiveness or sensitiveness

. Ho
of demand for a commodity to the changes in its price. More precisely, elasticity of
demand is the percentage change in demand as a result of one per cent change in the
price of the commodity. A formal definition of price elasticity of demand (ep) is given as
Percentage change in quantity demanded

td g
ep =
Percentage change in price
. L in
A general formula2 for calculating coefficient of price elasticity, derived from this
definition of elasticity, is given as follows:
vt sh
Q P Q P
ep =   
Q P Q P
P li

Q P
=  …(2.1)
P Q
ub

where Q = original quantity demanded, P = original price, Q = change in quantity


demanded and P = change in price.
P

It is important to note here that a minus sign (–) is generally inserted in the formula
before the fraction in order to make the elasticity coefficient a non-negative value.3
s

The elasticity can be measured between any two points on a demand curve (called
arc elasticity) or at a point (called point elasticity).
a

Arc Elasticity
ik

The measure of elasticity of demand between any two finite points on a demand curve
is known as arc elasticity. For example, measure of elasticity between points J and K
V

(Fig. 2.3) is the measure of arc elasticity. The movement from point J to K on the
demand curve (Dx) shows a fall in the price from Rs. 20 to Rs. 10 so that
P = 20 – 10 = 10. The fall in price causes an increase in demand from 43 units to 75
units so that Q = 43 – 75 = – 32. The elasticity between points J and K (moving from
J to K) can be calculated by substituting these values into the elasticity formula as
follows:
Q P
ep = –  (with minus sign)
P Q
Self-Instructional
Material 47
Analysis of Demand
32 20
=   1.49 ...(2.2)
10 43

This means that a one per cent decrease in price of commodity X results in a 1.49
NOTES per cent increase in demand for it.
Problem in Using Arc Elasticity: The arc elasticity should be measured and used
carefully, otherwise it may lead to wrong decisions. Arc elasticity co-efficients differ
between the same two finite points on a demand curve if direction of change in price is
reversed. For instance, as estimated in Eq. (2.2), the elasticity between points J and K—

se
moving from J to K equals 1.49. It may be wrongly interpreted that the elasticity of
demand for commodity X between points J and K equals 1.49 irrespective of the direction
of price change. But it is not true. A reverse movement in the price, i.e., the movement
from point K to J implies a different elasticity co-efficient (0.43). Movement from point

u
K to J gives P = 10, P = 10 – 20 = –10, Q = 75 and Q = 75 – 43 = 32. By substituting

. Ho
these values into the elasticity formula, we get

td g
. L in
vt sh
P li

Fig. 2.3 Linear Demand Curve


ub

32 10
ep = – . = 0.43 ...(2.3)
10 75
P

The measure of elasticity co-efficient in Eq. (2.3) for the reverse movement in
price is obviously different from one given by Eq. (2.2). It means that the elasticity
s

depends also on the direction of change in price. Therefore, while measuring price
elasticity, the direction of price change should be carefully noted.
a

Some Modifications: Some modifications have been suggested in economic literature


ik

to resolve the problems associated with arc elasticity.


First, the problem arising due to the change in the direction of price change may be
V

avoided by using the lower values of P and Q in the elasticity formula, so that
Q Pl
ep = – .
P Ql

where Pl = 10 (the lower of the two prices) and Ql = 43 (the lower of the two quantities).
Thus,
32 10
ep = – . = 0.74 ...(2.4)
10 43
Self-Instructional
48 Material
This method is however devoid of the logic of calculating percentage change Analysis of Demand
because the choice of lower values of P and Q is arbitrary—it is not in accordance with
the rule of calculating percentage change.
Second, another method suggested to resolve this problem is to use the average
of upper and lower values of P and Q in fraction P/Q. In that case the formula is NOTES

Q ( P1  P2 ) / 2
ep = – 
P (Q1  Q2 ) / 2

Q1  Q2 ( P1  P2 ) 2

se
or ep = – . …(2.5)
P1  P2 (Q1  Q2 ) 2

where subscripts 1 and 2 denote lower and upper values of prices and quantitites.

u
Substituting the values from our example, we get,

. Ho
43  75 (20  10) 2
ep = – . = 0.81
20  10 (43  75) 2

This method too has its own drawbacks as the elasticity co-efficient calculated
through this formula refers to the elasticity mid-way between P1 P2 and Q1 Q2. The

td g
elasticity co-efficient (0.81) is not applicable for the whole range of price-quantity
. L in
combinations at different points between J and K on the demand curve (Fig. 2.4)—it
only gives a mean of the elasticities between the two points.
vt sh
Point Elasticity
Point elasticity on a linear demand curve. Point elasticity is also a way to resolve the
problem in measuring the elasticity. The concept of point elasticity is used for measuring
P li

price elasticity where change in price is infinitesimally small.


ub

Point elasticity is the elasticity of demand at a finite point on a demand curve,


e.g., at point P or B on the linear demand curve MN in Fig. 2.4. This is in contrast to the
arc elasticity between points P and B. A movement from point B towards P implies
change in price (P) becoming smaller and smaller, such that point P is almost reached.
P

Here the change in price is infinitesimally small. Measuring elasticity for an infinitesimally
small change in price is the same as measuring elasticity at a point. The formula for
measuring point elasticity is given below.
a s
ik
V

Fig. 2.4 Point Elasticity


Self-Instructional
Material 49
Analysis of Demand

P Q
Point elasticity (ep) = Q  P ...(2.6)
NOTES
Q Q
Note that has been substituted for in the formula for arc elasticity. The
P P

Q
derivative is reciprocal of the slope of the demand curve MN. Point elasticity is
P

se
thus the product of price-quantity ratio at a particular point on the demand curve and the
reciprocal of the slope of the demand line. The reciprocal of the slope of the straight line
MN at point P is geometrically given by QN/PQ. Therefore,

u
Q QN
=

. Ho
P PQ

Note that at point P, price P = PQ and Q = OQ. By substituting these values in Eq.
(2.6), we get

td g
PQ QN QN
. L in ep =  
OQ PQ OQ

Given the numerical values for QN and OQ, elasticity at point P can be easily
vt sh
obtained. We may compare here the arc elasticity between points J and K and point
elasticity at point J in Fig. 2.3. At point J,
QN 108  43
P li

ep = = = 1.51
OQ 43
ub

Note that ep = 1.51 is different from various measures of arc elasticities


(i.e., ep = 1.49, ep = 0.43, ep = 0.7, and ep = 0.81).
As we will see below, geometrically, QN/OQ = PN/PM. Therefore, elasticity of
P

demand at point P (Fig. 2.4) may be expressed as


PN
s

ep =
PM
a

Proof. The fact that ep = PN/PM can be proved as follows. Note that in Fig.
8.8, there are three triangles— MON, MRP and PQN—and MON, MRP and
ik

PQN are right angles. Therefore, the other corresponding angles of the three triangles
will always be equal and hence, MON, MRP and PQN are similar.
V

According to geometrical properties of similar triangles, the ratio of any two sides
of a triangles are always equal to the ratio of the corresponding sides of the other
triangles. By this rule, between PQN and MRP,
QN RP
=
PN PM

Self-Instructional
50 Material
Since RP = OQ, by substituting OQ for RP in the above equation, we get Analysis of Demand

QN OQ
=
PN PM
NOTES
QN PN
It follows that =
OQ PM

It means that price elasticity of demand at point P (Fig. 2.4) is given by


PN

se
ep =
PM

It may thus be concluded that the price elasticity of demand at any point on a

u
linear demand curve is equal to the ratio of lower segment to the upper segments of the
line, i.e.,

. Ho
td g
. L in
vt sh
P li
ub

Fig. 2.5 Non-linear Demand Curve


P

Lower segment
ep =
Upper segment
s

Point elasticity on a non-linear demand curve. The ratio Q/ P in respect of


a

a non-linear demand curve is different at each point. Therefore, the method used to
measure point elasticity on a linear demand curve cannot be applied straightaway. A
ik

simple modification in technique is required. In order to measure point elasticity on a


non-linear demand curve, the chosen point is first brought on a linear demand curve.
V

This is done by drawing a tangent through the chosen point. For example, suppose we
want to measure elasticity on a non-linear demand curve, DD (Fig. 2.5) at point P. For
this purpose, a tangent MN is drawn through point P. Since demand curve DD and the
line MN pass through the same point (P), the slope of the demand curve and that of the
line at this point is the same. Therefore, the elasticity of demand curve at point P will be
equal to that of the line at this point. Elasticity of the line at point P can be measured as

Self-Instructional
Material 51
Analysis of Demand

NOTES

u se
Fig. 2.6 Point Elasticities of Demand

. Ho
P P PQ QN QN
ep =  =  
Q P OQ PQ OQ

QN PN

td g
As proved above, geometrically, =
OQ PM
. L in To conclude, at midpoint of a linear demand curve, ep = 1. Note that in Fig. 2.6,
point P falls on the mid point of demand curve MN. At point, P, therefore, e = 1. It
vt sh
follows that at any point above the point P, ep > 1, and at any point below the point P, ep
< 1. According to this formula, at the extreme point N, ep = 0, and at extreme point M, ep
is undefined because division by zero is undefined. It must be noted here that these
results are relevant between points M and N.
P li
ub

2.4.2 Measuring Price Elasticity from a Demand Function


The price elasticity of demand for a product can be measured directly from the demand
function. In this section, we will describe the method of measuring price elasticity of
P

demand for a product from the demand function—both linear and non-linear. It may be
noted here that if a demand function is given, arc elasticity can be measured simply by
assuming two prices and working out P and Q. We will, therefore, confine ourselves
s

here to point elasticity of demand with respect to price.


a

Price Elasticity from a Linear Demand Function


ik

Suppose that a linear demand function is given as


Q = 100 – 5P
V

Given the demand function, point elasticity can be measured for any price. For
example, suppose we want to measure elasticity at P = 10. We know that
Q P
ep = 
P Q

The term Q/P in the elasticity formula is the slope of the demand curve. The
slope of the demand curve can be found by differentiating the demand function. That is,

Self-Instructional
52 Material
Analysis of Demand
Q  (100  5 P )
=  5
P P

Having obtained the slope of the demand curve as Q / P = – 5, ep at P = 10 can


be calculated as follows. Since, P = 10, Q = 100 – 5(10) = 50. By substituting these NOTES
values into the elasticity formula, we get,
10
ep = (– 5) = –1
50

se
Similarly, at P = 8, Q = 100 – 5(8) = 60 and
ep = – 5 (8/60) = – 40/60 = – 0.67
And at P = 15, Q = 100 – 5(15) = 25, and

u
ep = – 5(15/25) = – 75/25 = – 3

. Ho
Price Elasticity from a Non-linear Demand Function
Suppose a non-linear demand function of multiplicative form is given as follows.
Q = aP–b

td g
. L in
and we want to compute the price elasticity of demand. The formula for computing the
price elasticity is the same, i.e.,
vt sh
Q P
ep =  …(2.7)
P Q

What we need to compute the price-elasticity coefficient is to find first the value
P li

of the first term, Q/ P, i.e., the slope of the demand curve. The slope can be obtained
ub

by differentiating the demand function, Thus,


Q
= – baP–b-1 …(2.8)
P
P

By substituting Eq. (2.8) in Eq. (2.7), ep can be expressed as

P
s

e p = – baP–b–1  
Q
a

 baP  b
ik

= …(2.9)
Q
V

Since Q = aP – b, by substitution, we get


 baP  b
ep = = –b …(2.10)
aP  b

Equation (2.10) shows that when a demand function is of a multiplicative or power


form, price elasticity coefficient equals the power of the variable P. This means that
price elasticity in the case of a multiplicative demand function remains constant all along
the demand curve regardless of a change in price.

Self-Instructional
Material 53
Analysis of Demand 2.4.3 Price Elasticity and Total Revenue
A firm aiming at enhancing its total revenue would like to know whether increasing or
decreasing the price would achieve its goal. The price-elasticity coefficient of demand
NOTES for its product at different levels of its price provides the answer to this question. The
simple answer is that if ep > 1, then decreasing the price will increase the total revenue
and if eq < 1, then increasing the price will increase the total revenue. To prove this point,
we need to know the total revenue (TR) and the marginal revenue (MR) functions and
measures of price-elasticity are required. Since TR = Q.P, we need to know P and Q.
This information can be obtained through the demand function. Let us recall our demand

se
function given as
Q = 100 – 5P

u
Price function (P) can be derived from the demand function as

. Ho
P = 20 – 0.2Q …(2.11)
Given the price function, TR can be obtained as
TR = P . Q = (20 – 0.2Q)Q = 20Q – 0.2Q2
From this TR-function, the MR-function can be derived as

td g
. L in TR
MR = = 20 – 0.4Q
Q
The TR-function is graphed in panel (a) and the demand and MR functions are
vt sh
presented in panel (b) of Fig. 2.7. As the figure shows, at point P on the demand curve,
e = 1 where output, Q = 50. Below point P, e < 1 and above point P, e > 1. It can be seen
in panel (a) of Fig. 2.7 that TR increases so long as e > 1; TR reaches its maximum level
P li

where e = 1; and it decreases when e < 1.


ub
P
a s
ik
V

Self-Instructional Fig. 2.7 Price Elasticity and Total Revenue


54 Material
The relationship between price-elasticity and TR is summed up in Table 2.1. As the Analysis of Demand
table shows, when demand is perfectly inelastic (i.e., ep = 0 as is the case of a vertical
demand line) there is no decrease in quantity demanded when price is raised and vice
versa. Therefore, a rise in price increases the total revenue and vice versa.
In case of an inelastic demand (i.e., ep < 1), quantity demanded increases by NOTES
less than the proportionate decrease in price and hence the total revenue falls when
price falls. The total revenue increases when price increases because quantity demanded
decreases by less than the proportionate increase in price.
If demand for a product is unit elastic (ep = 1) quantity demanded increases (or

se
decreases) in the proportion of decrease (or increase) in the price. Therefore, total
revenue remains unaffected.
If demand for a commodity has ep > 1, change in quantity demanded is greater

u
than the proportionate change in price. Therefore, the total revenue increases when
price falls and vice versa.

. Ho
The case of infinitely elastic demand represented by a horizontal straight line is
rare. Such a demand line implies that a consumer has the opportunity to buy any quantity
of a commodity and the seller can sell any quantity of a commodity, at a given price. It is
the case of a commodity being bought and sold in a perfectly competitive market. A
seller, therefore, cannot charge a higher or a lower price.

td g
. L in
Table 2.1 Elasticity, Price-change and Change in TR

Elasticity Change in Change in


vt sh
Co-efficient Price TR
e=0 Increase Increase
Decrease Decrease
P li

e<1 Increase Increase


ub

Decrease Decrease
e=1 Increase No change
Decrease No change
P

e>1 Increase Decrease


Decrease Increase
e= Increase Decrease to zero
s

Decrease Infinite increase*


a

*
Subject to the size of the market.
ik

2.4.4 Price Elasticity and Marginal Revenue


The relationship between price-elasticity and the total revenue (TR) can be known more
V

precisely by finding the relationship between price-elasticity and marginal revenue (MR).
MR is the first derivative of TR-function and TR = P.Q (where P = price, and Q =
quantity sold). The relationship between price-elasticity, MR and TR is shown below.
Since TR = P.Q,
 ( P  Q) P
MR =  PQ
Q Q

 Q P 
= P 1    …(2.12)
 P Q  Self-Instructional
Material 55
Analysis of Demand
Q P
Note that  in Eq. (2.12) is the reciprocal of elasticity. That is,
P Q

Q P 1
NOTES  =–
P Q ep

1 Q P
By substituting – for  in Eq. (2.12), we get
e P Q

se
 1 
MR = P 1   …(2.13)
 ep 

u
Given this relationship between MR and price-elasticity of demand, the decision-

. Ho
makers can easily know whether it is beneficial to change the price. If e = 1,
MR = 0. Therefore, change in price will not cause any change in TR. If e < 1, MR < 0,
TR decreases when price decreases and TR increases when price increases. And, if e >
1, MR > 0, TR increases if price decreases and vice versa.
Price Elasticity, AR and MR Given the Eq. (2.13), the formula for price elasticity

td g
(ep) can be expressed in terms of AR and MR. We know that P = AR. So Eq. (2.13) can
. L in
be written as

 1 
MR = AR 1  
vt sh
ep
 

AR
P li

MR = AR –
ep
ub

By rearranging the terms, we get


AR
MR – AR = –
P

ep

MR  AR 1

s

or AR ep
a

The reciprocal of this equation gives the measure of the price elasticity (ep) of
ik

demand which can be expressed as


AR AR
= – ep or ep =
V

MR  AR AR  MR

2.4.5 Determinants of Price Elasticity of Demand


We have noted above that price-elasticity of a product may vary between zero and
infinity. However, price-elasticity of demand, at a given price, varies from product to
product depending on the following factors.
1. Availability of Substitutes. One of the most important determinants of elasticity of
demand for a commodity is the availability of its close substitutes. The higher the degree
Self-Instructional
56 Material
of closeness of the substitutes, the greater the elasticity of demand for the commodity. Analysis of Demand
For instance, coffee and tea may be considered as close substitutes for one another. If
price of one of these goods increases, the other commodity becomes relatively cheaper.
Therefore, consumers buy more of the relatively cheaper good and less of the costlier
one, all other things remaining the same. The elasticity of demand for both these goods NOTES
will be higher. Besides, the wider the range of the substitutes, the greater the elasticity.
For instance, soaps, toothpastes, cigarettes, etc., are available in different brands, each
brand being a close substitute for the other. Therefore, the price-elasticity of demand for
each brand is much greater than that for the generic commodity. On the other hand,
sugar and salt do not have close substitutes and hence their price-elasticity is lower.

se
2. Nature of Commodity. The nature of a commodity also affects the price-elasticity
of its demand. Commodities can be grouped as luxuries, comforts and necessities. Demand

u
for luxury goods (e.g., high-price refrigerators, TV sets, cars, decoration items, etc.) is
more elastic than the demand for necessities and comforts because consumption of

. Ho
luxury goods can be dispensed with or postponed when their prices rise. On the other
hand, consumption of necessary goods, (e.g., sugar, clothes, vegetables) cannot be
postponed and hence their demand is inelastic. Comforts have more elastic demand than
necessities and less elastic than luxuries. Commodities are also categorized as durable
goods and perishable or non-durable goods. Demand for durable goods is more elastic

td g
than that for non-durable goods, because when the price of the former increases, people
either get the old one repaired instead of replacing it or buy a ‘second hand’.
. L in
3. Weightage in the Total Consumption. Another factor that influences the elasticity
vt sh
of demand is the proportion of income which consumers spend on a particular commodity.
If proportion of income spent on a commodity is large, its demand will be more elastic.
On the contrary, if the proportion of income spent on a commodity is small, its demand is
less price-elastic. Classic examples of such commodities are salt, matches, books, pens,
P li

toothpastes, etc. These goods claim a very small proportion of income. Demand for
ub

these goods is generally inelastic because increase in the price of such goods does not
substantially affect the consumer’s budget. Therefore, people continue to purchase almost
the same quantity even when their prices increase.
P

4. Time Factor in Adjustment of Consumption Pattern. Price-elasticity of demand


depends also on the time consumers need to adjust their consumption pattern to a
new price: the longer the time available, the greater the price-elasticity. The reason is
s

that over a period of time, consumers are able to adjust their expenditure pattern to price
changes. For instance, if the price of TV sets is decreased, demand will not increase
a

immediately unless people possess excess purchasing power. But over time, people may
ik

be able to adjust their expenditure pattern so that they can buy a TV set at a lower (new)
price. Consider another example. If price of petrol is reduced, the demand for petrol
does not increase immediately and significantly. Over time, however, people get incentive
V

from low petrol prices to buy automobiles resulting in a significant rise in demand for
petrol.
5. Range of Commodity Use. The range of uses of a commodity also influences
the price-elasticity of its demand. The wider the range of the uses of a product, the
higher the elasticity of demand for the decrease in price. As the price of a multi-use
commodity decreases, people extend their consumption to its other uses. Therefore, the
demand for such a commodity generally increases more than the proportionate increase
in its price. For instance, milk can be taken as it is and in the form of curd, cheese, ghee
Self-Instructional
Material 57
Analysis of Demand and butter-milk. The demand for milk will therefore be highly elastic for decrease in
price. Similarly, electricity can be used for lighting, cooking, heating and for industrial
purposes. Therefore, demand for electricity has a greater elasticity. However, for the
increase in price, such commodities have a lower price-elasticity because the consumption
NOTES of a normal good cannot be cut down substantially beyond a point when the price of the
commodity increases.
6. Proportion of Market Supplied. The elasticity of market demand also depends on
the proportion of the market supplied at the ruling price. If less than half of the
market is supplied at the ruling price, price-elasticity of demand will be higher than 1 and

se
if more than half of the market is supplied, e < 1.
2.4.6 Cross-Elasticity of Demand

u
The cross-elasticity is the measure of responsiveness of demand for a commodity to the
changes in the price of its substitutes and complementary goods. For instance, cross-

. Ho
elasticity of demand for tea is the percentage change in its quantity demanded with
respect to the change in the price of its substitute, coffee. The formula for measuring
cross-elasticity of demand for tea (et, c) and the same for coffee (ec, t) is given below.
Percentage change in demand for tea (Qt )

td g
et,c=
Percentage change in price of coffee ( Pc )
. L in =
Pc Qt
. …(2.14)
Qt Pc
vt sh
Pt Qc
and ec, t = . …(2.15)
Qc Pt
P li

The same formula is used to measure the cross-elasticity of demand for a good
ub

with respect to a change in the price of its complementary goods. Electricity to electrical
gadgets, petrol to automobiles, butter to bread, sugar and milk to tea and coffee, are the
examples of complementary goods.
P

It is important to note that when two goods are substitutes for one another, their
demand has positive cross-elasticity because increase in the price of one increases the
demand for the other. And, the demand for complementary goods has negative cross-
s

elasticity, because increase in the price of a good decreases the demand for its
complementary goods.
a

Uses of Cross-Elasticity
ik

An important use of cross-elasticity is to define substitute goods. If cross-elasticity


between any two goods is positive, the two goods may be considered as substitutes of
V

one another. Also, the greater the cross-elasticity, the closer the substitute. Similarly, if
cross-elasticity of demand for two related goods is negative, the two may be considered
as complementary of one another: the higher the negative cross-elasticity, the higher the
degree of complementarity.
The concept of cross-elasticity is of vital importance in changing prices of products
having substitutes and complementary goods. If cross-elasticity in response to the price
of substitutes is greater than one, it would be inadvisable to increase the price; rather,
reducing the price may prove beneficial. In case of complementary goods also, reducing
Self-Instructional
58 Material
the price may be helpful in maintaining the demand in case the price of the complementary Analysis of Demand
good is rising. Besides, if accurate measures of cross-elasticities are available, the firm
can forecast the demand for its product and can adopt necessary safeguards against
fluctuating prices of substitutes and complements.
NOTES
2.4.7 Income-Elasticity of Demand
Apart from the price of a product and its substitutes, consumer’s income is another
basic determinant of demand for a product. As noted earlier, the relationship between
quantity demanded and income is of positive nature, unlike the negative price-demand

se
relationship. The demand for most goods and services increases with increase in
consumer’s income and vice versa. The responsiveness of demand to the changes in
income is known as income-elasticity of demand.

u
Income-elasticity of demand for a product, say X, (i.e., ey) may be defined as:

. Ho
X q
Xq Y X q
ey =   …(2.16)
Y X q Y
Y

td g
(where Xq = quantity of X demanded; Y = disposable income; Xq = change in quantity
of X demanded; and Y = change in income)
. L in
Obviously, the formula for measuring income-elasticity of demand is the same as
that for measuring the price-elasticity. The only change in the formula is that the variable
vt sh
‘income’ (Y) is substituted for the variable ‘price’ (P). Here, income refers to the disposable
income, i.e., income net of taxes. All other formulae for measuring price-elasticities may
by adopted to measure the income-elasticities, keeping in mind the difference between
P li

them and the purpose of measuring income-elasticity.


ub

To estimate income-elasticity, suppose, for example, government announces a 10


per cent dearness allowance to its employees. As a result average monthly salary of
government employees increases from `20,000 to `22,000. Following the pay-hike,
monthly petrol consumption of government employees increases from 150 litre per month
P

to 165 litre. The income-elasticity of petrol consumption can now be worked out as
follows. In this case, Y = `22,000 – `20,000 = `2,000, and Q (oil demand) = 165 litre
s

– 150 litre = 15 litre. By substituting those values in Eq. (2.16), we get


a

20, 000 15
ey =  1
150 2, 000
ik

It means that income elasticity of petrol consumption by government employees


equals 1. It means that a one per cent increase in income results in a one per cent
V

increase in petrol consumption.


Unlike price-elasticity of demand, which is always negative,4 income-elasticity of
demand is always positive5 because of a positive relationship between income and quantity
demanded of a product. But there is an exception to this rule. Income-elasticity of
demand for an inferior good is negative, because of the inverse substitution effect. The
demand for inferior goods decreases with increase in consumer’s income. The reason is
that when income increases, consumers switch over to the consumption of superior
substitutes, i.e., they substitute superior goods for inferior ones. For instance, when
Self-Instructional
Material 59
Analysis of Demand income rises, people prefer to buy more of rice and wheat and less of inferior foodgrains;
non-vegetarians buy more of meat and less of potato, and travellers travel more by plane
and less by train.

NOTES Nature of Commodity and Income-Elasticity


For all normal goods, income-elasticity is positive though the degree of elasticity varies
in accordance with the nature of commodities. Consumer goods of the three categories,
viz., necessities, comforts and luxuries have different elasticities. The general pattern of
income-elasticities of different goods for increase in income and their effect on sales

se
are given in Table 2.2.

Table 2.2. Income-Elasticities

u
Consumer goods Co-efficient of Effect on sales

. Ho
income-elasticity with change
in income

1. Essential goods Less than one (ey < 1) Less than proportionate
change in sale

td g
2. Comforts Almost equal to unity Almost proportionate
. L in (ey  1) change in sale
3. Luxuries Greater than unity More than proportionate
(ey > 1) increase in sale
vt sh

Income-elasticity of demand for different categories of goods may, however, vary


from household to household and from time to time, depending on the choice and
P li

preference of the consumers, levels of consumption and income, and their susceptibility
ub

to ‘demonstration effect’. The other factor which may cause deviation from the general
pattern of income-elasticities is the frequency of increase in income. If frequency of rise
in income is high, income-elasticities will conform to the general pattern.
P

Uses of Income-Elasticity in Business Decisions


While price and cross elasticities of demand are of greater significance in the pricing of
s

a product aimed at maximizing the total revenue in the short run, income-elasticity of a
product is of a greater significance in production planning and management in the long
a

run, particularly during the period of a business cycle. The concept of income-elasticity
can be used in estimating future demand provided that the rate of increase in income and
ik

income-elasticity of demand for the products are known. The knowledge of income
elasticity can thus be useful in forecasting demand, when a change in personal incomes
V

is expected, other things remaining the same. It also helps in avoiding over-production or
under-production.
In forecasting demand, however, only the relevant concept of income and data
should be used. It is generally believed that the demand for goods and services increases
with increase in GNP, depending on the marginal propensity to consume. This may be
true in the context of aggregate national demand, but not necessarily for a particular
product. It is quite likely that increase in GNP flows to a section of consumers who do
not consume the product in which a businessman is interested. For instance, if the major
proportion of incremental GNP goes to those who can afford a car, the growth rate in
Self-Instructional
60 Material
GNP should not be used to calculate income-elasticity of demand for bicycles. Therefore, Analysis of Demand
the income of only a relevant class or income-group should be used. Similarly, where the
product is of a regional nature, or if there is a regional division of market between the
producers, the income of only the relevant region should be used in forecasting the
demand. NOTES
The concept of income-elasticity may also be used to define the ‘normal’ and
‘inferior’ goods. The goods whose income-elasticity is positive for all levels of income
are termed ‘normal goods’. On the other hand, goods whose income-elasticities are
negative beyond a certain level of income are termed ‘inferior goods’.

se
2.4.8 Advertisement or Promotional Elasticity of Sales
The expenditure on advertisement and on other sales-promotion activities does help in

u
promoting sales, but not in the same degree at all levels of the total sales and total ad-
expenditure. The concept of advertisement elasticity is useful in determining the optimum

. Ho
level of advertisement expenditure. The concept of advertisement elasticity assumes a
greater significance in deciding on advertisement expenditure, particularly when the
government imposes restriction on advertisement cost or there is competitive advertising
by the rival firms. Advertisement elasticity (eA) of sales may be defined as

td g
S/S S A
eA =   …(2.17)
. L in A/A A S

where S = sales; S = increase in sales; A = initial advertisement cost, and


vt sh
A = additional expenditure on advertisement.
Suppose, for example, a company increases its advertising expenditure from
Rs. 10 million to Rs. 20 million, and as a result, its sales increase from 50,000 units to
P li

60,000 units. In this case A = 20 million – 10 million = Rs. 10 million, and S = 60,000
ub

– 50,000 = 1000 units. By substituting these values in ad-elasticity formula (2.17), we get

10, 000 10
eA =   0.2
P

10 50, 000

It means that a one per cent increase in ad-expenditure results in only


s

0.2 per cent increase in sales.


a

Interpretation of Advertisement Elasticity The advertisement elasticity of sales


varies between eA = 0 and eA = . Interpretation of some measures of advertising
ik

elasticity is given below.


V

Elasticities Interpretation
eA = 0 Sales do not respond to the advertisement expenditure.
eA > 0 but < 1 Increase in total sales is less than proportionate to the increase
in advertisement expenditure.
eA = 1 Sales increase in proportion to the increase in expenditure on
advertisement.
eA > Sales increase at a higher rate than the rate of increase of
advertisement expenditure.

Self-Instructional
Material 61
Analysis of Demand Determinants of Advertisement Elasticity
Some important factors that determine ad-elasticity are the following.
(i) The level of total sales. In the initial stages of sale of a product, particularly of one
NOTES which is newly introduced in the market, advertisement elasticity is greater than unity.
As sales increase, ad-elasticity decreases. For instance, after the potential market is
supplied, the function of advertisement is to create additional demand by attracting more
consumers to the product, particularly those who are slow in adjusting their consumption
expenditure to provide for new commodities. Therefore, demand increases at a rate
lower than the rate of increase in advertisement expenditure.

se
(ii) Advertisement by rival firms. In a highly competitive market, the effectiveness
of advertisement by a firm is also determined by the relative effectiveness of advertisement

u
by the rival firms. Simultaneous advertisement by the rival firms reduces sales of sales
by a firm.

. Ho
(iii) Cumulative effect of past advertisement. In case expenditure incurred on
advertisement in the initial stages is not adequate enough to be effective, elasticity may
be very low. But over time, additional doses of advertisement expenditure may have a
cumulative effect on the promotion of sales and advertising elasticity may increase

td g
considerably.
(iv) Other factors. Advertisement elasticity is affected also by other factors affecting
. L in
the demand for a product, e.g., change in products’ price, consumers’ income and growth
of substitutes and their prices.
vt sh
2.4.9 Elasticity of Price Expectations
Sometimes, mainly during the period of price fluctuations, consumer’s price expectations
P li

play a much more important role than any other factor in determining the demand for a
commodity. The concept of price-expectation-elasticity was devised and popularized by
ub

J.R. Hicks in 1939. The price-expectation-elasticity refers to the expected change in


future price as a result of change in current prices of a product. The elasticity of price-
expectation is defined and measured by the formula given below.
P

Pf / Pf Pf Pc
ex =   …(2.18)
Pc / Pc Pc Pf
s

where Pc and Pf are current and future prices respectively.


a

The coefficient ex gives the measure of expected percentage change in future


ik

price as a result of 1 per cent change in present price. If ex > 1, it indicates that future
Check Your Progress change in price will be greater than the present change in price, and vice versa.
V

4. Why is the concept If ex = 1, it indicates that the future change in price will be proportionately equal to the
of elasticity of change in the current price.
demand important?
5. What is point The concept of elasticity of price-expectation is very useful in formulating future
elasticity of pricing policy. For example, if ex > 1, it indicates that sellers will be able to sell more in
demand? the future at higher prices. Thus, businessmen may accordingly determine their future
6. What are the uses pricing policy.
of income-elasticity
in business
decisions?

Self-Instructional
62 Material
Analysis of Demand
2.5 DEMAND FORECASTING
In two preceding chapters, we have dealt with consumer’s decision-making behaviour—
how consumers decide what quantity of a commodity to consume; how they allocate the NOTES
total consumption expenditure on various goods and services; how collective decisions
of consumers reflect in market demand; and how total demand responds to change in its
determinants. The theory of demand discussed so far deals with current demand whereas
a major concern of businessmen, especially the big one, is ‘what would be the future
demand for their product?’ This question arises because the knowledge about future

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demand for the firm’s product helps it a great deal in forward planning of production,
acquiring inputs (man, material and capital), managing finances and chalking out future
pricing strategy, etc. For this purpose, businessmen make their own estimates or even a

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‘guesstimate’ of the future demand for their product or take the help of specialized
consultants or market research agencies to get the demand for their product forecast.

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There are a variety of methods used for demand forecasting, that are used depending on
the purpose and perspective of forecasting. In this section, we discuss the methods of
estimating future demand, i.e., methods of demand forecasting. Let us first look at the
need for demand forecasting in some detail.

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2.5.1 Why Demand Forecasting
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The business world is characterized by risk and uncertainty and, therefore, most business
decisions are made under the condition of risk and uncertainty. One way to reduce the
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adverse effects of risk and uncertainty is to acquire knowledge about the future demand
prospects for the product. The information regarding the future demand for the product is
obtained by demand forecasting. Demand forecasting is predicting the future demand
for firm’s product. The knowledge about the future demand for the product helps a great
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deal in the following areas of business decision-making.


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 Planning and scheduling production


 Acquiring inputs (labour, raw material and capital)
 Making provision for finances
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 Formulating pricing strategy


 Planning advertisement
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Demand forecasting assumes greater significance where large-scale production


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is involved. Large-scale production requires a good deal of forward planning as it involves


a long gestation period. The information regarding future demand is also essential for the
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existing firms to be able to avoid under or over-production. Most firms are, in fact, very
often confronted with the question as to what would be the future demand for their
products because they will have to acquire inputs and plan their production accordingly.
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The firms are hence required to estimate the future demand for their products. Otherwise,
their functioning will be shrouded with uncertainty and their objective may be defeated.
This problem may not be of a serious nature for small firms which supply a very
small fraction of the total demand, and whose product caters to the short-term or seasonal
demand or the demand of a routine nature. Their past experience and business skills
may be sufficient for the purpose of planning and production. But, firms working on a
large scale find it extremely difficult to obtain a fairly accurate estimate of future market
demand.6 In some situations, it is very difficult to obtain information needed to make
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Analysis of Demand even short-term demand forecasts and thus it is extremely difficult to make long-term
forecasts. Under such conditions, it is not possible for the firm to determine how changes
in specific demand variables like price, advertisement expenditure, credit terms, prices
of competing products, etc., will affect demand. It is nevertheless indispensable for the
NOTES large firms to have at least an approximate estimate of the demand prospects. For,
demand forecast plays an important role in planning the acquiring of inputs, both men
and material (raw material and capital goods), organizing production, advertising the
product, and organizing sales channels. These functions can hardly be performed
satisfactorily in an atmosphere of uncertainty regarding demand prospects for the product.
The prior knowledge of market-size, therefore, becomes an essential element of decision-

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making by the large-scale firms.
2.5.2 Steps in Demand Forecasting

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The objective of demand forecasting is achieved only when forecast is made systematically

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and scientifically and when it is fairly reliable. The following steps are generally taken to
make systematic demand forecasting.
(i) Specifying the objective. The objective or the purpose of demand forecasting
must be clearly specified. The objective may be specified in terms of (a) short-term or

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long-term demand, (b) the overall demand for a product or for firm’s own product, (c)
the whole or only a segment7 of the market for its product, or (d) firm’s market share.
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The objective of demand forecasting must be determined before the process of forecast
is started. This has to be the first step.
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(ii) Determining the time perspective. Depending on the firm’s objective, demand
may be forecast for a short period, i.e., for the next 2-3 years, or for a long period. In
demand forecasting for a short period – 2-3 years – many of the demand determinants
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can be taken to remain constant or not to change significantly. In the long run, however,
demand determinants may change significantly. Therefore, the time perspective of demand
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forecasting must be specified.


(iii) Making choice of method for demand forecasting. As we will see below, a
number of different demand forecasting methods are available. However, all methods
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are not suitable for all kinds of demand forecasting because the purpose of forecasting,
data requirement of a method, availability of data and time frame of forecasting vary
from method to method. The demand forecaster has therefore to choose a suitable
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method keeping in view his purpose and requirements. The choice of a forecasting
a

method is generally based on the purpose, experience and expertise of the forecaster. It
depends also to a great extent on the availability of required data. The choice of a
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suitable method saves not only time and cost but also ensures the reliability of forecast to
a great extent.
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(iv) Collection of data and data adjustment. Once method of demand forecasting is
decided on, the next step is to collect the required data—primary or secondary or both.
The required data is often not available in the required mode. In that case, data needs to
be adjusted—even massaged, if necessary—with the purpose of building data series
consistent with data requirement. Sometimes the required data has to be generated from
the secondary sources.
(v) Estimation and interpretation of results. As mentioned above, the availability of
data often determines the method, and also the trend equation to be used for demand
forecasting. Once required data is collected and forecasting method is finalized, the final
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64 Material
step in demand forecasting is to make the estimate of demand for the predetermined Analysis of Demand
years or the period. Where estimates appear in the form of an equation, the result must
be interpreted and presented in a usable form.

NOTES
2.6 TECHNIQUES OF DEMAND FORECASTING
The various techniques of demand forecasting are listed in the chart on the next page. In
this section, we have explained the various demand forecasting methods and their
limitations.

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2.6.1 Survey Methods
Survey methods are generally used where the purpose is to make short-run forecast of

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demand. Under this method, consumer surveys are conducted to collect information

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about their intentions and future purchase plans. This method includes:
(i) Survey of potential consumers’ plan
(ii) Opinion poll of experts
Let us now discuss the two methods of survey and look at their limitations.

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(i) Consumer Survey Method—Direct Interviews. The consumer survey method of
demand forecasting involves direct interview of the potential consumers. Consumers
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can be interviewed by any of the following methods, depending on the purpose, time and
cost of survey.
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(a) Complete enumeration, (b) Sample survey, or (c) End-use method.
These consumer survey methods are used under different conditions and for
different purposes. Their advantages and disadvantages are described below.
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The most direct and simple way of assessing future demand for a product is to
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interview the potential consumers or users and to ask them what quantity of the product
under reference they would be willing to buy at different prices over a given period, say,
one year. This method is known as direct interview method. This method may cover
almost all the potential consumers or only selected groups of consumers from different
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cities or parts of the area of consumer concentration. When all the consumers are
interviewed, the method is known as complete enumeration survey or comprehensive
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interview method and when only a few selected representative consumers are
interviewed, it is known as sample survey method. In the case of industrial inputs,
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interviews or postal inquiry of only end-users of a product may be required. Let us now
describe these methods in detail.
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(a) Complete Enumeration Method. In this method, almost all potential users of
the product are contacted and are asked about their future plan of purchasing the product
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in question. The quantities indicated by the consumers are added together to obtain the Check Your Progress
probable demand for the product. For example, if majority of households in a city report
7. How does demand
the quantity (q) they are willing to purchase of a commodity, then total probable demand
forecasting help in
(Dp) may be calculated as business decision-
making?
n
Dp = q1 + q2 + q3 + …+ qn = q
i 1
i
8. Mention the steps
in demand
forecasting.
where q1, q2, q3 etc. denote demand by the individual households 1, 2, 3, etc.
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Material 65
66
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Material
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Analysis of Demand

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Chart: Techniques of Demand Forecasting
This method has certain limitations. It can be used successfully only in case of Analysis of Demand
those products whose consumers are concentrated in a certain region or locality. In case
of a widely dispersed market, this method may not be physically possible or may prove
very costly in terms of both money and time. Besides, the demand forecast through this
method may not be reliable for the following reasons. NOTES
(i) consumers themselves may not know their actual demand in future and hence
may be unable or unwilling to answer the query;
(ii) even if they answer, their answers to hypothetical questions may be hypothetical—
not real;

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(iii) consumers’ response may be biased according to their own expectations about
the market conditions; and
(iv) their plans may change with a change in the factors not included in the

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questionnaire.

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(b) Sample Survey Method. Sample survey method is used when population of the
target market is very large. Under sample survey method, only a sample of potential
consumers or users is selected for interview. Consumers to be surveyed are selected
from the relevant market through a sampling method. Method of survey may be direct
interview or mailed questionnaire to the sample-consumers. On the basis of the information

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obtained, the probable demand may be estimated through the following formula.
. L in Dp =
HR
(H . AD)
HS
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where Dp = probable demand forecast; H = census number of households from the
relevant market; Hs = number of households surveyed or sample households; HR =
number of households reporting demand for the product; AD = average expected
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consumption by the reporting households (= total quantity reported to be consumed by


the reporting households  numbers of households).
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This method is simpler, less costly and less time-consuming compared to the
comprehensive survey method. This method is generally used to estimate short-term
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demand of business firms, government departments and agencies and also of the
households who plan their future purchases. Business firms, government departments
and other such organizations budget their expenditure at least one year in advance. It is,
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therefore, possible for them to supply a fairly reliable estimate of their future purchases.
Even the households making annual or periodic budgets of their expenditure can provide
a

reliable information about their purchases.


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The sample survey method is the most widely used survey method to forecast
demand. This method, however, has some limitations similar to those of complete
enumerations or exhaustive survey method. The forecaster, therefore, should not attribute
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more reliability to the forecast than is warranted. Besides, the sample survey method
can be used to verify the demand forecast made by using quantitative or statistical
methods. Although some authors8 suggest that this method should be used to supplement
the quantitative method for forecasting rather than to replace it, this method can be
gainfully used where the market is localized. Sample survey method can be of greater
use in forecasting where quantification of variables (e.g., feelings, opinion, expectations,
etc.) is not possible and where consumer’s behaviour is subject to frequent changes.

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Material 67
Analysis of Demand (c) The End-Use Method. The end-use method of demand forecasting has a
considerable theoretical and practical value, especially in forecasting demand for inputs.
Making forecasts by this method requires building up a schedule of probable aggregate
future demand for inputs by consuming industries and various other sectors. In this
NOTES method, technological, structural and other changes that might influence the demand,
are taken into account in the very process of estimation. This aspect of the end-use
approach is of particular importance.
Stages in the end-use method. The end-use method of demand forecasting consists
of four distinct stages of estimation.

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In the first stage, it is necessary to identify and list all the possible users of the
product in question. This is, of course, a difficult process, but it is fundamental to this
method of forecasting. Difficulty arises because published data on the end-users is

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rarely available. Despatch records of the manufacturers, even if available, need not
necessarily provide the number of all the final users. Records of the sales pattern by

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individual firms or establishments are difficult to be assembled. In several cases, sales
channel of the products covers such a wide network and there are so many wholesale
and retail agencies in the chain, that it would be virtually impossible to organize and
collect data from all these sources so as to know all the end-uses of the product.

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Where relevant and adequate data is not available, the managers need to have a
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thorough knowledge of the product and its uses. Such knowledge and experience need
to be supplemented by consultations and discussions with manufacturers or their
associations, traders, users, etc. Preparation of an exhaustive list of all possible end-
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users is, in any case, a necessary step. Despite every effort made to trace all the end-
users, it is quite likely that some of the current users of the product are overlooked. In
order to account for such lapses, it may be necessary at the final stage of estimation to
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provide some margin for error. A margin or allowance is also necessary to provide for
possible new applications of the product in the future.
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The second stage of this method involves fixing suitable technical ‘norms’ of
consumption of the product under study. Norms have to be established for each and every
end-use. Norms are usually expressed in physical terms either per unit of production of the
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complete product or in, some cases, per unit of investment or per capita use. Sometimes,
the norms may involve social, moral and ethical values, e.g., in case of consumption of
drugs, alcohol or running a dance bar. But value-based norms should be avoided as far as
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possible because it might be rather difficult to specify later the types and sizes of the
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product in question if value norms are used.


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The establishment of norms is also a difficult process mainly due to lack of data.
For collecting necessary data, the questionnaire method is generally employed. The
preparation of a suitable questionnaire is of vital importance in the end-use method, as
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the entire subsequent analysis has to be based on and conclusions to flow mainly from
the information collected through the questionnaires. Where estimating future demand is
called for in great detail, such as the types and sizes of the concerned product, framing
of the questionnaire requires a good knowledge of all the variations of the product. For
a reliable forecast, it is necessary that response is total; if not, then as high as possible.
Having established the technical norms of consumption for the different industries
and other end-uses of the product, the third stage is the application of the norms. For
this purpose, it is necessary to know the desired or targeted levels of output of the
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68 Material
individual industries for the reference year and also the likely development in other Analysis of Demand
economic activities that use the product and the likely output targets.
The fourth and final stage in the end-use method is to aggregate the product-
wise or use-wise content of the item for which the demand is to be forecast. This NOTES
aggregate result gives the estimate of demand for the product as a whole for the terminal
year in question. By the very nature of the process of estimation described here, it is
obvious that the end-use approach results in what may be termed as a “derived” demand.
Advantages. The end-use method has two exclusive advantages.

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First, it is possible to work out the future demand for an industrial product in
considerable details by types and size. In other methods, the future demand can be
estimated only at the aggregate level. This is because past data are seldom available in

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such details as to provide the types and sizes of the product demanded by the economy.
Hence, projections made by using the past data, either by the trend method, regression

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techniques or by historical analogies produce only aggregate figures for the product in
question. On the other hand, by probing into the present use-pattern of consumption of
the product, the end-use approach provides every opportunity to determine the types,
categories and sizes likely to be demanded in future.

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Second, in forecasting demand by the end-use approach, it is possible to trace
and pinpoint at any time in future as to where and why the actual consumption has
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deviated from the estimated demand. Besides, suitable revisions can also be made from
time to time based on such examination. If projections are based on other methods and
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if actual consumption falls below or rises above the estimated demand, all that one can
say is that the economy has or has not picked up as anticipated. One cannot say exactly
which use of the product has not picked up and why. In the case of end-use method,
however, one can.
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(ii) Opinion Poll Methods. The opinion poll methods aim at collecting opinions of
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those who are supposed to possess knowledge of the market, e.g., sales representatives,
sales executives, professional marketing experts and consultants. The opinion poll methods
include:
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(a) Expert-opinion method


(b) Delphi method
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(c) Market studies and experiments


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(a) Expert-Opinion Method. Firms having a good network of sales representatives


can put them on to the work of assessing the demand for the target product in the areas,
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regions or cities that they represent. Sales representatives, being in close touch with the
consumers or users of goods, are supposed to know the future purchase plans of their
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customers, their reactions to the market changes, their response to the introduction of a
new product, and the demand for competing products. They are, therefore, in a position
to provide at least an approximate, if not accurate, estimate of likely demand for their
firm’s product in their region or area. The estimates of demand thus obtained from
different regions are added up to get the overall probable demand for a product. Firms
not having this facility, gather similar information about the demand for their products
through the professional market experts or consultants, who can predict the future demand
by using their experience and expertise. This method is also known as opinion poll
method.
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Analysis of Demand Limitations Although this method too is simple and inexpensive, it has its own limitations.
First, estimates provided by the sales representatives or professional experts are
reliable only to an extent depending on their skill and expertise to analyze the market and
their experience.
NOTES
Secondly, demand estimates may involve the subjective judgement of the assessor
which may lead to over or under-estimation.
Finally, the assessment of market demand is usually based on inadequate
information available to the sales representatives as they have only a narrow view of the

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market. The factors of wider implication, such as change in GNP, availability of credit,
future prospects of the industry, etc., fall outside their purview.
(b) Delphi Method.9 Delphi method of demand forecasting is an extension of the

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simple expert opinion poll method. This method is used to consolidate the divergent

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expert opinions and to arrive at a compromise estimate of future demand. The process
is simple.
Under the Delphi method, the experts are provided information on estimates of
forecasts of other experts along with the underlying assumptions. The experts may
revise their own estimates in the light of forecasts made by other experts. The consensus

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of experts about the forecasts constitutes the final forecast. It may be noted that the
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empirical studies conducted in the USA have shown that unstructured opinions of the
experts is the most widely used forecast technique. This may appear a bit unusual in as
much as this gives the impression that sophisticated techniques, e.g., simultaneous
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equations model and statistical methods, are not the techniques which are used most
often. However, the unstructured opinions of the experts may conceal the fact that
information used by experts in expressing their forecasts may be based on sophisticated
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techniques. The Delphi technique can be used for cross-checking information on forecasts.
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(c) Market Studies and Experiments. An alternative method of collecting necessary


information regarding current and also future demand for a product is to carry out market
studies and experiments on consumer’s behaviour under actual, though controlled, market
conditions. This method is known in common parlance as market experiment method.
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Under this method, firms first select some areas of the representative markets—three
or four cities having similar features, viz., population, income levels, cultural and social
background, occupational distribution, choices and preferences of consumers. Then,
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they carry out market experiments by changing prices, advertisement expenditure and
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other controllable variables in the demand function under the assumption that other
things remain the same. The controlled variables may be changed over time either
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simultaneously in all the markets or in the selected markets.10 After such changes are
introduced in the market, the consequent changes in the demand over a period of time (a
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week, a fortnight, or a month) are recorded. On the basis of data collected, elasticity
coefficients are computed. These coefficients are then used along with the variables of
the demand function to assess the future demand for the product.
Alternatively, market experiments can be replaced by consumer clinics or
controlled laboratory experiments. Under this method, consumers are given some
money to buy in a stipulated store goods with varying prices, packages, displays, etc.
The experiment reveals the consumers’ responsiveness to the changes made in prices,
packages and displays, etc. Thus, the laboratory experiments also yield the same
information as the market experiments. But the former has an advantage over the latter
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70 Material
Limitations The market experiment methods have certain serious limitations and Analysis of Demand
disadvantages that reduce the usability and reliability of this method.
First, a very important limitation of the experimental methods is that they are very
expensive. Therefore, experimental methods cannot be afforded by small firms. NOTES
Secondly, being a costly affair, experiment are usually carried out on a scale too small to
permit generalization with a high degree of reliability.
Thirdly, experimental methods are based on short-term and controlled conditions which
may not exist in an uncontrolled market. Hence the results may not be applicable to the

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uncontrolled long-term conditions of the market.
Fourthly, changes in socio-economic conditions during the field experiments, such as
local strikes or lay-offs, aggressive advertising by competitors, political changes, natural

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calamities may invalidate the results.
Finally, a big disadvantage of experimental methods is that ‘tinkering with price increases

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may cause a permanent loss of customers to competitive brands that might have been
tried.’11
Despite these limitations, however, the market experiment method is often used
to provide an alternative estimate of demand and also ‘as a check on results obtained

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from statistical studies.’ Besides, this method generates elasticity co-efficients that are
necessary for statistical analysis of demand relationships. For example, an experiment
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of this kind was conducted by Simmons Mattress Company (US). It put on sale two
types of identical mattresses—one with Simmons label and the other with an unknown
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name at the same price and then at different prices for determining the cross-elasticity.
It was found that at the same price, Simmons mattress sold 15 to 1; and at a price higher
by 5 dollars it sold 8 to 1, and at a price higher by 25 per cent, it sold almost 1 to 1.12
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2.6.2 Statistical Methods


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In the foregoing sections, we have described survey and experimental methods of


estimating demand for a product on the basis of information supplied by the consumers
themselves and on-the-spot observation of consumer behaviour. In this section, we will
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explain statistical methods which utilize historical (time-series) and cross-sectional data
for estimating long-term demand. Statistical methods are considered to be superior
techniques of demand estimation for the following reasons.
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(i) In the statistical methods, the element of subjectivity is minimum,


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(ii) Method of estimation is scientific as it is based on the theoretical relationship


between the dependent and independent variables,
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(iii) Estimates are relatively more reliable, and


(iv) Estimation involves smaller cost.
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Three kinds of statistical methods are used for demand projection.


(1) Trend Projection Methods,
(2) Barometric Methods
(3) Econometric Method
These statistical methods are described here briefly.
1. Trend Projection Methods Trend projection method is a ‘classical method’ of
business forecasting. This method is essentially concerned with the study of movement
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Material 71
Analysis of Demand of variables through time. The use of this method requires a long and reliable time-series
data. The trend projection method is used under the assumption that the factors responsible
for the past trends in the variable to be projected (e.g., sales and demand) will continue
to play their part in future in the same manner and to the same extent as they did in the
NOTES past in determining the magnitude and direction of the variable. This assumption may be
quite justified in many cases.
However, since cause - and- effect relationship is not revealed by this method, the
projections made on the trend basis are considered by many as a mechanical or a ‘naïve’
approach. Nevertheless, “There is nothing uncomplimentary in the adoption of such an

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approach. It merely represents one of the several means to obtain an insight of what the
future may possibly be and whether or not the projections made using these means are
to be considered as most appropriate will depend very much on the reliability of past

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data and on the judgement that is to be exercised in the ultimate analysis.”13

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In projecting demand for a product, the trend method is applied to time-series
data on sales. Long standing firms may obtain time-series data on sales from their own
sales department and books of account. New firms can obtain the necessary data from
the older firms belonging to the same industry.

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There are three techniques of trend projection based on time-series data.
. L in (a) Graphical method,
(b) Fitting trend equation or least square method
(c) Box-Jenkins method
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In order to explain these methods, let us suppose that a local bread manufacturing
company wants to assess the demand for its product for the years 2007, 2008 and 2009.
For this purpose, it uses time-series data on its total sales over the past 10 years. Suppose
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its time-series sales data is given as in Table 2.3.


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Table 2.3 Time-Series Data on Sale of Bread

Year 1997 1998 1999 2000 2001 2002 2003 2004 2005
P

2006

Sales of Bread (000 tonnes) 10 12 11 15 18 14 20 18 21


25
s

Let us first use the graphical method and project demand for the year, 2009.
a

(a) Graphical Method. In this method, annual sales data is plotted on a graph paper and a
line is drawn through the plotted points. Then a free hand line is so drawn that the total
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distance between the line and the points is minimum.The dotted line M is drawn through the
mid-values of variations and lineS is a straight trend line. The solid, fluctuating line shows the
actual trend, while the dotted lines show the secular trend. By extending the trend lines
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(marked M and S), we can forecast an approximate sale of 26,200 tonnes in 2009.
Although this method is very simple and least expensive, the projections made
through this method are not very reliable. The reason is that the extension of the trend
line involves subjectivity and personal bias of the analyst. For example, an optimist may
take a short-run view, say since 2004, and extend the trend line beyond point P towards
O, and predict a sale of 30,000 tonnes of bread in 2009. On the other hand, a conservative
analyst may consider the fluctuating nature of sales data and expect the total sale in
2009 to remain the same as in 2006 as indicated by the line PC. One may even predict
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72 Material
a fall in the sale to 25,000 tonnes, if one over-emphasizes the fluctuating nature of sales Analysis of Demand
in one’s judgement. This is indicated by the line PN.
(b) Fitting Trend Equation: Least Square Method. Fitting trend equation is a
formal technique of projecting the trend in demand. Under this method, a trend line (or
curve) is fitted to the time-series sales data with the aid of statistical techniques.14 The NOTES
form of the trend equation that can be fitted to the time-series data is determined either
by plotting the sales data (as shown in Fig. 9.1) or by trying different forms of trend
equations for the best fit.
When plotted, a time-series data may show various trends. We will, however,

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discuss here only the most common types of trend equations, viz., (i) linear, and
(ii) exponential trends.
(i) Linear Trend. When a time-series data reveals a rising trend in sales, then a

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straightline trend equation of the following form is fitted:

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S = a + bT …(2.19)
where S = annual sales, T = time (years), a and b are constants. The parameter b gives
the measure of annual increase in sales.
The co-efficients a and b are estimated by solving the following two equations
based on the principle of least square.

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S = na + bT
. L in ...(i)
ST = aT + bT2 ...(ii)
The terms included in Eqs. (i) and (ii) are calculated using sales data given in
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Table 2.3 and presented in Table 2.4.
By substituting numerical values given in Table 2.4 in Eqs. (i) and (ii), we get
164 = 10 a + 55b …(iii)
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1024 = 55 a + 385b …(iv)


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By solving Eqs. (iii) and (iv), we get the trend equation as


S = 8.26 + 1.48T
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Table 2.4 Estimation of Trend Equation

Year Sales T T2 ST
s

1997 10 1 1 10
a

1998 12 2 4 24
1999 11 3 9 33
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2000 15 4 16 60
2001 18 5 25 90
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2002 14 6 36 84
2003 20 7 49 140
2004 18 8 64 144
2005 21 9 81 189
2006 25 10 100 250

n = 10 S = 164 T = 55 T2 = 385 ST = 1024

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Analysis of Demand Having estimated the trend equation, it is quite easy to project the sales for 2007,
2008 and 2009 i.e., for the 11th, 12th and 13th years, respectively. The calculation procedure
is given below.
2007 S2 = 8.26 + 1.48 (11) = 24,540 tonnes
NOTES
2008 S3 = 8.26 + 1.48 (12) = 26,020 tonnes
2009 S4 = 8.26 + 1.48 (13) = 27,500 tonnes
Treatment of the Abnormal Years Time series data on sales may reveal, more
often than not, abnormal years. An abnormal year is one in which sales are abnormally

se
low or high. Such years create a problem in fitting the trend equation and lead to under
or over-statement of the projected sales. Abnormal years should, therefore, be carefully
analyzed and data be suitably adjusted. The abnormal years may be dealt with (i) by
excluding the year from time-series data, (ii) by adjusting the sales figures of the year to

u
the sales figures of the preceding and succeeding years, or (iii) by using a ‘dummy’

. Ho
variable.
(ii) Exponential Trend. When the total sale (or any dependent variable) has increased
over the past years at an increasing rate or at a constant percentage rate per time unit,
then the appropriate trend equation to be used is an exponential trend equation of any of
the following forms.

td g
(1) If trend equation is given as
. L in Y = aebT …(2.20)
then its semi-logarithmic form is used
vt sh
log Y = log a + bT …(2.21)
This form of trend equation is used when growth rate is constant.
P li

(2) If trend equation takes the following form


Y = aTb
ub

…(2.22)
then its double logarithmic form is used.
log Y = log a + b log T …(2.23)
P

This form of trend equation is used when growth rate is increasing.


(3) Polynomial trend of the form
s

Y = a + bT + cT2 …(2.24)
a

In these equations a, b and c are constants, Y is sales, T is time and e = 2.718.


ik

Once the parameters of the equations are estimated, it becomes quite easy to forecast
demand for the years to come.
The trend method is quite popular in business forecasting because of its simplicity.
V

It is simple to apply because only time-series data on sales are required. The analyst is
supposed to possess only a working knowledge of statistics. Since data requirement of
this method is limited, it is also inexpensive. Besides, the trend method yields fairly
reliable estimates of the future course of demand.
Limitations The first limitation of this method arises out of its assumption that the
past rate of change in the dependent variable will persist in the future too. Therefore, the
forecast based on this method may be considered to be reliable only for the period during
which this assumption holds.
Self-Instructional
74 Material
Second, this method cannot be used for short-term estimates. Also it cannot be Analysis of Demand
used where trend is cyclical with sharp turning points of troughs and peaks.
Third, this method, unlike regression analysis, does not bring out the measure of
relationship between dependent and independent variables. Hence, it does not yield the
necessary information (e.g., price and income elasticities) that can be used for future NOTES
policy formulations. These limitations need to be borne in mind while making the use of
this method.
(c) Box-Jenkins Method. Box-Jenkins method15 of forecasting is used only for
short-term projections and predictions. Besides, this method is suitable for forecasting

se
demand with only stationary time-series sales data. Stationary time-series data is one
that does not reveal a long-term trend. In other words, Box-Jenkins technique can be
used only in those cases in which time-series analysis depicts monthly or seasonal

u
variations recurring with some degree of regularity.
When sales data of various commodities are plotted, many commodities will

. Ho
show a seasonal or temporal variation in sales. For examples, sale of woollen clothes
will show a hump during months of winter in all the years under reference. The sale of
new year greeting cards will be particularly high in the last week of December every
year. Similarly the sale of desert coolers is very high during the summers each year.

td g
This is called seasonal variation. Box-Jenkins technique is used for predicting demand
where time-series sales data reveals this kind of seasonal variation.
. L in
According to the Box-Jenkins approach, any stationary time-series data can be
analyzed by the following three models:
vt sh
(i) Autoregression model,
(ii) Moving average model
(iii) Autoregressive-moving average model
P li

The autoregressive-moving average model is the final form of the Box-Jenkins


ub

model. The three models are, in fact, the three stages of Box-Jenkins method. The
purpose of the three models of Box-Jenkins method is to explain movements in the
stationary series with minimized error term, i.e., the unexplained components of stationary
P

series.
The steps and models of the Box-Jenkins approach are described briefly here
with the purpose of introducing Box-Jenkins method to the reader rather than providing
s

the entire methodology.16


a

Steps in Box-Jenkins Approach. As mentioned above, Box-Jenkins method


can be applied only to stationary time-series data. Therefore, the first step in Box-
ik

Jenkins approach is to eliminate trend from the time series data. Trend is eliminated by
taking first differences of time-series data, i.e., subtracting observed value of one period
V

from the observed value of the preceding year. After trend is elimated, a stationary time-
series is created.
The second step in the Box-Jenkins approach is to make sure that there is
seasonality in the stationary time-series. If a certain pattern is found to repeat over time,
there is seasonality in the stationary time-series.
The final step is to use the models to predict sales in the intended period.
We give here a brief description of the Box-Jenkins models that are used in the
same sequence.
Self-Instructional
Material 75
Analysis of Demand (i) Autoregressive Model. In a general autoregressive model, the behaviour of a variable
in a period is linked to the behaviour of the variable in future periods. The general form
of the autoregressive model is given below.

NOTES Yt = a1 Yt–1 + a2 Yt–2 + …+ an Yt–n + et ...(2.25)

This model states that the value of Y in period t depends on the values of Y in
periods t – 1, t – 2 …t – n. The term et is the random portion of Yt that is not explained
by the model. If estimated value of one or some of the coefficients a1, a2, …an are
different from zero, it reveals seasonality in data. This completes the second step.

se
The model (2.25), however, does not specify the relationship between the value
of Yt and residuals (et ) of previous periods. Box-Jenkins method uses moving average
method to specify the relationship between Yt and et, the values of residuals in previous

u
years. This is the third step. Let us now look at the moving average model of Box-

. Ho
Jenkins method.

(ii) Moving Average Model. The moving average model estimates Yt in relation to
residuals (et) of the previous years. The general form of moving average model is given
below.

td g
Yt = m + b1 et – 1 + b2 et – 2 …+ bp et – p + et ...(2.26)
. L in
where m is the mean of the stationary time-series and et–1, et–2, …et–p are the residuals,
the random components of Y in t – 1, t – 2, …t – p periods.
vt sh
(iii) Autoregressive-Moving Average Model. After moving average model is
estimated, it is combined with autoregressive model to form the final form of the Box-
Jenkins model, called autoregressive-moving average model, given below.
P li

Yt = a1 Yt–1 + a2 Yt–2 + …+ an Yt–n + b1 et–1 + b2 et–2


ub

+ …+ bp et–p + et …(2.27)

Box-Jenkins method of forecasting demand is a sophisticated and complicated


method. This method is, however, impracticable without the aid of computer.
P

Moving Average Method: An Alternative Technique


s

As noted above, the moving average model of Box-Jenkins method is a part of a


complicated technique of forecasting demand in period t on the basis of its past values.
a

There is a simple, rather a naïve, yet useful method of using moving average to forecast
ik

demand. This method assumes that demand in a future year equals the average of
demand in the past years. The formula of simple moving average method is expressed
as
V

1
Dt = (Xt–1 + Xt–2 + …+ Xt–n)
N

where Dt = demand in period t; Xt–1, t–2 …t–n = demand or sales in previous years; N =
number of preceding years.
According to this method, the likely demand for a product in period t equals the
average of demand (sales) in several preceding years. For example, suppose that the
number of refrigerators sold in the past 7 years in a city is given as Table 2.5 and we
Self-Instructional want to forecast demand for refrigerators for the year 2007.
76 Material
Table 2.5 Sale of Refrigerators: 2000-2006 Analysis of Demand

Year 2000 2001 2002 2003 2004 2005 2006


Sales (’000) 11 12 12 13 13 15 15
NOTES
Given this sales data, demand for 2007 will be computed as follows.
1
D2007 = (15 + 15 + 13 + 13 + 12 + 12 + 11) = 13
7
Thus, the demand for refrigerators for 2007 is forecast at 13,000 units. Now

se
suppose that the actual sales of refrigerators in the city in 2007 turns out to be 15,000
refrigerators against the forecast figure of 13,000. Given the actual sales figure for
2007, the demand for 2008 can be forecast as

u
1
D2008 = (15 + 15 + 15 + 13 + 13 + 12 + 12) = 13.57

. Ho
7

Note that, in the moving average method, the sale of 2007 is added and the sale of
2000 (the last of the preceding years) is excluded from the formula. The reason is, that
the demand has to be forecast on the basis of sales in the past 7 years.

td g
The moving average method is simple and can be used to make short-term forecasts.
This method has a serious limitation, which has to be borne in mind while using it. In the
. L in
case of rising trend in sales, this method yields an underestimate of future demand, as
can be seen in the above example. And, in case of declining trend in sales, it may yield an
vt sh
overestimate of future demand. One way of reducing the margin of over and under-
estimation is to take the average of fluctuations and add it to the moving average forecasts.
This method is, in fact, more suitable where sales fluctuate frequently within a limited
P li

range.
2. Barometric Method of Forecasting. The barometric method of forecasting follows
ub

the method meteorologists use in weather forecasting. Meteorologists use the barometer
to forecast weather conditions on the basis of movements of mercury in the barometer.
Following the logic of this method, many economists use economic indicators as a
P

barometer to forecast trends in business activities. This method was first developed and
used in the 1920s by the Harvard Economic Service. It was, however, abandoned as it
had failed to predict the Great Depression of the 1930s.17 The barometric technique was
s

however revived, refined and developed further in the late 1930s by the National Bureau
of Economic Research (NBER) of the US. It has since then been used often to forecast
a

business cycles in the US.18


ik

It may be noted at the outset that the barometric technique was developed to
forecast the general trend in overall economic activities. This method can nevertheless
V

be used to forecast demand prospects for a product, not the actual quantity expected to
be demanded. For example, allotment of land by the Delhi Development Authority (DDA)
to the Group Housing Societies (a lead indicator) indicates higher demand prospects for
building materials—cement, steel, bricks, etc.
The basic approach of barometric technique is to construct an index of relevant
economic indicators and to forecast future trends on the basis of movements in the
index of economic indicators. The indicators used in this method are classified as:

Self-Instructional
Material 77
Analysis of Demand (a) leading indicators
(b) coincidental indicators
(c) lagging indicators
NOTES A time-series of various indicators is prepared to read the future economic trend.
The leading series consists of indicators which move up or down ahead of some other
series. Some examples of leading indicators are: (i) index of net business investment; (ii)
new orders for durable goods; (iii) change in the value of inventories; (iv) index of the
prices of the materials; and (v) corporate profits after tax.

se
The coincidental series, on the other hand, are the ones that move up or down
simultaneously with the level of general economic activities. Some examples of the
coincidental series are: (i) number of employees in the non-agricultural sector; (ii) rate
of unemployment; (iii) gross national product at constant prices; and (iv) sales recorded

u
by the manufacturing, trading and the retail sectors.

. Ho
The lagging series, consist of those indicators that follow a change after some
time-lag. Some of the indices that have been identified as lagging series by the NBER
are: (i) labour cost per unit of manufactured output, (ii) outstanding loans, and
(iii) lending rate for short-term loans.

td g
The various indicators are chosen on the basis of the following criteria:
. L in (i) Economic significance of the indicator: the greater the significance, the
greater the score of the indicator,
(ii) Statistical adequacy of time-series indicators: a higher score is given to an
vt sh
indicator provided with adequate statistics,
(iii) Conformity with overall movement in economic activities,
(iv) Consistency of series to the turning points in overall economic activity,
P li

(v) Immediate availability of the series, and


(vi) Smoothness of the series.
ub

The problem of choice may arise because some of the indicators appear in more
than one class of indicators. Furthermore, it is not advisable to rely on just one of the
indicators. This leads to the usage of what is referred to as the diffusion index. A diffusion
P

index is the percentage of rising indicators. A diffusion index copes up with the problem
of differing signals given by the indicators. In calculating a diffusion index, for a group of
indicators, scores allotted are 1 to rising series, ½ to constant series and zero to falling
s

series. The diffusion index is obtained by the ratio of the number of indicators, in a
a

particular class, moving up or down to the total number of indicators in that group. Thus,
if three out of six indicators in the lagging series are moving up, the index shall be 50 per
ik

cent. It may be noted that the most important one is the diffusion index of the leading
series. However, there are problems of identifying the leading indicator for the variables
under study.
V

Leading indicators can be used as inputs for forecasting aggregate economic


variables, GNP, aggregate consumers’ expenditure, aggregate capital expenditure, etc.
The only advantage of this method is that it overcomes the problem of forecasting the
value of independent variable under the regression method. The major limitations of this
method are: (i) it can be used only for short-term forecasting, and (ii) a leading indicator
of the variable to be forecast is not always easily available.
3. Econometric Methods. The econometric methods combine statistical tools with
economic theories to estimate economic variables and to forecast the intended economic
Self-Instructional
78 Material
variables. The forecasts made through econometric methods are much more reliable Analysis of Demand
than those made through any other method. The econometric methods are, therefore,
most widely used to forecast demand for a product, for a group of products and for the
economy as a whole. We explain here briefly the use of econometric methods for
forecasting demand for a product. NOTES
An econometric model may be a single-equation regression modelor it may consist
of a system of simultaneous equations. Single-equation regression serves the purpose of
demand forecasting in the case of most commodities. But, where explanatory economic
variables are so interrelated and interdependent that unless one is determined, the other

se
cannot be determined, a single-equation regression model does not serve the purpose. In
that case, a system of simultaneous equations is used to estimate and forecast the target
variable.

u
The econometric methods are briefly described here under two basic methods.

. Ho
(1) Regression method
(2) Simultaneous equations model
These methods are explained here briefly.
(1) Regression Method. Regression analysis is the most popular method of demand

td g
estimation. This method combines economic theory and statistical techniques of estimation.
Economic theory is employed to specify the determinants of demand and to determine
. L in
the nature of the relationship between the demand for a product and its determinants.
Economic theory thus helps in determining the general form of demand function. Statistical
vt sh
techniques are employed to estimate the values of parameters in the estimated equation.
In regression technique of demand forecasting, one needs to estimate the demand
function for a product. Recall that in estimating a demand function, demand is a ‘dependent
P li

variable’ and the variables that determine the demand are called ‘independent’ or
‘explanatory’ variables. For example, demand for cold drinks in a city may be said to
ub

depend largely on ‘per capita income’ of the city and its population. Here demand for
cold drinks is a ‘dependent variable’ and ‘per capita income’ and ‘population’ are the
‘explanatory’ ‘variables.’
P

While specifying the demand functions for various commodities, the analyst may
come across many commodities whose demand depends, by and large, on a single
s

independent variable. For example, suppose in a city, demand for such items as salt and
sugar is found to depend largely on the population of the city. If this is so, then demand
a

functions for salt and sugar are single-variable demand functions. On the other hand,
ik

the analyst may find that demand for sweets, fruits and vegetables, etc. depends on a
number of variables like commodity’s own price, price of its substitutes, household incomes,
population, etc. Such demand functions are called multi-variable demand functions. For
V

a single-variable demand function, simple regression equation is used and for multiple
variable functions, multi-variable equation is used for estimating demand function. The
single-variable and multi-variable regressions are explained below.
(a) Simple or Bivariate Regression Technique. In simple regression technique, a
single independent variable is used to estimate a statistical value of the ‘dependent
variable’, that is, the variable to be forecast. The technique is similar to trend fitting. An
important difference between the two is that in trend fitting, the independent variable is
‘time’ (t) whereas in a regression equation, the chosen independent variable is the single
Self-Instructional
Material 79
Analysis of Demand most important determinant of demand. Besides, the regression method is less mechanical
than the trend fitting method of projection.
Suppose we have to forecast demand for sugar for a country for 2006-07 on the
NOTES basis of 7-year data given in Table 2.6. When this data is graphed, it produces a
continuously rising trend in demand for sugar with rising population. This shows a linear
trend. Now, country’s demand for sugar in 2006-07 can be obtained by estimating a
regression equation of the form
Y = a + bX …(2.28)

se
where Y is sugar consumed, X is population, and a and b are the two parameters.
For an illustration, consider the hypothetical data on a country’s annual consumption
of sugar given in Table 2.6.

u
Table 2.6 Annual Consumption of Sugar

. Ho
Year Population (millions) Sugar Consumed (million tonnes)

1999–2000 10 40
2000–01 12 50

td g
2001–02 15 60
. L in 2002–03
2003–04
20
25
70
80
2004–05 30 90
vt sh
2005–06 40 100

Equation (2.28) can be estimated by using the ‘least square’ method. The procedure
P li

is the same as shown in Table 2.4. That is, the parameters a and b can be estimated by
solving the following two linear equations:
ub

Yi = na + bXi …(i)


XiYi = Xi a + bX2i …(ii)
P

The procedure of calculating the terms in Eqs. (i) and (ii) above is presented in
Table 2.7.
s

Table 2.7 Calculation of Terms of the Linear Equations


(Figures in million)
a

2
Year Population Sugar X XY
ik

(X) consumed (Y)


1999–2000 10 40 100 400
V

2000–01 12 50 144 600


2001–02 15 60 225 900
2002–03 20 70 400 1400
2003–04 25 80 625 2000
2004–05 30 90 900 2700
2005–06 40 100 1600 4000

n = 7 Xi = 152 Yi = 490 Xi2 = 3994 XiYi = 12000

By substituting the values from Table 2.7 into Eqs. (i) and (ii), we get
Self-Instructional
80 Material
490 = 7a + 152b …(iii) Analysis of Demand

12,000 = 152a + 3994b …(iv)


By solving Eqs. (iii) and (iv), we get
a = 27.44 and b = 1.96 NOTES

By substituting values for a and b in Eq. (9.10), we get the estimated regression
equation as
Y = 27.44 + 1.96 X ...(2.29)

se
Given the regression Eq. (2.29), the demand for sugar for 2006-07 can be easily
projected if population for 2006-07 can be known. Supposing population for 2006-07 is
projected to be 50 million, the demand for sugar in 2006-07 can be estimated as follows.

u
Y = 27.44 + 1.96(50) = 126 million tonnes

. Ho
The simple regression technique is based on the assumptions (i) that independent
variable will continue to grow at its past growth rate, and (ii) that the relationship between
the dependent and independent variables will continue to remain the same in the future
as in the past. (For further details and for the test of the reliability of estimates, consult
a standard book on statistics).

td g
(b) Multi-variate Regression. The multi-variate regression equation is used where
. L in
demand for a commodity is considered to be a function of explanatory variables greater
than one.
vt sh
The procedure of multiple regression analysis is briefly described here. The first
step in multiple regression analysis is to specify the variables that are supposed to explain
the variations in demand for the product under reference. The explanatory variables are
generally chosen from the determinants of demand, viz., price of the product, price of its
P li

substitutes, consumers’ income and their tastes and preferences. For estimating the
ub

demand for durable consumer goods, (e.g., TV sets, refrigerators, houses, etc.), the
other explanatory variables that are considered are availability of credit and rate of
interest. For estimating demand for capital goods (e.g., machinery and equipment), the
relevant variables are additional corporate investment, rate of depreciation, cost of capital
P

goods, cost of other inputs (e.g., labour and raw materials), market rate of interest, etc.
Once the explanatory or independent variables are specified, the second step is
s

to collect time-series data on the independent variables. After necessary data is collected,
the third and a very important step is to specify the form of equation which can
a

appropriately describe the nature and extent of relationship between the dependent and
ik

independent variables. The final step is to estimate the parameters in the chosen equation
with the help of statistical techniques. The multi-variate equation cannot be easily estimated
manually. Therefore, the equation has to be estimated with the help of a computer.
V

Specifying the Form of Equation The reliability of the demand forecast depends
to a large extent on the form of equation and the degree of consistency of the explanatory
variables in the estimated demand function. The greater the degree of consistency, the
higher the reliability of the estimated demand and vice versa. Adequate precaution should,
therefore, be taken in specifying the equation to be estimated. Some common forms of
multi-variate demand functions are given below.
Linear Function Where the relationship between demand and its determinants
is given by a linear equation, the most common form of equation used for estimating
demand is given below. Self-Instructional
Material 81
Analysis of Demand Qx = a – bPx + cY + dPy + jA …(2.30)

where Qx = quantity demanded of commodity X; Px = price of commodity X;


Y = consumers’ income, Py = price of the substitute; A = advertisement expenditure; a is
NOTES a constant (the intercept), and b, c, d and j are the parameters expressing the relationship
between demand and Px, Y, Py and A, respectively.
In a linear demand function, quantity demanded is assumed to change at a constant
rate with a change in independent variables Px, Y, Py and A. The parameters (regression
co-efficients) are estimated by using the least square method. After parameters are

se
estimated, the demand can be easily forecast if data on independent variables for the
reference period is available. Suppose, the estimated equation for sugar takes the following
form:

u
Qs = 50 – 0.75Ps + 0.1Y + 1.25 Py + 0.05A …(2.31)

. Ho
The numerical values in this equation express the quantitative relationship19 between
demand for sugar and the variables with which it is associated. More precisely, regression
co-efficients give the change in demand for sugar as a result of unit change in the
explanatory variables. For instance, it reveals that a change of one rupee in the sugar
price results in a 0.75 tonne change in sugar demand and a change of one rupee in

td g
income leads to a 0.1 tonne change in sugar demand, and so on.
. L in
Power Function It may be noted that in linear Eq. (2.30), the marginal effect of
independent variables on demand is assumed to be constant and independent of change
in other variables. For example, it assumes that the marginal effect of change in price is
vt sh
independent of change in income or other independent variables, and so on. However,
one can find cases in which it is theoretically and also empirically found that the marginal
effect of the independent variables on demand is neither constant nor independent of the
P li

value of all other variables included in the demand function. For example, the effect of
rise in sugar price may be neutralized by a rise in consumers income. In such cases, a
ub

multiplicative form of equation which is considered to be ‘the most logical form of demand
function’ is used for estimating demand for a product. The multiplicative form of demand
function or power function is given as
P

Qx = a Px–b Yc Pyd Aj …(2.32)


The algebraic form of multiplicative demand function can be transformed into a
s

log-linear form for convenience in estimation, as given below.


a

log Qx = log a – b log Px + c log Y + d log Py + j log A …(2.33)


The log-linear demand function can be estimated by the least square regression
ik

technique. The estimated function yields the intercept a and the values of the regression
co-efficients. After regression co-efficients are estimated and data on the independent
V

variables for the years to come are obtained, forecasting demand becomes an easy task.
Reliability of Estimates As mentioned earlier, statistical methods are scientific, devoid
of subjectivity, and they yield fairly reliable estimates. But the reliability of forecast
depends also on a number of other factors.
A very important factor in this regard is the choice of the right kind of variables
and data. Only those independent variables which have a causal relationship between
the dependent and independent variables should be included in the demand function. The
relationship between the dependent and independent variables should be clearly defined.

Self-Instructional
82 Material
Besides, the reliability of estimates also depends on the form of demand function Analysis of Demand
used. The forecaster should, therefore, bear in mind that there is no hard and fast rule
and an a priori basis of determining the most appropriate form of demand function. The
demand function to be estimated is generally determined by testing different forms of
functions. Whether a particular form of function is a good fit is judged by the coefficient NOTES
of determination, i.e., the value of R2. The value of R2 gives the proportion of the total
variation in the dependent variable explained by the variation in the independent variables.
The higher the value of R2, the greater the explanatory power of the independent variables.
Another test is the expected sign of co-efficients of independent variables. What

se
is more important, therefore, is to carefully ascertain the theoretical relationship between
the dependent and the independent variables.
(2) Simultaneous Equations Model. We may recall that regression technique of

u
demand forecasting consists of a single equation. In contrast, the simultaneous equations
model of forecasting involves estimating several simultaneous equations. These equations

. Ho
are, generally, behavioural equations, mathematical identities and market-clearing
equations.
Furthermore, regression technique assumes one-way causation, i.e., only the
independent variables cause variations in the dependent variable, not vice versa. In

td g
simple words, regression technique assumes that a dependent variable affects in no
way the independent variables. For example, in demand function D = a – bP used in
. L in
the regression method, it is assumed that price affects demand, but demand does not
affect price. This is an unrealistic assumption. On the contrary, forecasting through
econometric models of simultaneous equations enables the forecaster to take into
vt sh
account the simultaneous interaction between dependent and independent variables.
The simultaneous equations method is a complete and systematic approach to
forecasting. This technique uses sophisticated mathematical and statistical tools that are
P li

beyond the scope of this book20. We will, therefore, restrict ourselves here only to the
ub

basic features of this method of forecasting.


The first step in this technique is to develop a complete model and specify the
behavioural assumptions regarding the variables included in the model. The variables
P

that are included in the model are called (i) endogenous variables, and
(ii) exogenous variables.
Endogenous variables. The variables that are determined within the model are
s

called endogenous variables. These are included in the model as dependent variables,
a

i.e., the variables that are to be explained by the model. These are also called ‘controlled’
variables. It is important to note that the number of equations included in the model
ik

must equal the number of endogenous variables.


Exogenous variables. Exogenous variables are those that are determined outside
V

the model. These are inputs of the model. Whether a variable is treated as endogenous
or exogenous depends on the purpose of the model. The examples of exogenous variables
are ‘money supply, ‘tax rates’, ‘government spending’, ‘time’, and ‘weather’, etc. The
exogenous variables are also known as ‘uncontrolled’ variables.
The second step in this method is to collect the necessary data on both endogenous
and exogenous variables. More often than not, data is not available in the required form.
Sometimes data is not available at all. In such cases, data has to be adjusted or corrected
to suit the model and, in some cases, data has to be even generated from the available
primary or secondary sources.
Self-Instructional
Material 83
Analysis of Demand After the model is developed and necessary data are collected, the third step is
to estimate the model through some appropriate method. Generally, a two-stage least
square method is used to predict the values of exogenous variables.
Finally, the model is solved for each endogenous variable in terms of exogenous
NOTES
variables. Then by plugging the values of exogenous variables into the equations, the
objective value is calculated and prediction is made.

Example
For an example, consider a simple macroeconomic model, given below:

se
Yt = Ct + It + Gt + NXt …(2.34)
where

u
Yt = Gross national product,

. Ho
Ct = Total consumption expenditure,
It = Gross private investment,
Gt = Government expenditure,

td g
NXt = Net exports (X – M) where M = imports
. L in and subscript t represents a given time unit.
Equation (2.34) is an identity, that may be explained with a system of simultaneous
vt sh
equations. Suppose in Eq. (2.34)
Ct = a + bYt ...(2.35)
It = 20 ...(2.36)
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Gt = 10 ...(2.37)
ub

NX = 5 ...(2.38)
In the above system of equations, Yt and Ct are endogenous variables and It , Gt
P

and NXt are exogenous variables. Eq. (2.35) is a regression equation that has to be
estimated. Equations (2.36), (2.37) and (2.38) show the values of exogenous variables
determined outside the model.
s

Suppose we want to predict the value of Yt and Ct simultaneously. Suppose also


a

that when we estimate Eq. (2.35), we get


Ct = 100 + 0.75 Yt ...(2.39)
ik

Now, using this equation system, we may determine the value of Yt as


Yt = Ct + 20 + 10 + 5 = Ct + 35
V

Since Ct = 100 + 0.75 Yt, by substitution, we get


Yt = 100 + 0.75 Yt + 35
then Yt – 0.75 Yt = 100 + 35
0.25 Yt = 135
and Yt = 135/0.25 = 540
We may now easily calculate the value of Ct (using Yt = 540). Since
Ct = 100 + 0.75 Yt = 100 + 0.75 (540) = 505
Self-Instructional
84 Material
Thus, the predicted values are Analysis of Demand

Yt = 540 and Ct = 505


Thus, Yt = 505 + 20 + 10 + 5 = 540
It is important to note here that the example of the econometric model given NOTES
above is an extremely simplified model. The econometric models used in actual practice
are generally very complex. They include scores of simultaneous equations.
However, this method is theoretically superior to the regression method. The
main advantage of this method is that it is capable of capturing the effect of

se
interdependence of the variables. But, its limitations are similar to those of the regression
method. The use of this method is sometimes hampered by non-availability of adequate
data.

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2.7 SUMMARY

. Ho
 The law of demand states the nature of relationship between the quantity demanded
of a product and the price of the product. Although quantity demanded of a
commodity depends also on many other factors, e.g., consumer’s income, price
of the substitutes and complementary goods, consumer’s taste and preferences,

td g
advertisement, etc., the current price is the most important and the only determinant
. L in
of demand in the short run.
 The market demand for a product is determined by a number of factors, viz. price
vt sh
of the product, price and availability of the substitutes, consumer’s income, his
own preference for a commodity, utility derived from the commodity,
‘demonstration effect’, advertisement, credit facility by the sellers and banks,
off-season discounts, number of the uses of the commodity, population of the
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country, consumer’s expectations regarding the future trend in the price of the
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product, consumers’ wealth, past levels of demand, past levels of income,


government policy, etc.
 From managerial point of view, the knowledge of nature of relationship alone is
not sufficient. What is more important is the extent of relationship or the degree
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of responsiveness of demand to the changes in its determinants. The degree of


responsiveness of demand to the change in its determinants is called elasticity of
s

demand.
 The business world is characterized by risk and uncertainty and, therefore, most
a

business decisions are made under the condition of risk and uncertainty. One way
ik

to reduce the adverse effects of risk and uncertainty is to acquire knowledge Check Your Progress
about the future demand prospects for the product. The information regarding the 9. How is the
future demand for the product is obtained by demand forecasting. complete
V

 Survey methods are generally used where the purpose is to make short-run forecast enumeration
method carried out?
of demand. Under this method, consumer surveys are conducted to collect 10. Name the three
information about their intentions and future purchase plans. types of opinion
 A time-series of various indicators is prepared to read the future economic trend. poll methods.
11. Why are statistical
The leading series consists of indicators which move up or down ahead of some
methods considered
other series. Some examples of leading indicators are: (i) index of net business superior for demand
investment; (ii) new orders for durable goods; (iii) change in the value of estimation?
inventories; (iv) index of the prices of the materials; and (v) corporate profits
after tax. Self-Instructional
Material 85
Analysis of Demand  An econometric model may be a single-equation regression model or it may consist
of a system of simultaneous equations. Single-equation regression serves the
purpose of demand forecasting in the case of most commodities.

NOTES
2.8 KEY TERMS
 Law of demand: It can be stated as all other things remaining constant, the
quantity demanded of a commodity increases when its price decreases and
decreases when its price increases.

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 Substitute goods: Two commodities are deemed to be substitutes for each
other if change in the price of one affects the demand for the other in the same
direction.

u
 Complementary goods: A commodity is deemed to be a complement of another

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when it complements the use of the other. In other words, when the use of any
two goods goes together so that their demand changes (increases or decreases)
simultaneously, they are treated as complements.
 Elasticity of demand: It is the degree of responsiveness of demand to the change
in its determinants.

td g
 Arc Elasticity: It is the measure of elasticity of demand between any two finite
. L in points on a demand curve.
 Cross-elasticity: It is the measure of responsiveness of demand for a commodity
vt sh
to the changes in the price of its substitutes and complementary goods.
 Econometric methods: They combine statistical tools with economic theories
to estimate economic variables and to forecast the intended economic variables.
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2.9 ANSWERS TO ‘CHECK YOUR PROGRESS’


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1. The ceteris paribus assumption is ‘in case all other things remain unchanged’.
2. Prestige goods are those which are consumed mostly by the rich section of the
P

society, such as luxury cars, stone-studded jewellery, costly cosmetics, antiques


and so on. Demand for such goods arises only beyond a certain level of the
s

consumer’s income.
3. Availability of credit to the consumers from the sellers, banks, relations and friends
a

or from any other source encourages the consumers to buy more than what they
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would buy in the absence of credit facility. That is why the consumers who can
borrow more can consume more than those who can borrow less.
4. The concept of elasticity of demand plays a crucial role in business decisions
V

regarding manoeuvring of prices with a view to making larger profits. For instance,
when cost of production is increasing, the firm would want to pass the rising cost
on to the consumer by raising the price. Firms may decide to change the price
even without any change in the cost of production.
5. It is the elasticity of demand at a finite point on the demand curve. The concept of
point elasticity is used for measuring price elasticity where change in price is
infinitesimally small.

Self-Instructional
86 Material
6. The concept of income-elasticity can be used in estimating future demand, provided Analysis of Demand
that the rate of increase in income and income-elasticity of demand for the products
are known. The knowledge of income elasticity can thus be useful in forecasting
demand, when a change in personal incomes is expected, other things remaining
the same. NOTES
7. Demand forecasting helps in the following areas of business decision making:
 Planning and production schedule
 Acquiring inputs (labour, raw material and capital)
 Making provision for finances

se
 Formulating pricing strategy
 Planning advertisement

u
8. The steps in the demand forecasting include:

. Ho
(i) Specifying the objective
(ii) Determining the time perspective
(iii) Selecting the method of demand forecasting
(iv) Collection of data and data adjustment

td g
(v) Estimation and interpretation of results
9. In this method, almost all potential users of the product are contacted and are
. L in
asked about their future plan of purchasing the product in question. The quantities
indicated by the consumers are added together to obtain the probable demand for
vt sh
the product.
10. The three types of opinion poll methods include expert-opinion method, Delphi
method and market studies and experiments.
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11. Statistical methods are considered to be superior techniques of demand estimation


for the following reasons:
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 In the statistical methods, the element of subjectivity is minimum


 Method of estimation is scientific as it is based on the theoretical relationship
between the dependent and independent variables
P

 Estimates are relatively more reliable


 Estimation involves smaller cost
a s

2.10 QUESTIONS AND EXERCISES


ik

Short-Answer Questions
V

1. Define the law of demand.


2. Name and briefly describe the various types of consumer goods.
3. Write a short note on the demonstration effect.
4. How does distribution of national income affect the demand for a commodity?
5. What are the uses of cross-elasticity of demand?
6. List the determinants of advertisement elasticity.
7. What are the advantages of the end-use method of demand forecasting?
Self-Instructional
Material 87
Analysis of Demand 8. Briefly discuss the Box-Jenkins method of demand forecasting.
9. What are endogenous and exogenous variables in a forecasting model?
Long-Answer Questions
NOTES
1. Define price elasticity of demand and show how the formula for it is derived.
2. Explain how price elasticity is measured using a demand function.
3. Examine the determinants of price elasticity of demand.
4. Explain why demand forecasting is necessary.

se
5. Describe in detail the survey method of demand forecasting.
6. Identify the limitations of market experiment methods.

u
2.11 FURTHER READING

. Ho
Dwivedi, D. N. 2008. Managerial Economics, Seventh Edition. New Delhi: Vikas
Publishing.
Keat, Paul G. and Philip, K. Y. Young. 2003. Managerial Economics: Economics

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Tools for Today’s Decision Makers, Fourth Edition. Singapore: Pearson
Education.
. L in
Keating, B. and J. H. Wilson. 2003. Managerial Economics: An Economic Foundation
for Business Decisions, Second Edition. New Delhi: Biztantra.
vt sh
Mansfield, E., W. B. Allen, N. A. Doherty, and K. Weigelt. 2002. Managerial
Economics: Theory, Applications and Cases, Fifth Edition. NY: W. Orton &
Co.
P li

Peterson, H. C. and W. C. Lewis. 1999. Managerial Economics, Fourth Edition.


Singapore: Pearson Education.
ub

Salvatore, Dominick. 2001. Managerial Economics in a Global Economy, Fourth


Edition. Australia: Thomson-South Western.
Thomas, Christopher R. and Maurice S. Charles. 2005. Managerial Economics:
P

Concepts and Applications, Eighth Edition. New Delhi: Tata McGraw-Hill.


Endnotes
s

1. Mansfield, Edwin, op. cit., p. 52.


a

2. The elasticity formula is derived as follows:


ik

Q1  Q2 Q
 100
Q1 Q Q P1
ep   1  
P1  P2 P P Q1
 100
V

P1 P1

where P1 is old price, P2 is new price Q1 is quantity demanded at P1 and Q2 is quantity


demanded at P2.
3. Price-elasticity of demand calculated without a minus sign will always be a negative value
because either P or Q will carry a negative sign due to inverse relationship between
price and quantity demanded. This gives a negative value of elasticity whereas in the
concept of elasticity, a negative value has no meaningful interpretation expect that it
indicates inverse relationship between P and Q. The negative elasticity coefficient is
rather misleading. The ‘minus’ sign is, therefore, inserted as a matter of ‘linguistic’
Self-Instructional convenience, to make the coefficient of elasticity non-negative. Sometimes, ‘it is also
88 Material
suggested to ignore the negative sign in the numerator and denominator of the elasticity Analysis of Demand
formula. The elasticity in Eq. (8.9) ignores the negative sign.
4. Except in case of Giffen’s goods.
5. With the exception of inferior goods.
NOTES
6. Eugene, F. Brigham, and James L. Pappas, Managerial Economics, The Dryden Press,
Hinsdale. Illinois, 1976. p. 129.
7. The market segment may be defined in terms of geographical region, income-groups of
the consumers or a particular section of the society (e.g., libraries and students segment
of market for textbooks).

se
8. For example, Brigham, Eugene F. and James L. Pappas, op. cit., pp. 548–49.
9. The origin of “Delphi method” is traced to Greek mythology. In ancient Greece, Delphi
was an oracle of Apollo and served as a medium for consulting deities. In modern times,
Delphi method was developed by Olaf Helmer at the Rand Corporation of the US, as a

u
method of obtaining a consensus of panelists without direct interaction between them.

. Ho
(J.R. Davis and S. Chang, Managerial Economics (Prentice-Hall, N.J., 1986, p. 191).
10. Brigham, Eugene F. and James, L. Pappas, op. cit., p. 135.
11. Webb, Samuel C., Managerial Economics, (Houghton Miffln Company, Boston, 1976), p.
156.
12. Dean, J., Managerial Economics, (Englewood Cliffs, N.J., Indian Edn., 1960), p. 181.

td g
13. Balakrishna, S., Techniques of Demand Forecasting for Industrial Products, p. 4.
. L in
14. The statistical technique used to find the trend line, i.e., the ‘least square method’, has
already been discussed in Chapter 5.
15. This method was suggested by G.E.P. Box and G.M. Jenkins in their book, Time Series
vt sh
Analysis: Forecasting and Control (Holdan-Day, San Francisco, 1970).
16. Computer programs on Box-Jenkins method are available for use.
17. Lange, O., Introduction to Econometrics, 2nd Edn. (Oxford Pergamon Press, 1962), pp.
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85–95.
ub

18. A summary of use and findings of this method can be had from R. Davis and Semoon
Chang, Principles of Managerial Economics (Prentice-Hall, NJ, 1986).
19. Estimated values of parameters, – 0.75, 0.1, 1.25 and 0.05 are the regression co-efficients of
demand with respect to Px, Y, Py and A, respectively.
P

20. For detailed discussion on the use of econometric methods in business decision, see J.W.
Elliott, Econometric Analysis for Management Decisions (Homewood, Irwin, 1973).
a s
ik
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Self-Instructional
Material 89
V
ik
as
P
ub
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vt sh
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use
Theory of Consumer

UNIT 3 THEORY OF CONSUMER Demand

DEMAND
NOTES
Structure
3.0 Introduction
3.1 Unit Objectives
3.2 Consumer Behaviour
3.3 Cardinal Utility Approach

se
3.3.1 Meaning and Measurability of Utility
3.3.2 Total and Marginal Utility
3.3.3 Law of Diminishing Marginal Utility

u
3.3.4 Consumer’s Equilibrium
3.4 Ordinal Utility Approach

. Ho
3.4.1 Meaning and Nature of Indifference Curve and Indifference Map
3.4.2 Diminishing Marginal Rate of Substitution (MRS)
3.4.3 Properties of Indifference Curves
3.4.4 Consumer’s Equilibrium
3.4.5 Income and Substitution Effects
3.5 Revealed Preference Approach

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3.6 Summary . L in
3.7 Key Terms
3.8 Answers to ‘Check Your Progress’
3.9 Questions and Exercises
vt sh
3.10 Further Reading

3.0 INTRODUCTION
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In this unit, you will learn in detail about the cardinal and ordinal utility approaches to
ub

consumer demand. You will also be introduced to Paul Samuelson’s revealed preference
theory.
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3.1 UNIT OBJECTIVES


s

After going through this unit, you will be able to:


a

• Discuss the significance of consumer behaviour


• Explain the cardinal utility approach to consumer demand
ik

• Explain the ordinal utility approach to consumer demand


• Describe the revealed preference theory
V

3.2 CONSUMER BEHAVIOUR


The central theme of the traditional theory of consumer behaviour is a consumer’s
utility maximizing behaviour. The fundamental postulate of the consumption theory is
that a consumer—an individual or a household—is a utility maximizing entity and all
consumption decisions are directed towards maximization of total utility.

Self-Instructional
Material 91
Theory of Consumer However, ‘can utility be measured?’ has been a matter of dispute. Neo-classical
Demand
economists, Marshall and his followers, assumed that utility is cardinally measurable.
They formulated their theory of consumer behaviour on this very assumption. The modern
economists have however rejected the assumption of cardinal measurability of utility
NOTES and have instead assumed ordinal measurability of utility. Milton Friedman, instead of
resolving the issue of measurability of utility, preferred to rely on the preferences and
choices revealed by the consumers and developed his own Revealed Preference theory
of consumer behaviour. Accordingly, there are three major approaches to the analysis of
consumer behaviour:
(i) Cardinal Utility Approach, adopted by the neo-classical economists, widely

se
known as Marshallian approach;
(ii) Ordinal Utility Approach, known also as Indifference Curve Analysis; and

u
(iii) Revealed Preference Approach of Paul Samuelson.
In this unit, we discuss Cardinal Utility Theory of consumer demand and see how cardinalists

. Ho
have derived the demand curve. In subsequent sections, we shall take up the Ordinal
Utility Theory and some recent developments in the theory of consumer behaviour, viz.,
‘Revealed Preference Theory’ and ‘Cardinal Utility Approach involving Risk in Choices’.
The indifference technique was invented and used by Francis Y. Edgeworth 1

td g
(1881) to show the possibility of exchange of commodities between two individuals.
. L inAbout a decade later, Irving Fisher2 (1892) used indifference curve to explain consumer’s
equilibrium. Both Edgeworth and Fisher, however, believed in cardinal measurability of
utility. It was Vilfred Pareto3 who introduced, in 1906, the ordinal utility hypothesis to the
vt sh
indifference curve analysis. In the subsequent decades, many significant contributions
were made by Eugen E. Slutsky,4 W.E. Johnson,5 and A.L. Bowley.6 Yet, indifference
curve technique could not gain much ground in the analysis of consumer behaviour till
early 1930s. In 1934, John R. Hicks and R.G.D. Allen7 developed systematically the
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ordinal utility theory as a powerful analytical tool of consumer analysis. Later, Hicks
ub

provided a complete exposition of indifference curve technique in his Value and Capital.
Though in his later work, A Revision of Demand Theory, he has dropped some of his
earlier assumptions, indifference analysis is regarded as the most powerful tool of
consumer analysis.
P

The fundamental departure that indifference curve analysis makes from the
Marshallian marginal utility analysis is the hypothesis that utility can be measured only
s

ordinally, not cardinally. Recall that ‘cardinalists’ assumed that utility is cardinally
measurable, and that utility of one commodity is independent of other commodities. In
a

contract, the ‘Ordinalists’ believe that cardinal measurement of utility is neither feasible
ik

nor necessary to analyse consumer’s behaviour. According to ordinalists, all that is


required to analyse consumer’s behaviour is that the consumer should be able to order
his preferences. In fact, the consumer is able to express his preference for the quantity
V

of a commodity to that of others. For example, a consumer can always say that he
prefers to buy 10 kg of wheat to 5 kg of rice.
Assumptions of Ordinal Utility Theory
The indifference curve analysis of consumer’s behaviour makes, at least implicitly, the
following assumptions:
1. Rationality. The consumer is a rational being. He aims at maximizing his total
satisfaction, given his income and prices of goods and services he consumes.
Self-Instructional Furthermore, he has full knowledge of his circumstances.
92 Material
2. Ordinal Utility. Indifference curve analysis assumes that utility can be expressed Theory of Consumer
Demand
only ordinally. That is, the consumer is able to tell only the order of his preferences.
3. Transitivity and Consistency of Choice. Consumer’s choices are transitive.
Transitivity of choice means that if a consumer prefers A to B and B to C, he must
prefer A to C. Or, if he treats A = B and B = C, he must treat A = C, Consistency NOTES
of choice means that, if he prefers A to B in one period, he will not prefer B to A
in another period or treat them as equal. The transitivity and consistency in
consumer’s choices may be symbolically expressed as follows.
Transitivity. If A > B, and B > C, then A > C, and

se
Consistency. If A > B, in one period, then B >/ A or B ≠ A in another..
4. Nonsatiety. It is also assumed that the consumer is not oversupplied with goods
in question and that he has not reached the point of saturation in case of any

u
commodity. Therefore, a consumer always prefers a larger quantity of all the
goods.

. Ho
5. Diminishing Marginal Rate of Substitution. The marginal rate of substitution
means the rate at which a consumer is willing to substitute one commodity (X) for
another (Y), i.e., the units of Y he is willing to give up for one unit of X so that his
total satisfaction remains the same. This rate is given by ∆Y/∆X. The assumption is

td g
that ∆Y/∆X goes on decreasing, when a consumer continues to substitute X for Y.
(We shall know more about marginal rate of substitution in the subsequent sections).
. L in
3.3 CARDINAL UTILITY APPROACH
vt sh

The Cardinal Utility Theory of consumer demand was developed by the classical
economists, viz. Gossen (1854) of Germany, William Stanley Jevons (1871) of England,
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Leon Walras (1874) of France, Karl Menger (1840–1921) of Austria. Neo-classical


economists, particularly Alfred Marshall (1890) made significant refinements in the
ub

Cardinal Utility Theory. This led the Cardinal Utility Theory to be known as ‘Neo-
classical Utility Theory’ and also as ‘Marshallian Utility Theory’ of demand.
Before we proceed to describe the Cardinal Utility Theory, let us first explain the
P

basic concepts and axioms used in this theory.


3.3.1 The Meaning and Measurability of Utility
s

(a) The Meaning of Utility


a

The notion of ‘Utility’ was introduced to social thought by the British philosopher, Jeremy
ik

Bentham, in the 18th century and to economics by William Stanley Jevons in the 19th
century. In its economic meaning, the term ‘utility’ is synonymous with ‘pleasure’,
V

‘satisfaction’ and a sense of fulfilment by desire. A person consumes a commodity


because he or she derives pleasure out it. In other words, he derives utility from the
consumption of the goods and services.
In abstract sense, the term ‘utility’ refers to the power or property of a
commodity to satisfy human needs. For example, bread has the power to satisfy hunger;
water quenches our thirst; books fulfill our desire for knowledge; and postal stamps take
our letters to their destination, and so on. All the goods that people hold or consume
possess utility. Utility can also be defined as the ‘want-satisfying power’ of a commodity.
But it is not absolute—it is relative. It is relative to a person’s need. In other words,
Self-Instructional
Material 93
Theory of Consumer whether a commodity possesses utility depends on whether a person needs that
Demand
commodity. All the persons need not derive utility from all the commodities. For example,
non-smokers do not derive any utility from cigarettes; strict vegetarians do not derive
any utility from meat and chicken; a book on economics has no utility for those who are
NOTES not students of economics, and so on. The utility derived by a person from a commodity
depends on his or her intensity of desire for that commodity: the greater the need, the
greater the utility.
Besides, utility of some commodities depends on the availability of complementary
goods. For example, electricity operated gadgets (e.g. TV, VCR, computers, refrigerators)
yield utility only where electricity is available and petrol has utility only for those who

se
possess an automobile.
Furthermore, the concept of utility is ‘ethically neutral’. It is neutral between
good and bad and between useful and harmful. For example, some drugs are bad and

u
harmful, for everybody but they yield utility to the drug-addicts. Utility is free from moral

. Ho
values. It is not subject to social desirability of consuming a commodity. Eating beef may
be immoral or socially undesirable for Hindus, but if a Hindu takes it, it satisfies his
hunger.
(b) Measurability of Utility

td g
Measurability of utility has been and remains a debatable issue. Essentially, utility is a
. L inpsychological phenomenon—it is a feeling of pleasure or a feeling of satisfaction and
achievement. Can utility be measured in Quantitative or numeral terms? As mentioned
above, the early and the modern economists have different answers to this question.
vt sh
The classical and neo-classical economists held the view that utility is
quantitatively or cardinally measurable. It can be measured like height, weight, length
and temperature. Their method of measuring utility can be described as follows:
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(i) Walras, a classical economist, used the term ‘util’ meaning ‘units of utility’. The
ub

term was used as an accounting unit like kilogram, meter, etc.


(ii) The classical economists used ‘util’ as the measure of utility under the assumption
that one unit of money equals one ‘util’. It implies that price that a consumer pays
for a commodity equals the utility derived from the commodity.
P

(iii) They assumed that marginal utility of money remains constant, i.e. the utility one
derives from each successive unit of money income remains constant whatever
s

the stock of money one holds.


a

This method of measuring utility has been rejected by the modern economists.
For, it was realized over time that absolute or cardinal measurement of utility is not
ik

possible. The difficulties in measuring utility proved insurmountable. Money was not
found to be a reliable measure of utility because the utility of money itself changes with
V

change in its stock. Neither economists nor psychologists nor other scientists could
devise a reliable technique for measuring the feeling of satisfaction or utility. The modern
economists have therefore discarded the concept of cardinal utility.
Notwithstanding the problems in quantitative measurement of utility, the
consumption theory based on cardinal utility concept provides deep insight into the
consumer psychology and consumer behaviour and remains an indispensable element of
consumption theory. In fact, it serves as a starting point in the study of further advances

Self-Instructional
94 Material
in the theory of consumer behaviour. In this unit, we discuss the theory of consumer Theory of Consumer
Demand
behaviour based on cardinal utility concept. The consumer theory based on ordinal utility
is discussed in the next Section.
3.3.2 Total and Marginal Utility NOTES
The concept of cardinal utility makes it possible to define the Total and Marginal
Utility in quantitative terms. Total utility (TU), with reference to a single commodity,
may be defined as the sum of the utility derived from all the units consumed of the
commodity. For example, if a consumer consumes 4 units of a commodity and derives

se
U1, U2, U3 and U4 utils from the successive units consumed, then
TU = U1 + U2 + U3 + U4
If he consumes n units, the total utility (TU) from n units can be expressed as

u
TUn = U1 + U2 + U3 + ... + Un

. Ho
In case the number of commodities consumed and their units are greater than
one, then
TU = TUx + TUy + TUz + ... + TUn
where subscripts x, y, z and n denote commodities.

td g
Marginal Utility may be defined in three ways.
. L in
One, marginal utility is the utility derived from the marginal or the last unit consumed.
Two, marginal utility is the addition to the total utility—the utility derived from the
vt sh
consumption or acquisition of one additional unit. Or, Marginal Utility (MU) is the change
in the total utility resulting from the change in the consumption.
TU
Thus, MU =
P li

Q

where ΔTU = change in total utility, and ΔQ = change in quantity consumed of a


ub

commodity.
Three, marginal utility (MU) may also be expressed as
P

MU = TUn – TUn–1
3.3.3 The Law of Diminishing Marginal Utility
s

The law of diminishing marginal utility is central to the cardinal utility analysis of the
a

consumer behaviour. This law states that as the quantity consumed of a commodity
increases per unit of time, the utility derived by the consumer from the successive units
ik

goes on decreasing, provided the consumption of all other goods remains constant. This
law stems from the facts (i) that the utility derived from a commodity depends on the
intensity or urgency of the need for that commodity, and (ii) that as more and more
V

quantity of a commodity is consumed, the intensity of desire decreases and therefore the
utility derived from the marginal unit decreases. For example, suppose you are very
hungry and are offered sandwiches to eat. The satisfaction which you derive from the
first bite of sandwich would be the maximum because intensity of your hunger was the
highest. When you take the second bite, you derive lower satisfaction because the intensity
of your hunger is reduced due to consumption of the first bite of sandwich. As you go on

Self-Instructional
Material 95
Theory of Consumer eating more and more sandwiches, the intensity of your hunger goes on decreasing and
Demand
therefore the satisfaction which you derive from the successive units goes on decreasing.
This phenomenon is generalized in the form of a theory called the Law of Diminishing
Marginal Utility.
NOTES Numerical Example. Table 3.1 present a numerical illustration of the law of diminishing
marginal utility. As the table shows, total utility (TU) increases with increase in consumption
of sandwiches, but at a decreasing rate. It means that MU decreases with increase in
consumption. This is shown in the last column of the table.
Table 3.1 Total and Marginal Utility

se
Sandwiches Total Utility (TU) Marginal Utility
0 0 0 – 0 = 0

u
1 30 30 – 0 = 30
2 50 50 – 30 = 20

. Ho
3 60 60 – 50 = 10
4 65 65 – 60 = 5
5 65 65 – 65 = 0
60 60 – 65 = – 5

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It may be seen in the table that the total utility reaches its maximum at 66 utils
. L inwhen 5 sandwiches are consumed. Here, MU = 1. Consumption of the 6th sandwich
yields negative utility of 6 and therefore total utility starts declining.
Graphic Illustration. The law of diminishing marginal utility is graphically illustrated
vt sh
in Fig. 3.1 (a) and (b). The total utility (TU) and marginal utility (MU) curves have been
obtained by plotting the data given in Table 3.1. The total utility curve goes on rising till
the 5th sandwich is consumed [Fig. 3.1 (a)]. Note that the TU curve is rising but at a
diminishing rate. It shows decrease in the MU, i.e., the utility added to the total. The
P li

diminishing MU is shown by the MU curve in Fig. 3.1 (b). Beyond 5 sandwiches consumed,
ub

the marginal utility turns negative. It means that additional consumption of sandwiches
yields disutility in the form of discomfort or displeasure.
Assumptions
P

The law of diminishing marginal utility holds only under certain given conditions. These
conditions are often referred to as the assumptions of the law.
s

First, the unit of the consumer goods must be standard, e.g. a cup of tea, a bottle of cold
drink, a pair of shoes or trousers. If the units are excessively small or large, the law may
a

not hold.
ik

Second, consumer’s taste or preference must remain unchanged during the period of
consumption.
V

Third, there must be continuity in consumption and where break in continuity is necessary,
it must be appropriately short.

Self-Instructional
96 Material
Theory of Consumer
Demand

NOTES

Marginal Utility

u se
Fig. 3.1 Total and Diminishing Marginal Utility: Cardinal Approach

. Ho
Fourth, the mental condition of the consumer must remain normal during the period of
consumption of a commodity. If a person is eating and also drinking (alcohol) the utility
pattern will not be certain.
Given these conditions, the law of diminishing marginal utility holds universally. In

td g
some cases, e.g. accumulation of money, collection of hobby items like stamps, old
. L in
coins, rare paintings and books, and melodious songs, marginal utility may initially increase
rather than decrease, but it does decrease eventually. It may thus be stated that the Law
of Diminishing Marginal Utility generally operates universally.
vt sh
3.3.4 Consumer’s Equilibrium
As mentioned earlier, a consumer is assumed to be a utility maximizer. A consumer
P li

reaches equilibrium position, when he maximizes his total utility given his income and
prices of commodities he consumes. Analysing consumer’s equilibrium requires answering
ub

the question as to how a consumer allocates his money income between the various
goods and services he consumers to maximize his total utility.
Before we proceed, let us describe the assumptions of the Marshallian approach
P

to the determination of consumer’s equilibrium.


Assumptions
s

1. Rationality. It is assumed that the consumer is a rational being in the sense


a

that he satisfies his wants in the order of their merit. It means that he consumes
first a commodity which yields the highest utility and the last which gives the
ik

least.
2. Limited Money Income. The consumer has a limited money income to spend
V

on the goods and services he consumes.


3. Maximization of Satisfaction. Every rational consumer intends to maximize
his satisfaction from his given money income.
4. Utility is Cardinally Measurable. The cardinalists assume that utility is
cardinally measurable, i.e. it can be measured in absolute terms. For them, utility
of one unit of a commodity equals the amount of money paid for it.

Self-Instructional
Material 97
Theory of Consumer 5. Diminishing Marginal Utility. The utility gained from successive units of a
Demand
commodity consumed decreases as a consumer consumes a larger quantity of
the commodity.
6. Constant Utility of Money. The marginal utility of money (MUm) remains
NOTES constant and each unit of money has utility equal to 1, i.e., MUm=1.
7. Utility is Additive. Cardinalists maintain that utility is not only cardinally
measurable but also utility derived from various goods and services consumed by
a consumer can be added together to obtain the total utility. The additivity of the
utility can be expressed through a utility function. Suppose that the basket of

se
goods and services consumed by a consumer contains n items, and their quantities
expressed as q1, q2, q3,..., qn. The total utility function (TU) of the consumer is
expressed as

u
U = f(q1, q2, q3, ..., qn)
Given the utility function, the total utility gained from n items is expressed as

. Ho
TUn = U1(q1) + U2(q2) + U3(q3) ··· + Un(qn)
Consumer Equilibrium: One Commodity Case
A consumer consumes a large number of goods and services. Let us however begin our

td g
analysis of consumer’s equilibrium with a simple case of a consumer consuming only
one commodity. Although unrealistic, this case provides an insight for analysing a general
. L incase of consumer behaviour.
To illustrate consumer’s equilibrium, let us suppose that a consumer with certain
vt sh
money income consumes only one commodity, X. Since both his money income and
commodity X have utility for him, he can either spend his money income on commodity
X or retain it with himself. If the consumer holds his total income, the marginal utility of
P li

commodity X (i.e., MUx) is bound to be greater than marginal utility of money income
(MUm). In that case, total utility can be increased by exchanging money for the
ub

commodity. Therefore, a utility maximizing consumer exchanges his money income for
the commodity so long as MUx > MUm. As assumed above, marginal utility of commodity
of X is subject to diminishing returns whereas marginal utility of money income (MUm)
P

remains constant. Therefore, the consumer will exchange his money income for
commodity X so long as MUx > Px (MUm). The utility maximizing consumer reaches his
equilibrium—the level of his maximum satisfaction—where
s

MUx = Px(MUm) ... (3.1)


a

Equation (3.1) states the necessary condition for utility maximization. Alternatively,
the consumer reaches equilibrium where
ik

=1 ... (3.2)
V

Consumer’s equilibrium in a single-commodity case is illustrated graphically in


Fig. 3.2. The horizontal line Px(MUm) shows the constant utility of money weighed by
Px, the price of commodity X and MUx curve represents the diminishing marginal utility
of commodity X.

Self-Instructional
98 Material
Theory of Consumer
Demand

NOTES

se
Fig. 3.2 Consumer’s Equilibrium: Cardinal Approach

u
As Fig. 3.2 shows, the Px(MUm) line and MUx curve intersect at point E, where

. Ho
MUx = Px(MUm). Therefore, consumer is in equilibrium at point E. At any point above E,
MUx > Px(MUm). Therefore, if consumer exchanges his money income for commodity
X, he increases his satisfaction. At any point below E, MUx < Px (MUm), the consumer
can therefore increase his satisfaction by reducing his consumption. That is, at any point
other than E, consumer gets satisfaction less than maximum. Therefore, point E is the

td g
point of consumer’s equilibrium.
. L in
Consumer Equilibrium: The General Case— The Law of Equi-Marginal
Utility
vt sh
We have explained above consumer’s equilibrium in a single commodity case. In reality,
however, a consumer consumes a large number of goods. The MU schedules of different
commodities is not the same. Some commodities yield a higher MU schedule and some
P li

lower. MU of some goods decreases more rapidly than that of others. A rational and
utility maximizing consumer consumes commodities in the order of their utilities. He
ub

picks up first the commodity which yields the highest utility and then the commodity
yielding the second highest utility and so on. He switches his expenditure from one
commodity to another in order of their marginal utility. He continues to switch his
P

expenditure from one commodity to the other till he reaches a stage where MU of each
commodity is the same per unit of expenditure.
s

Let us now analyse a simple two-commodity case. We assume that a consumer


consumes only two commodities X and Y, their prices being Px and Py, respectively.
a

Following the equilibrium rule of single commodity case, the consumer distributes his
income between commodities X and Y, so that
ik

MUx = Px(MUm)
V

and MUy = Py(MUm)


or alternatively, in terms of Eq. (3.2) consumer is in equilibrium where

= ... (3.3)

and = ... (3.4)

Self-Instructional
Material 99
Theory of Consumer Equations (3.3) and (3.4) may be written together and equilibrium condition for two-
Demand
commodity case can be expressed as

=1=
NOTES

or = ... (3.5)

Since, according to assumption 6, MUm = 1, Eq. (3.5) may be rewritten as

se
= ... (3.6)

u
or = ... (3.7)

. Ho
Equation (3.7) leads to the conclusion that the consumer reaches his equilibrium
when the marginal utility derived from each unit of money, say each rupee, spent on the
two commodities X and Y is the same.

td g
. L in3.4 ORDINAL UTILITY APPROACH
In the preceding section, we have explained the cardinal utility theory of consumer
vt sh
behaviour. In this section, we will discuss the ordinal utility theory of consumer behaviour.
The technique economists use under ordinal utility approach is called indifference curve.
The basis of indifference curve is the assumption that a consumer is able to make
different combinations of any two substitute goods such that each combination of goods
P li

yields the same level of satisfaction, that is, the consumer is indifferent when it comes to
ub

making a choice. A graphical presentation of such combinations of two substitute goods


produces a curve, called ‘indifference curve’.
The indifference technique was invented and used by Francis Y. Edgeworth (1881)
to show the possibility of exchange of commodities between two individuals. About a
P

decade later, Irving Fisher (1892) used indifference curve to explain consumer’s
equilibrium. Both Edgeworth and Fisher, however, believed in cardinal measurability of
s

utility. It was Vilfred Pareto who introduced, in 1906, the ordinal utility hypothesis to the
indifference curve analysis. In the subsequent decades, many significant contributions
a

were made by Eugen E. Slutsky, W.E. Johnson, and A.L. Bowley. Yet, the indifference
curve technique could not gain much ground in the analysis of consumer behaviour till
ik

Check Your Progress early 1930s. In 1934, John R. Hicks and R.G.D. Allen developed systematically the
ordinal utility theory as a powerful analytical tool of consumer analysis. Later, Hicks
1. Name the
V

economists provided a complete exposition of indifference curve technique in his Value and Capital.
associated with the To have a comparative view, recall that ‘cardinalists’ assumed that utility is cardinally
Cardinal Utility measurable, and that utility of one commodity is independent of other commodities. In
Theory of contrast, the ‘Ordinalists’ believe that cardinal measurement of utility is neither feasible
consumer demand.
nor necessary to analyse consumer’s behaviour. According to ordinalists, all that is
2. What do you
understand by the
required to analyse consumer’s behaviour is that the consumer should be able to order
law of diminishing his preferences. In fact, the consumer is able to express his preference for the quantity
marginal utility? of a commodity to that of others. The section provides a detailed discussion on the
ordinal utility approach to the analysis of consumer behaviour.
Self-Instructional
100 Material
3.4.1 Meaning and Nature of Indifference Curve and Indifference Map Theory of Consumer
Demand
An indifference curve may be defined as the locus of points, each representing a different
combination of two goods but yielding the same level of utility or satisfaction. Since each
combination of two goods yields the same level of utility, the consumer is indifferent between NOTES
any two combinations of goods when it comes to making a choice between them. A
consumer is very often confronted with such a situation in real life. Such a situation arises
because he consumes a large number of goods and services, and often he finds that one
commodity serves as a substitute for another. It gives him an opportunity to substitute one
commodity for another, and to make various combinations of two substitutable goods. It

se
may not be possible for him to tell how much utility a particular combination gives, but it is
always possible for him to tell which one between any two combinations is preferable to
him. It is also possible for him to tell which combinations give him equal satisfaction. If a
consumer is faced with equally good combinations, he would be indifferent between the

u
combinations. When such combinations are plotted graphically, the resulting curve is known

. Ho
as indifference curve. Indifference curve is also called Iso-utility Curve and Equal
Utility Curve.
For example, suppose that a consumer consumes only two commodities X and Y
and he makes five combinations which he calls a, b, c, d and e. All these combinations
yield him equal utility. Therefore, he is indifferent between the different combinations of

td g
the two commodities, X and Y. His combinations are presented in Table 3.2, which may
be called indifference schedule—a schedule of various combinations of two goods—
. L in
between which a consumer is indifferent. The last column of the table shows an undefined
utility (u) derived from each combination of X and Y. If combinations a, b, c, d, and e
given in Table 3.2 are plotted and joined to form a smooth curve (as shown in Fig. 3.2),
vt sh
the resulting curve is known as indifference curve. On this curve, one can locate many
other points showing many other combinations of X and Y which yield the same
satisfaction. Therefore, the consumer is indifferent between the different combinations
P li

revealed by the indifference curve.


ub

Table 3.2 Indifference Schedule of Commodities X and Y

Combination Commodity Y Commodity X Utility


P

a 25 5 u
b 15 7 u
c 10 12 u
d 6 20 u
s

e 4 30 u
a

The Indifference Map


ik

We have drawn a single indifference curve in Fig. 3.3 on the basis of an indifference
schedule given in Table 3.2. The combinations of the two commodities, X and Y, given in
the indifference schedule or those indicated by the indifference curve are by no means
V

the only combinations of the two commodities. The consumer may be faced with many
other combinations with less of one or both the goods—each combination yielding the
same level of satisfaction but less than the level of satisfaction indicated by the indifference
curve IC in Fig. 3.3. Therefore, another indifference curve can be drawn, say, through
points f, g and h. Note that this indifference curve falls below the curve IC given in
Fig. 3.3. Similarly, he may be faced with many other combinations with more of one or
both the goods—each combination yielding the same satisfaction—but greater than the
satisfaction indicated by the lower indifference curves. Thus, another indifference curve

Self-Instructional
Material 101
Theory of Consumer can be drawn above the IC given in Fig. 3.3, say, through points j, k, and l. This exercise
Demand
may be repeated as many times as one wants, each time generating a new indifference
curve.

NOTES

u se
. Ho
td g
Fig. 3.3 Indifference Curve
. L in In fact, the area between X and Y axes is known as indifference plane or
commodity space. This plane is full of finite points and each point on the place indicates
vt sh
a different combination of goods X and Y. Intuitively, it is always possible to locate any
two or more points indicating different combinations of goods X and Y yielding the same
satisfaction. It is thus possible to draw a number of indifference curves without intersecting
or touching the other, as shown in Fig. 3.4. The set of indifference curves, IC1, IC2, IC3
P li

and IC4 drawn in this manner make the indifference map. In fact, an indifference map
ub

may contain any number of indifference curves, ranked in the order of consumer’s
preferences.
P
a s
ik
V

Fig. 3.4 The Indifference Map

Self-Instructional
102 Material
Assumptions of ordinal utility theory Theory of Consumer
Demand
The indifference curve analysis of consumer’s behaviour is based on the following
assumptions:
1. Rationality. The consumer is a rational being. He aims at maximizing his total NOTES
satisfaction, given his income and prices of goods and services he consumes.
Furthermore, he has full knowledge of his choices and preferences.
2. Ordinal Utility. Indifference curve analysis assumes that utility can be
expressed only ordinally or comparatively. That is, the consumer is able to tell

se
only the order of his preferences.
3. Transitivity and Consistency of Choice. Consumer’s choices are transitive.
Transitivity of choice means that if a consumer prefers A to B and B to C, he

u
must prefer A to C. Or, if he treats A = B and B = C, he must treat A = C,
Consistency of choice means that, if he prefers A to B in one period, he will not

. Ho
prefer B to A in another period or treat them as equal. The transitivity and
consistency in consumer’s choices may be symbolically expressed as follows.
Transitivity. If A > B, and B > C, then A > C, and
Consistency. If A > B, in one period, then B  A or B ≠ A in another.

td g
4. Nonsatiety. It is also assumed that the consumer is not oversupplied with goods
. L in
in question and that he has not reached the point of saturation in case of any
commodity. Therefore, a consumer always prefers a larger quantity of all the
goods.
vt sh
5. Diminishing Marginal Rate of Substitution. The marginal rate of substitution
means the rate at which a consumer is willing to substitute one commodity (X) for
another (Y), i.e. the units of Y he is willing to give up for one unit of X so that his
P li

total satisfaction remains the same. This rate is given by ΔY/ΔX. The assumption
is that ΔY/ΔX goes on decreasing, when a consumer continues to substitute X for
ub

Y. The marginal rate of substitution has been discussed in detail in the following
section.
P

3.4.2 Diminishing Marginal Rate of Substitution (MRS)


When a consumer makes different combination of two goods, yielding the same level of
s

satisfaction, he substitutes one good for another. The rate at which he substitutes one
good for the other is called the ‘Marginal Rate of Substitution (MRS)’. One of the basic
a

postulates of indifference curve analysis is that (MRS) diminishes. The axiomatic


assumption of ordinal utility theory is analogous to the assumption of ‘Diminishing Marginal
ik

Utility’ in cardinal utility theory. The postulate of diminishing marginal rate of


substitution states an observed behavioural rule that when a consumer substitutes one
V

commodity (say X) for another (say Y), the ‘Marginal Rate of Substitution’ (MRS)
decreases as the stock of X increases and that of Y decreases.
Measuring MRS
Conceptually, the MRS is the rate at which one commodity can be substituted for another,
the level of satisfaction remaining the same. The MRS between two commodities, X and
Y, can also be defined as the number of units of X which are required to replace one unit
of Y (or number of units of Y that are required to replace one unit of X), in the combination
of the two goods so that the total utility remains the same. It implies that the utility of
Self-Instructional
Material 103
Theory of Consumer units of X (or Y) given up is equal to the utility of additional units of Y (or X) added to the
Demand
basket.
To explain symbolically the concept of MRS, let us suppose that the utility function
of a consumer is given as
NOTES
U = f (X, Y) ... (3.8)
Let us now suppose that the consumer substitutes X for Y. When the consumer
foregoes some units of Y, his stock of Y decreases by – ΔY. His loss of utility may be
expressed as
– ΔY . MUy

se
On the other hand, as a result of substitution, his stock of X increases by ΔX. His
utility from ΔX equals

u
+ ΔX . MUx
For the total utility U to remain the same, – ΔY. MUy must be equal to ΔX.MUx.

. Ho
That is,
– ΔY.MUy + ΔX.MUx = 0 ...(3.9)
Rearranging the terms in Eq. (3.9), we get MRS of X for Y as

td g
Y MU x
–  ... (3.10)
. L in X MU y

Here, ΔY/ΔX is simply the slope of the indifference curve, which gives the MRSx,y
when X is substituted for Y. Similarly, ΔX/ΔY gives MRSy,x when Y is substituted for X.
vt sh
 Y MU x 
 MRSx ,y   X  MU  
and 
y 
= Slope of indifference curve
P li

 X MU y 
 MRSy , x    
 Y MU x 
ub

Diminishing MRS
P

As mentioned, the basic postulate of ordinal utility theory is that the MRSx,y (or MRSy,x)
decreases. That is, the number of units of a commodity that a consumer is willing to
sacrifice for an additional unit of another goes on decreasing when he goes on substituting
s

one commodity for another. The diminishing MRSx,y which can be obtained from Table
3.2, are presented in Table 3.3.
a

Table 3.3 The Diminishing MRS between Commodities X and Y


ik

Movements Change in Y Change in X MRSy,x


on IC (–ΔY) (Δ X) (ΔY/ΔX)
V

From point a to b – 10 2 – 5.0


From point b to c – 5 5 – 1.0
From point c to d – 4 8 – 0.5
From point d to e – 2 10 – 0.2

As Table 3.3 shows, when the consumer moves from point a to b on the indifference
curve (Fig. 3.3) he gives up 10 units of commodity Y and gets only 2 units of commodity
X, so that

Self-Instructional
104 Material
Theory of Consumer
−∆ − Demand
= = = −

As he moves down from points b to c, he loses 5 units of Y and gains 5 units of X,
giving
NOTES
−∆Y 5
MRS y , x = = = −1
∆X 5
The MRSy,x goes on decreasing as the consumer moves further down along the
indifference curve. The diminishing marginal rate of substitution causes the indifference
curves to be convex to the origin.

se
The diminishing marginal rate of substitution can also be illustrated graphically, as
shown in Fig. 3.5.

u
. Ho
a

b a

c
b

td g
d
c
IC
IC
. L in
vt sh
Fig. 3.5 Diminishing Marginal Rate of Substitution

As the consumer moves from point a to b, to c, and to d, he gives up a constant


P li

quantity of Y, (i.e., ∆Y1 = ∆Y2 = ∆X3). To substitute a constant quantity of ∆Y, he


requires an increasing quantity of X (i.e., ∆X1 < ∆X2 < ∆X3). Since MRS is given by the
ub

slope of the indifference curve, (i.e., ∆Y/∆X), arranging the slopes between points a and
b, b and c, and c and d, in descending order, we get
∆ ∆ ∆
P

> >
∆ ∆ ∆

These inequalities show that MRS (= ∆Y/∆X) goes on decreasing as the consumer
s

moves from point a towards point d.


a

The diminishing MRS is geometrically illustrated in Fig. 3.5 (b). The lines tangent to
the indifference curve at points a, b and c measure the slope of the curve at these
ik

points. It can be seen from the figure, that as the consumer moves from point a towards
d, the tangential lines become flatter indicating decrease in the slope of the indifference
curve. This also proves the decrease in MRS all along the indifference curve.
V

Why does MRS diminish?


The negative slope of the indifference curve implies that two commodities are not perfect
substitutes for each other. In case they are perfect substitutes, the indifference curve
will be a straight line with a negative slope. Since goods are not perfect substitutes for
each other, the subjective value attached to the additional quantity (i.e., MU) of a
commodity decreases fast in relation to the other commodity whose total quantity
is decreasing. Therefore, when the quantity of one commodity (say, X) increases and
Self-Instructional
Material 105
Theory of Consumer that of other (say, Y) decreases, it becomes increasingly difficult for the consumer to
Demand
sacrifice more and more units of commodity Y for one unit of X. But, if he is required to
sacrifice additional units of Y, he will demand increasing units of X to maintain the level
of his satisfaction. As a result, the MRS decreases.
NOTES Furthermore, when the combination of two goods at a point of indifference curve is
such that it includes a large quantity of one commodity, (say, Y) and a small quantity of
the other (commodity X), then consumer’s capacity to sacrifice Y is greater than to
sacrifice X. Therefore, he can sacrifice a large quantity of Y in favour of a smaller
quantity of X. This is an observed behavioural rule that the consumer’s willingness and

se
capacity to sacrifice a commodity is greater when its stock is greater and it is lower
when the stock of a commodity is smaller. These are the reasons why MRS decreases
all along on the indifference curve.

u
3.4.3 Properties of Indifference Curves

. Ho
Indifference curves have the following four basic properties or characteristics:
1. Indifference curves have a negative slope;
2. Indifference curves are convex to the origin;
3. Indifference curves do not intersect;

td g
. L in 4. Upper indifference curves indicate a higher level of satisfaction than the lower
ones.
These properties of indifference curves, in fact, reveal consumer’s behaviour, as well as
his choices and preferences, and are therefore very important in the modern theory of
vt sh
consumer behaviour.
Shifts in Budget Line
P li

The budget line changes its position following the change in consumer’s income and
ub

prices of the commodities. If a consumer’s income increases, prices of X and Y remaining


the same, budget line shifts upwards remaining parallel to the original budget line. As
shown in Fig. 3.6, given the consumer’s income (M), Px and Py, the budget line is given
by line AB. If M increases, (prices remaining the same) the budget line will shift to CD.
P

If in the next period M decreases by the same amount, the budget line will shift backward
to its original position AB.
a s
ik
V

Fig. 3.6 Shift in the Budget Line


Self-Instructional
106 Material
Likewise, income remaining the same, if prices change, the budget line changes Theory of Consumer
Demand
its position. For example, M and Py remaining constant at their original level, if Px
decreases, point B will shift to F and the budget line will shift to AF. Similarly, M and Px
remaining constant, if Py increases, the budget line shifts to EB.
NOTES
Slope of the Budget Line
The slope of the budget line is of great importance in determining consumer’s equilibrium.
The slope of the budget line (AB) in Fig. 3.7 is given by the following ratios.

=

se

Since OA = M/Py and OB = M/Px (Fig. 3.7) the slope of the budget line may be
rewritten as

u
= = ... (3.11)

. Ho
As Eq. (3.11) shows, the slope of the budget line equals the price ratio (Py/Px).

td g
. L in
vt sh
P li
ub

Fig. 3.7 Slope of the Budget Line


P

3.4.4 Consumer’s Equilibrium


The consumer attains his equilibrium when he maximizes his total utility, given his income
s

and market prices of goods and services he consumes. Under indifference curve analysis
of consumer behaviour, a necessary condition for utility maximization is given as MRS
a

must be equal to the ratio of commodity prices. Considering our earlier two-commodity
model, the necessary (or the first order) condition may be expressed as
ik

MRS
= =
V

x,y

This is a necessary but not sufficient condition of consumer’s equilibrium. Another


condition, a second order or supplementary condition is that the necessary condition
must be fulfilled at the highest possible indifference curve.
Consumer’s equilibrium is illustrated in Fig. 3.8. A hypothetical indifference map of
the consumer is shown by indifference curves IC1, IC2 and IC3. The line AB is the
hypothetical budget line. Both necessary and supplementary conditions of consumer’s
equilibrium are fulfilled at point E, where indifference curve IC2 is tangent to the budget
Self-Instructional
Material 107
Theory of Consumer line, AB. Since both, the curve IC2 and the budget line, AB, pass through point E, therefore,
Demand
at this point, the slopes of the indifference curve IC2 and the budget line (AB) are equal.
The consumer is therefore in equilibrium at point E.
That the consumer is in equilibrium at point E can also be proved algebraically. We
NOTES know from Eq. (3.10) that the slope of an indifference curve is given by

− = =

We know also that the slope of the budget line is given by Eq. (3.11) as

se
=

At point E, MRSy,x = Py/Px. Therefore, the consumer is in equilibrium at point E. The

u
tangency of IC2 with the budget line indicates that IC2 is the highest possible indifference
curve which the consumer can reach, given his budgetary constraint and the prices. At

. Ho
equilibrium point E, the consumer consumes OQx of X and OQy of Y, which yield him
maximum satisfaction.

td g
. L in
vt sh
P li
ub
P

Fig. 3.8 Equilibrium of the Consumer

Although the necessary condition is satisfied also on two other points, J and K, these
s

points do not satisfy the supplementary or the second order condition of consumer’s
equilibrium. Indifference curve IC1 is not the highest possible curve on which the
a

necessary condition is fulfilled. Since indifference curve IC1 lies below the curve IC2, at
ik

any point on IC1, the level of satisfaction is lower than the level of satisfaction indicated
by IC2. So long as the utility maximizing consumer has the opportunity to reach the
curve IC2, he would not like to settle on a lower curve.
V

From the information contained in Fig. 3.8, it can be proved that the level of satisfaction
at point E is greater than that on any point on IC1. Suppose that the consumer is at point
J. If he moves to point M, he will be equally well-off because points J and M are on the
same indifference curve. If he moves from point J to M, he will have to sacrifice JP of
Y and take PM of X. But in the market, he can exchange JP of Y for PE of X. That is, he
gets extra ME (= PE – PM) of X. Since ME gives him extra utility, point E yields a utility
higher than the point M. Therefore, point E is preferable to point M. The consumer will
therefore, have a tendency to move to point E from any point at the curve IC1, in order
Self-Instructional
108 Material
to reach the highest possible indifference curve, all other things (taste, preference, and Theory of Consumer
Demand
prices of goods) remaining the same.
Another fact which is obvious from Fig. 3.8 is that, due to budget constraint, the
consumer cannot move to an indifference curve placed above and to the right of IC2.
For example, his income would be insufficient to buy any combination of two goods at
NOTES
the curve IC3. Note that IC3 falls beyond the budget line.
To conclude, a utility maximizing consumer, given his income, taste and preferences
and prices of goods, will attain his equilibrium when MRS = price ratio at the highest
possible indifference curve.

se
3.4.5 Income and Substitution Effects
As mentioned earlier, price effect consists of two effects: (i) income effect, and

u
(ii) substitution effect. Income effect occurs due to increase in real income resulting
from the decrease in the price of a commodity. Substitution effect occurs due to

. Ho
consumer’s inherent tendency to substitute cheaper goods for the relatively expensive
ones.
In this section, we explain how total price effect is split into its two components—
income and substitution effects. There are two approaches of decomposing the total

td g
price effect into income and substitution effects, viz.
(i) Hicksian approach, and
. L in
(ii) Slutsky approach.
vt sh
The two methods of measuring the income and substitution effects are explained and
illustrated below. We consider first the case of ‘normal goods’ and then take up the case
of ‘inferior goods’.
P li
ub
P
a s
ik
V

Fig. 3.9 Income and Substitution Effects: Hicksian Approach

(i) Hicksian Approach


The Hicksian method of decomposing income and substitution effects is demonstrated
in Fig. 3.9 Let the consumer be in equilibrium initially at point P on indifference curve
IC1 and budget line MN, where he consumes PX1 of Y and OX1 of X. Now, let the price
of X fall, all other things remaining the same, so that new budget line is MN″. The new
Self-Instructional
Material 109
Theory of Consumer budget line (MN″) is tangent to IC2 at point Q. Thus, when price of X falls, the consumer
Demand
reaches a new equilibrium at point Q. At this point, he buys additional quantity (X1X3) of
X. That is, total price effect = X1X3.
Now the problem is how to split the price effect (X1X3) into income and substitution
NOTES effects. We know that
Price Effect = Income Effect + Substitution Effect
If one of these effects is measured, we can find the other. The general practice is to
eliminate first the income effect from the price effect and measure the substitution
effect. Income effect is then obtained by subtracting the substitution effect from the

se
total price effect. The Hicksian method of eliminating income effect is to reduce
consumer’s income (by way of taxation) so that he returns to his original indifference
curve, IC1, keeping in view the new price ratio. This has been done by drawing a budget

u
line (MN′) parallel to MN″ and tangent to indifference curve IC1. The budget line, MN′
is tangent to indifference curve IC1 at point R. The point R represents the equilibrium of

. Ho
the consumer at new price ratio of X and Y, after the elimination of the real income
effect caused by fall in the price of X. The movement of the consumer from P to R
shows his response to the changes in relative price ratio, his real income being held
constant at its original level. The consumer’s movement from point P to R means an

td g
increase in quantity demanded of X by X1X2. This change in quantity demanded (X1X2)
. L inis called substitution effect. The substitution effect may thus be defined as the change
in quantity demanded resulting from a change in relative price after the real-income-
effect of price change is eliminated.
vt sh
P li
ub
P
a s
ik

Fig. 3.10 Price Consumption Curve


V

If we subtract substitution effect, X1X2, from the total price effect, X1X3, we get the
income effect. That is,
Income effect = X1X3 – X1X2 = X3X3
Graphically, the income effect (X2X3) occurs when the consumer moves from point
R to Q. In other words, consumer’s movement from R to Q and the corresponding
change in quantity demanded (X2X3) is the income effect caused by the increase in real

Self-Instructional
110 Material
income of the consumer due to fall in price of X. The income-effect of a change in the Theory of Consumer
Demand
price of a commodity may thus be defined as the change in quantity demanded of
that commodity resulting exclusively from a change in the real income, all other
things remaining the same.
NOTES
(ii) Slutsky Approach
Slutsky’s method of measuring income and substitution effects of price effect is similar
to the Hicksian method. Both the methods approach the problem by holding consumer’s
real income constant. But there is a difference in the two methods of measuring the
real-income-effect of a fall in the price of a commodity. The difference lies in the level

se
at which real income is held constant.
Hicksian method considers the real-income-effect of a fall in the price of a commodity

u
equal to an amount which, if taken away from the consumer, brings him back to his
original indifference curve, at the new price ratio, irrespective of the change in the

. Ho
original combination of the two goods. This is accomplished by drawing an imaginary
budget line tangent to the original indifference curve, as shown by MN′ in Fig. 3.10.
On the other hand, according to the Slutskian method, the real-income-effect of a
fall in the price of a commodity equals only that amount which, if taken away from the
consumer leaves with him an adequate income to buy the original combination of two

td g
goods after the change in price ratio. This approach to measuring the real-income-
. L in
effect makes the imaginary budget line pass through the original equilibrium point P.
The Slutskian method of splitting the total price-effect into income and substitution
vt sh
effects is demonstrated in Fig. 3.11. Suppose that the consumer is initially in equilibrium
at point P on indifference curve IC1. When the price of X falls, other things remaining
the same, the consumer moves to another equilibrium point (Q) at indifference curve
IC3. The movement from point P to Q increases consumer’s purchase of X by X1X3.
P li

This is the price effect caused by the fall in price of X. The problem now is to measure
ub

the substitution and income effects. To measure the substitution effect, the income
effect has to be eliminated first. This can be done by taking away the increase in
consumer’s real income resulting from the fall in price of X. It is here that Slutskian
approach differs from the Hicksian approach. According to the Slutskian approach,
P

consumer’s real income is so reduced that he is able to purchase his original combination
of the two goods (i.e. OX1 of X and PX1 of Y) at the new price ratio. This has been
s

accomplished by drawing an imaginary budget line, M′N′, through point P, which is


parallel to MN,′. Since the whole commodity space is full of indifference curves, one of
a

the indifference curves will be tangent to the imaginary budget M′N′ as shown by the
point R on indifference curve IC2. The equilibrium point R shows the additional quantity
ik

(X1X2) of X, i.e., purely as a result of substitution effect. The quantity X1X2 is therefore
the substitution effect. Now income effect (IE) can be found by subtracting the
V

substitution effect (SE) from the price effect (PE) as given below.
Income Effect = PE – SE = IE
= X 1X 3 – X 1X 2 = X 1X 3

Self-Instructional
Material 111
Theory of Consumer
Demand

NOTES

u se
Fig. 3.11 Income and Substitution Effects: Slutsky Approach

. Ho
In Fig. 3.11, the movement from P to R and the consequent increase in the quantity
purchased of X (i.e., X1X2) is substitution effect. Similarly the consumer’s movement
from R to Q and the consequent increase in the quantity (X2X3) purchased of X is
income effect.

td g
. L in(iii) Hicksian Approach vs Slutskian Approach
Let us now compare the Hicksian and Slutskian approaches of splitting price effect into
substitution and income effects and also their results. As mentioned above, the Slutskian
vt sh
approach attempts to hold only apparent real income constant, which is obtained by
adjusting consumer’s real income by the amount of ‘cost-difference’ so that the consumer
is left with an income just sufficient to buy the original combination of the goods. The
P li

Hicksian approach holds constant the real income expressed in terms of original level
of satisfaction so that the consumer is able to stay on the original indifference curve
ub

though the combination of X and Y is different from the original one. To express the
difference graphically, The Hicksian method puts the consumer on the original
indifference curve whereas the Slutskian method makes the consumer move on to an
P

upper indifference curve.


The two approaches are compared in Fig. 3.12. Let the consumer initially be in
equilibrium at point P on indifference curve IC1. When price of X falls, the consumer
s

moves to point Q. The movement from P to Q is the total price effect which equals X1X4
a

of commodity X. Till this point, there is no difference between the Slutskian and the
Hicksian approaches. But beyond this point, they differ. According to the Slutskian
ik

approach, the movement from point P to T is the substitution effect and movement from
T to Q is the income effect. According to the Hicksian approach, the movement from P
V

to R is the substitution effect and movement from R to Q is the income effect. The
substitution and income effects of Slutskian and Hicksian approaches are summarized
in quantitative terms in the following table.
Method Price Substitution Income
Effect Effect Effect
Hicksian X1X4 X1X2 X2X4
Slutskian X1X4 X1X3 X3X4

Self-Instructional
112 Material
As depicted in Fig. 3.12, there is a good deal of difference between the Hicksian Theory of Consumer
Demand
and the Slutskian measures of income and substitution effects. But it can be shown that
if change in price is small the difference between the Slutskian and Hicksian measures
would be small and if DP tends to be zero, the difference would also be zero.
NOTES

u se
. Ho
Fig. 3.12 Hicksian Approach vs. Slutskian Approach

td g
Apart from the above difference between the two approaches, there are some
other differences between them. While the Hicksian approach is considered as a ‘highly
. L in
persuasive solution’ to the problems of splitting price effect into substitution and income
effects, the Slutskian approach is intuitively ‘perhaps less satisfying’. But the merit of
vt sh
the Slutskian approach is that substitution and income effects can be directly computed
from the observed facts, whereas Hicksian measure of these effects cannot be obtained
without the knowledge of consumer’s indifference map.
P li

Both the methods however have their own merits. The merit of the Slutskian method,
what Hicks calls ‘cost-difference’ method, lies in its property that it makes income-
ub

effect easy to handle. Hicks has himself recognized this merit of the Slutskian method.
The merit of the Hicksian method or ‘compensating variation method’ is that it is a more
convenient method of measuring the substitution effect. In Hick’s own words, ‘The
P

merit of the cost-difference method is confined to [its] property... that its income effect
is peculiarly easy to handle. The compensating variation method [i.e., his own method]
does not share in this particular advantage; but it makes up for its clumsiness in relation
s

to income effect by its convenience with relation to the substitution effect.’


a

Need for splitting income and substitution effects


ik

We have discussed above the Hicksian and Slutskian method of decomposing income
and substitution effects of the price effect. Let us now look into the need for separating
income effect and the substitution effect. As Hicks has pointed out, ‘substitution effect
V

is absolutely certain; it must always work in favour of an increase in demand for a


commodity when the price of that commodity falls. Thus, the behaviour of substitution
effect is predictable: it follows directly from the principle of diminishing marginal rate of
substitution. On the contrary, ‘income effect is not so reliable’ and its behaviour is
unpredictable in general. In fact, whether income-effect is positive or negative depends
on whether a commodity is treated by the consumer as a ‘superior’ or ‘inferior’ good.
Since the subjective valuation of a commodity may vary from person to person, the
response of the consumer in general to the change in real income becomes uncertain
Self-Instructional
Material 113
Theory of Consumer and unpredictable. It is quite likely that while in some cases, substitution effect works in
Demand
positive direction, income effect works in negative direction. In such cases, a systematic
analysis of price-demand relationships becomes an extremely difficult task. It therefore
becomes necessary to eliminate the unpredictable income effect so that ‘the systematic
NOTES and predictable behaviour of the substitution effect can be revealed’. That is why the
attempts to measure and split away the income effect from the price effect.
Income and substitution effects of price change on inferior goods
We have examined in the foregoing section, the income and substitution effects of a
change in price on the consumption of ‘normal’ or ‘superior’ goods. We will see, in this

se
section, how income and substitution effects of a price change work on the consumption
of an inferior commodity.
As mentioned above, an ‘inferior good’ is one whose consumption decreases with

u
increase in consumer’s income. In other words, an ‘inferior good’ is one for which

. Ho
income-effect is negative. The reason for income effect on the consumption of an
‘inferior good’ being negative is the human desire to improve his standard of living. In
general, when income of a consumer increases, he has a tendency to reduce his
consumption of ‘inferior goods’ and increase the consumption of ‘superior’ or ‘normal’
goods.

td g
. L inIncome and substitution effects of income change
The income-effect on the consumption of an ‘inferior good’ (say, X), is illustrated in
Fig. 3.13.
vt sh
In the figure, the vertical axis measures money income and the horizontal axis
measures an inferior good, X. Let us suppose that the consumer is initially in equilibrium
at point E1 where he purchases OX3 units of X. As his income increases from OM1 to
P li

OM2, price of X remaining constant, his budget line M1 N1 shifts to M2 N2 and he reaches
an upper indifference curve IC2. His new equilibrium point is E2 where he consumes
ub

only OX2 units of X. Note that OX2 < OX3. That is, his consumption of X decreases. It
decreases further to OX1 when his income increases to OM3. The curve joining
equilibrium points E1, E2 and E3 is ICC for the inferior commodity (X). For most part of
P

it, ICC has a negative slope showing negative income effect on the consumption of X.
a s
ik
V

Fig. 3.13 Income Effect: Inferior Goods Case


Self-Instructional
114 Material
It should be borne in mind that inferiority or superiority is not an absolute or instrinsic Theory of Consumer
Demand
property of a commodity. These properties often arise out of consumer’s taste and
preference. However, a number of commodities is generally treated by the consumers
as inferior to their substitutes. For example, bajra and millet are inferior to wheat and
rice; cotton fabrics are inferior to silk and synthetic cloth; coal and charcoal (even NOTES
kerosene) are inferior fuel to cooking gas; bidi is inferior to cigarettes; bus and railway
services are inferior to air services.
Income and substitution effects of price change
Let us now examine the income and substitution effects caused by a fall in the price of

se
X, assumed to be an inferior good. The income and substitution effects of a fall in price
of X are presented in Fig. 3.14. Let the consumer be in equilibrium at point P, where
budget line M1N1 is tangent to indifference curve IC1. At point P, the equilibrium

u
combination of X and Y consists of OX1 of X and PX1 of Y. Now let the price of X fall,
other things remaining the same, so that the budget line shifts to M1N3 and the consumer

. Ho
moves to equilibrium R. The movement from P to R is the price effect, which equals
X1X2. To eliminate the income effect from the price effect, M2N2, following the Hicksian
method, let us draw an imaginary budget line, M2N2 tangent to the original indifference
curve IC1. The budget line M2N2 is tangent to IC1 at point Q, which is equilibrium point
after the elimination of income effect. Consumer’s movement from P to Q means an

td g
increase in the quantity consumed of X by X1X3. This is substitution effect which results
. L in
from a fall in the price of X. Note that substitution effect (X1X3) is greater than the price
effect (X1X2) in case of inferior goods.
Let us now look at the income effect of change in price of an inferior good. The
vt sh
movement from Q to R shows negative income effect, (i.e., decrease in the quantity
demanded of X. The negative income effect may be computed from Fig. 3.14 as follows.
PE – SE = IE
P li

X 1X 2 – X 1X 3 = – X 2X 3
ub

Note that in case of an ‘inferior good’, income and substitution effects, both being
negative, work in opposite directions. That is, while income effect of a fall in the price of
an inferior good causes a decrease in the consumption of the good, substitution effect
P

causes an increase in its quantity demanded.


a s
ik
V

Fig. 3.14 Income and Substitution Effects: Inferior Good Case

It is important to note here that, in case of an inferior good, substitution effect (X1X3)
is greater than the income effect (X1X3). That is, negative substitution effect outweighs
the negative income effect. It means that a stronger substitution effect causes a net Self-Instructional
Material 115
Theory of Consumer increase in the demand for an inferior good, even though there exists a negative income
Demand
effect. This shows that the law of demand applies to most inferior goods.
Giffen goods and giffen paradox
NOTES In case of an inferior good, income and substitution effects of a price change work in
opposite directions and that substitution effect outweighs the income effect so that
there is net increase in the quantity demanded of an inferior good when its price falls. It
means that the law of demand applies to an ‘inferior good’ as well as to a ‘normal
good’.
However, there are certain cases of inferior goods to which the law of demand does

se
not apply. Such goods are known as Giffen goods. In case of Giffen goods, income and
substitution effects work in the same direction, and income effect is more powerful than
the substitution effect. In other words, in case of Giffen goods, income effect outweighs

u
the substitution effect. This phenomenon causes a paradoxical situation, i.e. when price
of an inferior good increases, its quantity demanded increases. This paradox is known

. Ho
as Giffen paradox. The Giffen paradox is an exception to the law of demand.
Marshall attributed this paradox to Robert Giffen though there is no mention of this
paradox in Giffen’s own writings. Besides, economists doubt whether Giffen’s paradox
was actually observed. But, since this paradox is useful in explaining an exception to the

td g
law of demand, it is retained in the economic literature.
. L in The Giffen’s paradox is illustrated in Fig. 3.15. Let us suppose that the consumer is
initially in equilibrium at P. Now, let the price of commodity X decrease, price of Y
remaining constant, so that the consumer moves to equilibrium R on IC2. As a result of
vt sh
this movement, quantity demanded of X decreases by X1X2.
Let us now separate the income and substitution effects of the price effect X1X2 and
see their behaviour in the case of a Giffen good. Following the Hicksian method, let us
P li

eliminate the income effect by drawing an imaginary budget line M1N2 parallel to the
budget line M2N3 and tangent to the original indifference curve IC1. The imaginary
ub

budget line is tangent to IC1 at point Q. The consumer’s movement from P to Q and the
consequent increase in the quantity demanded of X by X2X3 is the substitution effect.
P
a s
ik
V

Fig. 3.15 Giffen’s Paradox

Income effect = – X1X2 – X2X3 = – X1X3


It may be observed from the Fig. 3.15 that income effect (–X1X3) is greater
than substitution effect (X2X3). Obviously, income effect outweighs the subs-
Self-Instructional
116 Material
titution effect. The net result, therefore, is decreased in the quantity demanded of Theory of Consumer
Demand
X as its price decreases. That is, contrary to the law of demand, the demand for
a Giffen good decreases when its price decreases and it increases when its price increases.
The case of a Giffen good exists when the consumer spends a major portion of his
income on an inferior good. This kind of situation may be imagined to have existed in
NOTES
case of most poor families of the underdeveloped countries, who spend a major portion
of their wage income on some inferior foodgrains (bajra or millet). Given the prices of
inferior foodgrains, poor families may possibly afford some quantity of superior
consumption items. But when the prices of inferior foodgrains go up, they are forced to

se
curtail their expenditure on superior items and spend more on inferior items because
these are still the cheaper food items available to the poor families.
It may finally be noted that all Giffen goods are inferior goods, but not all inferior

u
goods are Giffen goods. The important distinction between Giffen goods and non-
Giffen inferior goods is that the demand curve for the former has a positive slope, the

. Ho
demand curve for the latter has a negative slope.

3.5 REVEALED PREFERENCE APPROACH

td g
In succession to Hicks-Allen ordinal utility approach, Samuelson formulated, in 1947, his
own ‘Revealed Preference Theory’ of consumer behaviour. The main merit of the
. L in
revealed preference theory is that the ‘law of demand’ can be directly derived from the
revealed preference axioms without using indifference curve and most of its restrictive
vt sh
assumptions. What is needed is simply to record the observed behaviour of the consumer
in market, i.e., what basket of goods a consumer buys at different prices. Besides, the
revealed preference theory is also capable of establishing the existence of indifference
curves and their convexity. For its merits, revealed preference theory is treated as ‘the
P li

third root of the logical theory of demand’.


ub

Assumptions
Revealed preference hypothesis is based on the following straightforward assumptions.
P

1. Rationality. The consumer is assumed to be a rational being. In his order of


preferences, he prefers a larger basket of goods to the smaller ones.
2. Transitivity. Consumer’s preferences are assumed to be transitive. That is,
s

given the alternative baskets of goods, A, B, and C, if the consumer considers


a

A > B and B > C, then he considers A > C.


3. Consistency. It is also assumed that consumer’s taste remains constant and
ik

consistent. Consistency implies that if a consumer, given his circumstances,


prefers A to B, he will not prefer B to A under the same conditions.
V

4. Price incentive. Given the collection of goods, the consumer can be induced to
buy a particular collection by providing his sufficient price incentive. That is, for
each collection, there exists a price line which makes it attractive for the consumer.
Revealed Preference Axiom
The rule of revealed preference can be stated as follows. Given the budgetary constraint
and alternative baskets of goods having the same price, if a consumer chooses a particular
baskets, he reveals his preference. Suppose, for example, there are two alternative
Self-Instructional
Material 117
Theory of Consumer baskets A and B of two goods X and Y. Both the baskets being equally expensive, if a
Demand
consumer chooses basket A rather than basket B, he reveals his preference for basket A.
If a consumer chooses a particular basket, he does so either because be likes it
more or it is less expensive than the other. In the this example, if the consumer chooses
NOTES A rather than B because it is cheaper, then the preference for A is not revealed because
the consumer might regret not having been able to buy basket B. But, if both baskets are
equally expensive, then there is only one plausible explanation that the consumer likes A
more than B. In this case, the consumer reveals his preference for A.

u se
. Ho
td g
. L in Quantity of X

Fig. 3.16 Revealed Preference


vt sh
The revealed preference axiom is illustrated in Fig. 3.16. The consumer’s budgetary
constraint has been shown by his budget line MN. If he chooses a particular bundle of X
and Y, e.g., a bundle represented by point A on the budget line, it implies that he prefers
P li

point A to any other point on the budget line, say point B. Since point B is on the budget
line it is as expensive as A. If consumer chooses point A, it is revealed preferred to B,
ub

and B is revealed inferior to A. Any point below the budget line, like point C, represents
a smaller and cheaper basket of X and Y and hence, is not revealed as inferior to A.
Therefore, any point above the budget line, like point D, represents a larger and more
P

expensive basket of goods than indicated by point A. Hence, it cannot be inferior to A.


Check Your Progress
3. What is an
3.6 SUMMARY
s

indifference curve?
4. What is the
a

Marginal Rate of • The central theme of the traditional theory of consumer behaviour is a consumer’s
Substitution
ik

utility maximizing behaviour. The fundamental postulate of the consumption theory


(MRS)?
is that a consumer—an individual or a household—is a utility maximizing entity
5. What are the
approaches of and all consumption decisions are directed towards maximization of total utility.
V

decomposing the • Milton Friedman, instead of resolving the issue of measurability of utility, preferred
total price effect
into income and to rely on the preferences and choices revealed by the consumers and developed
substitution his own Revealed Preference theory.
effects?
• The Cardinal Utility Theory of consumer demand was developed by the classical
6. Who postulated the
theory of revealed economists, viz. Gossen (1854) of Germany, William Stanley Jevons (1871) of
preference and what England, Leon Walras (1874) of France, Karl Menger (1840–1921) of Austria.
was its main merit? Neo-classical economists, particularly Alfred Marshall (1890) made significant
refinements in the Cardinal Utility Theory.
Self-Instructional
118 Material
• The notion of ‘Utility’ was introduced to social thought by the British philosopher, Theory of Consumer
Demand
Jeremy Bentham, in the 18th century and to economics by William Stanley Jevons
in the 19th century. In its economic meaning, the term ‘utility’ is synonymous with
‘pleasure’, ‘satisfaction’ and a sense of fulfilment by desire.
• The law of diminishing marginal utility is central to the cardinal utility analysis of NOTES
the consumer behaviour. This law states that as the quantity consumed of a
commodity increases per unit of time, the utility derived by the consumer from the
successive units goes on decreasing, provided the consumption of all other goods
remains constant.

se
• A consumer reaches equilibrium position, when he maximizes his total utility given
his income and prices of commodities he consumes.
• The technique which economists use under ordinal utility approach is called

u
indifference curve. The basis of indifference curve is the assumption that a
consumer is able to make different combinations of any two substitute goods

. Ho
such that each combination of goods yields the same level of satisfaction that is,
the consumer is indifferent when it comes to making a choice.
• Slutsky’s method of measuring income and substitution effects of price effect is
similar to the Hicksian method. Both the methods approach the problem by holding

td g
consumer’s real income constant. But there is a difference in the two methods of
measuring the real-income-effect of a fall in the price of a commodity. The
. L in
difference lies in the level at which real income is held constant.
• There are certain cases of inferior goods to which the law of demand does not
vt sh
apply. Such goods are known as Giffen goods. In case of Giffen goods, income
and substitution effects work in the same direction, and income effect is more
powerful than the substitution effect.
P li

3.7 KEY TERMS


ub

• Utility: It refers to the power or property of a commodity to satisfy human needs.


• Law of diminishing marginal utility: The law states that as the quantity consumed
P

of a commodity increases per unit of time, the utility derived by the consumer
from the successive units goes on decreasing, provided the consumption of all
other goods remains constant.
s

• Indifference curve: It is the technique used by economists under ordinal utility


a

approach. The basis of the technique is the assumption that a consumer is able to
make different combinations of any two substitute goods such that each
ik

combination of goods yields the same level of satisfaction that is, the consumer is
indifferent when it comes to making a choice.
V

• Income effect: This occurs due to increase in real income resulting from the
decrease in the price of a commodity
• Substitution effect: This occurs due to consumer’s inherent tendency to substitute
cheaper goods for the relatively expensive ones.

Self-Instructional
Material 119
Theory of Consumer
Demand 3.8 ANSWERS TO ‘CHECK YOUR PROGRESS’
1. The Cardinal Utility Theory of consumer demand was developed by the classical
NOTES economists, viz. Gossen (1854) of Germany, William Stanley Jevons (1871) of
England, Leon Walras (1874) of France, Karl Menger (1840–1921) of Austria.
2. The law of diminishing marginal utility is central to the cardinal utility analysis of
the consumer behaviour. This law states that as the quantity consumed of a
commodity increases per unit of time, the utility derived by the consumer from the
successive units goes on decreasing, provided the consumption of all other goods

se
remains constant.
3. An indifference curve may be defined as the locus of points, each representing a
different combination of two goods but yielding the same level of utility or

u
satisfaction. Since each combination of two goods yields the same level of utility,

. Ho
the consumer is indifferent between any two combinations of goods when it comes
to making a choice between them.
4. When a consumer makes different combination of two goods, yielding the same
level of satisfaction, he substitutes one good for another. The rate at which he
substitutes one good for the other is called the Marginal Rate of Substitution

td g
(MRS).
. L in 5. There are two approaches for decomposing the total price effect into income
and substitution effects:
(i) Hicksian approach, and
vt sh
(ii) Slutsky approach.
6. Paul Samuelson formulated, in 1947, his ‘Revealed Preference Theory’ of
consumer behaviour. The main merit of the revealed preference theory is that the
P li

‘law of demand’ can be directly derived from the revealed preference axioms
ub

without using indifference curve and most of its restrictive assumptions.

3.9 QUESTIONS AND EXERCISES


P

Short-Answer Questions
s

1. Define utility.
a

2. List the assumptions of the law of diminishing marginal utility.


3. Define and give the formula for computing the law of equi-marginal utility.
ik

4. Write a brief note on Slutsky’s method of measuring income and substitution


effects of price effect.
V

5. Briefly discuss the Giffen paradox.


Long-Answer Questions
1. Identify the assumptions of the ordinal utility theory.
2. Explain how utility is measured?
3. Describe the assumptions of the Marshallian approach to the determination of
consumer’s equilibrium.
Self-Instructional
120 Material
4. Explain the meaning and nature of indifference curve and indifference map. Theory of Consumer
Demand
5. Explain in detail the reveal preference approach given by Paul Samuelson.

3.10 FURTHER READING NOTES

Dwivedi, D. N. 2008. Managerial Economics, Seventh Edition. New Delhi: Vikas


Publishing.
Keat, Paul G. and Philip, K. Y. Young. 2003. Managerial Economics: Economics
Tools for Today’s Decision Makers, Fourth Edition. Singapore: Pearson

se
Education.
Keating, B. and J. H. Wilson. 2003. Managerial Economics: An Economic Foundation
for Business Decisions, Second Edition. New Delhi: Biztantra.

u
Mansfield, E., W. B. Allen, N. A. Doherty, and K. Weigelt. 2002. Managerial

. Ho
Economics: Theory, Applications and Cases, Fifth Edition. NY: W. Orton
& Co.
Peterson, H. C. and W. C. Lewis. 1999. Managerial Economics, Fourth Edition.
Singapore: Pearson Education.

td g
Salvatore, Dominick. 2001. Managerial Economics in a Global Economy, Fourth
Edition. Australia: Thomson-South Western.
. L in
Thomas, Christopher R. and Maurice S. Charles. 2005. Managerial Economics:
Concepts and Applications, Eighth Edition. New Delhi: Tata McGraw-Hill.
vt sh
P li
ub
P
a s
ik
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Self-Instructional
Material 121
V
ik
as
P
ub
P li
vt sh
. L in
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use
Input-Output Decisions

UNIT 4 INPUT-OUTPUT DECISIONS


Structure
NOTES
4.0 Introduction
4.1 Unit Objectives
4.2 Law of Supply
4.3 Elasticity of Supply
4.4 Production Function

se
4.5 Short-run and Long-run Production Function
4.6 Short-run and Long-run Cost Functions
4.6.1 Short-run Cost-Output Relations
4.6.2 Short-run Cost Functions and Cost Curves

u
4.6.3 Cost Curves and the Law of Diminishing Returns
4.6.4 Some Important Cost Relationships

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4.6.5 Output Optimization in the Short-run
4.6.6 Long-run Cost-Output Relations
4.7 Summary
4.8 Key Terms
4.9 Answers to ‘Check Your Progress’

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4.10 Questions and Exercises
4.11 Further Reading. L in
4.0 INTRODUCTION
vt sh
Whatever the objective of business firms, achieving optimum efficiency in production or
minimizing cost for a given production is one of the prime concerns of the business
P li

managers. In fact, the very survival of a firm in a competitive market depends on their
ability to produce at a competitive cost. Therefore, managers of business firms endeavour
ub

to minimize the production cost of a given output or, in other words, maximize the output
from a given quantity of inputs. In their efforts to minimize the cost of production, the
fundamental questions that managers are faced with are:
P

(i) How can production be optimized or cost minimized?


(ii) How does output respond to change in quantity of inputs?
s

(iii) How does technology matter in reducing the cost of production?


a

(iv) How can the least-cost combination of inputs be achieved?


(v) Given the technology, what happens to the rate of return when more plants are
ik

added to the firm?


In this unit, you will learn about the supply elasticity and production and cost functions.
V

4.1 UNIT OBJECTIVES


After going through this unit, you will be able to:
 Define the law of supply
 Explain the concept of elasticity of supply
 Discuss the application and derivation of production function
Self-Instructional
Material 123
Input-Output Decisions  Describe the short-run and long-run production functions and their significance
 Describe the short-run and long-run cost functions and their significance

NOTES 4.2 LAW OF SUPPLY


The supply of a commodity depends on its price and cost of its production. In other
words, supply is the function of price and production cost.1 The law of supply is, however,
expressed generally in terms of price-quantity relationship. The law of supply can be
stated as follows: The supply of a product increases with the increase in its price

se
and decreases with decrease in its price, other things remaining constant. It implies
that the supply of a commodity and its price are positively related. This relationship holds
under the assumption that “other things remain the same”. “Other things” include

u
technology, price of related goods (substitute and complements), and weather and climatic
conditions in case of agricultural products.

. Ho
4.3 ELASTICITY OF SUPPLY
Like the law of demand, the law of supply states only the nature of relationship between

td g
the change in the price of a commodity and the quantity supplied thereof. The law does
not quantify the relationship. The quantitative relationship is measured by the price
. L in
elasticity of supply.
The price elasticity of supply is the measure of responsiveness of the quantity
vt sh
supplied of a good to the changes in its market price. The coefficient of price elasticity
of supply (ep) is the measure of percentage change in the quantity supplied of a product
due to a given percentage change in its price. The formula of supply elasticity is given as
P li

% change in quantity supplied (Q)


ep =
ub

% change in price ( P)

Q Q Q P
ep =  
P P P Q
P

Note that the formula for measuring the price elasticity of supply is the same as
for the price elasticity of demand, without a minus sign. Given the formula, price elasticity
s

of supply can be easily measured.


a

Example. Suppose that the supply curve for a commodity is given an SS in Fig. 4.1 and
we want to measure the price elasticity of the supply for a price rise in price between
ik

points J and P. In that case


Q = 60 – 100 = – 40
V

P = 5 – 7.5 = – 2.5
P = 5 and Q = 60
By substituting these values into the elasticity formula, we get
Q P 40 5
ep =     1.33
P Q 2.5 60

Consider another example. Suppose we want to measure the price elasticity of


supply between points P and K, i.e., for price rise from ` 7.5 to ` 10. Here,
Self-Instructional
124 Material
Input-Output Decisions
100  120 7.5
ep = 
7.5  10 100

20 7.5
=  = 0.6
2.5 100 NOTES
The price elasticity of a supply curve like one given in Fig. 4.1 may vary between
zero and infinity depending on the levels of the supply. For example, as we have seen
above, e > 1 between point J to P and e < 1 between point P to K. It can be noted that the
price elasticity below point P is greater than unity and it is less than unity beyond point K.

se
Thus, a supply curve is said to be (i) elastic when e > 1, (ii) inelastic when e < 1, and
(iii) unitary elastic when e = 1. A perfectly inelastic supply has e = 0 throughout its length
and is a straight vertical line. A perfectly elastic supply curve has e = ¥ all along its

u
length is a straight horizontal line.

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. L in
vt sh
P li
ub
P
s

Fig. 4.1 Price Elasticity of Supply Curve


a

Determinants of the Price Elasticity of Supply


ik

The price elasticity of the supply depends on the following factors:


V

Time Period. Time period is the most important factor in determining the elasticity of
the supply curve. In a very short period, the supply of most goods is fixed and inelastic.
In the short run, the supply tends to remain inelastic. In the long run, the supply of all the
products gains its maximum elasticity because of increase in and expansion of firms,
new investments, improvement in technology, and a greater availability of inputs.
It is important to note here that short and long periods are not fixed in terms of
days, months or years. It varies depending on the nature of the product. For example, for
the supply of perishable commodities like milk and fish in a city, a week’s time may be a
short period. For agricultural products, 6 months may be a short period. But in regard to
Self-Instructional
Material 125
Input-Output Decisions the local supply of petroleum products in India, a period of five years or even more may
be regarded as a short period.
Law of Diminishing Returns. The other factor that determines the elasticity of
supply is the Law of Diminishing Returns. We will discuss this law later in detail when
NOTES we take up the laws of production. Here, it suffices to say that if the law of diminishing
returns come in force at an early level of production, cost increases rapidly. As a result,
supply tends to becomes less and less elastic.

4.4 PRODUCTION FUNCTION

se
Production function is a mathematical presentation of input-output relationship. More
specifically, a production function states the technological relationship between inputs

u
and output in the form of an equation, a table or a graph. In its general form, it specifies
the inputs on which depends the production of a commodity or service. In its specific

. Ho
form, it states the quantitative relationships between inputs and output. Besides, the
production function represents the technology of a firm, of an industry or of the economy
as a whole. A production function may take the form of a schedule or a table, a graphed
line or curve, an algebraic equation or a mathematical model. But each of these forms of

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a production function can be converted into its other forms.
. L in A real-life production function is generally very complex. It includes a wide range
of inputs, viz., (i) land and building; (ii) labour including manual labour, engineering staff
and production manager, (iii) capital, (iv) raw material, (v) time, and (vi) technology. All
vt sh
these variables enter the actual production function of a firm. The long-run production
function is generally expressed as
Q = f(LB, L, K, M, T, t)
P li

where LB = land and building L = labour, K = capital, M = raw materials,


T = technology and t = time.
ub

The economists have however reduced the number of input variables used in a
production function to only two, viz., capital (K) and labour (L), for the sake of
convenience and simplicity in the analysis of input-output relations. A production function
P

with two variable inputs, K and L, is expressed as


Q = f(L, K)
s

The reasons for excluding other inputs are following.


a

Land and building (LB), as inputs, are constant for the economy as a whole,
and hence they do not enter into the aggregate production function. However, land and
ik

building are not a constant variable for an individual firm or industry. In the case of
individual firms, land and building are lumped with ‘capital’.2
V

In case of ‘raw materials’ it has been observed that this input ‘bears a constant
relation to output at all levels of production’. For example, cloth bears a constant relation
to the number of garments. Similarly, for a given size of a house, the quantity of bricks,
cement, steel, etc. remains constant, irrespective of number of houses constructed. To
consider another example, in car manufacturing of a particular brand or size, the quantity
of steel, number of the engine, and number of tyres and tubes are fixed per car. Therefore,
raw materials are left out of production function. So is the case, generally, with time and
space. Also, technology (T) of production remains constant over a period of time. That
is why, in most production functions, only labour and capital are included.
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126 Material
We will illustrate the tabular and graphic forms of a production function when we Input-Output Decisions
move on to explain the laws of production. Here, let us illustrate the algebraic or
mathematical form of a production function. It is this form of production function that is
most commonly used in production analysis.
To illustrate the algebraic form of production function, let us suppose that a coal NOTES
mining firm employs only two inputs—capital (K) and labour (L)—in its coal production
activity. As such, the general form of its production function may be expressed as
QC = f (K, L) …(4.1)
where QC = the quantity of coal produced per time unit,

se
K = capital, and L = labour.
The production function (4.1) implies that quantity of coal produced depends on

u
the quantity of capital (K) and labour (L) employed to produce coal. Increasing coal
production will require increasing K and L. Whether the firm can increase both K and L

. Ho
or only L depends on the time period it takes into account for increasing production, i.e.,
whether the firm considers a short-run or a long-run.
By definition, as noted above, short-run is a period in which supply of capital is inelastic.
In the short-run, therefore, the firm can increase coal production by increasing only

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labour since the supply of capital in the short run is fixed.3 Long-run is a period in which
supply of both labour and capital is elastic. In the long-run, therefore, the firm can
. L in
employ more of both capital and labour. Accordingly, there are two kinds of production
functions:
vt sh
(i) Short-run production function; and
(ii) Long-run production function.
The short-run production function or what may also be termed as ‘single variable
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input production function’, can be expressed as


ub

Q = f ( K , L ), where K is a constant …(4.2a)


For example, suppose a production function is expressed as
Q = bL
P

where b = DQ/DL gives constant return to labour.


In the long-term production function, both K and L are included and the function
s

takes the following form.


a

Q = f (K, L) …(4.2b)
As mentioned above, a production function can be expressed in the form of an
ik

equation, a graph or a table, though each of these forms can be converted into its other
forms. We illustrate here how a production function in the form of an equation can be
V

converted into its tabular form. Consider, for example, the Cobb-Douglas production
function—the most famous and widely used production function4—given in the form of
an equation as
Q = AKaLb …(4.3)
(where K = Capital, L = Labour, and A, a and b are parameters and b = 1 – a)
Production function (4.3) gives the general form of Cobb-Douglas production
function. The numerical values of parameters A, a and b, can be estimated by using
actual factory data on production, capital and labour. Suppose numerical values of
Self-Instructional
Material 127
Input-Output Decisions parameters are estimated as A = 50, a = 0.5 and b = 0.5. Once numerical values are
known, the Cobb-Douglas production function can be expressed in its specific form as
follows.
Q = 50 K0.5 L0.5
NOTES
This production function can be used to obtain the maximum quantity(Q) that can
be produced with different combinations of capital (K) and labour (L). The maximum
quantity of output that can be produced from different combinations of K and L can be
worked out by using the following formula.

se
Q  50 KL or Q  50 K L
For example, suppose K = 2 and L = 5. Then
Q  50 2 5  158

u
and if K = 5 and L = 5, then

. Ho
Q  50 5 5  250
Similarly, by assigning different numerical values to K and L, the resulting output
can be worked out for different combinations of K and L and a tabular form of production

td g
function can be prepared. Table 4.1 shows the maximum quantity of a commodity that
can be produced by using different combinations of K and L, both varying between 1
. L in
and 10 units.
Table 4.1 Production Function in Tabular Form
vt sh
P li
ub
P
a s

Check Your Progress


ik

1. What is the
relationship
between supply Table 4.1 shows the units of output that can be produced with different combinations
and price, as per the
V

law of supply? of capital and labour. The figures given in Table 4.1 can be graphed in a three-dimensional
2. How are the short diagram.
and long periods of We now move on to explain the laws of production, first with one variable input
price elasticity of
supply determined?
and then with two variable inputs. We will then illustrate the laws of production with the
3. What inputs does
help of production function.
the real-life Before we proceed, it is important to note here that four combinations of K and
production function
include?
L—10K + 1L, 5K + 2L, 2K + 5L and 1K + 10L—produce the same output, i.e., 158 units.
When these combinations of K and L producing the same output are joined by a line, it
Self-Instructional
128 Material
produces a curve as shown in the table. This curve is called ‘Isoquant’. An isoquant is a Input-Output Decisions
very important tool used to analyze input-output relationship.

4.5 SHORT-RUN AND LONG-RUN PRODUCTION NOTES


FUNCTION
The laws of production state the relationship between output and input. In the short-run,
input-output relations are studied with one variable input (labour), other inputs (especially,
capital) held constant. The laws of production under these conditions are called the

se
‘Laws of Variable Proportions’ or the ‘Laws of Returns to a Variable Input’. In this
section, we explain the ‘laws of returns to a variable input’.

u
The Law of Diminishing Returns to a Variable Input

. Ho
The Law of Diminishing Returns. The law of diminishing returns states that when
more and more units of a variable input are used with a given quantity of fixed
inputs, the total output may initially increase at increasing rate and then at a
constant rate, but it will eventually increase at diminishing rates. That is, the marginal
increase in total output decreases eventually when additional units of a variable factor

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are used, given quantity of fixed factors.
Assumptions. The law of diminishing returns is based on the following assumptions:
. L in
(i) labour is the only variable input, capital remaining constant;
vt sh
(ii) labour is homogeneous;
(iii) the state of technology is given; and
(iv) input prices are given.
P li

To illustrate the law of diminishing returns, let us assume (i) that a firm (say, the
coal mining firm in our earlier example) has a set of mining machinery as its capital (K)
ub

fixed in the short-run, and (ii) that it can employ only more mine-workers to increase its
coal production. Thus, the short-run production function for the firm will take the following
form.
P

Qc = f(L), K constant
Let us assume also that the labour-output relationship in coal production is given
s

by a hypothetical production function of the following form.


a

Qc = – L3 + 15L2 + 10L …(4.4)


Given the production function (4.4), we may substitute different numerical values
ik

for L in the function and work out a series of Qc, i.e., the quantity of coal that can be
produced with different number of workers. For example, if L = 5, then by substitution,
V

we get
Qc = – 53 + 15 × 52 + 10 × 5 = – 125 + 375 + 50 = 300
A tabular array of output levels associated with different number of workers
from 1 to 12, in our hypothetical coal-production example, is given in Table 4.2 (Cols. 1
and 2).
What we need now is to work out marginal productivity of labour (MPL) to
find the trend in the contribution of the marginal labour and average productivity of
labour (APL) to find the average contribution of labour.
Self-Instructional
Material 129
Input-Output Decisions Marginal Productivity of Labour (MPL) can be obtained by differentiating the
production function (4.4). Thus,
Q
MPL = L = – 3L2 + 30L + 10 …(4.5)
NOTES
By substituting numerical value for labour (L) in Eq. (4.5), MPL can be obtained at
different levels of labour employment. However, this method can be used only where
labour is perfectly divisible and L  0. Since, in our example, each unit of L = 1,
calculus method cannot be used.

se
Alternatively, where labour can be increased at least by one unit, MPL can be
obtained as
MPL = TPL – TPL–1

u
The MPL worked out by this method is presented in Col. 3 of Table 4.2.
Average Productivity of Labour (APL) can be obtained by dividing the production

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function by L. Thus,

 L3  15L2  10 L
APL = = –L2 + 15L + 10 ...(4.6)
L

td g
Now APL can be obtained by substituting the numerical value for L in Eq. (4.6).
APL obtained by this method is given in Col. 4 of Table 4.2.
. L in Tables 4.2 Three Stages of Production
vt sh
No. of Workers Total Product Marginal Average Stages of
(N) (TPL) Product* Product Production
(tonnes) (MPL) (APL) (based on MPL)
(1) (2) (3) (4) (5)
P li

1 24 24 24 I
2 72 48 36 Increasing
ub

3 138 66 46 returns
4 216 78 54
5 300 84 60
6 384 84 64
P

7 462 78 66 II
8 528 66 66 Diminishing
9 576 48 64 returns
s

10 600 24 60
a

11 594 – 6 54 III
12 552 – 42 46 Negative returns
ik

*MPL = TPn – TPn–1. MPL calculated by differential method will be different from that given in
Col. 3.
V

The information contained in Table 4.2 is presented graphically in panels (a) and
(b) of Fig. 4.1. Panel (a) of Fig. 4.1 presents the total product curve (TPL) and panel
(b) presents marginal product (MPL) and average product (APL) curves. The TPL schedule
demonstrates the law of diminishing returns. As the curve TPL shows, the total output
increases at an increasing rate till the employment of the 5th worker, as indicated by the
increasing slope of the TPL curve. (See also Col. 3 of the table). Employment of the 6th
worker contributes as much as the 5th worker. Note that beyond the employment of the
6th worker, although TPL continues to increase (until the 10th worker), the rate of increase
in TPL (i.e., MPL) begins to fall. This shows the operation of the law of diminishing
Self-Instructional returns.
130 Material
The three stages in production. Table 4.2 and Fig. 4.1 present the three usual stages in Input-Output Decisions
the application of the laws of diminishing returns.

NOTES

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td g
. L in
vt sh

Fig. 4.2 Total, Average and Marginal Products


P li

In Stage I, TPL increases at increasing rate. This is indicated by the rising MPL till
ub

the employment of the 5th and 6th workers. Given the production function (4.4), the 6th
worker produces as much as the 5th worker. The output from the 5th and the 6th
workers represents an intermediate stage of constant returns to the variable factor,
labour.
P

In Stage II, TPL continues to increase but at diminishing rates, i.e., MPL begins to
decline. This stage in production shows the law of diminishing returns to the variable
s

factor. Total output reaches its maximum level at the employment of the 10th worker.
Beyond this level of labour employment, TPL begins to decline. This marks the beginning
a

of Stage III in production.


ik

To conclude, the law of diminishing returns can be stated as follows. Given


the employment of the fixed factor (capital), when more and more workers are employed,
the return from the additional worker may initially increase but will eventually decrease.
V

Factors Behind the Laws of Returns. As shown in Fig. 4.2, the marginal productivity
of labour (MPL) increases is Stage I, whereas it decreases in Stage II. In other words, in
Stage I, Law of Increasing Returns is in operation and in Stage II, the law of Diminishing
Returns is in application. The reasons which underly the application of the laws of
returns in Stages I and II may be described as follows.
One of the important factors causing increasing returns to a variable factor is the
indivisibility of fixed factor (capital). The minimum size of capital is given as it cannot
be divided to suit the number of workers. Therefore, if labour is less than its optimum
Self-Instructional
Material 131
Input-Output Decisions number, capital remains underutilized. Let us suppose that optimum capital-labour
combination is 1:6. If capital is indivisible and less than 6 workers are employed, then
capital would remain underutilized. When more and more workers are added, utilization
of capital increases and also the productivity of additional worker. The second and the
NOTES most important reason for increase in labour productivity is the division of labour that
becomes possible with the employment of additional labour, until optimum capital-labour
combination is reached.
Once the optimum capital-labour ratio is reached, employment of additional workers
amounts to substitution of capital with labour. But, technically, there is a limit to which

se
one input can be substituted for another. That is, labour cannot substitute for capital
beyond a limit. Hence, to replace the same amount of capital, more and more workers
will have to be employed because per worker marginal productivity decreases. Also,
with increasing number of workers, capital remaining the same, capital-labour ratio goes

u
on decreasing. As a result, productivity of labour begins to decline. This marks the

. Ho
beginning of the second stage.
Application of the Law of Diminishing Returns
The law of diminishing returns is an empirical law, frequently observed in various
production activities. This law, however, may not apply universally to all kinds of productive

td g
activities since it is not as true as the law of gravitation. In some productive activities, it
. L in
may operate quickly, in some its operation may take a little longer time and in some
others, it may not appear at all. This law has been found to operate in agricultural
production more regularly than in industrial production. The reason is, in agriculture,
vt sh
natural factors play a predominant role whereas man-made factors play the major role
in industrial production. Despite the limitations of the law, if increasing units of an input
are applied to the fixed factors, the marginal returns to the variable input decrease
P li

eventually.
The Law of Diminishing Returns and Business Decisions. The law of diminishing
ub

returns as presented graphically has a relevance to the business decisions. The graph
can help in identifying the rational and irrational stages of operations. It can also tell the
business managers the number of workers (or other variable inputs) to apply to a given
P

fixed input so that, given all other factors, output is maximum. As Fig. 4.1 exhibits,
capital is presumably underutilized in Stage I. So a firm operating in Stage I is required to
increase labour, and a firm operating in Stage III is required to reduce labour, with a
s

view to maximizing its total production. From the firm’s point of view, setting an output
a

target in Stages I and III is irrational. The only meaningful and rational stage from the
firm’s point of view is Stage II in which the firm can find answer to the question ‘how
ik

many workers to employ’. Figure 4.1 shows that the firm should employ a minimum of
7 workers and a maximum of 10 workers even if labour is available free of cost. This
means that the firm has a limited choice—ranging from 7 to 10 workers. How many
V

workers to employ against the fixed capital and how much to produce can be answered,
only when the price of labour, i.e., wage rate, and that of the product are known. This
question is answered below.
Determining Optimum Employment of Labour
It may be recalled from Fig. 4.1 that an output maximizing coal-mining firm would like to
employ 10 workers since at this level of employment, the output is maximum. The firm
can, however, employ 10 workers only if workers are available free of cost. But labour
Self-Instructional
is not available free of cost—the firm is required to pay wages to the workers. Therefore,
132 Material
the question arises as to how many workers will the firm employ—10 or less or more Input-Output Decisions
than 10—to maximize its profit. A simple answer to this question is that the number of
workers to be employed depends on the output that maximizes the firm’s profit, given
the product price and the wage rate. This point can be proved as follows.
You know that profit is maximum where NOTES
MC = MR
In our example here, since labour is the only variable input, marginal cost (MC)
equals marginal wages (MW), i.e., MC = MW.

se
As regards MR, in case of factor employment, the concept of Marginal Revenue
Productivity (MRP) is used. The marginal revenue productivity is the value of product
resulting from the marginal unit of variable input (labour). In specific terms, marginal
revenue productivity (MRP) equals marginal physical productivity (MPL) of labour

u
multiplied by the price (P) of the product, i.e.,

. Ho
MRP = MPL × P
For example, suppose that the price (P) of coal is given at ` 10 per quintal. Now,
MRP of a worker can be known by multiplying its MPL (as given in Table 4.2) by `10.
For example, MRP of the 3rd worker (see Table 4.2) equals 66 × 10 = ` 660 and of the
4th worker, 78 × 10 = ` 780. Likewise, if the entire column (MPL) is multiplied by ` 10,

td g
it gives us a table showing marginal revenue productivity of workers. Let us suppose
. L in
that wage rate (per time unit) is given at ` 660. Given the wage rate, the profit maximizing
firm will employ only 8 workers because at this employment, MRP = wage
rate = MRP of 8th worker; 66 × 10 = ` 660. If the firm employs the 9th worker, his
vt sh
MRP = 48 × 10 = ` 480 < ` 660. Clearly, the firm loses ` 180 on the 9th worker. And, if
the firm employees less than 8 workers, it will not maximize profit.
P li

Graphic Illustration
ub

The process of optimum employment of variable input (labour) is illustrated graphically


in Fig. 4.2. When relevant series of MRP is graphed, it produces a MRP curve like one
shown in Fig. 4.2. Similarly, the MRP curve for any input may be drawn and compared
with MC (or MW) curve. Labour being the only variable input, in our example, let us
P

suppose that wage rate in the labour market is given at OW (Fig. 4.2). When wage rate
is constant, average wage (AW) equals the marginal wage (MW) i.e., AW = MW, for the
entire range of employment in the short-run. When AW = MW, the supply of labour is
s

shown by a straight horizontal line, as shown by the line AW = MW.


a

With the introduction of MRP curve and AW = MW line (Fig. 4.3), a profit
maximizing firm can easily find the maximum number of workers that can be optimally
ik

employed against a fixed quantity of capital. Once the maximum number of workers is
determined, the optimum quantity of the product is automatically determined.
V

Fig. 4.3 Determination of Labour Employment in the Short-Run Self-Instructional


Material 133
Input-Output Decisions The marginality principle of profit maximization says that profit is maximum when
MR = MC. This is a necessary condition of profit maximization. Fig. 4.2 shows that
MRP = MW (= MC) are equal at point P, the point of intersection between MRP and AW
= MW. The number of workers corresponding to this point is ON. A profit maximizing
NOTES firm should therefore employ only ON workers. Given the number of workers, the total
output can be known by multiplying ON with average labour productivity (AP).
Long-Term Laws of Production: Production with Two Variable Inputs
We have discussed in the preceding section the technological relationship between inputs

se
and output assuming labour to be the only variable input, capital held constant. In this
section, we will discuss the relationship between inputs and output under the condition
that both the inputs, capital and labour, are variable factors. In the long-run, supply of
both the inputs is supposed to be elastic and firms can hire larger quantities of both

u
labour and capital. With larger employment of capital and labour, the scale of production

. Ho
increases. The technological relationship between changing scale of inputs and output is
explained under the laws of returns to scale. The laws of returns to scale can be
explained through the production function and isoquant curve technique. The most
common and simple tool of analysis is isoquant curve technique. We will, therefore, first
introduce and elaborate on this tool of analysis. The laws of return to scale will then be

td g
explained through isoquant curve technique. The laws of returns to scale through
production function will be explained in the next section.
. L in
Isoquant Curves and their Properties
vt sh
The term ‘isoquant’ has been derived from the Greek word iso meaning ‘equal’ and
Latin word quantus meaning ‘quantity’. The ‘isoquant curve’ is, therefore, also known
as ‘Equal Product Curve’ or ‘Production Indifference Curve’. An isoquant curve can
P li

be defined as the locus of points representing various combinations of two inputs—


capital and labour—yielding the same output. An ‘isoquant curve’ is analogous to an
ub

‘indifference curve’, with two points of distinction: (a) an indifference curve is made of
two consumer goods while an isoquant curve is constructed of two producer goods
(labour and capital), and (b) an indifference curve assumes a level of satisfaction whereas
an isoquant measures output of a commodity.
P

An idea of isoquant can be had from the curve connecting 158 units from 4
different combinations of capital and labour given in Table 4.1.
s

Isoquant curves are drawn on the basis of the following assumptions:


a

(i) there are only two inputs, viz., labour (L) and capital (K), to produce a commodity
ik

X;
(ii) both L and K and product X are perfectly divisible;
V

(iii) the two inputs—L and K—can substitute each other but at a diminishing rate as
they are imperfect substitutes; and
(iv) the technology of production is given.
Given these assumptions, it is technically possible to produce a given quantity of
commodity X with various combinations of capital and labour. The factor combinations
are so formed that the substitution of one factor for the other leaves the output unaffected.
This technological fact is presented through an isoquant curve (IQ1 = 100) in Fig. 4.3.
The curve IQ1 all along its length represents a fixed quantity, 100 units of product X. This
quantity of output can be produced with a number of labour-capital combinations. For
Self-Instructional
134 Material
example, points A, B, C, and D on the isoquant IQ1 show four different combinations of Input-Output Decisions
inputs, K and L, as given in Table 4.3, all yielding the same output—100 units. Note that
movement from A to D indicates decreasing quantity of K and increasing number of L.
This implies substitution of labour for capital such that all the input combinations yield the
same quantity of commodity X, i.e., IQ1 = 100. NOTES

u se
. Ho
td g
. L in Fig. 4.4 Isoquant Curves

Table 4.3 Capital Labour Combinations and Output


vt sh
Points Input Combinations Output
K + L
A OK4 + OL 1 = 100
P li

B OK3 + OL 2 = 100
C OK2 + OL 3 = 100
ub

D OK1 + OL 4 = 100

Properties of Isoquant Curves


P

Isoquants, i.e., production indifference curves, have the same properties as consumer’s
indifference curves. Properties of isoquants are explained below in terms of inputs and
output.
s

(a) Isoquants have a negative slope. An isoquant has a negative slope in the
a

economic region5 and in the economic range of isoquant. The economic region
is the region on the production plane and economic range of isoquant is the range
ik

in which substitution between inputs is technically feasible. Economic region is


also known as the product maximizing region. The negative slope of the isoquant
V

implies substitutability between the inputs. It means that if one of the inputs is
reduced, the other input has to be so increased that the total output remains
unaffected. For example, movement from A to B on IQ1 (Fig. 4.4) means that if
K4 K3 units of capital are removed from the production process, L1L2 units of
labour have to be brought in to maintain the same level of output.
(b) Isoquants are convex to the origin. Convexity of isoquants implies two things:
(i) substitution between the two inputs, and (ii) diminishing marginal rate of
technical substitution (MRTS) between the inputs in the economic region. The
MRTS is defined as
Self-Instructional
Material 135
Input-Output Decisions
K
MRTS = = slope of the isoquant
L
In plain words, MRTS is the rate at which a marginal unit of labour can substitute
NOTES a marginal unit of capital (moving downward on the isoquant) without affecting
the total output. This rate is indicated by the slope of the isoquant. The MRTS
decreases for two reasons: (i) no factor is a perfect substitute for another, and
(ii) inputs are subject to diminishing marginal returns. Therefore, more and more
units of an input are needed to replace each successive unit of the other input. For
example, suppose various units of K (minus sign ignored) in Fig. 4.4 are equal,

se
i.e.,
K1 = K2 = K3
the corresponding units of L substituting K go (in Fig. 4.4) on increasing, i.e.,

u
L1 < L2 < L3

. Ho
As a result, MRTS = K/L goes on decreasing, i.e.,
K1 K 2 K 3
 
L1 L2 L3

td g
(c) Isoquants are non-intersecting and non-tangential. The intersection or
. L in tangency between any two isoquants implies that a given quantity of a commodity
can be produced with a smaller as well as a larger input-combination. This is
untenable so long as marginal productivity of inputs is greater than zero. This
point can be proved graphically. Note that in Fig. 4.5, two isoquants intersect
vt sh
each other at point M. Consider two other points—point J on isoquant marked
Q1 = 100 and point K on isoquant marked Q2 = 200 such that points K and J fall
on a vertical line KL2, denoting the same amount of labour (OL2) but different
P li

units of capital—KL2 units of capital at point K and JL2 units of capital at point J.
Note that point M is common to both the isoquants. Given the definition of isoquant,
ub

one can easily infer that a quantity that can be produced with the combination of
K and L at point M can be produced also with factor combination at points J and
K. On the isoquant Q1 = 100, factor combinations at points M and J yield 100
P

units of output. And, on the isoquant Q2 = 200, factor combinations at M and K


yield 200 units of output. Since point M is common to both the isoquants, it follows
that input combinations at J and K are equal in terms of output. This implies that
s

in terms of output,
a
ik
V

Self-Instructional
136 Material Fig. 4.5 Intersecting Isoquants
OL2(L) + JL2(K) = OL2(L) + KL2(K) Input-Output Decisions

Since OL2 is common to both the sides, it means,


JL2(K) = KL2(K)
But it can be seen in Fig. 4.5 that NOTES
JL2(K) < KL2(K)
But the intersection of the two isoquants means that JL2 and KL2 are equal in
terms of their output. This is wrong. That is why isoquants will not intersect or be
tangent to each other. If they do, it violates the laws of production.

se
(d) Upper isoquants represent higher level of output. Between any two isoquants,
the upper one represents a higher level of output than the lower one. The reason
is, an upper isoquant has a larger input combination, which, in general, produces a

u
larger output. Therefore, upper isoquant has a higher level of output.

. Ho
For instance, IQ2 in Fig. 4.6 will always indicate a higher level of output than IQ1.
For, any point at IQ2 consists of more of either capital or labour or both. For example,
consider point a on IQ1 and compare it with any point at IQ2. The point b on IQ2
indicates more of capital (ab), point d more of labour (ad) and point c more of both,
capital and labour. Therefore, IQ2 represents a higher level of output (200 units) than

td g
IQ1 indicating 100 units.
. L in
vt sh
P li
ub
P
s

Fig. 4.6 Comparison of Output at Two Isoquants


a

Isoquant Map and Economic Region of Production


ik

Isoquant map. An isoquant map is a set of isoquants presented on a two-dimensional


plane as shown by isoquants Q1, Q2, Q3 and Q4 in Fig. 4.7. Each isoquant shows various
combinations of two inputs that can be used to produce a given quantity of output. An
V

upper isoquant is formed by a greater quantity of one or both the inputs than the input
combination indicated by the lower isoquants. For example, isoquant Q2 indicates a
greater input-combination than that shown by isoquant Q1 and so on.

Self-Instructional
Material 137
Input-Output Decisions

NOTES

u se
Fig. 4.7 Isoquant Map

. Ho
In the isoquant map, each upper isoquant indicates a larger input-combination
than the lower ones, and each successive upper isoquant indicates a higher level of
output than the lower ones. This is one of the properties of the isoquants. For example,
if isoquant Q1 represents an output equal to 100 units, isoquant Q2 represents an output

td g
greater than 100 units. As one of the properties of isoquants, no two isoquants can
intersect or be tangent to one another.
. L in
Economic region. Economic region is that area of production plane in which substitution
between two inputs is technically feasible without affecting the output. This area is
vt sh
marked by locating the points on the isoquants at which MRTS = 0. A zero MRTS
implies that further substitution between inputs is technically not feasible. It also
determines the minimum quantity of an input that must be used to produce a given
P li

output. Beyond this point, an additional employment of one input will necessitate employing
additional units of the other input. Such a point on an isoquant may be obtained by
ub

drawing a tangent to the isoquant and parallel to the vertical and horizontal axes, as
shown by dashed lines in Fig. 4.7. By joining the resulting points a, b, c and d, we get a
line called the upper ridge line, Od. Similarly, by joining the points e, f, g and h, we get
P

the lower ridge line, Oh. The ridge lines are locus of points on the isoquants where the
marginal products (MP) of the inputs are equal to zero. The upper ridge line implies that
MP of capital is zero along the line, Od. The lower ridge line implies that MP of labour
s

is zero along the line, Oh.


a

The area between the two ridge lines, Od and Oh, is called ‘Economic Region’
or ‘technically efficient region’ of production. Any production technique, i.e., capital-
ik

labour combination, within the economic region is technically efficient to produce a


given output. And, any production technique outside this region is technically inefficient
since it requires more of both inputs to produce the same quantity of output.
V

Other Forms of Isoquants


We have introduced above a convex isoquant that is most widely used in traditional
economic theory. The shape of an isoquant, however, depends on the degree of
substitutability between the factors in the production function. The convex isoquant
presented in Fig. 4.4 assumes a continuous substitutability between capital and labour
but at a diminishing rate. The economists have, however, observed other degrees of
substitutability between K and L and have demonstrated the existence of three other
Self-Instructional
kinds of isoquants.
138 Material
1. Linear Isoquants. A linear isoquant is presented by the line AB in Fig. 4.8. A Input-Output Decisions
linear isoquant implies perfect substitutability between the two inputs, K and L.
The isoquant AB indicates that a given quantity of a product can be produced by
using only capital or only labour or by using both. This is possible only when the
two factors, K and L, are perfect substitutes for one another. A linear isoquant NOTES
also implies that the MRTS between K and L remains constant throughout.

u se
. Ho
td g
Fig. 4.8 Linear Isoquant
. L in
The mathematical form of the production function exhibiting perfect substitutability
of factors is given as follows.
vt sh
If Q = f(K, L) then, = aK + bL ...(4.7)
The production function means that the total output, Q, is simply the weighted
sum of K and L. The slope of the resulting isoquant from this production function
P li

is given by – b/a. This can be proved as shown below.


ub

Given the production function,


Q Q
MPK = a and MPL = b
K L
P

MPL MPL  b
Since MRTS = and 
MPK MPK a
s

b
a

Therefore, MRTS = = slope of the isoquant


a
ik

The production function exhibiting perfect substitutability of factors is, however,


unlikely to exist in the real world production process.
2. Isoquants with Fixed Factor-Proportion or L-Shaped Isoquants. When
V

a production function assumes a fixed proportion between K and L, the isoquant


takes ‘L’ shape, as shown by isoquants Q1 and Q2 in Fig. 4.9. Such an isoquant
implies zero substitutability between K and L. Instead, it assumes perfect
complementarity between K and L. The perfect complementarity assumption
implies that a given quantity of a commodity can be produced by one and only one
combination of K and L and that the proportion of the inputs is fixed. It also
implies that if the quantity of an input is increased and the quantity of the other
input is held constant, there will be no change in output. The output can be increased
only by increasing both the inputs proportionately.
Self-Instructional
Material 139
Input-Output Decisions As shown in Fig. 4.9, to produce Q1 quantity of a product, OK1 units of K and OL1
units of L are required. It means that if OK1 units of K are being used, OL1 units
of labour must be used to produce Q1 units of a commodity. Similarly, if OL1 units
of labour are employed, OK1 units of capital must be used to produce Q1. If units
NOTES of only K or only L are increased, output will not increase. If output is to be
increased to Q2, K has to be increased by K1K2 and labour by L1L2. This kind of
technological relationship between K and L gives a fixed proportion production
function.

u se
. Ho
td g
. L in Fig. 4.9 The L-Shaped Isoquant
vt sh
A fixed-proportion production function, called Leontief function, is given as
Q = f(K, L) = min (aK, bL) …(4.8)
where ‘min’ means that Q equals the lower of the two terms, aK and bL. That is,
P li

if aK > bL, Q = bL and if bL > aK, then Q = aK. If aK = bL, it would mean that
ub

both K and L are fully employed. Then the fixed capital labour ratio will be K/L =
b/a.
In contrast to a linear production function, the fixed-factor-proportion production
function has a wide range of application in the real world. One can find many
P

techniques of production in which a fixed proportion of labour and capital is fixed.


For example, to run a taxi or to operate a photocopier, one needs only one labour.
s

In these cases, the machine-labour proportion is fixed. Any extra labour would be
redundant. Similarly, one can find cases in manufacturing industries where capital-
a

labour proportions are fixed.


ik

3. Kinked Isoquants or Linear Programming Isoquants. The fixed proportion


production function (Fig. 4.9) assumes that there is only one technique of production,
and capital and labour can be combined only in a fixed proportion. It implies that
V

to double the production, one would require doubling both the inputs, K and L. The
line OB (Fig. 4.9) shows that there is only one factor combination for a given level
of output. In real life, however, the businessmen and the production engineers
find in existence many, but not infinite, techniques of producing a given quantity of
a commodity, each technique having a different fixed proportion of inputs. In fact,
there is a wide range of machinery available to produce a commodity. Each
machine requires a fixed number of workers to work it. This number varies from
machine to machine. For example, 40 persons can be transported from one place
to another by two methods: (i) by hiring 10 taxis and 10 drivers, or (ii) by hiring a
Self-Instructional
140 Material
bus and 1 driver. Each of these methods is a different process of production and Input-Output Decisions
has a different fixed proportion of capital and labour. Handlooms and power
looms are other examples of two different factor proportions. One can similarly
find many such processes of production in manufacturing industries, each process
having a different fixed-factor proportion. NOTES
Let us suppose that for producing 10 units of a commodity, X, there are four
different techniques of production available. Each techniques has a different fixed
factor-proportion, as given in Table 4.4.
Table 4.4 Alternative Techniques of Producing 100 Units of X

se
S. No. Technique Capital + Labour Capital/labour ratio
1 OA 10 + 2 10:2
2 OB 6 + 3 6:3

u
3 OC 4 + 6 4:6
4 OD 3 + 10 3:10

. Ho
The four hypothetical production techniques, as presented in Table 4.4, have been
graphically presented in Fig. 4.10. The ray OA represents a production process
having a fixed factor-proportion of 10K:2L. Similarly, the other three production
processes having fixed capital-labour ratios 6:3, 4:6 and 3:10 have been shown by

td g
the rays OB, OC and OD respectively. Points A, B, C and D represent four
different production techniques. By joining the points, A, B, C and D, we get a
. L in
kinked isoquant, ABCD.
Each of the points on the Kinked Isoquant represents a combination of capital
vt sh
and labour that can produce 100 units of commodityX. If there are other processes
of production, many other rays would be passing through different points between
A and B, B and C, and C and D, increasing the number of kinks on the isoquant
P li

ABCD. The resulting isoquant would then resemble the typical isoquant. But
there is a difference—each point on a typical isoquant is technically feasible, but
ub

on a kinked isoquant, only kinks are the technically feasible points.


P
a s
ik
V

Fig. 4.10 Fixed Proportion Techniques of Production

The kinked isoquant is used basically in linear programming. It is, therefore, also
called linear programming isoquant or activity analysis isoquant.

Self-Instructional
Material 141
Input-Output Decisions Elasticity of Factor Substitution
We have introduced earlier the concept of the marginal rate of technical substitution
(MRTS) and have noted that MRTS decreases along the isoquant. MRTS refers only to
NOTES the slope of an isoquant, i.e., the ratio of marginal changes in inputs. It does not reveal
the substitutability of one input for another—labour for capital—with changing combination
of inputs.
The economists have devised a method of measuring the degree of substitutability
of factors, called the Elasticity of Factor Substitution. The elasticity of substitution (s)
is formally defined as the percentage change in the capital-labour ratio (K/L) divided

se
by the percentage change in marginal rate of technical substitution (MRTS), i.e.,

Percentage change in K L  ( K / L) ( K / L)
= or  =  ( MRTS ) ( MRTS )

u
Percentage change in MRTS

. Ho
Since all along an isoquant, K/L and MRTS move in the same direction, the value
of s is always positive. Besides, the elasticity of substitution (s) is ‘a pure number,
independent of the units of the measurement of K and L, since both the numerator and
the denominator are measured in the same units’.
The concept of elasticity of factor substitution is graphically presented in Fig.

td g
4.11. The movement from point A to B on the isoquant IQ, gives the ratio of change in
. L in
MRTS. The rays OA and OB represent two techniques of production with different
factor intensities. While line OA indicates capital intensive technique, line OB indicates
labour intensive technique. The shift from OA to OB gives the change in factor intensity.
vt sh
The ratio between the two factor intensities measures the substitution elasticity.
P li
ub
P
a s

Fig. 4.11 Graphic Derivation of Elasticity of Substitution


ik

The value of substitution elasticity depends on the curvature of the isoquants. It


varies between 0 and µ, depending on the nature of production function. It is, in fact, the
V

production function that determines the curvature of the various kinds of isoquants. For
example, in case of fixed-proportion production function [see Eq. (4.8)] yielding an L-
shaped isoquant, s = 0. If production function is such that the resulting isoquant is linear
(see Fig. 4.8), s = ¥. And, in case of a homogeneous production function of degree 1 of
the Cobb-Douglas type, s = 1.
Laws of Returns to Scale
Having introduced the isoquants—the basic tool of analysis—we now return to the laws
of returns to scale. The laws of returns to scale explain the behaviour of output in
Self-Instructional
142 Material
response to a proportional and simultaneous change in inputs. Increasing inputs Input-Output Decisions
proportionately and simultaneously is, in fact, an expansion of the scale of production.
When a firm expands its scale, i.e., it increases both the inputs proportionately, then
there are three technical possibilities:
NOTES
(i) total output may increase more than proportionately;
(ii) total output may increase proportionately; and
(iii) total output may increase less than proportionately.
Accordingly, there are three kinds of returns to scale:

se
(i) Increasing returns to scale;
(ii) Constant returns to scale, and

u
(iii) Diminishing returns to scale.
So far as the sequence of the laws of ‘returns to scale’ is concerned, the law of

. Ho
increasing returns to scale is followed by the law of constant and then by the law of
diminishing returns to scale. This is the most common sequence of the laws.
Let us now explain the laws of returns to scale with the help of isoquants for a
two-input and single output production system.

td g
Increasing Returns to Scale
. L in
When inputs, K and L, are increased at a certain proportion and output increases more
than proportionately, it exhibits increasing returns to scale. For example, if quantities
vt sh
of both the inputs, K and L, are successively doubled and the resultant output is more
than doubled, the returns to scale is said to be increasing. The increasing returns to scale
is illustrated in Fig. 4.12. The movement from point a to b on the line OB means doubling
the inputs. It can be seen in Fig. 4.12 that input-combination increases from 1K + 1L to
P li

2K + 2L. As a result of doubling the inputs, output is more than doubled: it increases from
ub

10 to 25 units, i.e., an increase of 150%. Similarly, the movement from point b to point c
indicates 50% increase in inputs as a result of which the output increases from 25 units
to 50 units, i.e., by 100%. Clearly, output increases more than the proportionate increase
in inputs. This kind of relationship between the inputs and output shows increasing
P

returns to scale.
a s
ik
V

Fig. 4.12 Increasing Returns to Scale


Self-Instructional
Material 143
Input-Output Decisions The Factors Behind Increasing Returns to Scale
There are at least three plausible reasons for increasing returns to scale.
(i) Technical and managerial indivisibilities. Certain inputs, particularly
NOTES mechanical equipments and managers, used in the process of production are
available in a given size. Such inputs cannot be divided into parts to suit small
scale of production. For example, half a turbine cannot be used and one-third or a
part of a composite harvester and earth-movers cannot be used. Similarly, half of
a production manager cannot be employed, if part-time employment is not
acceptable to the manager. Because of indivisibility of machinery and managers,

se
given the state of technology, they have to be employed in a minimum quantity
even if scale of production is much less than the capacity output. Therefore,
when scale of production is expanded by increasing all the inputs, the productivity

u
of indivisible factors increases exponentially because of technological advantage.
This results in increasing returns to scale.

. Ho
(ii) Higher degree of specialization. Another factor causing increasing returns
to scale is higher degree of specialization of both labour and machinery, which
becomes possible with increase in scale of production. The use of specialized
labour suitable to a particular job and of a composite machinery increases

td g
productivity of both labour and capital per unit of inputs. Their cumulative effects
. L in contribute to the increasing returns to scale. Besides, employment of specialized
managerial personnel, e.g., administrative manager, production managers sales
manager and personnel manager, contributes a great deal in increasing production.
vt sh
(iii) Dimensional relations. Increasing returns to scale is also a matter of dimensional
relations. For example, when the length and breadth of a room (15 × 10 = 150
sq. ft.) are doubled, then the size of the room is more than doubled: it increases to
P li

30 × 20 = 600 sq. ft. When diameter of a pipe is doubled, the flow of water is
more than doubled. In accordance with this dimensional relationship, when the
ub

labour and capital are doubled, the output is more than doubled and so on.
Constant Returns to Scale
P

When the increase in output is proportionate to the increase in inputs, it exhibits constant
returns to scale. For example, if quantities of both the inputs, K and L, are doubled and
output is also doubled, then the returns to scale are said to be constant. Constant returns
s

to scale are illustrated in Fig. 4.13. The lines OA and OB are ‘product lines’ indicating
a

two hypothetical techniques of production with optimum capital-labour ratio. The isoquants
marked Q = 10, Q = 20 and Q = 30 indicate the three different levels of output. In the
ik

figure, the movement from points a to b indicates doubling both the inputs. When inputs
are doubled, output is also doubled, i.e., output increases from 10 to 20. Similarly, the
movement from a to c indicates trebling inputs—K increase to 3K and L to 3L. This
V

leads to trebling the output—from 10 to 30.

Self-Instructional
144 Material
Input-Output Decisions

NOTES

u se
Fig. 4.13 Constant Returns to Scale

. Ho
Alternatively, movement from point b to c indicates a 50 per cent increase in both
labour and capital. This increase in inputs results in an increase of output from 20 to 30
units, i.e., a 50 per cent increase in output. In simple words, a 50 per cent increase in
inputs leads to a 50 per cent increase in output. This relationship between a proportionate
change in inputs and the same proportional change in outputs may be summed up as

td g
follows.
. L in
1K + 1L  10
2K + 2L  20
vt sh
3K + 3L  30
This kind of relationship between inputs and output exhibits constant returns to
scale.
P li

The constant returns to scale are attributed to the limits of the economies of scale.6
With expansion in the scale of production, economies arise from such factors as
ub

indivisibility of fixed factors, greater possibility of specialization of capital and labour, use
of more efficient techniques of production, etc. But there is a limit to the economies of
scale. When economies of scale reach their limits and diseconomies are yet to begin,
P

returns to scale become constant. The constant returns to scale take place also where
factors of production are perfectly divisible and where technology is such that capital-
labour ratio is fixed. When the factors of production are perfectly divisible, the production
s

function is homogeneous of degree 1 showing constant returns to scale.


a

Decreasing Returns to Scale


ik

The firms are faced with decreasing returns to scale when a certain proportionate
increase in inputs, K and L, leads to a less than proportionate increase in output. For
V

example, when inputs are doubled and output is less than doubled, then decreasing returns
to scale is in operation. The decreasing returns to scale is illustrated in Fig. 4.14. As the
figure shows, when the inputs K and L are doubled, i.e., when capital-labour combination
is increased from 1K + 1L to 2K + 2L, the output increases from 10 to 18 units. This
means that when capital and labour are increased by 100 per cent, output increases by
only 80 per cent. That is, increasing output is less that the proportionate increase in
inputs. Similarly, movement from point b to c indicates a 50 per cent increase in the
inputs. But, the output increases by only 33.3 per cent. This exhibits decreasing returns
to scale.
Self-Instructional
Material 145
Input-Output Decisions

NOTES

u se
Fig. 4.14 Decreasing Return to Scale

. Ho
Causes of Diminishing Return to Scale
The decreasing returns to scale are attributed to the diseconomies of scale. The
economists find that the most important factor causing diminishing returns to scale is

td g
‘the diminishing return to management’, i.e., managerial diseconomies. As the size of
the firms expands, managerial efficiency decreases. Another factor responsible for
. L in
diminishing returns to scale is the limitedness or exhaustibility of the natural resources.
For example, doubling of coal mining plant may not double the coal output because of
vt sh
limitedness of coal deposits or difficult accessibility to coal deposits. Similarly, doubling
the fishing fleet may not double the fish output because availability of fish may decrease
in the ocean when fishing is carried out on an increased scale.
P li

4.6 SHORT-RUN AND LONG-RUN COST


ub

FUNCTIONS
The theory of cost deals with the behaviour of cost in relation to a change in output. In
P

other words, the cost theory deals with cost-output relations. The basic principle of the
cost behaviour is that the total cost increases with increase in output. This simple
s

statement of an observed fact is of little theoretical and practical importance. What is of


importance from a theoretical and managerial point of view is not the absolute increase
a

in the total cost but the direction of change in the average cost (AC) and the marginal
Check Your Progress cost (MC). The direction of change in AC and MC—whether AC and MC decrease or
ik

4. What is the law of increase or remain constant—depends on the nature of the cost function. A cost function
diminishing returns is a symbolic statement of the technological relationship between the cost and output.
V

to a variable input? The general form of the cost function is written as


5. What is the concept
of MRP in the TC = f (Q)
context of factor
employment?  T C/ Q > 0 …(4.9)
6. What is an isoquant The specific form of the cost function depends on whether the time framework
curve?
chosen for cost analysis is short-run or long-run. It is important to recall here that some
7. What is elasticity of
factor substitution?
costs remain constant in the short-run while all costs are variable in the long-run. Thus,
depending on whether cost analysis pertains to short-run or to long-run, there are two

Self-Instructional
146 Material
kinds of cost functions: (i) short-run cost functions, and (ii) long-run cost functions. Input-Output Decisions
Accordingly, the cost output relations are analysed in short-run and long-run framework.
4.6.1 Short-Run Cost-Output Relations
In this section, we will analyse the cost-output relations in the short-run. The long-run NOTES
cost output relations are discussed in the following section.
Before we discuss the cost-output relations, let us first look at the cost concepts and
the components used to analyse the short-run cost-output relations.
The basic analytical cost concepts used in the analysis of cost behaviour are

se
Total, Average and Marginal costs. The total cost (TC) is defined as the actual cost that
must be incurred to produce a given quantity of output. The short-run TC is composed of
two major elements: (i) total fixed cost (TFC), and (ii) total variable cost (TVC). That

u
is, in the short-run,

. Ho
TC = TFC + TVC ...(4.10)
As mentioned earlier, TFC (i.e., the cost of plant, building, etc.) remains fixed in
the short run, whereas T VC varies with the variation in the output.
For a given quantity of output (Q), the average cost, (AC), average fixed cost

td g
(AFC) and average variable cost (AVC) can be defined as follows.
T C T F C  TV C
. L in AC =
Q

Q
vt sh
TFC TVC
=  = AFC + AVC
Q Q
P li

T FC TV C
Thus, AFC = and AVC =
Q Q
ub

and AC = AFC + AVC ...(4.11)


Marginal cost (MC) is defined as the change in the total cost divided by the
P

change in the total output, i.e.,


TC
MC = ...(4.12)
Q
a s

TC
In fact, MC is the first derivative of cost function, i.e.,
Q
ik

It may be added here that since TC = TFC + TVC and, in the short-run,
TFC = 0, therefore, TC = TVC. Furthermore, under the marginality concept, where
V

Q = 1, MC = TVC. Now we turn to cost function and derivation of various cost


curves.
4.6.2 Short-Run Cost Functions and Cost Curves
The cost-output relations are determined by the cost function and are exhibited through
cost curves. The shape of the cost curves depends on the nature of the cost function.
Cost functions are derived from actual cost data of the firms. Given the cost data, cost
functions may take a variety of forms, e.g., linear, quadratic or cubic, yielding different
Self-Instructional
Material 147
Input-Output Decisions kinds of cost curves. The cost curves produced by linear, quadratic and cubic cost
functions are illustrated below.

1. Linear Cost Function. A linear cost function takes the following form.
NOTES
TC = a + bQ …(4.13)

(where TC = total cost, Q = quantity produced, a = TFC, and b = Change in TVC due to
change in Q.

se
Given the cost function [Eq. (4.13)], AC and MC can be obtained as follows.
TC a  bQ a
AC = =  +b
Q Q Q

u
TC

. Ho
and MC = b
Q

Note that since ‘b’ is a constant, MC remains constant throughout in case of a


linear cost function.

td g
To illustrate a linear cost function, let us suppose that an actual cost function is
given as
. L in TC = 60 + 10Q …(4.14)
Give the cost function (4.14), one can easily work out TC, TFC, TVC, MC and
vt sh
AC for different levels of output (Q) and can present them in the form of a table as
shown in Table 4.5.
P li
ub
P
a s
ik
V

Fig. 4.15 Linear Cost Functions

Self-Instructional
148 Material
Table 4.5 Tabular Cost Function Input-Output Decisions

Output Q TFC = 60 TVC = 10Q TC = 60 + 10Q MC = b = 10 AC = 60/Q + 10

1 60 10 70 – 70.0
2 60 20 80 10 40.0 NOTES
3 60 30 90 10 30.0
4 60 40 100 10 25.0
5 60 50 110 10 22.0
6 60 60 120 10 20.0

se
7 60 70 130 10 18.6
8 60 80 140 10 17.5
9 60 90 150 10 16.6
10 60 100 160 10 16.0

u
Table 4.5 presents a series of Q and corresponding TFC, TVC, TC, MC and AC

. Ho
for output Q from 1 to 10. The figures in Table 4.5, graphed in Fig. 4.15, shows the
relationship between total costs and output.
Furthermore, given the cost function (4.14), AC can be worked out as follows

td g
60
AC   10 and MC = 10
. L in Q

Fig. 4.15 shows the behaviour of TC, TVC and TFC. The horizontal line shows
TFC and the line TVC = 10Q shows the movement in TVC with change in Q. The total
vt sh
cost function is shown by TC = 60 + 10Q.
More important is the behaviour of AC and MC curves in Fig. 4.16. Note that, in
case of a linear cost function, while MC remains constant, AC continues to decline with
P li

the increase in output. This is so simply because of the logic of the linear cost function.
ub
P
a s
ik
V

Fig. 4.16 AC and MC Curves Derived from Linear Cost Function

2. Quadratic Cost Function. A quadratic cost function is of the form

TC = a + bQ + Q2 ....(4.15)

where a and b are constants and TC and Q are total cost and total output respectively.
Self-Instructional
Material 149
Input-Output Decisions Given the cost function (4.15), AC and MC can be obtained as follows.
TC a  bQ  Q 2 a
AC = = = +b+Q ...(4.16)
Q Q Q
NOTES
TC
MC = = b + 2Q ...(4.17)
Q

Let the actual (or estimated) cost function be given as

se
TC = 50 + 5Q + Q2 …(4.18)
Given the cost function (4.18),

u
50 C
AC = +Q+5 and MC = Q = 5 + 2Q
Q

. Ho
The cost curves that emerge from the cost function (4.18) are graphed in
Fig. 4.17 (a) and (b). As shown in panel (a), while fixed cost remains constant at 50,
TVC is increasing at an increasing rate. The rising TVC sets the trend in the total cost
(TC). Panel (b) shows the behaviour of AC, MC and AVC in a quadratic cost function.

td g
Note that MC and AVC are rising at a constant rate whereas AC declines till output 8
. L in
and then begins to increase.
vt sh
P li
ub
P
a s
ik
V

Fig. 4.17 Cost Curves Derived from a Quadratic Cost Function


Self-Instructional
150 Material
3. Cubic Cost Function A cubic cost function is of the form Input-Output Decisions

TC = a + bQ – cQ2 + Q3 …(4.19)
where a, b and c are the parametric constants.
NOTES
From the cost function (4.19), AC and MC can be derived as follows.

TC a  bQ  cQ 2  Q 3
AC = =
Q Q

se
a TC
= + b – cQ + Q2 and MC = = b – 2 cQ + 3Q2
Q Q

Let us suppose that the cost function is empirically estimated as

u
TC = 10 + 6Q – 0.9Q2 + 0.05Q3 …(4.20)

. Ho
Note that fixed cost equals 10. TVC can be obtained by subtracting 10—the fixed
cost—from TC-function (4.20).
Thus, TVC = 6Q – 0.9Q2 + 0.05Q3 …(4.21)

td g
The TC and TVC, based on Eqs. (4.22) and (4.23) respectively, have been
calculated for Q = 1 to 16 and presented in Table 4.6. The TFC, TVC and TC have been
. L in
graphically presented in Fig. 4.18. As the figure shows, TFC remains fixed for the whole
range of output, and hence, takes the form of a horizontal line—TFC. The TVC curve
shows that the total variable cost first increases at a decreasing rate and then at an
vt sh
increasing rate with the increase in the output. The rate of increase can be obtained
from the slope of TVC curve. The pattern of change in the TVC stems directly from the
law of increasing and diminishing returns to the variable inputs. As output increases,
P li

larger quantities of variable inputs are required to produce the same quantity of output
due to diminishing returns. This causes a subsequent increase in the variable cost for
ub

producing the same output.


P
a s
ik
V

Fig. 4.18 TC, TFC and TVC Curves

Self-Instructional
Material 151
Input-Output Decisions Table 4.6 Cost-Output Relations

Q FC TVC TC AFC AVC AC MC

(1) (2) (3) (4) (5) (6) (7) (8)


NOTES 0 10 0.0 10.00 – – – –
1 10 5.15 15.15 10.00 5.15 15.15 5.15
2 10 8.80 18.80 5.00 4.40 9.40 3.65
3 10 11.25 21.25 3.33 3.75 7.08 2.45
4 10 12.80 22.80 2.50 3.20 5.70 1.55

se
5 10 13.75 23.75 2.00 2.75 4.75 0.95
6 10 14.40 24.40 1.67 2.40 4.07 0.65
7 10 15.05 25.05 1.43 2.15 3.58 0.65

u
8 10 16.00 26.00 1.25 2.00 3.25 0.95
9 10 17.55 27.55 1.11 1.95 3.06 1.55

. Ho
10 10 20.00 30.00 1.00 2.00 3.00 2.45
11 10 23.65 33.65 0.90 2.15 3.05 3.65
12 10 28.80 38.80 0.83 2.40 3.23 5.15
13 10 35.75 45.75 0.77 2.75 3.52 6.95
14 10 44.80 54.80 0.71 3.20 3.91 9.05

td g
15 10 56.25 66.25 0.67 3.75 4.42 11.45
. L in 16 10 70.40 80.40 0.62 4.40 5.02 14.15

From equations (4.20) and (4.21), we may derive the behavioural equations for
AFC, AVC and AC. Let us first consider AFC.
vt sh
Average Fixed Cost (AFC) As already mentioned, the costs that remain fixed for a
certain level of output make the total fixed cost in the short-run. The fixed cost is
represented by the constant term ‘a’ in Eq. (4.19) and a = 10 in Eq. (4.20). We know
P li

that
ub

TFC
AFC = …(4.22)
Q

Substituting 10 for TFC in Eq. 4.22, we get


P

10
AFC = …(4.23)
Q
s

Equation (4.23) expresses the behaviour of AFC in relation to change in Q. The


a

behaviour of AFC for Q from 1 to 16 is given in Table 4.6 (Col. 5) and presented graphically
ik

by the AFC curve in Fig. 4.19. The AFC curve is a rectangular hyperbola.
V

Self-Instructional
152 Material
Input-Output Decisions

NOTES

u se
. Ho
Fig. 4.19 Short-run Cost Curves

TVC
Average Variable Cost (AVC). As defined above, AVC =

td g
Q
. L in
Given the TVC function [Eq. (4.21)], we may express AVC as follows.
6Q  0.9Q 2  0.05Q 3
vt sh
AVC =
Q

= 6 – 0.9 Q + 0.05Q2 ...(4.24)


P li

Having derived the AVC function in Eq. (4.24), we may easily obtain the behaviour
ub

of AVC in response to change in Q. The behaviour of AVC for output from


Q = 1 to 16 is given in Table 4.6 (Col. 6), and graphically presented in Fig. 4.19 by the AVC
curve.
P

Critical Value of AVC The critical value of Q (in respect of AVC) is one that
minimizes AVC. From Eq. (4.24), we may compute the critical value of Q in respect of
AVC. The AVC will be minimum when its (decreasing) rate of change equals zero. This
s

can be accomplished by differentiating Eq. (4.24) and setting it equal to zero. Thus,
critical value of Q can be obtained as follows.
a

AVC
Critical value of Q = Q = – 0.9 + 0.10Q = 0
ik

0.10 Q = 0.9
V

Q=9
In our example, the critical value of Q = 9. This can be verified from Table 4.6.
The AVC is minimum (1.95) at output 9.
TC
Average Cost (AC) The average cost (AC) is defined as AC = .
Q

Self-Instructional
Material 153
Input-Output Decisions Substituting Eq. (4.20) for TC in the above equation, we get
10  6Q  0.9Q 2  0.05Q 3
AC =
Q
NOTES
10
= Q + 6 – 0.9Q + 0.05Q2 ...(4.25)

The Eq. (4.25) gives the behaviour ofAC in response to change in Q. The behaviour
of AC for Q = 1 to 16 is given in Table 4.6 (Col. 7) and graphically presented in Fig. 4.19

se
by the AC curve. Note that AC curve is U-shaped.
Minimization of AC. One objective of business firms is to minimize AC of their
product. The level of output that minimizes AC can be obtained by differentiating Eq.

u
(4.25) and setting it equal to zero. Cost-minimizing Q can be obtained as follows.
AC 10

. Ho
  0.9  0.1Q = 0
Q Q 2

When we simplify this equation by multiplying it by Q2, it takes the form of a


quadratic equation as

td g
10 – 0.9Q2 + 0.1Q3 = 0
. L in When this equation is multiplied by 10, for simplification, it takes the form,
Q3 – 9Q2 – 100 = 0 ...(4.26)
vt sh
By solving7 equation (4.26), we get Q = 10.
Thus, the critical value of output in respect of AC is 10. That is, AC reaches its
P li

minimum at Q = 10. This can be verified from Table 4.6.


ub

Marginal Cost (MC) The concept of marginal cost (MC) is particularly useful in
economic analysis. MC is technically the first derivative of the TC function. Given the
TC function in Eq. (4.20), the MC function can be obtained as
P

TC
MC = Q = 6 – 1.8Q + 0.15Q2 ...(4.27)
s

Equation (4.27) represents the behaviour of MC. The behaviour of MC for


Q = 1 to 16 computed as MC = TCn– TCn–1 is given in Table 4.6 (Col. 8) and graphically
a

presented by the MC curve in Fig. 4.19. The critical value of Q with respect to MC is 6
ik

or 7. This can be seen from Table 4.6.

4.6.3 Cost Curves and the Law of Diminishing Returns


V

We now return to the law of diminishing returns and explain it through the cost curves.
Figs. 4.18 and 4.19 present the short-term law of production i.e., the law of diminishing
returns. Let us recall the law: it states that when more and more units of a variable input
are applied, other inputs held constant, the returns from the marginal units of the variable
input may initially increase butthey decrease eventually. The same law can also be interpreted
in terms of decreasing and increasing costs. The law can then be stated as, if more and
more units of a variable input are applied to a given amount of a fixed input, the marginal
cost initially decreases, but eventually increases. Both interpretations of the law yield the
Self-Instructional
154 Material
same information—one in terms of marginal productivity of the variable input, and the Input-Output Decisions
other in terms of the marginal cost. The former is expressed through a production function
and the latter through a cost function.
Fig. 4.19 presents the short-run laws of return to a variable input in terms of cost
of production. As the figure shows, in the initial stage of production, both AFC and AVC NOTES
are declining because of internal economies. Since AC = AFC + AVC, AC is also declining.
This shows the operation of the law of increasing returns in the initial stage of production.
But beyond a certain level of output (i.e., 9 units in our example), while AFC continues
to fall, AVC starts increasing because of a faster increase in the TVC. Consequently, the

se
rate of fall in AC decreases. The AC reaches its minimum when output increases to 10
units. Beyond this level of output, AC starts increasing which shows that the law of
diminishing returns comes into operation. The MC curve represents the change in both
the TVC and TC curves due to change in output. A downward trend in the MC shows

u
increasing marginal productivity of the variable input due mainly to internal economies

. Ho
resulting from increase in production. Similarly, an upward trend in theMC shows increase
in TVC, on the one hand, and decreasing marginal productivity of the variable input, on
the other.
4.6.4 Some Important Cost Relationships

td g
Some important relationships between costs used in analysing the short-run cost-behaviour
may now be summed up as follows:
. L in
(a) Over the range of output AFC and AVC fall, AC also falls.
vt sh
(b) When AFC falls but AVC increases, change in AC depends on the rate of change
in AFC and AVC.
(i) if decrease in AFC > increase in AVC, then AC falls,
P li

(ii) if decrease in AFC = increase in AVC, AC remains constant and


(iii) if decrease in AFC < increase in AVC, then AC increases.
ub

(c) AC and MC are related in following ways.


(i) When MC falls, AC follows, over a certain range of output. When MC is
falling, the rate of fall in MC is greater than that of AC, because while MC
P

is attributed to a single marginal unit, AC is distributed over the entire output.


Therefore, AC decreases at a lower rate than MC.
(ii) Similarly, when MC increases, AC also increases but at a lower rate for
s

the reason given in (i). There is, however, a range of output over which the
a

relationship does not exist. Compare the behaviour of MC and AC over the
range of output from 6 units to 10 units (see Fig.4.19). Over this range of
ik

output, MC begins to increase while AC continues to decrease. The reason


for this can be seen in Table 4.5: when MC starts increasing, it increases at
V

a relatively lower rate that is sufficient only to reduce the rate of decrease
in AC—not sufficient to push the AC up.
(iii) MC curve intersects AC curve at its minimum. The reason is, while AC
continues to decrease, MC begins to rise. Therefore, they are bound to
intersect. Also, when AC is at its minimum, it is neither increasing nor
decreasing: it is constant. When AC is constant, AC = MC. That is the point
of intersection.

Self-Instructional
Material 155
Input-Output Decisions 4.6.5 Output Optimization in the Short-run
The technique of output optimization has already been discussed in last sections.
Optimization technique is repeated here for completeness.
NOTES Let us suppose that a short-run cost function is given as
TC = 200 + 5Q + 2Q2 …(4.28)
As noted earlier, the level of output is optimized at the level of production at which
MC = AC. In other words, at optimum level of output, AC = MC. Given the cost function
in Eq. (4.20),

se
200  5Q  2Q 2
AC = Q

u
200
= Q + 5 + 2Q ...(4.29)

. Ho
TC
and MC = Q = 5 + 4Q ...(4.30)

By equating AC and MC equations, i.e., Eqs. (4.29) and (4.30), respectively, and

td g
solving them for Q, we get the optimum level of output. Thus,
. L in 200
Q + 5 + 2Q = 5 + 4Q = 2Q
vt sh
2Q2 = 200
Q2 = 100
P li

Q = 10
Thus, given the cost function (4.28), the optimum output is 10.
ub

4.6.6 Long-run Cost-Output Relations


In the context of production theory, long-run is defined as a period in which all the inputs
P

become variable. The variability of inputs is based on the assumption that in the long-run,
supply of all the inputs, including those (especially capital) held constant in the short-run,
s

becomes elastic. The firms are, therefore, in a position to expand the scale of their
production by hiring a larger quantity of all the inputs. The long-run cost output relations,
a

therefore, imply the relationship between the changing scale of the firm and the total
output, whereas in the short-run, this relationship is essentially one between the total
ik

output and the variable cost (labour). Specifically, long-run cost-output relations refers
to the behaviour of TC, AC and MC in response to simultaneous and proportionate
V

charge in both labour and capital costs.

Self-Instructional
156 Material
Input-Output Decisions

NOTES

u se
. Ho
td g
. L in
vt sh
Fig. 4.20 Long-run Total and Average Cost Curves

To understand the long-run-cost-output relations and to derive long-run cost curves,


P li

it will be helpful to imagine that a long-run is composed of a series of short-run production


ub

decisions. As a corollary of this, long-run cost curve is composed of a series of short-run


cost curves. With this perception of long-run-cost-out relationship, we may now show
the derivation of the long-run cost curves and study their relationship with output.
P

Long-run Total Cost Curve (LTC)


In order to draw the long-run total cost curve, let us begin with a short-run situation.
s

Suppose that a firm having only one plant has its short-run total cost curve as given by
STC1, in panel (a) of Fig. 4.20. Let us now suppose that the firm decides to add two
a

more plants over time, one after the other. As a result, two more short-run total cost
ik

curves are added to STC1, in the manner shown by STC2 and STC3 in Fig. 4.20 (a). The
LTC can now be drawn through the minimum points of STC1, STC2 and STC3 as shown
by the LTC curve corresponding to each STC.
V

Long-run Average Cost Curve (LAC)


Like LTC, long-run average cost curve (LAC) is derived by combining the short-run
average cost curves (SACs). Note that there is one SAC associated with each STC.
The curve SAC1 in panel (b) of Fig. 4.20 corresponds to STC1 in panel (a). Similarly,
SAC2 and SAC3 in panel (b) correspond to STC2 and STC3 in panel (a), respectively.
Thus, given the STC1, STC2, STC3 curves in panel (a) of Fig. 4.20, there are three
corresponding SAC curves as given by SAC1, SAC2, and SAC3 curves in panel (b) of
Self-Instructional
Material 157
Input-Output Decisions Fig. 4.20. Thus, the firm has a series of SAC curves, each having a bottom point showing
the minimum SAC. For instance, C1Q1 is minimum AC when the firm has only one plant.
The AC decreases to C2Q2 when the second plant is added and then rises to C3Q3 after
the addition of the third plant. The LAC curve can be drawn through the SAC1, SAC2 and
NOTES SAC3 as shown in Fig.4.20 (b). The LAC curve is also known as the ‘Envelope Curve’
or ‘Planning Curve’ as it serves as a guide to the entrepreneur in his plans to expand
production.
The SAC curves can be derived from the data given in the STC schedule, from
STC function or straightaway from the LTC curve.8 Similarly, LAC curve can be derived

se
from LTC-schedule, LTC function or from LTC-curve.
The relationship between LTC and output, and between LAC and output can now
be easily derived. It is obvious from the LTC that the long-run cost-output relationship is

u
similar to the short-run cost-output relation. With the subsequent increases in the output,
LTC first increases at a decreasing rate, and then at an increasing rate. As a result, LAC

. Ho
initially decreases until the optimum utilization of the second plant and then it begins to
increase. These cost-output relations follow the ‘laws of returns to scale’. When the
scale of the firm expands, unit cost of production initially decreases, but ultimately
increases as shown in Fig. 4.20 (b). The decrease in unit cost is attributed to the internal
and external economies and the eventual increase in cost, to the internal and external

td g
diseconomies. The economies and diseconomies of scale are discussed in the following
. L in
section.
Long-run Marginal Cost Curve (LMC)
vt sh
The long-run marginal cost curve (LMC) is derived from the short-run marginal cost
curves (SMCs). The derivation of LMC is illustrated in Fig. 4.21 in which SACs, SMCs
and LAC are the same as in Fig.4.20 (b). To derive the LMC, consider the points of
P li

tangency between SACs and the LAC, i.e., points A, B and C. In the long-run production
planning, these points determine the output at the different levels of production. Each of
ub

these outputs has an SMC. For example, if we draw a perpendicular from point A, it
intersects SMC1 at point M determining SMC at MQ1. The same process can be repeated
for points B and C to find out SMC at outputs Q2 and Q3. Note that points B and C
P

determine SMC at BQ2 and CQ3 respectively. A curve drawn through points M, B and
N, as shown by the LMC, represents the behaviour of the marginal cost in the long-run.
This curve is known as the long-run marginal cost curve, LMC. It shows the trends in
s

the marginal cost in response to the changes in the scale of production.


a

Some important inferences may be drawn from Fig. 4.20. The LMC must be
equal to SMC for the output at which the corresponding SAC is tangent to the LAC. At
ik

the point of tangency, LAC = SAC. Another important point to notice is that LMC intersects
LAC when the latter is at its minimum, i.e., point B. There is one and only one short-run
V

plant size whose minimum SAC coincides with the minimum LAC. This point is B where
SAC2 = SMC2 = LAC = LMC

Optimum Plant Size and Long-Run Cost Curves


The short-run cost curves are helpful in showing how a firm can decide on the optimum
utilization of the plant—the fixed factor, or how it can determine the output level that
minimizes cost. Long-run cost curves, on the other hand, can be used to show how a
firm can decide on the optimum size of the firm.
Self-Instructional
158 Material
Input-Output Decisions

NOTES

u se
. Ho
Fig. 4.21 Derivation of LMC

Conceptually, the optimum size of a firm is one which ensures the most efficient
utilization of resources. Practically, the optimum size of the firm is one that minimizes the
LAC. Given the state of technology over time, there is technically a unique size of the

td g
firm and level of output associated with the least-cost concept. In fig. 4.21, the optimum
size of the firm consists of two plants represented by SAC1 and SAC2. The two plants
. L in
together produce OQ2 units of a product at minimum long-run average cost (LAC) of
BQ2. The downtrend in the LAC indicates that until output reaches the level of OQ2,
vt sh
the firm is of less than optimal size. Similarly, expansion of the firm beyond production
capacity OQ2, causes a rise in SMC and, therefore, in LAC. It follows that given the
technology, a firm aiming to minimize its average cost over time must choose a plant
P li

that gives minimum LAC where SAC = SMC = LAC = LMC. This size of plant assures
the most efficient utilization of the resources. Any change in output level—increase or
ub

decrease—will make the firm enter the area of inoptimality.

4.7 SUMMARY
P

 The law of supply is, expressed generally in terms of price-quantity relationship.


The law of supply can be stated as follows: The supply of a product increases
s

with the increase in its price and decreases with decrease in its price, other things
a

remaining constant.
 Time period is the most important factor in determining the elasticity of the supply
ik

curve. In a very short period, the supply of most goods is fixed and inelastic. In
the short run, the supply tends to remain inelastic. In the long run, the supply of all Check Your Progress
V

the products gains its maximum elasticity because of increase in and expansion of
8. What are the
firms, new investments, improvement in technology, and a greater availability of elements that make
inputs. up short-run total
 Production function is a mathematical representation of input-output relationship. cost?
9. What is the
More specifically, a production function states the technological relationship
relationship
between inputs and output in the form of an equation, a table or a graph. between optimum
 The laws of production state the relationship between output and input. In the plant size and long-
run cost curves?
short-run, input-output relations are studied with one variable input (labour), other
inputs (especially, capital) held constant. The laws of production under these
Self-Instructional
Material 159
Input-Output Decisions conditions are called the ‘Laws of Variable Proportions’ or the ‘Laws of Returns
to a Variable Input’.
 The term ‘isoquant’ has been derived from the Greek word iso meaning ‘equal’
and Latin word quantus meaning ‘quantity’. The ‘isoquant curve’ is, therefore,
NOTES also known as ‘Equal Product Curve’ or ‘Production Indifference Curve’.
 The specific form of the cost function depends on whether the time framework
chosen for cost analysis is short-run or long-run. It is important to recall here that
some costs remain constant in the short-run while all costs are variable in the
long-run.

se
 The short-run cost curves are helpful in showing how a firm can decide on the
optimum utilization of the plant—the fixed factor, or how it can determine the
output level that minimizes cost. Long-run cost curves, on the other hand, can be

u
used to show how a firm can decide on the optimum size of the firm.

. Ho
4.8 KEY TERMS
 Law of supply: The supply of a product increases with the increase in its price
and decreases with decrease in its price, other things remaining constant.

td g
 Price elasticity of supply: It is the measure of responsiveness of the quantity
. L in supplied of a good to the changes in its market price.
 Production function: It states the technological relationship between inputs and
vt sh
output in the form of an equation, a table or a graph.
 Law of diminishing returns: The law of diminishing returns states that when
more and more units of a variable input are used with a given quantity of fixed
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inputs, the total output may initially increase at increasing rate and then at a
constant rate, but it will eventually increase at diminishing rates.
ub

 Marginal revenue productivity: It is the value of product resulting from the


marginal unit of variable input (labour).
 Isoquant curve: It can be defined as the locus of points representing various
P

combinations of two inputs—capital and labour—yielding the same output.


s

4.9 ANSWERS TO ‘CHECK YOUR PROGRESS’


a

1 As per the law of supply, the supply of a product increases with the increase in its
ik

price and decreases with decrease in its price, other things remaining constant. It
implies that the supply of a commodity and its price are positively related. This
relationship holds under the assumption that “other things remain the same”. “Other
V

things” include technology, price of related goods (substitute and complements),


and weather and climatic conditions in case of agricultural products.
2. Short and long periods are not fixed in terms of days, months or years. It varies
depending on the nature of the product. For example, for the supply of perishable
commodities like milk and fish in a city, a week’s time may be a short period. For
agricultural products, 6 months may be a short period. But in regard to the local
supply of petroleum products in India, a period of five years or even more may be
regarded as a short period.
Self-Instructional
160 Material
3. A real-life production function is generally very complex. It includes a wide range Input-Output Decisions
of inputs, viz., (i) land and building; (ii) labour including manual labour, engineering
staff and production manager, (iii) capital, (iv) raw material, (v) time, and (vi)
technology. All these variables enter the actual production function of a firm.
4. The law of diminishing returns states that when more and more units of a variable NOTES
input are used with a given quantity of fixed inputs, the total output may initially
increase at increasing rate and then at a constant rate, but it will eventually increase
at diminishing rates. That is, the marginal increase in total output decreases
eventually when additional units of a variable factor are used, given quantity of

se
fixed factors.
5. In case of factor employment, the concept of Marginal Revenue Productivity
(MRP) is used. The marginal revenue productivity is the value of product resulting

u
from the marginal unit of variable input (labour). In specific terms, marginal revenue
productivity (MRP) equals marginal physical productivity of labour multiplied by

. Ho
the price of the product.
6. An isoquant curve can be defined as the locus of points representing various
combinations of two inputs—capital and labour—yielding the same output.
7. The economists have devised a method of measuring the degree of substitutability

td g
of factors, called the Elasticity of Factor Substitution. The elasticity of substitution
(s) is formally defined as the percentage change in the capital-labour ratio (K/L)
. L in
divided by the percentage change in marginal rate of technical substitution
(MRTS).
vt sh
8. The short-run TC is composed of two major elements: (i) total fixed cost (TFC),
and (ii) total variable cost (TVC).
9. The short-run cost curves are helpful in showing how a firm can decide on the
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optimum utilization of the plant—the fixed factor, or how it can determine the
output level that minimizes cost. Long-run cost curves, on the other hand, can be
ub

used to show how a firm can decide on the optimum size of the firm.

4.10 QUESTIONS AND EXERCISES


P

Short-Answer Questions
s

1. What is the price elasticity of supply? Give the equation for calculating it.
a

2. Which are the two types of production functions and what is the difference between
ik

them?
3. What are the assumptions on which the law of diminishing returns is based?
V

4. Briefly describe the various types of isoquants.


5. What are the causes of diminishing returns to scale?
Long-Answer Questions
1. Identify the determinants of the price elasticity of supply.
2. What is a production function? What is its significance? How is it calculated?
3. How is the law of diminishing returns applied in business decisions?

Self-Instructional
Material 161
Input-Output Decisions 4. Discuss isoquant curves and their properties in detail.
5. Identify the factors behind increasing returns to scale.

NOTES 4.11 FURTHER READING


Dwivedi, D. N. 2008. Managerial Economics, Seventh Edition. New Delhi: Vikas
Publishing.
Keat, Paul G. and Philip, K. Y. Young. 2003. Managerial Economics: Economics

se
Tools for Today’s Decision Makers, Fourth Edition. Singapore: Pearson
Education.
Keating, B. and J. H. Wilson. 2003. Managerial Economics: An Economic Foundation

u
for Business Decisions, Second Edition. New Delhi: Biztantra.
Mansfield, E., W. B. Allen, N. A. Doherty, and K. Weigelt. 2002. Managerial

. Ho
Economics: Theory, Applications and Cases, Fifth Edition. NY: W. Orton &
Co.
Peterson, H. C. and W. C. Lewis. 1999. Managerial Economics, Fourth Edition.
Singapore: Pearson Education.

td g
Salvantore, Dominick. 2001. Managerial Economics in a Global Economy, Fourth
. L in Edition. Australia: Thomson-South Western.
Thomas, Christopher R. and Maurice S. Charles. 2005. Managerial Economics:
Concepts and Applications, Eighth Edition. New Delhi: Tata McGraw-Hill.
vt sh
Endnotes
1. Koutsoyiannis, A. op. cit., p. 70.
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2. Supply of capital may, of course, be elastic in the short-run for an individual firm under
perfect competition but not for all the firms put together. Therefore, for the sake of
ub

convenience in explaining the laws of production, we will continue to assume that, in the
short-run, supply of capital remains inelastic.
3. This production function was constructed first by Paul H. Douglas in his book The
P

Theory of Wages (Macmillan, NY, 1924). The function was developed further by C.W.
Cobb and Paul H. Douglas in their joint paper “A Theory Production” in Am. Eco. Rev.,
March 1928. Since then this production function is known as Cobb-Douglas Production
s

Function.
4. The concept of economic region is discussed in detail in the next section.
a

5. The ‘economies of scale’ are discussed in detail in the following section.


ik

6. There may be some nominal payment for the use of public utilities in the form of tax, which
may not cover the full cost thereof.
7. One method of solving quadratic equation is to factorize it and find the solution. Thus,
V

Q3 – 9Q2 – 100 = 0
(Q – 10) (Q2 + Q + 10) = 0
For this to hold, one of the terms must be equal to zero. Suppose
(Q2 + Q + 10) = 0
Then, Q – 10 = 0 and Q = 10.
8. The SAC curves can be obtained by measuring the slope of STC at different levels of
output. For a simple exposition of the method, see Leftwich, R.H., The Price System, and
Resource Allocation (The Dryden Press, Illinois), 4th edn., Appendix to Ch. 8.
Self-Instructional
162 Material
Price and Output

UNIT 5 PRICE AND OUTPUT Determination

DETERMINATION
NOTES
Structure
5.0 Introduction
5.1 Unit Objectives
5.2 Competition and Market Structures

se
5.2.1 Features of Perfect Competition
5.2.2 Price and Output Determination under Perfect Competition
5.3 Monopoly
5.3.1 Demand and Revenue Curves under Monopoly

u
5.3.2 Cost and Supply Curves under Monopoly
5.3.3 Profit Maximization under Monopoly

. Ho
5.3.4 Absence of Supply Curve in a Monopoly
5.3.5 Price Discrimination in a Monopoly
5.3.6 Measures of Monopoly Power
5.4 Oligopoly, Non-Price Competition
5.4.1 Oligopoly: Meaning and Characteristics

td g
5.4.2 Duopoly Models
5.4.3 Oligopoly Models
. L in
5.4.4 Game Theory Approach to Oligopoly
5.5 Summary
5.6 Key Terms
vt sh
5.7 Answers to ‘Check Your Progress’
5.8 Questions and Exercises
5.9 Further Reading
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5.0 INTRODUCTION
ub

Apart from objectives, another factor that plays an important role in a firm’s choice of
price and output is the market structure. The term ‘market structure’ refers to the
P

organizational features of an industry that influence the firm’s behaviour in its choice of
price and output. Market structure is an economically significant feature of the market.
s

It affects the behaviour of firms in respect of their production and pricing behaviour. It
is classified on the basis of organizational features of the industry, more specifically, on
a

the basis of degree of competition among firms. In general, the organizational features
ik

include the number of firms, distinctiveness of their products, elasticity of demand and
the degree of control over the price of the product.
In this unit, we present a brief description of the market structure—the playing
V

field of firms. In contrast to perfect competition, monopoly is the extreme opposite form
of a product market. In case of perfect competition, the number of sellers is so large that
no one has any power whatsoever to influence the market price. A monopoly firm, on
the other hand, has the sole power to influence the market price. While under perfect
competition no seller can afford to discriminate between the buyers of different categories,
the monopolists practice price discrimination as a matter of policy. You will also learn, in
this unit, about the sources of monopoly, price and output determination in the short and

Self-Instructional
Material 163
Price and Output long run, price discrimination and comparison of price and output under perfect competition
Determination
and monopoly.
In this unit, you will also learn about price and output determination in a market
structure which is more realistic in the modern business world—called oligopoly.
NOTES Oligopoly is similar to monopolistic competition with two very important differences:
(i) under monopolistic competition, the number of sellers is very large and under
oligopoly it is a few, and (ii) under oligopoly, the competition between firms is much
more intensive.

se
5.1 UNIT OBJECTIVES
After going through this unit, you will be able to:

u
• Understand the degrees of competition and market structure

. Ho
• Understand the process of price and output determination under perfect
competition
• Explain the definition, sources and features of monopoly
• Describe price discrimination in a monopoly

td g
• Describe the measures of monopoly power
. L in • Understand the meaning and characteristics of an oligopoly
• Analyse duopoly models
vt sh
• Discuss oligopoly models
• Describe the game theory approach to oligopoly
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5.2 COMPETITION AND MARKET STRUCTURES


ub

The market structure is generally classified on the basis of the degree of competition as
follows:
P

(i) Perfect competition


(ii) Imperfect competition
s

(a) Monopolistic competition


(b) Oligopoly with and without product differentiation
a

(c) Duopoly
ik

(iii) Monopoly
The basic features of these kinds of market are summarized below. However, a
V

brief description of each kind of market is given follow.

Self-Instructional
164 Material
Table 5.1 Types of Markets Price and Output
Determination
Type of Market No. of Nature of Product Firm’s
Firms Over Price Control
(i) Perfect Competition Very Homogeneous (wheat None NOTES
large sugar, vegetables....)
(ii) Imperfect Competition
(a) Monopolistic Many Real or perceived Some
Competition (most retail trade) difference in product
(b) Oligopoly Few (i) Product without Some
differentiation,

se
e.g., aluminium, steel,
and chemicals, etc.
(ii) Differentiated
products (tea, TV

u
Refrigerator,
toothpastes,

. Ho
soaps, detergents,
automobiles)
(iii) Monopoly Single Products without close Full but
substitutes, like gas, usually
electricity and regulated
water supply.

td g
Perfect Competition . L in
Perfect competition is a market situation in which a large number of producers offer a
homogeneous product to a very large number of buyers of the product. The number of
vt sh
sellers is so large that each seller offers a very small fraction of the total supply, and
therefore, has no control over the market price. Likewise, the number of buyers is so
large that each buyer buys an insignificant part of the total supply and has no control
over the market price. Both buyers and sellers are ‘price takers’, not ‘price makers’.
P li

The price of a commodity is determined in this kind of markets by the market demand
ub

and market supply. Each seller faces a horizontal demand curve (with e = ∞), which
implies that a seller can sell any quantity at the market determined price.

This kind of market is, however, more of a hypothetical nature rather than
P

being a common or realistic one. Some examples of a perfectly competitive market


include stock markets, vegetable markets, wheat and rice where goods are sold
s

by auction.
Imperfect Competition
a

Perfect competition, in strict sense of the term, is a rare phenomenon. In reality, markets
ik

for most goods and services have imperfect competition. Imperfect competition is said
to exist when a number of firms sell identical or differentiated products with some
V

control over the price of their product. Barring a few goods like shares and vegetable
markets, you name any commodity, its market is imperfect. In spite of a large number of
dealers (arhatias) in the wheat market, the Food Corporation of India is the biggest
buyer and seller of wheat in India, with a great degree of control over wheat prices.
Imperfect competition creates two different forms of markets with different number
of producers and with different degrees of competition, classified as (a) monopolistic
competition, (b) oligopoly (c) monopoly.

Self-Instructional
Material 165
Price and Output (a) Monopolistic Competitions: Monopolistic competition is a kind of market in
Determination
which a large number of firms supply differentiated products. The number of
sellers is so large that each firm can act independently of others, without its
activities being watched and countervailed by others. Besides, it is not only
NOTES extremely difficult to keep track of competitors’ strategy, but also it is not of any
avail. In this respect, it is similar to perfect competition. It differs from perfect
competition in that the products under monopolistic competition are somewhat
differentiated whereas they are identical under perfect competition. There is free
entry and free exit.
(b) Oligopoly: Oligopoly is an organizational structure of an industry in which a

se
small number of firms supply the entire market, each seller having a considerable
market share and control over the price. Most industries in our country are
oligopolistic. A small number of companies supply the entire tea, medicines,

u
cosmetics, refrigerators, TV and VCRs, cars, trucks, jeeps, and so on. The

. Ho
producers of all these goods have some control over the price of their products.
Their products are somewhat differentiated, at least made to look different in the
consumers’ perception. Therefore, demand curve for their product has high
elasticity, but less than infinity, unlike under perfect competition.
(c) Monopoly: Monopoly is the market of a single seller with control over his price

td g
and output. Monopoly is antithesis of perfect competition. Absolute monopolies
. L in are rare these days. They are found mostly in the form of government monopolises
in public utility goods, e.g., electricity, radio broadcasting, water, rail and postal
services.
vt sh
Why are Markets Imperfect?
Imperfect competition arises mainly from the barriers to entry. Barriers to entry are
P li

created by several factors.


(i) The large size firms which enjoy economies of scale can cut down their prices
ub

to the extent that can eliminate new firms or prevent their entry to the industry, if they so
decide.
(ii) In some countries, like India, licencing policy of the government creates barrier
P

for the new firms to enter an industry.


(iii) Patenting of rights to produce a well-established product or a new brand of a
s

commodity prevents new firms from producing that commodity.


a

(iv) Sometimes entry of new firms to an industry is prevented by a law with a


view to enabling the existing ones to have economies of scale so that prices are low.
ik

5.2.1 Features of Perfect Competition


A perfectly competitive market is characterized by complete absence of rivalry among
V

the individual firms. In fact, under perfect competition as conceived by the economists,
competition among the individual firms is so widely dispersed that it amounts to no
competition. Perfect competition is characterized by the following assumptions.
1. Large Number of Buyers and Sellers. Under perfect competition, the number
of sellers is assumed to be so large that the share of each seller in the total supply
of a product is so small that no single firm can influence the market price by
changing its supply. Therefore, firms are price-takers not price-makers. Similarly,
the number of buyers is so large that the share of each buyer in the total demand
Self-Instructional
166 Material
is so small that no single buyer or a group of buyers can influence the market Price and Output
Determination
price by changing their individual or group demand for a product.
2. Homogeneous Product. The commodities supplied by all the firms of an
industry are assumed to be homogeneous or approximately identical. Homogeneity
of the product implies that buyers do not distinguish between products supplied by NOTES
the various firms of an industry. Product of each firm is regarded as a perfect
substitute for the products of other firms. Hence, no firm can gain any competitive
advantage over the other firms. This assumption limits the power of any firm to
charge a price which is even slightly higher than the market price.

se
3. Perfect Mobility of Factors of Production. Another important characteristic
of perfect competition is that the factors of production (especially, labour and
capital) are freely mobile between the firms. Labour can freely change the firms
as there is no barrier on labour mobility—legal, language, climate, skill, distance

u
or otherwise. There is no trade union. Capital can also move freely from one firm

. Ho
to another. No firm has any kind of monopoly over any industrial input. This
assumption guarantees that factors of production—labour, capital, and entrepren-
eurship—can enter or quit a firm or the industry whenever it is found desirable.
4. Free Entry and Free Exit. There is no legal or market barrier on entry of
new firms to the industry. Nor is there any restriction on exit of the firms from the

td g
industry. That is, a firm may enter the industry and quit it at its will. Thus, when
. L in
normal profit of the industry increases, new firms enter the industry and if profits
decrease and better opportunities are available, firms leave the industry.
5. Perfect Knowledge about the Market Conditions. There is perfect
vt sh
knowledge about the market conditions. All the buyers and sellers have full
information regarding the prevailing and future prices and availability of the
commodity. As Marshall puts it, ‘... though everyone acts for himself, his knowledge
P li

of what others are doing is supposed to be generally sufficient to prevent him


from taking a lower or paying a higher price than others are doing.’1 Information
ub

regarding market conditions is available free of cost. There is no uncertainty.


6. No Government Interference. Government does not interfere in any way
with the functioning of the market. There are no taxes or subsidies; no licencing
P

system, no allocation of inputs by the government, or any kind of other direct


control. That is, the government follows the free enterprise policy. Where there
s

is intervention by the government, it is intended to correct the market imperfections.


7. Absence of Collusion and Independent Decision-Making. Perfect
a

competition assumes that there is no collusion between the firms, i.e., they are not
ik

in league with one another in the form of guild or cartel. Nor are the buyers in
collusion between themselves. There are no consumers’ associations, etc. This
condition implies that buyers and sellers take their decisions independently and
V

they act independently.


Perfect vs Pure Competition
Sometimes a distinction is made between perfect competition and pure competition.
The difference between the two is a matter of degree. While ‘perfect competition’ has
all the features mentioned above, ‘pure competition’ does not assume perfect mobility
of factors and perfect knowledge. That is, perfect competition less perfect mobility
and knowledge is pure competition. ‘Pure competition’ is ‘pure’ in the sense that it
has absolutely no element of monopoly. Self-Instructional
Material 167
Price and Output The perfect competition, as characterized above, is considered as a rare
Determination
phenomenon in the real business world. However, the actual markets that approximate
the conditions of perfectly competitive market include the security markets for stocks
and bonds, and agricultural markets like local vegetable markets. Despite its limited
NOTES scope, perfect competition model has been the most popular model used in economic
theories due to its analytical value.
5.2.2 Price and Output Determination under Perfect Competition
Under perfect competition, market price in a perfectly competitive market is determined
by the market forces, viz., demand and supply. Here, market demand refers to the

se
demand for the industry as a whole. It is equal to the sum of the quantity demanded by
the individuals at different prices. Similarly, market supply is the sum of quantity supplied
by the individual firms in the industry at a given price. The market price is therefore

u
determined for the industry as a whole and is given for each individual firm and for each
buyer. Thus, every seller in a perfectly competitive market is a ‘price-taker’, not a

. Ho
‘price-maker’.
In a perfectly competitive market, therefore, the main problem of a firm is not to
determine the price of its product but to find its output at the given price so that profit is
maximized.

td g
. L in The role of market forces and the mode of price determination depends on the
time taken by supply position to adjust itself to the changing demand conditions. Price
determination is analysed under three different time periods: (i) Market period or very
short-run; (ii) short-run; and (iii) long-run.
vt sh
I. Price Determination in the Market Period or Very Short-Run
The market period or very short-run refers to a time period in which quantity supplied is
P li

absolutely fixed or, in other words, supply response to change in price is nil. In the
market period, therefore, the total output of the product is fixed. Each firm has a given
ub

quantity of commodity to sell. The aggregate supply of all the firms makes the market
supply. The supply curve is perfectly inelastic, as shown by line SQ in Fig. 5.1. In this
situation, price is determined entirely by the demand conditions. For instance, suppose
P

that the number of marriage-houses (or tents) available per month in a city is given at
OQ (Fig. 5.1), so that the supply curve takes the shape of a vertical straight line SQ. Let
us also suppose that the monthly demand curve for marriage-houses is given by the
s

demand curve, D1.


a

Demand and supply curves intersect each other at point M, determining the
rental at MQ. Let us now suppose that during a particular month demand for marriage-
ik

houses suddently increases because a relatively large number of parents decide to


celebrate the marriage of their daughters and sons due to, say, non-availability of auspicious
V

dates for some time to come. Consequently, the demand curve shifts upward to D2. The
demand curve D2 intersects the supply curve at point P. The equilibrium rate of rental is
thus determined at PQ. This becomes parametric price for all the buyers. Note that the
rise in the rental from MQ to PQ is caused by the upward shift in the demand curve and
that market supply curve remains perfectly inelastic in the market period. The other
example of very short-run markets may be of perishable commodities like fish, milk,
vegetable, etc. and of non-perishable commodities like shares and bonds.

Self-Instructional
168 Material
Price and Output
Determination

NOTES

u se
Fig. 5.1 Determination of Market Price

. Ho
II. Price Determination in the Short-Run
While in market period (or very short-run), supply is absolutely fixed, in the short-run it
is possible to increase (or decrease) the supply by increasing (or decreasing) the variable
inputs. In the short-run, therefore, supply curve is elastic, unlike a straight vertical line in

td g
the market period. Supply curve in the short-run approximates the SMC curve.
. L in
Under competitive conditions the process of price determination and output
adjustment in the short-run is given in Fig. 5.2(a) and 5.2(b). Figure 5.2(a) shows demand
curve DD and supply curve SS intersect at point P determining the price at OP1. This
vt sh
price is fixed for all the firms in the industry.
Given the price PQ (= OP1), in Fig. 5.2(a), an individual firm can produce and sell
any quantity at this price. But any quantity will however not yield maximum profit. The
P li

firms will have to adjust their output to the price OP1. The process of output determination
ub

is presented through Fig. 5.2(b).


P
a s
ik
V

(a) (b)

Fig. 5.2 Pricing under Perfect Competition: Short-run

Since a firm can sell any quantity at price OP1, the demand for the firm’s product
is given by a horizontal straight line, AR = MR. Price being constant, its average revenue
(AR) and marginal revenue (MR) are equal. Firm’s upward sloping MC curve beyond its Self-Instructional
Material 169
Price and Output AVC curve represents its supply curve. Firm’s MR and MC curves intersect each other
Determination
at point E. This is the firm’s equilibrium point. The perpendicular EM determines the
profit-maximizing output at OM. At this output, firm’s MR = MC, which satisfies both
the first order and the second order conditions of maximum profit. The total maximum
NOTES profit is shown by the area P1 TNE. The total profit (η) may be calculated as
η = (AR – AC)Q
In Fig. 5.2(b),
AR = EM
AC = NM

se
and Q = OM
By substituting the values from Fig. 5.2(b), we get

u
η = (EM – NM) OM

. Ho
Since EM – EN = EN
η = EN × OM
This is the maximum profit that a firm can make, given the cost and revenue
conditions as presented in Fig. 5.2(b).

td g
Now, if price falls to OP2 due to downward shift in the demand curve to D′D′, the
firm will be in equilibrium at point E′. Here again the firm’s AR′ = MR′ = MC. But its
. L in
AR < AC. Therefore, the firm incurs loss. But, in the short-run, it may not be desirable to
close down so long as it covers its MC.
vt sh
III. Price Determination in the Long Run
Unlike in the short-run, the supply curve in the long-run is supposed to be more elastic.
Long-run brings in two additional factors in operation which make the supply curve
P li

more elastic. First, in the long-run, it becomes possible for the existing firms to increase
ub

their output by increasing the size of their plant. Second, and what is more important,
new firms may enter and some existing ones may leave the industry. Entry and exit of
firms bring about the long-run variation in the output. If cost and revenue conditions in
the long-run are such that some firms are making losses and are not able to adjust their
P

plant-size and cost structure to the market price, such firms leave the industry. This
makes the market supply curve shift leftward causing a rise in the price. The increase in
s

market price increases the excess profit of the profit-making firms. Under the conditions
of the perfect competition (i.e., free entry and exit), the pure profit would invite many
a

new firms to the industry. This will make supply curve shift rightward, causing a decrease
in the price, which will eventually take away the excess or pure profits. All firms earn
ik

only normal profit. Let us now explain the price and output determination in the long-
run and also the equilibrium of the firm and of the industry.
V

As in the short-run, market price is determined in the long-run by the market


forces of demand and supply. Let us suppose that the market demand curve is given by
DD′ which is relevant for both short-run and long-run, and short-run supply curve is
given by SS1 in Fig. 5.3(a). The market demand curve DD′ and market supply curve SS1
intersect each other at point P1 and the short-run market price is determined at OP0. At
this price, the firms find their short-run equilibrium at point E1 and each of them produces2
output OQ1. The total market supply equals OQ1 × No. of firms = ON1 [in panel (a) of
Fig. 5.3] and the industry is in short-run equilibrium.

Self-Instructional
170 Material
Given the cost and revenue conditions in Fig. 5.3(b), the firms are making super Price and Output
Determination
normal profit of E1M per unit. The existence of super normal profit in the short-run leads
to increase in the market supply on two accounts: one, new firms will enter the industry
attracted by the super normal profits, and two, the existing firms would expand their
plant-size because returns to scale would increase as shown by the LAC. As a result, the NOTES
market supply would increase so that supply curve shifts rightward to SS2 [Fig. 5.3(a)].
The shift in supply curve brings down the market price to OP′ which is the long-run
equilibrium price. Thus, equilibrium price is once again determined in the market.

u se
. Ho
td g
. L in
(a) (b)

Fig. 5.3 Long-run Equilibrium of the Firm


vt sh
Equilibrium of the Firm in the Long Run
The firms are in equilibrium in the long-run when their
P li

AR = MR = LMC = LAC = SMC = SAC


ub

It means the firms of an industry reach their equilibrium position in the long-run
where both a short-run and long-run equilibrium conditions coincide. In a perfectly
competitive market, the cost and revenue conditions are given for the firms. What the
firms can do, therefore, is to adjust their output to the given revenue and cost conditions
P

in order to maximize their profit. Let us now illustrate the process of adjustment of
output so as to reach the equilibrium in the long-run.
s

Suppose that the firms are in equilibrium at point E1 in Fig. 5.3(a) where they
make excess profits AR – SAC1 = EM per unit. This gives incentives to the firms to
a

expand their scale of production, i.e., they add more plants to the existing ones. As a
result, market supply increases. Besides, supply also increases because new firms enter Check Your Progress
ik

the industry. Therefore, the market supply curve SS1 tends to shift rightward causing a 1. Define perfect
fall in price to OP´. On the other hand, due to increase in demand for inputs, cost tends competition and list
V

its characteristics.
to rise. But so long as economies of scale are greater than the diseconomies of scale, the
2. What are the three
LAC tends to decrease and it pays firms to expand their plant-size. When a stage is different degrees of
arrived where P < LAC, firms incur losses. The firms which are not able to make competition created
adjustment in the plant-size or scale of production leave the industry. This works in two by imperfect
directions. On the one hand, supply decreases and price increases, and on the other, competition?
demand for inputs decreases which causes a decrease in the input prices. This process 3. What is ‘short run’
from the pricing
of adjustment continues until LAC is tangent to P = AR = MR for each firm in the point of view?
industry.

Self-Instructional
Material 171
Price and Output
Determination 5.3 MONOPOLY: DEFINITION, SOURCES AND
FEATURES
NOTES The term pure monopoly signifies an absolute power to produce and sell a product
which has no close substitute. In other words, a monopoly market is one in which there
is only one seller of a product having no close substitute. The cross-elasticity of demand
for a monopolized product is either zero or negative. In a monopolized market structure,
the industry is a single-firm-industry. Firm and industry are identical in a monopoly setting.

se
Moreover, the precise definition of monopoly has been a matter of opinion and
purpose. For instance, in the opinion of Joel Dean,3 a monopoly market is one in which ‘a
product of lasting distinctiveness is sold’. The monopolized product has distinct physical
properties recognized by its buyers and the distinctiveness lasts over many years. Such

u
a definition is of practical importance if one recognizes the fact that most commodities

. Ho
have their substitutes varying in degree and it is entirely for the consumers or users to
distinguish between them and to accept or reject a commodity as the substitute. Another
concept of pure monopoly has been advanced by D.H. Chamberlin4 who envisages the
control of all goods and services by the monopolist. But such a monopoly has hardly ever
existed, hence his definition is unrealistic. In the opinion of some others, any firm facing

td g
a sloping demand curve is a monopolist. This definition, however, includes all kinds of
firms except those under perfect competition.5 We will, however, adopt for our purpose
. L in
here a general definition of a pure monopoly: a pure monopoly means an absolute power
to produce and sell a commodity which has no close substitute.
vt sh
Some important features of monopoly are the following:
1. There is a single seller of a product which has no close substitute.
2. A monopoly firm is a price maker, not a price taker.
P li

3. Under monopoly, there is absence of supply curve.


ub

4. A monopoly makes a single-firm industry.


Sources and Kinds of Monopolies
P

The emergence and survival of a monopoly is attributed to the factors which prevent the
entry of other firms into the industry. The barriers to entry are therefore the sources of
monopoly power. The major sources of barriers to entry to a monopolized market are
s

described here briefly.


a

(i) Legal Restrictions. Some monopolies are created by the law in the public
interest. Most state monopolies in the public utility sector, including postal, telegraph
ik

and telephone services, radio, generation and distribution of electricity, railways,


airlines and state roadways, etc. are public monopolies that are created by the
V

public law. The state may create monopolies in the private sector also by restricting
entry of other firms by law or by granting patent rights. Such monopolies are
intended to reduce cost of production to the minimum by enlarging the size and
investing in technological innovations. Such monopolies are known as franchise
monopolies.
(ii) Control over Key Raw Materials. Some firms acquire monopoly power
because of their traditional control over certain scarce and key raw materials,
which are essential for the production of certain other goods, e.g., bauxite, graphite,

Self-Instructional
172 Material
diamond, etc., Aluminium Company of America, for instance, had monopolized Price and Output
Determination
the aluminium industry before the World War II because it had acquired control
over almost all sources of bauxite supply.6 Such monopolies are often called ‘raw
material monopolies’. The monopolies of this kind emerge also because of
monopoly over certain specific knowledge or technique of production. NOTES
(iii) Efficiency. A primary and technical reason for growth of monopolies is the
economies of scale. In some industries, long-run minimum cost of production or
the most efficient scale of production almost coincides with the size of the market.
Under this condition, the large-size firm finds it profitable in the long-run to eliminate
the competition by cutting down its price for a short period. Once monopoly is

se
established, it becomes almost impossible for the new firms to enter the industry
and survive. Monopolies existing on account of this factor are known as natural
monopolies. A natural monopoly emerges either due to technical efficiency or is

u
created by the law on efficiency grounds.

. Ho
(iv) Patent Rights. Another source of monopoly is the patent right of the firm for
a product or for a production process. Patent rights are granted by the government
to a firm to produce a commodity of specified quality and character or to use a
specified technique of production. Patent rights gives a firm exclusive rights to
produce the specified commodity or to use the specified technique of production.

td g
Such monopolies are called patent monopolies.
. L in
5.3.1 Demand and Revenue Curves under Monopoly
The nature of revenue curves under monopoly depends on the nature of demand curve
vt sh
a monopoly firm faces. We have noted earlier that in a perfectly competitive market,
firms face a horizontal, straight-line demand curve. It signifies that an individual firm of
an industry can sell any quantity at the prevailing price. Under monopoly, however, there
P li

is no distinction between the firm and the industry. The monopoly industry is a single-
firm industry. The monopoly firm is, therefore, capable of influencing the industry price
ub

by changing the level of its production which is eventually the industry output. Besides,
a monopoly firm is free to choose between price-quantity combination. It can fix higher
price and sell a lower quantity and vice versa. For these reasons, a monopoly firm
P

faces a demand curve with a negative slope. What is important in the context of
monopoly pricing is the relation between firm’s average revenue (AR) curve and its
marginal revenue (MR) curve. The analysis is therefore repeated here for ready reference.
s

Relation between AR and MR Curves


a

The relationship between AR and MR curves plays an important role in price and output
ik

determination under monopoly. Therefore, before we explain price and output


determination, let us look at technical relationship between AR and MR. The relationship
between AR (= P) and MR can be specified in the following way:
V

Recall that total revenue, TR, equals P times Q, i.e.,


TR = P·Q
and marginal revenue, MR, is obtained by differentiating TR = P·Q with respect to P.
Thus,
∂ ∂
MR = ∂ = +

Self-Instructional
Material 173
Price and Output
Determination
=
FG +
∂ IJ ...(5.1)
H ∂ K
Q P
NOTES Note that is the reciprocal of the elasticity..
P Q

Q P
Thus, =–
P Q

se

By substituting − for ⋅ in Eq. 5.1, we get

u
MR = P
FG IJ ...(5.2)
H −
K

. Ho
or MR = P – ...(5.3)

Since P = AR

td g
MR = AR – ...(5.4)
. L in This relationship between MR and AR can be derived geometrically. Consider the
AR and MR curves in Fig. 5.4.
vt sh
P li
ub
P
a s
ik

Fig. 5.4 Relationship between AR and MR Curves

Let us suppose that price is given at PQ (=BO). The elasticity at point P on the
V

AR curve can be expressed as:

e = = =

where e = elasticity of demand curve.


Since OB = PQ

∴ e = ...(5.5)
Self-Instructional
174 Material
It can be proved7 that AB = PT. By substituting PT for AB in Eq. 5.5, we get Price and Output
Determination

e= ...(5.6)

Since PT = PQ – TQ, Eq. 5.6 may be written as NOTES

e= − ...(5.7)

It can be seen from Fig. 5.4 that at price OB, PQ = AR and TQ = MR. Therefore,
Eq. 5.7 can be expressed as:

se
e =

u
and MR = AR – ...(5.8)

. Ho
Note that Eq. 5.4 is the same as Eq. 5.8.
Given the Eq. 5.7, AR can be easily obtained.

Since MR = AR –

td g
1
or MR = AR 1
. L ine
...(5.9)
vt sh
AR =

1
P li

or AR = MR ...(5.10)
e 1
ub

The general relationships between AR and MR are given by Eq. (5.9) and Eq.
(5.10). A general pattern of relations between AR and MR can be easily obtained from
Eq. (5.9) as follows. Given the negative slope of the demand curve,
P



s


a


∞,
ik

An important aspect of relation between AR and MR curves that needs to be


V

noted is that the slope of the MR curve is twice that of the AR curve.8
5.3.2 Cost and Supply Curves under Monopoly
In the short-run, cost conditions faced by a monopoly firm are, for all practical purposes,
identical to those faced by a firm under perfect competitions, particularly when a monopoly
firm is a competitive buyer in the input market. But in case a monopoly firm uses specified
inputs9 for which there is no general market and holds the position of a monopolist in the
input-market, then the price of the inputs depends on the monopolist’s demand for it,
given the supply condition. The monopoly firm may then face a positively sloping supply
Self-Instructional
Material 175
Price and Output curve in the input market, and its cost curves would be different from those of firms
Determination
under perfect competition. In fact, the monopoly firm would face a rising supply price
and its cost curves would rise rapidly. In general, however, most monopoly firms use
unspecified inputs, and they are one among many buyers of the inputs. In the short-run,
NOTES therefore, a monopoly firm is faced with usual U-shaped AC and MC curves.
We have noted that under perfect competition, the MC curve forms the basis of
firm’s supply curve. It is important to note here that the MC curve is not the
monopolist’s supply curve. In fact, under monopoly, there is no unique relation between
market price and quantity supplied. Therefore, there is no supply curve under monopoly.

se
5.3.3 Profit Maximization under Monopoly
The objective of a monopoly firm, like all other firms, is assumed to be profit maximization.
Profit maximization is, however, not necessarily the sole objective of the firm. The

u
monopoly firm may seek to maximize its utility function,10 particularly where management

. Ho
of the firm is divorced from its ownership. But, as mentioned earlier, most common
objectives of business firm assumed in traditional theory of pricing is profit maximization.
We will therefore explain the equilibrium of monopoly firm in short run and long-run
under profit maximization hypothesis.

td g
Monopoly Equilibrium in the Short Run
. L in
Like any other firm, a monopoly firm reaches its equilibrium where it maximizes its total
profits. As noted earlier, profits are maximum where the two following conditions are
fulfilled: (i) that MC = MR—the necessary condition, and (ii) that the MC curve must
vt sh
intersect the MR curve from below under increasing cost condition—the supplementary
condition. The monopoly firm fixes its price and output in accordance with the these
conditions.
P li
ub
P
a s
ik
V

Fig. 5.5 Price Determination under Monopoly: Short-run

The price and output determination under monopoly, and also the firm’s equilibrium,
are demonstrated in Fig. 5.5. The AR = D and MR curves show the revenue conditions,
while SMC and SAC present the short-run cost conditions faced by the monopoly firm.
Given the revenue and cost curves, the decision rule for selecting profit maximizing
output and price is the same as for a firm in the competitive industry, i.e., firm’s MR =
MC and slope of MC > the slope of MR. Therefore, the monopoly firm chooses a price-
output combination for which MR = SMC. The MR and SMC curves intersect each
other at point N. Thus, the profit maximizing output for the firm is OQ, since at this
Self-Instructional
176 Material
output firm’s MR = SMC. Given the demand curve AR = D, the output OQ can be sold Price and Output
Determination
per time unit at only one price, i.e., PQ(= OP1). Thus, the determination of equilibrium
output simultaneously determines the price for the monopoly firm. Once price and output
are determined, the total profits are also simultaneously determined.
At output OQ and price PQ, the monopoly firm maximizes its profit. Its per unit NOTES
monopoly or super-normal profit (i.e., AR – SAC) is (PQ – MQ) = PM. Its total profit π
= OQ × PM. Since OQ = P2M, π = P2M × PM, as shown by the shaded area. Since in
the short-run cost and revenue conditions are not expected to change, the equilibrium of
the monopoly firm will remain stable.

se
Two Common Misconceptions
There are two common misconceptions about monopoly firm which must be cleared
before we proceed.

u
One of the misconceptions is that a monopoly firm necessarily makes super normal

. Ho
profits. There is, however, no guarantee that monopoly firm will always make profits in
the short run. In fact, whether a monopoly makes profits or losses in the short run
depends on its revenue and cost conditions. It is quite likely that its SAC lies above its AR
as shown in Fig. 5.6. The monopoly firm then makes losses to the extent of
PM × OQ = P2MPP1. The firm may yet continue to produce and sell in the hope of

td g
making profits in the long-run. The monopoly firm, like a competitive firm, will, however,
. L in
stick to the maximization rules (i.e., MR = MC) in order to minimize its losses.
Another common misconception about monopoly is that the demand curve faced
by a monopoly firm is perfectly inelastic so that it can charge any price it likes. In fact,
vt sh
the demand curve faced by a monopolist is both firm’s and industry’s demand curve.
And, most market demand curves are negatively sloped being highly elastic towards
their upper end and highly inelastic towards their lower end. The equilibrium output of
P li

the monopolist that maximizes his profits will always be within the elastic region of the
demand curve, if his MC ≠ 0.
ub
P
a s
ik
V

Fig. 5.6 Monopoly Equilibrium in the Short-run: Losses

Monopoly Equilibrium in the Long Run


The long-run conditions faced by a monopolist are different from those faced by
competitive firms in an important respect, i.e., the entry of new firms into the industry.
While in a competitive industry, there is free entry of new firms to the industry, a monopoly
firm is protected from competition by the barriers to entry. Self-Instructional
Material 177
Price and Output Protected by barriers to entry, a monopoly firm gets an opportunity to expand the
Determination
size of its plant with a view to maximizing its long-run profits. The expansion of the
plant-size may, however, be subject to such conditions as (a) size of the market; (b)
expected economic profits; and (c) risk of inviting legal restrictions. Assuming none of
NOTES these conditions limits the expansion of monopoly firm, the general case of monopoly
equilibrium in the long-run is illustrated in Fig. 5.7. The AR and MR curves show the
market demand and marginal revenue conditions faced by the monopoly firm. The LAC
and LMC curves show the long-run cost conditions. The profit maximizing monopoly
firm equalises its LMC and MR at output OQ2. The price at which the total output OQ2
can be sold is P2Q2. Thus, in the long-run equilibrium, price is P2Q2 and equilibrium

se
output is OQ2. This output-price combination maximizes the monopolist’s long-run profits.
The total monopoly profit is shown by the area LP2SM.

u
. Ho
td g
. L in
vt sh

Fig. 5.7 Monopoly Equilibrium in the Long-run


P li

It may be noted at the end that if there are barriers to entry, the monopoly firm
ub

would not reach the optimal scale of production in the long-run, nor will it make the full
use of its existing capacity. This case can be verified from Fig. 5.7. The optimum size of
the plant is given by point B, i.e., at the minimum LAC. But the monopoly firm settles at
P

less than optimal output because optimum size of the plant will not yield the maximum
profit.
Also, if the size of the market and the cost conditions permit, a profit maximizing
s

monopoly firm may even exceed the optimum size of the plant and overutilize its long-
a

run capacity. Figure 5.8 depicts the more-than-optimal size of the plant and its
overutilisation. The optimum size of the plant is given at point B, the point of intersection
ik

between LAC and LMC, whereas the monopoly firm chooses output at M where his
profit is maximum. Alternatively, the monopoly firm may find its equilibrium just at the
V

optimum size of the plant. This is possible only when the market-size is just large enough
to permit optimization and full utilization of the plant size. This possibility has been illustrated
in Fig. 5.9.

Self-Instructional
178 Material
Price and Output
Determination

NOTES

se
Fig. 5.8 Monopoly Equilibrium: Overutilization of Point Size

u
. Ho
td g
. L in
vt sh

Fig. 5.9 Monopoly Equilibrium at Optimal Size of the Plant


P li

5.3.4 Absence of Supply Curve in a Monopoly


ub

As already explained, there is no unique or precise supply curve under monopoly. Let us
now examine this fact by using the concept of equilibrium output. We know that supply
P

curve presents a unique relationship between price and quantity demanded. This unique
relationship between market price and quantity supplied does not exist under monopoly.
The reason is, that a profit-maximizing monopoly firm does not determine its output
s

where P = MC or where AR = MC. Rather, it determines its equilibrium output where


a

MR = MC. Therefore, a unique relationship between price (AR = P) and quantity supplied
cannot be traced. It is therefore quite possible to trace (i) that given the MC, the same
ik

output is supplied at different prices, and (ii) that at a given price, different quantities are
supplied if the two downward sloping demand curves have different elasticities. The
two cases are illustrated in Figs. 5.10 and 5.11, respectively.
V

Self-Instructional
Material 179
Price and Output
Determination

NOTES

u se
Fig. 5.10 The Same Quantity Supplied at Two Different Prices

. Ho
As Fig. 5.10 shows, given the MC, the same quantity OQ can be supplied at two
different prices—OP1 when demand curve is D1 and OP2 when demand curve is D2.
Obviously, there is no unique relationship between price and quantity supplied.
Figure 5.11 presents the case of two different quantities supplied at the same

td g
price, OP. Given the MC, quantity OQ1 is supplied when demand curve is D1 and quantity
OQ 2 is supplied when demand curve is D 2 at the same price OP. In
. L in
this case too, there is no unique relationship between price and quantity supplied. It is
thus clear that there is no unique supply curve under monopoly.
vt sh
P li
ub
P
a s
ik

Fig. 5.11 Different Quantities Supplied at the Same Price

5.3.5 Price Discrimination in a Monopoly


V

The theory of pricing under monopoly, as discussed above, gives the impression that
once a monopoly firm fixes up the price of its product, the same price is charged from all
the consumers. This however may not be the case. A monopolist, simply by virtue of its
monopoly power, is capable of charging different prices from different consumers or
groups of consumers. When the same (or slightly differentiated) product is sold at different
prices to different consumers, it is called price discrimination. When a monopolist sells
the same product at different prices to different buyers, the monopoly is called a
discriminatory monopoly.
Self-Instructional
180 Material
Consumers are discriminated in respect of prices on the basis of their incomes or Price and Output
Determination
purchasing powers, geographical location, age, sex, quantity they purchase, their
association with the sellers, frequency of visits to the shop, the purpose of the use of the
commodity or service, and on other grounds which the seller may find suitable.
A common example of consumers being discriminated on the basis of their incomes NOTES
is found in medical and legal professions. Consulting physicians and lawyers (having
excess capacity) charge different fees from different clients on the basis of their paying
capacity. Delhi Vidyut Board charges different rates of tariffs for different grades and
purpose of units of electricity consumed. Price discrimination on the basis of age is
found in railways, roadways and airways: children below 15 years are charged only half

se
the adult-rates. Price discrimination on the basis of quantity purchased is very common.
It is generally found that private businessmen charge lower price (or give discount)
when bulk-purchase is made. In case of public utility services, however, lower rates are

u
charged when commodity or service is consumed in smaller quantity, for example, lower

. Ho
rates on the first few calls by the telephone owners, and no surcharge on electricity upto
certain level of consumption. The most common practice of price discrimination is found
in cinema shows, musical concerts, game-shows, etc.
For the purpose of price discrimination, the product or service in question may be
identical or slightly modified. Services of consulting physicians and lawyers, for example,

td g
are identical. The services of railways, roadways and entertainment shows may be
slightly modified by providing more comfortable seats for the purpose of price
. L in
discrimination. The modification in service may involve some additional cost. But price
differentials are much more than is justified by cost differentials.
vt sh
Although price discrimination is the most common practice under monopoly, it
should not mean that this practice exists only under monopoly. Price discrimination is
also quite common in other kinds of market structures, particularly where market
P li

imperfection exists. Most business firms discriminate between their customers on the
basis of personal relationship, quantity purchased, duration of their association with the
ub

firm as buyers, and so on.


Necessary Conditions for Price Discrimination
P

First, the market for different class of consumers must be separable so that buyers of
low-price market are not in a position to resell the commodity in the high-price market
for such reason as (i) geographical distance involving high cost of transportation, e.g.,
s

domestic versus foreign markets; (ii) exclusive use of the commodity, e.g., doctor’s
a

services, entertainment shows, and (iii) lack of distribution channels, e.g., transfer of
electricity and gas.
ik

Second, if market is divided into submarkets, the elasticity of demand must be


different in each submarket. The purpose of price-discrimination is to maximize the
V

profit by exploiting the markets with different price elasticities. It is the difference in
price-elasticities that provides opportunity for price discrimination. If price-elasticities of
demand in different markets are the same, price discrimination would not serve the
objective of profit maximization.
Third, the seller must possess some monopoly over the supply of the product to
be able to distinguish between different classes of consumers, and to charge different
prices.

Self-Instructional
Material 181
Price and Output Degrees of Price Discrimination
Determination
The degree of price discrimination refers to the extent to which a seller can divide the
market and can take advantage of it in extracting the consumer’s surplus. According to
NOTES Pigou,11 there are three degrees of price-discrimination practised by the monopolists: (i)
first degree price discrimination; (ii) second degree price discrimination; and (iii) third
degree price discrimination.
(a) First Degree Price Discrimination.12 The discriminatory pricing that attempts
to take away the entire consumers’ surplus is called first degree discrimination.
First degree discrimination is possible only when a seller is in a position to know

se
the price each buyer is willing to pay. That is, he knows his buyer’s demand curve
for his product. Under perfect price discrimination, the seller sets the price at the
highest possible level at which all those who are willing to buy the product at that
price buy at least one unit each. When the consumer’s surplus of this section

u
of consumers is exhausted, he gradually lowers down the prices so that the

. Ho
consumer’s surplus of the users of the subsequent units can be extracted.
This method of pricing is continued until the whole consumer’s surplus available
at the price where MR = MC is extracted. Also consider the case of services of
exclusive use, e.g. medical services. A doctor who knows or can guess the paying
capacity of his patients can charge the highest possible fee from presumably the

td g
richest patient and the lowest fee from the poorest one. The first degree of price
. L in discrimination is the limit of discriminatory pricing.
(b) Second Degree Price Discrimination. Under the second degree of
discriminatory pricing, the firm charges different prices from different class of
vt sh
consumers— high, middle and low income consumers. The monopolist adopting
the second degree price discrimination intends to siphon off only the major part
of the consumer’s surplus, rather than the entire of it. The second degree price
discrimination is feasible where (i) the number of consumers is large and price
P li

rationing can be effective, as in case of utility services like telephones and natural
gas; (ii) demand curves of all the consumers are identical; and (iii) a single rate is
ub

applicable for a large number of buyers. As shown in Fig. 5.12, a monopolist using
a second degree price discrimination charges price OP1 for the first few units,
OQ1 and price OP2 for the next O1Q2, units, and price OP3 for the next additional
P

purchase of Q2Q3 units. Thus, by adopting a block-pricing system, the monopolist


maximizes his total revenue (TR) as:
TR = (OQ1·AQ1) + (Q1Q2 · BQ2) + (Q2Q3 · CQ3)
a s
ik
V

Self-Instructional
Fig. 5.12 Second Degree Price Discrimination
182 Material
If a monopolist is restrained from price discrimination and is forced to choose any Price and Output
Determination
one of the three prices, OP1, OP2, or OP3, his total revenue will be much less.
(c) Third Degree Price Discrimination. When a profit maximizing monopoly
sets different prices in different markets having demand curves with different
elasticities, it is using third degree price discrimination. When a monopolist is NOTES
faced with two or more markets, completely separated from each other—each
having a demand curve with different elasticity—a uniform price cannot be set
for all the markets without loosing profits. The monopolist is therefore required to
allocate total output between the different markets so that profit can be maximized
in all the markets. The profit in each market would be the maximum only when

se
the MR = MC in each market. The monopolist therefore divides total output
between the markets so that in all the markets MR = MC. The process of allocation
of output and determination of price for different markets is illustrated in Fig.

u
5.13. Suppose that a monopolist has to sell goods in only two markets, A and B.

. Ho
The two markets are so separated that resale of commodity is not possible. The
demand curve (Da) and marginal revenue curve (MRa) given in Fig. 5.13(a)
represent the AR and MR curves in market A and curves Da and MRb, in Fig.
5.13(b) represent AR and MR curves, respectively, in market B. The horizontal
summation of demand curves Da and Db gives the total demand curve for the two

td g
markets, as shown by the curve AR = D, and horizontal summation of MRa and
MRb is given by the curve MR (Fig. 5.13). The firm’s marginal cost is shown by
. L in
the curve MC which intersects MR at point E. Thus, optimum level of output for
the firm is determined at OQ. At this level of output, MR = MC. Since the whole
vt sh
of OQ cannot be profitably sold in any one market because of their limited size,
the firm has to allocate the output between the two markets.
The monopolist allocates output OQ between the two markets in such
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proportions that the necessary condition of profit maximization is satisfied in both


the markets. That is, in both the markets MC = MR. The profit maximizing output
ub

for each market can be obtained by drawing a line from point E and parallel to
X-axis, through MRb and MRa. The points of intersection on curves MRa and
MRb at points a and b, respectively, determine the optimum share for each market.
As shown in Fig. 5.13, the monopoly firm maximizes its revenue in market A by
P

selling OQa units at price AQa, and by selling OQb units in market B at price BQb.
a s
ik
V

(a) (c)
(b)
Fig. 5.13 Third Degree Price Discrimination

Self-Instructional
Material 183
Price and Output The firm’s total equilibrium output OQ = OQa + OQb. Since at OQa, MRb = MC
Determination
in market A, and at OQb, MRb = MC in market B,
MC = EQ = MRa = MRb
NOTES Thus, the equilibrium condition is satisfied in both market segments, and the
monopoly firm adopting the third degree method of price discrimination maximizes its
profits.
The third degree method of price discrimination is most suitable where the total
market is divided between the home and foreign markets. However, it need not be
limited only to domestic and foreign markets. It may be suitably practised between any

se
two or more markets separated from each other by any or more of such factors as
geographical distance, transport barriers or cost of transportation, legal restrictions on
the inter-regional or interstate transportation of commodities by individuals, etc.

u
Is Price Discrimination Justified?

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Price discrimination has been condemned as illegal and immoral. The objection is: why
charge higher price from some and lower price from others while there is no extra
advantage to those who pay higher price or why benefit some at the cost of some
others? In the United Kingdom and the United States, railways were prohibited from

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charging discriminatory rates.13 Discriminatory pricing has also been criticised as a
destructive tool in the hands of a monopoly. For, in the past, large corporations had
. L in
sought to use price discrimination to prevent the growth of competition. Besides, price
discrimination may cause malallocation of resources and, hence, may be deterrent to
social welfare. This is, however, not the case always. In some cases price discriminations
vt sh
is socially advantageous. In fact as Lipsey has observed, ‘whether an individual judges
price discrimination to be good or bad is likely to depend upon the details of the case as
well as upon his own personal value judgements.’ He adds, ‘Certainly there is nothing in
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economic theory to suggest that price discrimination is always in some sense worse than
non-discrimination under conditions of monopoly or oligopoly.’14
ub

Price discrimination is, however, considered to be desirable in certain specific


cases on the following grounds:
First is the case of goods and services which are essential for the society as a
P

whole but their production is uneconomic in the sense that long-run average cost curve
(LAC) lies much above the aggregated market demand curve as shown in
s

Fig. 5.14. Such goods and services cannot be produced. But, production of such goods
and services can be possible if price discrimination is permitted. Price discrimination
a

thus becomes essential for the survival of the industry.


ik
V

Self-Instructional
184 Material
Price and Output
Determination

NOTES

u se
. Ho
Fig. 5.14 Price Discrimination for Industry’s Survival

Suppose, for example, (i) that there are two markets I and II, (ii) that individual
demand curves for the two markets, I and II, are given as D1 and D2, (iii) market

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demand curve is given by ABC, and (iv) the long-run average cost curve is given by LAC
(Fig. 5.14). Note that LAC lies throughout above the total demand curve ABC. Therefore,
. L in
production is not possible if one price is to be charged. But, if price discrimination is
adopted and prices are so charged in the two markets that the total revenue exceeds
LAC at some level of output, then monopoly may profitably survive to the advantage of
vt sh
the society. Let us suppose that the monopolist sets price OP1 in the market I in which
demand is less elastic and OP2 in market II in which demand is highly elastic. He would
sell OQ1 units at price OP1 in market I and OQ2 at price OP2 in market II. His total
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output would then be at OQ = OQ1 + OQ2. His total revenue (TR) would be:
ub

TR = (OP1 × OQ1) + (OP2 × OQ2)


and suppose
AR = (OP1 × OQ1 + OP2 × OQ2)/OQ = OPa
P

At output OQ, the LAC is OT. Thus his total cost,


TC = OQ × OT = OQST
s

and his total revenue,


a

TR = OQ × OPa = OQRPa
Since OQRPa > OQST, the monopoly firms not only covers its cost but also
ik

makes excess profit. Its total profit,


π = OQRPa – OQST = PaRST
V

This kind of situation arises mostly in public utility services, like railways, roadways,
post and telegraph services, etc., in which high paying sector of the market subsidises
the low paying sector. But, if low-paying sector is not subsidised, no production would be
possible.
Second, discriminatory pricing can be adopted with justification where a uniform,
single profitable price is likely to restrict the output and deprive many (particularly the
people of lower income groups) of the essential goods or service. If doctors in private
practice, for example, who often change discriminatory price for their services, are
Self-Instructional
Material 185
Price and Output asked to charge a uniform fee from all the patients, they would charge a fee high enough
Determination
to maintain the level of their income. The high fee may deprive the poor of the doctor’s
service and may force them to opt for inferior or inadequate treatment. The result of the
uniform high fee will be that the rich patients who can pay a still higher fee gain as they
NOTES pay a price lower than what they could afford, and on the other hand, poor patients are
deprived of proper medical service.
Third, there may be cases where a section of consumers gains more than the
people of other sections from the use of the same product. From the use of electricity,
for example, factory-owners gain more than the households. In such cases, uniform
price would be unjustified from a normative point of view, provided the

se
objective is not to restrain the domestic consumption of electricity and spare it for
productive purposes. There is, on the other hand, full justification for discriminatory
pricing of electricity.

u
Government Regulation of Monopoly Prices

. Ho
The existence of monopolies in a market economy is criticised on the grounds that they
restrict production and consumption, widen income and wealth disparities, exploit
consumers and employees, cause distortions in allocation of resources, reduce the prospect
of employment, and cause loss of social welfare. In most countries, therefore, there is

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general apathy towards the monopolies. Consequently, governments in the market
economies attempt to control and regulate monopolies to the advantage of the society.
. L in
There are various measures—direct, indirect, legal and otherwise—to control and regulate
the monopolies. However, we discuss here only the price regulation of natural monopolies.
vt sh
Price regulation is a common feature in case of natural monopolies. When the
size of the market is small relative to the optimum size of the firm, market size cannot
support more than one firm of optimal size. The monopoly in such a market is a natural
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monopoly. The natural monopoly is thus protected by market size itself. The government
may either nationalize such monopolies or regulate their prices so as to eliminate the
ub

excess profits. If the government intends to regulate the monopoly price, the question
arises: what price should be fixed for the monopolist to charge? The two alternative
prices that have been suggested are: one that allows some excess profit to the monopolist,
P

and the second that allows only normal profit to the monopolist. Both the alternative
prices, along with their repercussion on output, are illustrated in Fig. 5.15. An unregulated
monopoly would produce OQ1 units, charge price OP3, and make excess profit of MT =
s

MQ1 – TQ1 per unit. If monopoly price is regulated, one possible price is given at point
P where LMC = AR, the price being OP2 (= PQ2). Alternatively, price may be fixed at
a

point C where AR = LAC and price = OP1 (= CQ3). When OP1 is the price set for the
ik

monopolist, only a normal profit is allowed to the firm, but output is maximum possible
under the given cost and revenue conditions. If price is fixed at OP2, the monopolist gets
some excess profit, but the output is less than that at price OP1. In both the cases,
V

however, the total output under regulated monopoly is much higher than that under
unregulated monopoly. Which of the two alternative prices (OP1 and OP2) is more
appropriate is a matter of debate.

Self-Instructional
186 Material
Price and Output
Determination

P3 M LMC
LAC

NOTES
P
P2 C
P1
T

se
AR=D
MR
O Q1 Q2 Q3
Output

u
Fig. 5.15 Government Regulated Monopoly

. Ho
5.3.6 Measures of Monopoly Power
It is only in rare cases that monopolies have absolute power. Monopoly power varies
from industry to industry. The degree of monopoly power matters a great deal in pricing

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and output decisions of a monopolist. Besides, measuring monopoly power is required
also in connection with control and regulation of monopolies. We discuss here the various
. L in
measures of monopoly power.
Measuring monopoly power has been a difficult proposition. The efforts to devise
vt sh
a measure of monopoly power have not yielded any universal or non-controversial
measure. As Hunter has observed, ‘The idea of devising a measure of monopoly power,
with reference both to its general incidence and to particular situation has been and
probably always will remain an attractive prospect for economists who wish to probe in
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this field.’15 If not for any other reason, then for ‘sheer intellectual curiosity’, economy
ub

theorists feel compelled to work on this problem, as they ‘could not with good conscience
go on talking about ‘great’ or ‘little’ monopoly power or about various degrees of monopoly
without trying to ascertain the meaning of these words.’16
P

Therefore, to devise at least a ‘conceivable’ measure of monopoly, even if ‘practical’


measurement is impossible, continues to interest the economists, for at least two reasons.
First, apart from intellectual curiosity people would like to know about the economy in
s

which they live, its industrial structure, and the industries from which they get their
supplies. Second, growth of monopolies has forced governments of many countries to
a

formulate policies and devise legislative measures to control and regulate monopolies. If
ik

the government is to succeed in its policy of restraining monopoly, it must have at least
some practicable measure of monopoly and monopolistic trade practices.
Although economists have devised a number of devices to measure the degree of
V

monopoly power, none of the measures is free from flaws. Yet, the various measures do
provide an insight into the monopoly power and its impact on the market structure.
Besides, they also help in formulating an appropriate public policy to control and regulate
the existing monopolies. We discuss here briefly the various measures of monopoly
power suggested by the economists.
1. Number-of-Firms Criterion. One of the simplest measures of degree of
monopoly power is to count the number of firms in an industry. The smaller
the number of firms, the greater the degree of monopoly power of each
Self-Instructional
Material 187
Price and Output firm in the industry, and conversely, the larger the number of firms, greater
Determination
the possibility of absence of monopoly power. As a corollary of this, if there
is a single firm in an industry, the firm has an absolute monopoly power. This
criterion seems to have been derived from the characteristics of the perfect
NOTES competition in which the number of firms is so large that each firm supplies
only an insignificant proportion of the market and no firm has any control on
the price.
This criterion has, however, a serious drawback. The number of firms
alone does not reveal much about the relative position of the firms within
the industry because (i) ‘firms are not of equal size,’ and (ii) their number

se
does not indicate the degree of control each firm exercises in the industry.
Therefore, the numerical criterion of measuring monopoly power is of little
practical use.

u
2. Concentration Ratio. The concentration ratio is one of the widely used
criteria used for measuring monopoly power. The concentration ratio is

. Ho
obtained by calculating the percentage share of the largest group of the
firms in the total output of the industry. ‘The number of firms chosen for
calculating the ratio usually depends on some fortuitous element—normally
the census of production arrangements of the country concerned.’17 In

td g
Britain, the share of the largest three firms of a census industry, and in the
. L in USA, the share of the largest four firms is the basis of calculating
concentration ratio.18 Apart from the share of the largest firms in the industry-
output, ‘[the] size of the firm and the concentration of control in the industry
vt sh
may be measured...in terms of production capacity, value of assets, number
of employees or some other characteristics.’19
These measures too are, however, not free from drawbacks as they
involve statistical and conceptual problems. Production capacity, for example,
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may not be straightaway used as it may include ‘unused, obsolete or excess


ub

capacity’; the value of assets involves valuation problem as accounting


method of valuation and market valuation of assets may differ. Employment
figures may not be relevant in case of capital intensive industries. The use
of such figures may be misleading. The two other convenient measures are
P

‘gross output value’ or ‘net output’ (value added). But the former involves
the risk of double counting, while the latter, involves the omission of inter-
s

establishment transfers.20
Another important objection to these measures of degree of monopoly
a

power is that they do not take into account the size of the market. Size of
the market may be national or local. A large number of firms supplying the
ik

national market may be much less competitive than the small number of
firms supplying the local market. For, it is quite likely that the national market
V

is divided among the thousand sellers so that each seller has status of a
monopolist in his own area.
The most serious defect of concentration ratio as an index of monopoly
power is that it does not reflect the competition from other industries. The
degree of competition is measured by the elasticity of substitution between
the products of different industries. The elasticity of substitution may be
different under different classification of industries. Therefore, an industry
with concentration ratio under one classification of industries may have a
very low elasticity of substitution and hence a high degree of monopoly.
Self-Instructional
188 Material
But, if classification of industries is altered, the same industry with a high Price and Output
Determination
concentration ratio may have a very low elasticity of substitution, and hence,
may show a low degree of monopoly.
3. Excess Profitability Criteria. J.S. Bain and, following him, many other
economists have used excess profit as a measure of monopoly power. If NOTES
profit rate of a firm continues to remain sufficiently higher than all opportunity
costs required to remain in the industry, it implies that neither competition
among sellers nor entry of new firms prevents the firm from making a pure
or monopoly profit. While calculating the excess profit, the opportunity cost
of owner’s capital and margin for the risk must be deducted from the actual

se
profit made by the firm. Assuming no risk, the degree of monopoly may be
obtained by calculating the divergence between the opportunity costs (O)
and the actual profit, (P), as (P – O)/P. If [(P – O)/P] = O, there exists no

u
monopoly, and if [(P – O)/P] > O, there is monopoly. The higher the value of
(P – O)/P, the greater the degree of monopoly.

. Ho
Another measure of degree of monopoly based on excess profitability
has been provided by A.P. Lerner.21 According to him, the degree of monopoly
power (MP) may be measured as:

td g
MP =
where P = price, MC = marginal cost. Since for a profit maximizing
. L in
firm, MR = MC, Lerner’s measure of monopoly power, MP, may also be
expressed as:
vt sh

MP =
Since P/(P – MR) = e, (P – MR)/P = 1/e, i.e., MP equals to the reciprocal
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of elasticity. Thus, Lerner’s measure of monopoly power may be expressed


also as MP = 1/e. It may thus be inferred that lower the elasticity, the
ub

greater the degree of monopoly, and vice versa. According to Lerner’s


formula, monopoly power may exist even if firm’s AR = AC and it earns
only normal profit.
P

Lerner’s formula of measuring the degree of monopoly power is


considered to be theoretically most sound. Nevertheless, it has been criticised
on the following grounds.
s

First, it is suggested that any formula devised to measure degree of


a

monopoly power should bring out the difference between the monopoly
output and competitive output or the ‘ideal’ output under the optimum
ik

allocation of resources. The divergence between P and MC used in Lerner’s


formula does not indicate the divergence between the monopoly and the
V

‘ideal’ output. Lerner has possibly used the divergence between P and MC
as the substitute for the divergence between monopoly and ‘ideal’
output. ‘This substitution of a price-cost discrepancy for a difference between
actual and ‘ideal’ output is probably the greatest weakness of formula which
is supposed to measure deviation from the optimum allocation of
resources.’22
Second, price-cost discrepancy may arise for reasons other than
monopoly, and price and cost may be equal or close to each other in spite of
monopoly power.
Self-Instructional
Material 189
Price and Output Third, since data on MC are hardly available, this formula is of little
Determination
practical use for policy purposes.
4. Triffin’s Cross-Elasticity Criterion. Triffin’s criterion seems to have been
derived from the definition of monopoly itself. According to this criterion,
NOTES cross-elasticity is taken as the measure of degree of monopoly—the lower
the cross-elasticity of the product of a firm, the greater the degree of its
monopoly power. However, this criterion is based on the inter-relationships
between the individual firms and indicates only the relative power of each
firm. It does not furnish a single index of monopoly power.

se
5.4 OLIGOPOLY, NON-PRICE COMPETITION

u
5.4.1 Oligopoly: Meaning and Characteristics

. Ho
Oligopoly23 is a form of market structure in which a few sellers sell differentiated or
homogeneous products. ‘How few are the sellers’ is not easy to define numerically in
the oligopolistic market structure. The economists are not specified about a definite
number of sellers for the market to be oligopolistic in its form. It may be two,24 three,
four, five or more. In fact, the number of sellers depends on the size of the market.

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Given the size of the market, if number of sellers is such that each seller has command
over a sizeable proportion of the total market supply25 then there exists oligopoly in the
. L inmarket.
The products traded by the oligopolists may be differentiated or homogeneous.
vt sh
Accordingly, the market may be characterized by heterogeneous oligopoly or
homogeneous (or pure) oligopoly. In automobile industry, Maruti Zen, Hyundai’s Santro,
Daewoo’s Matis, Fiat’s Palio and Tata’s Indica, etc., are the outstanding examples of
P li

differentiated oligopoly. Similarly, cooking gas of Indane and of Burshane are the examples
of homogeneous oligopoly. Differentiated oligopolies include automobiles, cigarettes,
ub

refrigerators, TV industries. Pure oligopoly includes such industries as cooking gas,


Check Your Progress cement, baby food, cable wires, dry batteries, etc. Other examples of oligopolistic industries
4. What are the
are aluminium, paints, tractors, steel, tyres and tubes.
P

important features
of monopoly?
Characteristics of Oligopoly
5. How does a profit- The basic characteristics of oligopolistic market structure are the following:
s

maximizing
monopoly firm 1. Intensive Competition. The characteristic fewness of their number brings
a

determine its price oligopolist in intensive competition with one another. Let us compare oligopoly
and output?
with other market structures. Under perfect competition, competition is non-existent
ik

6. What are price


discrimination and
because the number of sellers is so large that no seller is strong enough to make
discriminatory any impact on market conditions. Under monopoly, there is a single seller and,
V

monopoly? therefore there is absolutely no competition. Under monopolistic competition,


7. On what bases are number of sellers is so large that degree of competition is considerably reduced.
consumers But, under oligopoly, the number of sellers is so small that any move by one seller
discriminated
against in respect of immediately affects the rival sellers. As a result, each firm keeps a close watch
prices? on the activities of the rival firms and prepares itself with a number of aggressive
8. What are the and defensive marketing strategies. To an oligopolist, business is a ‘life’ of constant
measures of struggle as market conditions necessitate making moves and counter-moves. This
monopoly power?
kind of competition is not found in other kinds of market. Oligopoly is the highest
form of competition.
Self-Instructional
190 Material
2. Interdependence of Business Decisions. The nature and degree of Price and Output
Determination
competition among the oligopolists makes them interdependent in respect of
decision-making. The reason for inter-dependence between the oligopolists is
that a major policy change made by one of the firms affects the rival firms seriously
and immediately, and forces them to make counter-moves to protect their interest. NOTES
Therefore, each oligopolist, while making a change in his price, advertisement,
product characteristics, etc. takes it for granted that his actions will cause reaction
by the rival firms. Thus, interdependence is the source of action and reaction,
moves and counter-moves by the competing firms. An illuminating example of
strategic manoeuvering by the oligopoly firm has been given by Robert A. Meyer.26

se
To quote the example, one of the US automobile companies announces in
September27 an increase of $180 in the list price of its new car model. Following
it, a few days later, a second company announces an increase of only $80 and a

u
third announces increase of $91. The first company makes a counter-move: it
suddenly reduces the increase in list price to $71 from $180 announced earlier.

. Ho
One can now expect that other firms will follow the first in price-cutting. Obviously,
there is a good deal of uncertainty in the behaviour of firms.
3. Barrier to Entry. An oligopolistic market structure is also characterized, in the
long run, by strong barriers to entry of new firms to the industry. If entry is free,

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new firms attracted by the super-normal profits, if it exists, enter the industry and
the market eventually becomes competitive. Usually barriers to entry do exist in
. L in
an oligopolistic market. Some common barriers to entry are economies of scale,
absolute cost advantage to old firms, price-cutting, control over important inputs,
vt sh
patent rights and licencing, preventive price and existence of excess capacity.
Such factors prevent the entry of new firms and preserve the oligopoly.
Oligopoly Models: An Overview
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The uncertainty in respect of behaviour pattern of a oligopoly firms arising out of their
ub

unpredictable action and reaction makes systematic analysis of oligopoly extremely


difficult. Under the circumstances, a wide variety of behaviour pattern has been observed:
they may come in collusion with each other or ‘may try to fight each other to the death’.
The agreement may last or may break-down soon. Indeterminateness of price and output
P

therefore becomes the basic feature of oligopolistic markets. In accordance with the
variety of behaviours, economists have developed a variety of analytical models based
s

on different behavioural assumptions. Among notable models are Cournot’s Duopoly


model (1838), Bertrand’s model (1883), Edgeworth’s model (1897), Stackelberg’s
a

leadership model (1930), Hotelling’s model (1930s), Chamberlin’s model (1933), Sweezy’s
kinked-demand curve model (1939), Neumann and Morgenstern’s game theory model
ik

(1944), and Baumol’s sales maximization model. None of these models, however, provides
a universally acceptable analysis of oligopoly, though these models do provide insight
V

into the behavioural pattern of oligopolists. Moreover, these models are studied for their
pedagogic importance.
The analytical models of oligopoly, suggested by the economists, may be classified
under two broad categories:
(i) Duopoly models
(ii) General oligopoly models
The oligopoly models may be further sub-classified as (a) Non-collusive models,
and (b) Collusive models.
Self-Instructional
Material 191
Price and Output 5.4.2 Duopoly Models
Determination
When there are only two sellers of a product, there exists duopoly, a special case of
oligopoly. Duopoly is a special case in the sense that it is the limiting case of oligopoly as
NOTES there must be at least two sellers to make the market oligopolistic in nature. Here we
will discuss some classical models of douploy.
I. Cournot’s Duopoly Model
Augustin Cournot,28 a French economist, was the first to develop a formal duopoly
model in 1838. To illustrate his model, Cournot assumed:

se
(a) two firms, A and B, each owning an artesian mineral water wells;
(b) both operate their wells at zero marginal cost;29

u
(c) both face a downward sloping straight line demand curve;
(d) each seller acts on the assumption that his competitor will not react to his decision

. Ho
to change his output and price. This is Cournot’s behavioural assumption.
On the basis of this model, Cournot has concluded that each seller ultimately
supplies one-third of the market and both the sellers charge the same price. And, one-
third of the market remains unsupplied.

td g
Cournot’s duopoly model is presented in Fig. 5.16. To begin the analysis, suppose
that A is the only seller of mineral water in the market. In order to maximize his profits
. L in
or revenue, he sells quantity OQ at which his MC = O = MR, at price OP1. His total
profit is OP1PQ.
vt sh
P li
ub
P
a s
ik

Fig. 5.16 Price and Output Determination under Doupoly: Cournot’s Model

Now let B enter the market. The part of market open to him equals QM which is
V

half of the total market.30 Note that QM is the part of the market left unsupplied by A. It
meaus that B can sell his product in the remaining half of the market, PM being the
relevant part of demand curve for him. B assumes that A will not change his price and
output because he is making the maximum profit. That is, B assumes that A will continue
to sell OQ at price OP1. Thus, the market available to him is QM and the relevant
demand curve is PM. When he draws his MR curve, PN, it bisects QM at point N where
QN = NM. In order to maximize his revenue, B sells QN at price OP2 = P′N. His total
revenue is maximum at QRP′N. Note that B supplies only QN = 1/4 = 1/2 × 1/2 of the
market.
Self-Instructional
192 Material
With the entry of B, price falls to OP2. Therefore, A’s expected profit falls to Price and Output
Determination
OP2RQ. Faced with this situation, A attempts to adjust his price and output to the changed
conditions. He assumes that B will not change his output QN and price OP2 as he (B) is
making the maximum profit. Accordingly, A assumes that B will continue to supply 1/4 of
the market and, therefore, he has 3/4 = 1 – 1/4 of the market available to him. To NOTES
maximize his profit, A will supply 1/2 (3/4) = 3/8 of the market. Note that A’s market
share has fallen from 1/2 to 3/8.
Now it is B’s turn to react. Following Cournot’s assumption, B assumes that A will
continue to supply only 3/8 of the market and the market open to him equals 1 – (3/8) =
5/8. To maximize his profit under the new conditions, B will supply

se
1/2 (5/8) = 5/16 of the market. It is now for A to reappraise the situation and adjust his
price and output accordingly.

u
This process of action and reaction continues in successive periods. In the process,
A continues to loose his market share and B continues to gain. Eventually, a situation is

. Ho
reached when their market share equals at 1/3 each. Any further attempt to adjust
output produces the same result. The firms, therefore, reach their equilibrium position
with each supplying 1/3 of the market and 1/3 of the market remaining unsupplied.
The process through which firm reach their equilibrium, according to Cournot’s
model, may be illustrated as presented in the following table.

td g
Table 5.2 Market Sharing in Cournot’s Model
. L in
vt sh
1 1 1
=
2 2 4
1 1 3 1 3 5
1 1
P li

2 4 8 2 8 16
1 5 11 1 11 21
ub

1 1
2 16 32 2 32 64
1 21 43 1 43 85
1 1
2 64 128 2 128 256
P
s

1 1 1 1 1 1
1 1
2 3 3 2 3 3
a
ik

Cournot’s equilibrium solution is stable. For, given the action and reaction, it is not
possible for any of the two sellers to increase their market share. Cournot’s model of
duopoly can be extended to the case of general oligopoly. For example, suppose there
V

are three sellers, the industry and firms will be in equilibrium when each firm supplies
1/4 of the market. The three sellers together supply 3/4 = 3 (1/4) of the market, 1/4 of
the market remaining unsupplied. The formula for determining the share of each seller in
an oligopolistic market is Q ÷ (n + 1), where Q = market size, and n = number of sellers.

Self-Instructional
Material 193
Price and Output Algebra of Cournot’s Model
Determination
Cournot’s duopoly model may also be presented algebraically. Let us suppose that market
demand function is given by a linear function as:
NOTES Q = 90 – P …(5.10)
We have noted above that, under zero cost condition, profit is maximum where
MC = MR = 0 and profit-maximizing output equals Q/2.
Thus, when firm A is a monopolist in the market, his profit-maximizing output
(OA), according to the profit-maximizing rule under zero cost condition, is given by

se
QA = 1/2 (90 – P) …(5.11)
When another firm, B, enters the market, its profit-maximizing output equals
QB = 1/2[1/2(90 – P)] …(5.12)

u
Thus, the respective share of firms, A and B is fixed at QA and QB. The division of

. Ho
market output may be expressed as:
Q = QA + QB = 90 – P ….(5.13)
The demand function for the firm A may now be expressed as:
QA = (90 – QB) – P …(5.14)

td g
. L in and for the firm B as:
QB = (90 – QA) – P …(5.15)
Given the demand function (5.14), the market open to firm A (at P = 0) is
vt sh
90 – QB. The profit-maximizing output for A can be written as:

QA = ...(5.16)
P li

and for B, as:


ub


QB = ...(5.17)

The Eqs. (5.16) and (5.17) represent the reaction functions of firms A and B,
P

respectively. For example, consider Eq. (5.16). The profit-maximizing output of firm A
depends on the value of QB, i.e., the output which firm B is assumed to produce. If firm
B chooses to product 30 units, (i.e., Q B = 30), then A’s output = 30
s

[= (90 – 30)1/2]. If firm B chooses to produce 60 units, A’s output = 15 (= 90 – 60) 1/2).
Thus, Eq. (5.16) is the reaction function of firm A. It can be similarly shown that Eq.
a

(5.17) is the reaction function of firm B.


ik

Criticism
Although Cournot’s model yields a stable equilibrium, it has been criticised on the following
V

grounds:
First, Cournot’s behavioural assumption [assumption (d), mentioned earlier] is
naive to the extent that it implies that firms continue to make wrong calculations about
the competitor’s behaviour. That is, each seller continues to assume that his rival will not
change his output even though he repeatedly observes that his rival firm does change its
output.
Second, Cournot’s assumption of zero cost of production is unrealistic though
dropping this assumption does not alter his model.
Self-Instructional
194 Material
II. Bertrand’s Duopoly Model Price and Output
Determination
Betrand, a French mathematician, criticised Cournot’s model and developed his own
model of duopoly in 1883. His model differs from that of Cournot in respect of its
behavioural assumption. While under Cournot’s model, each seller assumes his rival’s NOTES
output to remain constant, under Bertrand’s model, each seller determines his price on
the assumption that his rival’s price, rather than his output, remains constant.
Bertrand’s model concentrates on price-competition. His analytical tools are
reaction functions of the duopolists. Reaction functions of the duopolists are derived on
the basis of iso-profit curves. An iso-profit curve, for a given level of profit, is drawn on

se
the basis of various combinations of prices charged by rival firms. Assuming two firms
A and B, the two axis of the plane on which iso-profit curves are drawn measure one
each the prices of the two firms. Iso-profit curves of the two firms are convex to their

u
respective price axis, as shown in Figs. 5.17. and 5.18. Iso-profit curves of firm A are
convex to its price-axis PA (Fig. 5.17) and those of firm B are convex to PB (Fig. 5.18).

. Ho
td g
. L in
vt sh
P li

Fig. 5.17 A’s Reaction Curve Fig. 5.18 B’s Reaction Curve
ub

To explain the implication of an iso-profit curve, consider curve A in Fig. 5.17. It


shows that A can earn a given profit from the various combinations of its own and its
P

rival’s price. Price combinations at points a, b and c, gor example, on iso-profit curve A1,
yield the same level of profit. If firm B fixes its price PB1, firm A has two alternative
prices, PA1 and PA2, to make the same level of profits. When B reduces its price, A may
s

either raise its price or reduce it. A will reduce its price when he is at point c and raise its
price when he is at point a. But there is a limit to which this price adjustment is possible.
a

This point is given by point b. So there is a unique price for A to maximize its profits. This
ik

unique price lies at the lowest point of the iso-profit curve. The same analysis applies to
all other iso-profit curves. If we join the lowest points of the iso-profit curves A1, A2 and
A3, we get A’s reaction curve. Note that A’s reaction curve has a rightward slant. This is
V

so because, iso-profit curve tend to shift rightward when A gains market from its rival B.

Self-Instructional
Material 195
Price and Output
Determination

NOTES

se
Fig. 5.19 Duopoly Equilibrium: Bertand’s Model

u
Following the same process, B’s reaction curve may be drawn as shown in Fig.
5.18. The equilibrium of duopolists suggested by Bertrand’s model may be obtained by

. Ho
putting together the reaction curves of the firms A and B as shown in Fig. 5.19. The
reaction curves of A and B intersect at point E where their expectations materialize.
Point E is therefore equilibrium point. This equilibrium is stable. For, if anyone of the
firms deviates from the equilibrium point, it will generate a series of actions and reactions
between the firms which will lead them back to point E.

td g
Criticism
. L in
Bertrand’s model has, however, been criticised on the same grounds as Cournot’s model.
Bertrand’s implicit behavioural assumption that firms never learn from their past
vt sh
experience is naive. Furthermore, if cost is assumed to be zero, price will fluctuate
between zero and the upper limit of the price, instead of stabilizing at a point.
P li

III. Edgeworth’s Duopoly Model


Edgeworth31 developed his model of duopoly in 1897. Edgeworth’s model follows
ub

Bertrand’s assumption that each seller assumes his rival’s price, instead of his output, to
remain constant. His model is illustrated in Fig. 5.20.
Let us suppose that there are two sellers, A and B, in the market. The entire
P

market M′M in Fig. 5.20 is equally divided between the two sellers who face identical
demand curves. A has his demand curve as DA and B as DB. Let us also assume that
s

seller A has a maximum capacity of output OM and B has a maximum output capacity of
OM′. The ordinate OD measures the price.
a

To begin the analysis of Edgeworth’s model, let us suppose that A is the only
ik

seller in the market. Following the profit-maximizing rule of a monopoly seller, he sells
OQ and charges a price, OP2. His monopoly profit, under zero cost, equals OP2EQ.
Now, B enters the market and assumes that A will not change his price since he is
V

making maximum profit. With this assumption, B sets his price slightly below A’s price
(OP2) and is able to sell his total output and also to capture a substantial position of A’s
market.
Seller A now realizes the reduction in his sale. In order to regain his market, A
sets his price slightly below B’s price. This leads to price-war between the sellers. The
price-war takes the form of price-cutting which continues until price reaches OP1. At
this price both A and B are able to sell their entire output A sells OM and B sells OM′.
The price OP1 could, therefore, be expected to be stable. But, according to Edgeworth,
Self-Instructional price OP1 should not be stable.
196 Material
Price and Output
Determination

NOTES

se
Fig. 5.20 Edgeworth’s Model of Duopoly

The reason is that, once price OP1 is set in the market, the sellers observe an
interesting fact. That is, each seller realizes that his rival is selling his entire output and

u
he will therefore not change his price, and each seller thinks that he can raise his price to
OP2 and can make pure profit. This realization forms the basis of their action and reaction.

. Ho
Let seller A, for example, take the initiative and raise his price to OP2. Assuming A to
retain his price OP2, B finds that if he raises his price to a level slightly below OP2, he
can sell his entire output at a higher price and make greater profits. Therefore, B raises
his price according to his plan.

td g
Now it is A’s turn to appraise the situation and react. A finds that his price is
higher than that of B’s. His total sale falls. Therefore, assuming B to retain his price, A
. L in
reduces his price slightly below B’s price. Thus, the price-war between A and B begins
once again. This process continues indefinitely and price keeps moving up and down
vt sh
between OP1 and OP2. Obviously, according to Edgeworth’s model of duopoly,
equilibrium is unstable and indeterminate since price and output are never determined.
In the words of Edgeworth, there will be an indeterminate tract through which the index
P li

of value will oscillate, or, rather will vibrate irregularly for an indefinite length of time.’32
Edgeworth’s model, like Cournot’s and Bertrand’s model is based on a naïve
ub

assumption, i.e., each seller continues to assume that his rival will never change his price
or output even though they are proved repeatedly wrong. But, Hotelling remarked that
Edgeworth’s model is definitely an improvement upon Cournot’s model in that it assumes
P

price, rather than output, to be the relevant decision variable for the sellers.
IV. Stackelberg’s Leadership Model
s

Stackelberg,33 a German economist, developed his leadership model of duopoly in 1930.


a

His model is an extension of Cournot’s model. Stackelberg assumes that one of the
duopolists (say A) is sophisticated enough to play the role of a leader and the other
ik

(say B) acts as a follower. The leading duopolist A recognizes that his rival firm B has a
definite reaction function which A uses into his own profit function and maximises his
profits.
V

Suppose market demand function is given as in (5.10), i.e., Q = 90 – P and B’s


reaction function is given as in Eq. (5.18), i.e.,

QB = …(5.18)

Now, let A incorporate B’s reaction function into the market function and formulate
his own demand function as:
QA = 90 – QB – P …(5.19)
Self-Instructional
Material 197
Price and Output Since QB = (90 – QA)/2, Eq. (15.9) may be written as
Determination

QA = − −

NOTES
or QA = + −

or 2QA = 90 + QA – 2P …(5.20)
QA = 90 – 2P
Thus, by knowing B’s reaction function, A is able to determine his own demand

se
function. Following the profit-maximization rule, A will fix his output at 45 units
(= 90/2), i.e., half of the total demand at zero price.
Now, if seller A produces 45 units and seller B sticks to his own reaction function,

u
he will produce:

. Ho

QB = = 22.5 units ...(5.21)

Thus, the industry output will be


45 + 22.5 = 67.5.

td g
The problem with Stackelberg’s model is that it does not decide as to which of the
firms will act as leader (or follower). If each firm assumes itself to be the leader and the
. L in
other to be the follower, then Stackelberg’s model will be indeterminate with unstable
equilibrium.
vt sh
5.4.3 Oligopoly Models
We have already mentioned that there are two kinds of oligopoly models: (i) non-collusive
P li

models and (ii) collusive models. We will first discuss the non-collusive models and then
the collusive models. The non-collusive models of oligopoly explain the price and output
ub

determination in a market structure in which oligopolists recognize their interdependence.


Chamberlin’s non-collusive model of oligopoly, i.e., ‘small group’ model, is considered a
major contribution to the theory of oligopoly. Another famous model of this category is
P

Sweezy’s kinked demand curve model.


I. Non-Collusive Models of Oligopoly
s

(a) Chamberlin’s Model of Oligopoly: The ‘Small Group’ Model: The classical
models of duopoly assumed independent action by the rival firms in their attempt
a

to maximize their profits. Chamberlin rejected the assumption of independent


ik

action by the competing firms. He developed his own model of oligopoly assuming
interdependence between the competitors. He argued that firms do not act
independently. They do recognize their mutual interdependence. Firms are not as
V

‘stupid’ as assumed in the models of Cournot, Edgeworth and Bertrand. In his


own words, ‘When a move by one seller evidently forces the other to make a
counter-move, he is very stupidly refusing to look further than his nose if he
proceeds on the assumption that it will not.’34 Chamberlin suggests that each
seller seeking to maximize his profit reflects well and looks into the consequences
of his move.35 The total consequence of a seller’s move consists of both its direct
and indirect effects. The direct effects are those which results from a seller’s
own action, rival sellers not reacting to his action. The indirect effects are those
which result from the reaction of the rival sellers to the moves made by a seller.
Self-Instructional
198 Material
Chamberlin suggests in his model that, if rival firms are assumed to recognize Price and Output
Determination
their interdependence and act accordingly, a stable equilibrium can be reached
where each firm charges monopoly price. When all firms are in equilibrium, industry
profit is maximized. Chamberlin’s oligopoly model of ‘small group’ can be best
understood if presented in the framework of Cournot’s duopoly model since NOTES
Chamberlin follows Cournot to develop his own model.
Cournot’s model is reproduced in Fig. 5.21, except the ordinate JK. Assuming
there are two firms, A and B, let A first enter the market as a monopolist. Following
the profit maximization rule, firm A will produce OQ and charge monopoly price
OP2 (= PQ). When firm B enters the market, it considers that PM is its demand

se
curve. Under Cournot’s assumption, firm B will sell output QN at price OP1. As a
result, market price falls from OP2 to OP1. It is now A’s turn to appraise the
situation. At this point, Chamberlin deviates from Cournot’s model. According to

u
Cournot’s model, firm A does not recognize their interdependence and acts
independently. Chamberlin, however, assumes that firm A does recognize the

. Ho
interdependence between them and it does recognize the fact that B will react to
its decisions. Therefore, firm A decides to compromise with the existence of firm
B, and decides to reduce its output to OK which is half of the monopoly output,
OQ. Its output OK equals B’s output QN (= KQ). In its turn, firm B also recognizes

td g
their interdependence. It realizes that KQ is the most profitable output for it.
Thus, the industry output is OQ which is the same as monopoly output, and market
. L in
price is OP2 (= PQ) which equals monopoly price. Thus, according to Chamberlin,
by recognizing their interdependence, the firms reach an equilibrium which is the
vt sh
same as monopoly equilibrium and share the market equally. One of the firms
supplies OK and the other supplies KQ where OK + KQ = OQ, the profit
maximising monopoly output. This equilibrium is stable because under the condition
of interdependence, firms do not gain by changing their price and output.
P li

Chamberlin’s model is regarded as an improvement over the earlier models,


ub

at least in respect of its behavioural assumption of interdependence. His model


has, however, been criticised on the grounds that his idea of joint profit maximization
is beset with problems of estimating demand and cost functions. Unless demand
and cost functions are fully known to the competitors, joint profit maximization is
P

doubtful.
as
ik
V

Fig. 5.21 Chamberlin’s Model of Stable Oligopoly Equilibrium


Self-Instructional
Material 199
Price and Output (b) Sweezy’s Kinked-Demand Curve Model of Oligopoly: The origin of kinked-
Determination
demand curve can be traced in Chamberlin’s theory of monopolistic competition.
Later, Hall and Hitch36 used kinked-demand curve to explain rigidity of prices in
oligopolistic market. However, neither Chamberlin nor Hall and Hitch used kinked-
NOTES demand curve as a tool of analysis in their respective theories. It was Paul M.
Sweezy37 who used the kinked-demand curve in his model of price stability in
oligopolistic market.
The kinked-demand curve model developed by Paul M. Sweezy has features
common to most oligopoly pricing models. This is the best known model to explain
relatively more satisfactorily the behaviour of the oligopolistic firms. The kinked-

se
demand curve analysis does not deal with price and output determination. Instead,
it seeks to establish that once a price-quantity combination is determined, an
oligopoly firm will not find it profitable to change its price even in response to the

u
small changes in the cost of production. The logic behind this proposition is as

. Ho
follows. An oligopoly firm believes that if it reduces the price of its product, the
rival firms would follow and neutralize the expected gain from price reduction.
But, if it raises the price, the firms would either maintain their prices or even
indulge in price-cutting, so that the price-raising firms stand to lose, at least, a part
of its market share. This behaviour is true for all the firms. The oligopoly firms

td g
would, therefore, find it more desirable to maintain the prevailing price and output.
. L in To look more closely at the kinked-demand curve analysis, let us look into
the possible actions and reactions of the rival firms to the price changes made by
one of the firms.
vt sh
There are three possible ways in which rival firms may react to change in
price by one of the firms: (i) the rival firms follow the price changes, both cut and
hike; (ii) the rival firms do not follow the price changes; (iii) rival firms do not
P li

react to price-hikes but they do follow the price-cutting. If rival firms react in
manners (i) an oligopoly firm taking lead in changing prices will face demand
ub

curve dd´ in Fig. 5.22. If rival firms react in manner (ii), the firm faces demand
curve DD´. The demand curve dd′ which is based on reaction (i) is less elastic
than the demand curve DD′ which is based on reaction (ii). Demand curve dd′ is
P

less elastic because changes in demand in response to changes in price are


restrained by the counter-moves by the rival firms.
a s
ik
V

Fig. 5.22 Kinked-demand Analysis


Self-Instructional
200 Material
Given the two demand curves, let point P represent the equilibrium price-quantity Price and Output
Determination
combination of an oligopolist. Let us now introduce reaction (iii), i.e., rival firms follow
the oligopolist leading in price-cutting when he reduces his price but do not follow him
when he increases his price. This asymmetrical behaviour of the rival firms makes only
a part of each of the two demand curves relevant for the oligopolist. This can be established NOTES
by allowing an oligopolist to alternatively increase and decrease his price. If an oligopolist
increases his price and his rivals do not follow him, he loses a part of his market to his
rivals. The demand for his product decreases considerably indicating a greater elasticity.
The oligopolist is, therefore, forced down from demand curve dP to DP. Thus, the
relevant segment of demand curve for the oligopolist is DP.

se
On the other hand, if an oligopolist decreases his price, the rival firms, react by
cutting down their prices by an equal amount or even more. This counter move by the
competitors prevents the oligopolist from taking full advantage of price-cut along the

u
demand curve DD′. Therefore, his demand curve below point P rotates down. Thus, the
relevant segment of demand curve for the oligopolist (below point P) is Pd′. If the two

. Ho
relevant segments of the two demand curves are put together, the relevant demand
curve for the oligopolist is DPd′ which has a kink at point P. Therefore, it is called a
‘Kinked-demand curve’.
Consider now the relationship between AR (=D) and MR. We know that

td g
MR = AR–AR/e. The MR curve, drawn on the basis of this relationship, will take a
shape as shown by DJKL in Fig. 5.22. It is discontinuous between point J and K, at
. L in
output OQ. Suppose that the original marginal cost curve resembles MC1 which intersects
MR at point K. Since at output OQ, the necessary condition of maximum profit
vt sh
(MR = MC) is satisfied, the oligopolist is earning maximum profit. Now, if marginal cost
curve shifts upwards to MC2 or to any level between points J and K, his profit would not
be affected. Therefore, he has no motivation for increasing or decreasing his price. It is
P li

always beneficial to stick to the price and output. Thus, both price and output are stable.
The oligopolists will think of changing their price and output only if MC rises
ub

beyond point J or decreases below point K (Fig. 5.22). But, even if it so happens, price
and output would tend to stabilize. Suppose that the general level of costs rises for the
industry so that MC moves above point J. The oligopolists will ultimately find it profitable
P

to raise the price. When one of the oligopolists raises his price, his competitors match the
price increase. As a result, the kinked-demand curve shifts upward to a new position
and the point of kink shifts rightward and horizontally. Again, at the new price there is no
s

incentive for any oligopolist to raise his price. Therefore, price tends to stabilize.
a

Alternatively, if MC moves down below point K, firms get incentive to reduce


their price. When one firm cuts its price, others follow with matching price-reduction.
ik

There is a possibility of competitors reducing their prices by a greater margin. The only
way to prevent this situation is that the oligopolist must keep his costs as low as possible,
at least lower than that of his competitors. This is the reason why there is keen
V

technological competition in an oligopolistic market. In other words, there is incentive for


oligopoly finds to use new and efficient technique of production, to introduce new products,
to make innovations, to increase their productivity or to reduce their cost of production to
the possible minimum. They find it safe to concentrate on efficiency rather than to
indulge in price-war.

Self-Instructional
Material 201
Price and Output Some Implications of Sweezy’s Model
Determination
According to Sweezy, his model for price stability in an oligopolistic market has the
following implications:
NOTES First, since elasticity of the demand curve below point P is assumed to be less
than unity and MR beyond a point is negative, the conditions of short-run equilibrium are
not precise. That is, profit maximization rule, MC= MR, cannot be applied to the short-
run conditions.
Second, since MC can shift up and down between the finite points J and K (Fig.
5.21), MR remaining the same, his model deviates from the marginal productivity theory,

se
i.e., factor prices do not equal their marginal revenue productivity.
Third, any short-term disturbance in MC will not affect the equilibrium price or
output and the total profits. Thus, the general belief that a successful strike by the trade

u
unions reduces profits gets little theoretical support from Sweezy’s model.

. Ho
Criticism
The major criticism against this model is that it explains only the stabilization of output
and price. It does not tell, why and how the initial price is fixed at a certain level. The
Sweezy’s thesis must therefore be regarded as an ex-post rationalization rather than as

td g
an ex-ante explanation of market equilibrium.38
. L in Besides, Sweezy’s claim of price stability does not stand the test of empirical
verification: there is a surprising lack of price rigidity. Monopoly prices have been found
more stable than oligopoly prices. However, economists are divided on the issue of price
vt sh
rigidity. While Stigler39 doubts the existence of kinked-demand curve and price rigidity,40
Liebhafsky41 finds considerable evidence of price rigidity in the US. Cohen and Cyert
argue that kink in the demand curve and price rigidity may exist for a brief period for
P li

lack of inter-firm information, particularly when new and unknown rivals enter the market.
They are of the opinion that kink is clearly not a stable long-run equilibrium.42
ub

IV. Collusive Models of Oligopoly


From the non-collusive models, we now turn to the collusive models of the oligopoly
P

theory. In the non-collusive models, oligopoly firms are assumed to act independently. In
the collusive models, however, firms are assumed to act in unison, i.e., in collusion with
one another. This assumption is based on empirical facts, rather than being conjectural.
s

Why Collusion?
a

There are at least three major factors which bring collusion between the oligopolistic
ik

firms. First, collusion reduces the degree of competition between the firms and helps
them act monopolistically in their effort of profit maximization. Second, collusion reduces
V

the oligopolistic uncertainty surrounding the market since cartel members are not supposed
to act independently and in the manner that is detrimental to the interest of other firms.
Third, collusion forms a kind of barrier to the entry of new firms.
Collusion between oligopoly firms may take many forms depending on their relative
strength, their objective and legal status of collusion.43 There are, however, two main
types of collusion (a) Cartels; and (b) Price leadership.

Self-Instructional
202 Material
(a) Cartels under Oligopoly Price and Output
Determination
A cartel is a formal organization of the oligopoly firms in an industry. Cartels are the
perfect form of collusion. A general purpose of cartels is to centralize certain managerial
decisions and functions of individual firm in the industry with a view to promoting common NOTES
benefits. Cartels may be in the form of open collusion or secret collusion. Whether
open or secret, cartel agreements are explicit and formal in the sense that agreements
are enforceable on member firms trying to pursue an independent pricing policy. Cartels
are therefore regarded as the perfect form of collusion. Cartels and cartel type agreements
between the firms in manufacturing and trade are illegal in most countries. Yet, cartels in

se
the broader sense of the term exist in the form of trade associations, professional
organizations and the like.
A cartel performs a variety of services for its members. The two typical services

u
of central importance are (i) fixing price for joint maximization of industry profits; and
(ii) market-sharing between it members.

. Ho
Cartels and Profit Maximization
Let us suppose that a group of firms producing a homogeneous commodity forms a
cartel aiming at joint profit maximization. The firms appoint a central management board

td g
with powers to decide the following aspects:
(i) the total quantity to be produced;
. L in
(ii) the price at which the product has to be sold; and
(iii) share of each firm in the total output.
vt sh
The central management board is provided with cost figures of individual firms.
Besides, it is supposed to obtain the necessary data required to formulate the market
demand (AR) curve. The management board calculates the marginal cost (MC) and
P li

marginal revenue (MR) for the industry. Furthermore, the management board holds the
ub

position of a multiplant monopoly. It determines the price and output for each firm in the
manner a multiplant monopoly determines the price and output for each plant.
The model of price and output determination for each is presented in Fig. 5.23. It
is assumed for the sake of convenience that there are only two firms, A and B, in the
P

cartel. Their respective cost curves are given in the first two panels of Fig. 5.23. In the
third panel, the AR and MR curves represent the revenue conditions of the industry.
s

The MC curve is the summation of MC curves of the individual firms. The MC and MR
intersect at point C determining the industry output at OQ. The market price is determined
a

at PQ. The industry output OQ is so allocated between firms A and B that for each of
them MC = MR. The share of each firm in the industry output, OQ, can be determined
ik

by drawing a line from point C and parallel to X-axis through MC2 and MC1. The points
of intersection C1 and C2 determine the level of output for firms A and B, respectively.
V

Thus, the share of each of the two firms A and B, is determined at Oq1 and Oq2,
respectively, where Oq1 + Oq2 = OQ. Their respective profit can be computed as (Pm –
firm’s ac) × firm’s output, which is maximum. The total profit of each firm may be
different. But there is no motivation for changing price-quantity combination, since their
individual profit is maximum.

Self-Instructional
Material 203
Price and Output
Determination

NOTES

se
Fig. 5.23 Price and Output Determination under Cartel

u
Critical Appraisal

. Ho
Although monopoly solution to joint profit maximization by cartels looks theoretically
sound, William Fellner gives the following reasons why joint profits may not be maximized.
First, it is difficult to estimate market demand curve accurately since each firm
thinks that the demand for its own product is more elastic than the market demand curve
because its product is a perfect substitute for the product of other firms.

td g
. L in Second, similarly an accurate estimation of industry’s MC curve is highly
improbable for lack of adequate and correct cost data. If industry’s MC is incorrectly
estimated, industry output can be only incorrectly determined. Hence, joint profit
maximization is doubtful.
vt sh
Third, cartel negotiations take a long time. During the period of negotiation, the
composition of the industry and its cost structure may change. This may render the
estimates irrelevant, even if they are correct. Besides, if the number of firms increase
P li

beyond 20 or so, cartel formation becomes difficult, or even if it is formed, it soon breaks
ub

down.
Fourth, there are ‘chiselers’ who have a strong temptation to give secret
concessions to their customers. This tendency in the members reduces the prospect of
joint profit maximization.
P

Fifth, if cartel price, like monopoly price, is very high, it may invite government
attention and interference. For the fear of government interference, members may not
s

charge the cartel price.


a

Sixth, another reason for not charging the cartel price is the fear of entry of new
firms. The high cartel price which yields monopoly profit may attract new firms to the
ik

industry. To prevent the entry of new firms, some firms may decide on their own not to
charge the cartel price.
V

Finally, another reason for not charging the cartel price is the desire to build a
public image or good reputation. Some firms may, to this end, decide to charge only a fair
price and realize only a fair profit.
Cartel and Market Sharing
The market-sharing cartels are more common because this kind of collusion permits a
considerable degree of freedom in respect of style of the product, advertising and other
selling activities. There are two main methods of market allocations: (i) non-price
competition, and (ii) quota system.
Self-Instructional
204 Material
(i) Non-price Competition Price and Output
Determination
The non-price competition agreements are usually associated with loose cartels. Under
this kind of arrangement between the firms, a uniform price is fixed and each firm is
allowed to sell as much as it can at the cartel price. The only requirement is that firms NOTES
are not allowed to reduce the price below the cartel price.
The cartel price is a bargain price. While low-cost firms press for a low price, the
high-cost firms press for a higher price. But the cartel price is so fixed by mutual consent
that all member firms are able to make some profits. But the firms are allowed to
compete with one another in the market on a non-price basis, i.e., they are allowed to

se
change the style of their product, innovate new designs, and to promote their sales by
advertising.
Whether this arrangement works or breaks down depends on the cost conditions

u
of the individual firms. If some firms expect to increase their profits by violating the
price agreements, they will indulge in cheating by charging lower price. This may lead to

. Ho
a price-war and cartel may break-down.
(ii) Quota System
The second method of market-sharing is quota system. Under this system, the cartel

td g
fixes a quota of market-share for each firm. There is no uniform principle for fixing
quota. In practice, however, the main considerations are: (i) bargaining ability of a firm
. L in
and its relative importance in the industry, (ii) the relative sales of the firms in pre-cartel
period, and (iii) production capacity of the firm. The choice of base period depends on
vt sh
the bargaining ability of the firm.
Another popular basis of market-sharing is the geographical division of market.
Examples of this kind of market-sharing are mostly found in the case of international
P li

markets.
Unequal Quota for Unequal Firms. Fixation of quota is a difficult proposition.
ub

Nevertheless, some theoretical guidelines for market-sharing have been suggested by


the economists: (i) unequal quota for unequal firms, i.e., firms with different cost curves,
and (ii) equal quota for equal firms—firms with identical cost and revenue curves.
P

A reasonable criterion of ideal market-sharing can be to share the total market


between the cartel members in such proportions that the industry’s marginal cost equals
the marginal cost of individual firms. This criterion is illustrated in Fig. 5.24. The profit
s

maximizing output of the industry is OQ. The industry output OQ is shared between the
a

two firms A and B, as Oq1 and Oq2, respectively. Note that OQ = Oq1 + Oq2. At output
Oq1, mc of firm A equals industry’s marginal cost, MC, and at output Oq2, mc of firm B
ik

equals MC. Thus, under quota system, the quota for firms A and B may be fixed as Oq1
and Oq2, respectively. Given the quota allocation, the firm may set different prices for
V

their product depending on the position and elasticity of their individual demand curves.
This criterion is identical to the one adopted by a multiplant monopolist in the short-run,
to allocate the total output between the plants.
Equal Quota for Equal Firms. Another reasonable criterion for market-sharing
under quota system is equal market-share for equal firms. This criterion is applicable
where all have identical cost and revenue curves. This criterion also leads to a monopoly
solution. It also resembles Chamberlin’s duopoly model.
To illustrate the quota allocation, let us assume that there are only two firms, A
and B. Their AR, MR and MC curves are given as shown in Fig. 5.24(a) and (b). The
Self-Instructional
Material 205
Price and Output market revenue and cost curves, which are obtained by adding up individual revenue
Determination
and cost curves, respectively, are presented in part (c) of the figure. The industry output
is determined at OQM. The quota for each firm, which maximizes their profits, is so
determined that OQM = OQA + OQB. Given the identical cost and revenue conditions,
NOTES OQA = OQB. That is, market is divided equally between firms A and B. This result can
be obtained also by drawing an ordinate from point R where price line (PM) intersects
the MR.

u se
. Ho
Fig. 5.24 Quota Allocation under Cartel Agreements

td g
. L in It may be mentioned at the end that cartels do not necessarily create the conditions
for price stability in an oligopolistic market. Most cartels are loose. Cartel agreements
are generally not binding on the members. Cartels do not prevent the possibility of entry
of new firms. On the contrary, by ensuring monopoly profits, cartels in fact create
vt sh
conditions which attract new firms to the industry. Besides, chiselers and free-riders
create conditions for instability in price and output.
P li

(b) Price Leadership Models of Oligopoly


ub

Collusion through price leadership is another form of collusion between oligopoly firms.
Price leadership is an informal position of a firm in an oligopolistic setting to lead other
firm in fixing price of their product. This leadership may emerge spontaneously due to
technical reasons or out of tacit or explicit agreements between the firms to assign
P

leadership role to one of them.


The spontaneous price leadership may be the result of such technical reasons as
s

size, efficiency, economies of scale or firm’s ability to forecast market conditions


accurately or a combination of these factors. The most typical case of price leadership
a

is the leading role played by the dominant firm, the largest firm in the industry. The
dominant firm takes lead in price changes and the smaller ones follow. Sometimes price
ik

leadership is barometric. In the barometric price leadership, one of the firms, not
necessary the dominant one, takes lead in announcing change in price, particularly when
V

such a change is due but is not affected due to uncertainty in the market.
The price leadership is possible under both product homogeneity and product
differentiation or heterogeneity. There may be, however, price differentials
commensurating with product differentiation. Price differentials may also exist on account
of cost differentials.
Another important aspect of price leadership is that it often serves as a means to
price discipline and price stabilization. Achievement of this objective establishes an
effective price leadership. Such price leadership can, however, exist only when
Self-Instructional
206 Material
(i) number of firms is small; (ii) entry to the industry is restricted; (iii) products are, by Price and Output
Determination
and large, homogeneous; (iv) demand for industry is inelastic or has a very low elasticity;
and (v) firms have almost similar cost curves.
The three common types of price leaderships are:
NOTES
(i) Price leadership by a low-cost firm;
(ii) Price leadership by a dominant firm; and
(iii) Barometric price-leadership.
(i) Price Leadership by a Low-cost Firm

se
How price and output decisions are taken under price leadership of a low-cost firm is
illustrated in Fig. 5.25. Suppose all the firms face identical revenue curves as shown by
AR = D and MR. But the largest firm or the low-cost firm, has its cost curves as shown

u
by AC1 and MC1 whereas all other rival firms, smaller in size have their cost curves as
shown by AC2 and MC2. The largest firm has the economies of scale and its cost of

. Ho
production is lower than that of other firms. Given the cost and revenue conditions, the
low-cost firm would find it most profitable to fix its price at OP 2
(= LQ2) and sell quantity OQ2. Since at this level of output its MC = MR, its profit will be
maximum. On the other hand, the high-cost firms would be in a position to maximize
their profit at price OP3 and quantity OQ1. However, if low-cost firms charge profit

td g
maximizing price OP3, they would lose their customers to the low-cost firm charging a
. L in
lower price OP2. The high-cost firms are, therefore, forced to accept the price OP2 and
recognize the price leadership of the low-cost firm. Note that the low-cost firm can
eliminate other firms and become a monopolist, by cutting its price down to OP1. At
vt sh
price OP1, the low-cost firm can sell the same quantity OQ2 and make, of course, only
normal profit as its AC = price OP1. But, it may not do so for the fear of anti-monopoly
laws.
P li
ub
P
a s
ik

Fig. 5.25 Price Leadership by a Low-cost Firm


V

(ii) Price Leadership by the Dominant Firm


Price leadership by the dominant firm is more common than by a low-cost firm. In the
analysis of price leadership by a dominant firm, it is assumed that there exists a large-
size firm in the industry which supplies a large proportion of the total market. The
dominance of the large firm is indicated by the fact that it could possibly eliminate all its
rival firms by price-cutting. But then the large firm gains the status of a monopoly which
may create legal problems. The dominant firm, therefore, compromises with the existence
of rival firms in the market. It uses its dominance to set its price so as to maximize its
Self-Instructional
Material 207
Price and Output price. The smaller firms have no alternative but to accept the price set by the dominant
Determination
firm. The smaller firms recognize their position and behave just like a firm in a perfectly
competitive market. That is, smaller firms assume that their demand curve is a straight
horizontal line.
NOTES The price leadership and market sharing between the dominant firm and the other
firms as a group is illustrated in Fig. 5.26. Suppose that the market demand curve is
given by DDM in part (a) of the figure. The problem confronting the dominant firm is to
determine its price and output that will maximise its profits, leaving the rest of the market
to be jointly supplied by the small firms. Now the dominant firm has to find its own
demand curve. Given the market demand curve (DDm) and joint supply curve of small

se
firms (SSs), the dominant firm finds its demand curve by deducting from the market
demand the quantity supplied jointly by the small firms below the equilibrium price. The
part of the market demand not supplied by the small firms will be its own share. Thus,

u
the market share of the dominant firm equals the market demand less the share of small

. Ho
firms.
Suppose, for example, equilibrium price is set at OP3, the total supply by the
smaller firms is P3E which equals the market demand. Therefore, at price OP3, the
market left for the dominant firm is zero. When price is market demand is out

td g
of which is supplied by smaller firms. The market unsupplied by the smaller firms is
AB. Thus, at price
. L in the demand for dominant firm’s product equals:
− =
vt sh
Similarly, when price is reduced to OP2, the demand for dominant firm’s product
is CF. Following this process, the market-share of the dominant firm at other prices can
be easily obtained.
P li

The information so derived and plotted graphically gives P3DL as the demand
curve for the dominant form [Fig. 5.26(b)]. Since the relation between AR and MR is
ub

known, the MR curve for the dominant firm can be derived as MRL [Fig. 5.26(b)]. If the
MC curve of the dominant firm is assumed to be given as MCL, its profit maximizing
output will be OQL and price = PQL.
P

Once the dominant firm sets its price at the market demand curve for the
small firms is the horizontal straight line because they can sell, at this price, as much
s

as they can produce. But, in order to maximize their joint profits, small firms will produce
a

only Recall that given the price, the line is the same as their AR = MR line and
their supply curve P1SS, intersects AR = MR at point A. For small firms, therefore,
ik

profit-maximizing output is
V

Self-Instructional
208 Material
Price and Output
Determination

NOTES

se
(a) Small Firms (b) Dominant Firm

Fig. 5.26 Price Determination by the Dominant Firm

u
Finally, the dominant firm sets its price at which is accepted by the small

. Ho
firms. Thus, the dominant firm plays the role of a price leader. If it wants to eliminate the
small firm, it may set its price at OP1 (though at a loss in the short run) at which small
firms would not be able to survive. But, for the legal reason already mentioned, the
dominant oligopoly firm would not do so. It would prefer, and be content, with its position

td g
of a price leader.
(iii) Barometric Price Leadership
. L in
Another form of price leadership is barometric price leadership. In this form of price
vt sh
leadership, a firm initiates well publicised changes in price that are generally followed by
the rival firms in the industry. The price leader may not necessarily be the largest firm of
the industry. The barometric firm is, however, supposed to have a better knowledge of
prevailing market conditions and has an ability to predict the market conditions more
P li

precisely than any of its competitors. This qualification of the barometric firm should
ub

have been established in the past. Price decisions by a firm having the qualifications of
price leadership is regarded as a barometer which reflects the changes in business
conditions and environment of the industry. The price changes announced by the barometric
firm serves as a barometer of changes in demand and supply conditions in the market.
P

The barometric leadership evolves for various reasons of which the major ones
are the following.
s

First, the rivalry between the larger firms may lead to cut-throat competition to
the disadvantage of all the firms. On the other hand, rivalry between the larger firms
a

may make them unacceptable as a leader. So a firm which has better predictive ability
ik

emerges as price leader.


Second, most firms in the industry may have neither the capacity nor the desire
to make continuous calculations of cost, demand and supply conditions. Therefore, they
V

find it advantageous to accept the price changes made by a firm which has a proven
ability to make reasonably good forecasts.
Third, Kaplan44 et. al. state that barometric price leadership often develops as a
reaction to a long economic warfare in which all the firms are losers.
Critical Appraisal of the Price Leadership Model
The price leadership model, yields a stable solution to the problem of oligopoly pricing
and output determination, only if small firms faithfully follow the leader, i.e., small firms
Self-Instructional
Material 209
Price and Output produce a right quantity and charge the price set by the dominant firm. Besides, the
Determination
model requires that the dominant firm should be both a large and low-cost firm. For, if a
firm does not enjoy the advantages of being large enough and, consequent upon it, the
advantages of its low cost, it cannot act as a price leader.
NOTES In practice, however, one finds many cases of price leadership by a firm which is
neither a large nor a low-cost firm. But such cases are found mostly under recessionary
conditions when a relatively smaller firm reduces its price to survive in the market.
Furthermore, if a leading firm loses its cost advantages, it also loses its leadership.
Such cases are frequent in the real business world. Leadership also changes following

se
the innovations of products and techniques of production by the smaller firms.
Besides, where there are many large firms of equal size and have some cost
advantage, price leadership of any firm or group of firms becomes less probable,

u
particularly when number of small firms is smaller than that of large firms. Under such
conditions, barometric leadership emerges.

. Ho
Lastly, it is assumed that entry of new firms is prevented either by low-cost or by
initial high cost. In practice, however, many firms having the capacity to diversify their
products enter the industry with relatively initial low-cost.
For these reasons, leadership model is not a realistic one as it is based on unrealistic

td g
assumptions. For the same reasons, the solution given by leadership model may not be
stable.
. L in
Concluding Remarks on Oligopoly Models
vt sh
Most oligopoly models concentrate on price competition. In reality, however, as it is
obvious from the above discussion that oligopolists may be reluctant to wage price-war
and encroach upon each other’s market-share. It means that there is an absence of
P li

price-competition in the oligopolistic market structure. The absence of price-competition


should not mean the absence of competition among oligopoly firms. In fact, the competition
ub

among oligopoly firms takes the form of non-price competition. The forms of non-
price competition are diverse. Yet, there are two most important methods of non-price
competition.
P

First, non-price competition involves product differentiation which is intended


to attract new customers by creating preference for the new design and variety of
product.
s

Second, perhaps the most important technique of non-price competition is


a

advertisement. The primary objective of advertising is to make the demand curve for
the product shift upward. The sellers try to encroach on the markets of other sellers
ik

through advertising. Advertising is also necessary to retain the market-share if there is


tough competition between the firms.
V

5.4.4 Game Theory Approach to Oligopoly


We have discussed in this unit so far the classical non-collusive models of oligopoly firms
and collusive models, i.e., price and output determination under cartel system. The
conclusion that emerges from the classical models is that none of the models discussed
so far explains satisfactorily the actions and reactions of oligopoly firms and price and
output determination in an oligopoly market. However, the search for a reasonable
explanation of the behaviour of the oligopoly firms does not end here. The classical
theories show, in fact, only the beginning of the effort to analyse firms’ behaviour in an
Self-Instructional
210 Material
oligopoly market. In recent years, economists have attempted to use a mathematical Price and Output
Determination
technique called game theory to explain the collusion among the oligopoly firms. The
game theory approach was developed45 in 1944 by a mathematician John von Neumann
(1903–57), and an economist Oscar Margenstern (1902–77). In recent times, the game
theory approach is regarded as ‘economists’ most widely used approach to analyse NOTES
oligopoly behaviour’.46
The game theory approach uses the apparatus of game theory—a mathematical
technique—to show how oligopoly firms play their game of business. The game theory
approach uses two fundamental tools—strategic actions by the firms and pay-off
matrix of their actions—to find the optimum solution. As already mentioned, the first

se
systematic attempt was made in this field by von Neumann and Margenstern. Though
their work was followed by many others, Martin Shubik 47 is regarded as the ‘most
prominent proponent of the game-theory approach’ who seems to believe that the only

u
hope for the development of a general theory of oligopoly is the games theory.48 Though

. Ho
his hope does not seem to be borne out by further attempts in this area, the usefulness of
game theory in revealing the intricate behavioural pattern of the oligopoly firms cannot
be denied. Here, we present an elementary description of the game theory as applied to
oligopoly.49 We will first illustrate the nature of the problem faced by the oligopoly firms
in their strategy formulation.

td g
Nature of the Problem: Prisoners’ Dilemma
. L in
The nature of the problem faced by the oligopoly firms is best explained by the Prisoners’
Dilemma Game. To illustrate prisoners’ dilemma, let us suppose that there are two
vt sh
persons, A and B who are partners in a case of kidnapping for ransom. On a tip-off, the
CBI arrests A and B on suspicion of their involvement in kidnapping a person. They are
arrested and lodged in separate jails with no possibility of communication between them.
They are being interrogated separately by the CBI officials with following conditions
P li

disclosed to them in isolation.


ub

1. If you confess your involvement in kidnapping, you will get a five-year


imprisonment.
2. If you deny your involvement and your partner denies too, you will be set free for
P

lack of evidence.
3. If one of you confesses and turns approver, and other does not, then one who
confesses gets a two-year imprisonment, and one who does not confess gets
s

ten-year imprisonment.
a

Given these conditions, each suspect has two options open to him: (i) to confess,
and (ii) not to confess. Now, both A and B face a dilemma on how to decide whether or
ik

not to confess. While taking a decision, both have a common objective, i.e., to minimize
the period of imprisonment. Given this objective, the option is quite simple that both of
V

them deny their involvement in kidnapping. But, there is no certainty that if one denies,
the other will also deny: the other may confess and turn approver, with this uncertainty,
the dilemma in making a choice still remains. If A denies, for example, his involvement,
and B confesses (settles for a two-year imprisonment), then A gets a ten-year jail term.
So is the case with B. If they both confess, then they get a five-year jail term each. Then
what to do? That is the dilemma. The nature of their problem of decision-making is
illustrated in the Table 5.3 in the form of a ‘pay-off matrix’. The pay-off matrix shows
the pay-offs of their different options in terms of the number of years in jail.

Self-Instructional
Material 211
Price and Output Given the conditions, it is quite likely that both the suspects may opt for ‘confession’,
Determination
because neither A knows what AR will do nor B knows what A will do. When they both
confess, each gets a 5-year jail term. This is the second best option. For his decision to
confess, A might formulate his strategy in the following manner. He argues to himself: If
NOTES I confess (though I am innocent), I will get a maximum of five years’ imprisonment. But,
if I deny (which I must) and B confesses and turns approver, I will get ten years’
imprisonment. And, that will be the worst of the worst. It is quite likely that suspect B
also reasons out in the same manner, even if he too is innocent. If they both confess,
they would avoid 10 year’s imprisonment, the maximum possible jail sentence under the
law. This is the best they could achieve under the given conditions.

se
Table 5.3 Prisoner’s Dilemma

u
. Ho
td g
Relevance of Prisoners’ Dilemma to Oligopoly
. L in
The prisoners’ dilemma illustrates the nature of problems oligopoly firms are confronted
vt sh
with in the formulation of their business strategy with respect to strategic advertising,
price-cutting and cheating in case of a cartel. Look at the nature of problems an oligopoly
firm is confronted with when it plans to increase its advertisement expenditure (ad-
expenditure for short). The basic issue is whether or not to increase the ad-expenditure.
P li

If the answer is ‘do not increase’, then the questions are: will the rival firms increase ad-
ub

expenditure or will they not? And if they do, what will be the consequences for the firm
under consideration? And, if the answer is ‘increase’, then the following questions arise:
what will be the reaction of the rival firms? Will they increase or will they not increase
their ad-expenditure? What will be the pay-off if they do not and what if they do? If the
P

rival firms do increase their advertising, what will be the pay-off to the firm? Will the
firm be a net gainer or a net loser? The firm will have to find the answer to these queries
under the conditions of uncertainty. It will have to anticipate actions, reactions and
s

counteraction by the rival firms and chalk out to own strategy. It is in case of such
a

problems that the case of prisoners’ dilemma becomes an illustrative example.


ik

Application of Game Theory to Oligopoly


Let us now apply the game theory to our example of ‘whether or not to increase ad-
V

expenditure’, assuming that there are only two firms, A and B, i.e., the case of a duopoly.
We know that in all the games, the players have to anticipate the move made by the
opposite player(s) and formulate their own strategy to counter the different possible
moves by the rival. To apply the game theory to the case of ‘whether or not to increase
ad-expenditure’ the firm needs to know or anticipate the following:
(i) Counter moves by the rival firm in response to increase in ad-expenditure by this
firm, and
(ii) The pay-offs of this strategy when (a) the rival firm does not react, and (b) the
Self-Instructional rival firm does make a counter move by increasing its ad-expenditure.
212 Material
After this data is obtained, the firm will have to decide on the best possible strategy Price and Output
Determination
for playing the game and achieving its objective of, say, increasing sales and capturing a
larger share of the market. The best possible strategy in game theory is called the
‘dominant strategy’. A dominant strategy is one that gives optimum pay-off, no matter
what the opponent does. Thus, the basic objective of applying the game theory is to NOTES
arrive at the dominant strategy.
Table 5.4 Pay-off Matrix of the Ad-Game
(Increase in sales in million Rs)

u se
. Ho
Suppose that the possible outcomes of the ad-game under the alternative moves
are given in the pay-off matrix presented in Table 5.4.

td g
As the matrix shows, if Firm A decides to increase its ad-expenditure, and Firm B
counteracts A’s move by increasing its own ad-expenditure, Firm A’s sales go up by
. L in
`20 million and that of Firm B by `10 million. And, if Firm A increases its advertisement
and B does not, then Firm A’s sales gain is `30 million and there is no gain to Firm B. One
vt sh
can similarly find the pay-offs of the stategy ‘Don’t increase’ in case of both the firms.
Given the pay-off matrix, the question arises what strategy should Firm A choose
to optimize its gain from extra ad-expenditure, irrespective of counteraction by the rival
P li

Firm B. It is clear from the pay-off matrix that Firm A will choose the strategy of
increasing the ad-expenditure because, no matter what Firm B does, its sales increase
ub

by at least `20 million. This is, therefore, the dominant strategy for Firm A. A better
situation could be that when Firm A increases its expenditure on advertisement, Firm B
does not. In that case, Firm A’s sales could increase by `30 million and sales of Firm B
P

do not increase. But there is a greater possibility that Firm B will go for counter-advertising
in anticipation of losing a part of its market to Firm A in future. Therefore, a strategy
based on the assumption that Firm B will not increase its ad-expenditure involves a great
s

of uncertainty.
a

Nash Equilibrium. In the preceding description, we have used a very simple


example to illustrate the application of game theory to an oligopolistic market setting,
ik

with the simplifying assumptions: (i) that strategy formulation is a one-time affair, (ii)
that one firm initiates the competitive warfare and other firms only react; and (iii) that
there exists a dominant strategy—a strategy which gives an optimum solution. The
V

real-life situation is, however, much more complex. There is a continuous one-to-one
and tit-for-tat kind of warfare. Actions, reactions and counteractions are regular
phenomena. Under these conditions, a dominant strategy is often non-existent. To
analyse this kind of situation, John Nash,50 an American mathematician, developed a
technique, known as Nash equilibrium technique, which seeks to establish that each
firm does the best it can, given the strategy of its competitors and a Nash equilibrium is
one in which none of the players can improve their pay-off given the strategy of
the other players. In case of our example, Nash equilibrium can be defined as one in
Self-Instructional
Material 213
Price and Output which none of the firms can increase its pay-off (sales) given the strategy of the rival
Determination
firm.
The Nash equilibrium can be illustrated by making some modifications in the pay-
off matrix given in Table 5.4. Now we assume that action and counter action between
NOTES Firms A and B is a regular phenomenon and the pay-off matrix that appears finally is
given in Table 5.5. The only change in the modified pay-off matrix is that if neither Firm
A nor Firm B increases its ad-expenditure, then pay-offs change from (15, 5) to (25, 5).
It can be seen from the pay-off matrix (Table 5.5) that Firm A has no more a
dominant strategy. Its optimum decision depends now on what Firm B does. If Firm B

se
increases its ad-expenditure, Firm A has no option but to increase its advertisement
expenditure. And, if Firm A reinforces its advertisement, Firm B will have to follow the
suit. On the other hand, if Firm B does not increase its ad-expenditure, Firm A does the
best by increasing its ad-expenditure. Under these conditions, the conclusion that both

u
the firms arrive at is to increase ad-expenditure if the other firm does so, and ‘don’t

. Ho
increase’, if the competitor ‘does not increase’. In the ultimate analysis, however, both
the firms will decide to increase the ad-expenditure. The reason is that if none of the
firms increases advertisement, Firm A gains more in terms of increase in its sales (`25
million) and the gain of Firm B is much less (`5 million only). And, if Firm B increases
advertisement expenditure, its sales increase by `10 million. Therefore, Firm B would do

td g
best to increase its ad-expenditure. In that case, Firm A will have no option but to
increase its ad-expenditure, Thus, the final conclusion that emerges is that both the
. L in
firms will go for advertisement war. In that case, each firm finds that it is doing the best
given what the rival firm is doing. This is the Nash equilibrium.
vt sh
Table 5.5 Pay-off Matrix of the Ad-Game
(Increase in sales in million Rs)
P li
ub

Check Your Progress


9. What is an
oligopoly?
P

10. According to
Chamberlin, what
are the effects of
s

sellers move?
However, there are situations in which there can be more than one Nash equilibrium.
11. How are collusive
If we change the pay-off, for example, in the south-east corner from (25, 5) to (22, 8)
a

models different
from non-collusive each firm may find it worthless to wage advertisement war and may settle for ‘don’t
ik

models of increase’ situation. Thus, there are two possible Nash equilibria.
oligopoly?
12. How is quota Concluding Remarks
V

determined under
the collusive model What we have presented here is an elementary introduction to the game theory. It can
of oligopoly? be used to find equilibrium solution to the problems of oligopolistic market setting under
13. Why is game theory different assumptions regarding the behaviour of the oligopoly firms and market conditions.
applied to
oligopoly analysis?
However, despite its merit of revealing the nature and pattern of oligopolistic warfare,
14. What is the essence
game theory often fails to provide a determinate solution.51
of the Nash
equilibrium?

Self-Instructional
214 Material
Price and Output
5.5 SUMMARY Determination

• Perfect competition is a market situation in which a large number of producers


offer a homogeneous product to a very large number of buyers of the product. NOTES
The number of sellers is so large that each seller offers a very small fraction of
t