BE - B69c0.course Pack PDF

PGEMP @ SPJIMR
Business Economics Pre Foundation Phase – Batch 69C0

Credit Faculty : Class sessions:5
1 Dr. Pallavi Mody
Course Introduction
Businesses do not operate in vacuum; they operate in an environment that constitutes a large
number of exogenous factors. Regardless of the sophistication of knowledge with the
management about their organization, no meaningful decision can be taken, without taking into
account the business environment.
Economics at PGEMP is conducted over two courses:
1. Business Economics -Pre Foundation Phase (Contact 0) – 1 credit
To give an understanding of the various Micro Economic concepts relating to business for
facilitating productive decision making for the organization and to provide the foundation for
decision making by the firm within the context of the micro environment.
2. Business Environment - Foundation Phase (Contact 1&2) – 1.5 credits
To gain an insight into the Macroeconomic concepts and Environment, which serve as critical
inputs for effective decision making. To derive an ability to scan your business environment with
the lens of Global Bench Marking Reports and an understanding of the various socio, economic
and political factors that affect businesses.
Overview of the course ‘Business Economics’ Pre Foundation Phase (Contact0):
Business Economics is a course that introduces microeconomic concepts and analyses supply
and demand. This course provides knowledge of various aspects of Managerial Economics that
are useful for decision making in business relating to Price, Costs of Production, Consumer
Behavior and Market Structures.
The course deals with theories of the firm and individual behavior, competition, costs of
production and market structures. Understanding the behavior of modern day consumers,
supply side production analysis and evaluating competition and the market structure is of prime
significance.
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PGEMP @ SPJIMR

1 Dr. Pallavi Mody
Themes
The following are the themes for ‘Business Economics’‘

Theme No: Topic Session:
Theme 1 Introduction to Economics Session 1
Theme 2 Demand analysis Session 2
Theme 3 Cost of production Session 3
Theme 4 Market Structures Session 4 & 5
Course Learning Outcomes
The Business Economics course is framed in a way to provide a holistic view and facilitate
better decision making ability.
At the end of the Business Economics course, participants will be able:
1. To gain an understanding of the microeconomics concepts for effective and productive

organizational decision making.
2. To have better understanding of consumer behavior to shape business strategies around
them.
3. To understand the demand and supply dynamics of the company and industry as a whole.
4. To understand the various costs of production and to apply various microeconomic
concepts including incentives/disincentives and opportunity costs.
5. To understand different market structures and their impact on company strategy and
profitability.
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PGEMP @ SPJIMR

1 Dr. Pallavi Mody
Pedagogy
The pedagogic mix includes class lectures, case studies, student exercises, along with the
prescribed textbook, articles, notes on concepts and assignments.
Resources
• Textbook: ‘Principles of Economics ’ by Mankiw (7th Edition)

• Besides the text book, students can access the Institute Library.
• Additional resources may include a variety of print & visual resources, handouts along
with class PPTs that will be shared on the Ekosh website.
Evaluation Pattern
C0
Off-campus Assignments 50%
Pre Foundation Exam 50%
This course pack is for the ‘Business Economics’ Course Contact 0 only
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PGEMP @ SPJIMR

1 Dr. Pallavi Mody
Course Outline (Contact 0)
Theme 1 – Introduction to Economics
Session Theme/Topic Activity in Pre-reads Other reading

class
1 Themes of Microeconomics: Class Mankiw Chapter 1
Session
• Consumer Choice
• Marginal Utility
Mankiw Chapter 2
Theme 2 – Demand Analysis

class
2 • Demand and Factors Class Mankiw Chapter 4
Affecting Demand session
• Elasticity of Demand and class Mankiw Chapter 5
• Consumer Surplus exercises
Mankiw Chapter 6
. Mankiw Chapter 7
Theme 3 –Costs of Production

class
3 • Concept of Costs Class Mankiw Chapter 13
• Cost Curves Session
• Long Run, Short Run and class
periods exercises
• Law of Diminishing
Return
• Economies and
Diseconomies of Scale
• Production Function and
Producer Surplus
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PGEMP @ SPJIMR

1 Dr. Pallavi Mody
Theme 4 –Market Structures

class
4&5 • Various Types of Market Class Mankiw Chapter 14
Structures Session Mankiw Chapter 15
• Revenue and Profit Mankiw Chapter 16
Maximisation Mankiw Chapter 17
• Market Equilibrium
OFF-CAMPUS ASSIGNMENTS
General Guidelines for Assignments
• Application assignments are given to encourage participants to relate their classroom

learning with their actual experience in work setting
• Participants are expected to bring in relevant concepts and theoretical frameworks in
their answers to the application assignments.
• While participants may discuss their ideas with their peers and may refer to different
sources of information, they should ensure that their answers most definitely reflect their
own thinking & analysis.
• If other sources of data / information have been quoted in your submissions then it
should be referenced.
• All assignment submissions should be through Ekosh.
• Plagiarism will be strictly penalized.
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PGEMP @ SPJIMR

1 Dr. Pallavi Mody
Application Assignment no 1: (10 Marks)
Costs of Production:
Describe any two measures taken by your company to reduce the long term cost of its product/service.
Guidelines:
Introduce your company and any one product/service of your company for this assignment, in a
couple of lines.
Elaborate on the measures taken to reduce the cost over a long period of time. You may support the
answer with graphs, figures and historic data.
Demand Analysis:
Identify any two product categories that have witnessed the Law of Demand function.
Guidelines:
Choose any two product categories. The two categories chosen can be belonging to the same
industry or different industry.
Explain in detail how the Law of Demand functions and is applicable to the two products chosen.
Market Structure:
1. A) Which market category does your industry belong to? Give reasons to justify your answer. (5m)
2. B) What are the challenges faced by your company while operating in this market structure? (5m)
Guidelines:
Introduce your company and choose any 1 product/service of your company for this assignment.
1. A) State the market category that your firm belongs to. (Monopoly/perfect Competition/Monopolistic
Competition/Oligopoly). Elaborate on the typical characteristics of this kind of market that are
prevalent in this industry.
2. B) State the problems that your firm faces due to above mentioned characteristics and elaborate on
how it tackles these problems to increase market share/profitability.
Please note: Marks will be deducted if any answer exceeds 300 words excluding charts, diagrams
and tables.
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MODULE 1: INTRODUCTION TO MANAGERIAL ECONOMICS
Managerial Economics comprises two disciplines. Management and Economics.
According to Peter Drucker, “Management is the discipline of organizing a firm’s scarce

resources to achieve its desired objectives”
According to Campbell McConnell “Economics is the study of the behavior of human beings in
producing, distributing and consuming material goods and services in a world of scarce
resources”
Managerial Economics is therefore the use of Economics in business decision making.
Let us consider an example to find out what Managerial Economics actually comprises.
The Saab division of General Motors made huge losses. In order to break even or cover all costs,
it had to sell at least 80,000 cars annually which it was unable to do since 2009. The following
chart depicts the shortfall in Saab’s global sales.
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In 2010 Saab was acquired by Spyker cars and it continued to make losses. In order to overcome
this, Spyker cars undertook the following steps:
• It introduced a new model called the Phoenix which is a cross over utility vehicle. A cross
utility vehicle is an ordinary car made to look like a rugged off-road vehicle.
• It entered into a deal with BMW for supply of BMW power trains (engines) for its future
models
• It lined up new distribution arms in China and Russia which were two big markets
hungry for fancy cars.
These steps were supposed to enhance the demand for the car without reducing the price, in spite
of competition from other auto companies. These steps were expected to facilitate an increase in
sales or revenue to at least reach the target of 80,000 cars per year.
As we can see from this example, the company took decisions relating to price, exploration of
new markets and facilitating adequate value addition. Such decisions are based on certain
fundamentals of Economics.
Managerial Economics therefore, deals with those fundamentals that are useful for decision
making in business.
In this pre-program module of Managerial Economics we will cover four modules:
• Demand and Supply

• Elasticity of Demand and Supply
• Production and Cost
• Market Structures
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MODULE 2 : DEMAND AND SUPPLY
In any business, the consumer or customer plays a very crucial role. It is therefore very important
to have an adequate understanding of consumer behavior, in order to take the right decisions.
The willingness and ability of a consumer to buy a product is extremely vital for any company.
This willingness and ability to buy a product is termed as DEMAND.
Let us not mix up ‘demand’ and ‘want’. A person has unlimited wants but demand relates to only
those wants for which a person has a willingness and ability to purchase
The basis of demand in consumer behavior is utility.
Utility refers to the satisfaction a person obtains from consuming a product or service.
When a person consumes a particular product, he gets a certain amount of satisfaction. If we
assume that we can measure this satisfaction using a unit of measure called utils, then the total
utils a person gets by consuming a certain number of units of the product or service is called
TOTAL UTILITY.
Now, as a person consumes more and more units the additional utils of satisfaction he gets from
every additional unit is called MARGINAL UTILITY.
According to a well-known Economist of the 19th century, Alfred Marshall, as a person consumes
more and more of a product or service, the marginal utility falls with every additional unit
consumed. This is called ‘The Law of Diminishing Marginal Utility’.
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Let us use an example to illustrate this very useful law:
Let us consider Sam’s consumption of chocolates. Even though Sam is very fond of chocolates, he is
likely to get bored and tired of them as he consumes more and more of them. As a result, his
Marginal Utility of chocolates tends to fall, become zero and then even negative This is depicted in
the following table and chart.
Units of Total Marginal

Chocolate Utility Utility
1 10 10
2 18 8
3 24 6
4 28 4
5 28 0
6 24 -2
30
20
Total
Utility
10
Marginal
Utility
0
1 2 3 4 5 6
-10
We can see in the chart that when Sam consumes one chocolate he gets satisfaction measured in
utils equal to 10. When he increases his consumption of chocolates to 2,he gets only 8 additional
utils of satisfaction, when he consumes the third chocolate he gets only 6 additional utils and so
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on. The additional utils of satisfaction that Sam derives with every additional chocolate
consumed is the Marginal Utility. The sum of Marginal utilities is the total utility derived. For
example, when he consumes the first chocolate, he gets 10 utils, when he consumes the second
chocolate he gets 8 utils, therefore his total utility after the second chocolate is 18. Similarly the
total utility after the third chocolate is 24 utils and so on.
As seen in the chart measuring chocolates on the X axis and utility on the Y axis, the following
holds true:
• As Sam consumes more and more chocolates, Total Utility increases and after a point
decreases.
• When Total Utility Increases, Marginal Utility is positive but decreases.
• When Total Utility is constant Marginal Utility is Zero
• When Total Utility Decreases, Marginal Utility becomes negative.
Marginal Utility is therefore the slope of the Total Utility curve since it measures the rate of
change in Total Utility.
We can use an equation to represent this relationship.
MU = ∆ TU/ ∆ Q ( change in TU/Change in Q)

Where,
MU is Marginal Utility
TU is Total Utility
Q is quantity of chocolates
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Now let us change the situation a little bit. What if Sam has to pay for the chocolates he
consumes? If we assume that the price of each chocolate is $6, then Sam will compare the MU
he gets from each additional chocolate he consumes and accordingly decide whether he should
go ahead with consuming the chocolate. This is depicted in the following table:
Units of Total Marginal Price

Chocolate Utility Utility ($)
1 10 10 6
2 18 8 6
3 24 6 6
4 28 4 6
5 28 0 6
6 24 -2 6
For the first unit of chocolate, Sam gets a MU of 10 utils, which is greater than the price he pays
which is $ 6. For the second unit, his MU is 8 which is again greater than the price. At the third
unit, his MU is equal to price and for every unit beyond that, the MU is less than price.
Therefore how many chocolates will Sam consume?
Sam will obviously consume three chocolates because any chocolate more than three is not
worth consuming since the MU or satisfaction he gets is less than price he has to pay for it. Sam
will therefore consume that many chocolates at which MU is equal to price, not more, not less.
The condition for equilibrium is therefore :

MU = Price
If now, the price of chocolates were to fall to $4, then how will Sam’s consumption change?
The above table indicates that Sam will now consume 4 chocolates at which the MU is equal to
the new price. This means that Sam will consume more when price falls.
On the other hand, if the price were to rise to $8 then he will consume 2 chocolates which means
that Sam will consume less with a price rise.
From this we can conclude that the MU curve is also the demand curve which is clear in
this figure.
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MU/
PRICE
P1 MU = P1
P2 MU = P2
Q1 Q2
UNITS OF CHOCOLATE
This will help us understand why the MU curve is also the demand curve.
If we reduce the price from P1, that is $ 6 to P2 that is $ 4 then the new equilibrium will shift
Q1, that is 3 chocolates to Q2 that is 4 chocolates which means that Sam will consume more
when price falls.
Therefore at P1 or price = $ 6, MU = P1)
At P2 or Price = $4, MU = P2
The MU curve is therefore also the demand curve.
A very useful concept that emerges from this discussion is ‘Consumer’s Surplus’. Most of the
time, consumers are willing to pay more than what they actually pay. This is because; their
Marginal Utility is very often more than the price.
The difference between the MU or the amount that a consumer is willing to pay for something
and what he actually pays is called the consumer’s surplus.
In our earlier example, at 1 unit of chocolate Sam has an MU of 10 and the price is $6 and so his
consumer’s surplus is 10 – 6 = 4.
The sum of all such surplus on each unit consumed is the total consumer’s surplus which is the
area of the triangle shown in the following figure.
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In our earlier
MU/
PRICE
Consumer's
Surplus
UNITS OF CHOCOLATE
Consumer’s surplus is an important concept for the seller because, he can use this to formulate
different forms of pricing for his product and thus enhance his gain.
A seller actually faces a market demand curve for his product. The market demand curve is the
sum of the demand curves of all individual consumers comprising a particular market for a
certain product or service.
Let us use an example to find out how a market demand curve can be derived.
Let us assume that George wants to set up a new restaurant offering buffet lunches. He studies
the market and finds that there are three categories of prospective customers, High income
group, middle income group and low income group. He surveys the behavior of these groups
and finds out their MU or willingness to pay. His findings are summarized in the following table.
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Price High Middle Low Market
($) Income Income income Demand
Group Group group
10 0 0 0 0
9 1 0 0 1
8 2 1 0 3
7 3 2 1 6
6 4 3 2 9
The figures appearing below each group represents the number of buffet lunches purchased by
each group in a week at the corresponding price. This is obviously a function of their marginal
utility. For instance, when the price of a buffet lunch is $ 10, no consumer from any group is
willing to purchase a buffet lunch in a week. This is because the price is greater than their MU of
the buffet lunch. If the price is $ 9, only one consumer from the high income group and no
consumer from the other two groups is willing to purchase a buffet lunch. The last column
represents the total market demand for buffet lunches at each price. This column when
represented in a graph shows the relationship between price and the market demand for buffet
lunches as seen in the following figure. This curve is therefore called the market demand curve.
PRICE
10
9
8
7
6
MARKET
DEMAND
0
1 3 6 9
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Let us now see how the concept of consumer’s surplus can be applied by a seller.
The consumer’s surplus derived from the market demand curve represents a potential for the
seller to charge a higher price to some consumers who are willing to pay more for the product
or service and thus increase their revenue and profits. This is done by segmenting the market
and charging a different price to each segment depending on their willingness to pay. For this
however it is important to also differentiate the product offered to each segment.
Examples are:
• The Airline Industry offers different services at different prices to their First class,
Business class and Economy class passengers.
• A telecom company caters to different segments by offering different schemes with a
different price combination of rentals and per minute charges.
• An automobile company offers different variants of the same model of a vehicle at
different prices to cater to different segments according to their willingness to pay.
We can conclude our discussion on ‘Demand’ by stating the Law of Demand
“Ceteris Paribus (all factors affecting demand, other than price, remaining
constant), when the price of a product falls the demand rises and when the price
rises the demand falls.”
This is also referred to as a movement along the demand curve as depicted in the
following figure.
PRICE
P1
P2
Q1 Q2 UNITS
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Demand for a product can change due to factors other than price. Some of the factors (other than
price) affecting demand are as follows:
• Income of the consumers.
• Population.
• Price of related goods.
• Change in tastes and preferences.
When there is a change in any of these factors, there is a shift of the demand curve implying
that at the same price there is either a higher or lower demand.
For example, if there is an increase in the income of people in a region then the market demand
curve for cars may increase as represented by a shift of the demand curve to the right from D1 to
D2 in the following figure.
PRICE
D2
D1
Q1 Q2 UNITS OF
CARS
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Now let us move on to supply.
Supply relates to the quantity of a product or service that a seller is willing to offer at a particular
market price, given the cost of producing it.
The supply curve represents the relationship between the quantity supplied by the seller and the
market price of the product and service.
Ceteris Paribus (all other factors, affecting supply, remaining constant), the seller will supply
more when the price rises and will supply less when the price falls. The supply curve is therefore
upward sloping as shown in the following figure.
PRICE S
P2
P1
Q1 Q2 UNITS
SUPPLIED
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Factors other than price also affect supply. They are as follows:
• Input prices.
• The state of technology.
• Expected price of the product.
• Number of firms in the industry.
When there is a change in any of these factors, there is a shift of the supply curve implying that
at the same price there is either a higher or lower supply.
For example, if there is an increase in the input prices then the supply may decrease as
represented by a shift of the supply curve to the left from S1 to S2 in the following figure.
S2
S1
PRICE
Q2 Q1 UNITS
SUPPLIED
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Have you ever wondered how prices are determined in the market? Why is it that the price of
certain products is high and some others have low price?
This price is a result of the interaction between the demand and supply of a product.
Let us use the example of the price of wheat represented in the following figure to understand
this.
PRICE
OF
WHEAT S
P1
P
D1
D
Q1 KILOGRAMS OF WHEAT
The price of wheat is determined by the market forces of demand and supply in a competitive
environment, at the point where demand meets supply. In the above figure, the market price is
P where the demand curve cuts the supply curve. If now, demand increases ( due to a factor
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other than price) the demand curve shifts to the right and given that the supply remains the
same, the new price is determined at a higher level P1 where the new demand curve D1
intersects the supply curve.
A change and shift in either the demand or supply curve brought about by a change in a factor
affecting demand or supply, other than price, leads to the determination of a new market
equilibrium price.
Have you realized that the price of gold has been rising after the financial crisis of 2008? This is
an outcome of a change in market equilibrium price resulting from a rise in the demand for
gold. Due to rising risks associated with financial assets like bonds and shares, after the crisis,
investors have been diverting funds towards investment in gold. This led to an increase in the
demand for gold and a shift in the demand curve, the supply remaining the same, resulted in a
rise in the price of gold.
Demand and Supply are therefore the main factors affecting the price of all products and
services in the economy.
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MODULE 3: ELASTICITY OF DEMAND AND SUPPLY
Pricing forms an important part of decision making in Business. A firm may be required to either
raise or reduce the price of the product to achieve a certain objective like facilitate an increase
in sales or revenue. This module deals with the concept of elasticity of demand that is the
underlying foundation of pricing decisions.
Sales or revenue is measured by multiplying the price per unit of the product with the number
of units sold (P*Q). A change in price leads to a tradeoff resulting from the law of demand
discussed in the previous module.
When the price is raised, as per the law of demand, it leads to a fall in demand. Therefore the
price rise puts two opposite pressures on the sales. From the price side there is an upward
pressure and from the demand or quantity side there is a downward pressure. The final
pressure on sales will depend on which of the two is stronger, the rise in price or the fall in
demand. This relative strength depends on the price elasticity of demand.
Price elasticity of demand = percentage change in demand /percentage change in price
= {(∆ Q/Q)/( ∆ P/P)}
Let us use an example to illustrate the concept.
Consider that Haagen Dazs is selling its ice cream cones at S$5 each and at this price it can sell
1000 cones per day in Singapore. When the company decided to raise the price to S$ 6, they
found that the number of cones sold per day came down to 900.
By considering the above mentioned data, we can calculate the price elasticity of demand for
Haagen Dazs cones as follows:
Price elasticity of demand =(( 900- 1000/1000)/(6-5)/5) = -0.5
The negative sign indicates the inverse relationship between price and demand and 0.5
indicates the magnitude of the relationship between price and demand. In this case, it implies
that the percentage change in quantity is less than the percentage change in price and elasticity
is less than one.
A word of caution here,….when considering whether elasticity is less than one, greater than one
or equal to one, the sign has to be ignored.
Let us now discuss the various forms of price elasticity of demand. They are:
• Perfectly Elastic
• Relatively Elastic
• Unit Elastic
• Perfectly inelastic
• Relatively inelastic
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Perfectly Elastic Demand
In highly competitive markets, the firm has no control over price and can therefore sell any
number of units at the same market price. The demand curve facing such a firm is horizontal
and the firm’s product is said to have perfectly elastic demand.
In such markets, the firm faces a horizontal demand curve like this one:
PRICE PRICE
D
S
P
P
QUANTITY DEMANDED
In the figure, the price is determined by the market at P. The firm has to sell all units at the same
price. If it raises the price even a little, then demand will fall to zero. If it lowers the price, then
demand will rise infinitely, that is, all the competitors’ customers will now buy from this firm.
The firm cannot however lower the price, since competition has ensured that the market price
is at the lowest possible level. Elasticity is therefore said to be infinite:
e=∞
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We now move on to Relatively Elastic Demand
In some sectors like the FMCG (Fast Moving Consumer Goods) sector, each firm has some
limited control over the price but still faces stiff competition in the market. That is why products
in this sector have similar prices but not same price. The demand for the firm’s product in such a
sector is said to be relatively elastic. This means that the percentage change in demand is greater
than the percentage change in price.
This is depicted in the adjoining figure. When price rises from P1 to P2, the demand falls more
than proportionately from Q1 to Q2.
elasticity is said to be greater than 1:
e > 1.
Thus, the demand curve is a downward sloping and relatively flat:
PRICE
P2
P1
D
Q2 Q1
QUANTITY DEMANDED
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Unit Elasticity of Demand
In some cases, the change in quantity demanded is equal to the change in price.
Such a demand is said to be unit elastic and elasticity is equal to one:
When price rises from P1 to P2,
the demand falls in equal proportion from Q1 to Q2.
e=1
PRICE
P2
P1
Q2 Q1
QUANTITY DEMANDED
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Perfectly Inelastic Demand
In the case of a pure monopoly where the single seller does not face any competition, the change
in price brings about no change in the quantity demanded. In such a case elasticity is said to be
Zero.
e=0
The demand curve in such a case is vertical:
PRICE
P2
P1
Q1
QUANTITY DEMANDED
In this case, the demand curve is vertical.This is normally a hypothetical case because even a
monopolist faces competition from products that are remote substitutes. For instance, air
transport service faces competition from railways.
Relatively Inelastic Demand
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In some sectors, each firm has more control over the price. The demand for the firm’s product in
such a sector is said to be relatively inelastic. When price rises from P1 to P2, the demand falls
less than proportionately from Q1 to Q2.This means that the percentage change in demand is less
than the percentage change in price and elasticity is said to be less than 1:
e<1
PRICE
P2
P1
Q2 Q1
QUANTITY DEMANDED
So then what do you think?
If a firm’s product has price elasticity of demand less than 1 and it wants to increase its sales,
should it raise the price or reduce the price?
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Obviously it should raise the price because, for such a product, a rise in price will lead to a less
than proportionate fall in demand leading to an increase in sales.
Now try this one!
If the firm’s product has a relatively elastic demand what should it do to increase sales?
The price should be lowered. This is because for such a product a fall in price will lead to a more
than proportionate rise in demand leading to an increase in sales.
Elasticity of Demand is one of the most important concepts of Economics used in business
decision making. The following example will help you understand it better:
Sunflower Corporation’s Vice-President circulates a memo to the top management in which he

argues for a reduction in the price of the firm’s product. He says that such a price will increase
the firm’s sales.
The firm’s marketing manager does not agree with the Vice-President and he points out that the
price elasticity of demand for the firm’s product is about - 0.7. Why is this fact relevant?
This fact is relevant because since the elasticity of demand is less than 1, a fall in price would
lead to a less than proportionate rise in demand or in other words, the percentage rise in demand
will be less than the percentage fall in price. This would bring about a fall in sales rather than a
rise in sales.
Another important point that should be noted is that, at the current price, Sunflower Corporation
has a price elasticity of demand of -0.7. At a different price, its elasticity will be different.
This brings us to the concept of point elasticity of demand
The price elasticity of demand on every point of the demand curve is different. This can be
understood from the following:
Price elasticity of demand = {(∆ Q/Q)/( ∆ P/P)}
= (∆ Q/ ∆ P)/(P/Q).
Q/ P relates to the slope of the demand curve and P/Q relates to a point on the demand curve.
In a linear demand curve, though the slope of the curve remains the same on all points of the
demand curve, the P/Q is different. On the upper part of the demand curve P/Q is higher and so
elasticity is higher and greater than one. On the lower part of the demand curve since P/Q is
lower, the elasticity of demand is lower and less than one. At the mid-point of the demand curve
elasticity is equal to one.
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PRICE
e>1
e=1
e<1
QUANTITY DEMANDED
Besides Price Elasticity of Demand, there are other forms of Elasticity of demand.
We will discuss two of them:

• Income Elasticity of Demand
• Cross Elasticity of Demand
Income elasticity of demand = percentage change in quantity demanded / percentage change in

income = (∆Q/Q)/( ∆I/I) = (∆Q/∆I) (I/Q) (Where I stands for income).
Income elasticity of demand is usually positive because when incomes rise, consumers normally
buy more of a product or service. In some cases however, like travel in public transport for
instance, people consume lesser when their incomes rise since they can now afford a better
product or service like travel in one’s own car. Such a product or service is called inferior and
the income elasticity is negative.
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A seller cannot ignore the price change undertaken by other sellers especially of products that are
either substitutes or complements to his own product. The impact of a change in the price of such
a related product on the demand of the seller’s product is called cross elasticity of demand
Cross elasticity of demand = % change in quantity demanded of product A / % change in price of

product B= (∆Q /Q )/( ∆P /P ) = (∆Q /∆P ) (P /Q )
A A B B A B B A
Cross elasticity can be negative or positive and this depends on whether A and B are substitutes
or complements.
In the case of substitute products like Pepsi and Coke, the cross elasticity of demand is positive
since the fall in the price of Pepsi will bring about a fall in the demand for coke.
In the case of complements like automobiles and petrol, the cross elasticity of demand is
negative, since a rise in the price of petrol will bring about a fall in the demand for automobiles.
Now let us quickly discuss Price elasticity of Supply which is similar to elasticity of demand.
The price elasticity of supply measures how much the quantity supplied responds to a change in
price. In other words, the elasticity of supply depends on the flexibility of the sellers to change
the supply of the goods they produce with respect to the change in the price of the good.
Price elasticity of supply = percentage change in quantity supplied/ percentage change in price.
= (∆Qs/Qs)/( ∆P/P) = (∆Q /∆P) (P/Q )
s s
Let us use and example to illustrate the application of the concept:
If the price of oil in the international market rises from $ 90 to $ 100 per barrel and the supply of
oil by Saudi Arabia increases from 8 m barrels per day to 9 m barrels per day, then the price
elasticity of supply = ((9 – 8)/9) / ((100-90)/90)= 0.1
Elasticity of supply is usually positive because when there is a rise in price, there is a rise in
supply.
What is the significance of price elasticity = 0.1?
Here, since elasticity of supply is less than one it implies that the production and supply of oil in
Saudi Arabia is less flexible with respect to price.
We will now discuss the types of elasticity of supply.
30
Perfectly Elastic Supply.
In such a case, the supply curve is horizontal implying that at any price higher than P, the supply
is infinite and at any price less than P, the supply is zero. Elasticity of supply is said to be
infinitely elastic. Such a supply curve is represented in the following figure.
PRICE
e=∞
P
QUANTITY SUPPLIED
We now move on to Relatively Elastic Supply
In some cases supply is said to be relatively elastic implying that a small difference in price will
bring about a large change or more than proportionate change in supply. The supply curve is
therefore flat but upward sloping as seen in the figure..
When price rises from P1 to P2, the supply rises more than proportionately from Q1 to Q2.
31
elasticity of supply is said to be greater than 1:
e > 1.
PRICE
P2
P1
Q1 Q2
QUANTITY SUPPLIED
Unit Elasticity of Supply
In some cases, the change in quantity supplied is equal to the change in price. Such supply is said
to be unit elastic and elasticity is equal to one:
e=1
32
In this figure, we see that a rise in price from P to P1 leads to a proportionate rise in supply by Q1Q2.
PRICE
P2
P1
Q1 Q2
QUANTITY SUPPLIED
Perfectly Inelastic Supply

In some cases supply is not flexible and the change in price brings about no change in the
quantity demanded. In such a case elasticity of supply is said to be Zero.
33
e=0
The supply curve in such a case is vertical: A rise in price from P1 to P2 leads to no change in
supply.
PRICE
P2
P1
Q
QUANTITY SUPPLIED
Relatively Inelastic Supply

In some sectors, each firm has more control over the price. The supply for the firm’s product in
such a sector is said to be relatively inelastic. This means that the percentage change in supply is
less than the percentage change in price and elasticity is said to be less than 1:
e < 1. This is depicted in the following figure.
34
PRICE
S
P2
P1
Q1 Q2
QUANTITY SUPPLIED
When price rises from P1 to P2, supply rises less than proportionately from Q1 to Q2
The various types of Price Elasticity of Supply is illustrated in the following box.
35
Besides pricing decisions of sellers, price elasticity of demand and supply are useful in analyzing
the impact of a commodity tax on a consumer and a seller.
When the government imposes a tax on a commodity, the price the buyer has to pay increases
and the price the seller receives decreases. This is illustrated in the following figure.
36
D
PANEL A
L
S
PANEL B
S
L
T
D
M
In panel A, the tax is = LM. The demand is relatively inelastic and the supply is relatively elastic.
With the tax, the buyer’s price increases by TL and the seller’s price decreases by TM. The
increase in buyer’s price is more than decrease in seller’s price.
In panel B, demand is relatively elastic and supply is relatively inelastic and so the increase in
buyer’s price (TL) is less than the decrease in seller’s price (TM)
37
PRODUCTION AND COST
We now move on to a different aspect of Microeconomics, that is cost.
If a company’s primary objective of being in business is to earn profits then we know that it is
important to minimize the cost of production.
In order to understand cost we have to first understand what a production function is.
A production function is a functional relationship between units of output produced and units of
inputs used given a certain technology. It relates to a particular time period, for example a day, a
week, a month etc. It is assumed that in a production function, all units of inputs are most
efficiently used.
A production function can be represented as:
100Q = f (10 R, 2L,3K………T)
Here Q stands for quantity of output, R stands for raw material, L stands for labour, K stands for
capital and T stands for technology.
This relationship states that, to produce 100 units of output most efficiently, the firm would need
10 units of raw material, 2 units of labour and 3 units of capital with a constant particular
technology. If the technology changes then this functional relationship changes.
This production function therefore helps us to understand what is the most efficient combination
of inputs required to produce a certain level of output. If a firm is using, for instance 5 units of
labour to produce 100 units of output with this technology, then it is inefficient and would
require to reduce its labour input to 2 units.
There are two forms of Production functions:
• Short run production function

• Long run production function
In the short run production function, some factors are fixed. Here the firm operates with a
given capacity constraint and so the firm cannot increase output infinitely without incurring
higher costs.
In a long run production function, all factors are variable and so there is also a change in
capacity. This production function involves the crucial decision of capacity change.
Let us now understand what is exactly meant by a short run production function with the help of
an example.
38
The number of chips packets the Uncle Chips factory can produce per day depends on the
number of workers it employs. This is given in the following table.
Units Total Marginal

of Product Product
Labor
0 0 0
1 8 8
2 17 9
3 18 1
4 18 0
5 16 -2
In the table we see that for zero workers zero chips are produced. When there is an increase in
the number of workers, there is an increase in the number of chips packets that are produced per
day, up to a certain number of workers. For example, 1 worker produces 8 packets of chips, two
produce 17 packets and so on. This represents the total output or Total Product or TP.
We notice that the increase in the output is not proportionate to the increase in workers.
The first worker produces 8 packets but the second worker adds on 9 more packets, the third
worker adds on one more packet and so on. This addition made to total product by every
additional worker is called the Marginal Product or MP.
Marginal Product or MP is the rate of change in the total product TP or the slope of TP.
This can be represented in the following equation:
MP = ∆TP/∆L, where L stands for units of labour employed.
There are actually three stages operating in the production function represented in the table.
Stage 1 represnts the movement from labor 1 to 2. Here Total Product increases at an increasing
rate and therefore Marginal Product increases. Marginal Product increases between the first and
second worker from 8 packets of chips to 9 packets
Stage 2 represents movement from labor 2 to 3. Here Total Product increases at a decreasing
rate and Marginal Product decreases. Marginal Product falls between the second worker and the
third worker, from 9 packets to 1 packet of chips.
Stage 3 represents movement from labor 4 to 5. Here Total Product falls and Marginal Product
becomes negative. In this stage we see that marginal product falls to a negative 2.
This is called the Law of Diminishing returns or The Law of Variable Proportions.
This law operates because there is a variable proportion between the fixed factor and the variable
factor.
39
There are two main types of factor resources in the short run: Fixed factors and Variable
factors.
The use of fixed factors remains constant in the short run.

Examples of fixed factors are:
Land/Factory/Office premises
Machinery
Factors that change with output are called variable factors. Examples of variable factors are”
• Raw material
• Fuel
• Labour
In this example, in the beginning; the fixed factor is more in comparison to the variable factor
and so marginal product increases with additional labor or variable factor used. Later on the
variable factor labor is large in comparison to the fixed factor and so the marginal product falls
and becomes negative.
This varying proportion of inputs therefore causes a variation in productivity and therefore costs.
It is this law that influences the variation in costs in the short run when output is increased by
increasing the variable factors and the capacity is fixed.
We will now move on to examine two important types of cost.
Opportunity cost
Sunk cost
A cost concept that is used not only in business but in day to day living is opportunity cost.
Opportunity cost is the benefit forgone from the next best use of a factor resource.
For example, the opportunity cost of using steel to manufacture cars is the benefit derived from
using steel for its next best alternative use which maybe washing machines. That is, steel could
have also been used to manufacture washing machines and this would have yielded a benefit.
This forgone benefit is the lost opportunity or opportunity cost to a manufacturer of using this
steel to manufacture cars instead.
A concept that is significant for a firm when it has to decide on closing down or selling off its
business is Sunk Cost.
Sunk Costs are costs that are incurred and cannot be recovered even if the firm closes down.
40
For example, the costs incurred on office furniture are sunk costs because even if the firm closes
down, it cannot recover these costs.
The opportunity cost of this furniture is zero and so it cannot be considered in future decision
making.
After having discussed these forms of costs let us try to understand how a firm’s costs vary with
output in the short run.
For this, we will return to our example of Uncle Chips discussed before.
Given the following information, you should try to derive the costs for Uncle Chips using the
earlier table.
Units of Total Product Marginal

Labor Product
0 0 0
1 8 8
2 17 9
3 18 1
4 18 0
5 16 -2
If the fixed costs per day for Uncle chips is $ 100, the raw material cost is $1 per packet of chips
and the labor cost is $20 per worker per day, find out the Total Variable Cost, Total Fixed cost
and Total Cost for uncle chips at different levels of output or Total Product using the earlier table
.
Of course for, this, you need to first be able to say which are the variable costs and which is the
fixed cost.
41
The variable factors in this example are labour and raw material. Why is this so?...because these
factors, if used in varied quantities would lead to a variation in output.
and so the cost of labour plus raw material is the variable cost and the fixed cost is given to you.
We will derive each of the short run costs slowly:
The first concept is Total Fixed Cost or TFC

TFC is the cost incurred on all the fixed factors of production. Since the use of total fixed factors
do not change with output, the fixed cost remains the same at all levels of output or total product.
In our example, the fixed cost is $100 and so the TFC remains $100 at all levels of total product
or output as represented in this table:
TOTAL PRODUCT TOTAL FIXED

(Q) COST (TFC) ($)
0 100
8 100
17 100
18 100
18 100
16 100
If we represent this on a graph with TFC measured on the Y axis and total product or output
measured on the X axis, we will derive a horizontal flat curve implying that the total fixed cost
remains constant at all levels of output.
Total
Fixed
Cost
TFC
OUTPUT
42
The next concept is Total Variable Cost or TVC.
Total Variable Cost or TVC is the cost incurred on variable factors and therefore varies with
output.
In our example, there are two variable factors, labour and raw material. The total variable cost is
therefore the cost incurred on these two factors. This is calculated by finding out the total labour
cost and total raw material cost incurred at each level of total output.
The TVC so derived is represented in the table.
TOTAL VARIABLE
TOTAL COSTS
PRODUCT
(TVC) = RAW
(Q)
MATERIAL COST
+ LABOR COST
0
8 28
17 57
18 78
18 98
16 116
For example, for 8 packets of chips, 1 worker and 8 units of raw material are used. The cost
incurred on one worker is $20 per day and for 8 units of raw material is 8*$1, that is $8.For 8
packets of chips, therefore, the TVC or total variable cost is $20+$8 = $28. Similarly, we derive
$57 as total variable cost for 17 units and $ 78 for 18 packets of chips and so on.
If we represent this on a graph with TVC measured on the Y axis and total product or output
measured on the X axis, we will derive an upward sloping curve implying that the total variable
cost rises with output. This rise in TVC need not be linear or in other words, TVC need not rise
at a constant rate. The rate at which TVC will rise will depend on the way the TVC changes with
additional output.
43
Total TVC
Variable
Cost
TVC
OUTPUT
The sum of total fixed cost and total variable cost is total cost.
TOTAL COST (TC) = Total Fixed Cost + Total Variable Cost = TFC +TVC This is represented
in the following table:
•
TOTAL
VARIABLE
TOTA COSTS TOTAL
TOTAL L (TVC) = COST
PRODUCT FIXED RAW (TC) =
(Q) COST MATERIAL TFC
(TFC) COST + +TVC
LABOR
COST
0 100
8 100 28 128
17 100 57 157
18 100 78 178
18 100 98 198
16 100 116 216
44
For 8 packets of chips, the total cost is total variable cost, $28 + total fixed cost$100 =
$128. In the same way, the total cost for 17 units can be derived as 157 and so on.
If we represent this on a graph with Total Cost or TC measured on the Y axis and total product or
output measured on the X axis, we will derive an upward sloping curve implying that the total
cost rises with output.
TC
Total
Cost
TC,
TFC
TFC
OUTPUT
Since TC is the Sum of TFC and TVC, at zero output, Total cost is equal to total fixed cost.
This means that the TC curve starts on a positive value on the Y axis and from that point with the
increase in output, TC rises. The rise in TC depends on the rise in TVC, since TFC does not
change, and so the rate of change in TC is equal to the rate of change in TVC.
45
We can represent total cost total fixed cost and total variable costs as follows:
TC
Total
Cost TVC
TC,
TFC
TFC
OUTPUT
As can be seen from the figure, the slope of the TC curve is the same as the slope of the TVC
curves, or in other words, the total cost and total variable cost changes at the same rate.
That brings us to the next concept of cost and that is marginal cost. The rate at which total cost or
total variable cost changes is called marginal cost.
Marginal Cost is the addition made to Total Cost by producing one more unit of a product.
MARGINAL COST =Change in Total Cost/ Change in quantity= ∆TC/∆Q
The following table shows the variation in Marginal Cost as the output varies.
46
TOTAL
COST MARGINAL
(TC) = COST =
TFC ∆TC/∆Q
+TVC
128 3.5
157 3.2
178 21
198
216
Between 8 packets and 17 packets every packet incurs a marginal cost or additional cost of
change in total cost/ change in number of units or packets of chips produced,
At 17 packets, Marginal Cost is equal to 157 of total cost at 17 packets minus 128 of total cost at
8 packets divided by 17 minus 8 which is equal to 29 divided by 9 equal to 3.5.
The marginal cost between 17 and 18 packets is $21.
If we represent this on a graph with Marginal Cost or MC measured on the Y axis and total
product or output measured on the X axis, we will derive a U shaped curve implying that as
output increases, at first total cost rises at a falling rate and then total cost rises at a rising rate.
47
MC
Marginal
Cost
OUTPUT
Now we move on to deriving the average costs.
Average costs include the following:
• Average Fixed Cost (AFC)

• Average Variable Cost (AVC)
• Average Cost (AC)
• Average Fixed Cost refers to the per unit fixed cost and is measured as Total Fixed
Cost/Quantity = TFC/Q.
• AFC is represented in the following table:For the first 8 packets, fixed cost is $100
and so the average fixed cost is $100/8 = $12.5. For 17 packets, the Total Fixed
Cost remains $100 and so the Average Fixed Cost = $100/17 = $5.9 and so on.
48
AVERAGE FIXED
TOTAL PRODUCT TOTAL FIXED
COST (AFC) =
(Q) COST (TFC)
TFC/Q
0
100
8
100 12.5
17
100 5.9
18
100 5.6
18
100 5.6
16
100 6.3
Since Average Fixed Cost = Total Fixed Cost/output and since the total fixed cost remains
constant, as output increases, Average Fixed Cost decreases. This is represented in the following
graph:
AFC
AFC
Quantity of
output
49
Average Variable cost, AVC, refers to the per unit variable cost. It is measured as Total Variable
Cost/output.
The Average Variable costs for Uncle Chips is represented in the following table:For 8 packets
of chips, total Variable Cost = $ 28 and so the AVC = $28/8 = 3.5.
For 17 packets, Total Variable Cost = $ 57 and so AVC = $57/17 = $ 3.4 and so on.
TOTAL
VARIABLE
COSTS AVERAGE
TOTAL
(TVC) = VARIABLE
PRODUCT
RAW COST (AVC) =
(Q)
MATERIAL TVC/Q
COST +
LABOR COST
8
28 3.5
17
57 3.4
18
78 4.3
18
98 5.4
The AVC curve is a U shaped curve. For the initial units of output, AVC falls and then it rises.
This is represented in the following Graph.
AVC AVC
Output
The AVC Curve is U shaped because of the operation of the law of variable proportions. In the
beginning, when productivity rises or Marginal Product rieses then Average Variable Cost falls.
Later, when productivity falls average variable cost rises.
50
Average Cost is the per unit Total Cost. It is the sum of the average fixed cost and Average
Variable cost.
Average Cost can be represented in the following table:For 8 packets of chips, the average fixed
cost is $12.5 and the Average Variable Cost is $3.5. Therefore, the Average Cost or AC =
$12.5+$3.5 = $16. Similarly, for 17 packets, the average fixed cost is $5.9 and the average
variable cost is $ 3.4. Therefore the average cost = $5.9+$3.4 = $ 9.2 and so on.
TOTAL
VARIABL
AVERAG E COSTS
AVERAGE AVERAGE
TOTAL E FIXED (TVC) =
VARIABLE COSTS
PRODUCT COST RAW
COST (AVC) ( AC)= AFC
(Q) (AFC) = MATERIA
= TVC/Q +AVC
TFC/Q L COST +
LABOR
COST
8
12.5 28 3.5 16
17
5.9 57 3.4 9.2
18
5.6 78 4.3 9.9
18
5.6 98 5.4 11
16
6.3 116 7.3 13.5
51
The AC curve can be represented in the following graph:
AC AC
Output
Since the Average Cost is the sum of the Average Fixed Cost and Average Variable Cost, it is U
shaped.
At fewer units of output, Average Variable Cost, AVC, is falling and Average Fixed Cost, AFC,
is also falling and as a result Average Cost, AC, falls. as seen in the figure.
After a certain level of output, Q in the figure, AVC starts rising but AFC continues to fall. The
course of the AC from thereon depends on the relative strength of the fall in AFC and the rise in
AVC.
At first, the fall in AFC is stronger and so AC continues to fall up to a certain level of output Q1.
In that output range,Q1Q2, AC and AVC move in opposite directions.
After that, the rise in AVC becomes stronger than the fall in AFC and so AVC starts falling
Another important point to note is that the Marginal Cost curve cuts the Average Cost Curve and
Average Variable Cost curve at their minimum points. In other words, when AC is minimum,
MC=AC and when AVC is minimum MC = AVC.
52
MC
COST
AC
COST
AVC
Units of Output
53
Here is a snapshot of the average cost, average fixed cost and average variable cost.
TOTAL
VARIABL
TOTA AVERAG
AVERAG E COSTS AVERAG
UNITS TOTAL MARGIN AVERAG L E
E FIXED (TVC) = E COSTS
OF PRODUC AL E FIXE VARIABL
COST RAW ( AC)=
LABOU T PRODUC PRODUC D E COST
(AFC) = MATERI AFC
R (Q) T T COST (AVC) =
TFC/Q AL COST +AVC
(TFC) TVC/Q
+ LABOR
COST
0 0 0
100
1 8 8
8 100 12.5 28 3.5 16
2 17 9
8.5 100 5.9 57 3.4 9.2
3 18 1
6 100 5.6 78 4.3 9.9
4 18 0
4.5 100 5.6 98 5.4 11
5 16 -2
3.2 100 6.3 116 7.3 13.5
To sum up our discussion on short run costs, here are some cost formulae that will help you.
• AVERAGE FIXED COST (AFC) = Total Fixed Cost/Quantity = TFC/Q

• TOTAL VARIABLE COSTS (TVC) = Raw material cost + Labor cost ( in the Uncle
Chips example)
• AVERAGE VARIABLE COST (AVC) =Total Variable Cost/ Quantity= TVC/Q
54
• AVERAGE COSTS ( AC)= Average Fixed Cost + Average Variable Cost= AFC
+AVC
• TOTAL COST (TC) = Total Fixed Cost + Total Variable Cost = TFC +TVC
• MARGINAL COST =Change in Total Cost/ Change in quantity= ∆TC/∆Q
After having understood the short run costs and their calculation, try solving this practice
problem.
Scholar is a small company that has a subcontract to produce instructional materials for disabled
children in public school districts. The owner rents several small rooms in an office building in
the suburbs for $600 a month and has leased computer equipment that costs $480 a month.
Complete the following table.
Output
(Instructional Average
Modules per Variable Average Variable Average Marginal
Month) Fixed Costs Total Fixed Cost Total Cost
Costs Cost Cost Cost
0 1080
1 1080 400 1,480 400
2 965 450
3 1,350 2,430
4 1,900 475
5 2,500 216
6 4,280 700
7 4,100
8 5,400 135
9 7,300
10 10,880 980
Once you finish, check your answers…
55
Output Average
(Instructional Variable Average Variable
Modules per Fixed Costs Total Cost Fixed Cost Cost Average Marginal
Month) Costs Total Cost Cost
0 1080
1 1080 400 1,480 1080 400 1480 400
2 1080 850 1930 540 425 965 450

3 1080 1,350 2,430 360 450 810 500
4 1080 1,900 2,980 270 475 745 550
5 1080 2,500 3,580 216 500 716 600
6 1080 3,200 4,280 180 533.3 713.33 700
7 1080 4,100 5,180 154.3 585.7 740 900
8 1080 5,400 6,480 135.0 675 810 1,300
9 1080 7,300 8,380 120 811.1 931.11 1900
10 1080 9800 10,880 108 980 1088 2500
So far, we have discussed the short run costs.
We now will find out how the costs vary in the long run.
In the long run all factors of production are variable. This means that the firm may choose to
change the capacity of production like machinery and land or factory/office premises.
56
The firm may do this in order to expand its business and increase the scale of production
resulting from a larger demand for its product or service.
Scale therefore relates to the capacity and a larger scale relates to a larger capacity and larger
output produced.
Since this expansion incurs a cost, the firm has to ensure that the increased market demand will
sustain in the long run. Such an expansion of scale is therefore related to the long run and all
costs associated with scale expansion are referred to as long run costs.
As the firm expands its capacity and scale of operation, it experiences some advantages in cost
known as economies of scale.
Capacity expansion also leads to some disadvantages in cost known as diseconomies of scale.
Some examples of economies are:

• Scale expansion helps the producer to negotiate on the price of the raw material and
other purchases it needs to make.
• A larger output would also lead to a fall in the per unit transportation cost since the
transport facility will be utilized more efficiently.
• A larger firm is also able to get finances at a lower interest cost.
Diseconomies arise on account of a lack of coordination between various departments of the

large firm. This leads to wastages and thus a higher cost.
For example, if the purchase department of a firm does not coordinate with the production
department then there may be excesses or shortages in material purchase which would lead to
higher costs.
As a firm expands the scale of operation, there are three stages that it goes through:
• Increasing returns to scale
• Constant returns to scale
• Decreasing returns to scale
In the initial phase of scale expansion, the economies of scale are greater than the diseconomies
of scale and so the firm enjoys increasing returns to scale expansion. This means that the firm
experiences a lower long run average cost.
57
In the second phase of scale expansion, the economies of scale are equal to the diseconomies of
scale and so the firm enjoys constant returns to scale expansion. This means that the firm
experiences a constant long run average cost.
In the last phase of scale expansion, the economies of scale are less than the diseconomies of
scale and so the firm experiences decreasing returns to scale expansion. This means that the
firm experiences a higher long run average cost. This phase is certainly not desirable and
therefore the firm needs to take utmost care when it becomes very large. It needs to use modern
techniques to overcome the inter-departmental coordination problems.
The long run average cost or LAC can be represented in the following figure:
COST Increasing Decreasing

Returns to Returns to
Scale Scale
Constant Returns to Scale
OUTPUT
The falling part of the LAC curve is associated with increasing returns to scale. The flat part of
the LAC curve is associated with constant returns to scale and the rising part of the LAC curve is
associated with decreasing returns to scale.
THE DAIMLER-CHRYSLER MERGER IS A GOOD EXAMPLE OF THESE SCALE

ECONOMIES
Late on the night of May 6, 1998, executives of Chrysler Corporation and Daimler-Benz agreed
on a $40 billion merger, creating the world's fifth largest automobile manufacturer. Most industry
analysts considered the merger a good match, with each company's strengths compensating the
other's weaknesses. Prior to the merger, Chrysler Corporation was the world's sixth largest car
company, with $61.2 billion in annual revenues, $60.4 billion of assets and 121,000 employees.
In 1997, Daimler-Benz, the fifteenth largest auto maker had revenues of $68.9 billion, $76.2
58
billion in assets, and slightly more than 300 employees. Chrysler was considerably more
profitable in 1997, with a profit margin of 6.3%, compared to 2% at Daimler-Benz. The variation
in profit margins reflects differences in management philosophy: Chrysler, if necessary, is
willing to sacrifice quality for profit; while the Daimler-Benz motto is quality at all costs.
Daimler -Benz had a healthy cash flow, but little potential for growth. Chrysler, on the other
hand, had growth potential, but little excess cash.
The new company, Daimler-Chrysler, valued at $40 billion, was expected to generate sales of
$130 billion and employ more than 400,000 people. The merger was a large step in the
globalization and consolidation of the automobile industry. Daimler-Chrysler ranked behind the
largest company, General Motors, which owned Opel and had controlling interest in Saab; Ford,
the second largest, owner of Jaguar and one-third of Mazda; Toyota, the third largest; and
Volkswagen/Audi/Rolls Royce, the world's fourth largest car company.
The merger offers several advantages, including cost savings, increased revenues, and larger
global market shares than either company had individually. The new company was expected to
save approximately $7 billion by combining research and development in areas such as safety
and fuel technology. By purchasing common parts, such as engines, transmissions, door locks
and seats, Daimler-Chrysler anticipated savings of $1.2 billion to $5 billion annually for the next
several years.
The combined companies were expected to have increased sales of 75,000 vehicles. The merger
with Daimler-Benz would help Chrysler build its markets outside of the United States; while
Chrysler's marketing could help create much needed mass appeal for Mercedes. Chrysler, maker
of the most popular minivans, could help Daimler Benz design a minivan for the European
market. Daimler-Benz, with plenty of cash and experience in producing luxury cars, could help
Chrysler with the production of the Chronos, its new super luxury sedan.
59
Module 4: Market Structures
Before we discuss the different forms of market structures, it is important to understand the
difference between a firm and industry.
A Firm is a single unit producing and selling a particular product or service.

An Industry is a collection of firms producing and selling the same product or service.
For example, General Motors is a firm operating in the automobile sector and all firms in the
automobile sector like Ford, Daimler, Toyota, Honda etc. form the Automobile industry.
A firm pursuing such an objective seeks to maximize the gap between Total Revenue (TR) and
Total Cost (TC).Total Revenue is the price per unit of the product sold by the firm multiplied by
the total quantity sold. That is:
Total Revenue = Price * Quantity
Total cost refers to the cost incurred by the firm on all the fixed and variable factors used in
production. That is,
Total Cost = Total Fixed Cost + Total Variable Cost
Some firms also aim at Sales or Revenue Maximization
A firm pursuing such an objective seeks to maximize its sales or revenue in order to gain a larger
market share in the industry it operates. Such a firm may maximize revenue or sales even at the
cost of some profit.
IN ECONOMICS, IT IS USUALLY ASSUMED THAT A FIRM MAXIMIZES PROFITS.
Another clarification that requires to be made is the distinction between price and cost. Many
people confuse price with cost and use them interchangeably. But these are certainly not the
same.
Price refers to what the consumer pays for a unit of the product or service he purchases. It is the
selling price.
Cost refers to what the producer pays for producing the product or service. It is the cost of
production.
Let us now turn to profit maximization. We will use an example to understand it.
South West Leather Designs is a company based in New York, manufacturing belts for the mid
segment customers.
The following table has details of the price and the cost structure of the firm.
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OUTPUT PRICE TOTAL TOTAL PROFIT
($) COST REVENUE ($)
($) ($)
0 40 40000
1000 35 42000 35000 -7000
2000 32.5 43500 65000 21500
3000 28 45500 84000 38500
4000 25 48500 100000 51500
5000 21.5 52500 107500 55000
6000 18.92 57500 113520 56020
7000 17 63750 119000 55250
8000 15.35 73750 122800 49050
Let us understand this table better:

Here we see that when the firm determines a price equal to $40, it is not able to sell any belts.
This is because nobody is willing to buy even one belt at that price. Here we will assume that the
producer will only produce that many belts that can be sold.
We further notice that even though nothing is produced, the firm still incurs a total cost equal to
$40,000.Taking a cue from what you learnt in the last module, it is clear that this is the fixed cost
that the firm incurs on the fixed factors like land and machinery used. Total revenue and profits
at zero belts is obviously zero.
Now if the firm decides to sell 1000 belts, then it has to lower the price to $35. It incurs a total
cost of $42000.Since it is now clear that the fixed cost is $40000, the additional cost of $2000 on
1000 units is the total variable cost. The total revenue is 1000 *$35 =$35000. The firm however
makes a negative profit of$7000. This is because even though the revenue is able to recover the
entire variable cost, the burden of fixed cost being large, the firm will need to sell few more belts
to be able to recover both the variable and fixed cost.
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The firm will as discussed earlier, seek to produce and sell that many units at which it earns
maximum profits. In this example, the firm’s total profit is maximum when 6000 belts are
produced because at that point, its total revenue minus total cost or profits are maximum..
Therefore South West Leather Designs should ideally manufacture 6000 belts in a day if it wants
to maximize profits..
Beyond 6000, the sales or revenue is still increasing but the profits are decreasing.
As seen in the table, Total Revenue or TR increases with output sold. Therefore the TR rises.
Here it is worth commenting on the rate at which the Total Revenue rises. If you look carefully
at the data in the table, as output increases, total revenue increases at a decreasing rate. For
instance, between 1000 and 2000 belts sold, the total revenue increases from $35000 to $65000,
which is an increase of $30000. Between 2000 and 3000 belts, the rise in revenue is $65000 to
$84000, which is $19000,
Let us now represent the Total Revenue on a graph.
TOTAL
REVENUE
TR
QUANTITY
In this graph we see that as quantity sold rises, the total revenue rises but at a diminishing rate. It
is clear from the TR curve, that its slope is falling with every additional unit.How do we know
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this? imagine if we were to draw a tangent to the TR curve at each consecutive point on the
curve, such tangents are flatter indicating a falling slope.
Since there is an increase in output by 1000 belts between 1000 and 2000 belts, each additional
belt is bringing in a revenue of $30000/1000 = $30.
This is called Marginal Revenue, MR is derived as ∆TR/∆Q or change in total revenue divided
by change in quantity, where TR stand for Total Revenue and Q stands for quantity or output or
number of belts. Marginal Revenue is the addition made to total revenue by selling an additional
unit.
∆TR/∆Q or MR is also the rate at which TR rises or the slope of TR.
Between 2000 and 3000 belts, the rise in revenue is $65000 to $84000, which is $19000, Again
applying the formula of ∆TR/∆Q , marginal revenue or the additional revenue by selling an
additional belt has fallen to $19000/1000=$19. We therefore see that the marginal revenue or the
addition made to revenue with each unit sold or the rate of change in total revenue, falls as more
and more units are sold.
We now move on to Total Cost and Marginal Cost.
Marginal Cost is the addition made to total cost by producing an additional belt.
Between 0 and 1000 belts, the total cost increases by $2000 and so the marginal cost or
additional cost on every additional belt is $2000/1000=$2.
Between 1000 and 2000 belts, the total cost increases by$1500 and so the marginal cost is
$1500/1000= $1.5.
Now, between 2000 and 3000 belts, the marginal cost increases to $2000/1000= $2. As you have
already learnt from the last module, that marginal cost first falls and then rises. Marginal cost is
the rate of change in total cost or the slope of total cost. Therefore, MC = ∆TC/∆Q. We can
represent this on a graph.
TOTAL TC
COST
63
QUANTITY
As seen in the graph the Total Cost curve first rises at a falling rate and then rises at a rising rate.
Again imagine tangents drawn on points of the TC curve. We see that at first the tangents
become flatter, indicating a falling slope and then they become steeper indicating a rising slope.
The slope of the total cost curve is the marginal cost.
The point of profit maximization can be represented on a graph using the Total Revenue and
Total Cost curves in the following manner:
TOTAL TC
REVENUE
A
TR
Q1 Q2 QUANTITY
We see in the figure that at point C, the TR curve intersects the TC curve. Q1 is therefore the
breakeven point or the output at which total revenue covers the entire total cost.
It is only after this point that the firm starts making profit. Profits are maximized at point A on
the TR curve and point B on the TC curve or at output Q2.At this output Total Revenue minus
Total Cost is maximum.
At such a quantity Q, the slope of the TR curve is equal to the slope of the TC curve.
As discussed before, the slope of TR is MR and the slope of TC is MC.
Therefore at the point of profit maximization, MR = MC
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Let us use our example of South West Leather Designs to understand this better.
TOTAL MARGINAL TOTAL MARGINAL PROFIT

PRICE
OUTPUT COST COST REVENUE REVENUE
($)
($) ($) ($) ($) ($)
0 40 40000
1000 35 42000 2 35000 -7000
2000 32.5 43500 1.5 65000 30 21500
3000 28 45500 2 84000 19 38500
4000 25 48500 3 100000 16 51500
5000 21.5 52500 4 107500 7.5 55000
6000 18.92 57500 5 113520 6.02 56020
7000 17 63750 6.25 119000 5.48 55250
8000 15.35 73750 10 122800 3.8 49050
Though, as per the table, the firm earns maximum profits at 6000 units, if we examine it closely,
we realize that at 6000 belts, Marginal Revenue is $6.02 and Marginal Cost is $5. This means
that there is still more scope to earn some more profit. But at 7000 belts Marginal Revenue is
$5.48 and Marginal Cost rises above marginal revenue to $ 6.25.Therefore, actually the profits
are maximum between 6000 and 7000 belts where MR = MC.
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At this point, we also notice that the MC is rising. Why is this so? Because at this point if
marginal cost were falling then there would still be scope for earning more profit on additional
units because a falling marginal cost would fall below the marginal revenue and the outcome
would be a positive profit earned on those units. In the case of a rising marginal cost , however,
the possibility of earning profits on extra units does not therefore exist. At the unit where
marginal revenue equals marginal cost, the firm does not earn any profit on that unit. But
remember that it has earned all its profit from the earlier units it has sold.
Therefore we can say that for profit maximization, there are two main conditions:
1) MR=MC
2) MC is rising at that point.
Though profit maximization is the objective for all firms irrespective of the market structure they
are operating in, the extent to which the firm can earn profits depends on the market structure or
the extent of competition it faces from other firms in the industry.
What is a market structure?
A Market Structure relates to:

• The number of buyers and sellers of a particular product or service and the interaction
between them.
• The competition (or lack of competition) among the buyers.
• The competition (or lack of competition) among the sellers.
Why is the market structure important?
Because:
• The market share available to a single firm can be determined.
• The quantity that the single firm can sell can be determined.
• The pricing power available to a firm can be determined.
There are different forms of market structure:
• PERFECT COMPETITION
• MONOPOLY
• MONOPOLISTIC COMPETITION
• OLIGOPOLY
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Under Perfect Competition,
• There are a large number of sellers and buyers.

• The sellers sell exactly identical or homogenous goods or services.
• There are no barriers to entry in such an industry. Any firm can easily enter the industry
and start business.
• The price is determined by the market forces of demand and supply and the firm accepts
or takes the market price. It has no control over price and can sell any quantity at that
price. The firm therefore faces a horizontal demand curve.
• The industry as a whole faces a downward sloping demand curve.
Under Prefect Competition, a firm faces a flat demand curve because the price is determined in
the market and the firm takes that price and can sell any quantity at that price.
The demand curve facing such a firm is horizontal and the firm’s product is said to have
perfectly elastic demand as seen in panel B of this figure.
The price is determined by the market as seen in panel A at P.
The firm has to sell all units at the same price. If it raises the price even a little, then demand will
fall to zero. If it lowers the price, then demand will rise infinitely, that is, all the competitors’
customers will now buy from this firm.
The firm cannot however lower the price, since competition has ensured that the market price is
at the lowest possible level. Elasticity is therefore said to be infinite: e = ∞
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PRICE PRICE
PANEL A PANEL B
QUANTITY DEMANDED
Under Perfect Competition, since price remains constant, the Total Revenue Curve is a linear
upward sloping curve. TR is linear because with every additional unit sold, the revenue increases
by the same amount, arising out of a constant price, and so the TR increases at a constant rate.
This is represented in the following figure.
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TC TR
TR, TC
QB Q
QUANTITY
The slope of the TR curve is also marginal revenue, and so under Perfect Competition Price is
equal to marginal revenue. Marginal Revenue is therefore constant and the MR curve is therefore
a horizontal curve as shown in the figure.
MR,
MC
MC
A B MR
Q
QUANTITY 69
As discussed before, marginal cost curve is a U shaped curve.
Now let us consider the conditions of profit maximization in this case.
• MR = MC
• MC is rising.
As seen here, MR = MC at two points A and B. At A, MC has just become equal to MR and falls
below MR after that. This is when the firm starts making profits. It goes on making profits on
every additional unit produced till point B is reached. It is therefore at point B that profits are
maximum, because beyond that point , MC rises above MR and the firm starts incurring losses
on every additional unit after that which eats away some of the earlier profits earned.
• Perfect Competition is a hypothetical market but yet there are real cases in which though
the products are not exactly identical, they are very close to this kind of a market
structure.
• The market for agricultural products like wheat, rice, corn, fruits and vegetables are
nearly perfectly competitive.
• The dotcom companies which came into existence in the year 2000 were almost perfectly
competitive. There were very few barriers to entry in this sector. Internet access for firms
was relatively cheap and because there was an already established business-to- business
market in Internet services, the necessary software and design skills necessary to
establish a presence in cyberspace were already available. Given these circumstances
there was a surge in these companies at that time. Not all of them could survive because
there was no room for differentiation and exclusivity. They became price takers and many
of them had to exit the business when they realized that it was not viable to continue.
Now lets turn to Monopoly:
A monopolist is a single seller of a product or service.

• There are strong barriers to entry in this market structure. Barriers include government
protected barriers like patents, single ownership of scarce resources used in the
production of the product, reputation and brand building by a firm etc.
• In practical terms however, monopoly can be extended to include firms having monopoly
power on account of having established exclusivity in a brand and are therefore
considered to be monopolists of those brands.
• Under monopoly, the firm and industry are the same and so a monopolist faces a
downward sloping demand curve.
• A monopolist has the power to price the product and can sell a lesser quantity at a higher
price.
• A monopolist also has the power to charge a different price to different consumers
depending on their willingness to pay. This is called price discrimination.
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• Harley Davidson is a great example of a brand with a story. Davidson has become an iconic
brand whose brand story articulates the values of the company in a way that is all about the
customer. The bond between Davidson and it's customers runs deep with emotion, mythology,
pride and aspiration.
• Harley Davidson established monopoly power or pricing power on account of its brand building
exercise which revolved around creating an image of rule breakers who choose to make their
own paths. These strong-willed rule breakers are rebels and outlaws who stand up for what they
believe in. They challenge the world as we know it. They are individually motivated. They
represent a release of pent-up passions. They are aware of limitations in society and they set
out to break the rules and challenge conventions. They feel the excitement of being just a little
bit “bad.” They stand out because they do not conform to the normal. Harley-Davidson’s Story
can be told from the point of view of many different people. The lawyer escapes his high-stress
job to experience the freedom of the open road. The young man needs to define himself
as someone who stands out from the crowd. From each manifestation of this Story flows Harley-
Davidson’s brand promise—the pursuit of freedom.
Another market structure of which many industries are a part is Monopolistic Competition.
• In this market structure there are a large number of firms selling differentiated products.
• They are therefore monopolists of their own brand but heavily compete with one another
mainly because of the number of competitors that exist. In such a market, the barriers to
entry are not very strong.
• This market structure is a combination of monopoly and perfect competition.
• Firms compete with each other by way of :
Price
Product Differentiation
Advertising
The US Credit Card industry is a fine example of Monopolistic Competition.
In the early 1990s, the credit card industry in the US witnessed an onslaught of new players
wooing customers with offers of low interest rates and small non-existent fees. Some 6000 firms
now offer credit cards in the U.S. including some very successful specialist issuers. These
developments have posed a dilemma for the established players in the industry, principally
Citicorp and Chase Manhattan.
They could have cut prices to match those of specialist issuers; Chase reckons that the no-fee,
low rate deals it currently offers to new cardholders are as attractive as anything in the market.
Such deals might help banks to refresh their established portfolios. But existing customers are
increasingly unwilling to go on paying old prices. Lowering prices across the board would have
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an immediate and ire effect on profits. Credit cards generate a predictable flow of cash, which
banks obviously don’t want to give up.
That is why their response to date has been more prosaic. They have done little except count
their blessings and hope to slow the erosion of their market share. True…Citicorp has…tried to
hang on its customers by segmenting them and launching an array of cards designed to appeal to
different groups.
The last form of market structure is a very unique one. It is the one that has challenged
business to the maximum and led to a whole lot of studies in business strategy.
This very interesting market structure is called Oligopoly.
• Oligopoly is a market structure in which there are few sellers selling almost similar
products.
• Each firm has a considerably large market share in the industry.
• Since the products are almost similar, the price is similar and also rigid. For example,
the price of Pepsi and Coke is the same and is also not changed very often. This is
because, if one of them raises the price, the other will not and so there is no point for
either of them to raise the price. If one of them lowers the price, the other firm will also
lower the price and then there is again no point for either of them to lower the price.
Price rigidity can be explained by The Kinked Demand Curve model propounded by Paul Sweezy. The
kinked demand curve is seen in the figure
PRICE
QUANTITY DEMANDED
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This figure depicts the demand curve faced by a firm operating under Oligopoly. As we can see, at the
kink the price is rigid at P. This is because, if the firm raises the price, its competitor will not raise the
price, since it is more rational not to do so as this would be an opportunity for the competitor to gain a
larger share of the market. The demand curve for prices higher than P is therefore more elastic and
therefore flatter. This means that the firm will lose a lot of demand when it raises the price above P
since its competitor will not raise the price.
On the other hand, when the firm lowers the price below P, its competitor will follow and also
lower price in the fear that it will lose market share if it does not do so. This will lead to a less
rise in demand for the firm’s product when the firm lowers the price. At price below P, the
demand curve is less elastic and therefore steeper.
We thus see that there is no benefit of either raising the price or lowering the price and so price
remains rigid at the kink.
Each firm’s action affects the other firms greatly and they in turn are likely to react to the first firm’s
action. Each firm has to therefore consider the other’s firm’s reaction before acting on its own. This is
similar to a game of chess.
One doesn’t have to go too far to find an appropriate example of Oligipoly. There are a whole lot of
them: The Global Oil Market, the Cement Industry, The Steel Industry and believe it or not…the Cola
Industry!
• Pepsi and Coke operate in an oligopolistic market.

• The products sold by both are similar. Product differentiation is not possible and has
been unsuccessful when an attempt was made, for example Pepsi introduced Blue Pepsi
but the product did not sell.
• The price of Pepsi and Coke is the same and remains rigid over a long period of time.
• One also sees constant advertising wars between these two competitors.
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The following table represents a snapshot of all the four market structures.
PERFECT MONOPOLY MONOPOLISTIC OLIGOPOLY

COMPETITION COMPETITION
NUMBER A large number Only one A large number of A few sellers
OF SELLERS of buyers and seller sellers
sellers
TYPE OF Homogenous or Unique and Differentiated Usually similar
PRODUCT identical product branded products and less
SOLD product differentiated
product
PRICE A single same High pricing Different prices Price is almost
market power. Price determined by similar.
determined determined by sellers based on
price charged by seller. ability to
all firms. differentiate the
product.
PRIMARY Quantity of Price to be The product Quantity or
DECISION product to be determined differentiation and price decision
BY THE sold selling or marketing based on
FIRM costs to be incurred competitors’
reactions
INDUSTRIES It is a Government Fast Moving Airlines service
USUALLY hypothetical monopolies Consumer Goods industry,
FALLING market structure like Railway Industries like Aircraft
UNDER THE but the closest and Defense, soaps, detergents manufacturing
MARKET industry that fits Manufacturers toothpastes, industry, Steel
STRUCTURE this structure is of patented biscuits etc. industry,
Agricultural and drugs. Telecom
Food industry industry, Global
oil industry.
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PERFECT COMPETITION
As discussed in the pre-program module, Perfect Competition is a market structure in

which a firm faces a horizontal demand curve .
This implies that price is taken by the firm from the market and the firm has no power to
change the price. If it raises the price a little, demand will fall to zero. If it lowers the
price a little demand will rise infinitely. This is because the large numbers of sellers sell
the same identical products. Demand faced by the firm under perfect competition is
therefore perfectly elastic.
This is depicted in the following figure:
PRICE PRICE
PANEL A PANEL B
P
P P = AR =MR
QUANTITY DEMANDED
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We see that in panel A, the intersection of the demand and supply curves determine the
market price P. In panel B, we see that at this price the firm has a horizontal demand
curve at which the price is constant and the demand is perfectly elastic.
Since firms have no control and power over price, they can only determine the output
they should sell so as to maximize profits. At the given price a firm can sell any quantity.
It will sell a quantity such that Marginal Revenue (MR) = Marginal Cost (MC).
For a perfectly competitive firm, MR is equal to price since price is constant. This means
that MR which is the addition made to Total Revenue is always same and equal to price
because every additional unit is sold at the same price.
AR is always equal to price because TR = P*Q and AR = TR/Q.
Therefore under Perfect Competition, AR =P=MR.

Since the price is given to the firm, the only decision it can take is to find out what is the
level of output it should produce and sell. For this it uses the condition of profit
maximization, that is MR = MC and MC is rising as depicted in the figure.
PRICE
MC
A B
MR
QUANTITY
As seen in the figure, MR = MC at two points A and B.
At A, MC has just become equal to MR and falls below MR after that. This is when the
firm starts making profits. It goes on making profits on every additional unit produced till
point B is reached.
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It is therefore at point B that profits are maximum, because beyond that point MC rises
above MR and the firm starts incurring losses on every additional unit after that which
eats away some of the earlier profits earned.
Therefore there are two conditions of profit maximization:
1) MR = MC
2) MC is rising.
Given that a perfectly competitive firm is given a price by the market, it cannot compete
in terms of price. What is the option for such a firm then?
The obvious answer is that, such a firm should determine the quantity at which it can
maximize profits at the given price. In the short run, there are four possibilities the firm
could be facing under the constraints of a fixed given price.
They are:
1) When price is greater than Average Cost (AC) then the firm earns profits.
2) When price is equal to Average Cost the firm earns only normal profit.
3) When the price is less than Average Cost the firm incurs a loss .
And lastly,
4) If Price is less than AC and also less than AVC
Let us now analyze each of these situations separately:
1) It can so happen that either due to higher demand or lower supply, price or
average revenue is greater than the firm’s average cost. In such a case, its but
obvious that the firm will make positive profits.
Let us use a diagram to discuss this:
Price
MC
profits AC
E
P MR =AR=P
T L
0
Q
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Output
As we see in the graph, the firm’s average cost curve is below the price or average
revenue curve. The point of equilibrium or the point at which the firm makes
maximum profits is point E where the following two conditions are fulfilled:
MR = MC
MC is rising
At the point E, the firm sells an output equal to OQ, and don’t forget that at this
level of output production, it maximizes profits.
We can find out its profits or area of profits in this graph.
At OQ output, price or average revenue the firm earns is OP or QE. Therefore the
total revenue it earns is Price * quantity sold, that is OP *OQ which is = the area
of the rectangle OPEQ.
At OQ output, the firm’s average cost is QL or OT. Therefore, its total cost is the
area of the rectangle OTLQ.
The profits earned by the firm is equal to Total Revenue minus total cost, that is
equal to A(OPEQ) – A(OTLQ) that is equal to A(TPEL).
2) Another situation that a firm is likely to experience at a given market price is that
price or average revenue is equal to average cost. In such a case, the firm just
earns that amount of revenue which covers the entire cost.It is important her to
note that, this cost also includes a certain minimum profit that the owner or
entrepreneur should get as an income for the services he renders. Such a minimum
profit which is a part of cost is called normal profit. We can therefore say that in
such a situation, the firm earns normal profits.
We can represent this situation in the following graph:
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Price
MC
AC
E
P MR =AR=P
0
Q
Output
As we see in the graph, the average cost curve lies on the average revenue curve.
The point of equilibrium or the point where marginal revenue is equal to marginal
cost on the rising portion of the marginal cost curve is E. At this point, the firm
produces OQ output. The average revenue or price is OP and therefore the total
revenue = OP*OQ = A (OPEQ).
The average cost at this output is EQ and therefore the total cost = EQ*OQ, which
is again equal to A(OPEQ). Since total revenue is equal to total cost, the firm does
not earn any excess profits and so the firm is said to earn only the normal profit
included in the cost in this case.
3) A third possible situation for the firm is that average cost is higher than
average revenue or price. In such a situation, the firm’s revenue falls short of
its cost and therefore the firm incurs negative profit or loss. This represented
in the following graph:
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Price
MC
AC
L
T
P MR =AR=P
E
0
Q
Output
As we see in the graph, the firm’s average cost curve is above the price or average
revenue curve. The point of equilibrium or the point at which the firm makes
maximum profits is point E where the following two conditions are fulfilled:
MR = MC
MC is rising
At the point E, the firm sells an output equal to OQ.
We can find out its profits or area of profits in this graph.
At OQ output, price or average revenue the firm earns is OP or QE.Therefore the

total revenue it earns is Price * quantity sold, that is OP *OQ which is = the area
of the rectangle OPEQ.
At OQ output, the firm’s average cost is QL or OT. Therefore, its total cost is the
area of the rectangle OTLQ.
The profits earned by the firm is equal to Total Revenue minus total cost, that is
equal to A(OPEQ) – A(OTLQ) . Now here we notice, that total cost or A(OTLQ)
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is greater than total revenue or A(OPEQ). As a result, the firm\s profit = negative
A(TPEL) or a loss equal to that area.
How then can we say that E is the point of profit maximization? What is meant by
this is that at E,if the average cost is below average revenue, the firm makes
profits and such profits are maximum at that point. On the other hand, if at E, the
average cost is higher than average revenue, like in this case, then the firm incurs
a loss but such losses are minimum. At any other point or output in this case,
losses would have been higher.The point of profit maximization should therefore
be considered as the best point to operate at which either profits are maximum or
losses are minimum.
Now what do you recommend for such a firm incurring a loss? Should the firm
continue operations, or should it close down its business?
Now this is a very important decision for the firm. In business, let us understand,
there are bound to be instances of losses now and then. That does not mean that
the firm should take a hasty decision and close down the business. It is foolish to
do such a thing without considering several factors. IN the first place, the firm
may want to wait and see whether the situation improves or not. What do we
mean by an improvement? It means that either the market price will rise or the
cost will fall. In either case, the firm’s losses will reduce and there may come a
stage when it starts making positive profits again. Since an analysis depends on
the abilities and foresight, risk taking ability and business acumen of the
entrepreneur. Sometimes, the firm may just decide that it wants to close down its
business because it cannot bear the losses. Sometimes, it may be ready to wait and
bear losses for some time, maybe because it has a backing in terms of reserves
accumulated when the going was good or because it is confident that it has access
to funds at a low interest cost.
Anyhow, during this waiting period, the firm has to still decide whether it should
continue operations or not. By that we mean whether it should continue producing
and selling the product or shut down its factory temporarily. Here, it is important
to remember the difference between Shut down and close down.
Shut down relates to a temporary shutting down of operations and does not
involve the selling off of assets. Close down refers to the permanent close down
of business which also involves the selling off of assets.
Shut down is therefore more of a short run phenomenon and close down is more
of a long run phenomenon.
Coming back to the decision this firm has to take given that it is incurring a loss
and given that the firm is prepared to wait and not close down business till things
improve, it still needs to decide whether during this waiting period it should
temporarily shut down operations or not.
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For this, the firm will compare its losses in the two situations of continuing with
operations and shutting down operations. When the firm continues operations, it
incurs a certain loss equal to the difference between the total cost and total
revenue, which is A (PTEL) in this example. When it shuts down, it has to incur
the fixed costs anyway because it has not sold off its assets. Therefore, if the loss
is greater than fixed cost, it makes sense for the firm to shut down during the short
run. On the other hand, if loss is less than fixed cost, it makes sense for the firm to
continue operations.
When the loss is less than the fixed cost, it means that the revenue is covering the
entire variable cost and also a part of the fixed cost. Let us not forget, that the first
priority for the firm is to cover its variable costs. In such a case, it implies that the
firm’s price or average revenue should be greater than average variable cost, only
then can the toral revenue cover the entire variable costs. But of course, its
average revenue will be less than its average cost.
Let us represent this case in the following graph.
AC
Price MC
L
T AVC
E
P MR =AR=P
S
R
0
Q
Output
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Here we see that the average variable cost (AVC) is less than average revenue or
price . At the equilibrium quantity Q, total revenue is equal to area (OPEQ). Total
cost is equal to area OTLQ. It is clear that the total revenue does not cover the
total cost. Average variable cost is equal to RQ and total variable cost = average
variable cost * output, that is RQ*OQ, that is equal to A (OSRQ). Fixed cost is
equal to total cost minus variable cost.
Here total cost = A(OTLQ) and total variable cost = A(OSRQ), therefore, total
fixed cost = A(OTLQ) minus A(OSRQ) = A(STLR)
It is evident from this that the total revenue, A(OPEQ) not only covers the entire
variable cost A(OSRQ) but also a part of the fixed cost. The part of fixed cost that
is covered by the revenue is A(SPER).
Another way of looking at this is that the loss is less than the fixed cost.
Loss is = A(PTLE) and fixed cost is A(STLR) and therefore the loss is less than
fixed cost.
In such a case therefore, the firm can continue operations in the short run so long
as the revenue covers the entire variable cost and a part of the fixed cost or in
other words its price or Average Revenue is less than AC but greater than
Average Variable Cost or AVC. This is because if the firm decides to shut down
its operations (that is, shut down operations and not produce any output and not
close down the business) then the firm will incur a fixed cost which will be larger
than the loss incurred in production. By operating the business, at least a part of
the fixed cost is covered
The firm continues to operate in the short run in spite of losses ( given that price is
greater than AVC) because it is hopeful that things will improve in the long run. It hopes
that some of its competitors may not survive this loss and so will slowly leave the
industry leading to a fall in industry supply and a rise in industry price . This will help the
firm to better its position in the long run .How long it can survive with a loss and hope for
things to improve will depend on its ability to survive or the amount of reserves it has or
loans it will get to pay for the loss. It is only a strong firm which has existed for a long
period and grown its business and reserves which will be able to survive with a loss.
4) The last situation that a firm can encounter in the short run is that the price is
not only lesser than the average cost but also lesser than the average variable
cost. Such a situation is represented in the following graph which depicts that
83
both the average cost curve, AC as well as the average variable cost curve,
AVC are higher than average revenue or price and so both these curves lie
above the average revenue curve
AC
Price MC
L
T AVC
R
S
P MR =AR=P
0
Q
This means that the revenue will not cover even the variable cost then it means
that the loss is greater than the fixed cost or the firm loses all the fixed cost and
also a part of the variable cost. In such a scenario it is better for the firm to shut
down operations and wait for things to improve. When it shuts down it has to
incur only fixed cost as a loss.
In such a case, we cannot mark a point of equilibrium because a firm will

never operate at such a point..
In analyzing a situation the following steps have to be followed
a) Is MR = MC and is MC rising
84
b) Is Price greater than or less than AC
c) If Price is less than AC then is price at least greater than AVC. If Price is
greater than AVC in case of a loss then the firm can continue operations in the
short run. If Price is less than AVC then the firm should shut down.
What do you think happens in the long run?
In each of the above 4 situations, in the long run there will be changes brought about due
to a variation in price.
Let us take the first situation of profits, where price is greater than AC. This will not last
forever, because, on seeing that the existing firms are earning profits, other firms find this
business lucrative and also enter this industry, as a result of which the supply rises and
the price falls. This happens till all the profits of existing firms are wiped away and all
firms earn normal profit or operate such that price is equal to average cost. This is
represented in the following figure:
PANEL A
PANEL B
PRICE D S PRICE
S1
MC
AC
P E
P
P1 P1 E1 P = AR =MR
Q Q1 Qo Q
85
Panel A in the figure denotes the price determined in the industry or market where total
demand is equal to total supply. Panel B represents the revenue and cost for an individual
firm.
As we see in the figure, the original price is determined at P in the market where demand,
Dis equal to supply S. At this price the firm is at equilibrium at E where MR =MC and
produces and sells output Q. At this output, the Average cost is less than price and so the
firm earns profits in the short run. In the long run however, when more firms enter the
industry, the supply curve shifts to the right and the new supply curve is S1. A new price
P1 is determined. As we can see, at this price P1, the firm’s average cost is equal to price
and the firm earns only normal profit. It is interesting to note, that at the new price P1, the
industry quantity demanded and supplied rises from Q to Q1 but the firm’s supply falls
from Q to Qo.This is obviously because the firm has to share the market with more firms
now.
Now what if the firm makes a loss in the short run? In the long run such a firm will make
normal profit because some firms will start leaving the industry and the supply will fall
and price will rise. We can represent this in the following graph.
PANEL A
PANEL B
PRICE S1 PRICE
D S
MC AC
P1 E1
P1
P E
P
P = AR =MR
Qo Q Q Q1
86
As we see in the figure, the original price is determined at P in the market where demand,
D is equal to supply S. At this price the firm is at equilibrium at E where MR =MC and
produces and sells output Q. At this output, the Average cost is more than price and so
the firm incurs a loss in the short run. In the long run however, when some firms exit the
industry, the supply curve shifts to the left and the new supply curve is S1. A new price
P1 is determined. As we can see, at this price P1, the firm’s average cost is equal to price
and the firm earns only normal profit. It is interesting to note, that at the new price P1, the
industry quantity demanded and supplied falls from Q to Qo but the firm’s supply rises
from Q to Q1.This is obviously because the firm has to now share the market with lesser
firms than before.
We can conclude that in whatever situation a perfectly competitive firm is in the short
run, in the long run it earns only normal profit. This relates to the fact that there is free
entry and exit of firms into and from the industry and new firms are attracted when
existing firms earns profits and some firms easily exit when losses are incurred.
87

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PGEMP @ SPJIMR

Business Economics Pre Foundation Phase – Batch 69C0

Economics at PGEMP is conducted over two courses:

1. Business Economics -Pre Foundation Phase (Contact 0) – 1 credit

2. Business Environment - Foundation Phase (Contact 1&2) – 1.5 credits

Overview of the course ‘Business Economics’ Pre Foundation Phase (Contact0):

Business Economics Pre Foundation Phase – Batch 69C0

The following are the themes for ‘Business Economics’‘

Theme 1 Introduction to Economics Session 1

Theme 2 Demand analysis Session 2

Theme 3 Cost of production Session 3

Theme 4 Market Structures Session 4 & 5

Course Learning Outcomes

At the end of the Business Economics course, participants will be able:

1. To gain an understanding of the microeconomics concepts for effective and productive

Business Economics Pre Foundation Phase – Batch 69C0

• Textbook: ‘Principles of Economics ’ by Mankiw (7th Edition)

Business Economics Pre Foundation Phase – Batch 69C0

Course Outline (Contact 0)

Theme 1 – Introduction to Economics

Session Theme/Topic Activity in Pre-reads Other reading

Theme 2 – Demand Analysis

Session Theme/Topic Activity in Pre-reads Other reading

Theme 3 –Costs of Production

Session Theme/Topic Activity in Pre-reads Other reading

Business Economics Pre Foundation Phase – Batch 69C0

Theme 4 –Market Structures

Session Theme/Topic Activity in Pre-reads Other reading

General Guidelines for Assignments

• Application assignments are given to encourage participants to relate their classroom

Business Economics Pre Foundation Phase – Batch 69C0

Application Assignment no 1: (10 Marks)

Application Assignment no 2: (10 Marks)

Application Assignment no 3: (10 Marks)

Managerial Economics comprises two disciplines. Management and Economics.

According to Peter Drucker, “Management is the discipline of organizing a firm’s scarce

In this pre-program module of Managerial Economics we will cover four modules:

• Demand and Supply

This willingness and ability to buy a product is termed as DEMAND.

Units of Total Marginal

We can use an equation to represent this relationship.

MU = ∆ TU/ ∆ Q ( change in TU/Change in Q)

Units of Total Marginal Price

The condition for equilibrium is therefore :

We can conclude our discussion on ‘Demand’ by stating the Law of Demand

Thus, the demand curve is a downward sloping and relatively flat:

Relatively Inelastic Demand

So then what do you think?

Now try this one!

Sunflower Corporation’s Vice-President circulates a memo to the top management in which he

This brings us to the concept of point elasticity of demand

We will discuss two of them:

Income elasticity of demand = percentage change in quantity demanded / percentage change in

Cross elasticity of demand = % change in quantity demanded of product A / % change in price of

Let us use and example to illustrate the application of the concept:

We will now discuss the types of elasticity of supply.

We now move on to Relatively Elastic Supply

Unit Elasticity of Supply

Perfectly Inelastic Supply

Relatively Inelastic Supply

We now move on to a different aspect of Microeconomics, that is cost.

100Q = f (10 R, 2L,3K………T)

There are two forms of Production functions: