UNIT I – PART - A

1. What is Managerial Economics? (April 2012,)

Managerial economics is the "application of the economic concepts and economic analysis to
the problems of formulating rational managerial decisions". managerial economics means the
application of economic theory to the problem of management. Managerial economics may
be viewed as economics applied to problem solving at the level of the firm.
2. What is optimisation?( APRIL 2013)
Optimisation is the best use of available scarce resources in such a way that the satisfaction
level is maximum. So we can say minimum usage of resources and maximum level of output.
it is often impossible to optain precise information about the pattern of future revenues costs
and interest rates. therefore, the process of economic optimization is futile.
3. Define sales maximisation.( APRIL 2013) . (NOV 2016)
Sales maximisation is a theoretical objective of a firm which involves selling as many units
of a good or service as possible, without making a loss. This means sacrificing some short-
term profit with a view to achieving a longer term gain. For example, while seasonal ‘sales’
may result in lower profits, space is created as stocks are cleared, and more profitable lines
can be introduced.
4. Is managerial economics related to OR and OB? If yes, give reasons. (APRIL
2014)
Yes, It is related to OR and OB. Linear programming deals with those programming
problems where the relationship among the variables is linear. It is a useful tool for the
managerial economist for reducing transportation costs and allocating purchase amongst
different supplies and site depots. Dynamic programming helps in solving certain types of
sequential decision problems. Input-output analysis is a technique for analysing inter-industry
relation. Queueing is a particular application of the statistical decision theory. It is employed
to get the optimum solution.

5. What does managerial economics stresses upon? (APRIL 2014)

The managerial economics stress upon such as risk, demand production, cost, pricing, market
structure etc.
6. Define managerial economics.(APRIL 2015, APRIL 2016, APRIL 2017, NOV
2016)
Prof. Evan J Douglas defines Managerial Economics as “Managerial Economics is concerned
with the application of economic principles and methodologies to the decision making
process within the firm or organization under the conditions of uncertainty”
7. What is profit maximisation? (APRIL 2015, APRIL 2016)
Profit maximisation predicting the behaviour of business firms in the real world, as well as in
predicting the behaviour of price and output under different market conditions.
Profit maximisation has been the prime objective of classical business organizations. To
maximise profit, certain conditions must be met, the first being that at optimum profit-
maximising point, the firm’s marginal revenue must equal marginal cost. Second, to ensure
that maximum profit is attained, the second derivative of the profit function is expected to be
less than zero.
8. What is the principle of consumer equilibrium? (APRIL 2016)
The principle of consumer equilibrium is the consumer can either buy X or retain his money
income Y. Under these conditions, the consumer is in equilibrium when the marginal utility of
X is equated to its market price (pX).
Symbolically we have,
MUX = pX
If the marginal utility of X is greater than its price, the consumer can increase its welfare by
purchasing more units of X. Similarly, if the marginal utility of X is less than its price, the
consumer can increase his total satisfaction by cutting down the quantity of X and keeping
more of his income unspent. Therefore, he attains the maximization of his utility when MUX
= pX.

9. What is meant by decision - making? (NOV 2012)

Decision making by management is purely economic in nature, because it involves choices
among a set of alternatives alternative course of action. The optimal decision making is an act
of optimal economic choice, considering objectives and constraints. This justifies an
evaluation of management decisions through concepts, precepts, tools and techniques of
economic analysis.
10. Define capital management. (NOV 2012)
A managerial accounting strategy focusing on maintaining efficient levels of both
components of working capital, current assets and current liabilities, in respect to each other.
11. State the elements of managerial economics. (NOV 2013)
(a) Economics provides a set of concepts and precepts.

(b) These concepts and precepts furnish us the tools and techniques of analysis.

(c) Economic analysis is an aid to understand business practice in a given environment and
thereby to make business decisions which are primarily economic in nature.

(d) Decision making is the basic function of Management.

(e) Economics is, therefore, a valuable guide to Management.

12. Define decision making. (NOV 2013)

Decision making is the process of making a choice between a number of options and
committing to a future course of actions.
Decision making is the process of making business decisions involving money. All economic
decisions of any consequence require the use of some sort of accounting information, often in
the form of financial reports.

13. Identify the role of cost in managerial decision making. (NOV 2013)
Cost, revenue and profit are the three most important factors in determining the success of
business. A business can have high revenue, but if the costs are higher, it will show no profit
and is destined to go out of business when available capital runs out. Managing costs and
revenue to maximize profit is key for any entrepreneur.
14. How do managerial economist provide ways of thinking? (NOV 2013) or Identify
the role of managerial economist in forward planning. (NOV 2014)
The managerial economist has to gather economic data, analyse all relevant
information about the business environment and prepare position papers on issues facing the
firm and the industry. In the case of industries prone to rapid theological advances, the
manager may have to make continuous assessment of tl1e impact of changing technology.
The manager' may need to evaluate the capital budget in the light of short and long-
range financial, profit and market potentialities. Very often, he also needs to prepare speeches
for the corporate executives. It is thus clear that in practice, managerial economists perform
many and various functions. However, of all these, the marketing functions, i.e., sales force
listing an industrial market research, are the most important.
15. Is Managerial economics related to accounting? (NOV 2013)
Yes. There exits a very close link between Managerial economics and the concepts
and practices of accounting. Accounting data and statement constitute the language of business.
Accounting was treated as just bookkeeping.
Cost and revenue information and their classification are influenced
considerably by the accounting profession. Managerial economics and accounting familiar
with generation, interpretation, and use of accounting data. The focus of accounting within the
enterprise is fast changing from the concept of book keeping to that of managerial decision
making.
16. Define economic analysis. (NOV 2014)
The study of forces that determine the distribution of scarce resources. Economic analysis
provides insight into how markets operate, and offers methods for attempting to
predict future market behavior in response to events, trends, and cycles. Economic analysis is
also used by governments to determine tax rates and evaluate the financial health of the
nation or state.

17. What is the main objective of managerial economics? (NOV 2014)

 Integrating economic theory with business practice.
 Using economics tools to analyze business situations.
 Applying economic principles to solve business problems.
 Using economic ideas for crisis management.
 Facilitating demand analysis and demand forecasting.
 Allocating scarce resources for optimizing returns.
 Enabling risk taking and uncertainly bearing.
 Helping in profit maximization.
 Pursuing the larger objectives of the firm other than profit maximization.
 Formulating short-term and long-term business strategies.
18. List out any two roles of managerial economist. (NOV 2015)
Economists may analyze issues such as consumer demand and sales to help a company
maximize its profits. Economists also work for research firms and think tanks, where they
study and analyze a variety of economic issues.

19. What is macro-economic condition? (NOV 2015)

National or state-level economic factors. These influence the whole aggregated economy. Changes in
employment levels, gross national product (GNP), and prices, be it deflation or inflation, are typical
influences.

20. What is discounting principle? (NOV 2015)

The discounting principle requires looking at the value of a sum of money in the present day
and comparing it to the value of the money after an amount of time. The situation where we
will use the money at a future date.

PART –B

PART – B
1. State the objectives of Modern Firm. (APRIL 2012)
The main objectives of firms are:
1. Profit maximisation
2. Sales maximisation
3. Increased market share/market dominance
4. Social/environmental concerns
5. Profit satisficing
6. Co-operatives/
Sometimes there is an overlap of objectives. For example, seeking to increase market share,
may lead to lower profits in the short-term, but enable profit maximisation in the long run.
Profit maximisation
Usually, in economics, we assume firms are concerned with maximising profit. Higher profit
means:
 Higher dividends for shareholders.
 More profit can be used to finance research and development.
 Higher profit makes the firm less vulnerable to takeover.
 Higher profit enables higher salaries for workers
Alternative aims of firms
However, in the real world, firms may pursue other objectives apart from profit
maximisation.
1. Profit Satisfying
 In many firms, there is a separation of ownership and control. Those who own the
company (shareholders) often do not get involved in the day to day running of the company.
 This is a problem because although the owners may want to maximise profits, the
managers have much less incentive to maximise profits because they do not get the same
rewards, (share dividends)
 Therefore managers may create a minimum level of profit to keep the shareholders
happy, but then maximise other objectives, such as enjoying work, getting on with other
workers. (e.g. not sacking them) This is the problem of separation between owners and
managers.
 This ‘principal-agent‘ problem can be overcome, to some extent, by giving managers
share options and performance related pay although in some industries it is difficult to
measure performance.
2. Sales maximisation
Firms often seek to increase their market share – even if it means less profit. This could occur
for various reasons:
 Increased market share increases monopoly power and may enable the firm to put up
prices and make more profit in the long run.
 Managers prefer to work for bigger companies as it leads to greater prestige and
higher salaries.
 Increasing market share may force rivals out of business. E.g. the growth of
supermarkets have lead to the demise of many local shops. Some firms may actually engage
in predatory pricing which involves making a loss to force a rival out of business.
3. Growth maximisation
This is similar to sales maximisation and may involve mergers and takeovers. With this
objective, the firm may be willing to make lower levels of profit in order to increase in size
and gain more market share. More market share increases their monopoly power and ability
to be a price setter.
4. Long run profit maximisation
In some cases, firms may sacrifice profits in the short term to increase profits in the long run.
For example, by investing heavily in new capacity, firms may make a loss in the short run but
enable higher profits in the future.
5. Social/environmental concerns
A firm may incur extra expense to choose products which don’t harm the environment or
products not tested on animals. Alternatively, firms may be concerned about local community
/ charitable concerns.
 Some firms may adopt social/environmental concerns into part of its branding. This
can ultimately help profitability as the brand becomes more attractive to consumers.
 Some firms may adopt social/environmental concerns on principal alone – even if it
does little to improve sales/brand image.
6. Co-operatives
Co-operatives may have completely different objectives to a typical PLC. A co-operative is
run to maximise the welfare of all stakeholders – especially workers. Any profit the co-
operative makes will be shared amongst all members.
Diagram showing different objectives of firms

 Q1 = Profit maximisation (MR=MC)

 Q2 = Revenue Maximisation (MR=0)
 Q3 = Marginal cost pricing (P=MC) – allocative efficiency
 Q4 = Sales maximisation – maximum sales while still making normal profit
(AR=ATC)

2. State the relationship between managerial economics and accounting.(APRIL

2013)
Accounting and managerial economics:
 Accounting data and statement constitute the language of business gone are the days when
accounting was treated as just bookkeeping. Now it’s
far more behind bookkeeping. Cost and revenue information and
t h e i r c l a s s i f i c a t i o n are influenced considerably by the accounting profession. Familiar
with generation, interpretation, and use of accounting data. The focus of accounting within the
enterprise is fast changing from the concept of bookkeeping to that of managerial decision
making.
3. Explain positive and normative analysis. (APRIL 2014)
Positive economics:
It deals with description and explanation of economic behaviour, Economics and Managerial
economics. Managerial economics draws on positive economics by utilizing the relevant theories
as a basis for prescribing choices. A pos itive
s tatemen t is a s tatementabou t w hat is and w hich contains no indication of app
roval or disapproval. It’s not like that positive statement
isa l w a y s r i g h t , p o s i t i v e s t a t e m e n t c a n b e w r o n g . P o s i t i v e s t a t e m e n t i
s a statement about what exists.
Normative economics:
It is concerned with prescription or what ought to be done. In norma
t i v e economics, it is inevitable that value judgment are made as to what should and
what s h o u l d n o t b e d o n e . M a n a g e r i a l e c o n o m i c s i s a p a r t o f n o r m a t i v
e economics as its focus is more on prescribing choice and action and less on
explaining what has happened. It expresses a judgment about whether a situation is desirable or
undesirable.
4. Explain the fundamental concepts that aid decision-making. (APRIL 2015)
The decision-making process consists of: (a) identifying the problem (b) diagnosing
the situation, (c) collecting and analyzing data relevant to the issue, (d) ascertaining solutions
that may be used in solving the problem, (e) analyzing these alternative solutions, (f)
selecting the one that appears most likely to solve the problem, and (g) implementing it. Yet
the decision making process is much more than simply following a list of steps; a great deal
of subjective as well as objective evaluation must take place. For example, the personal
values of the top manager will play a significant role in the assignment of risk and uncertainty
probabilities. In many cases even modern managerial decision making may well be 75
percent subjective, 25 percent objective.
Nevertheless the manager must be as rational as possible, drawing upon all available
techniques and guidelines in choosing among the various alternatives Some of the techniques
that are most useful in this process include the Laplace criterion, the maximin criterion, the
maximize criterion marginal analysis financial analysis, and the Delphi technique. And these
represent only a few of the techniques available to the modern manager Modern decision
making is notable for the great variety of decision-making aids it has discovered.
The creativity and decision making, creative thinking has four stages: preparation,
incubation, illumination, and verification. There are a number of techniques that can be used
to help stimulate creative thinking. Two of the most popular are brainstorming and the
Gordon technique. Recent interest has also been generated in the area of whole, brain
thinking: teaching managers to use both sides of their brain Left, brain thinkers are being
taught to be more creative; right-brain thinkers are being shown how to approach problem
solving more logically an d sequentially.
5. Explain the scope of Managerial Economics.(APRIL 2016)
Managerial Economics is a developing subject. The scope of managerial economics
refers to its area of study. Managerial economics has its roots in economic theory. The
empirical nature of managerial economics makes its scope wider. Managerial economics
provides management with strategic planning tools that can be used to get a clear perspective
of the way the business world works and what can be done to maintain profitability in an ever
changing environment.
Managerial economics refers to those aspects of economic theory and application
which are directly relevant to the practice of management and the decision making process
within the enterprise. Its scope does not extend to macro-economic theory and the economics
of public policy which will also be of interest to the manager. While considering the scope of
managerial economics we have to understand whether it is positive economics or normative
economics.

6. Discuss the uses of managerial economics (APRIL 2017)

 Deciding the price of a product and the quantity of the commodity to be produced.
 Deciding whether to manufacture a product or to buy from another manufacturer.
 Choosing the production technique to be employed in the production of a given
product.
 Deciding on the level of inventory a firm will maintain of a product or raw material.
 Deciding on the advertising media and the intensity of the advertising campaign.
 Making employment and training decisions making decisions regarding further
business investment and the mode of financing the investment.
 Tools of managerial economics can be applied equally well to decision problems of
non-profit organizations.
 Managerial economics is helpful in making optimal decisions, one should be aware
that it only describes the predictable economic consequences of a managerial decision.
7. State the relationship between managerial economics and macro-economics.
(NOV 2012) (NOV 16)
Microeconomics studies the actions of individual consumers and firms. Managerial
economics is an applied specialty of this branch. Macroeconomics deals with the
performance, structure, and behaviour of an economy as a whole. Managerial economics
applies microeconomic theories and techniques to management decisions. It is more limited
in scope as compared to microeconomics. Macroeconomists study aggregate indicators such
as GDP, unemployment rates to understand the functions of the whole economy.
Microeconomics and managerial economics both encourage the use of quantitative
methods to analyze economic data. Businesses have finite human and financial resources;
managerial economic principles can aid management decisions in allocating these resources
efficiently. Macroeconomics models and their estimates are used by the government to assist
in the development of economic policy.
Macroeconomics deals with the study of entire economy. It considers all the factors
such as government policies, business cycles, national income, etc.
8. Describe the five kinds of internal economies. (NOV 2013)
"Internal economies are those economies in production which occur to the firm itself when it
expands its output or enlarge its scale of production".
Types of Internal Economies of Scale
Following are the types of Internal economies of scale:
1. Administrative or Managerial Economies
2. Technical Economies
3. Marketing Economies or Commercial Economies
4. Indivisibility
5. Financial Economies
1. Administrative or Managerial Economies
When a firm expands its output or enlarges the scale of production it follows the principle of
division of labour and creates special departments e.g. marketing, production, cost,
processing cost accountant, marketing manager etc. and as a result production process works
smoothly. The entrepreneur gives attention to more important jobs e.g. import and export
problems, credit from banks and concessions from the government etc. The administrative
expenditures do not increase proportionally with the output and thus the firm benefits.
2. Technical Economies
Technical economies arise due to the large scale production because there is a mechanical
advantage in the use of large machines. Technical economies may arise due to large size of
the plant because it requires less energy, less staff, and proportionately less cost of installing
the plant. Specialized persons can only be employed with large machinery and plant. Thus,
large scale producer benefits from specialists.
3. Marketing Economies or Commercial Economies
These economies arise from the purchase of raw material and sale of finished goods. When
output of a firm increases, it purchases large quantity of raw material and gets preference by
the firms they deal with e.g., freight concession, cheap credit and prompt delivery etc.
4. Indivisibility
We can get total benefit from most of the factors of production when they are being used at
full capacity. If smaller output is being produced it means that they are not working according
to their efficiency. This may be due to indivisibility of factors of production.
5. Financial Economies
Another type of internal economies of scale is financial economies, these may arise due to the
reason that large scale firms have better credit facilities i.e. credit at cheaper rates, concession
from the government for credit

9. Explain the common elements emphasized by managerial economists. (NOV

2014)
The following aspects may be said to be inclusive under managerial economics:
 Demand analysis and forecasting.
 Cost and production analysis.
 Pricing decisions, policies and practices.
 Profit management.
 Capital management.
These aspects may also be defined as the ‘Subject-Matter of Managerial Economics’. In
recent years, there is a trend towards integrations of managerial economics and operations
research. Hence, techniques such as linear programming, inventory models and theory of
games have also been regarded as a part of managerial economics.

Demand Analysis and Forecasting:

A business firm is an economic organization, which transforms productive resources
into goods that are to be sold in a market. A major part of managerial decision-making
depends on accurate estimates of demand. This is because before production schedules can be
prepared and resources are employed, a forecast of future sales is essential. This forecast can
also guide the management in maintaining or strengthening the market position and enlarging
profits. The demand analysis helps to identify the various factors influencing demand for a
firm’s product and thus provides guidelines to manipulate demand. Demand analysis and
forecasting, thus, is essential for business planning and occupies a strategic place in
managerial economics. It comprises of discovering the forces determining sales and their
measurement. The chief topics covered in this are:
 Demand determinants
 Demand distinctions
 Demand forecasting.
Cost and Production Analysis.
A study of economic costs, combined with the data drawn from the firm’s accounting
records, can yield significant cost estimates. These estimates are useful for management
decisions. The factors causing variations in costs must be recognised and thereby should be
used for taking management decisions. This facilitates the management to arrive at cost
estimates, which are significant for planning purposes. An element of cost uncertainty exists
in this because all the factors determining costs are not always known or controllable.
Therefore, it is essential to discover economic costs and measure them for effective profit
planning, cost control and sound pricing practices. Production analysis is narrower in scope
than cost analysis. The chief topics covered under cost and production analysis are:
 Cost concepts and classifications
 Cost-output relationships
 Economics of scale
 Production functions
 Cost control.
Pricing Decisions, Policies and Practices.
Pricing is a very important area of managerial economics. In fact price is the origin of
the revenue of a firm. As such the success of a business firm largely depends on the accuracy
of price decisions of that firm. The important aspects dealt under area, are as follows:
 Price determination in various market forms
 Pricing methods
 Differential pricing product-line pricing and price forecasting.
Profit Management.
Business firms are generally organized with the purpose of making profits. In the long run,
profits provide the chief measure of success. In this connection, an important point worth
considering is the element of uncertainty existing about profits. This uncertainty occurs
because of variations in costs and revenues. These are caused by factors such as internal and
external. If knowledge about the future were perfect, profit analysis would have been a very
easy task. However, in a world of uncertainty, expectations are not always realized. Thus
profit planning and measurement make up the difficult area of managerial economics. The
important aspects covered under this area are:
 Nature and measurement of profit.
 Profit policies and techniques of profit planning.

Capital Management.
Among the various types and classes of business problems, the most complex and
troublesome for the business manager are those relating to the firm’s capital investments.
Capital management implies planning and control and capital expenditure. In this procedure,
relatively large sums are involved and the problems are so complex that their disposal not
only requires considerable time and labor but also top-level decisions. The main elements
dealt with cost management are:
 Cost of capital
 Rate of return and selection of projects.

The various aspects outlined above represent the major uncertainties, which a business firm
has to consider viz., demand uncertainty, cost uncertainty, price uncertainty, profit uncertainty
and capital uncertainty. We can, therefore, conclude that the role of managerial economics is
mainly concerned with applying economic principles and concepts to adjust with the various
uncertainties faced by a business firm.

10 Identify the relationships of managerial economics with applied economics.

(NOV 2014)
Managerial Economics is economics applied to decision making. It is a special branch
of economics, bridging the gap between pure economic theory and managerial practice.
Economics has two main branches—micro-economics and macro-economics.
Micro-economics:
‘Micro’ means small. It studies the behaviour of the individual units and small
groups of units. It is a study of particular firms, particular households, individual prices,
wages, incomes, individual industries and particular commodities. Thus micro-economics
gives a microscopic view of the economy.
The roots of managerial economics spring from micro-economic theory. In price
theory, demand concepts, elasticity of demand, marginal cost marginal revenue, the short and
long runs and theories of market structure are sources of the elements of micro-economics
which managerial economics draws upon. It makes use of well known models in price theory
such as the model for monopoly price, the kinked demand theory and the model of price
discrimination.
Macro-economics:
‘Macro’ means large. It deals with the behaviour of the large aggregates in the
economy. The large aggregates are total saving, total consumption, total income, total
employment, general price level, wage level, cost structure, etc. Thus macro-economics is
aggregative economics.
It examines the interrelations among the various aggregates, and causes of
fluctuations in them. Problems of determination of total income, total employment and
general price level are the central problems in macro-economics.
Macro-economies is also related to managerial economics. The environment, in
which a business operates, fluctuations in national income, changes in fiscal and monetary
measures and variations in the level of business activity have relevance to business decisions.
The understanding of the overall operation of the economic system is very useful to the
managerial economist in the formulation of his policies.
Macro-economics contributes to business forecasting. The most widely used model in
modern forecasting is the gross national product model.

11. Examine the role of cost in managerial decision making. (NOV 2014).
1. Direct and Indirect Cost 2. Opportunity Vs. Outlay Cost 3. Relevant Costs and Irrelevant
Costs 4. Past vs. Future Cost 5. Traceable (Separable) and Common Costs 6. Out of Pocket
and Book Costs 7. Committed and Discretionary Costs 8. Marginal and Incremental or
Differential Cost and Others.
Direct and Indirect Cost:
In the commercial world, some costs are incurred that can be directly attributed to the produc-
tion of one unit of a commodity. It is usually possible to determine the cost of raw materials,
labour inputs and machine time involved with production of each unit.
On the contrary, the cost of fuel, office and administrative expenses, depreciation of plant,
machinery and buildings and other items cannot be easily and accurately separated and
attributed to individual units of output (except on an arbitrary basis).
Cost and management accountants speak of the direct, or cost per unit, when they refer to
separate costs of the first category. Likewise, they refer to indirect or overhead costs when
they refer to the joint costs of the second category. The build-up of total cost showing how
direct and indirect costs are related.

Direct and indirect costs do not necessarily coincide with the economist’s concepts of fixed
and variable costs. The criterion used by the economist to draw a distinction between fixed
and variable cost is whether or not the cost varies with the level of output. But the criterion
used by the accountant is whether or not the cost is separable with respect to the production
of individual units of output.
To establish the equivalence between economist’s cost concepts and accountant’s cost
concept we must search out or identify that part of the indirect or overhead cost which varies
with the level of output.
In cost accounting, overhead expenses are often divided into two components:
(a) Variable overhead and
(b) Fixed overhead
In which case variable overhead expense per unit must be added to the direct cost per unit to
arrive at the economist’s concept of average variable cost.
Opportunity Vs. Outlay Cost:
We often draw a distinction between outlay cost and opportunity cost on the basis of the
nature of sacrifice. In managerial decision-making, a cost is not really a cost unless it requires
a sacrifice of alternatives, i.e., unless it is an opportunity cost. Therefore, it is the most
important concept for managerial decision-making.
On the contrary, the concept of cost which normally enters into the accounts of a business is
known as outlay cost. Outlay cost refers to the actual expenditure incurred on raw materials
and other productive facilities. Such costs involve “financial expenditure at some time and
hence are recorded in the book of accounts.”
On the contrary, opportunity costs “take the form of profits from alternative ventures that are
foregone by using limited facilities for a particular purpose. Since they represent only
sacrificed alternatives, they are never recorded as such in the financial accounts.”
For most productive resources such as capital goods and machinery which have already been
bought and are in the possession of the firm, the original price is not relevant for decision-
making.
Their value now depends entirely on the possibilities that are open to the firm at present. The
use of an idle machine that has no alternative use is cost-free for a particular purpose,
regardless of the amount of depreciation being charged on the machine. Likewise, if the
output of a mini steel plant or glass factory cannot be sold profitably, there is no opportunity
cost associated with letting out the plant.
Only if the decision maker can find a genuine profitable use for the space that had been lying
idle, one can assign a so-called user cost to the previously idle work space.
In the use of a machine or an equipment that has been completely written off the book, the
accounts involve a cost if its use for the purpose under consideration, requires the giving up
of alternative opportunities. In short, the cost of using a resource for one purpose is its value
in the best alternative use which has to be given up. This is the essence of the opportunity
cost principle.
Opportunity costs are implicit in nature. If a firm cannot use the raw material it has already
purchased, and no one else can be found who wants it, then the material is valueless
irrespective of what was originally paid for it. If we use it for one purpose it cannot obviously
be used for another.
Consequently opportunity costs are incurred by using resources to accomplish some objective
as opposed to using the same resources to accomplish some other goal. In reality, we hardly
come across any resource which has no alternative use.
Relevant Costs and Irrelevant Costs:
Costs that will be incurred as a result of a decision are known as relevant costs. These are
relevant for future decision-making. On the contrary, costs that have already been incurred
irrespective of what is being done by the firm at present are irrelevant costs. They have no
relevance as far as current decisions are concerned.
Past vs. Future Cost:
Joel Dean has drawn a distinction between past and future costs. He has highlighted the point
that “Most of the important managerial uses to which cost information is put actually require
forecasts of future costs, rather than ‘actual costs’, i.e., unadjusted records of past
costs.” Since managerial decisions are always forward-looking, cost forecasting is essential.
Cost forecasting is essential for expenditure control, projection of future income statements,
capital investment decisions, pricing, and decision on developing new products and dropping
old products.
Traceable (Separable) and Common Costs:
Business managers often find it necessary to draw a distinction between common and
traceable (separable) costs. Most modern business firms produce more than one product and
are thus faced with the problem of common costs. In such cases, it is difficult to attribute
costs to particular products inasmuch as they result from the mix of products rather than one
product taken at a time.
However, by applying incremental reasoning, it is possible to resolve much of the confusion
that arises when managers try to determine which costs are common and which are traceable
to a particular product. It is quite easy to determine how much a change in output of a single
product, brings about a change in a particular kind of cost. But it is quite difficult to
determine a product’s fair share of that cost.
However, what is really relevant for managerial decision-making is the change in cost rather
than its traceability. But it is necessary to take into consideration those situations in which an
increase in the output of product A results in an increase (or decrease) in the marginal cost of
product B.
Such problems are important in obtaining the product mix in those industries in which the
same raw materials or processes result in a variety of end products.
Out of Pocket and Book Costs:
Out-of-pocket costs refer to cost that involve “current payments to outsiders as opposed to
book costs, such as depreciation, that do not require current cash expenditures”. The
payments for raw materials are an out-of-pocket cost. However, all out-of pocket costs are
not variable, e.g., the night watchman’s salary.
Book costs can be “converted into out-of-pocket costs by selling assets and leasing them back
from the buyer”. For example, you can sell your factory building but can continue to use it by
paying rent to the new owner. The rental payment then replaces the depreciation charge and
interest cost of owned capital.
In an expansion problem, book costs, such as depreciation, do not exist, since the new
equipment has not been purchased. Often managers use the term ‘out-of-pocket costs’ to
mean incremental costs. But the salary of a supervisor requires a cash outlay which may not
be incremental for a given increase in output. Often the term ‘out-of-pocket’ is ambiguous on
what is really intended.
Committed and Discretionary Costs:
Businessmen and economists often speak of “completely fixed expense”. This expression is
open to diverse interpretations.
The following cost concepts are distinguished:
(a) Escapable Costs:
Cost which are fixed as long as operations are going on, but which are escapable if operations
are shut down. An example will be the salaries of the supervisory staff.
(b) Stand-by Fixed Costs:
Costs which are to be incurred even if production is halted but which are escapable if the
company is liquidated. These costs are inescapable in the short run but escapable in the long
run. Wages of watchmen or the minimum heating expense required to prevent the freezing of
pipes are obvious examples.
(c) Committed Costs:
Costs which cannot be escaped even if the company is dissolved and the assets sold are
known as unavoidable contractual costs. Such would be true of the depreciation on equipment
which has no market value.
These costs are not economic costs in the true sense since the opportunity costs are nil. But
they may appear in the accounts. These costs should be called ‘completely sunk costs’, since
they are not escapable under any circumstances.
(d) Discretionary Costs:
They are costs which are not the result of output but which are at the discretion of
management. Examples are advertising expense, research expense, and consultants’ fees. This
category may sometimes include a substantial part of wages and salaries. These expenses go
under the names of “programmed fixed costs” or “discretionary expenses”.
In retail markets, e.g., in grocery stores, costs can be broken down into three categories: fixed
costs, discretionary fixed and variable costs. The discretionary fixed costs are those that
remain fixed with respect to volume but subject to managerial decisions.
Services such as factory clearance and maintenance, garbage haulage, legal and accounting
services could be curtailed at a zero level of output. The most important item in this category,
labour cost, is clearly not a variable cost in grocery shops.
Marginal and Incremental or Differential Cost:
We have already introduced the concept of marginal cost. Marginal cost has been defined as
the addition to total cost which results from the production of one extra unit. This conception
is of limited value for decision-making, because an increment of one unit is often too small to
have any operational significance.
It is easy to measure marginal cost when the firm or plant produces a single homogeneous
product by the use of facilities which are devoted solely to that product. But in practice it is
difficult to measure marginal cost accurately because most products require the use of both
specialist and multi-purpose machinery and share the use of the latter with other products.
The concept of incremental or avoidable (escapable) cost generalizes the concept of marginal
cost. And, for most practical decision problems, the two terms incremental cost and
differential cost are used synonymously. Underlying these two cost concepts is the notion of a
change in the total costs resulting from the implementation of a decision.
The decision may involve change in production, marketing or any other business activity. For
example, the decision to float a new share, install a data processing system or launch a new
advertising campaign is not directly reflected by a change in production. Still there is a
change in total cost.
So the change in total cost that results from a change in an activity is incremental cost. If, for
example, a firm opens up a new channel of distribution, many elements of cost will remain
unaffected.
But some additional costs have to be incurred, e.g., additional salesmen are to be employed,
the information has to be brought to the notice of new customers through trade journals or
newspapers and so forth. Some management has to compute the addition to costs which
would result from the decision.
This additional cost has to be compared with the additional revenue that is likely to accrue as
a result of the decision. These costs are escapable if the decision frees the enterprise from
raising funds that would have been required otherwise.
If, by reducing production by 10% a firm can save material cost by Rs. 2,000 and labour cost
by Rs. 1,000, these costs are escapable. But since no permanent worker (like a line
supervisor) can be laid off as a result of the decision, their salaries do not enter into the
escapable-costs calculation.
There are certain practical limits to the extent to which the incremental cost analysis can be
applied. Gorden Sillingham has suggested that minor variations in costs arising out of the
decision may have to be ignored.
It is in this context that he developed the concept of attributable cost. This is defined as the
cost per unit that could be avoided, on the average, if a product or function was totally
discontinued without changing the supporting organisation structure.
As for the use of incremental cost concept in decision-making, it is now evident that the
perspective differences among alternatives are the only relevant factors to be considered. In
any business, all past receipts and expenditures as also many future ones are not at all
affected by a particular choice.
Costs that are not affected as a result of the decision are called sunk (historical) costs and are
irrelevant for decision-making. On the other hand, a cost is incremental if it results from a
decision. For example, the decision maker must consider incremental interest if the decision
requires additional capital expenditure on a project.
However, incremental costs need not necessarily vary with output, product or absolute cash
outlays. For example, suppose, after a major thunder shower, Indian Airlines management has
to decide whether or not to put on an extra flight from Patna to Ranchi.
The relevant costs to be considered here are the extra fuel costs, wear and tear on tires, the
out-of-pocket costs associated with ground crews in both locations, wages, salaries and
expenses associated with the flight itself and airport tax (landing fees), if any. What has to be
overlooked is the portion of depreciation that continues regardless of whether or not the extra
flight is added.
In some situations, incremental costs and opportunity costs may be placed in the same
category, i.e., “the incremental cost is the foregone opportunity of using limited resources in
one activity as compared with another.”
By contrast, the cost of using an idle factory space is zero, because it has no alternative uses.

12. Explain the characteristics of managerial economics. (NOV 15)

Characteristics Of Managerial Economics.

• Managerial economics is micro-economic in character. This is because the unit of study is a
firm and its problems. Managerial economics does not deal with the entire economy as a unit
of study.
• Managerial economics largely uses that body of economic concepts and principles, which is
known as Theory of the Firm or Economics of the Firm. In addition, it also seeks to apply
profit theory, which forms part of distribution theories in economics.
• Managerial economics is concrete and realistic. But it also involves complications ignored
in economic theory in order to face the overall situation in which decisions are made.
Economic theory ignores the variety of backgrounds and training found in individual firms.
Conversely, managerial economics is concerned more with the particular environment that
influences decision-making.
• Managerial economics belongs to normative economics rather than positive economics.
Normative economy is the branch of economics in which judgments about the desirability of
various policies are made. Positive economics describes how the economy behaves and
predicts how it might change. In other words, managerial economics is prescriptive rather
than descriptive. It remains confined to descriptive hypothesis.
• Managerial economics also simplifies the relations among different variables without
judging what is desirable or undesirable. For instance, the law of demand states that as price
increases, demand goes down or vice-versa but this statement does not imply if the result is
desirable or not. Managerial economics, however, is concerned with what decisions ought to
be made and hence involves value judgments. This further has two aspects: first, it tells what
aims and objectives a firm should pursue; and secondly, how best to achieve these aims in
particular situations. Managerial economics, therefore, has been described as normative
microeconomics of the firm.
• Macroeconomics is also useful to managerial economics since it provides an intelligent
understanding of the business environment. This understanding enables a business executive
to adjust with the external forces that are beyond the management’s control but which play a
crucial role in the well being of the firm. The important forces are: business cycles, national
income accounting, and economic policies of the government like those relating to taxation
foreign trade, anti-monopoly measures and labour relations.

UNIT – I PART – C

1. Discuss the important concepts of economics. (APRIL 2012)

Wants : Simply the desires of citizens. Wants are different from needs as we will see below.
Wants are a means of expressing a perceived need. Wants are broader than needs.
Needs: These are basic requirements for survival like food and water and shelter. In recent
years we have seen a perceived shift of certain items from wants to needs. Telephone service,
to many, is a need. I would argue, however, that they are wrong.
Scarcity : The fundamental economic problem facing ALL societies. Essentially it is how to
satisfy unlimited wants with limited resources. This is the issue that plagues all government
and peoples.
Factors of Production/Resources : these are those elements that a nations has at its disposal
to deal with the issue of scarcity. How efficiently these are used determines the measure of
success a nation has. They are
 Land - natural resources, etc.
 Capital - investment monies.
 Labor - the work force; size, education, quality, work ethic.
 Entrepreneurs - inventive and risk taking spirit.
 The "Three Basic Economic Questions" - these are the questions all nations must ask when
dealing with scarcity and effcientlly allocating their resources.
 What to produce?
 How to produce?
 For whom to produce?
Economics - Economics is the study the production and distribution of goods and services, it
is the study of human efforts to satisfy unlimited wants with limited resources.
Opportunity Cost - the cost of an economic decision. The classic example is "guns or butter."
What should a nation produce; butter, a need, or guns, a want? What is the cost of either
decision? If we choose the guns the cost is the butter. If we choose butter, the cost is the guns.
nations bust always deal with the questions faced by opportunity cost. It is a matter of
choices. Resources are limted thus we cannot meet every need or want.
Free Products: Air, sunshine are and other items so plentiful no one could own them.
Economists are interested in "economic products" - goods and services that are useful,
relatively scarce and transferable.
Good: tangible commodity. These are bought, sold, traded and produced.
Consumer Goods: Goods that are intended for final use by the consumer.
Capital Goods: Items used in the creation of other goods. factory machinery, trucks, Durable
Goods: Any good that lasts more than three years when used on a regular basis.
Non Durable Goods: Any item that lasts less than 3 years when used on a regular basis.
Services: Work that is performed for someone. Service cannot be touched or felt.
Consumers: people who use these goods and services.
Conspicuous Consumption: Use of a good or service to impress others.
Value: An assignment of worth. The assignment is usually based upon the utility (usefulness)
or scarcity of the item (supply and demand).
Utility: capacity to be useful.
Paradox of value: assignment of the highest value to those things we need the least, like
water and the highest things we often don't need at all like diamonds. Why do we do this?
Good question. I do not have an answer.
Wealth: the sum collection of those economic products that are tangible, scarce and useful.
Productivity - the ability to produce vast amounts of goods (economic products) in an
efficient manner. The American capilist economy is productive because:
 We use our resource efficiently.
 We specialize to increase efficiency and productivity.
 We invest in Human Capital (our labor pool)
2. An efficient business manager should have a thorough knowledge of business
environment- Explain. (APRIL 2013)
Business environment is the sum total of all external and internal factors that influence
a business. The manager should keep in mind that external factors and internal factors can
influence each other and work together to affect a business.
A health and safety regulation is an external factor that influences the internal environment of
business operations. Additionally, some external factors are beyond your control. These
factors are often called external constraints.
External Factors
Political factors are governmental activities and political conditions are known by business
manager. Examples include laws, regulations, tariffs and other trade barriers, war, and social
unrest.
Macroeconomic factors are factors that affect the entire economy. Examples include things
like interest rates, unemployment rates, currency exchange rates, consumer confidence,
consumer discretionary income, consumer savings rates, recessions, and depressions.
Microeconomic factors are factors such as market size, demand, supply, relationships with
suppliers and our distribution chain, such as retail stores that sell our products, and the
number and strength of your competition.
Social factors are basically sociological factors related to general society and social relations
that affect your business. Social factors include social movements, such as environmental
movements, as well as changes in fashion and consumer preferences. For example, clothing
fashions change with the season, and there is a current trend towards green construction and
organic foods.
Technological factors are technological innovations that can either benefit or hurt your
business. Some technological innovations can increase your productivity and profit margins,
such as computer software and automated production. On the other hand, some technological
innovations pose an existential threat to a business, such as Internet streaming challenging the
DVD rental business.
Internal factors:
Value System:
The value system of an organisation means the ethical beliefs that guide the organisation in
achieving its mission and objective. The value system of a business organisation also
determines its behaviour towards its employees, customers and society at large.
Mission and Objectives:
The objective of all firms is assumed to be maximization of long-run profits. But mission is
different from this narrow objective of profit maximization.
Organisation Structure:
The nature of organisational structure has a significant influence over decision making
process in an organisation. An efficient working of a business organisation requires that its
organisation structure should be conducive to quick decision making.
Corporate Culture and Style of Functioning of Top Management:
Corporate culture is generally considered as either closed and threatening or open and
participatory.
Quality of Human Resources:
The success of a business organisation depends to a great extent on the skills, capabilities,
attitudes and commitment of its employees.
Labour Unions:
Labour unions are other factor determining internal environment of a firm. Unions
collectively bargain with top managers regarding wages, working conditions of different
categories of employees. Smooth working of a business organisation requires that there
should be good relations between management and labour union.
Physical Resources and Technological Capabilities:
Physical resources such as plant and equipment, and technological capabilities of a firm
determine its competitive strength which is an important factor determining its efficiency and
unit cost of production.
3. Elaborate the role of cost in managerial decision making. (APRIL 2014)
The costs which should be used for decision making are often referred to as "relevant costs".
CIMA defines relevant costs as 'costs appropriate to aiding the making of specific
management decisions'.
To affect a decision a cost must be:
a) Future: Past costs are irrelevant, as we cannot affect them by current decisions and they are
common to all alternatives that we may choose.
b) Incremental: ' Meaning, expenditure which will be incurred or avoided as a result of
making a decision. Any costs which would be incurred whether or not the decision is made
are not said to be incremental to the decision.
c) Cash flow: Expenses such as depreciation are not cash flows and are therefore not relevant.
Similarly, the book value of existing equipment is irrelevant, but the disposal value is
relevant.
Other terms:
d) Common costs: Costs which will be identical for all alternatives are irrelevant, e.g. rent or
rates on a factory would be incurred whatever products are produced.
e) Sunk costs: Another name for past costs, which are always irrelevant, e.g. dedicated fixed
assets, development costs already incurred.
f) Committed costs: A future cash outflow that will be incurred anyway, whatever decision is
taken now, e.g. contracts already entered into which cannot be altered.
Opportunity cost
Relevant costs may also be expressed as opportunity costs. An opportunity cost is the benefit
foregone by choosing one opportunity instead of the next best alternative.
Example
A company is considering publishing a limited edition book bound in a special leather. It has
in stock the leather bought some years ago for $1,000. To buy an equivalent quantity now
would cost $2,000. The company has no plans to use the leather for other purposes, although
it has considered the possibilities:
a) of using it to cover desk furnishings, in replacement for other material which could cost
$900
b) of selling it if a buyer could be found (the proceeds are unlikely to exceed $800).
In calculating the likely profit from the proposed book before deciding to go ahead with the
project, the leather would not be costed at $1,000. The cost was incurred in the past for some
reason which is no longer relevant. The leather exists and could be used on the book without
incurring any specific cost in doing so. In using the leather on the book, however, the
company will lose the opportunities of either disposing of it for $800 or of using it to save an
outlay of $900 on desk furnishings.
The better of these alternatives, from the point of view of benefiting from the leather, is the
latter. "Lost opportunity" cost of $900 will therefore be included in the cost of the book for
decision making purposes.
The relevant costs for decision purposes will be the sum of:
i) 'avoidable outlay costs', i.e. those costs which will be incurred only if the book project is
approved, and will be avoided if it is not
ii) the opportunity cost of the leather (not represented by any outlay cost in connection to the
project).
This total is a true representation of 'economic cost'.

4. Discuss the difference between 'Economics' and 'Managerial Economics'.

(APRIL 2015) (NOV 2016)
Both managerial economics and traditional economics involve the production, distribution,
and consumption of goods and services, and are both reflected from the basic economic
principle of using the factors of production in an efficient manner for the production of output
of goods and services.
The main difference between the branches of economics is that traditional economics is
primitive and is used in underdeveloped and less technologically advanced economies,
whereas managerial economics is a result of globalization and evolution of economics to
include managerial decision making. Managerial economics makes the use of sophisticated
modelling systems and statistical data in decision making regarding production volumes,
pricing and distribution channels, whereas traditional economics involves the use of farming,
hunting, and pastoral activities by individuals to meet their daily consumption needs.
Economics vs. Managerial Economics
• Traditional economics is employed by less developed nations with no sophisticated
management systems, whereas managerial economics is used by modern day high-tech
economies.
• Managerial economics is concerned with modelling systems and complex managerial
decision making, whereas traditional economics is concerned with the production of food and
other necessities to meet daily requirements of individuals.
• Managerial economics represents the development that a traditional economy has been
through with globalization, development in technology and modernization of economic
theories to suit managerial decision making.

5. Discuss the role of Managerial Economist. (APRIL 2016)

1. Study of the Business Environment:
Every firm has to take into consideration such external factors as the growth of national
income, volume of trade and the general price trends, for its policy decision.
A firm works within a business environment. The basic elements of business environment for
a firm are the trend of growth of national economy and world economy and phase of the
business cycle in which the economy is moving.
At what rate and where is population getting concentrated? Where are the demand prospects
for established and new products? Where are the prospective markets? These questions lead
the economists into purposeful studies of the economic environment.
The international economic outlook is a very important environmental factor for exporting
firms. The nature and degree of competition within the industry in which a firm is placed are
also a part of the business environment. The kind of economic policies pursued by the
government constitute a powerful dement of the business environment of a firm.
What are the priorities of the new five-year plan? In which sectors of the economy have the
outlays been increased? What are the budgetary trends? What about changes in expenditure,
tax rates tariffs and import restrictions? What export incentives are being given? For all
purposes, the economists play a significant role.
2. Business Plan and Forecasting:
The business economists can help the management in the formulation of their business plan
by forecasting and economic environment. The management can easily decide the timing and
locating of their specific action. The managerial economist has to interpret the national
economic trends and industrial outlook for their relevance to the firm in which he is working.
He advises top management by means of short, business like practical notes. In a partially
controlled economy like India, the business economist translates the government’s intentions
in business jargon and also transmits the reaction of the industry to propose changes in
government policy.
3. Study of Business Operations:
The business economist can also help the management in decision making relating to the
internal operations of a firm, i.e., in deciding about price, rate of operations, investment and
growth of the firm for offering this advice: the economist has specific analytical and
forecasting techniques which yield meaningful conclusions.
What will be the reasonable sales and profit budget for the next year? What are the suitable
production schedules and inventory policies? What changes in wage and price policies are
imperative now? What would be the sources of finance? Thus, he is trained to answer such
questions posed by the top management.
4. Economic Intelligence:
The business economist also provides general intelligence services by supplying the
management with economic information of general interest so that they can talk intelligently
in conferences and seminars. They are also supplied the facts and figures for preparing the
annual reports of the firm. Those facts and figures are collected by the business economist as
he understands the literature available on business activities.
5. Specific Functions:
Business economists are now performing specific functions as consultants also. Their specific
functions are demand forecasting, industrial market research, pricing problems of industry,
production programmes, investment analysis and forecasts. They also offer advice on trade
and public relations, primary commodities and capital projects in agriculture, industry,
transport and tourism and also of the export environment.
6. Participation in Public Debates:
The business economists participate in public debates organized by different agencies. Both
governments and society seek their advice. Their practical experience in business and
industry gives value to their observation. In nut shell a business economist can play a multi-
faceted role. He is not only an analyst of current trends and policies for his employers but
also a bridge between the businessmen in the specific industry and the government. He acts
as a spokesman of his firm and interpreter of the Government.
6. “Managerial Economics is prescriptive rather than descriptive” (ARIL 2017)
Yes, it is prescriptive. The various reasons are:
 Managerial economics is micro-economic in character. This is because the unit of
study is a firm and its problems. Managerial economics does not deal with the entire
economy as a unit of study.
 Managerial economics largely uses that body of economic concepts and principles,
which is known as Theory of the Firm or Economics of the Firm. In addition, it also seeks to
apply profit theory, which forms part of distribution theories in economics.
 Managerial economics is concrete and realistic. I avoids difficult abstract issues of
economic theory. But it also involves complications ignored in economic theory in order to
face the overall situation in which decisions are made. Economic theory ignores the variety of
backgrounds and training found in individual firms. Conversely, managerial economics is
concerned more with the particular environment that influences decision-making.
 Managerial economics belongs to normative economics rather than positive
economics. Normative economy is the branch of economics in which judgments about the
desirability of various policies are made. Positive economics describes how the economy
behaves and predicts how it might change. In other words, managerial economics is
prescriptive rather than descriptive. It remains confined to descriptive hypothesis.
 Managerial economics also simplifies the relations among different variables without
judging what is desirable or undesirable. For instance, the law of demand states that as price
increases, demand goes down or vice-versa but this statement does not imply if the result is
desirable or not. Managerial economics, however, is concerned with what decisions ought to
be made and hence involves value judgments. This further has two aspects: first, it tells what
aims and objectives a firm should pursue; and secondly, how best to achieve these aims in
particular situations. Managerial economics, therefore, has been described as normative
microeconomics of the firm.
 Macroeconomics is also useful to managerial economics since it provides an
intelligent understanding of the business environment. This understanding enables a business
executive to adjust with the external forces that are beyond the management’s control but
which play a crucial role in the well being of the firm. The important forces are: business
cycles, national income accounting, and economic policies of the government like those
relating to taxation foreign trade, anti-monopoly measures and labour relations.
7. Explain the various objective of a modern firm. (NOV 2012)
The main objectives of firms are:
 Profit maximisation
 Sales maximisation
 Increased market share/market dominance
 Social/environmental concerns
 Profit satisficing
 Co-operatives/
Sometimes there is an overlap of objectives. For example, seeking to increase market share,
may lead to lower profits in the short-term, but enable profit maximisation in the long run.
Profit maximisation
Usually, in economics, we assume firms are concerned with maximising profit. Higher profit
means:
 Higher dividends for shareholders.
 More profit can be used to finance research and development.
 Higher profit makes the firm less vulnerable to takeover.
 Higher profit enables higher salaries for workers
Alternative aims of firms

However, in the real world, firms may pursue other objectives apart from profit
maximisation.
1. Profit Satisfying
 In many firms, there is a separation of ownership and control. Those who own the
company (shareholders) often do not get involved in the day to day running of the
company.
 This is a problem because although the owners may want to maximise profits, the
managers have much less incentive to maximise profits because they do not get
the same rewards, (share dividends)
 Therefore managers may create a minimum level of profit to keep the
shareholders happy, but then maximise other objectives, such as enjoying work,
getting on with other workers. (e.g. not sacking them) This is the problem of
separation between owners and managers.
 This ‘principal-agent‘ problem can be overcome, to some extent, by giving
managers share options and performance related pay although in some industries
it is difficult to measure performance.
2. Sales maximisation
Firms often seek to increase their market share – even if it means less profit. This could occur
for various reasons:
 Increased market share increases monopoly power and may enable the firm to put up
prices and make more profit in the long run.
 Managers prefer to work for bigger companies as it leads to greater prestige and
higher salaries.
 Increasing market share may force rivals out of business. E.g. the growth of
supermarkets have lead to the demise of many local shops. Some firms may actually
engage in predatory pricing which involves making a loss to force a rival out of
business.
3. Growth maximisation
This is similar to sales maximisation and may involve mergers and takeovers. With this
objective, the firm may be willing to make lower levels of profit in order to increase in size
and gain more market share. More market share increases their monopoly power and ability
to be a price setter.
4. Long run profit maximisation
In some cases, firms may sacrifice profits in the short term to increase profits in the long run.
For example, by investing heavily in new capacity, firms may make a loss in the short run but
enable higher profits in the future.
5. Social/environmental concerns
A firm may incur extra expense to choose products which don’t harm the environment or
products not tested on animals. Alternatively, firms may be concerned about local community
/ charitable concerns.
 Some firms may adopt social/environmental concerns into part of its branding. This
can ultimately help profitability as the brand becomes more attractive to consumers.
 Some firms may adopt social/environmental concerns on principal alone – even if it
does little to improve sales/brand image.
6. Co-operatives
Co-operatives may have completely different objectives to a typical PLC. A co-operative is
run to maximise the welfare of all stakeholders – especially workers. Any profit the co-
operative makes will be shared amongst all members.
Diagram showing different objectives of firms

 Q1 = Profit maximisation (MR=MC)

  Q2 = Revenue Maximisation (MR=0)
 Q3 = Marginal cost pricing (P=MC) – allocative efficiency
 Q4 = Sales maximisation – maximum sales while still making normal profit
(AR=ATC)
8. Describe the fundamental concepts of Managerial Economics. (NOV 2015)
Managerial Economics can be defined as amalgamation of economic theory with business
practices so as to ease decision-making and future planning by management. Managerial
Economics assists the managers of a firm in a rational solution of obstacles faced in the
firm’s activities. It makes use of economic theory and concepts. It helps in formulating
logical managerial decisions. The key of Managerial Economics is the micro-economic
theory of the firm. It lessens the gap between economics in theory and economics in
practice. Managerial Economics is a science dealing with effective use of scarce resources.
It guides the managers in taking decisions relating to the firm’s customers, competitors,
suppliers as well as relating to the internal functioning of a firm. It makes use of statistical
and analytical tools to assess economic theories in solving practical business problems.
Study of Managerial Economics helps in enhancement of analytical skills, assists in
rational configuration as well as solution of problems. While microeconomics is the study
of decisions made regarding the allocation of resources and prices of goods and services,
macroeconomics is the field of economics that studies the behavior of the economy as a
whole (i.e. entire industries and economies). Managerial Economics applies micro-
economic tools to make business decisions. It deals with a firm.
The use of Managerial Economics is not limited to profit-making firms and organizations.
But it can also be used to help in decision-making process of non-profit organizations
(hospitals, educational institutions, etc). It enables optimum utilization of scarce resources in
such organizations as well as helps in achieving the goals in most efficient manner.
Managerial Economics is of great help in price analysis, production analysis, capital
budgeting, risk analysis and determination of demand.Managerial economics uses
both Economic theory as well as Econometrics for rational managerial decision making.
Econometrics is defined as use of statistical tools for assessing economic theories by
empirically measuring relationship between economic variables. It uses factual data for
solution of economic problems. Managerial Economics is associated with the economic
theory which constitutes “Theory of Firm”. Theory of firm states that the primary aim of the
firm is to maximize wealth. Decision making in managerial economics generally involves
establishment of firm’s objectives, identification of problems involved in achievement of
those objectives, development of various alternative solutions, selection of best alternative
and finally implementation of the decision. The following figure tells the primary ways in
which Managerial Economics correlates to managerial decision-making.
 UNIT – II – PART - A
1. What is an indifference map? (APRIL 2012) (NOV 2015)
An indifference curve is a curve which represents all those combinations of goods which give
same satisfaction to the consumer. Since all the combinations on an indifference curve give
equal satisfaction to the consumer, the consumer is indifferent among them. In other words,
since all the combinations provide same level of satisfaction the consumer prefers them
equally and does not mind which combination he gets.

2. Write the law of diminishing marginal utility. (APRIL 2012)

The law of diminishing marginal utility is a law of economics stating that as a person
increases consumption of a product while keeping consumption of other products constant,
there is a decline in themarginal utility that person derives from consuming each additional
unit of that product.

3. What is meant by perfectly inelastic demand? (APRIL 2012)

Perfectly inelastic demand is one in which a change in price produce no change in demand.
4. What is demand? (APRIL 2012) (APRIL 2016) (NOV 2012)
The demand in economics means both the desire to purchase as well as the ability to pay for
the good. Demand is different from the quantity demanded. Demand is the quantities that the
buyers are willing and able to buy at alternative prices during the given period of time
whereas quantity demanded is a specific amount that buyers are willing and able to buy at on
price.
5. Define utility. ( APRIL 2013)
The goods satisfy human wants. This want satisfying quality in a good is called Utility.
Utility is that quality in a commodity by virtue of which it is capable of satisfying a human
want. Air, water (free goods) and food, cloth etc. (economic goods) satisfies people’s wants
and hence they possess utility.
6. What are demand schedules? ( APRIL 2013) (APRIL 2017)
A demand schedule is how much of a given product a household would be willing to buy at
different prices. Demand curves are usually derived from demand schedules.
The demand curve is a graph illustrating how much of a given product a household would be
willing to buy at different prices.
7. What is income elasticity of demand? ( APRIL 2013) (NOV 2016)
Income elasticity of demand refers to the percentage change in quantity demanded due to
percentage change in income.
8. State the motives of demand for money. (APRIL 2014)
People demand commodities such as rice, wheat, clothes, etc. because these goods possess
utility. However, money does not possess any utility to directly satisfy the consumers. Money
is wanted by the people are as follows: (a) Transaction Motive (b) Precautionary Motive (c)
Speculative Motive.
9. List the exceptions to the law of demand. (APRIL 2014)
 Conspicuous goods
 Giffen goods
 The law has been derived assuming consumers to be rational and knowledgeable
about market-conditions.
 Similarly, in practice, a household may demand larger quantity of a commodity even
at a higher price because it may be ignorant of the ruling price of the commodity.
Under such circumstances, the law will not remain valid.
 The law of demand will also fail if there is any significant change in other factors on
which demand of a commodity depends.
10. Define price elasticity of demand. (APRIL 2014),(APRIL 2015)
The response of the consumers to a change in the price of a commodity is measured by the
price elasticity of the commodity demand. The responsiveness of changes in quantity
demanded due to changes in price is referred to as price elasticity of demand. The price
elasticity of demand is measured by dividing the percentage change in quantity demanded by
the percentage change in price.
Price Elasticity = Proportionate change in the Quantity Demanded /
Proportionate change in price
Percentage change in quantity demanded
= ----------------------------------------------
Percentage change in price
11. Name the types of elasticity of demand. (APRIL 2014)
 Price Elasticity Of Demand.
 Income Elasticity Of Demand.
 Cross Elasticity Of Demand.
12. State the aspects of income demand relationship. (APRIL 2014)
The income effect represents the change in an individual's or economy's income and shows
how that change impacts the quantity demanded of a good or service. The relationship
between income and quantity demanded is a positive one; as income increases, so does the
quantity of goods and services demanded. For example, when an individual's income
increases, that person demands more goods and services, thus increasing consumption, all
things equal.
13. What are the demand forecasting approaches? (APRIL 2014)
 Survey of Buyer’s-Intentions
 Collective Opinion or Sales Force Competitive Method
 Trend Projection or Time Trend of the Time Series
 Executive Judgment Method
 Economic Indicators
 Controlled Experiments
 Expert’s Opinions
14. What is marginal utility? (APRIL 2015)
Marginal utility measures the added satisfaction derived from a one unit increase in
consumption of a particular good or service, holding consumption of other goods and services
constant. The relationship between demand and marginal utility can explain the behaviour of
demand in relation to price.
15. What is Elasticity of demand? (APRIL 2015) (APRIL 2017)
Elasticity of Demand is a technical term used by economists to describe the degree of
responsiveness of the demand for a commodity due to a fall in its price. A fall in price leads
to an increase in quantity demanded and vice versa.
16. What is marginal revenue? (APRIL 2016)
It refers to the net additional income to the total revenue when an extra unit of the product is
sold. It is equal to the ratio between change in Total revenue and change in total output sold
in the market MR=ΔTC/ΔTO
17. What is marginal rate of substitution? (APRIL 2016) (NOV 2012)
Marginal Rate of Substitution (MRS) is the rate at which the consumer is prepared to
exchange goods X and Y. In the beginning the consumer is consuming 1 unit of food and 12
units of clothing. Subsequently, he gives up 6 units of clothing to get an extra unit of food, his
level of satisfaction remaining the same. The MRS here is 6.
Or
In economics, the marginal rate of substitution (MRS) is the rate at which a consumer is
ready to give up one good in exchange for another good while maintaining the same level of
utility. At equilibrium consumption levels (assuming no externalities), marginal rates of
substitution are identical.
18. State equi – marginal principles (APRIL 2017)
"Law of equi-marginal principle states that to maximise utility, consumers way allocate their
limited incomes among goods and services in such a way that the marginal utilities per dollar
(rupee) of expenditure on the last unit of each good purchased will be equal".
Equi - marginal principle suggests that available resources (inputs) should be so allocated
between the alternative options that the marginal productivity gains (MP) from the various
activities are equalised.
19. What is Indifference schedule? (NOV 2012) (NOV 2016)
An indifference schedule is a list of combination of two commodities, the list being so
arranged that a consumer is indifferent to the combinations, preferring none of them to any of
other.
20. What is Advertising elasticity of demand? (NOV 2012)
Advertising elasticity is a measure of an advertising campaign's effectiveness in generating
new sales. It is calculated by dividing the percentage change in the quantity demanded by the
percentage change in advertising expenditures.
21. What is effective demand? (NOV 2013)
Effective Demand, as opposed to latent demand when a customer/consumer is unable to
satisfy their demand, whether it is due to lack of information about the availability of a
product or due to lack of lack of money. Or effective demand is the “ability” to pay for goods
and services.
22. Define wealth in economics. (NOV 2013)
An individual who is considered wealthy, affluent, or rich is someone who has accumulated
substantial wealth relative to others in their society or reference group. In economics, net
worth refers to the value of assets owned minus the value of liabilities owed at a point in
time.
23. What are durable consumer goods? (NOV 2013)
Durable goods are a category of consumer products that do not need to be purchased
frequently because they are made to last for a long time (usually lasting for three years or
more). They are also called consumer durables or durables.
24. What does demand for a product imply? (NOV 2014)
A situation in which the demand for a product does not increase or decrease correspondingly
with a fall or rise in its price. From the supplier’s viewpoint, this is a highly desirable
situation because price and total revenue are directly related: an increase in price increase
total revenue despite a fall in the quantity demanded. An example of a product with inelastic
demand is gasoline.

25. Define direct demand. (NOV 2014)

Direct demand is the demand for goods and services that directly satisfy consumer desires. In
other words, direct demand is the demand for personal consumption products. The value or
worth of a good or service, its utility, is the prime determinant of direct demand.
26. What is Income effect? (NOV 2015)
Income effect refers to the changes in the real income of the consumer due to changes in
price. Real income may be defined as total units of goods purchased with a given amount of
money. When price of a particular commodity falls, the consumer‘s real income rises, though
money income remains the same. Thus, with the fall in the price of the commodity, the
purchasing power of the real income of the consumer will rise, i.e. the consumer can now
purchase the same amount of commodity with less money or he can now purchase more with
the same money. The reverse also holds good.
27. What do you mean by Isoquant? (NOV 2015)
An isoquant is a firm's counterpart of the consumer's indifference curve. An isoquant is a
curve that shows all the combinations of inputs that yield the same level of output.
'Iso' means equal and 'quant' means quantity. Therefore, an isoquant represents a constant
quantity of output.

28. Demand is law of demand? (NOV 2016)

Demand
The demand for a commodity is its quantity which consumers are able and willing to buy at
various prices during a given period of time.
Law of demand:
There is an inverse relationship between quantity demanded and its price. The people know
that when price of a commodity goes up its demand comes down. When there is decrease in
price the demand for a commodity goes up. There is inverse relation between price and
demand . The law refers to the direction in which quantity demanded changes due to change
in price.
So law of demand and demand inverse relationship.
29. Define ISO-quants(NOV 2016)
“The Iso- quants defined as the different combinations of two resources with which a firm
can produce equal amount of product.”
30. What are the properties of Isoquants? (APRIL 2012)
 Iso-Product Curves Slope Downward from Left to Right.
 Isoquants are Convex to the Origin.
 Two Iso-Product Curves Never Cut Each Other.
 Higher Iso-Product Curves Represent Higher Level of Output.
 Isoquants Need Not be Parallel to Each Other.

UNIT – II - PART B

1. Discuss the steps involved in demand forecasting. (APRIL 2012)

Steps in Demand Forecasting
Definition: Demand Forecasting is a systematic process of predicting the future demand for a
firm’s product. Simply, estimating the potential demand for a product in the future is called as
demand forecasting.
The demand forecasting finds its significance where the large-scale production is involved.
Such firms may often face difficulties in obtaining a fairly accurate estimation of future
demand. Thus, it is essential to forecast demand systematically and scientifically to arrive at
desired objective. Therefore, the following steps are taken to facilitate a systematic demand
forecasting:
Specifying the Objective: The objective for which the demand forecasting is to be done
must be clearly specified. The objective may be defined in terms of; long-term or short-term
demand, the whole or only the segment of a market for a firm’s product, overall demand for a
product or only for a firm’s own product, firm’s overall market share in the industry, etc. The
objective of the demand must be determined before the process of demand forecasting begins
as it will give direction to the whole research.
Determining the Time Perspective: On the basis of the objective set, the demand forecast
can either be for a short-period, say for the next 2-3 year or a long period. While forecasting
demand for a short period (2-3 years), many determinants of demand can be assumed to
remain constant or do not change significantly. While in the long run, the determinants of
demand may change significantly. Thus, it is essential to define the time perspective, i.e., the
time duration for which the demand is to be forecasted.
Making a Choice of Method for Demand Forecasting: Once the objective is set and the
time perspective has been specified the method for performing the forecast is selected. There
are several methods of demand forecasting falling under two categories; survey
methods and statistical methods.
The Survey method includes consumer survey and opinion poll methods, and the statistical
methods include trend projection, barometric and econometric methods. Each method varies
from one another in terms of the purpose of forecasting, type of data required, availability of
data and time frame within which the demand is to be forecasted. Thus, the forecaster must
select the method that best suits his requirement.
Collection of Data and Data Adjustment: Once the method is decided upon, the next step is
to collect the required data either primary or secondary or both. The primary data are the first-
hand data which has never been collected before. While the secondary data are the data
already available. Often, data required is not available and hence the data are to be adjusted,
even manipulated, if necessary with a purpose to build a data consistent with the data
required.
Estimation and Interpretation of Results: Once the required data are collected and the
demand forecasting method is finalized, the final step is to estimate the demand for the
predefined years of the period. Usually, the estimates appear in the form of equations, and the
result is interpreted and presented in the easy and usable form.
Thus, the objective of demand forecasting can only be achieved only if these steps are
followed systematically.
2. Explain the difference between ‘change in demand’ and ‘Amount demanded’.
(APRIL 2013) (APRIL 2016)
In economics the terms change in quantity demanded and change in demand are two
different concepts. Change in quantity demanded refers to change in the quantity purchased
due to increase or decrease in the price of a product. In such a case, it is incorrect to say
increase or decrease in demand rather it is increase or decrease in the quantity demanded. On
the other hand, change in demand refers to increase or decrease in demand of a product due to
various determinants of demand, while keeping price at constant.
 Changes in quantity demanded can be measured by the movement of demand curve,
while changes in demand are measured by shifts in demand curve. The terms, change in
quantity demanded refers to expansion or contraction of demand, while change in demand
means increase or decrease in demand.
Expansion and Contraction of Demand:
The variations in the quantities demanded of a product with change in its price, while
other factors are at constant, are termed as expansion or contraction of demand. Expansion of
demand refers to the period when quantity demanded is more because of the fall in prices of a
product. However, contraction of demand takes place when the quantity demanded is less due
to rise in the price o a product.
For example, consumers would reduce the consumption of milk in case the prices of
milk increases and vice versa. Expansion and contraction are represented by the movement
along the same demand curve. Movement from one point to another in a downward direction
shows the expansion of demand, while an upward movement demonstrates the contraction of
demand.
Demonstrates the expansion and contraction of demand:

When the price changes from OP to OP1 and demand moves from OQ to OQ1, it shows the
expansion of demand. However, the movement of price from OP to OP2 and movement of
demand from OQ to OQ2 show the contraction of demand.
Increase and Decrease in Demand:

Increase and decrease in demand are referred to change in demand due to changes in
various other factors such as change in income, distribution of income, change in consumer’s
tastes and preferences, change in the price of related goods, while Price factor is kept
constant Increase in demand refers to the rise in demand of a product at a given price.
On the other hand, decrease in demand refers to the fall in demand of a product at a
given price. For example, essential goods, such as salt would be consumed in equal quantity,
irrespective of increase or decrease in its price. Therefore, increase in demand implies that
there is an increase in demand for a product at any price. Similarly, decrease in demand can
also be referred as same quantity demanded at lower price, as the quantity demanded at
higher price.
Increase and decrease in demand is represented as the shift in demand curve. In the
graphical representation of demand curve, the shifting of demand is demonstrated as the
movement from one demand curve to another demand curve. In case of increase in demand,
the demand curve shifts to right, while in case of decrease in demand, it shifts to left of the
original demand curve.

Figure shows the increase and decrease in demand:

The movement from DD to D1D1 shows the increase in demand with price at constant (OP).
However, the quantity has also increased from OQ to OQ1.
Figure shows the decrease in demand:

Figure the movement from DD to D2D2 shows the decrease in demand with price at constant
(OP). However, the quantity has also decreased from OQ to OQ2.

3. Explain the different types of demand forecasting. (APRIL 2013)or Explain the
various methods of forecasting. (NOV 2012)
Forecasts can be broadly classified into:
(i) Passive Forecast and
(ii) Active Forecast.
Under passive forecast prediction about future is based on the assumption that the
firm does not change the course of its action. Under active forecast, prediction is done under
the condition of likely future changes in the actions by the firms.
From the view point of ‘time span’, forecasting may be classified into two, viz.,:
(i) Short term demand forecasting and (ii) long term demand forecasting. In a short
run forecast, seasonal patterns are of much importance. It may cover a period of three
months, six months or one year. It is one which provides information for tactical decisions.
Which period is chosen depends upon the nature of business. Such a forecast helps in
preparing suitable sales policy. Long term forecasts are helpful in suitable capital planning. It
is one which provides information for major strategic decisions. It helps in saving the
wastages in material, man hours, machine time and capacity. Planning of a new unit must
start with an analysis of the long term demand potential of the products of the firm.
There are basically two types of forecast, viz.,:
(i) External or national group of forecast, and
(ii) (ii) Internal or company group forecast.
External forecast deals with trends in general business. It is usually prepared by a
company’s research wing or by outside consultants. Internal forecast includes all those that
are related to the operation of a particular enterprise such as sales group, production group,
and financial group. The structure of internal forecast includes forecast of annual sales,
forecast of products cost, forecast of operating profit, forecast of taxable income, forecast of
cash resources, forecast of the number of employees, etc.
At different levels forecasting may be classified into:
(i) Macro-level forecasting,
(ii) Industry- level forecasting,
(iii) Firm- level forecasting and
(iv) Product-line forecasting.
Macro-level forecasting is concerned with business conditions over the whole
economy. It is measured by an appropriate index of industrial production, national income or
expenditure. Industry-level forecasting is prepared by different trade associations.
This is based on survey of consumers’ intention and analysis of statistical trends.
Firm-level forecasting is related to an individual firm. It is most important from managerial
view point. Product-line forecasting helps the firm to decide which of the product or products
should have priority in the allocation of firm’s limited resources.
Forecast may be classified into (i) general and (ii) specific. The general forecast may
generally be useful to the firm. Many firms require separate forecasts for specific products
and specific areas, for this general forecast is broken down into specific forecasts.

4. Explain the factors influencing demand forecast. (APRIL 2014)

1. Prevailing business conditions: While preparing demand forecast it becomes
necessary to study the general economic conditions very carefully. These include the price
level changes, change in national income, per-capita income, consumption pattern, savings
and investment habits, employment etc.
2. Conditions within the industry: Every business enterprise is only a unit of a
particular industry. Sales of that business enterprise are only a part of the total sales of that
industry. Therefore, while preparing demand forecasts for a particular business enterprise, it
becomes necessary to study the changes in the demand of the whole industry, number of units
within the industry, design and quality of product, price policy, competition within the
industry etc.
3. Conditions within the firm: Internal factors of the firm also affect the demand
forecast. These factors include plant capacity of the firm, quality of the product, price of the
product, advertising and distribution policies, production policies, financial policies etc.
4. Factors affecting export trade: If a firm is engaged in export trade also it should
consider the factors affecting the export trade. These factors include import and export
control, terms and conditions of export, exim policy, export conditions, export finance etc.
5. Market behavior : While preparing demand forecast, it is required to consider the
market behavior which brings about changes in demand.
6. Sociological conditions: Sociological factors have their own impact on demand
forecast of the company. These conditions relate to size of population, density, change in age
groups, size of family, family life cycle, level of education, family income, social awareness
etc.
7. Psychological conditions: While estimating the demand for the product, it becomes
necessary to take into consideration such factors as changes in consumer tastes, habits,
fashions, likes and dislikes, attitudes, perception, life styles, cultural and religious bents etc.
8. Competitive conditions: The competitive conditions within the industry may
change. Competitors may enter into market or go out of market. A demand forecast prepared
without considering the activities of competitors may not be correct.

5. Describe the factors influencing elasticity of demand. (APRIL 2015)

1. Nature of commodity:
Elasticity of demand of a commodity is influenced by its nature. A commodity for a
person may be a necessity, a comfort or a luxury.
i. When a commodity is a necessity like food grains, vegetables, medicines, etc., its demand
is generally inelastic as it is required for human survival and its demand does not fluctuate
much with change in price.
ii. When a commodity is a comfort like fan, refrigerator, etc., its demand is generally elastic
as consumer can postpone its consumption
iii. When a commodity is a luxury like AC, DVD player, etc., its demand is generally more
elastic as compared to demand for comforts.
iv. The term ‘luxury’ is a relative term as any item (like AC), may be a luxury for a poor
person but a necessity for a rich person.
2. Availability of substitutes:
Demand for a commodity with large number of substitutes will be more elastic. The
reason is that even a small rise in its prices will induce the buyers to go for its substitutes. For
example, a rise in the price of Pepsi encourages buyers to buy Coke and vice-versa.
Thus, availability of close substitutes makes the demand sensitive to change in the prices. On
the other hand, commodities with few or no substitutes like wheat and salt have less price
elasticity of demand.
3. Income Level:
Elasticity of demand for any commodity is generally less for higher income level groups in
comparison to people with low incomes. It happens because rich people are not influenced
much by changes in the price of goods. But, poor people are highly affected by increase or
decrease in the price of goods. As a result, demand for lower income group is highly elastic.
4. Level of price:
Level of price also affects the price elasticity of demand. Costly goods like laptop, Plasma
TV, etc. have highly elastic demand as their demand is very sensitive to changes in their
prices. However, demand for inexpensive goods like needle, match box, etc. is inelastic as
change in prices of such goods do not change their demand by a considerable amount.
5. Postponement of Consumption:
Commodities like biscuits, soft drinks, etc. whose demand is not urgent, have highly elastic
demand as their consumption can be postponed in case of an increase in their prices.
However, commodities with urgent demand like life saving drugs, have inelastic demand
because of their immediate requirement.
6. Number of Uses:
If the commodity under consideration has several uses, then its demand will be elastic. When
price of such a commodity increases, then it is generally put to only more urgent uses and, as
a result, its demand falls. When the prices fall, then it is used for satisfying even less urgent
needs and demand rises.
For example, electricity is a multiple-use commodity. Fall in its price will result in substantial
increase in its demand, particularly in those uses (like AC, Heat convector, etc.), where it was
not employed formerly due to its high price. On the other hand, a commodity with no or few
alternative uses has less elastic demand.
7. Share in Total Expenditure:
Proportion of consumer’s income that is spent on a particular commodity also influences the
elasticity of demand for it. Greater the proportion of income spent on the commodity, more is
the elasticity of demand for it and vice-versa. Demand for goods like salt, needle, soap, match
box, etc. tends to be inelastic as consumers spend a small proportion of their income on such
goods. When prices of such goods change, consumers continue to purchase almost the same
quantity of these goods. However, if the proportion of income spent on a commodity is large,
then demand for such a commodity will be elastic.
8. Time Period:
Price elasticity of demand is always related to a period of time. It can be a day, a week, a
month, a year or a period of several years. Elasticity of demand varies directly with the time
period. Demand is generally inelastic in the short period. It happens because consumers find
it difficult to change their habits, in the short period, in order to respond to a change in the
price of the given commodity. However, demand is more elastic in long rim as it is
comparatively easier to shift to other substitutes, if the price of the given commodity rises.
9. Habits:
Commodities, which have become habitual necessities for the consumers, have less elastic
demand. It happens because such a commodity becomes a necessity for the consumer and he
continues to purchase it even if its price rises. Alcohol, tobacco, cigarettes, etc. are some
examples of habit forming commodities. Finally it can be concluded that elasticity of demand
for a commodity is affected by number of factors. However, it is difficult to say, which
particular factor or combination of factors determines the elasticity. It all depends upon
circumstances of each case.

6. Describe the elasticity of demand and revenue relationship. (APRIL 2015)

Price elasticity of demand measures the responsiveness of quantity demanded to a
change in price. The law of demand says that when price falls (rises), quantity demanded
increases (decreases).
 When the quantity increase (or decrease) is greater than fall (rise) in price, elasticity
of demand is greater than 1. Hence, high responsiveness of demand to change in
price.
 When the quantity increase (decrease) is equal to fall (rise) in price, elasticity of
demand is equal to 1. Hence, responsiveness of demand is moderate to change in
price.
 When the quantity increase (decrease) is less than fall (rise) in price, elasticity of
demand is less than 1. Hence, responiseveness of demand is low to change in price.
We know, Revenue = Price (P) * Quantity (Q). Now for a producer the most
favourable situation is the last one when the consumers (demanders) have no option but to
decrease the quantity consumed by not much when price is increased.
To give an example, say right now the Revenue is ₹100 where P =10; Q= 10. Now ,
say the producer is aware of the fact that the price elasticity of demand is less than 1 and
therefore he decides to increase the price to ₹12 (20% increase in price). According to law of
demand, there will be a fall in quantity. But as elasticity of demand is less than 1, quantity of
demand will fall by less than 20% , say to 9 (fall of 10%).
New revenue effective after price increase will be 12*9 = ₹108.
Here, the producer has gained ₹8 in spite of a price increase. The point is, the
producer realised that the responsiveness of quantity demanded to increase in price is low, so
consumers don't have much of an option but to not let the total quantity demanded to fall by
too much. This is why such products are said to have a relatively inelastic demand. Examples
are: salt, cigarettes, alcohol.
In case of elastic demand (case 1), revenue will fall for an increase (or decrease) in price. In
case of unit elastic demand (case 2), revenue will remain unchanged for an increase (or
decrease) in price.

7. Explain the objectives and purposes of forecasting. (APRIL 2016) (NOV 2012)
Demand forecasting constitutes an important part in making crucial business decisions.
The objectives of demand forecasting are divided into short and long-term objectives.
i. Short-term Objectives:
a. Formulating production policy:
It helps in covering the gap between the demand and supply of the product. The demand
forecasting helps in estimating the requirement of raw material in future, so that the regular
supply of raw material can be maintained. It further helps in maximum utilization of
resources as operations are planned according to forecasts. Similarly, human resource
requirements are easily met with the help of demand forecasting.
b. Formulating price policy:
It refers to one of the most important objectives of demand forecasting. An organization sets
prices of its products according to their demand. For example, if an economy enters into
depression or recession phase, the demand for products falls. In such a case, the organization
sets low prices of its products.
c. Controlling sales:
It helps in setting sales targets, which act as a basis for evaluating sales performance. An
organization makes demand forecasts for different regions and fixes sales targets for each
region accordingly.
d. Arranging finance:
Implies that the financial requirements of the enterprise are estimated with the help of
demand forecasting. This helps in ensuring proper liquidity within the organization.
ii. Long-term Objectives:
a. Deciding the production capacity:
Implies that with the help of demand forecasting, an organization can determine the size of
the plant required for production. The size of the plant should conform to the sales
requirement of the organization.
b. Planning long-term activities:
Implies that demand forecasting helps in planning for long term. For example, if the
forecasted demand for the organization’s products is high, then it may plan to invest in
various expansion and development projects in the long term.
PURPOSE of FORECASTING:
Forecasting is an approach to determine what the future holds. It is an estimate of
what the future will look like that every function within an organization needs in order to
build their current plans. Today, all organizations operate in an atmosphere of uncertainty.
Decisions that are made by organizations today will affect future outcomes. Here are a few
examples:
The eventualities and contingencies of general economic business cycles. An
expansion following enlargement and growth in business involves the use of additional
machinery, personnel, and a re-allocation of facilities, Changes in management philosophies
and leadership styles, The use of mechanical technology. Dynamic changes in the quantity or
quality of products and/or services require a change in the organization structure.
6. Explain the theory of consumer behaviour. (APRIL 2017) or Explain the different
theories of consumer behaviour. (NOV 16)
1. Rationality:
The consumer is assumed to be rational he aims at the maximization of his utility,
given his income and market prices. It is assumed he has full knowledge (certainty) of all
relevant information.
Utility is ordinal:
It is taken as axiomatically true that the consumer can rank his preferences (order the
various ‘baskets of goods’) according to the satisfaction of each basket. He need not know
precisely the amount of satisfaction. It suffices that he expresses his preference for the
various bundles of commodities. It is not necessary to assume that utility is cardinally
measurable. Only ordinal measurement is required.
Diminishing marginal rate of substitution:
Preferences are ranked in terms of indifference curves, which are assumed to be
convex to the origin. This implies that the slope of the indifference curves increases. The
slope of the indifference curve is called the marginal rate of substitution of the commodities.
The indifference-curve theory is based, thus, on the axiom of diminishing marginal rate of
substitution.
The total utility of the consumer depends on the quantities of the commodities consumed
U = f (q1, q2,…, qx, qy,………….. qn)
Consistency and transitivity of choice:
It is assumed that the consumer is consistent in his choice, that is, if in one period he
chooses bundle A over B, he will not choose B over A in another period if both bundles are
available to him.
The consistency assumption may be symbolically written as follows:
If A > B, then B !> A
Similarly, it is assumed that consumer’s choices are characterised by transitivity: if bundle A
is preferred to B, and B is preferred to C, then bundle A, is preferred to C.
Symbolically we may write the transitivity assumption as follows:
If A > B, and B > C, then A > C
Equilibrium of the consumer:
To define the equilibrium of the consumer (that is, his choice of the bundle that
maximizes his utility) we must introduce the concept of indifference curves and of their slope
(the marginal rate of substitution), and the concept of the budget line. These are the basic
tools of the indifference curves approach.
Indifference curves:
An indifference curve is the locus of points – particular combinations or bundles of
goods-which yield the same utility (level of satisfaction) to the consumer, so that he is
indifferent as to the particular combination he consumes.
An indifference map shows all the indifference curves which rank the preferences of
the consumer. Combinations of goods situated on an indifference curve yield the same utility.
Combinations of goods lying on a higher indifference curve yield higher level of satisfaction
and are preferred. Combinations of goods on a lower indifference curve yield a lower utility.
An indifference curve is show and a partial indifference map is depicted in figure 2.6. It is
assumed that the commodities y and x can substitute one another to a certain extent but are
not perfect substitutes.
 The negative of the slope of an indifference curve at any one point is called the
marginal rate of substitution of the two commodities, x and y, and is given by the slope of the
tangent at that point
[Slope of indifference curve] = – dy/dx = MRSx,y
The marginal rate of substitution of x for y is defined as the number of units of
commodity y that must be given up in exchange for an extra unit of commodity x so that the
consumer maintains the same level of satisfaction. With this definition the proponents of the
indifference-curves approach thought that they could avoid the non-operational concept of
marginal utility.
In fact, what they avoid is the assumption of diminishing individual marginal utilities
and the need for their measurement. The concept of marginal utility is implicit in the
definition of the MRS, since it can be proved that the marginal rate of substitution (the slope
of the indifference curve) is equal to the ratio of the marginal utilities of the commodities
involved in the utility function
MRSx,y = MUx / MUy or MRSy,x = MUy/Mux
Furthermore, the indifference-curves theorists substitute the assumption of
diminishing marginal utility with another which may also be questioned, namely the
assumption that the indifference curves are convex to the origin, which implies diminishing
MRS of the commodities.
Properties of the indifference curves:
An indifference curve has a negative slope, which denotes that if the quantity of one
commodity (y) decreases, the quantity of the other (x) must increase, if the consumer is to
stay on the same level of satisfaction. The further away from the origin an indifference curve
lies, the higher the level of utility it denotes bundles of goods on a higher indifference curve
are preferred by the rational consumer. Indifference curves do not intersect. If they did, the
point of their intersection would imply two different levels of satisfaction, which is
impossible.
Proof:
The slope of a curve at any one point is measured by the slope of the tangent at that
point. The equation-of a tangent is given by the total derivative or total differential, which
shows the total change of the function as all its determinants change.
The total utility function in the case of two commodities x and y is
 It shows the total change in utility as the quantities of both commodities change. The
total change in U caused by changes in y and x is (approximately) equal to the change in y
multiplied by its marginal utility, plus the change in x multiplied by its marginal utility.
Along any particular indifference curve the total differential is by definition equal to zero.
Thus for any indifference curve

The indifference curves are convex to the origin. This implies that the slope of an
indifference curve decreases (in absolute terms) as we move along the curve from the left
downwards to the right: the marginal rate of substitution of the commodities is diminishing.
This axiom is derived from introspection, like the ‘law of diminishing marginal utility’ of the
cardinalist school.
The axiom of decreasing marginal rate of substitution expresses the observed
behavioural rule that the number of units of x the consumer is willing to sacrifice in order to
obtain an additional unit of y increases as the quantity of y decreases. It becomes increasingly
difficult to substitute x for y as we move along the indifference curve. In figure 2.9 the fifth
unit of y can be substituted for x by the consumer giving up x 1x2 of x; but to substitute the
second unit of y and still retain the same satisfaction the consumer must give up a much
greater quantity of x, namely x3 x4.
The budget constraint of the consumer:
The consumer has a given income which sets limits to his maximizing behaviour.
Income acts as a constraint in the attempt for maximizing utility. The income constraint, in
the case of two commodities, may be written
Y=Pxqx + Pyqy (2.1)
We may present the income constraint graphically by the budget line, whose equation
is derived from expression 2.1, by solving for qy
qy = 1 / Py Y – px / py qx
Assigning successive values to qx (given the income, Y and the commodity prices, Px,
Py), we may find the corresponding values of qy. Thus, if qx = 0 (that is, if the consumer
spends all his income on y) the consumer can buy Y/P y units of y. Similarly, if qy = 0 (that is,
if the consumer spends all his income on x) the consumer can buy Y/Px units of x. In figure
2.10 these results are shown by points A and B. If we join these points
This assumption implies that the commodities can substitute one another, but are not perfect
substitutes. If the commodities are perfect substitutes the indifference curve becomes a
straight line with negative slope (figure 2.7). If the commodities are complements the
indifference curve takes the shape of a right angle (figure 2.8).

In the first case the equilibrium of the consumer may be a corner solution, that is, a situation
in which the consumer spends all his income on one commodity. This is sometimes called
‘monomania’. Situations of ‘monomania’ are not observed in the real world and are usually
ruled out from the analysis of the behaviour of the consumer. In the case of complementary
goods, indifference-curves analysis breaks down, since there is no possibility of substitution

between the commodities.

With a line we obtain the budget line, whose slope is the ratio of the prices of the two
commodities. Geometrically the slope of the budget line is
OA / OB = Y / Py / Y / Px = Px / Py
Mathematically the slope of the budget line is the derivative

Derivation of the equilibrium of the consumer:

The consumer is in equilibrium when he maximizes his utility, given his income and the
market prices. Two conditions must be fulfilled for the consumer to be in equilibrium.
The first condition is that the marginal rate of substitution be equal to the ratio of commodity
prices
MRSx, y = MUx / MUy = Px / Py
This is a necessary but not sufficient condition for equilibrium. The second condition
is that the indifference curves be convex to the origin. This condition is fulfilled by the axiom
of diminishing MRSx, y, which states that the slope of the indifference curve decreases (in
absolute terms) as we move along the curve from the left downwards to the right.
Graphical presentation of the equilibrium of the consumer:
Given the indifference map of the consumer and his budget line, the equilibrium is defined by
the point of tangency of the budget line with the highest possible indifference curve (point e
in figure 2.11).
At the point of tangency the slopes of the budget line (P x/Py) and of the indifference curve
(MRSx, y = MUx/MUy) are equal:
MUX = MUy = PX / Py
Thus the first-order condition is denoted graphically by the point of tangency of the
two relevant curves. The second-order condition is implied by the convex shape of the
indifference curves. The consumer maximizes his utility by buying x and y of the two
commodities.
Mathematical derivation of the equilibrium:
Given the market prices and his income, the consumer aims at the maximization of his
utility. Assume that there are n commodities available to the consumer, with given market
prices P1, P2, .., Pn. The consumer has a money income (V), which he spends on the available
commodities.
Formally the problem may be stated as follows:

We use the ‘Lagrangian multipliers’ method for the solution of this constrained maximum.
The steps involved in this method may be outlined as follows:
(a) Rewrite the constraint in the form
(q1P1 + q2P2 + . . . + qn Pn – Y) = 0
(b) Multiply the constraint by a constant A, which is the Lagrangian multiplier
λ (q1P1 + q2P2 + . . . + qn Pn – Y) = 0
(c) Subtract the above constraint from the utility function and obtain the ‘composite function’
ɸ = U – λ (q1P1 + q2P2 + . . . + qn Pn – Y) = 0
It can be shown that maximization of the ‘composite’ function implies maximization of the
utility function.
The first condition for the maximization of a function is that its partial derivatives be equal to
zero. Differentiating ɸ with respect to q1, …, qnand λ, and equating to zero we find
 Thus, although in the indifference-curves approach cardinality of utility is not
required, the MRS requires knowledge of the ratio of the marginal utilities, given that the
first- order condition for any two commodities may be written as
MUx / MUy = Px / Py = MRS x,y
Hence the concept of marginal utility is implicit in the definition of the slope of the
indifference curves, although its measurement is not required by this approach. What is
needed is a diminishing marginal rate of substitution, which of course does not require
diminishing marginal utilities of the commodities involved in the utility function.
Derivation of the demand curve using the indifference-curves approach:
Graphical derivation of the demand curve:
As the price of a commodity, for example of x, falls, the budget line of the consumer
shifts to the right, from its initial position (AB) to a new position (AB) due to the increase in
the purchasing power of the given money income of the consumer. With more purchasing
power in his possession the consumer can buy more of x (and more of y). The new budget
line is tangent to a higher indifference curve (e.g. curve II). The new equilibrium occurs to
the right of the original equilibrium (for normal goods) showing that as price falls more of the
commodity will be bought.
If we allow the price of x to fall continuously and we join the points of tangency of
successive budget lines and higher indifference curves we form the so-called price-
consumption line (figure 2.12), from which we derive the demand curve for commodity x. At
point e1 the consumer buys quantity x1 at price y1. At point e2 the price, y2, is lower than y1,
and the quantity demanded has increased to x2, and so on. We may plot the price- quantity
pairs defined by the points of equilibrium (on the price-consumption line) to obtain a demand
curve, as shown in figure 2.13.

8.

The demand curve for normal commodities will always have a negative slope,
denoting the ‘law of demand,’ (the quantity bought increases as the price falls). In the
indifference-curves approach the ‘law of demand’ is derived from what is known as Slutsky’s
theorem, which states that the substitution effect of a price change is always negative (relative
to the price if the price increases, the quantity demanded decreases and vice versa). The
formal proof of Slutsky’s theorem involves sophisticated mathematics. However, we may
show graphically the implications of this theorem.
We saw that a fall in the price of x from P 1 to P2 resulted in an increase in the quantity
demanded from x1 to x2. This is the total price effect which may be split into two separate
effects, a substitution effect and an income effect. The substitution effect is the increase in the
quantity bought as the price of the commodity falls, after ‘adjusting’ income so as to keep the
real purchasing power of the consumer the same as before.
This adjustment in income is called compensating variation and is shown graphically
by a parallel shift of the new budget line until it becomes tangent to the initial indifference
curve (figure 2.14). The purpose of the compensating variation is to allow the consumer to
remain on the same level of satisfaction as before the price change. The compensated-budget
line’ will be tangent to the original indifference curve (I) at a point (e’ 1) to the right of the
original tangency (e1), because this line is parallel to the new budget line which is less steep
than the original one when the price of x falls. The movement from point e1 to e’1 shows the
substitution effect of the price change the consumer buys more of x now that it is cheaper,
substituting y for x.

However, the compensating variation is a device which enables the isolation of the
substitution effect, but does not show the new equilibrium of the consumer. This is defined by
point e2 on the higher indifference curve II. The consumer has in fact a higher purchasing
power, and, if the commodity is normal, he will spend some of his increased real income on
x, thus moving from x’1 to x2. This is the income effect of the price change.
The income effect of a price change is negative for normal goods and it reinforces the
negative substitution effect (figure 2.14). If, however, the commodity is inferior, the income
effect of the price change will be positive: as the purchasing power increases, less of x will be
bought. Still for most of the inferior goods the negative substitution effect will more than
offset the positive income effect, so that the total price effect will be negative. Thus the
negative substitution effect is in most cases adequate for establishing the law of demand.
(It is when the income effect is positive and very strong that the ‘law of demand’ does not
hold. This is the case of the Giffen goods, which are inferior and their demand curve has a
positive slope. Giffen goods are very rare in practice.)
It should be noted that although Slutsky’s theorem can be proved mathematically, its proof is
based on the axiomatic assumption of the convexity of the indifference curves.
Thus the demand for x is negatively related to its own price px and positively to income Y.
Similarly the demand for y is obtained by substituting qxpx in the budget constraint
qy = 1 / 2py Y
In our particular example the demand curves are symmetric due to the particular
multiplicative form of the consumer’s utility function which we assumed.
Critique of the indifference-curves approach:
The indifference-curves analysis has been a major advance in the field of consumer’s
demand. The assumptions of this theory are less stringent than for the cardinal utility
approach. Only ordinarily of preferences is required, and the assumption of constant utility of
money has been dropped.
The methodology of indifference curves has provided a framework for the measure-
ment of the ‘consumer’s surplus’, which is important in welfare economics and in designing
government policy.
Perhaps the most important theoretical contribution of this approach is the establish-
ment of a better criterion for the classification of goods into substitutes and complements.
Earlier theorists were using the total effect of a price change for this purpose, without
compensating for the change in real income. The classification was based on the sign of the
cross-elasticity of demand
eyx = ∂qy / ∂px. px / qy
Where the total change in the quantity of y was considered as a result of a change in
the price of x. A positive sign of the cross-elasticity implies that x and y are substitutes; a
negative sign implies that the commodities are complements. This approach may easily lead
to absurd classifications if the change in the price of x is substantial.
 For example, if the price of beef is halved it is almost certain that both the
consumption of beef and of pork will be increased, due to the increase of the real income of
the consumer. This would imply a negative cross-elasticity for pork, and hence pork would be
classified as a complementary commodity to beef!
Hicks’ suggested measuring the cross-elasticity after compensating for changes in real
income. Thus, according to Hicks, goods x and y are substitutes if, after compensating for the
change in real income (arising from the change in the price of x) a decrease in the price of x
leads to a decrease in the quantity demanded of y.
Although this criterion is theoretically more correct than the usual approach based on
the total change in the quantity of y as a result of a change in the price of x, in practice its
application is impossible because it requires knowledge of the individual preference
functions, which cannot be statistically estimated. On the other hand, the usual approach of
the total price effect is feasible because it requires knowledge of the market demand functions
which can be empirically estimated.
Although the advantages of the indifference-curves approach are important, the theory
has indeed its own severe limitations. The main weakness of this theory is its axiomatic
assumption of the existence and the convexity of the indifference curves. The theory does not
establish either the existence or the shape of the indifference curves. It assumes that they exist
and have the required shape of convexity.
Furthermore, it is questionable whether the consumer is able to order his preferences
as precisely and rationally as the theory implies. Also the preferences of the consumers
change continuously under the influence of various factors, so that any ordering of these
preferences, even if possible, should be considered as valid for the very short run. Finally,
this theory has retained most of the weaknesses of the cardinalist school with the strong
assumption of rationality and the concept of the marginal utility implicit in the definition of
the marginal rate of substitution.
Another defect of the indifference curves approach is that it does not analyze the
effects of advertising, of past behaviour (habit persistence), of stocks, of the interdependence
of the preferences of the consumers, which lead to behaviour that would be considered as
irrational, and hence is ruled out by the theory. Furthermore speculative demand and random
behaviour are ruled outlet these factors are very important for the pricing and output
decisions of the firm.
9. What are the various determinants of demand? (APRIL 2017)
Determinants of Demand
When price changes, quantity demanded will change. That is a movement along the
same demand curve. When factors other than price changes, demand curve will shift. These
are the determinants of the demand curve.
1. Income: A rise in a person’s income will lead to an increase in demand (shift demand curve
to the right), a fall will lead to a decrease in demand for normal goods. Goods whose demand
varies inversely with income are called inferior goods (e.g. Hamburger Helper).
2. Consumer Preferences: Favourable change leads to an increase in demand, unfavorable
change lead to a decrease.
3. Number of Buyers: the more buyers lead to an increase in demand; fewer buyers lead to
decrease.
4. Price of related goods:
a. Substitute goods (those that can be used to replace each other): price of substitute and
demand for the other good are directly related. Example: If the price of coffee rises, the
demand for tea should increase.
b. Complement goods (those that can be used together): price of complement and demand for
the other good are inversely related. Example: if the price of ice cream rises, the demand for
ice-cream toppings will decrease.
5. Expectation of future:
a. Future price: consumers’ current demand will increase if they expect higher future prices;
their demand will decrease if they expect lower future prices.
b. Future income: consumers’ current demand will increase if they expect higher future
income; their demand will decrease if they expect lower future income.
10. Describe the importance of Indifference curve with diagram. (NOV 2012)
1. In the theory of production:

The basic aim of a producer is to attain a low cost combination. Indifference curves are useful
in the realization of this objective. When we use these curves in the theory of production,
they are called iso-product curves. Producer’s equilibrium i.e. low cost combination is
obtained at the point where producer’s budget line becomes tangent to one of the iso-product
curves on the map.
2. In the theory of Exchange:

Prof. Edge worth used the technique of indifference curves to show the mutual gains from the
exchange of two goods between two consumers. Exchange makes it possible for both the
consumers to reach a higher level of satisfaction. The process of shifting to the higher level of
satisfaction is explained with the help of ‘contract curves.’
3. In the field of Rationing:

This technique can also be made use of in the field of rationing Ordinarily two commodities
are rationed out to different individuals, irrespective of their preferences. But if their
respective preferences are considered and the amounts of the two commodities be distributed
among consumers in accordance with their scale of preferences, each of them shall be in a
position to search a higher indifference curve and satisfaction.
4. In the measurement of consumer’s surplus:

Indifference curve technique has rehabilitated the old Marshallian concept of consumer’s
surplus that has lain buried almost for decades under the weight of unrealistic and illusory
assumptions. Consumer’s surplus can be measured with the help of this technique without
any need for making unrealistic assumptions.
5. In the field of taxation:

The technique is also applied to test preference between a direct and indirect tax. With the
help of indifference curves it can be shown that a direct tax is preferable to an indirect tax as
regards its effects on consumption and satisfaction of the tax payer. In view of the above
application of the technique, it may be asserted that it forms an integral part of the modern
welfare economics. However, there are certain writers who also assert that the indifference
curves technique is merely ‘the old wine in a new bottle’ for example, Prof. Robertson is of
the view that this analysis has substituted new concepts and equations in place of the old
ones.

11. Explain the time impact on elasticity. (NOV 2013)

The time period allowed following a price change – demand is more price elastic, the
longer that consumers have to respond to a price change. They have more time to search for
cheaper substitutes and switch their spending.

Price elasticity of demand is always related to a period of time. It can be a day, a week, a
month, a year or a period of several years. Elasticity of demand varies directly with the time
period. Demand is generally inelastic in the short period.

It happens because consumers find it difficult to change their habits, in the short period, in
order to respond to a change in the price of the given commodity. However, demand is more
elastic in long rim as it is comparatively easier to shift to other substitutes, if the price of the
given commodity rises.

12. How do you relate income elasticity of demand and business decisions? .(NOV
2013)
To classify normal and inferior goods

Any products that are manufactured by the producers can be classified into two types
– normal goods and inferior goods.
Normal goods – Goods whose demand is directly proportional to the income of the
consumers are known as normal goods. Simply, goods whose demand rises with rise in
income and whose demand falls with fall in income is known as normal goods e.g jewelry.
The coefficient of income elasticity of these goods is always positive.
Inferior goods – Goods whose demand is inversely proportional to the income of the
consumers are known as inferior goods. In other words, inferior goods are such goods whose
demand falls with rise in income and vice versa e.g. budget smart phones. The coefficient of
income elasticity of these goods is always negative. Knowledge about the nature of products
is important to any producers in order to make further decisions related to the goods in right
manner.
To know about stage of trade cycle

We have already known that demand of normal goods is directly proportional to the income
of consumers while demand of inferior goods is inversely proportional to the income of
consumers.
We see, people prefer riding public bus when their income is low but with comparatively high
income, same people start using cab for transportation. In this situation, public bus is an
inferior good while cab is a normal good.

Demand for normal goods increases during prosperity and decreases during regression.
Conversely, demand for inferior goods increases during regression and decreases during
prosperity. However, demands for goods that are necessary in our day to day lives are not
much affected during prosperity as well as during regression.
Figure: Trade cycle
For forecasting demand

Income elasticity of demand can be used for predicting future demand of any goods and
services in case when manufacturers have knowledge of probable future income of the
consumers.
For example: Let us suppose, ‘Wheels’ is a car manufacturing company which manufactures
luxury cars as well as small cars. The company has calculated that income elasticity of luxury
car (normal good) is +4 while income elasticity of small car (inferior good) is -5.
Let us also suppose that the company has undertaken a research and has found that consumer
income will rise by 3% in upcoming year.
Through the above information, Wheels can forecast by how much the demand of luxury car
and small car will undergo change in the upcoming year. This information can save the
company a lot of money by preventing overproduction or underproduction.
To determine price

Having knowledge of income elasticity of any product is essential in order to correctly price
them. Demand of income elastic goods or goods with positive income elasticity tends to fall
with fall in income of the demanding consumers. Thus, a reduction in price of the commodity
may help in increasing the demand and compensate the for the reduction in price by
generating more sales and revenue.
13. Bring out the features of a good forecasting method. (NOV 2014)
1. Plausibility

The management should have good understanding of the technique chose and they should
have confidence in the technique adopted. Then only proper interpretation will be made.
According to Joel Dean, the plausibility requirements can often increase the accuracy of the
result. Accuracy entails the executives to accept the results. Experienced executives will have
a market feel and they can contribute effectively.
2. Simplicity

The method chosen should be of simple nature or ease of comprehension by the executives.
Elaborate mathematical and econometric procedures are less desirable, if the management
does not really understand what the forecaster is doing.
3. Economy
Cost is a primary consideration which should be weighed against the importance of the
forecasts to the business operation. There is no point in adopting very high levels of accuracy
at great expense, if the forecast has little importance in the business.
4. Availability

Immediate availability of data is a vital requirement in forecasting method. The technique

should yield quick and meaningful result. Delay in result will adversely affect the managerial
decision. To conclude, the ideal forecasting method is the one which yields good returns and
costs in accuracy meets new circumstances with flexibility.
14. Write a note on : (NOV 15)
(a) Derived demand
Derived demand is demand that comes from (is derived) from the demand for something else.
Thus, the demand for machinery is derived from the demand for consumer goods that the
machinery can make. If there is low demand for consumer goods, there is low demand for the
machinery that can make them. Demand for bricks is derived from spending on new
construction projects.
(b) Autonomous demand.
An Autonomous demand for a product is one that arises independently of the demand for any
other good whereas a derived demand is one, which is derived from demand of some other
good. To look more closely at the distinction between the two kinds of demand, consider the
demand for commodities, which arise directly from the biological or physical needs of the
human beings, such as demand for food, clothes and shelter. The demand for these goods is
autonomous demand. Autonomous demand also arises as a’ result of demonstration effect,
rise in income, and increase in population and advertisement of new products. On the other
hand, the demand for a good that arises because of the demand for some other good is called
derived demand. For instance, demand for land, fertilizer and agricultural tools and
implements are derived demand, since the demand of goods, depends on the demand of food.
Similarly, demand for steel, bricks, cement etc., is a derived demand because it is derived
from the demand for houses and other kind of buildings. [n general, the demand for, producer
goods or industrial inputs is a derived one. Besides, demand for complementary goods (which
complement the use of other goods) or for supplementary goods (which supplement or
provide additional utility from the use of other goods) is a derived demand. For instance
petrol is complementary goods for automobiles and a chair is a complement to a table.
Consider some examples of supplement goods. Butter is supplement to bread, mattress is
supplement to cot and sugar is supplement to tea. Therefore, demand for petrol, chair, and
sugar would be considered as derived demand. The conceptual distinction between
autonomous demand and derived demand would be useful according to the point of view of a
businessman to the extent the former can serve as an indicator of the latter.
13. Write a note on demand estimation. (NOV 15)
The basic techniques of estimating demand functions and forecasting future sales and
prices. Estimation of demand functions is most often accomplished using the technique of
regression analysis. Two specifications for demand, linear and log-linear, are presented in this
chapter. When demand is specified to be linear in form, the coefficients on each of the
explanatory variables measure the rate of change in quantity demanded as that explanatory
variable changes, holding all other explanatory variables constant. In linear form, the
empirical demand specification is
Q = a + bP + cM + dPR
where Q is the quantity demanded, P is the price of the good or service, M is consumer
income, and PR is the price of some related good R. The estimated demand elasticities are
computed as
As in any regression analysis, the statistical significance of the parameter estimates can be
assessed by performing t-tests or examining p-values.
When demand is specified as log-linear, the demand function is written as
Q = aPbMcPdR
In order to estimate the log-linear demand function, it is converted to natural logarithms:
ln Q = ln a + b ln P + c ln M + d ln PR
In log-linear form, the elasticities of demand are constant, and the estimated elasticities are

To choose between these two specifications of demand, a researcher should consider

whether the sample data to be used for estimating demand are best represented by a demand
function with varying elasticities (linear demand) or by one with constant elasticity (log-
linear demand). When price and quantity observations are spread over a wide range of values,
elasticities are likely to vary, and a linear specification with its varying elasticities is usually a
more appropriate specification of demand. Alternatively, if the sample data are clustered over
a narrow price (and quantity) range, a constant-elasticity specification of demand, such as a
log-linear model, may be a better choice than a linear model.
The method of estimating the parameters of an empirical demand function depends on
whether the price of the product is market-determined or manager-determined. Managers of
price-taking firms do not set the price of the product they sell; rather, prices are endogenous
or "market-determined" by the intersection of demand and supply. Managers of price-setting
firms set the price of the product they sell by producing the quantity associated with the
chosen price on the downward-sloping demand curve facing the firm. Since price is manager-
determined rather than market-determined, price is exogenous for price-setting firms.
When estimating industry demand for price-taking firms, complications arise because
of the problem of simultaneity. The simultaneity problem refers to the fact that the observed
variation in equilibrium output and price is the result of changes in the determinants of both
demand and supply. Because output and price are determined jointly by the forces of supply
and demand, two econometric problems arise when a researcher tries to estimate the
coefficients of industry demand: the identification problem and the simultaneous equations
bias problem.
The identification problem involves determining whether it is possible to trace out the
true demand curve from the sample data. Industry demand is identified when supply includes
at least one exogenous variable that is not also in the demand equation. The problem of
simultaneous equations bias arises when price is an endogenous variable, as it is when price
is market-determined for price-taking firms. In order for the standard or ordinary least-
squares (OLS) regression procedure to yield unbiased parameter estimates, all explanatory
variables must be uncorrelated with the random error term in the demand equation. An
endogenous variable is always correlated with the error term in both the demand and supply
equations. (This can be verified by examining the reduced form equation for Q, which shows
how Q is related to all the exogenous variables and error terms in the system.) Because price
is an explanatory variable in the demand equation, and an endogenous variable in the case of
price-taking firms, a simultaneous equations bias will result when the OLS procedure is used
to estimate demand. The simultaneous equations bias is eliminated by estimating the
parameters of the industry demand equation using 2SLS.
When estimating the demand curve facing a price-setting firm—a firm that can
control or set the price of its product by varying its own level of production—the problem of
simultaneity does not arise. The demand curve for price-setting firms is estimated using the
ordinary least-squares (OLS) method of estimation.
Statistical forecasting models can be subdivided into two categories: time-series
models and econometric models. Time-series forecasts use the time-ordered sequence of
historical observations on a variable to develop a model for predicting future values of that
variable. Time-series models specify a mathematical model representing the generating
process, then use statistical techniques to fit the historical data to the mathematical model.
The simplest time-series forecast is a linear trend forecast where the generating process is
assumed to be the linear model Qt = a + bt. Using time-series data on Q, regression analysis is
used to estimate the trend line that best fits the data. If b is greater (less) than 0, sales are
increasing (decreasing) over time. If b equals 0, sales are constant over time.
When data exhibit cyclical variation, such as seasonal patterns, dummy variables can
be added to the time-series model to account for the seasonality. If there are N seasonal time
periods to be accounted for, N − 1 dummy variables are added to the demand equation. Each
dummy variable accounts for one of the seasonal time periods. The dummy variable takes a
value of 1 for those observations that occur during the season assigned to that dummy
variable and a value of 0 otherwise. This type of dummy variable allows the intercept of the
demand equation to take on different values for each season—the demand curve can shift up
and down from season to season.
In contrast to time-series models, econometric models use an explicit structural model
to explain the underlying economic relations. Econometric forecasting can be employed to
forecast future industry price and sales or to forecast future demand for price-setting firms.
The three steps for forecasting industry price and sales are
1. Estimate the industry demand and supply equations.
2. Locate industry demand and supply in the forecast period.
3. Calculate the intersection of future demand and supply.
Process by forecasting future copper price and consumption. The three steps for forecasting
the future demand for a price-setting firm are
1. Estimate the firm's demand function.
2. Forecast the future values of the demand-shifting variables.
3. Calculate the location of future demand.
Process by forecasting the future demand facing a pizza restaurant.
When making forecasts, analysts must be careful to recognize that the further into the
future the forecast is made, the wider the confidence interval or region of uncertainty.
Incorrect specification of the demand equation (as well as supply in the case of simultaneous
equations forecasts) can seriously undermine the quality of a forecast. An even greater
problem for accurate forecasting is posed by the occurrence of structural changes that cause
turning points in the variable being forecast. Forecasts often fail to predict turning points.
While there is no satisfactory way to account for unexpected structural changes, forecasters
should note that the further into the future you forecast, the more likely it is that a structural
change will occur.
This chapter concludes Part II of the text on demand analysis. In Part III of the text,
we will present the theory of production and cost. We also will describe the empirical
techniques used to estimate production functions and the various cost equations used by
managers to make output and investment decisions.
14. Discuss the importance of indifference curve with diagram. (NOV 16)
 1. In the theory of production:

The basic aim of a producer is to attain a low cost combination. Indifference curves are useful
in the realization of this objective.
When we use these curves in the theory of production, they are called iso-product curves.
Producer’s equilibrium i.e. low cost combination is obtained at the point where producer’s
budget line becomes tangent to one of the iso-product curves on the map.
2. In the theory of Exchange:

Prof. Edge worth used the technique of indifference curves to show the mutual gains from the
exchange of two goods between two consumers.
Exchange makes it possible for both the consumers to reach a higher level of satisfaction. The
process of shifting to the higher level of satisfaction is explained with the help of ‘contract
curves.’
3. In the field of Rationing:

This technique can also be made use of in the field of rationing Ordinarily two commodities
are rationed out to different individuals, irrespective of their preferences.
But if their respective preferences are considered and the amounts of the two commodities be
distributed among consumers in accordance with their scale of preferences, each of them
shall be in a position to search a higher indifference curve and satisfaction.
4. In the measurement of consumer’s surplus:

Indifference curve technique has rehabilitated the old Marshallian concept of consumer’s
surplus that has lain buried almost for decades under the weight of unrealistic and illusory
assumptions.
Consumer’s surplus can be measured with the help of this technique without any need for
making unralistic assumptions.
4. In the field of taxation:

The technique is also applied to test preference between a direct and indirect tax. With the
help of indifference curves it can be shown that a direct tax is preferable to an indirect tax as
regards its effects on consumption and satisfaction of the tax payer.
In view of the above application of the technique, it may be asserted that it forms an integral
part of the modern welfare economics.
However, there are certain writers who also assert that the indifference curves technique is
merely ‘the old wine in a new bottle’ for example, Prof. Robertson is of the view that this
analysis has substituted new concepts and equations in place of the old ones.

UNIT II PART – C

1. Analyse the determinants of demand for a product. (APRIL 2012) (APRIL 2014)
Determinants of Demand
When price changes, quantity demanded will change. That is a movement along the same
demand curve. When factors other than price changes, demand curve will shift. These are the
determinants of the demand curve.
1. Income: A rise in a person’s income will lead to an increase in demand (shift demand curve
to the right), a fall will lead to a decrease in demand for normal goods. Goods whose demand
varies inversely with income are called inferior goods (e.g. Hamburger Helper).
2. Consumer Preferences: Favorable change leads to an increase in demand, unfavorable
change lead to a decrease.
3. Number of Buyers: the more buyers lead to an increase in demand; fewer buyers lead to
decrease.
4. Price of related goods:
a. Substitute goods (those that can be used to replace each other): price of substitute and
demand for the other good are directly related.
Example: If the price of coffee rises, the demand for tea should increase.
b. Complement goods (those that can be used together): price of complement and demand for
the other good are inversely related.
Example: if the price of ice cream rises, the demand for ice-cream toppings will decrease.
5. Expectation of future:
a. Future price: consumers’ current demand will increase if they expect higher future prices;
their demand will decrease if they expect lower future prices.
b. Future income: consumers’ current demand will increase if they expect higher future
income; their demand will decrease if they expect lower future income.
2. Briefly explain the types of elasticity of demand. (APRIL 2012)
1. Positive income elasticity of demand (EY>0)
If there is direct relationship between income of the consumer and demand for the
commodity, then income elasticity will be positive. That is, if the quantity demanded for a
commodity increases with the rise in income of the consumer and vice versa, it is said to be
positive income elasticity of demand. For example: as the income of consumer increases,
they consume more of superior (luxurious) goods. On the contrary, as the income of
consumer decreases, they consume less of luxurious goods.

Positive income elasticity can be further classified into three types:

 Income elasticity greater then unity (EY > 1)
If the percentage change in quantity demanded for a commodity is greater than percentage
change in income of the consumer, it is said to be income greater than unity. For example:
When the consumer’s income rises by 3% and the demand rises by 7%, it is the case of
income elasticity greater than unity.
In the given figure, quantity demanded and consumer’s income is measured along X-axis and
Y-axis respectively. The small rise in income from OY to OY1 has caused greater rise in the
quantity demanded from OQ to OQ1 and vice versa. Thus, the demand curve DDshows
income elasticity greater than unity.
 Income elasticity equal to unity (EY = 1)
If the percentage change in quantity demanded for a commodity is equal to percentage
change in income of the consumer, it is said to be income elasticity equal to unity. For
example: When the consumer’s income rises by 5% and the demand rises by 5%, it is the
case of income elasticity equal to unity.

In the given figure, quantity demanded and consumer’s income is measured along X-axis and
Y-axis respectively. The small rise in income from OY to OY1 has caused equal rise in the
quantity demanded from OQ to OQ1 and vice versa. Thus, the demand curve DDshows
income elasticity equal to unity.
 Income elasticity less then unity (EY < 1)
If the percentage change in quantity demanded for a commodity is less than percentage
change in income of the consumer, it is said to be income greater than unity. For example:
When the consumer’s income rises by 5% and the demand rises by 3%, it is the case of
income elasticity less than unity.

In the given figure, quantity demanded and consumer’s income is measured along X-axis and
Y-axis respectively. The greater rise in income from OY to OY1 has caused small rise in the
quantity demanded from OQ to OQ1 and vice versa. Thus, the demand curve DDshows
income elasticity less than unity.
2. Negative income elasticity of demand ( EY<0)
If there is inverse relationship between income of the consumer and demand for the
commodity, then income elasticity will be negative. That is, if the quantity demanded for a
commodity decreases with the rise in income of the consumer and vice versa, it is said to be
negative income elasticity of demand. For example:
As the income of consumer increases, they either stop or consume less of inferior goods.
In the given figure, quantity demanded and consumer’s income is measured along X-axis and
Y-axis respectively. When the consumer’s income rises from OY to OY1 the quantity
demanded of inferior goods falls from OQ to OQ1 and vice versa. Thus, the demand
curve DD shows negative income elasticity of demand.
3. Zero income elasticity of demand ( EY=0)
If the quantity demanded for a commodity remains constant with any rise or fall in income of
the consumer and, it is said to be zero income elasticity of demand. For example: In case of
basic necessary goods such as salt, kerosene, electricity, etc. there is zero income elasticity of
demand.

In the given figure, quantity demanded and consumer’s income is measured along X-axis and
Y-axis respectively. The consumer’s income may fall to OY1 or rise to OY2 from OY, the
quantity demanded remains the same at OQ. Thus, the demand curve DD, which is vertical
straight line parallel to Y-axis shows zero income elasticity of demand.
3. Explain the assumptions of the law of diminishing marginal utility. (APRIL
2013) APRIL 2016)
Law Of Diminishing Marginal Utility Assumptions
1. The consumer who is consuming the goods should be logical and knowledgeable to
consume every unit of goods.
2. The goods which are to be consumed should be equal in size and shape.
3. Consumer should consume the goods without time gap.
4. The consumer’s income, preference, taste and fashion should not be changed while
consuming the goods.
5. To hold the law good, utility should be measured in countable units or cardinal
numbers. The utility obtained from those goods is measured in ‘utils’ unit.
6. As we know that money is the measuring rod of utility, being so, marginal utility of
money should remain constant during consumption of the goods.
4. Explain the approach to Indifference Curve Analysis. (APRIL 2015)
Indifference curve analysis is basically an attempt to improve cardinal utility analysis
(principle of marginal utility). The cardinal utility approach, though very useful in studying
elementary consumer behavior, is criticized for its unrealistic assumptions vehemently. In
particular, economists such as Edgeworth, Hicks, Allen and Slutsky opposed utility as a
measurable entity. According to them, utility is a subjective phenomenon and can never be
measured on an absolute scale. The disbelief on the measurement of utility forced them to
explore an alternative approach to study consumer behavior. The exploration led them to
come up with the ordinal utility approach or indifference curve analysis. Because of this
reason, aforementioned economists are known as ordinalists. As per indifference curve
analysis, utility is not a measurable entity. However, consumers can rank their preferences.

5. Discuss the determinants of supply. (APRIL 2015) (APRIL 2016)

When price changes, quantity supplied will change. That is a movement along the same
supply curve. When factors other than price changes, supply curve will shift. Here are some
determinants of the supply curve.

1. Production cost:
Since most private companies’ goal is profit maximization. Higher production cost will lower
profit, thus hinder supply. Factors affecting production cost are: input prices, wage rate,
government regulation and taxes, etc.

2. Technology:
Technological improvements help reduce production cost and increase profit, thus stimulate
higher supply.

3. Number of sellers:
More sellers in the market increase the market supply.

4. Expectation for future prices:

If producers expect future price to be higher, they will try to hold on to their inventories and
offer the products to the buyers in the future, thus they can capture the higher price.

6. Discuss the determinants of supply. Define income elasticity of demand and

distinguish its various types. (ARIL 2017)

Determinants of Supply
Definition: Determinants of supply are factors that may cause changes in or affect the
supply of a product in the market place. These factors include:

1. Production technology: an improvement of production technology increases the

output. This lowers the average and marginal costs, since, with the same production
factors, more output is produced.
2. Prices of production factors: a rise in the price of one or more production factors
leads to an increase in the production costs and vice versa.
3. Prices of other products: the supply of a product may be influenced by the prices of
other products, especially if the products are complementary.
4. Number of production units: as the number of production units increases, the total
supply of a product increases and vice versa.
5. Government policies: when taxes increase, the quantity supplied decreases because
the cost of production increases. When subsidies increase, the quantity supplied increases
because the cost of production decreases.
 6. Expectations of producers: if producers expect a rise in the price of a product, they
are likely to lower the quantity supplied and wait until the price goes up to sell the
product at a higher price.
7. Random, natural, and other factors: the supply of agricultural products is influenced
by natural phenomena and the weather conditions. Other factors affecting supply can be
extended strikes, floods, political instability etc.
Let’s look at an example.

7. Explain the importance of the Law of Diminishing marginal utility. (NOV 2012)
Law of Diminishing Marginal Utility. The law of demand is based on the law of
diminishing marginal utility which states that as the consumer purchases more and more units
of a commodity, the utility derived from each successive unit goes on decreasing. It means as
the price of the commodity falls, consumer purchases more of the commodity so that his
marginal utility from the commodity falls to be equal to the reduced price and vice-versa.
Influence of Diminishing Marginal Utility. We know that utility falls when we consume
more and more units but not in a uniform way. In case utility falls rapidly, it means that the
consumer has no other near substitutes. As a result, demand is inelastic. Conversely, if the
utility falls slowly, demand for such commodity would be elastic and raises much for a fall in
price.

The concept of consumer's surplus is derived from the law of diminishing marginal utility. As
we know from the law of diminishing marginal utility, the more of a thing we have, the lesser
marginal utility it has. In other words, as we purchase more of a good, its marginal utility
goes on diminishing. The consumer is in equilibrium when marginal utility is equal to given
price i.e., he purchases that many number of units of a good at which marginal utility is equal
to price (It is assumed that perfect competition prevails in the market). Since the price is fixed
for all the units of the good he purchases except for the one at margin, he gets extra utility;
this extra utility or extra surplus for the consumer is called consumer's surplus.
8. Explain the Law of Demand. (NOV 2013)
DEFINITION:
According to Alfred Marshall "The greater the amount to be sold, the smaller must be the
price at which it is offered in order that it may find purchasers, or in other words, the amount
demanded increases with a fall in price and diminishes with a rise in price".
We can understand simply like, other things being equal, quantity demanded will be more at a
lower price than at higher price. The law assumes that income, taste, fashion, prices of related
goods, etc. remain the same in a given period.
The law indicates the inverse relation between the price of a commodity and its quantity
demanded in the market. However, it should be remembered that the law is only an indicative
and not a quantitative statement. This means that it is not necessary that such variation in
demand be proportionate to the change in price.
The law of demand states that there is a negative, or inverse, relationship between price and
the quantity of a good demanded and its price.
This means that demand curves slope downward.
The Law of Demand states that when the price of a good rises, and everything else remains
the same, the quantity of the good demanded will fall.
In short, PQ
Note 1: “everything else remains the same” is known as the “ceteris paribus” or “other
things equal” assumption. In this context, it means that income, wealth, prices of other
goods, population, and preferences all remain fixed. Of course, in the real world other
things are rarely equal. Lots of things tend to change at once. But that’s not a fault of the
model; it’s a virtue. The whole point is to try to discover the effects of something without
being confused or distracted by other things.
Note 2: Is the law of demand really a “law”? Well, there may be some exceedingly rare
exceptions. But by and large the law seems to hold.
Note 3: I will use the word “normal” to refer to any good for which the law of demand
holds. Please note that this is different from the book’s definition of normal.
A Demand Curve is a graphical representation of the relationship between price and
quantity demanded (ceteris paribus). It is a curve or line, each point of which is a price-
Qd pair. That point shows the amount of the good buyers would choose to buy at that
price. Changes in demand or shifts in demand occur when one of the determinants of
demand other than price changes. In other words, shifts occur “when the ceteris are not
paribus.” The demand curve’s current position depend on those other things being equal,
so when they change, so does the demand curve’s position.
Examples:
1. The price of a substitute good drops. This implies a leftward shift.
2. The price of a complement good drops. This implies a rightward shift.
3. Incomes increase. This implies a rightward shift (for most goods).
4. Preferences change. This could cause a shift in either direction, depending on how
preferences change.
Demand versus Quantity Demanded. Remember that quantity demanded is a specific
amount associated with a specific price. Demand, on the other hand, is a relationship
between price and quantity demanded, involving quantities demanded for a range of
prices. “Change in quantity demanded” means a movement along the demand curve.
“Change in demand” refers to a shift of the demand curve, caused by something other
than a change in price.

9. Explain the various demand forecasting approaches. (NOV 2014) (NOV 2015)
Demand Forecasting Method # 1. Survey of Buyer’s-Intentions:
This is a short-term method of knowing and estimating customer’s demand. This is direct
method of estimating demand of customers as to what they intend to buy for the forthcoming
time—usually a year.
By this the burden of forecasting goes to the buyer. This method is useful for the producers
who produce goods in bulk.
Still their estimates should not entirely depend upon it. This method does not hold good for
household consumers because of their inability to foresee their choice when they see the
alternatives. Besides the household consumers there are many which make this method costly
and impracticable. It does not expose and measure the variables under management control.
Demand Forecasting Method # 2. Collective Opinion or Sales Force Competitive
Method:
Under this method, the salesman are nearest persons to the customers and are able to judge,
their minds and market. They better understand the reactions of the customers to the firms
products and their sales trends. The estimates of the different salesmen are collected and
estimates sales are predicted.
These estimates are revised from time to time with changes in sales price, product, designs,
publicity programmes, expected changes in competition, purchasing power, income distribu-
tion, employment and population. It makes use of collective wisdom of salesmen,
departmental heads and top executives.
Advantages:
(1) It is simple, common sense method involving no mathematical calculations.
(2) It is based on the first-hand knowledge of salesman and the persons directly connected
with sales.
(3) This method is particularly useful for sales of new product. It has the salesman’s
judgment.
Dis-advantages:
(1) It is a subjective approach.
(2) This method can be used only for short-term forecasting.
For long-term planning it is not useful.
Demand Forecasting Method # 3. Trend Projection or Time Trend of the Time Series:
This is the most popular method of analysing time series and is generally used to project the
time trend of the time series. A trend line can be filled through the series in visual or
statistical way by the method of least squares.
The analyst can make a plausible algebraic relation—may it be linear, a quadratic or
logarithmic between sales on one hand and independent variable time on the other. The trend
line is then projected into the future for purpose of extrapolation.
Advantages:
This method is most popular as it is simple and in-extensive and because of time series data
often exhibits a persistent growth trend.
Assumptions:
The basic assumption of this method is that the past rate of change of the variable under study
will be continuing in future. This assumption gives good safe results till the time series
exhibits a persistent tendency to move in the same direction.
When the burning point comes, the trend projection breaks down. Even though a forecaster
could hope normally to be correct in most forecasts when the turning points are few and
spaced at long intervals from each other.
In fact, the actual challenge of forecasting is in the prediction of turning points rather than in
the trend projection. At such turning points the management will have to change and revise its
sales and projection strategies most drastically.
There are four factors responsible for the characterization of time series.
They are:
1. Fluctuations and turning points.
2. Trend seasonal variations.
3. Cyclical fluctuations, and
4. Irregular or random forces.
The problem in forecasting is to separate and measure each of these factors.
This time series is expressed by the following equation:
O = TSCI
where, O = observed data
T = a secular tend
S = a seasonal factor
C = cyclical element
I = an irregular movement.
The usual practice is to calculate the trend first from the basic data. The trend values are then
taken out from the observed data (TSCI /T). The next step is to reckon the seasonal index that
is utilised to remove the seasonal effect (SCI/S).
It is fitted through chain to the remainder that also gives the irregular effect. This approach to
the breaking up of time series data is an analytical device of usefulness for the knowledge of
the nature of business fluctuations.
Assumptions:
(a) Analysis of movements would be in the order of trend, seasonal variations and cyclical
changes.
(b) The effects of every component are not dependent on any other components.
Demand Forecasting Method # 4. Executive Judgment Method:
Under this method opinions are sought from the executives of different discipline i.e.,
marketing, finance, production etc. and estimates for future demands are made. Thus, this is a
process of combining, averaging or evaluating in some other way the opinions and views of
the top executives.
Advantages:
The main advantages of this method are:
1. The forecasts can be made speedily by analysing the opinions and views of top executives.
The techniques is quite easy and simple.
2. No need of elaborate statistics:
There is no need of collecting elaborate. Statistics for the forecasts hence it is not much
expensive.
3. Only feasible method to follow:
In the absence of adequate data is it the only feasible method to be followed.
Dis-advantages:
The chief dis-advantages of the of this method are:
(1) No factual basis of such forecast:
There is no factual basis of such forecasts, so the method is inferior to others.
(2) No accuracy:
Accuracy cannot be claimed under this method.
(3) Responsibility for the accuracy of data cannot be fixed on any one.
5. Economic Indicators:
This method has its base for demand forecasting on few economic indicators.
(a) Construction contracts:
For demand towards building materials sanctioned for Cement.
(b) Personal Income:
Towards demand of consumer goods.
(c) Agricultural Income:
Towards demand of agricultural imports instruments, fertilisers, manner etc.
(d) Automobiles Registration:
Towards demand of car parts and petrol. These and other economic indicators are given by
specialised organisation. The analyst should establish relationship between the sale of the
product and the economic indicators to project the correct sales and to measure as to what
extent these indicators affect the sales. To establish relationship is not an easy task especially
in case of New Product where there is no past records.
Steps:
Following steps may be remembered:
(a) If there is any relationship between the demand for a product and certain economic
indicator.
(b) Make the relationship by the method of least squares and derive the regression equation.
Supposing the relationship is Linear the equation will be of the form y = α + bx. There can be
curvilinear relationship also.
(c) Once the regression equation is obtained any value of X (economic indicator) can be
applied to forecast the value of Y (demand).
(d) Past relationship may not recur. Therefore, need for value judgments are felt. Other new
factors may also have to be taken into consideration.
Limitations:
The limitations of economic indicators are as follows:
(1) It is difficult to find out an appropriate economic indicator.
(2) For few products it is not good, as no past data are available.
(3) This method of forecasting is best suited where relationship of demand with a particular
indicator is characterised by a Time Lag, such as construction contracts will give
consequence to demand for building materials with some amount of Time Lag.
But where the demand does not Lag behind the particular economic index, the utility is
restricted because forecast may have to be based on projected economic index itself that may
not result true.
Demand Forecasting Method # 6. Controlled Experiments:
Under this method, an effort is made to ascertain separately certain determinants of demand
which can be maintained, e.g., price, advertising etc. and conducting the experiment,
assuming etc., and conducting the experiment, assuming that the other factors remain
constant.
Thus, the effect of demand determinants like price, advertisement packing etc., on sales can
be assessed by either varying them over different markets or by varying them over different
time periods in the same market.
For example:
Different prices would be associated with different sales on that basis the price, quantity
relationship is estimated in the form of regression equation and used for forecasting purposes.
It must be noted that the market divisions here must be homogeneous with regard to income,
tastes etc.
Such experiments have been conducted widely in the USA and were successful. This is a new
experiment. This is quite new and less applied.
The main reasons for non-application of this method so far as follows:
1. The method is expensive and time consuming.
2. It is risky because it may lead to un-favourable reactions on dealers, consumers and
competitors.
 3. It is not always easy to determine what conditions should be taken to be constant and what
factors should be regarded as variable, so as to separated and measures their influence on
demand.
4. It is hard to satisfy the homogeneity of market conditions. In-spite of these drawbacks,
controlled experiments have sufficient potentialities to become a useful method for business
research and analysis in future.
Demand Forecasting Method # 7. Expert’s Opinions:
Under this method expert’s opinions are sought from specialists in the field, outside the
organisations or the organisation collects opinions from such specialists; views of expert’s
published in the newspaper and journals for the trade, wholesalers and distributors for the
company’s products, agencies and professional experts.
These opinions and views are analysed and deductions are made therefrom to arrive at the
figure of demand forecasts.
Advantages:
The advantages of this method are:
(1) Forecasts can be done easily and speedily.
(2) It is based on expert’s views and opinions hence estimates are nearly accurate.
(3) The method is suitable where past records of sales are not available.
(4) The method is economical because survey is done to collect the data. The expenses of
seeking the opinions and views of experts are much less than the expenses of actual survey.
Dis-advantages:
The important dis-advantages of this method are:
(1) Estimates for a market segment cannot be possible.
(2) The reliability of forecasting is always subjective because forecasting is not based on
facts.

10. Elaborate the different levels of demand forecast. (NOV 2014)

Definition: Demand Forecasting is a systematic process of predicting the future demand for
a firm’s product. Simply, estimating the potential demand for a product in the future is called
as demand forecasting.

The demand forecasting finds its significance where the large-scale production is involved.
Such firms may often face difficulties in obtaining a fairly accurate estimation of future
demand. Thus, it is essential to forecast demand systematically and scientifically to arrive at
desired objective. Therefore, the following steps are taken to facilitate a systematic demand
Specifying the Objective: The objective for which the demand forecasting is to be done
must be clearly specified. The objective may be defined in terms of; long-term or short-term
demand, the whole or only the segment of a market for a firm’s product, overall demand for a
product or only for a firm’s own product, firm’s overall market share in the industry, etc. The
objective of the demand must be determined before the process of demand forecasting begins
as it will give direction to the whole research.

1. Determining the Time Perspective: On the basis of the objective set, the demand
forecast can either be for a short-period, say for the next 2-3 year or a long period. While
forecasting demand for a short period (2-3 years), many determinants of demand can be
assumed to remain constant or do not change significantly. While in the long run, the
determinants of demand may change significantly. Thus, it is essential to define the time
perspective, i.e., the time duration for which the demand is to be forecasted.
2. Making a Choice of Method for Demand Forecasting: Once the objective is set and
the time perspective has been specified the method for performing the forecast is selected.
There are several methods of demand forecasting falling under two categories; survey
methods and statistical methods.

The Survey method includes consumer survey and opinion poll methods, and the statistical
methods include trend projection, barometric and econometric methods. Each method varies
from one another in terms of the purpose of forecasting, type of data required, availability of
data and time frame within which the demand is to be forecasted. Thus, the forecaster must
select the method that best suits his requirement.

3. Collection of Data and Data Adjustment: Once the method is decided upon, the
next step is to collect the required data either primary or secondary or both. The primary data
are the first-hand data which has never been collected before. While the secondary data are
the data already available. Often, data required is not available and hence the data are to be
adjusted, even manipulated, if necessary with a purpose to build a data consistent with the
data required.
4. Estimation and Interpretation of Results: Once the required data are collected and
the demand forecasting method is finalized, the final step is to estimate the demand for the
predefined years of the period. Usually, the estimates appear in the form of equations, and the
result is interpreted and presented in the easy and usable form.

Thus, the objective of demand forecasting can only be achieved only if these steps are
followed systematically.

11. Explain : (NOV 2015)

(a) Main features
(b) Causes of origin
(c) Demand curve
A Demand Curve is a graphical representation of the relationship between price and
quantity demanded (ceteris paribus). It is a curve or line, each point of which is a price-
Qd pair. That point shows the amount of the good buyers would choose to buy at that
price.
Changes in demand or shifts in demand occur when one of the determinants of demand
other than price changes. In other words, shifts occur “when the ceteris are not paribus.”
The demand curve’s current position depend on those other things being equal, so when
they change, so does the demand curve’s position.
Examples:
1. The price of a substitute good drops. This implies a leftward shift.
2. The price of a complement good drops. This implies a rightward shift.
3. Incomes increase. This implies a rightward shift (for most goods).
4. Preferences change.

When the data presented in the demand schedule can be plotted on a graph with quantities
demanded on the horizontal or X- axis and hypothetical prices on the vertical or Y- axis, and
a smooth curve is hypothetical prices on the vertical or Y- axis, and a smooth curve is drawn
Joining all the points so plotted, it gives a demand curve. Thus, the demand schedule is
translated into a diagram known as the demand curve.
The demand curve slopes downwards from left to right, showing the inverse relationship
between price and quantity.
(d) Short-run equilibrium of Monopoly.
A monopolistic firm would maximize profit by producing as many units of a good/service as it
would take to make Marginal Cost = Marginal Revenue, which is the short-run equilibrium.
This is the best option for the firm because producing one more unit of the good/service would
actually be inefficient and induce a loss on that unit as it would have MC > MR.

Under short-run monopoly firm tries to obtain maximum profit. In short run equilibrium
under monopoly the equilibrium of the firm can be discussed through following two
approaches:

Short run Supernormal Profit:

As we know monopoly firm has no competition in the whole market so it is very usual for
it to earn supernormal profit. When the average revenue (AR) is greater than the short run
average cost (SAC), firm will earn supernormal profit.

All such conditions are described in the following diagram.

Equilibrium point of firm is when

 MC = MR
 MC cuts MR from below

In diagram firms total revenue is OPAQ and total cost OCBQ

Short run Loss:

A monopoly firm may suffer from loss in short run period because in short run period at
least one input is fixed. If short run average cost (SAC) of monopoly firm passes above
the average revenue (AR), firm will go through loss.
 All such conditions are described in the diagram

shown as follows:

In diagram firms total revenue is OPGQ and total cost OCFQ.

Ad

12. What do you mean by Elasticity of demand? Explain the different measurement
of elasticity of demand. (NOV 2016)
Definition: The Elasticity of Demand measures the percentage change in quantity
demanded for a percentage change in the price. Simply, the relative change in demand for a
commodity as a result of a relative change in its price is called as the elasticity of demand.

Types of Elasticity of Demand

1. Price Elasticity of Demand: The price elasticity of demand, commonly known as the
elasticity of demand refers to the responsiveness and sensitiveness of demand for a product to
the changes in its price. In other words, the price elasticity of demand is equal to
 Numerically,

Where,
ΔQ = Q1 –Q0, ΔP = P1 – P0, Q1= New quantity, Q2= Original quantity, P1 = New price, P0 =
Original priceThe following are the main Types of Price Elasticity of Demand:
 Perfectly Elastic Demand
 Perfectly Inelastic Demand
 Relatively Elastic Demand
 Relatively Inelastic Demand
 Unitary Elastic Demand
2 Income Elasticity of Demand: The income is the other factor that influences the
demand for a product. Hence, the degree of responsiveness of a change in demand for a
product due to the change in the income is known as income elasticity of demand. The
formula to compute the income elasticity of demand is:

For most of the goods,

the income elasticity of demand is greater than one indicating that with the change in income
the demand will also change and that too in the same direction, i.e. more income means more
demand and vice-versa.
3 Cross Elasticity of Demand: The cross elasticity of demand refers to the change in
quantity demanded for one commodity as a result of the change in the price of another
commodity. This type of elasticity usually arises in the case of the interrelated goods such as
substitutes and complementary goods. The cross elasticity of demand for goods X and Y can

be expressed as: The

two commodities are said to be complementary, if the price of one commodity falls, then the
demand for other increases, on the contrary, if the price of one commodity rises the demand
for another commodity decreases. For example, petrol and car are complementary goods.

While the two commodities are said to be substitutes for each other if the price of one
commodity falls, the demand for another commodity also decreases, on the other hand, if the
price of one commodity rises the demand for the other commodity also increases. For
example, tea and coffee are substitute goods.

4 Advertising Elasticity of Demand: The responsiveness of the change in demand to

the change in advertising or rather promotional expenses, is known as advertising elasticity of
demand. In other words, the change in the demand as a result of the change in advertisement
and other promotional expenses is called as the advertising elasticity of demand. It can be
expressed as:
Numerically,

Where,
Q1 = Original Demand
5
Q2= New Demand
6
A1= Original Advertisement Outlay
7
A2 = New Advertisement Outlay

These are some of the important types of elasticity of demand that helps in understanding the
criteria of demand for the goods and services and the factors that influence the demand.

13. Explain the methods which are available for forecasting the demand for new
products (NOV 2016)
Methods of Demand Forecasting
Definition: Demand Forecasting is a systematic and scientific estimation of future demand
for a product. Simply, estimating the sales proceeds or demand for a product in the future is
called as demand forecasting.
There are several methods of demand forecasting applied in terms of; the purpose of
forecasting, data required, data availability and the time frame within which the demand is to
be forecasted. Each method varies from one another and hence the forecaster must select that
method which best suits the requirement.
The methods of forecasting can be classified into two broad categories:
1. Survey Methods: Under the survey method, the consumers are contacted directly and
are asked about their intentions for a product and their future purchase plans. This method is
often used when the forecasting of a demand is to be done for a short period of time. The
survey method includes:
 Consumer Survey Method
 Opinion Poll Methods
2. Statistical Methods: The statistical methods are often used when the forecasting of
demand is to be done for a longer period. The statistical methods utilize the time-series
(historical) and cross-sectional data to estimate the long-term demand for a product. The
statistical methods are used more often and are considered superior than the other techniques
of demand forecasting due to the following reasons:
 There is a minimum element of subjectivity in the statistical methods.
 The estimation method is scientific and depends on the relationship between the
dependent and independent variables.
 The estimates are more reliable
 Also, the cost involved in the estimation of demand is the minimum.
The statistical methods include:
 Trend Projection Methods
 Barometric Methods
 Econometric Methods
These are the different kinds of methods available for demand forecasting. A forecaster must
select the method which best satisfies the purpose of demand forecasting.

UNIT - III PART – A

1. Define economics of scale. (APRIL 2012)
An economy of scale is an economics term that describes a competitive advantage that large
entities have over smaller entities. It means that the larger the business, non-profit or
government, the lower its costs. For example, the cost of producing one unit is less when
many units are produced at once.
2. Define fixed and variable costs. (APRIL 2012)
Fixed cost: Some inputs are used over a period of time for producing more than one batch of
goods. The costs incurred in these are called fixed cost. For example amount spent on
purchase of equipment, machinery, land and building.
Variable cost: When output has increased the firm spends more on these items. For example
the money spent on labour wages, raw material and electricity usage. Variable costs vary
according to the output. In the long run all costs become variable.
3. What is meant by real cost of production? (APRIL 2012)
Business decisions are generally taken based on the monetary values of inputs and outputs.
Note that the quantity of inputs multiplied by their respective unit prices will give the cost of
production.
4. What is optimisation? ( APRIL 2013)
An optimisation technique is generally defined as the technique used in finding the value of
the independent variable(s) that maximises or minimises the value of the dependent variable.
5. What is law of variable proportion? ( APRIL 2013)(APRIL 2016)
In the long run all input factors are variable. The producer can appoint more workers,
purchase more machines and use more raw materials. Initially output per worker will increase
up to an extent. This is known as the Law of Diminishing Returns or the Law of Variable
Proportion. To understand the law of diminishing returns it is essential to know the basic
concepts of production.
6. Define sunk costs. ( APRIL 2013) (NOV 2013)
Sunk costs are expenditures that have been made in the past or be paid in the future a part of
contractual agreement of previous decision. For example, the money already paid for
machinery, equipment, inventory and future rental payment on a warehouse that must be paid
a part of a long term lease agreement are Sunk costs. In general, Sunk costs are not relevant
to economic decisions. Sometimes the Sunk costs are also called a non-avoidable or non-
escapable costs.
7. What is production function? (APRIL 2015) (APRIL 2017)
The relationship between the amount of resources employed and total product or output is
called production function.
When the production function is expressed as an equation it shall be as follows:
Q = f (Ld, L, K, M, T )
It can be expressed as Q = f1, f2, f3, f4, f5 > 0
8. What is out lay cost? (APRIL 2015)
Any concrete business expenses that can be identified in the past, present or future.Outlay
costs are easy to recognize and measure because they have actually been incurred. For
corporations, outlay costs for new projects include start-up, production and hiring costs. ...
Also referred to as "explicit costs."
9. Define Historical cost. (APRIL 2015) (NOV 2016)
The price paid for a plant originally at the time of purchase. historical cost refers to the cost
an asset acquired in the past.
10. What is incremental cost? (APRIL 2016)
Incremental cost: Is the addition to costs resulting from a change in the nature of level of
business activity. Change in cost caused by a given managerial decision.
Incremental costs also arise as a result of change in product line, addition or introduction of a
new product, replacement of worn out plant and machinery, replacement of old technique of
production with a new one, and the like.

11. What are short run cost? (APRIL 2017)

Short-Run Costs are costs which change as desired output changes, size of the firm remaining
constant. These costs are often referred to as variable costs.
12. State the law of return to scale(APRIL 2017)
The law of returns to scale explains the proportional change in output with respect to
proportional change in inputs.
In other words, the law of returns to scale states when there are a proportionate change in the
amounts of inputs, the behavior of output also changes.

13. What is opportunity cost? (NOV 2012)

Opportunity cost is the value of a resource in its next best use. It‘s the cost for the next best
alternative use. The opportunity cost is really meaningful in the decision making process. For
example, consider a firm that owns a building and the firm do not pay rent for its use. If the
building was rented to others, the firm could have earned rent. The foregone rent is an
opportunity cost of utilizing the office space and should be included as part of the cost of
business. Sometimes this opportunity cost, are called as alternative cost.
14. Define shutdown cost. (NOV 2012)
Cost incurred if the firm temporarily stops its operation. These can be saved by
continuing business.
15. How do you determine optimum output level? (NOV 2014)
The marginal cost of production can be tracked to show the optimal production level where
per-unit production cost is lowest and therefore profit margin is the highest. The marginal
cost of production is the difference in total and per-unit average costs of production that
results from producing one additional product unit.
16. Define capital. (NOV 2014)
Capital is one of the basic factors of production along with land and labor. It is the
accumulated assets of a business that can be used to generate income for the business. Capital
includes all goods that are made or created by humans and used for producing goods or
services. Capital can include physical assets, such as a production plant, or financial assets,
such as an investment portfolio. Some treat the knowledge, skills and abilities that employees
contribute to the generation of income as human capital.
17. How do you calculate markup on cost? (NOV 2014)
Markup is when a company produces or purchases a good at one price and then sells the good
for a higher price. By having markup on goods, a company is able to earn profits.
1. Determine the markup the company wants and the cost of the good. In the example, the
cost is $5 and the markup rate is 10 percent.
2. Subtract 1 from the markup rate. In the example, 1 minus 10 percent equals 90 percent or
0.9.
3. Divide the cost of the product by the number calculated in Step 2. In the example, $5
divided by 0.9 equals $5.56. So if the company uses a 10 percent markup, it will sell the
product for $5.56.
18. What do you mean by profits in economic sense? (NOV 2014)
An economic profit or loss is the difference between the revenue received from the sale of an
output and the opportunity cost of the inputs used. In calculating economic profit,
opportunity costs are deducted from revenues earned.
19. What are complementary goods? (NOV 2015)
Complementary good means a product that is interrelated with another product and
can be used with or accompanying another product.
Example:
Cars and Petrol, Shoes and Polish, Samosa and Potato, Computer Hardware and Computer
Software, Printer and Ink Cartridges, Torch and Battery, Pencils and Erasers, Gaming Portals
and DVD of Games.
20. What is Average fixed cost? (NOV 2015)
Total fixed cost divided by the level of output.
21. What do you meant by marginal cost? (NOV 2015)
Cost of producing an extra unit of output. Marginal Cost (MC) is the addition to total cost on
account of producing one additional unit of a product. It is the cost of the marginal unit
produced. Marginal cost of output can be computed as TCn – TCn-1, where n represents the
current number of units produced, and n-1 represents the previous number of units produced.
MC can also be computed by the following relationship:
MC = Change in TC = ΔTC
Change in Q ΔQ
22. What is past cost? (NOV 2016)
A past cost is money that has already been spent. These funds cannot be recovered, so the
related cost is irrelevant for decision-making purposes. A past cost is also known as a
sunk cost.
UNIT - III PART –B

1. Explain the types of internal economics of scale. (APRIL 2012)

As a firm increases its scale of operation, there are a number of reasons responsible
for a decline in its average cost. These include:
i. Buying economies:
 These are probably the best known type. Large firms that buy raw materials in bulk
and place large orders for capital equipment usually receive discount. This means that they
pay less for each item purchased. They may also receive better treatment than small firms in
terms of quality of the raw materials and capital equipment sold and the speed of delivery.
This is because the suppliers will be anxious to keep such large customers.
ii. Selling economies:
The total cost of processing orders, packing the goods and transporting them does not
rise in line with the number of orders. For instance, it costs less than twice as much to send
10,000 washing machines to customers than it does to send 5,000 washing machines. A lorry
that can transport 40 washing machines does not cost four times as much to operate as four
vans which can carry 10 washing machines each.
A large volume of output can also reduce advertising costs. The total cost of an
advertising campaign can be spread over more units and, again, discounts may be secured. A
whole page advertisement in a newspaper or magazine is usually less than twice the cost of a
half page advertised. Together, buying and selling economies of scale are sometimes referred
to as marketing economies.
iii. Managerial economies:
Large firms can afford to employ specialist staff as they can spread their pay over a
high number of units. Employing specialist buyers, accountants, human resource managers
and designers can increase the firm’s efficiency, reduce costs of production and raise demand
and revenue. Large firms can also engage in division of labour amongst their other staff. For
example, car workers specialize in a particular aspect of the production process.
iv. Financial economies:
Large firms usually find it easier and cheaper, to raise finance. Banks tend to be more
willing to lend to large firms because such firms are well known and have valuable assets to
offer as collateral. Banks often charge large borrowers less, per $ borrowed, in order to attract
them and because they know that the administrative costs of operating and processing large
loans are not significantly higher than the costs of dealing with small loans.
Large firms can also raise finance through selling shares which is not an available
option for sole traders and partnerships. Public limited companies can sell to the general
public. The larger and better known the companies are, the more willing people are to buy
their shares.
v. Technical economies:
The larger the output of a firm, the more viable it becomes to use large,
technologically advanced machinery. Such machinery is likely to be efficient, producing
output at a lower average cost than small firms.
vi. Research and development economies:
A large firm can have a research and development department, since running such a
department can reduce average costs by developing more efficient methods of production and
raise total revenue by developing new products.
vii. Risk bearing economies:
Larger firms usually produce a range of products. This enables them to spread the
risks of trading. If the profitability of one of the products it produces falls, it can shift its
resources to the production of more profitable products.

2. Define total revenue, average revenue and marginal revenue. (APRIL 2012)
1. Total Revenue:
The income earned by a seller or producer after selling the output is called the total
revenue. In fact, total revenue is the multiple of price and output. The behavior of total
revenue depends on the market where the firm produces or sells.
 “Total revenue is the sum of all sales, receipts or income of a firm.” Dooley Total
revenue may be defined as the “product of planned sales (output) and expected selling price.”
Clower and Due “Total revenue at any output is equal to price per unit multiplied by quantity
sold.” Stonier and Hague

2. Average Revenue:
Average revenue refers to the revenue obtained by the seller by selling the per unit
commodity. It is obtained by dividing the total revenue by total output. “The average revenue
curve shows that the price of the firm’s product is the same at each level of output.” Stonier
and Hague

3. Marginal Revenue:
Marginal revenue is the net revenue obtained by selling an additional unit of the
commodity. “Marginal revenue is the change in total revenue which results from the sale of
one more or one less unit of output.” Ferguson. Thus, marginal revenue is the addition made
to the total revenue by selling one more unit of the good. In algebraic terms, marginal
revenue is the net addition to the total revenue by selling n units of a commodity instead of n
– 1.
Therefore,
A. Koutsoyiannis, “The marginal revenue is the change in total revenue resulting from selling
an additional unit of the commodity.”
ADVERTISEMENTS:
If total revenue from (n) units is 110 and from (n – 1) units is 100.
in that case
MRnth = TRn – TRn _ 1 = 100 – 100
MRnth = 10
MR in mathematical terms is the ratio of change in total revenue to change in output
MR = ∆TR/∆q or dR/dq = MR
Total Revenue, Average Revenue and Marginal Revenue:
The relation of total revenue, average revenue and marginal revenue can be explained with
the help of table and fig.
Table Representation:
The relationship between TR, AR and MR can be expressed with the help of a table 1.

From the table 1 we can draw the idea that as the price falls from Rs. 10 to Re. 1, the output
sold increases from 1 to 10. Total revenue increases from 10 to 30, at 5 units. However, at 6th
unit it becomes constant and ultimately starts falling at next unit i.e. 7th. In the same way,
when AR falls, MR falls more and becomes zero at 6th unit and then negative. Therefore, it is
clear that when AR falls, MR also falls more than that of AR: TR increases initially at a
diminishing rate, it reaches maximum and then starts falling.
The formula to calculate TR, AR and MR is as under:
TR = P x q
Or TR = MR1 + MR2 + MR3 + MR3 +….. MR„
TR
AR = TR/q MR = TRn – TRn _ x
In fig. 1 three concepts of revenue have been explained. The units of output have been shown
on horizontal axis while revenue on vertical axis. Here TR, AR, MR are total revenue,
average revenue and marginal revenue curves respectively.
In figure 1 (A), a total revenue curve is sloping upward from the origin to point K. From
point K to K’ total revenue is constant. But at point K’ total revenue is maximum and begins
to fall. It means even by selling more units total revenue is falling. In such a situation,
marginal revenue becomes negative.
Similarly, in the figure 1 (B) average revenue curves are sloping downward. It means average
revenue falls as more and more units are sold.
In fig. 1 (B) MR is the marginal revenue curve which slopes downward. It signifies the fact
that MR with the sale of every additional unit tends to diminish. Moreover, it is also clear
from the fig. that when both AR and MR are falling, MR is less than AR. MR can be zero,
positive or negative but AR is always positive.

3. Describe the importance of laws of returns to scale. (APRIL 2013) (APRIL 2016)
The law of returns are often confused with the law of returns to scale. The law of
returns operates in the short period. It explains the production behavior of the firm with one
factor variable while other factors are kept constant. Whereas the law of returns to scale
operates in the long period. It explains the production behavior of the firm with all variable
factors.

There is no fixed factor of production in the long run. The law of returns to scale
describes the relationship between variable inputs and output when all the inputs, or factors
are increased in the same proportion. The law of returns to scale analysis the effects of scale
on the level of output. Here we find out in what proportions the output changes when there is
proportionate change in the quantities of all inputs. The answer to this question helps a firm
to determine its scale or size in the long run.

It has been observed that when there is a proportionate change in the amounts of
inputs, the behavior of output varies. The output may increase by a great proportion, by in the
same proportion or in a smaller proportion to its inputs. This behavior of output with the
increase in scale of operation is termed as increasing returns to scale, constant returns to scale
and diminishing returns to scale. These three laws of returns to scale are now explained, in
brief, under separate heads.
Increasing Returns to Scale:

If the output of a firm increases more than in proportion to an equal percentage increase in all
inputs, the production is said to exhibit increasing returns to scale.

For example, if the amount of inputs are doubled and the output increases by more than
double, it is said to be an increasing returns returns to scale. When there is an increase in the
scale of production, it leads to lower average cost per unit produced as the firm enjoys
economies of scale.

(2) Constant Returns to Scale:

When all inputs are increased by a certain percentage, the output increases by the same
percentage, the production function is said to exhibit constant returns to scale.

For example, if a firm doubles inputs, it doubles output. In case, it triples output. The
constant scale of production has no effect on average cost per unit produced.

(3) Diminishing Returns to Scale:

The term 'diminishing' returns to scale refers to scale where output increases in a smaller
proportion than the increase in all inputs.

For example, if a firm increases inputs by 100% but the output decreases by less than 100%,
the firm is said to exhibit decreasing returns to scale. In case of decreasing returns to scale,
the firm faces diseconomies of scale. The firm's scale of production leads to higher average
cost per unit produced.

Graph/Diagram:

The three laws of returns to scale are now explained with the help of a graph below:
The figure 11.6 shows that when a firm uses one unit of labor and one unit of capital, point a,
it produces 1 unit of quantity as is shown on the q = 1 isoquant. When the firm doubles its
outputs by using 2 units of labor and 2 units of capital, it produces more than double from
q = 1 to q = 3.

So the production function has increasing returns to scale in this range. Another output from
quantity 3 to quantity 6. At the last doubling point c to point d, the production function has
decreasing returns to scale. The doubling of output from 4 units of input, causes output to
increase from 6 to 8 units increases of two units only.

4. Explain the short-run cost output relationship. (APRIL 2013)

1. Cost-Output Relationship in the Short-Run
The cost concepts made use of in the cost behavior are Total cost, Average cost,
and Marginal cost. Total cost is the actual money spent to produce a particular quantity of
output. Total Cost is the summation of Fixed Costs and Variable Costs.
TC=TFC+TVC
Up to a certain level of production Total Fixed Cost i.e., the cost of plant, building, equipment
etc, remains fixed. But the Total Variable Cost i.e., the cost of labor, raw materials etc., vary
with the variation in output. Average cost is the total cost per unit. It can be found out as
follows.
AC=TC/Q
The total of Average Fixed Cost (TFC/Q) keep coming down as the production is
increased and Average Variable Cost (TVC/Q) will remain constant at any level of output.
Marginal Cost is the addition to the total cost due to the production of an additional unit of
product. It can be arrived at by dividing the change in total cost by the change in total output.
In the short-run there will not be any change in Total Fixed C0st. Hence change in total cost
implies change in Total Variable Cost only.
Units of Total fixedTotal Total costAverage Average Average Marginal
Output Q cost TFC variable (TFC +variable fixed costcost (TC/Q)cost MC
cost TVC TVC) TC cost (TVC /(TFC / Q)AC
Q) AVC AFC
0 – – 60 – – – –
1 60 20 80 20 60 80 20
2 60 36 96 18 30 48 16
3 60 48 108 16 20 36 12
4 60 64 124 16 15 31 16
5 60 90 150 18 12 30 26
6 60 132 192 22 10 32 42

The above table represents the cost-output relationship. The table is prepared on the
basis of the law of diminishing marginal returns. The fixed cost Rs. 60 May include rent of
factory building, interest on capital, salaries of permanently employed staff, insurance etc.
The table shows that fixed cost is same at all levels of output but the average fixed cost, i.e.,
the fixed cost per unit, falls continuously as the output increases. The expenditure on the
variable factors (TVC) is at different rate. If more and more units are produced with a given
physical capacity the AVC will fall initially, as per the table declining up to 3rd unit, and being
constant up to 4th unit and then rising. It implies that variable factors produce more efficiently
near a firm’s optimum capacity than at any other levels of output and later rises. But the rise
in AC is felt only after the start rising. In the table ‘AVC’ starts rising from the 5 th unit
onwards whereas the ‘AC’ starts rising from the 6th unit only so long as ‘AVC’ declines ‘AC’
also will decline. ‘AFC’ continues to fall with an increase in Output. When the rise in ‘AVC’
is more than the decline in ‘AFC’, the total cost again begin to rise. Thus there will be a stage
where the ‘AVC’, the total cost again begin to rise thus there will be a stage where the ‘AVC’
may have started rising, yet the ‘AC’ is still declining because the rise in ‘AVC’ is less than
the droop in ‘AFC’.
Thus the table shows an increasing returns or diminishing cost in the first stage and
diminishing returns or diminishing cost in the second stage and followed by diminishing
returns or increasing cost in the third stage.
The short-run cost-output relationship can be shown graphically as follows.
In the above graph the “AFC’ curve continues to fall as output rises an account of its spread
over more and more units Output. But AVC curve (i.e. variable cost per unit) first falls and
than rises due to the operation of the law of variable proportions. The behavior of “ATC’
curve depends upon the behavior of ‘AVC’ curve and ‘AFC’ curve. In the initial stage of
production both ‘AVC’ and ‘AFC’ decline and hence ‘ATC’ also decline. But after a certain
point ‘AVC’ starts rising. If the rise in variable cost is less than the decline in fixed cost, ATC
will still continue to decline otherwise AC begins to rise. Thus the lower end of ‘ATC’ curve
thus turns up and gives it a U-shape. That is why ‘ATC’ curve are U-shaped. The lowest point
in ‘ATC’ curve indicates the least-cost combination of inputs. Where the total average cost is
the minimum and where the “MC’ curve intersects ‘AC’ curve, It is not be the maximum
output level rather it is the point where per unit cost of production will be at its lowest.
The relationship between ‘AVC’, ‘AFC’ and ‘ATC’ can be summarized up as follows:
If both AFC and ‘AVC’ fall, ‘ATC’ will also fall.
When ‘AFC’ falls and ‘AVC’ rises
‘ATC’ will fall where the drop in ‘AFC’ is more than the raise in ‘AVC’.
‘ATC’ remains constant is the drop in ‘AFC’ = rise in ‘AVC’
‘ATC’ will rise where the drop in ‘AFC’ is less than the rise in ‘AVC’

5. Discuss the disadvantages of large scale production. (APRIL 2014)

1. Too Large:
The most obvious disadvantage is that as the size of business units expands beyond certain
points, it becomes too unwieldy for its managers to mange. As the concerns becomes large,
supervision becomes ineffective and wastage becomes more rampant.
2. Production Not According to Individual Tastes:
There is no fineness or perfection in the commodity. As they merely turn out certain
standardized goods they are unable to satisfy the individual tastes of the consumers. They
also lose contacts with consumers.

3. No Personal Contacts:
This lacks personal contact between the employers and employees. This may lead to friction,
misunderstanding, disputes and strikes in large units.
4. Not Flexible:
The large scale production cannot easily be adopted itself to the changing circumstances. As a
result it submits itself to the disadvantages of such changes
5. Monopoly:
As a result of large scale production, there always exists the fear of monopoly. It can either be
through wiping out small scale producers, through competition or by joining hands with
others and driving other producers out of the market. This leads to an increase in prices and
fall in the quality of the product.
6. Over-Production:
In the large scale production demand cannot be assessed accurately which leads either to
overproduction or underproduction.
7. Evils of Factory System:
Usually, large scale production is always associated with all the evils of factory system like
density, pollution etc.
8. Unequal Distribution of Wealth:
Large scale production leads to unequal distribution of wealth in a country. A big portion of
wealth is concentrated in the hands of mill owners. This creates unrest in the society. Thus, it
spoils the social atmosphere of the society.
9. Heavy loss and Dislocation:
The breakdown of large scale industries may lead to inflict loss and heavy burden and
dislocation of the economy.
10. Industrial Disputes:
The large scale production lose direct relationship with their employees. This leads to discord
and conflicts between owners as well workers. Result is the strikes, lockout etc. In turn, they
adversely affect the production.
11. War:
Under large scale production, producer makes efforts to sell their products in foreign markets.
Tension is created among different countries to capture these markets. This leads to the break
out the war.
12. Decline of Cottage and Small Scale Industries:
Large scale production reduces the cost of production. Goods are cheap. This leads to decline
of cottage and small scale industries as goods produced by them are costly.
13. Adverse Effect on Labourers:
Generally labourers become more dependent. This gives birth to laziness. As a result, they are
exploited and their physical and mental development is retarded.
14. Birth of Capitalism.
Large scale production is in the hands of capitalists rather than Government. Many evils
breed. In essence, large scale production has both advantages and disadvantages. If the
capitalists adopt a progressive attitude or the government undertakes the production itself, the
disadvantages can be avoided. Large scale production is very essential for the economic
development of the country.
6. Examine the factors influencing location of site. (APRIL 2014)
(1)Primary Factors:

(i) Availability of Raw Materials:

Raw material form major proportion of the finished product. Unrestricted and regular
supply of raw material is very necessary for carrying out unrestricted production. Nearness to
the source of raw material is very economical for an industrial unit. On account of this
consideration many industries have been set up near the source of supply of raw material
Sugar factories in Uttar Pradesh, Textile units in Maharashtra and Gujarat, Cement factories
in Madhya Pradesh and Jute industry in West-Bengal. Nearness to raw material is important
in case of heavy and bulky materials having lesser value such as coal and other weight losing
materials.
Raw materials can be divided into three:
(a) raw materials which are weight losing and cannot be preserved for a long time
e.g., fruits for juice making (b) raw materials which are bulky, heavy and weight losing in
nature, like iron ore etc. (c) raw materials which are not heavy and can be preserved for a
longer period of time, e.g., raw cotton.
Industry using third type of raw material can be located anywhere. Alford Weber has
given another type of raw materials called ubiquitous like clay sand and water which are
found everywhere and as such do not affect the location of an industry.
Another important point to be kept in mind that only nearness of raw materials is not
sufficient; it must also be easily accessible. Adequate transportation facilities should be
available for carrying the material from the source of supply. A guiding principle should be
followed in this regard i.e., “higher the proposition of the cost of raw materials to the total
cost, the greater is the possibility of choosing a site near the source of raw materials.”
(ii) Availability of labour:
Labour cost is one of the main constituents of the total cost of production. It
influences the total cost of production. Labour implies both the skilled and unskilled workers
needed for different types of activities. The supply of un-skilled labour does not create any
serious problem because such labour is available everywhere. Skilled labour is available only
at specific centres.
Industries requiring highly skilled labour have to select such sites which ensure
adequate and regular supply of required labour. Availability of skilled and efficient labour is
mainly responsible for the development of various industries in a particular region e.g., cotton
textile industry of Great Britain developed at Lancashire mainly on account of availability
efficient labour.
On account of mobility of labour, this factor does not materially affect the location of
an industrial unit. The labour can be attracted by providing various facilities and incentives
like housing, canteen, rest rooms, incentive wage plans etc.
In actual practice, if required skilled labour is not available in a particular region, the
available labour can be trained in the required skill or alternatively skilled and trained labour
can be migrated from other regions to the plant. But both these methods are time consuming
and involve a lot of expenditure which ultimately increase the cost of production.
(iii) Availability of Power and Fuel:
Availability of cheap power and fuel supply sources is another decisive factor in
selecting proper location of an industrial unit. In the past, coal was the main sources of power
supply for various types of heavy and large scale industries like iron and steel, cement and
aluminium etc., the industrial units which used to be located near coal supplying centres.
But at present, there are several other sources of power, e.g. electricity, gas, oil and water
power etc. On account of these various alternative sources of power supply, coal, as a main
source of power is getting lesser recognition. Rapid development of hydro-electric power has
provided wider choice for location of industrial units even at far flung and remote areas.
Modern industrialisation could not have been possible without the growth of hydroelectric
generating units.
(iv) Availability of Transport and Communication facilities:
Adequate and quick facilities of transport must be kept in mind for quick delivery of
raw materials to the factory and finished products to the market. Kimball and Kimball have
rightly pointed out that “The ideal plant is one centrally located and directly served by water,
rail, trucking and air facilities”.
In certain type of industries transportation is the sole factor which is taken into
consideration in deciding location of an industrial unit. For example, a cement factory is
always situated near the source of lime stone which is carried usually with the help of trolleys
to the factory.
Transportation is the life line of modern industry. The basic aim of selecting a
particular mode of transportation should be minimum transportation cost with maximum
transportation service. An industry should be located in the areas where there are already
developed means of transportation.
Faridabad in Haryana developed as an industrial town on account of availability of
both rail and road transportation. Phagwara serves another very good example of this type.
Certain port towns like Calcutta, Bombay and Madras have attained significant importance
on account of availability of excellent water and rail transportation facilities.
In modern times different modes of transportation and their increased efficiency and
flexibility have provided ample choice to the industrialists in the matter of location. Besides
transportation, communication services are also used to be of immense importance in
deciding the location of an industrial unit. A businessman needs regular information with
regard to changes in the price of raw materials and finished products and other valuable
information. On account of development of internet, mobile phones etc., this factor does not
affect the location of plant now a days.
(v) Nearness to Market:
Market greatly affects the establishment of an industrial unit and is in fact, dominant
factor in locating an industrial unit in modern times. The production of goods is undertaken
with the aim of selling them quickly which is possible only on account of nearness to market.
Industries using pure raw material (which do not lose their weight when turned into finished
products) may be situated away from the source of such raw materials. For example, wool is
primarily produced in Australia, but woollen hosieries are found throughout the world.
On the other hand, market as a factor of location will not affect much the location of
industries using heavy and weight losing raw material. For example, iron and textile units are
situated near the coal supplying centres. Similarly sugar factories are located very near the
sources of raw materials. Nearness to market is important in case of industries producing
consumer goods rather producers’ goods, this is because production of consumer goods
require constant adjustment of manufacturing programme on account of quick changes in the
tastes, preferences and buying habits of the consumers.
Markets may be national or regional. In case where the demand of the product is on
regional basis, the factory is usually situated near the major market for the product. For
example, a publishing house publishing Punjabi books cannot be located in Calcutta or
Bombay. Its ideal location would be Jalandhar, which is a leading publishing centre in
Punjab.
(2) Secondary Factors:

Besides the above primary factors, there are some other factors which have bearing on the
location of industries.
Following factors can be explained under this category:
(i) Nearness to adequate Banking and credit facilities:
For the efficient and smooth running of the business and for meeting working capital
requirements, banking facilities play an important role. Nearness to banks and other financial
institutions is an important consideration now-a- days in deciding location of an industrial
unit. This is because banking has become indispensable part of modern business. In case of
rural and small scale industries, banks and financial institutions play an important role and
provide invaluable service in order to cater their financial needs.
(ii) Facilities of Repairs:
In order to maintain uninterrupted production, facilities with regard to repairs of
machinery, plant and other components (in case of breakdown), must be kept in mind before
setting a factory. A large scale concern can afford to install its own repair workshops, whereas
small concerns may rely on various repair shops working near the factory.
(iii) Fire fighting facilities:
In order to protect the factory against the risk of fire, adequate fire fighting facilities
must be provided. Internal arrangements pertaining to fire extinguishers, sand buckets and
other firefighting equipment must be arranged. In case there arises the necessity of calling
fire brigades, proper preparations must be made for the same.
(iv) Soil, Climate and Topography of a place:
Soil and climatic conditions are very important for the establishment of various type
of industries like tea, coffee, rubber and tobacco. On account of this factor, jute industry
developed in West- Bengal and tea industry in Assam. Similarly topography (e.g., hilly or
rocky surface) of a place also influences location of an industry.
Areas which are frequently subjected to earthquakes and other natural calamities may
not attract many industries. Climate of a place also considerably affects the efficiency of
workers. Efficient workers are found in cool climatic regions.
On the other hand workers from tropical regions are not generally so efficient. This
also affects the establishment of an industrial unit. Another important point in this regard is
that means of transportation and communication are more in plains rather than in hilly areas.
That is why industries have developed largely in plains rather than in hilly areas.
(v) Govt, policies and regulations:
Industrial Development and Regulation Act of 1951 laid down clearly certain rules,
regulations and formalities to be complied before setting up an industrial unit. Prior
permission and licence is necessary under the Act before the setting up of a new industrial
unit. Certain cash incentives and concessions are also given by Govt, in order to promote a
particular industry in a particular region.
A careful thought to all these rules, regulations and provisions of Act must be given
before the establishment of an industrial unit. In order to develop industries on sound lines,
Govt, has declared certain areas as industrially backward or special economic zones.
Certain concession and subsidies like cheap land, power and tax concession and subsidised
raw materials etc., are provided in order to develop that particular area. Such measures are
undertaken by the Govt, in order to ensure balanced and regional growth of industries in
India.
(vi) Momentum of an early start:
This is another important factor affecting industrial location. A few industries start at a
place and gradually other similar type of industries start at that particular place. For example,
at Manimajra (a small town near Chandigarh) a few small automobile spare parts shops
started about two decades back, but now a fully fledged automobile market has developed in
that area. Similarly, at Ludhiana a few hosiery units started in the beginning, now Ludhiana
has become a very big hosiery articles producing centre in India.
Carpet industry developed gradually at Mirjapur district of Uttar Pradesh. There are various
reasons responsible for such a concentration of industries in a particular region viz., (i)
availability of required type of labour in a particular region, (ii) facilities of repairs and
maintenance on account of many repair shops and workshops operating in the areas, (iii)
Availability of transport, communication, banking and insurance facilities, (iv) Facilities of
managerial consultations and advice are also available.
(vii) Industrial atmosphere:
This factor refers to the thinking of the people with regard to a particular industry in a
particular area. They involve themselves completely in the intricacies and various operations
of the machines and implements being used in the industry. There is a complete industrial
atmosphere. Carpet industry at Bhadohi and Mirzapur serves a very good example of this
kind. Major population of these cities is engaged in carpet processing, carpet washing, carpet
weaving and carpet finishing.
Not only men, but women and children have also engaged themselves in this industry
directly or indirectly. Similarly, at Bombay film industry has developed. It is easier and
cheaper to produce a film in Bombay than in any other part of the country.
(viii) Personal factors:
Sometimes personal likes had dislikes also influence location of a particular industrial
unit. Henry Ford started manufacturing motor cars in Detroit because he belonged to that
place. Certain merchants belonging to Ahmedabad have made that place a leading textile
centre of India. But such personal likes and dislikes cannot influence location of an industrial
unit in the long run.
(xi) Tastes and preferences of people:
Before establishing an industrial unit in a particular region, buying habits, tastes, likes
and dislikes of people in that area must be taken into consideration. Purchasing power of the
people and composition of population in that region should be carefully studied. These
studies and surveys render valuable information which is greatly helpful in establishing and
industrial unit in particular region.
(x) Political and economic situation:
Political harmony and peace in a particular region encourage the establishment of
industrial units. On the other hand, disturbed political and economic set up discourages the
growth of industries in the region.
On account of Naxalites movement in West Bengal, Industries started moving out of
West Bengal. Similarly is the case in certain other states where, on account of political
disturbances, manufacturers have started thinking to settle elsewhere and further industrial
expansion has been greatly affected.
(xi) Possibilities of future expansion:
The area for location should be such as to provide all possible opportunities for future
development and expansion of the industrial unit without involving extra cost. Every
industrial undertaking is established with the aim to expand in future.
(xii) Existence of competitive industries:
Limited and healthy competition encourages the growth of industrial units in a
particular region. On the other hand, unhealthy competition retards the industrial growth in a
region.
(xiii) Availability of research facilities:
The main aim of any industrial undertaking is to have maximum production with
minimum cost. Constant research and experimentation is undertaken to develop products and
improved methods of production.
Large concerns can afford to have a separate research department to meet this end, but
in case of small and medium industrial units such facilities may be provided by specialised
scientific and research institutions. Existence of such specialised institutions must be kept in
mind before starting an industrial unit.

7. Explain the assumptions of law of variable proportion. (APRIL 2015)

"in a given state of technology, when the units of variable factor of production (L) are
increased within the units of other fixed factors, the marginal productivity increases at
increasing rate up to a point, after this point. it will become less and less"
Assumptions:
The assumptions of the law of variable proportion are given as below:
1. It is assumed that the technique of production should remain constant during
production.
2. It operates in the short-run because in the long run, fixed inputs become variable.
3. Some inputs must be kept constant.
4. The various factors are not to be used in rigidly fixed proportions but the law is based
upon the possibility of varying proportions. It is also called the law of proportionality.
5. It is assumed that all the units of variable factors of production are homogeneous in
amount and quality.
6. It is assumed that labor is a single variable factor.

8. Explain the Long-run Cost-output relationship. (APRIL 2015) (NOV 16)

Cost-output Relationship in the Long-Run
Long run is a period, during which all inputs are variable including the one, which are
fixes in the short-run. In the long run a firm can change its output according to its demand.
Over a long period, the size of the plant can be changed, unwanted buildings can be sold staff
can be increased or reduced. The long run enables the firms to expand and scale of their
operation by bringing or purchasing larger quantities of all the inputs. Thus in the long run all
factors become variable.
The long-run cost-output relations therefore imply the relationship between the total
cost and the total output. In the long-run cost-output relationship is influenced by the law of
returns to scale.
In the long run a firm has a number of alternatives in regards to the scale of
operations. For each scale of production or plant size, the firm has an appropriate short-run
average cost curves. The short-run average cost (SAC) curve applies to only one plant
whereas the long-run average cost (LAC) curve takes in to consideration many plants.
The long-run cost-output relationship is shown graphically with the help of “LCA’ curve.

To draw on ‘LAC’ curve we have to start with a number of ‘SAC’ curves. In the above figure
it is assumed that technologically there are only three sizes of plants – small, medium and
large, ‘SAC’, for the small size, ‘SAC2’ for the medium size plant and ‘SAC3’ for the large
size plant. If the firm wants to produce ‘OP’ units of output, it will choose the smallest plant.
For an output beyond ‘OQ’ the firm wills optimum for medium size plant. It does not mean
that the OQ production is not possible with small plant. Rather it implies that cost of
production will be more with small plant compared to the medium plant.
For an output ‘OR’ the firm will choose the largest plant as the cost of production will
be more with medium plant. Thus the firm has a series of ‘SAC’ curves. The ‘LCA’ curve
drawn will be tangential to the entire family of ‘SAC’ curves i.e. the ‘LAC’ curve touches
each ‘SAC’ curve at one point, and thus it is known as envelope curve. It is also known as
planning curve as it serves as guide to the entrepreneur in his planning to expand the
production in future. With the help of ‘LAC’ the firm determines the size of plant which
yields the lowest average cost of producing a given volume of output it anticipates.

9. Explain the three phases of returns to scale. (APRIL 2016)

PHASES OF RETURNS TO SCALE
Three phases of returns to scale:
The modifications in output as an outcome of changes in scale can be studied in 3 phases.
They are:
Increasing returns to scale:
When the increase in all factors leads to a greater than proportionate augment in output, it is
termed as increasing returns to scale. For illustration, when all the inputs are raised by 5
percent, the output rises by more than 5 percent that is, by 10%. In this situation the marginal
product will be increasing.

Constant returns to scale:

When we increase all the factors (that is, scale) in a specified proportion, the output will raise
in similar proportion that is, a 5 percent increase in all the factors will outcome in an
equivalent proportion of 5 percent raise in the output. Here the marginal product is steady.

Decreasing returns to scale:

When the increase in every factor leads to a less than proportionate increase in output, it is
termed as decreasing returns to scale that is, when all the factors are raised by 5 percent, the
output will rise by less than 5 percent that is, by 3 percent. In this stage marginal product will
be declining.
Table: Returns to scale
 Figure: Returns to Scale
The figure above elucidates the different phases of returns to scale. Whenever marginal
product increases (i.e., AB), net product rises at an increasing rate. Therefore there is
increasing returns to scale. Whenever Marginal Product stays constant (i.e., BC), Total
Product raises at a constant rate and this stage is termed as constant returns to scale.
Whenever Marginal Product reduces (i.e., CMP), Total Product rises at a declining rate and it
is termed as decreasing returns to scale.

10. Discuss different types of cost concepts (APRIL 2017)

A. Some Accounting Cost Concepts:

1. Opportunity Cost and Actual Cost:

Opportunity cost refers to the loss of earnings due to opportunities foregone due to
scarcity of resources. If resources were unlimited, there would be no need to forego any
income-yielding opportunity and, therefore, there would be no opportunity cost. Resources
are scarce but have alternative uses with different returns. Incomes maximizing resource
owners put their scarce resources to their most productive use and forego the income
expected from the second best use of the resources.
Therefore, the opportunity cost may be defined as the expected returns from the
second best use of the resources foregone due to the scarcity of resources. The opportunity
cost it is also called Alternative cost. For example, suppose that a person has a sum of Rs. 1,
00,000 for which he has only two alternative uses. He can buy either a printing machine or,
alternatively, a lathe machine. From printing machine, he expects an annual income of Rs.
20,000 and from the lathe, Rs. 15,000.
If he is a profit maximizing investor, he would invest his money in printing machine
and forego the expected income from the lathe. The opportunity cost of his income from
printing machine is the expected income from the lathe, i.e., Rs. 15,000.
The opportunity cost arises because of the foregone opportunities. Thus, the opportunity cost
of using resources in printing business, the best alternative is the expected return from the
lathe, the second best alternative. In assessing the alternative cost, both explicit and implicit
costs are taken into account.

Associated with the concept of opportunity cost is the concept of economic rent or
economic profit. For example, economic rent of the printing machine is the excess of its
earning over the income expected from the lathe (i.e., Rs. 20,000 – Rs. 15,000 = Rs. 5,000).
The implication of this concept for business man is that investing in printing machine is
preferable so long as its economic rent is greater than zero. Also, if firms know the economic
rent of the various alternative uses of their resources, it will be helpful in the choice of the
best investment avenue.
On the other hand, actual costs are those which are actually incurred by the firm in
payment for labour, material, plant, building, machinery, equipment, travelling and transport,
advertisement, etc. The total money expenses, recorded in the books of accounts are, for all
practical purposes, the actual costs. Actual cost comes under the accounting concept.
2. Business Costs and Full Costs:
Business costs include all the expenses which are incurred to carry our business. The
concept of business costs is similar to the actual or real costs. Business costs “include all the
payments and contractual obligations made by the firm together with the book cost of
depreciation on plant and equipment”.
These cost concepts are used for calculating business profits and losses and for filling
returns for income-tax and also for other legal purposes. Full costs, on the contrary, include
business costs, opportunity cost and normal profit. The opportunity cost includes the expected
earnings from the second best use of the resources, or the market rate of interest on the total
money capital, and also the value of entrepreneur’s own services which are not charged for in
the current business. Normal profit is a necessary minimum earning in addition to the
opportunity cost, which a firm must get to remain in its present occupation.
3. Explicit and Implicit or Imputed Costs:
Explicit costs refer to those which fall under actual or business costs entered in the
books of accounts. The payments for wages and salaries, materials, license fee, insurance
premium, depreciation charges are the examples of explicit costs. These costs involve cash
payments and are recorded in normal accounting practices.
In contrast with these costs, there are not certain other costs which do not take the
form of cash outlays, nor do they appear in the accounting system. Such costs are known as
implicit or imputed costs. Implicit costs may be defined as the earning expected from the
second best alternative use of resources. For instance, suppose an entrepreneur does not
utilize his services in his own business and works as a manager in some other firm on a salary
basis.
If he starts his own business, he foregoes his salary as manager. This loss of salary is
the opportunity costs of income from his own business. This is an implicit cost of his own
business; implicit, because the entrepreneur suffers the loss, but does not charge it as the
explicit cost of his own business. Thus, implicit wages, rent and interest are the highest
wages, rents and interest which owner’s labour, building and capital can respectively earn
from their second best use.
Implicit costs are not taken into account while calculating the loss or gains of the business,
but they form an important consideration in whether or not a factor would remain in its
present occupation. The explicit and implicit costs together make the economic cost.
4. Out-of-Pocket and Book Costs:
Out-of-pocket costs means costs that involve current cash payments to outsiders while
book costs such as depreciation do not require current cash payments. In concept, this
distinction is quite different from traceability and also from variability with output. Not all
out-of- pocket costs are variable, e.g., salaries paid to the administrative staff.
Neither are they all direct, e.g., the electric power bill. Book costs are in some cases
variable and in some cases readily traceable, and hence become a part of direct costs. The
distinction primarily shows how cost affects the cash position. Book costs can be converted
into out-of-pocket costs by selling the assets and having them on hire. Rent would then
replace depreciation and interest.
While undertaking expansion, book costs do not come into the picture until the assets
are purchased. Yet the question to be answered is: What will be the gross earnings of the
investment during its life time and do they justify the outlay? Transfer of old equipment to
new areas will bring book costs into the picture.
B. Some Analytical Cost Concepts:

5. Fixed and Variable Costs:

Fixed costs are those costs which are fixed in volume for a certain given output. Fixed
cost does not vary with variation in the output between zero and certain level of output. The
costs that do not vary for a certain level of output are known as fixed cost.
The fixed costs include:
(i) Cost of managerial and administrative staff.
(ii) Depreciation of machinery, building and other Axed assets, and
(iii) Maintenance of land, etc. The concept of fixed cost is associated with short-run.
Variable costs are those which vary with the variation in the total output. They are a
function of output. Variable costs include cost of raw materials, running cost on fixed capital,
such as fuel, repairs, routine maintenance expenditure, direct labour charges associated with
the level of output, and the costs of all other inputs that vary with output.
6. Total, Average and Marginal Costs:
Total cost represents the value of the total resource requirement for the production of
goods and services. It refers to the total outlays of money expenditure, both explicit and
implicit, on the resources used to produce a given level of output. It includes both fixed and
variable costs. The total cost for a given output is given by the cost function.
Average cost:
Average cost (AC) is of statistical nature, it is not actual cost. It is obtained by
dividing the total cost (TC) by the total output (Q), i.e.
AC = TC / Q = average cost
Marginal cost:
Marginal cost is the addition to the total cost on account of producing an additional
unit of the product. Or, marginal cost is the cost of marginal unit produced. Given the cost
function, it may be defined as
MC = TC/ Q
These cost concepts are discussed in detail in the following section. Total, average and
marginal cost concepts are used in economic analysis of firm’s production activities.
7. Short-Run and Long-Run Costs:
Short-run and long-run cost concepts are related to variable and fixed costs
respectively, and often marked in economic analysis interchangeably. Short-run costs are the
costs which vary with the variation in output, the size of the firm remaining the same. In
other words, short-run costs are the same as variable costs. Long-run costs, on the other hand,
are the costs which are incurred on the fixed assets like plant, building, machinery, etc. Such
costs have long-run implication in the sense that these are not used up in the single batch of
production.
Long-run costs are, by implication, the same as fixed costs. In the long-run, however,
even the fixed costs become variable costs as the size of the firm or scale of production
increases. Broadly speaking, ‘the short-run costs are those associated with variables in the
utilization of fixed plant or other facilities whereas long-run costs are associated with the
changes in the size and kind of plant.’
8. Incremental Costs and Sunk Costs:
Incremental costs are closely related to the concept of marginal cost but with a
relatively wider connotation. While marginal cost refers to the cost of the marginal unit of
output, incremental cost refers to the total additional cost associated with the marginal batch
of output.
The concept of incremental cost is based on the fact that in the real world, it is not
practicable for lack of perfect divisibility of inputs to employ factors for each unit of output
separately. Besides, in the long run, firms expand their production; hire more men, materials,
machinery and equipments.
The expenditures of this nature are incremental costs and not the marginal cost (as
defined earlier). Incremental costs arise also owing to the change in product lines, addition or
introduction of a new product, replacement of worn out plant and machinery, replacement of
old technique of production with a new one, etc.
The Sunk costs are those which cannot be altered, increased or decreased, by varying
the rate of output. For example, once it is decided to make incremental investment
expenditure and the funds are allocated and spent, all the preceding costs are considered to be
the sunk costs since they accord to the prior commitment and cannot be revised or reversed or
recovered when there is change in market conditions or change in business decisions.
9. Historical and Replacement Costs:
Historical costs are those costs of an asset acquired in the past whereas replacement
cost refers to the outlay which has to be made for replacing an old asset. These concepts own
their significance to unstable nature of price behaviour. Stable prices over time, other things
given, keep historical and replacement costs on par with each other. Instability in asset prices
makes the two costs differ from each other. Historical cost of assets is used for accounting
purposes, in the assessment of net worth of the firm. The replacement cost figures in the
business decision regarding the renovation of the firm.
10. Private and Social Costs:
There are not certain other costs which arise due to functioning of the firm but are not
normally marked in the business decisions nor does are such cost explicitly borne by the
firms. The costs of this category are borne by the society.
Thus, the total cost generated by a firm’s working may be divided into two categories:
(i) Those paid out or provided for by the firms, and
(ii) Those not paid or borne by the firms- it includes use of resource freely available plus the
disutility created in the process of production.
The costs of the former category are known as private costs and of the latter category
are known as external or social costs. The example of social cost are: Mathura Oil Refinery
discharging its wastage in the Yamuna river causes water pollution; Mills and factories
located in a city cause air pollution by emitting smoke. Similarly, plying cars, buses, trucks,
etc., cause both air and noise pollution. Such pollutions cause tremendous health hazards
which involve health cost to the society as a whole. Such costs are termed external costs from
the firm’s point of view and social cost from society’s point of view.
The relevance of the social costs lies in understanding the overall impact of firm’s
working on the society as a whole and in working out the social cost of private gains. A
further distinction between private costs and social costs is therefore in order.
Private costs are those which are actually incurred or provided for by an individual or
a firm on the purchase of goods and services from the market. For a firm, all the actual costs
both explicit and implicit are private costs. Private costs are internalized costs that are
incorporated in the firm’s total cost of production.Social costs on the other hand, refer to the
total cost to the society on account of production of a commodity. Social costs include both
private cost and the external cost.
Social costs include:
(a) The cost of resources for which the firm is not compelled to pay a price, i.e., atmosphere,
rivers, lakes, and also for the use of public utility services like roadways, drainage system,
etc., and
(b) The cost in the form of ‘disutility’ created through air, water and noise pollutions, etc. The
costs of category.
(b) Generally assumed to equal the total private and public expenditures are incurred to
safeguard the individual and public interest against the various kinds of health hazards
created by the production system. The private and public expenditure, however, serve only as
an indicator of ‘public disutility’, they do not give the exact measure of the public disutility
or the social costs.
C. Other Costs Concepts:

11. Urgent and Postponable Cost:

Urgent costs are those costs which must be incurred in order to continue operations of
the firm. For example, the costs of materials and labour which must be incurred if production
is to take place.
Postponable costs refer to those costs which can be postponed at least for some time
e.g., maintenance relating to building and machinery. Railways usually make use of this
distinction. They know that the maintenance of rolling stock and permanent way can be
postponed for some time.
Therefore their maintenance expenditure is incurred mainly in periods of slack
activity when the rolling stock is comparatively idle. During World War II most maintenance
was virtually postponed due to the rush of work in railways as also in other factories. Such
postponement of maintenance expenditure tends to create employment during periods of
slack activity and thus serves as an anti-cyclical measure.
12. Escapable and Unavoidable Costs:
Escapable costs refer to costs which can be reduced due to a contraction in the
activities of a business enterprise. It is the net effect on costs that is important, not just the
costs directly avoidable by the contraction. And the difficult problem is estimating these
indirect effects rather than directly savable costs.
For Example:
1. Closing apparently unprofitable branch house-storage costs of other branches and
transportation charges would increase.
2. Reducing credit sales-costs estimated may be less than the benefits otherwise available.
Escapable costs are different from controllable and discretionary costs. The latter are like
chopping off the additional fat and are not directly associated with a special curtailment
decision.
13. Controllable and Non-Controllable Costs:
The concept of responsibility accounting leads directly to the classification of cost as
controllable or uncontrollable. The controllability of a cost depends upon the levels of
responsibility under consideration. A controllable cost may refer to one which is reasonably
subject to regulation by the executive with whose responsibility that cost is being identified.
Thus a cost which is uncontrollable at one level of responsibility may be regarded as
controllable at some other, usually higher level.
The control- liability of certain cost may be shared by two or more executives. For
example, materials cost where price paid is the responsibility of the purchasing department
and the usage is the responsibility of the production supervisor. This distinction is primarily
useful for expense and efficiency control.
Direct material and direct labour costs are usually controllable. Regarding so for,
overhead costs, some costs are controllable and others are not. Indirect labour, supplies and
electricity are usually controllable. An allocated cost is not controllable. It varies with the
formula adopted for allocation and is independent of the actions of the supervisor.
14. Direct and Indirect Costs (Traceable and Common Costs):
A direct or traceable cost is that which can be identified easily and indisputably with a
unit of operation (costing unit/cost centre). Common or indirect costs are those that are not
traceable to any plant, department or operation, or to any individual final product. To take an
example, the salary of a divisional manager, when division is a costing unit, will be a Direct
Cost.
The monthly salary of the general manager, when one of the divisions is a costing
unit, would be an Indirect Cost. The salary of the manager of the other division is neither a
direct nor an indirect cost. Thus, whether a specific cost is direct or indirect depends upon the
costing unit under consideration. The concepts of direct and indirect costs are meaning-less
without identification of the relevant costing unit.

11. Explain Cobb-Douglas production function and its properties (APRIL 2017)
While discussing the production theory of the firm, economists C. W. Cobb and P. H. Douglas
used a special form of production function, which is known as the Cobb-Douglas Production
Function. Cobb-Douglas (C-D) production function is of the form
Q = ALαKβ ………………………………… (1)
where L = quantity used of labour
K = quantity used of capital
Q = quantity of output produced
A, α, β = positive constants.
Actually, the parameter A is the efficiency parameter. It serves as an indicator of the state of
technology. The higher the value of A, the higher would be the level of output that can be
produced by any particular combination of the inputs.
Also α and β are the distribution parameters. They have to do with the relative factor shares
in the product. Here it is assumed that the firm uses two inputs, labour (L) and capital (K) and
produces only one product (Q).
Properties of the Cobb-Douglas Production Function:
The C-D production functions possess a number of important properties which have made it
widely useful in the analysis of economic theories. We shall now discuss them.
C-D production function (1) is a homogeneous function, the degree of homogeneity of the
function being α + β. For here we obtain
A (tL)α (tK)β = tα + β A LαKβ = ta +β Q (1a)
where t is a positive real number.
We obtain from (1a) that if L and K are increased by the factor t, Q would increase by the
factor tα +β. Also (1a) gives us that the condition for the C-D function (1) to become
homogeneous of degree one (or linearly homogeneous) is
α + β = 1. (2)
In that case, (1) would give us that if L and K are increased by the factor t, then Q would also
increase by the factor t. If the C-D production function is homogeneous of any degree α + β
as in (1) and (1a), then (1) may be called the generalized version of the C-D function.
On the other hand, if the C-D function is homogeneous of degree one as given by (1) and (2),
then the function is called a linearly homogeneous C-D function.
Properties of Cobb-Douglas Production Function, Homogeneous of Degree One:
The C-D production function of degree one may be written
Q=ALαKβ.α + β= 1 (3)
The properties of this function, i.e., (3), are
(i) Average and marginal products of L and K, i.e., AP L, APK, MPL, and MPK would all be the
functions of L-K or K-L ratio. Let us now establish this property.
We are given:
Q = ALα K1, 0 < α < 1 (... α, β > 0 and α + β =1) (4)
⇒Q/L = ALα-1K1-α
⇒Q/L = A (K/L)1-α
⇒APL = g (K/L) [... By definition, Q/L = APL] (5)
i.e., APL is a function of K-L ratio.
Similarly, from (8.103), we have:
Q/K = ALαK−α
⇒ Q/K = A (L/K)α
⇒ APK = h (L/K) [... Q/K = APK] (6)
i.e., APK is a function of K-L ratio.
Again, from (8.103), we have
∂Q/∂L = αA.Lα−1. K1-α
= αA (K/L)1−α
⇒ MPL = ϕ (K/L) [...∂Q/∂L = MPL] (7)
i.e., MPL is a function of K-L ratio.
Lastly, from (8.103), we have
∂Q/∂K = (1−α) ALαK−α
= (1-α) A(L/K)α
⇒ MPK = Ψ (L/K) [...∂Q/∂K = MPK] (8)
i.e., MPK is a function of L-K ratio.
We have seen above that APL, APK, MPL and MPK are all functions of the K-L ratio.
Therefore, if the firm changes the quantities of L and K keeping their ratio unchanged, all
these average and marginal products would remain constant. In other words, they can change
only when firm changes L and K in different proportions.
(ii) Since in the case of C-D production function (8.103), we have obtained both
MPL and MPK to be functions of L-K ratio, this function have the following property
also:
MRTSL.K = MPL/MPK = function of L/K ratio. (9) would
As we know, MRTSL,K is the marginal rate of technical substitution of L for K.
(iii) In the case of C-D production function (4), the AP L and MPLcurves and the APK and
MPK curves, all would be downward sloping. That is, if the firm increases the use of one of
the inputs, that of the other remaining unchanged, then the AP and the MP of the former input
would decrease. Let us establish this property.
From eqns. (5) and (7), we obtain:
MPL = αA (K/L)1−α = αAPL
⇒ MPL < APL (... 0 < α < 1) (10)
Again, from (8.106) we obtain
∂/∂L (MPL) = αAK1−α (α−1) Lα−2
= α (α−1) AK1-αL α−2 < 0 (11)
..
[ . 0 < α <1]
It is clear from (11) that the slope of the MP L curve is negative, i.e., this curve is downward
sloping to the right. In other words, as L rises, K remaining constant, MPL diminishes.
Again, from (8.104), we obtain:
∂/∂L (APL) = AK1−α (α−1) Lα−2
= A (α−1) K1-αL α−2 < 0 (12)
[... 0 < α <1]
(12) gives us that the slope of the APL curve is negative, i.e., this curve is also downward
sloping like the MPL curve.
As we know from the AP L – MPL relation, if the APL curve is downward sloping, then we
would have, MPL < APL, i.e., the MPL curve would lie below the APL curve (8.6.4, 8.6.5). We
have already obtained, of course, in (10) that MPL would be less than APL.
We have obtained above that in the case of C-D production function (3), both AP L and
MPL curves would be downward sloping to the right and the MP L curve would lie below the
APL curve. Similarly, from equations (6) and (8), we may establish that both APK and
MPK curves would be downward sloping and the MPK curve would lie below the APK curve.
(iv) In the case of C-D production function (4), coefficient of partial elasticity of Q w.r.t. a
change in L, K remaining constant, would be EQL= a = constant, and the coefficient of partial
elasticity of Q w.r.t. a change in K, L remaining constant, would be E QL = 1 – α = constant.
We may establish this property in the following way.
By definition, we have

We also have

Hence, the property (iv) is established. This property holds for the general C-D function of
any degree (α + β) as given by (1). In that case, the elasticities would be given by α and β,
respectively.
(v) For the C-D production function (4), the isoquants of the firm would be negatively sloped
and these curves would be convex to the origin. Let us establish this property. The C-D
production function is
Q = f (L,K) = ALαK1−α [(4)]
Taking total differential of (4), we obtain
dQ = (∂f/∂L) dL + (∂f/∂K) dK (15)
Now, for a movement from one point on an IQ to another (very close) point, dQ = 0 and in
that case (8.114) would give us
0 = (∂f/∂L) dL + (∂f/∂K) dK

Hence, we have obtained that for the C-D function (4), the slope of an IQ, viz, would
be negative. Again (16) would give us
d2K/dL2 = − α/1−α (−K/L2) = (α/1−α)(K/L2) > 0 (17)
It is clear from (17) that as L rises, the slope of the IQ, i.e., dK/dL, also rises or the absolute
slope of the IQ diminishes. This implies that an IQ would be convex to the origin. This
property may also be established if we use the general version of the C-D function as given
by (8.100) and (8.100a), i.e., this property holds for the C-D function homogeneous of any
degree, viz., a + p, a + P being not necessarily equal to 1.
(vi) For the C-D function (4), the expansion of the firm would be a straight line. We may
establish this property in the following way.
The production function (4) is
Q = f (L,K) = A.Lα. K1−α
As we know, the equation of the expansion path is

Where rL = price of labour (L) = constant

And rK = price of capital (K) = constant
Since rL, rK, α = constant and the power of Land K = 1, equation (19) is a linear equation. The
slope of this straight line is rL/rK. 1 –α/α = positive constant [... 0 < α < 1 and rL, rK > 0].
This straight line starts from the origin because when L = 0 in (19), we have K = 0.
Therefore, for the C-D homogeneous function of degree one (4), the expansion path of the
firm would start from the point of origin and it would be a straight line sloping upwards
towards right.
In the above analysis if we use eqn. (1) in place of eqn. (4), we would obtain that for C-D
production function, homogeneous of any degree, the expansion path would start from the
origin and it would be a straight line sloping upward towards right, i.e., this property also
holds for the general version of the C-D function, homogeneous of any degree, α + β.
(vii) For C-D production function (4), total output would be exhausted if the inputs L and K
are paid at the rate of their respective marginal product, i.e., L. MPL + K. MPK = Q.
We may prove this in the following way.
LMPL + KMPK
= LAαLα−1K1−α + KALα (1−α) K−α
= αALαK1−α + (1−α) ALαK1−α
= ALαK1−α (α + 1 −α)
= ALαK1−α
=Q (20)
Hence, the property is established. This property may also be established by using the general
version of the C-D function (1), i.e., this property holds, for C-D function homogeneous of
any degree.
(viii) For C-D production function (4), if labour (L) and capital (K) are paid at the rate of
their respective MPs, then the relative shares of labour and capital would be a and 1 – a
respectively. We may prove this in the following way.
Absolute share of L in total output = LMPL
And the relative share of labour = LMPL/Q
= LAαLα−1K1−α/ALαK1−α = α (21)
Also, the absolute share of L in total output = KMPK
And the relative share of K = KMPK/Q
= KALα(1−αK−α)
= 1−α (22)
Hence, the property is established. This property may also be established by using the general
C-D function (1a) homogeneous of any degree α + β. In that case, the relative shares of
labour and capital would be α and β respectively.

12. Explain the important methods of measuring cost output relation and their
merits. (NOV 2012)
Aspect # 1. Short-Run Cost Estimation:

The techniques of short-run cost estimation are the following:

a) Simple Extrapolation:
The term ‘extrapolation’ refers to the assignment of value to a sequence of results, beyond the
range of these actually given or determined. Unless we have a known functional relation
between the results (in which case extrapolation is merely the calculation of additional
values), any process of extrapolation assumes “that a relation is maintained beyond the range
and domain for which it is actually established.”
The simplest method of short-run cost estimation is “probably to ascertain the present level of
marginal or average variable costs and extrapolate this backward or forward to other output
levels.” Most business managers believe that both marginal and average variable costs of
their plants are constant over a range of output levels surrounding the current output level.
This implies that constant re– turns to the variable factors occur over this range of output. If
this constant efficiency situation actually exists in the short-run production process, then the
simple extrapolation method of cost estimation gives accurate results.
However, in reality, the short run production function exhibits diminishing returns to variable
factor, i.e., marginal costs rise after a certain stage of the production process. Therefore, if
marginal costs are simply believed to remain constant, when, in fact, they are increasing with
every additional unit of output, the simple extrapolation method may give erroneous results
and thus cause poor decisions to be made.
b) Gradient Analysis:
Gradient is the measure of the steepness of a slope, expressed in the Cartesian plane as the ra-
tio between differences of ordinates and abscissae. Then the gradient of the line PQ joining
P(x1, y1) to Q(x2,y2) is given by y2-y1/x2– x1.
It is then equal to tan 8, where 6 is the angle of slope as in Fig. 15.6.

Since output of a business firm does fluctuate from period to period, it is possible to
find two or more cost/output observations, in which case one can conduct gradient analysis. It
may be noted that the gradient of each cost category is the rate at which that cost category
changes with changes in the level of output.
If we exclude those cost changes which are not the result of changes in the output
level (e.g., an increase in annual licence fee), we can estimate the marginal cost (per unit)
over range of output under observation on the basis of the sum of the gradients.
In fact, three or more observations permit gradient analysis to accurately estimate the change
in marginal costs with changes in output levels. If we have various cost/output observations,
we can make use of the technique of regression analysis for short-run cost estimation.
(c) Time-Series Regression Analysis:
If we have a set of cost-output observations, we can apply regression analysis to
estimate the functional dependence of costs upon the volume of output and thus arrive at an
estimate of the marginal cost. If our object is to estimate the cost function for a particular
firm, we must make use of time- series data from the firm.
However, the problem with time-series data is that if, over the observation period, some
factors have changed, the results of regression analysis will be less reliable. Changes in factor
prices, for instance, due to inflation or market forces and/or factor productivities due to tech-
nological change and improvement in efficiency of labour may make regression analysis
irrelevant.
To eliminate these problems to the maximum possible extent the cost data should be
appropriately deflated by the price index, and time should be included as an independent
variable in the regression equation. This will make it possible to include any trend in the
relative prices or productivities in the co-efficient of the time variable.
One major drawback of this method is that it is subject to problems of measurement error. As
E. J. Douglas has commented: “The cost data should include all costs that are caused by a
particular output level, whether or not they are yet paid for.”
He has cited the example of management expense which should be expected to- vary
with the rate of output, but it may be delayed until it is more convenient to close down certain
sectors of the plant or facilities for maintenance purposes.
Hence the cost that is incurred in an earlier period is recorded in a later period and is
thus likely to understate the previous cost level and overstate the later cost level. True
enough, “our cost/output observations should be the result of considerable fluctuations of
output over a short period of time with no cost/output matching problems.”
Moreover, the choice of the functional form of the regression equation has major
implications for the estimate of the marginal cost curve which will be indicated by the
regression analysis. Three functional forms of costs considered earlier in this chapter may
now be considered.
If the short-run cost function is linear, i.e., if we specify that total variable cost is a
linear function of output such as TVC = a + bQ, the marginal cost estimation generated by the
regression analysis will be the parameter b. It is because marginal cost is the total variable
cost function with respect to output changes.
In Fig.we show, for a given set of data (based on various observations), the
consequent average variable cost and marginal cost curves that would be generated by
regression analysis in this case. In this case, the AVC will decline to approach the MC curve
asymptotically.

Alternatively, for the same set of data, we can use a quadratic cost function such as TVC = a
+ bQ + cQ2. In this case, the marginal cost will rise as a constant function of output. This is
shown in Fig. 15.8 where the hypothesized quadratic relationship is superimposed upon the
same data observations, with the resultant AVC and MC curves illustrated in the bottom half
of the diagram.
Finally, if we specify the functional form to be cubic, such as TVC = a -bQ- cQ 2 + dQ3, the
estimate of MC generated by regression analysis will be curvilinear and will increase as the
sequence of the output level. Fig. 15.9 illustrates such a cost- output relationship. We can
alternatively specify the functional relationship to be a power function.

The choice of the functional form depends upon the degree of accuracy to be
achieved. Since the results of regression analysis are used for decision-making purposes, one
must ensure that the marginal and average cost curves generated are the most accurate
representations of the cost/output relationships.
By plotting the total variable cost data against output, it may be possible to ascertain
that one of the above three functional forms best represents the apparent relationship existing
between the two variables and piece of information may be used for decision-making.
d) The Engineering Technique:
An alternative method of cost estimation is known as the engineering technique. It
simply consists of developing the relation that exists between the inputs and the output (on
the basis of the physical production function) and attaching cost values to the inputs in order
to obtain a TVC figure for each level of output.
We then have to calculate, or test for each level of output, the amount of each of the
variable factors necessary to produce that level of output. By attaching costs to these variable
factors, it is possible subsequently to calculate (estimate) the TVC for each level of output
and the corresponding AVC and MC.
In Fig. we draw average and marginal cost curves on the basis of actual data.
Interpolating through these observations it is possible to estimate marginal and average costs
by using the engineering technique.

Moreover, it is also possible to determine incremental costs associated with any

decision to increase or decrease output levels on the basis of the variable costs as calculated
by one or a combination of the above methods, after making an allowance for any
opportunity costs that are involved and any incremental fixed costs that may be necessitated.
It is necessary to calculate incremental fixed costs on the basis of the knowledge of the
production capacity of the fixed factors involved. This, in its turn, may require an
engineering-type investigation of the output capacities of particular fixed facilities.
Studies of Short-run Cost Behaviour:
Numerous empirical estimates of short-run cost have led to the conclusion that
marginal cost tends to be constant in the operating range of the firms studied.
Hence, it follows that AVC is constant at the same level (or is asymptotically approaching
that level) and declining due to the influence of declining AFC. ATC will also decline. In
other words, in most cases, a linear TVC function provides the best fit to the data
observations.
Long Run Cost Estimation:

When suitable actual cost-output data are available, statistical methods similar to
those used in short-run cost factors can be employed in analysing long-run behaviour of cost.
The method most commonly used for the purpose is cross-section method. A sample of inter-
firm differences is called a cross- section sample.
In a cross-section model, we may have the same sort of cost function but now the data relate
to different units of observation at a given point in time. Two other techniques used for long
term cost estimation are: the engineering technique and the survivor technique.
a) Cross-Section Method:
The long-run cost function can be estimated using either time-series cost-output data
collected on a plant (or firm) whose size has been variable over time, or cross-sectional cost-
output data collected on a sample of plants (firms) of different sizes at a particular point in
time.
Both the approaches require certain assumptions about technological and operating
conditions to be made in order to arrive at valid estimates of the long run cost function.
When one uses time-series cost-output data one encounters the usual problems of holding
constant all other factors (except output) that affect costs. In order to estimate the long-run
cost function from time-series data, one must make use of observation taken over a fairly
long period of time, usually a number of years, to allow for sufficient variation in plant size.
However, due to technological change and development of new products in the product line,
the long-run cost curve may shift over time.
If it is not possible to hold the effects of such changes constant, the cost-output data
will be measuring points on different long-run cost functions rather than on the same
function. Moreover, using time-series requires that costs be deflated to reflect changes in
prices over long periods of time.
The above reasons justify the use of the cross- sectional data in estimating long run
cost functions. Data observations from various plants at a fixed time period may be analysed
using the technique of regression analysis. Thus the researcher should collect pairs of data
observations relating the output level, to the total cost of obtaining the output level in each
plant, for a very short period of time.
Measures should be taken in such as a way as to avoid errors of measurement relating
either to the actual level or rate of output in that period, or to the actual level of costs that
should be associated with the level of output in each plant observed.
There is also need to specify the functional form of the equation and the problem here is the
same as in the case of short-run cost estimation. We have to choose the functional form that
best fits the data observations subject to each variable determining cost being significant at an
acceptable level.
The behaviour of long run average cost largely depends on economies and
diseconomies of scale. Therefore, the cubic function which is consistent with economies and
diseconomies of plant size would be most appropriate. If, however, a linear function best fits
the data, we may be driven to the conclusion that increasing returns to plant size prevail over
the range of data observations.
Finally, if a power function best fits the data, the numerical value of the exponent to
the output variable will indicate whether returns to plant size are increasing (if it is less than
one), or constant (if equal to one), or decreasing (if it is greater than one).
In addition to this problem which arises in a short-run cost analysis, further difficulties of a
conceptual nature are also encountered in estimating the long-run cost-output relationship by
statistical methods.
One major problem with cross-section data is that the observations collected may not
be points on the long-run average cost curve at all. This is shown in Fig. 15.11. It depicts the
five short run average cost curves (SAC 1, SAC2 etc.) of a firm. Each curve corresponds to a
specific plant. The estimated output/cost values are shown by the point on each short run cost
curve marked by an asterisk.
 This small piece of information suggests that the above analysis has over-estimated
the presence of economies and diseconomies of plant size in this particular case. It is because
of the fact that the observation points for each plant were not points of tangency with the
actual long-run cost curve.
The second problem that may arise with cross- section data is that various plants may
be operating in different areas or under different economic and non-economic environments.
As a result, there may be differences in factor prices and factory productivities among the
plants. If this problem exists, there may be cost differences among plants due to the two
above factors and regression analysis may fail to give accurate results.
b) The Survival Principle:
If there are economies of scale that a firm fails to exploit, long run average cost of
production will be higher than of competing firms; the firm will be too small for efficient
operation and must either grow or perish.
Many people believe that production by larger firms will be less costly on average
than by small firms. Even if a firm has to be large enough to exploit the economies of scale
that are available, bigger plants may encounter diseconomies of scale and be forced to reduce
the scope of their operations or sink.
If firms (production facilities) of a particular size tend to exist in an industry, this is
considered to be a good evidence of the requisites size that is most efficient. This is known as
the survival principle put forward by G. Stigler in 1958. Some economists have used this
principle to determine the most efficient scale of operations for a particular industry.
Stigler has devised a test for the presence or absence of economies or diseconomies of plant
size in specific industries which is based upon the survival principle stated above. The
implication is that the most efficient firms will be able to survive in the long run and even
increase their market share, while the less efficient ones will tend to become less important in
that industry with the passage of time.
The survival principle is a method of determining the optimum size (or range of sizes)
of firms within an industry. Stigler’s procedure was to classify the firms in an industry by size
and calculating the share of industry output coming from each size class over time.
If the share of industry output of a given class tends to decline over time, then this size class
is presumed to be relatively inefficient and to have higher LACs. On the contrary, an
increasing share of industry output over time indicates that the size class is relatively efficient
and has lower LACs.
The rationale of this approach is that the forces of competition will tend to eliminate
relatively inefficient firms, leaving only efficient (low-cost) firms to survive in the long run.
According to Stigler, “An efficient size of firm is one that meets any and all problems the
entrepreneur actually faces: strained labour relations, rapid innovation, government reg-
ulation, unstable foreign markets and what not.”
Merits:
 Two things may be said in favour of the survivor technique. Firstly, it is more direct
and simpler to apply than are alternative techniques for examining economies of scale.
Secondly, it avoids the accounting-cost allocation and resource valuation problems associated
with statistical methods and the hypothetical aspects of the engineering method of cost
estimation.
Limitations:
However, this method has two major limitations as well. Firstly, it does not utilize
actual cost data in the analysis. Thus, it is not possible to assess the magnitude of the cost
differentials among firms of differing size and efficiency. Secondly, due to legal factors, the
LAC curve derived by this technique may be distorted and may fail to measure the cost curve
postulated in traditional economics.
For example, in India, the MRTP Act (1969) discourages larger firms even though
economies of scale are likely to be stronger beyond present firm sizes of the so-called MRTP
companies.
Stigler’s test of the US steel industry for the years 1930 and 1951 indicated that both
the smallest and largest firms suffered a decline in their market share. The firms of
intermediate size grew or maintained their shares of industry output over this period and
hence appeared to be operating at the optimum sizes of plant.
Thus, the survival principles infer a LAC curve that slopes downward at first, is
constant over a wide range of output (in the intermediate stage) and then slopes upward at rel-
atively higher output levels. In other words, there are typically substantial ranges of output
for which LAC is roughly constant, as depicted in the middle of the LRAC curve in Fig.
15.12.

c) The Engineering Technique:

The engineering technique used in short-run cost functions may also be applied to
several plants of different sizes, at the same point in time, to arrive at an estimate of the long-
run cost function.
This approach needs a knowledge of production facilities and technology (such as
speed of machines, labour productivity and physical input-output transformation
relationships) to determine the most efficient (lowest average cost) combination of resources
(capital, labour, materials, etc.) to produce various levels of output.
It may be recalled that in the context of short- run cost estimation, the engineering
technique was used to find the cost curves of a particular firm at’ a fixed point of time. If the
same exercise is carried out with other plants that are available, one would be able to trace
out a series of short-run cost curves that are available to the firm at a definite time period.
Fig. 15.13 shows a hypothetical situation in which five different sizes of plants have been ob-
served and the SAC curve of each has been derived by the engineering technique. The
envelope of the SAC curves is the LAC curve.
One can infer from Fig. 15.13 that initially there are economies of plant size as one moves
from the first plant to the second plant. This stage is followed by relatively constant returns to
plant size as one progresses to the third and fourth plant, and decreasing returns to plant size
with the largest plant available.

Merits:
The engineering method has three major advantages over statistical methods. Firstly,
it is generally much easier with the engineering method to hold constant such factors as
prices of factors, product mix and production efficiency (technological progress).
This enables us to isolate the effects of changes in output on costs. Secondly, the long-run
cost function obtained by the engineering method is based on current technology whereas the
function obtained by the statistical method is based on a mix of old and current technology.
Finally, the engineering methods makes it possible to avoid some of the accounting problems
normally encountered when using the statistical approach.
Defects:
However, the major disadvantage of the method is that it deals only with the technical
aspects of the production process or plant. It completely ignores various other aspects
affecting cost behaviour such as “the management and entrepreneurial aspects, such as
recruiting and training workers, marketing the product(s), financing the operation and
administering the organisation.”
Haldi and Whitcomb made a study to isolate the various source of scale economies
within the plant. They collected data on the cost of individual units of equipment, the initial
investment in plant and equipment, and operating costs (namely labour, raw materials, and
utilities).
They found that “ in many basic industries such as petroleum refining, primary metals
and electric power, economies of scale are found up to very large plant sizes (often the largest
built or contemplated). These economies occurs mostly in the initial investment cost and in
operating labour cost, with no significant economies observed in raw material cost.”
Long-run Cost Estimation Studies:
Various empirical studies have been made of the long-run cost function. J. Johnson
developed long- run cost functions using both time-series and cross- section data. In the time-
series analysis, he fitted a cubic cost function with a linear trend variable to each of 23 firms
whose capital equipment had varied over the period 1928-1947. The cubic term was not
found to be statistically significant.
Most studies of long-rim cost functions have revealed that the long-run average cost
curve tended to be L-shaped, not U-shaped. This signified economies of plant size at
relatively low levels of output, followed by an extended range of constant returns to plant size
with no common tendency for per unit costs to rise at higher output. Statistical studies of
long-run cost behaviour fail to provide sufficient evidence on significant diseconomies of
scale (size).
Managerial uses of Empirical Cost Functions:
 Various important managerial decisions are based on estimates of cost curves such as
short- run choices of rates of output and prices, and long- run decisions about numbers, sizes
and locations of plants.
Pricing and output decisions are perhaps the most important for a profit-maximising
firm. Such decisions must be based on reliable estimates of short-run cost functions.
Capital investment decisions such as plant construction or expansion are long-term decisions
and are usually based on estimates of long-run cost functions. Long-run cost functions enable
progressive organisations to determine whether or not to make the investment, and what
should be optimum size of the plant under the present conditions. Decisions on plant size are
largely based on an accurate estimate of demand.
However, investment decision are most complex because demand can shift over time.
Moreover, the structure of factors affecting cost may also be expected to shift. These factors
make it advisable to build or expand plants in substantial increments of capacity.
It is important to note that past production and cost relationships may not always be relevant
to decisions about future investments in plant and equipment.
Empirical (statistical) estimates may require adjustments to reflect changes in future
prices, input combinations, nature of the product, product mix, scale of output, scale of plant,
the nature of the conversion process (i.e., conversion of inputs into output) and so forth; all
these are expected to effect future costs. Costs of future periods may not behave in the same
way as that in the past.
Cost Forecasting:

One of the most important problems before a professional manager is to surmise what
the cost of production is going to be in the future. Cost forecasting, therefore, is an important
topic in managerial economics. It must be emphasised at the very outset that cost forecasting
has to be differentiated from what is known as cost estimation.
The short and long run cost functions that we have discussed above can be statistically
estimated. It is this process of statistical determination of the cost-output relationship that is
referred to as cost estimation. As we have noted, both short and long-run cost functions refer
to the cost of production of the company at various levels of output.
The only difference between these two cost functions is that, in the short- run
function, the plant size is taken to be fixed while in the long-run function, it is considered to
be variable. It is to be specifically noted that the long-run cost function does not refer to cost
of production in the future.
It tells us what the cost of production at alternative levels of output would be today if
each level of output could be produced at an optimal plant size. Cost forecasting, on the other
hand, refers explicitly to the future. The question here is: what would be the cost of
production (of, say, a specified level of output) in the future?
We do not wish to imply that the problem of cost estimation is not important. Indeed,
as we have emphasised throughout our discussion above, a company must know its cost
function before it can hope to take optimal decisions regarding the level of output to be
produced and the size of the plant to be built.
However, we have already formed a fairly comprehensive idea about estimation techniques in
general in course of the discussion of demand analysis.
In particular, we are now familiar with the most important statistical estimation
technique, viz., regression analysis. Statistical cost functions can be estimated by applying
these techniques on the theoretical models of cost functions. Entering into a detailed
discussion of cost estimation will, therefore, involve a large dose of repetition. We have,
therefore, decided to concentrate on the problem of cost forecasting.
We have seen above that the cost function is derived from two types of information – the
production function and the prices of inputs. If these primary information remain unchanged,
the cost function will be totally unchanged.
It will be exactly the same as it is today. The problem of cost forecasting arises
because neither the production function nor the prices of the inputs would necessarily remain
unchanged in the future.
The production function, it may be recalled, is a technological relationship between
output and inputs. If productivity of the inputs changes (i.e., if from the same amounts of in-
puts we can extract a different level of output) the production function will change.
The prices of inputs used by the company, on the other hand, would change in pace with the
general level of factor prices (or, more generally, with the process of inflation or deflation) in
the economy. Future changes in factor productivities and in factor prices are, therefore, the
focus of attention in cost forecasting. We shall deal briefly with these two aspects of cost
forecasting separately.
13. Explain the methods of estimating cost functions. .(NOV 2013)
ESTIMATION OF COST FUNCTION.
Several methods exist for the measurement of the actual cost-output relation fora
particular firm or a group of firms, but the three broad approaches -accounting, engineering
and econometric - are the most important and commonly used.
Accounting Method This method is used by the cost accountants. In this method, the
cost-output relationship is estimated by classifying the total cost into fixed, variable and
semi-variable costs. These components are then estimated separately. The average variable
cost, the semi-variable cost which is fixed over a certain range of output, and fixed costs are
determined on the basis of inspection and experience. The total cost, the average cost and the
marginal cost for each level of output can then be obtained through a simple arithmetic
procedure. Although, the accounting method appears to be quite simple, it is a bit
cumbersome as one has to maintain a detailed breakdown of costs over a period to arrive at
good estimates of actual cost-output relationship. One must have experience with a wide
range of fluctuations in output rate to come up with accurate estimates.
Engineering Method The engineering method of cost estimation is based directly on
the physical relationship of inputs to output, and uses the price of inputs to determine costs.
This method of estimating real world cost function rests clearly on the knowledge that the
shape of any cost function is dependent on:(a) the production function and (b) the price of
inputs. We have seen earlier in this Unit while discussing the estimation of production
function that for a given the production function and input prices, the optimum input
combination for a given output level can be determined. The resultant cost curve can then be
formulated by multiplying each input in the least cost combination by its price, to develop the
cost function. This method is called engineering method as the estimates of least cost
combinations are provided by engineers. The assumption made while using this method is
that both the technology and factor prices are constant. This method may not always give the
correct estimate of costs as the technology and factor prices do change substantially over a
period of time. Therefore, this method is more relevant for the shortrun. Also, this method
may be useful if good historical data is difficult to obtain. But this method requires a sound
understanding of engineering and a detailed sampling of the different processes under
controlled conditions, which may not always be possible.
Econometric Method This method is also some times called statistical method and is
widely used for estimating cost functions. Under this method, the historical data on cost and
output are used to estimate the cost-output relationship. The basic technique of regression is
used for this purpose. The data could be a time series data of a firm in the industry or of all
firms in the industry or a cross-section data for a particular year from various firms in the
industry. Depending on the kind of data used, we can estimate short run or long run cost
functions. For instance, if time series data of a firm whose output capacity has not changed
much during the sample period is used, the cost function will be short run. On the other hand,
if cross-section data of many firms with varying sizes, or the time series data of the industry
as a whole is used, the estimated cost function will be the long run one. The procedure for
estimation of cost function involves three steps. First, the determinants of cost are identified.
Second, the functional form of the cost function is specified. Third, the functional form is
chosen and then the basic technique of regression is applied to estimate the chosen functional
form.
Functional Forms of Cost Function The following are the three common functional
forms of cost function in terms of total cost function (TC).a) Linear cost function: TC = a1 +
b1Qb) Quadratic cost function: TC = a2 + b2Q + c2Q2c) Cubic cost function: TC = a3 + b3Q
+ c3Q2 +d3Q3Where, a1, a2, a3, b1, b2, b3, c2, c3, d3 are constants. When all the
determinants of cost are chosen and the data collection is complete, the alternative functional
forms can be estimated by using regression software package on a computer. The most
appropriate form of the cost function for decision-making is then chosen on the basis of the
principles of economic theory and statistical inference. Once the constants in the total cost
function are estimated using regression technique, the average cost (AC) and marginal cost
(MC) functions for chosen forms of cost function will be calculated. The TC, AC and MC
cost functions for different functional forms of total cost function and their typical graphical
presentation and interpretation are explained below.

The typical TC, AC, and MC curves that are based on a linear cost function are shown in
Figure. These cost functions have the following properties:
TC is a linear function, where AC declines initially and then becomes quite flat approaching
the value of MC as output increases and MC is constant at b1.

The typical TC, AC, and MC curves that are based on a quadratic cost function are shown in
Figure These cost functions have the following properties:
TC increases at an increasing rate; MC is a linearly increasing function of output; and AC is a
U shaped curve.
The typical TC, AC, and MC curves that are based on a cubic cost function are shown in
Figure. These cost functions have the following properties:
TC first increases at a decreasing rate up to output rate Q1 in the Figure and then increases at
an increasing rate; and both AC and MC cost functions
are U shaped functions. The linear total cost function would give a constant marginal cost and
a monotonically falling average cost curve. The quadratic function could yield a U-shaped
average cost curve but it would imply a monotonically rising marginal cost curve. The cubic
cost function is consistent both with a U-shaped average cost curve and a U-shaped marginal
cost curve. Thus, to check the validity of the theoretical cost-output relationship, one should
hypothesize a cubic cost function.
An example of using estimated cost function: Using the output-cost data of a chemical firm,
the following total cost function was estimated using quadratic function: TC = 1016 – 3.36Q
+ 0.021Q2
a) Determine average and marginal cost functions.
b) Determine the output rate that will minimize average cost and the per unit cost at that rate
of output.
c) The firm proposed a new plant to produce nitrogen. The current market price of this
fertilizer is Rs 5.50 per unit of output and is expected to remain
at that level for the foreseeable future. Should the plant be built?
i) The average cost function is AC = (TC/Q) = (a2/Q) + b2 + c2Q
ii) The output rate that results in minimum per unit cost is found by taking the first derivative
of the average cost function, setting it equal to zero,
and solving for Q.

To find the cost at this rate of output, substitute 220 for Q in AC equation and solve it. AC =
(1016/Q) – 3.36 + 0.021Q = (1016/220) – 3.36 + (0.021 * 220)
Rs. 5.88 per unit of output.
iii) Because the lowest possible cost is Rs. 5.88 per unit, which is Rs. 0.38 above the market
price (Rs. 5.50), the plant should not be constructed.
Short Run and Long Run Cost Function Estimation
The same sorts of regression techniques can be used to estimate short run cost functions and
long run cost functions. However, it is very difficult to find
cases where the scale of a firm has changed but technology and other relevant factors have
remained constant. Thus, it is hard to use time series data to
estimate long run cost functions. Generally, regression analysis based on cross section data
has been used instead. Specially, a sample of firms of various
sizes is chosen, and a firm's TC is regressed on its output, as well as other independent
variables, such as regional differences in wage rates or other input prices.

Many studies of long run cost functions that have been carried out found that there are very
significant economies of scale at low output levels, but that
these economies of scale tend to diminish as output increases, and that the long run average
cost function eventually becomes close to horizontal axis at high output levels. Therefore, in
contrast to the U-shaped curve in Figure shown in previous unit, which is often postulated in
micro economic theory, the long run average cost curve tends to be L-shaped, as shown in
Figure .

Problems in Estimation of Cost Function

We confront certain problems while attempting to derive empirical cost functions from
economic data. Some of these problems are briefly discussed below. Long run average cost
curve Production and Cost Analysis181. In collecting cost and output data we must be certain
that they are properly paired. That is, the cost data applicable to the corresponding data on
output.2. We must also try to obtain data on cost and output during a time period when the
output has been produced at relatively even rate. If for example, a month is chosen as the
relevant time period over which the variables are measured, it would not be desirable to have
wide weekly fluctuations in the rate of output. The monthly data in such a case would
represent an average output rate that could disguise the true cost output relationship. Not only
should the output rate be uniform, but it also should be a rate to which the firm is fully
adjusted. Furthermore, there should be no disruptions in the output due to external factors
such as power failures, delays in receiving necessary supplies, etc. To generate the data
necessary for a meaningful statistical analysis, the observations must include a wide range of
rates of output. Observing cost-output data for the last 24 months, when the rate of output
was the same each month, would provide little information concerning the appropriate cost
function.3. The cost data is normally collected and recorded by accountants for their own
purposes and in a manner that it makes the information less than perfect from the perspective
of economic analysis. While collecting historical data on cost, care must be taken to ensure
that all explicit as well as implicit costs have been properly taken into account, and that all
the costs are properly identified by time period in which they wereincurred.4. For situations
in which more than one product is being produced with given productive factors, it may not
be possible to separate costs according to output in a meaningful way. One simple approach
of allocating costs among various products is based on the relative proportion of each product
in the total output. However, this may not always accurately reflect the cost appropriate to
each output.5. Since prices change over time, any money value cost would therefore relate
partly to output changes and partly to price changes. In order to estimate the cost-output
relationship, the impact of price change on cost needs to be eliminated by deflating the cost
data by price indices. Wages and equipment price indices are readily available and frequently
used to ‘deflate’ the moneycost.6. Finally, there is a problem of choosing the functional form
of equation or curve that would fit the data best. The usefulness of any cost function for
practical application depends, to a large extent, on appropriateness of the functional form
chosen. There are three functional forms of cost functions, which are popular, viz., linear,
quadratic and cubic. The choice of a particular function depends upon the correspondence of
the economic properties of the data to the mathematical properties of the alternative
hypotheses of total cost function. The accounting and engineering methods are more
appropriate than the econometric method for estimating the cost function at the firm level,
while the econometric method is more suitable for estimating the cost function at the industry
or national level. There has been a growing application of the econometric method at the
macro level and there are good prospects for its use even at the micro level. However, it must
be understood that the three approaches discussed above are not competitive, but are rather
complementary to each other. They supplement each other. The choice of a method there fore
depends upon the purpose of study, time and expense considerations.

EMPIRICAL ESTIMATES OF COST FUNCTION.

A number of studies using time series and cross-section data have been conducted to estimate
short run and long run cost behaviour of various industries. Table 10.3 lists a number of well-
known studies estimating short run average and marginal cost curves. These and many other
studies point one conclusion: in the short run a linear total variable cost function with
constant marginal cost is the relationship that appears to describe best the actual cost
conditions over the “normal” range of production. U-shaped average cost(AC) and marginal
cost (MC) curves have been found, but are less prevalent than one might expect.
Table lists a number of well known, long run average cost studies. In some industries, such
as light manufacturing (of baking products), economies of
size are relatively unimportant and diseconomies set in rather quickly, implying that a small
plant has cost advantages over a large plant. In other industries, such as meat packing or the
production of household appliances, the long run average cost curve is found to be flat over
an extended range of output, there by indicating that a variety of different plant sizes are all
more or less equally efficient. In some other industries such as electricity or metal (aluminum
and steel) production, substantial economies of size are found, thereby implying that a large
plant is most efficient. Rarely are substantial diseconomies of size found in empirical studies,
perhaps because of firms recognising that production beyond a certain range leads to sharply
rising costs. Therefore, they avoid such situations if all possible by building additional plants.
14. Discuss the forms of total cost function. .(NOV 2013)
1. Linear Cost Function:
A linear cost function may be expressed as follows:
TC = k + ƒ (Q)

where TC is total cost, k is total fixed cost and which is a constant and ƒ(Q) is variable
cost which is a function of output.

It may alternatively be expressed as:

TC = Y = a + bQ.

It is depicted in Fig The cost function here is derived from the basis of following
(implicit) assumptions:
(i) When output is zero, total cost is equal to total fixed cost. Moreover, the shorter the
short run, the more certain is the manager that fixed costs are sunk (historical) costs by
definition. If total fixed cost remains constant at all levels of output up to capacity, any
increase in total cost is traceable to change in total variable cost.
To be more specific, if factor prices remain constant over the relevant range of output, a
doubling of inputs would lead to an exactly doubling of output. In other words, there
would be constant returns to the variable factor.

(ii) We assume away the operation of the Law of Diminishing Returns. The linear cost
function in Fig. 15.2 reflects the short run cost condition of the firm. In the short run,
capacity (or plant size) is fixed. So the firm can vary its level of rate of output up to
capacity (i.e., with the existing plant).

(iii) Average (total) cost declines with an expansion of output.

Average cost may be expressed as:

AC = Y/Q

where Y is total cost and Q is output.

Marginal cost may be expressed as:

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MC ∆Y/∆Q = b

If-the cost function is continuous, marginal cost may be expressed as

MC = d (TC)/ dQ

In both the situations, MC = b and MC is constant and is a linear cost equation. Such a
constant MC curve appears as horizontal line parallel to the output axis as in Fig. 15.3.
The shorter the short run the greater the likelihood that statistical cost functions will have
a bias towards linearity. This bias may, as Coyne argues, “may be justifiable and, in
fact, reasonably valid if it occurs over the relevant range of a firm’s TPP curve.
Extrapolation of linear cost functions requiring output beyond the relevant range in
either direction and used for predictive purposes will generate misleading and
statistically insignificant results.”
If we apply the linear cost function in the cricket bat example we observe that the cost
curve assumes the existence of a linear production function. If a linear cost function is
found to exist, output of cricket bat would expand indefinitely and there would be a one-
to-one correspondence (relationship) between total output and total cost.

In other words, diminishing returns to the variable factor would not be observed. Such a
function would exist for the cricket bat factory only if the relevant range of output under
consideration was very small.

2. Quadratic Cost Function:

If there is diminishing return to the variable factor the cost function becomes quadratic.
There is a point beyond which TPP is not proportionate. Therefore, the marginal physical
product of the variable factor will diminish.

And if TPP actually falls MPP will be negative. In other words, there is a point beyond
which additional increases in output cannot be made. So costs rise beyond this point, but
output cannot. Such cost function is illustrated in Fig. 15.4.
 We have noted that if the cost function is linear, the equation used in preparing the total
cost curve in Fig. 15.2 is sufficient. But the quadratic cost function has one bend – one
bend less than the highest exponent of Q.

Total cost is equal to fixed cost when Q — 0, i.e., when no output is being produced.
However, as Q increases, fixed cost remains unchanged. Therefore, increases in total
costs are traceable to changes in variable cost.

It is to be highlighted that the major difference between the linear and quadratic cost
functions is the area of diminishing returns to the variable factors). If the cost function is
linear, variable cost increases at a constant rate.

It is quite reasonable to assume that linear cost functions exist regardless of the current
level of operating capacity at which the firm is producing. Rather, the truth is that as
output reaches the physical capacity limitations of existing plant and equipment in the
short run, variable costs rise because of the operation of the Law of Diminishing Returns
(or variable proportions).

Most economists agree that linear cost functions are valid over the relevant range of
output for the firm. Over this range of output, “no statistically significant improvement on
the linear hypothesis is achieved by the inclusion of second or higher degree terms in
output”; moreover, “supplementary tests, such as the examination of incremental cost
ratios, , usually confirm the linear hypothesis.”

3. Cubic Cost Function:

In traditional economics, we must make use of the cubic cost function as illustrated in
Fig. 15.5. Such a cost function is not of much empirical use. It does not provide
statistically significant improvements over the linear or quadratic cost function.
 Moreover, it is very difficult to calculate, interpret and apply, to test statistical hypothesis
regarding cost behaviour in manufacturing concerns.

15. Bring out the advantages of large-scale production. .(NOV 2013).

1. Internal Economies:
Internal economies arise within the firm because of the expansion of the size of a
particular firm.

They are called the economies of scale.

2. External Economies:
External economies arise with the expansion of the industry. These are generally the
result of large scale production and are associated with the advantages of localisation.

3. Division of Labour:
The large scale production is always associated with more and more division of labour.
With the division of labour per worker output increases. Hence, per unit labour cost is
reduced in large scale production.

4. Use of machines:
The large scale production always makes use of machines. So, all the advantages of the
use of machinery are available.

5. More Production:
The large scale industries can produce more goods. For instance, a big sugar factory can
use molasses to make spirits and thus can reduce the cost of production of sugar.

6. Economies of Organisation:
With an increase in the size of the firm, the cost of management is reduced.

7. Low Cost of Production:

The large scale production gives many types of economies. Suppose, there are two
different factories, each producing 500 units of a commodity. For these two factories,
there must be two managers. But if the scale of production is enlarged and in one factory
we start producing 1000 units of the same commodity, the work can be supervised by one
manager. In this way, in the large scale production, the salary of one manager is saved.
So, the cost of production is reduced.

8. Cheap and Easy Loans:

A large business can secure credit facilities at cheaper rates, because these firms enjoy
credit and reputation in the market due to their fixed assets. Banks and other financial
institutions willingly advance loans to these enterprises at a very low rate of interest.

9. Ancillary Industries:
With the development of large scale production, there arise many small industries which
use its by-products or supply inputs to it. Suppose, when the production of steel is
increased, many other auxiliary industries develop. The development of auxiliary
industries contributes to the industrialisation of the area and the industry itself.

10. Standard Goods:

The production of standardised goods is possible on account of the large-scale
production. Only a big motor company can produce standardised motor parts. Besides, it
is possible to sell and transport these goods to distant places only by big business houses.

11. Advertisement and Salesmanship:

A big concern can afford to spend large amounts of money on advertisement and
salesmanship. Ultimately, they do bear fruit. The amount of money spent on
advertisement per unit comes to a low figure when production is undertaken on a very
large scale. The salesmen can make a careful study of the individual markets and thus
acquire a hold on new markets or strengthen it on the old ones. Thus, a large scale
producer has a greater competitive strength.

12. Research:
The large scale production is conducive for the development of technology also. With
larger amount of capital and financial resources, the large scale firms can afford to spend
more on research and experiments which ultimately lead to the discovery of new
machines and cheaper techniques of production.

13. Economy of Buying and Selling:

A large concern usually buys things in large quantities and therefore, at low rates. It also
sells things in large quantities and can secure better terms.

14. Economies of Indivisibility:

 Many factors of production are not perfectly divisible. For instance, assume that one
machine can produce 100 units of a commodity, but we are producing only 50 units by
that machine. The machine is indivisible. If the scale of production is increased and we
start producing 100 units, per unit cost will be reduced. This is the economy of the
indivisible machines.

16. Explain the uses of ROI in various fields. (NOV 2014)

1. Better Measure of Profitability:
It relates net income to investments made in a division giving a better measure of
divisional profitability. All divisional managers know that their performance will be
judged in terms of how they have utilized assets to earn profit, this will encourage them to
make optimum use of assets. Also, it ensures that assets are acquired only when they are
sure to give returns in consonance with the organisation’s policy.

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Thus, the major focus of ROI is on the required level of investment. For a given business
unit at a given point of time, there is an optimum level of investment in each asset that
helps maximise earnings. A cost-benefit analysis of this kind helps managers find out the
rate of return that can be expected from different investment proposals. This allows them
to choose an investment that will enhance both divisional and organisational profit
performance as well as enable effective utilisation of existing investments.

2. Achieving Goal Congruence:

ROI ensures goal congruence between the different divisions and the firm. Any increase
in divisional ROI will bring improvement in overall ROI of the entire organization.

3. Comparative Analysis:
ROI helps in making comparison between different business units in terms of profitability
and asset utilization. It may be used for inter firm comparisons, provided that the firms
whose results are being compared are of comparable size and of the same industry. ROI a
good measure because it can be easily compared with the related cost of capital to decide
the selection of investment opportunities.

4. Performance of Investment Division:

 ROI is significant in measuring the performance of investment division which focuses on
earning maximum profit and making appropriate decisions regarding acquisition and
disposal of capital assets. Performance of investment centre manager can also be assessed
advantageously with ROI.

5. ROI as Indicator of Other Performance Ingredients:

ROI is considered the single most important measure of performance of an investment
division and it includes other performance aspects of a business unit. A better ROI means
that an investment centre has satisfactory results in other fields of performance such as
cost management, effective asset utilization, selling price strategy, marketing and
promotional strategy etc.

6. Matching with Accounting Measurements:

ROI is based on financial accounting measurements accepted in traditional accounting. It
does not require a new accounting measurement to generate information for calculating
ROI. All the numbers required for calculating ROI are easily available in financial
statements prepared in conventional accounting system. Some adjustments in existing
accounting numbers may be necessary to compute ROI, but this does not pose any
problem in calculating ROI.

17. Bring out the reasons for measuring profit. (NOV 2014)
Profitability is the primary goal of all business ventures. Without profitability the business
will not survive in the long run. So measuring current and past profitability and projecting
future profitability is very important.

Profitability is measured with income and expenses. Income is money generated from the
activities of the business. For example, if crops and livestock are produced and sold,
income is generated. However, money coming into the business from activities like
borrowing money do not create income. This is simply a cash transaction between the
business and the lender to generate cash for operating the business or buying assets.

Expenses are the cost of resources used up or consumed by the activities of the business.
For example, seed corn is an expense of a farm business because it is used up in the
production process. Resources such as a machine whose useful life is more than one year
is used up over a period of years. Repayment of a loan is not an expense, it is merely a
cash transfer between the business and the lender.

Profitability is measured with an “income statement”. This is essentially a listing of

income and expenses during a period of time (usually a year) for the entire
business. Information File Your Net Worth Statement includes - a simple income
statement analysis. An Income Statement is traditionally used to measure profitability of
the business for the past accounting period. However, a “pro forma income statement”
measures projected profitability of the business for the upcoming accounting period. A
 budget may be used when you want to project profitability for a particular project or a
portion of a business.

Reasons for Computing Profit

Whether you are recording profitability for the past period or projecting profitability for
the coming period, measuring profitability is the most important measure of the success
of the business. A business that is not profitable cannot survive. Conversely, a business
that is highly profitable has the ability to reward its owners with a large return on their
investment.

Increasing profitability is one of the most important tasks of the business managers.
Managers constantly look for ways to change the business to improve profitability. These
potential changes can be analyzed with a pro forma income statement or a Partial Budget.
Partial budgeting allows you to assess the impact on profitability of a small or
incremental change in the business before it is implemented.

A variety of Profitability Ratios (Decision Tool) can be used to assess the financial health
of a business. These ratios, created from the income statement, can be compared with
industry benchmarks. Also, Income Statement Trends (Decision Tool) can be tracked over
a period of years to identify emerging problems.

18. Explain return to scale. (NOV 15)

The terms 'economies of scale' and 'returns to scale' are related, but they mean very
different things in economics. While economies of scale refers to the cost savings that are
realized from an increase in the volume of production, returns to scale is the variation or
change in productivity that is the outcome from a proportionate increase of all the input.
An increasing returns to scale occurs when the output increases by a larger proportion
than the increase in inputs during the production process. For example, if input is
increased by 3 times, but output increases by 3.75 times, then the firm or economy has
experienced an increasing returns to scale.
A decreasing returns to scale occurs when the proportion of output is less than the
desired increased input during the production process. For example, if input is increased
by 3 times, but output is reduced 2 times, the firm or economy has experienced
decreasing returns to scale.
When increasing returns to scale occurs, it results in economies of scale. This is owing to
the fact that efficiency increases when organizations progress from small-scale to large-
scale production. A loss of efficiency in the production process, even when the production
has been expanded, results in decreasing returns to scale. This may occur if the
organization becomes too large to be operated as one single entity. In this case, there is no
economy of scale.

19. Describe the stages of law of variable proportion. (NOV 16)

The behaviour of output when the varying quantity of one factor is combined with a fixed
quantity of the other can be divided into three distinct stages. In order to understand these
three stages it is better to graphically illustrate the production function with one factor
variable.
This has been done in Fig. 16.3. In this figure, on the X-axis the quantity of the variable
factor is measured and on the F-axis the total product, average product and marginal
product are measured. How the total product, average product and marginal product a
variable factor change as a result of the increase in its quantity, that is, by increasing the
quantity of one factor to a fixed quantity of the others will be seen from Fig. 16.3.

In the top Danel of this figure, the

total product curve TP of variable factor goes on increasing to a point and alter that it
starts declining. In the bottom pane- average and marginal product curves of labour also
rise and then decline; marginal product curve starts declining earlier than the average
product curve.
The behaviour of these total, average and marginal products of the variable factor as
a result of the increase in its amount is generally divided into three stages which are
explained below:
Stage 1:
In this stage, total product curve TP increases at an increasing rate up to a point. In Fig.
16.3. from the origin to the point F, slope of the total product curve TP is increasing, that
is, up to the point F, the total product increases at an increasing rate (the total product
curve TP is concave upward upto the point F), which means that the marginal product MP
of the variable factor is rising.

From the point F onwards during the stage 1, the total product curve goes on rising but its
slope is declining which means that from point F onwards the total product increases at a
diminishing rate (total product curve TP is concave down-ward), i.e., marginal product
falls but is positive.

The point F where the total product stops increasing at an increasing rate and starts
increasing at the diminishing rate is called the point of inflection. Vertically corres-
ponding to this point of inflection marginal product is maximum, after which it starts
diminishing.

Thus, marginal product of the variable factor starts diminishing beyond OL amount of the
variable factor. That is, law of diminishing returns starts operating in stage 1 from point D
on the MP curve or from OL amount of the variable factor used.

This first stage ends where the average product curve AP reaches its highest point, that is,
point S on AP curve or CW amount of the variable factor used. During stage 1, when
marginal product of the variable factor is falling it still exceeds its average product and so
continues to cause the average product curve to rise.

Thus, during stage 1, whereas marginal product curve of a variable factor rises in a part
and then falls, the average product curve rises throughout. In the first stage, the quantity
of the fixed factor is too much relative to the quantity of the variable factor so that if some
of the fixed factor is withdrawn, the total product will increase. Thus, in the first stage
marginal product of the fixed factor is negative.

Stage 2:
In stage 2, the total product continues to increase at a diminishing rate until it reaches its
maximum point H where the second stage ends. In this stage both the marginal product
and the average product of the variable factor are diminishing but remain positive.
At the end of the second stage, that is, at point M marginal product of the variable factor
is zero (corresponding to the highest point H of the total product curve TP). Stage 2 is
very crucial and important because as will be explained below the firm will seek to
produce in its range.

Stage 3: Stage of Negative Returns:

In stage 3 with the increase in the variable factor the total product declines and therefore
the total product curve TP slopes downward. As a result, marginal product of the variable
factor is negative and the marginal product curve MP goes below the X-axis. In this stage
the variable factor is too much relative to the fixed factor. This stage is called the stage of
negative returns, since the marginal product of the variable factor is negative during this
stage.

It may be noted that stage 1 and stage 3 are completely symmetrical. In stage 1 the fixed
factor is too much relative to the variable factor. Therefore, in stage 1, marginal product
of the fixed factor is negative. On the other hand, in stage 3 the variable factor is too
much relative to the fixed factor. Therefore, in stage 3, the marginal product of the
variable factor is negative.

The Stage of Operation:

Now, an important question is in which stage a rational producer will seek to produce. A
rational producer will never choose to produce in stage 3 where marginal product of the
variable factor is negative. Marginal product of the variable factor being negative in stage
3, a producer can always increase his output by reducing the amount of the variable
factor.

It is thus clear that a rational producer will never be producing in stage 3. Even if the
variable factor is free, the rational producer will stop at the end of the second stage where
the marginal product of the variable factor is zero.

At the end point M of the second stage where the marginal product of the variable factor
is zero, the producer will be maximising the total product and will thus be making
maximum use of the variable factor. A rational producer will also not choose to produce
in stage 1 where the marginal product of the fixed factor is negative.

A producer producing in stage 1 means that he will not be making the best use of the
fixed factor and further that he will not be utilising fully the opportunities of increasing
 production by increasing quantity of the variable factor whose average product continues
to rise throughout the stage 1. Thus, a rational entrepreneur will not stop in stage 1 but
will expand further.

Even if the fixed factor is free (i.e., costs nothing), the rational entrepreneur will stop only
at the end of stage 1 (i.e., at point N) where the average product of the variable factor is
maximum. At the end point N of stage 1, the producer they will be making maximum use
of the fixed factor.

It is thus clear from above that the rational producer will never be found producing in
stage 1 and stage 3. Stage 1 and 3 may, therefore, be called stages of economic absurdity
or economic non-sense. The stages 1 and 3 represent non-economic regions in production
function.

A rational producer will always seek to produce in stage 2 where both the marginal
product and average product of the variable factor are diminishing. At which particular
point in this stage, the producer will decide to produce depends upon the prices of factors.
The stage 2 represents the range of rational production decisions.

We have seen above how output varies as the factor proportions are altered at any given
moment. We have also noticed that this input-output relation can be divided into three
stages. Now, the question arises as to what causes increasing marginal returns to the
variable factor in the beginning, diminishing marginal returns later and negative marginal
returns to the variable factor ultimately.

UNIT III PART -C

1. Explain economics of scale and different types of economies with illustration.
(APRIL 2013)
Definition: Economies of scale is an economics term that describes a competitive
advantage that large entities have over smaller entities. It means that the larger the business,
non-profit or government, the lower its costs. For example, the cost of producing one unit is
less when many units are produced at once.
Types of Economies of Scale
There are two main types of economies of scale: internal and external.
Internal economies are, as the name implies, internal to the company itself and controllable
by management. External economies are supported by external factors. These factors include
the industry, geographic location or government.
Internal Economies of Scale
Internal economies result from the sheer size of the company, no matter what industry it's in
or market it sells to. For example, large companies have the ability to buy in bulk. This
lowers the cost per unit of the materials they need to make their products. They can use the
savings to increase profits. Or, they can pass the savings to consumers and compete on price.
There are five main types of internal economies of scale.
1. Technical economies of scale result from efficiencies in the production process itself.
Research shows that manufacturing costs can fall 70-90 percent every time the business
doubles its output. Larger companies can take advantage of more efficient equipment. An
example is sophisticated data mining software that allows the firm to target its customers
more effectively. Large shipping companies can cut costs by using super-tankers, such as
the post-Panamax ships that carry as many as 16 trains. Finally, large companies achieve
technical economies of scale because they learn by doing. They’re far ahead of their smaller
competition on the learning curve.
1. Monopsony power is when a company buys so much of a product that it can negotiate
a lower price than its smaller competitors. For example, Wal-Mart can have lower prices
because its huge buying power gives it monopsony economies of scale.
2. Managerial economies of scale arise when firms can hire specialists to manage
specific areas of the company. An example is a seasoned sales executive.
1. Financial economies of scale means the company has cheaper access to capital. A
larger company can get funded from the stock market with an initial public offering. Big
firms usually have higher credit ratings, meaning they get lower interest rates on their bonds.
2. Network economies of scale occur primarily in online businesses. It costs almost
nothing to support each additional customer with existing infrastructure. So, any revenue
from the new customer is all profit for the business. A great example is eBay. (Source:
“Economies of Scale Examples,” FHS Economics.)
External Economies of Scale
A company has external economies of scale if it receives preferential treatment from the
government or other external sources simply because of its size. For example, most states will
lower taxes to attract large companies since they will provide jobs for their residents. A large
real estate developer can often convince a city to build roads and other infrastructure. This
saves the developer from paying those costs. Large companies can also take advantage of
joint research with universities. This lowers their own research expenses.
Small companies just don't have the leverage to take advantage of external economies of
scale.
But, they can band together and take advantage of geographic economies of scale by
clustering similar businesses in a small area. For example, artist lofts, galleries and
restaurants in a downtown art district benefit from being near each other.

2. Examine the reasons for existence of product line. (APRIL 2014)

A product line is a group of related products under a single brand sold by the same company.
Companies sell multiple product lines under their various brands.
Product Line Decisions:
 Product line group of products that are closely related because:
 They perform a similar function.
 Are sold to the same customer groups.
 Are marketed through same channels.
 Fall within given price range.
 Normally a product line is managed by a group of persons/ one person (product
 manager) to manage product line, starting point is product line analysis.
 Product Line Analysis:
Product line managers needs to know:
Sales.
Profits of each product in their product line.
Also they may take decisions on:
 Building.
 Maintaining.
 Harvesting.
 Divesting, a particular product.
For this, analysis consists of:
 Sales & profits analysis.
 Product line market profile/map.
 Sales & Profits Analysis:
 Percentage of total sales & profits contributed by each item line is tabulated.
 High consumer of sales/ profits on few items individual line vulnerability. In such
cases, those few contributors need to be monitored carefully.
 Low contributors are evaluated for growth potential. If growth is not possible they
may be dropped.

Product Line market profile/Map:

 Product line needs to be reviewed in terms of product’s positioning against
 competitor’s product line.
 Based on analysis marketer market determinants/ differentiators are identified
 a product map is created.
 Indicating position of own products & competition.
 Product map created using two differentiators at a time as the axes.
 Product map helps to:
 Identify Market Segment.
 Design product line marketing company.
Based on product line analysis decisions to be taken could be on:
 Product Line Length (Line Enlargement).
 Line Modernization.
 Line Featuring.
 Line Pruning.

3. Explain the budgeting and standard costing methods of cost control. (ARIL
2017)
A budget is a quantitative plan used as a tool for deciding which activities will be
chosen for a future time period. In a business, the budgeting for operations will include the
following: preparing estimates of future sales. preparing estimates of future cash collections
and disbursements. Budgeting represents the formation of the budget with the help and
coordination of all or the various departments of the firm.
Standard costing:
This is a technique which uses standards for cost and revenues for the purpose
of control through variance analysis.
The main advantages of standard costing are: Comparison is made between actual
performance & pre-determined standard, thereby exposing favorable or adverse variances. ...
As under standard costing system variances can be reported, cost control is more effective
under this system.
Controlling of business operations is the common objectives of both the systems
of standard costing & budgetary control. Accounting of variances between actual results & a
pre-determined plan is involved in both the techniques. Estimation of costs of products &
services is involved in standard costing process. Standard costing is one of the prominently used
systems of cost control. It aims at establishing standards of performance and target costs which are to
be achieved under a given set up working conditions. It is a pre-determined cost which determines
what each product or service should cost under certain situation.
Standard costing is defined as the preparation and use of standard costs, their
comparison with actual costs and the measurement and analysis of variances to their causes
and points of incidence. Standard costs should be obtained under efficient operations. It starts
with an estimate of what a product should cost during a future period given reasonable
efficiency Standard costs are established by bringing together information collected from
various sources within the company.
The degree of success is measured by a comparison of actual performance and
standard performance. For example, if the standard material input for a unit of production is
Rs. 500 and the actual cost is Rs 475 then the variance of Rs. (-) 25 is the measure of
performance, which shows that the actual performance is an improvement over the standard.
This comparison of actual costs with standard cost will help in fixing responsibility for non-
standard performance and will focus attention on areas in which cost improvement should be
sought by showing the source of loss and inefficiency.
Basic Requirements in the Use of Standard Costing:
The basic requirements are the following:
(i) The ability to establish a meaningful standard.
(ii) A system for measuring actual quantities and costs at the same level as the standard costs
and quantities.
(iii) The facilities to calculate variances over time, which will allow corrective action to be
taken.
Advantages of Standard Costing:
Standard costing has the following merits:
(i) It helps in establishing a yardstick with which the efficiency of performance is measured
that helps to exercise control.
(ii) It provides how the clear goal is to be achieved by providing incentive and motivation to
work.
(iii) It provides the management the basic information to fix selling price, transfer pricing,
etc.
(iv) It facilitates delegation of authority and fixation of responsibility.
(v) It helps in achieving optimum utilisation of plant capacity.
(vi) It provides means for cost reduction.
(vii) Variance analysis and reporting is helpful for taking corrective measures.
Limitations of Standard Costing:
Even though this method confers several benefits, there are certain difficulties which
are listed below:
(i) Application of standard costs is quite difficult in practice.
(ii) Frequently, standards become rigid over time and do not keep pace with changes in condi-
tions.
(iii) If the standards are outdated, loose, inaccurate and unreliable, they are more harmful.
(iv) It standards set are higher than reasonable, they act as discouraging factor.
(v) When there are random factors, it is difficult to explain variance properly.
(vi) Standard costing may be found to be unsuitable and costly in the case of firms dealing in
non-standard products.
(vii) It is difficult to distinguish between controllable and non-controllable variances.
(viii) Setting the standard costing are highly technical and mechanical.
Basis of Setting Standard Costs:
Without standards, a company’s management has no way of knowing its overall performance.
The standard costs are to be established by collecting all information pertaining to different
cost functions. The main basis of setting standard costs is technical and engineering aspects.
A major issue in standard costing is the determination of the tightness of standards which
may range from a desire for engineering perfection to very slack practices.
The other basis of setting standards is:
(i) Time of use—current standard and basic standard
(ii) Performance level—normal, ideal, expected, attainable standards, etc.
(iii)Price level—ideal, normal, current, basic standard
(iv) Output level—theoretical, practical, normal expected standards.
(a) Normal Standards:
Normal standards comprise:
(i) Ideal Standards:
The standards represent the maximum level of efficiency, i.e., using minimum resources to
complete the goal without any loss of time. In control terms, it is essential for standards to
motivate individuals towards their attainment. It is very difficult to use ideal standards. Ideal
standards are, therefore, more likely to be set for direct material costs and usage rather than
for direct labour or overhead costs.
(ii) Target Standards:
These are the standards which can be attained during a future specified budget period. These
are a modified version of ideal standard costs. Hence a certain amount of waste is permitted.
(b) Basic Standards:
Basic standards are those standards which are set at their initial level. In fact, basic standards
are not very pragmatic as they emphasize the past instead of the future. Their effectiveness is
very little in situations of change in production methods, range of products and prices.
(c) Currently attainable Standards:
Currently attainable standard costs are those costs that should be incurred currently under
efficient operating conditions, but making allowances for normal spoilage, unavoidable idle
time, unavoidable machine breakdown, set up time, etc. In other words, currently attainable
standards or expected standards are the target standards minus a realistic allowance for
normal or acceptable waste.
Tolerance Limit:
In reality, it is rare that the costs of the firm will exactly match the set standards. Management
cannot insist that every time the performance must match the rigid standards. Limits of these
deviations from the set standards which are called tolerance limits. The deviations are of two
types: Random and significant. Random deviations are those which arise purely due to
chance and are therefore uncontrollable. Significant deviations are those that have assignable
causes and are therefore largely subject to control of the management. Cost control must be
based on some measure of importance of these significant deviations.

4. Discuss the various assumptions of production function. (NOV 2012)

In economics, a production function relates physical output of a production process to
physical inputs or factors of production.

Assumption:
The two main assumptions of the production function are as follows
(i) Technology is invariant. If technology changes, it would result in alteration of the input-
output relationship, resulting in a production function.
(ii) It is assumed that firms utilise their inputs a maximum levels of efficiency.
 In other words, the production function includes all the technically efficient method of
production. If a production function includes only a single technical efficient method, we call
it a one-process production function. If it includes two efficient processes, it is a two process
production function.
Other assumption:
 It relates to a particular point of time
 Function of technical knowledge during that period of time remains constant
 Function of the producer uses the best technique available
 The function of the factors of production are divisible into most units.
 To understand the different stages of the production function, it is essential to
understand some important terms. Such as total product,
 Average product, marginal product,

5. Discuss the sources of limiting the profits. (NOV 2013)

There are seven sources of limiting the profits:

1. What Got You Here Takes You There
The market abounds with opportunities as vendors, distributors and customers
continue to optimize organizational and relationship efficiencies. Any standout success in
your company’s past will not have been due to the change in activities that drove it, but rather
in doing whatever it was when the competition didn’t. Winning NASCAR teams are
continuously inventing new things to get a small edge. Those that rely only on what was
“state-of-the-art” in the past are those who run in the back of the pack. If your company isn’t
inventing and implementing new and improved procedures and practices, for both sales and
operations, every year, you’ll have to get used to eating dust. The key to discovering better
practices isn’t out in the market, or in a magazines—it’s most often found in your own data.
This is what analytics are for. There’s no place that’s more reflective of what your company
does, or what your customers want, than in your own data.
2. It’s All About Our Products
In distribution we buy product, sell product, inventory product, and train on product.
To our very great detriment, we’ve become product oriented. In reality, no product is
inherently profitable on
its own. Profits are determined in how products are purchased by customers. For instance, a
$25 item sold and delivered by itself is a guaranteed loss, but when sold in quantity or added
to a large order, it’s a profit enhancer. You can’t manage profit by working directly with
products. Profits are driven by working with customers on how products are procured and
how much company infrastructure and resources are consumed in doing so. This, again, is
what advanced analytics are for. Yesterday’s market advantage from exclusive products or
territories has been replaced by operational advantages from exclusive understanding of
profit drivers from advanced analytics, and action capitalizing on this knowledge.
3. You Can Do the Math in Your Head
The reason why everyone is talking about analytics is because simple math can’t give you the
insights driven by the complex interactions of vendors, products, sales, operations and
customers inherent in your business model. Advanced systems track millions of individual
intersections of these elements, delivering surprising (and, often, counter-intuitive) insights
into profit-generation, and are coming into broad use because they give companies an edge.
Clearly, adopting profit-driving practices that less-capable competitors fail to recognize
confers market advantages, and deep analytics reveals a broad range of these opportunities.
4. Gross Margin Drives Profits
Adecade of experience overseeing tens of billions of dollars in distribution transactions
completely refutes this. Gross Margin is almost completely disconnected from profit, and is
in no way a reliable indicator of profitability. There are three elements of a profitable sale:
volume, pricing and costs. Gross Margin is a measure of pricing only, so it cannot suggest
actual profit in any way because it does not account for volume or costs. It’s like trying to
measure distance when you know the direction, but not the starting point or the destination—
it’s impossible. Nobody can get anywhere when your navigation direction is always “West.”
This is why gross margin management is a lousy way to run a business, and why initiatives
that manage or drive gross profit almost always fail to improve the bottom line. As an
industry, we’ve mastered the volume and pricing part of the equation, so today’s companies
are rising to the last challenge by employing advanced analytics to clearly understand what
can be done to manage complex interactions that drive costs and therefore profit.
5. Most Sales Contribute to Profit
This is what I believed ten years ago, when I was also trapped by the belief that profits were
gross margins-related. Since our margins were at or above acceptable levels, I felt every sale
made a contribution to the bottom line. This deadly belief leads directly to the biggest
misconception in distribution management— that since almost all sales contribute to profit,
getting more sales is the path to higher profits Really, most sales lose money. In fact, our
research shows that 62.5% of invoices in distribution are money-losing sales! Statistically,
increasing sales will reduce profits rates. In this shocking statistic is the insight that can
almost guarantee substantial profit gains—profits aren’t improved by having more sales,
they’re improved by shifting the balance between money-making and money-losing sales.
This one intuition has done more to rocket profits upward than any other. Companies acting
on this lead their industries, markets and associations in profit generation. They don’t need
bank lines and they don’t pay interest.
6. Sales Headcount Drives Profits
If you believe that all sales drive the bottom line, then you also have to believe that the best
way the drive those sales is with lots of sales reps. This is a painful hangover from the glory
days of opening new markets, when more accounts meant more business. Today, almost all
distribution companies have 1.5x–2x as many sales reps as they need, or can afford. This can
easily be seen in territories that
have 100+ accounts, most of which are too small to be profitable when commissions are paid.
(Rule of thumb: 6 calls/ year @ $100 cost / call @ 25% margin @ 25% commission = $9,600
annual revenue. Accounts below this mark are not likely viable for commissions, yet are the
bulk of commissionable accounts in most territories.) Frankly, having too many reps makes it
impossible
to pay good reps enough, and this is causing difficulty in hiring the younger reps we
desperately need to work effectively with their younger counterparts in customer accounts.
7. Our ERP System Tracks and Reports Profit
Executives rely heavily on ERP and financial systems that simply aren’t designed to calculate
detailed cost and profit. At their core, those systems were designed to manage inventory,
receivables, and to provide company-wide profit numbers sufficient for the bank and the IRS.
That’s it. Any branch or territory level profit numbers are based on estimates on a spreadsheet
someone cooked up months or years ago, and are no more indicative of real profit numbers in
current and future periods than the phases of the moon. A company can have accurate profit
numbers at this level only when they use a cost and profit analytics system designed for the
purpose, and then put the numbers it produces back into the accounting system.
6. Explain the limitations of break even analysis. (NOV 2013)
Limitations of breakeven analysis. Variable costs do not always stay the same. For
example, as output rises, the business may benefit from being able to buy inputs at lower
prices (buying power), which would reduce variable cost per unit.
Limitations of Break-Even Analysis:
1. In the break-even analysis, we keep everything constant. The selling price is assumed to be
constant and the cost function is linear. In practice, it will not be so.
2. In the break-even analysis since we keep the function constant, we project the future with
the help of past functions. This is not correct.
3. The assumption that the cost-revenue-output relationship is linear is true only over a small
range of output. It is not an effective tool for long-range use.
4. Profits are a function of not only output, but also of other factors like technological change,
improvement in the art of management, etc., which have been overlooked in this analysis.
5. When break-even analysis is based on accounting data, as it usually happens, it may suffer
from various limitations of such data as neglect of imputed costs, arbitrary depreciation
estimates and inappropriate allocation of overheads. It can be sound and useful only if the
firm in question maintains a good accounting system.
6. Selling costs are specially difficult to handle break-even analysis. This is because changes
in selling costs are a cause and not a result of changes in output and sales.
7. The simple form of a break-even chart makes no provisions for taxes, particularly
corporate income tax.
8. It usually assumes that the price of the output is given . In other words, it assumes a
horizontal demand curve that is realistic under the conditions of perfect competition.
9. Matching cost with output imposes another limitation on break-even analysis. Cost in a
particular period need not be the result of the output in that period.
10. Because of so many restrictive assumptions underlying the technique, computation of a
breakeven point is considered an approximation rather than a reality.

7. Explain : (NOV 2015)

(a) Economies of scale
economies of scale. Scale economies have brought down the unit costs of production and
have fed through to lower prices for consumers.
Most firms find that, as their production output increases, they can achieve lower costs per
unit. This can be illustrated as follows:
Economies of Scale
In the diagram above, you can see that unit costs fall from AC1 to AC2 when output increases
from Q1 to Q2. That illustrates the effect of economies of scale – so what are they?
Economies of scale are the cost advantages that a business can exploit by expanding their
scale of production. The effect of economies of scale is to reduce the average (unit) costs of
production.
There are many different types of economy of scale and depending on the particular
characteristics of an industry, some are more important than others.
Internal economies of scale
Internal economies of scale arise from the growth of the business itself. Examples include:
Technical economies of scale:
Large-scale businesses can afford to invest in expensive and specialist capital machinery. For
example, a supermarket chain such as Tesco or Sainsbury's can invest in technology that
improves stock control. It might not, however, be viable or cost-efficient for a small corner
shop to buy this technology.
Specialisation of the workforce
Larger businesses split complex production processes into separate tasks to boost
productivity. By specialising in certain tasks or processes, the workforce is able to produce
more output in the same time.
Marketing economies of scale
A large firm can spread its advertising and marketing budget over a large output and it can
purchase its inputs in bulk at negotiated discounted prices if it has sufficient negotiation
power in the market. A good example would be the ability of the electricity generators to
negotiate lower prices when negotiating coal and gas supply contracts. The major food
retailers also have buying power when purchasing supplies from farmers and other suppliers.

Managerial economies of scale

This is a form of division of labour. Large-scale manufacturers employ specialists to
supervise production systems, manage marketing systems and oversee human resources.
Financial economies of scale
Larger firms are usually rated by the financial markets to be more 'credit worthy' and have
access to credit facilities, with favourable rates of borrowing. In contrast, smaller firms often
face higher rates of interest on overdrafts and loans. Businesses quoted on the stock market
can normally raise fresh money (i.e. extra financial capital) more cheaply through the issue of
shares. They are also likely to pay a lower rate of interest on new company bonds issued
through the capital markets.
Network economies of scale
Network economies are best explained by saying that the extra cost of adding one more user
to the network is close to zero, but the resulting benefits may be huge because each new user
to the network can then interact, trade with all of the existing members or parts of the
network. The expansion of e-commerce is a great example of network economies of scale – it
doesn't cost Amazon.co.uk much (if anything) to add another 10,000 customers to its systems,
but the revenue and profit effect can be significant.

External economies of scale

External economies of scale occur within an industry. Examples of external economies of
scale include:
 Development of research and development facilities in local universities that
several businesses in an area can benefit from
 Spending by a local authority on improving the transport network for a local town or
city
 Relocation of component suppliers and other support businesses close to the main
centre of manufacturing are also an external cost saving

(b) Advantages of large scale of production.

(i) Economy of Specialized and Up-to-date Machinery:
There is a large scope for the use of machinery which results in lower costs. A large producer
can install an up-to-date and expensive machinery. He can also have his own repairing
arrangement. Specialized machinery can be employed for each job. The result is that
production is very economical. A small producer with a small market cannot keep the
machinery continuously working. Keeping it idle is uneconomical. A large producer can work
it continuously and reap the resulting economies.
(ii) Economy of Labour:
In a big concern, there is ample scope for division of labour. Specialized labour produces a
larger output and of better quality. It is only in a large business that every person can be put
on the job that he can best perform. The large-scale producer thus gets the best out of every
person he employs.

(iii) Economies of Bulk buying and selling:

While purchasing raw material and other accessories, a big business can secure specially
favourable terms on account of its large custom. Whine selling its goods, it can attract
customers by producing a greater variety and by ensuring prompt execution of orders. Even a
small rate of profit results in larger sales and higher net profits in a large-scale business.
(iv) Economies of Overhead Charges:
The expenses of administration and distribution per unit of production in a big business are
much less. Interest, the pay bill, and other overhead charges are the same whether production
is large or small. Thus, the same amount of expenditure being distributed over a larger output
results in a lower cost per unit.
(v) Economy in Rent:
A large-scale producer makes a saving in rent too. If the same factory is made to produce a
large quantity of goods, the same amount of rent is divided over a large output. This means
that the cost per unit in respect of rent comes to a much smaller amount.
(vi) Experiments and Research:
A large concern can afford to spend liberally on research and experiments. It is well known
that, in the long run, these expenses more than repay. Successful research may lead to the
discovery of a cheaper process. This may bring a large profit. Only a large-scale business can
incur such expenditure.
(vii) Advertisement and Salesmanship:

A big concern can afford to spend large amounts of money on advertisement and
salesmanship. Ultimately they do bear fruit. Also, the amount of money spent on
advertisement per unit comes to a low figure when production is on a large scale. The
salesman can make a careful study of individual markets and thus acquire a hold on new
markets or strengthen it on the old ones. Thus a large-scale producer has a greater
competitive strength.
(viii) Utilization of By-products:
A big business will not have to throw away any of its by-products or waste products. It will
be able to make an economical use of them. A small sugar factory has to throw away the
molasses, whereas a big concern can turn it into power-alcohol. By utilising by-products, it
can lower the cost of production.
(ix) Facing Adversity:
A big business can show better resistance in times of adversity. It has much larger resources.
Losses can be easily borne. A small concern will simply collapse under such a strain.
(x) Cheap Credit:
A large business can secure credit facilities at cheap rates. Its credit in the money market is
high and the banks are only too willing to give advances. Low cost of credit reduces cost of
production.
These are some of the advantages that a large-scale business has over a small-scale business.
It can produce better goods at lower cost. But let us see the other side.

UNIT –IV PART - A

1. Write a short note on local markets. (APRIL 2012)
Clients and customers who will buy a product in the region or area in which it is produced.
For marketing purposes it is important to know who will buy the product, where they are
located and how far they will travel to obtain the product. The local market includes
customers located within the region the product or services is produced or made available.
2. What is full-cost pricing? ( APRIL 2013)
Selling price arrived at by adding overheads and profit margin to the direct cost per unit of a
product. In a manufacturer’s overheads computation, less than full capacity utilization of the
plant is factored in to allow for fluctuations in the output. The profit margin is computed as a
fixed percentage of the average total cost of the product.

3. What is cash discounts? ( APRIL 2013) (APRIL 2015)

A cash discount is a deduction allowed by the seller of goods or by the provider of services in
order to motivate the customer to pay within a specified time. The seller or provider often
refers to the cash discount as a sales discount. The buyer often refers to the same discount as
a purchase discount.
4. Define market price. (APRIL 2014)
The market price is the current price at which an asset or service can be bought or sold.
Economic theory contends that the market price converges at a point where the forces of
supply and demand meet.
5. What do you mean by quantity discounts? (APRIL 2015)
A quantity discount is an incentive offered to a buyer that results in a decreased cost per unit
of goods or materials when purchased in greater numbers. A quantity discount is often
offered by sellers to entice buyers to purchase in largerquantities.

6. What is marginal cost pricing? (APRIL 2016) (NOV 2012)

This is used when demand is slack and market is highly competitive. Under marginal cost
pricing price of the product is the sum of variable cost plus a profit margin. This method is
used by firms to enter into a new market as well as to beat competitors. As this method
ignores the element of fixed cost, it cannot be adopted as a long term strategy.

7. Define ‘‘Differential pricing’’. (APRIL 2016)

Differential pricing is the strategy of selling the same product to different customers at
different prices. Consider the pricing behavior at an auction. Everyone has the same
information and bids on the same item.

8. What is dual pricing? (APRIL 2017) (NOV 2016)

Dual pricing is a situation in which the same product or service is sold at different prices in
different markets. There are a number of reasons why dual pricing may be employed,
including the following: An aggressive competitor may use dual pricingto drastically lower
its price in a new market
9. What is bid pricing? (APRIL 2017)
A bid price is the highest price that a buyer (i.e., bidder) is willing to pay for a good. It is
usually referred to simply as the "bid". In bid and ask, the bid price stands in contrast to the
ask price or "offer", and the difference between the two is called thebid–ask spread.
10. Define penetration strategy. (APRIL 2017)
Penetration strategy is the concept of taking aggressive action to greatly expand one's
share of total sales in a market. The resulting increased sales volume typically allows a
business to produce goods or obtain merchandise at lower cost, thereby allowing it to
generate a higher profit percentage. Also, as the organization acquires more market share,
this reduces the sales of its competitors, possibly forcing some to drop out of the market.
11. What is oligopoly(APRIL 2017)
The Oligopoly Market characterized by few sellers, selling the homogeneous or differentiated
products. In other words, the Oligopoly market structure lies between the pure monopoly and
monopolistic competition, where few sellers dominate the market and have control over the
price of the product.
12. What do you mean by distributor discounts? (NOV 2012) (NOV 2016)
Trade Discount. Or distributor discounts . A trade discount is the amount by which a product
manufacturer reduces the retail price of that product when it sells to a reseller (distributor or
wholesaler), rather than selling the product to the end customer. Trade Buyer.
13. State the significance of pricing. (NOV 2013)
Six significance of pricing and marketing strategy are as follows: (a) The planed market
position for the service product (b) The stage of the life – cycle of the service product (c)
Elasticity of demand (d) The competitive situation (e) The strategic role of price.
14. Define resale price maintenance. (NOV 2014)
Resale price maintenance a price in which the manufacturer and distributor or retail mutually
agree that the re-seller of the product will sell it at or above the minimum resale price or at or
below maximum resale price. Maximum resale price is the price ceiling and minimum resale
price is price floor. A re-seller of the product (retailer or distributor) cannot sell the product
above price ceiling or below the price floor.
15. Write a short note on limit pricing. (NOV 2015)
A limit price (or limit pricing) is a price, or pricing strategy, where products are sold by a
supplier at a price low enough to make it unprofitable for other players to enter the market.
This means that for limit pricing to be an effective deterrent to entry, the threat must in some
way be made credible.
16. What is price discrimination? (NOV 2015)
Price discrimination is a microeconomic pricing strategy where identical or largely similar
goods or services are transacted at different prices by the same provider in different markets.
UNIT IV PART B
1. What are the pricing objectives of a business firm? (APRIL 2012)
1. Profits-related Objectives:
Profit has remained a dominant objective of business activities.
Company’s pricing policies and strategies are aimed at following profits-related
objectives:
i. Maximum Current Profit:
One of the objectives of pricing is to maximize current profits. This objective is aimed at
making as much money as possible. Company tries to set its price in a way that more current
profits can be earned. However, company cannot set its price beyond the limit. But, it
concentrates on maximum profits.

ii. Target Return on Investment:

Most companies want to earn reasonable rate of return on investment.
Target return may be:
(1) fixed percentage of sales,
(2) return on investment, or
(3) a fixed rupee amount.
Company sets its pricing policies and strategies in a way that sales revenue ultimately
yields average return on total investment. For example, company decides to earn 20% return
on total investment of 3 crore rupees. It must set price of product in a way that it can earn 60
lakh rupees.

2. Sales-related Objectives:
The main sales-related objectives of pricing may include:
i. Sales Growth:
Company’s objective is to increase sales volume. It sets its price in such a way that more and
more sales can be achieved. It is assumed that sales growth has direct positive impact on the
profits. So, pricing decisions are taken in way that sales volume can be raised. Setting price,
altering in price, and modifying pricing policies are targeted to improve sales.
ii. Target Market Share:
A company aims its pricing policies at achieving or maintaining the target market share.
Pricing decisions are taken in such a manner that enables the company to achieve targeted
market share. Market share is a specific volume of sales determined in light of total sales in
an industry. For example, company may try to achieve 25% market shares in the relevant
industry.
iii. Increase in Market Share:
Sometimes, price and pricing are taken as the tool to increase its market share. When
company assumes that its market share is below than expected, it can raise it by appropriate
pricing; pricing is aimed at improving market share.
3. Competition-related Objectives:
Competition is a powerful factor affecting marketing performance. Every company tries to
react to the competitors by appropriate business strategies.
With reference to price, following competition-related objectives may be priorized:
i. To Face Competition:
Pricing is primarily concerns with facing competition. Today’s market is characterized by the
severe competition. Company sets and modifies its pricing policies so as to respond the
competitors strongly. Many companies use price as a powerful means to react to level and
intensity of competition.
ii. To Keep Competitors Away:
To prevent the entry of competitors can be one of the main objectives of pricing. The phase
‘prevention is better than cure’ is equally applicable here. If competitors are kept away, no
need to fight with them. To achieve the objective, a company keeps its price as low as
possible to minimize profit attractiveness of products. In some cases, a company reacts
offensively to prevent entry of competitors by selling product even at a loss.
iii. To Achieve Quality Leadership by Pricing:
Pricing is also aimed at achieving the quality leadership. The quality leadership is the image
in mind of buyers that high price is related to high quality product. In order to create a
positive image that company’s product is standard or superior than offered by the close
competitors; the company designs its pricing policies accordingly.
iv. To Remove Competitors from the Market:
The pricing policies and practices are directed to remove the competitors away from the
market. This can be done by forgoing the current profits – by keeping price as low as possible
– in order to maximize the future profits by charging a high price after removing competitors
from the market. Price competition can remove weak competitors.
4. Customer-related Objectives:
Customers are in center of every marketing decision.
Company wants to achieve following objectives by the suitable pricing policies and
practices:
i. To Win Confidence of Customers:
Customers are the target to serve. Company sets and practices its pricing policies to win the
confidence of the target market. Company, by appropriate pricing policies, can establish,
maintain or even strengthen the confidence of customers that price charged for the product is
reasonable one. Customers are made feel that they are not being cheated.
ii. To Satisfy Customers:
To satisfy customers is the prime objective of the entire range of marketing efforts. And,
pricing is no exception. Company sets, adjusts, and readjusts its pricing to satisfy its target
customers. In short, a company should design pricing in such a way that results into
maximum consumer satisfaction.
5. Other Objectives:
Over and above the objectives discussed so far, there are certain objectives that company
wants to achieve by pricing.
They are as under:
i. Market Penetration:
This objective concerns with entering the deep into the market to attract maximum number of
customers. This objective calls for charging the lowest possible price to win price-sensitive
buyers.
ii. Promoting a New Product:
To promote a new product successfully, the company sets low price for its products in the
initial stage to encourage for trial and repeat buying. The sound pricing can help the company
introduce a new product successfully.
iii. Maintaining Image and Reputation in the Market:
Company’s effective pricing policies have positive impact on its image and reputation in the
market. Company, by charging reasonable price, stabilizing price, or keeping fixed price can
create a good image and reputation in the mind of the target customers.
iv. To Skim the Cream from the Market:
This objective concerns with skimming maximum profit in initial stage of product life cycle.
Because a product is new, offering new and superior advantages, the company can charge
relatively high price. Some segments will buy product even at a premium price.
v. Price Stability:
Company with stable price is ranked high in the market. Company formulates pricing policies
and strategies to eliminate seasonal and cyclical fluctuations. Stability in price has a good
impression on the buyers. Frequent changes in pricing affect adversely the prestige of
company.
vi. Survival and Growth:
Finally, pricing is aimed at survival and growth of company’s business activities and
operations. It is a fundamental pricing objective. Pricing policies are set in a way that
company’s existence is not threatened.

2. Describe the skimming price strategy and state when this will be successful.
(APRIL 2013)
An approach under which a producer sets a high price for a new high-end product
(such as an expensive perfume) or a uniquely differentiated technical product (such as one-of-
a-kind software or a very advanced computer). Its objective is to obtain maximum revenue
from the market before substitutes products appear. After that is accomplished, the producer
can lower the price drastically to capture the low-end buyers and to thwart the copycat
competitors.

Increased Quality Perception

It’s no secret that quality is a key factor that customers consider when making buying
decisions, but not all consumers measure quality in the same way. Understanding that price is
a measure of quality for many buyers, companies often utilize price skimming to boost the
market perception of their wares with higher initial pricing.
By pricing goods high when they’re first released, companies create an impression of quality
and exclusivity that tends to attract early adopters.
Benefits from Early Adopters
While traditional pricing strategies appeal to all segments of the market, price
skimming tends to aid a firm in capturing early adopters. These buyers are willing to pay a
higher rate in exchange for being one of the first people to own a product.
Not only do early adopters contribute to your bottom line, but they also act as brand
ambassadors, encouraging others to try out your goods and services. Once early adapters
have spread the word about your products to other audiences, the firm can lower prices to
capture these buyers. The goal is to drop your prices before a copycat company comes in and
attempts to undersell you.
Development Cost Recovery
If your company spends a significant amount of money on product development,
employing a price skimming strategy can be a good way to recoup those costs. Development
costs for new innovations can be expensive. With price skimming, you have the chance to
gain back this spend in your first few sales. If your company tends to produce a steady stream
of new wares, price skimming may still be an effective strategy, since it doesn’t necessitate
the lowering of costs by increasing unit volume.

3. Bring out the main criticisms of cost plus pricing. (APRIL 2014)
Cost-plus pricing method is based on accounting data for total cost and not the
opportunity cost that the sale of product incurs. Moreover, the term 'profit margin' or 'costing
margin' is vague. The theory does not clarify how this costing margin is determined and
charged in the full cost by a firm.

The cost-plus pricing theory has been criticised on the following grounds:
1. This method is based on costs and ignores the demand of the product which is an important
variable in pricing.
2. It is not possible to accurately ascertain total costs in all cases.
3. This pricing method seems naive because it does not explicitly take into account the
elasticity of demand. In fact, where the price elasticity of demand of a product is low, the cost
plus price may be too low, and vice versa.
4. If fixed costs of a firm form a large proportion of its total cost, a circular relationship may
arise in which the price would rise in a falling market and fall in an expanding market. This
happens because average fixed cost per unit of output is low when output is large and when
output is small, average fixed cost per unit of output is low.
5. Cost-plus pricing method is based on accounting data for total cost and not the opportunity
cost that the sale of product incurs.
6. This method cannot be used for price determination of perishable goods because it relates
to long period.
7. The full-cost pricing theory is criticised for its adherence to a rigid price. Firms often lower
the price to clear their stocks during a recession. They also raise the price when costs rise
during a boom. Therefore, firms often follow an independent price policy rather than a rigid
price policy.
8. Moreover, the term ‘profit margin’ or ‘costing margin’ is vague. The theory does not clarify
how this costing margin is determined and charged in the full cost by a firm. The firm may
charge more or less as the just profit margin depending on its cost and demand conditions. As
pointed out by Hawkins, “The bulk of the evidence suggests that the size of the ‘plus’
margin varies it grows in boom times and it varies with elasticity of demand and
barriers to entry.”
9. The pricing process of industries reveal that the exact methods followed by firms do not
adhere strictly to the full-cost principle. The calculation of both the average cost and the
margin is a much less mechanical process than is usually thought. As a matter of fact,
businessmen are reluctant to tell economists how they calculated prices and to discuss their
relations with rival firms so as not to endanger their long-run profits or to avoid government
intervention and maintain good public image.
10. Prof. Earley’s study of the 110 ‘excellently managed companies’ in the U.S. does not
support the principle of full-cost pricing. Earley found a widespread distrust of full-cost
principle among these firms. He reported that the firms followed marginal accounting and
costing principles, and the majority of them followed pricing, marketing and new product
policies.
 4. Describe the importance of Product-line pricing. (APRIL 2015)
The process used by retailers of separating goods into cost categories in order to
create various quality levels in the minds of consumers. Effective product line pricing by a
business will usually involve putting sufficient price gaps between categories to inform
prospective buyers of quality differentials.

1. It is simpler and more efficient to use relatively fewer prices. The product and service
mix can then be tailored to select price points.
2. It can result in a smaller inventory than would otherwise be the case. It might increase
stock turnover and make inventory control simpler.
3. As costs change, the prices can remain the same, but the quality in the line can be
changed. For example, you may have bought a $20 tie 15 years ago. You can buy a $20 tie
today, but it is unlikely that today's $20 tie is of the same fine quality as it was in the past.

5. Explain the place and trade discrimination. (APRIL 2015)

Price discrimination is the practice of offering the same product to different customers at
different prices. It is a very common practice that is exercised by most businesses, often on a
regular basis. While the name sounds like an illegal practice or may conjure a negative image,
the reality is price discrimination is exercised in a legal and ethical way by most companies.
Types of Price Discrimination
There are three types, or degrees, of price discrimination:
The first degree of price discrimination is charging the price that consumers are
willing to pay. This may be in the form of negotiation or offering specials for individuals who
have been loyal customers or repeat shoppers. If you are in the market for a new or used car,
you will encounter the first degree of price discrimination when you go to negotiate the
purchase price. The better you are at negotiating, the bigger the discount you will likely be
offered.
The second degree focuses on discounts based on established terms. If you go to the
store and purchase three cans of soup and receive the fourth free, you have experienced the
second degree of price discrimination. Another aspect of the second degree of price
discrimination is offering premium packages for a discounted price. If you buy a premium
snack package at the movie theater that includes a large popcorn, large drink, and box of
candy, they may take $1 off the price. You can choose to buy the package or not, but if you
buy only a large popcorn and drink, the movie theater will charge you the full price.
The third degree of price discrimination is offering discounts to members of an
organization or people who belong to a general group. These are two organizations that are
widely known to have discounts negotiated for their members. Hopefully you aren't asked if
you qualify for the senior discount, but if you are, you know that being over 55 or 60 usually
gives you automatic membership in the seniors discount group, which means special
discounts on prices.

6. Explain the method of pricing to ‘‘Public utilities’’. (APRIL 2016) (NOV 2012)
Public Utility Pricing:
Pricing of Public Utility Services
There are a number of principles which govern the pricing of public utility services.
There are public utilities like education, sewage, roads etc. which may be supplied free to the
public and their costs should be covered through general taxation. Dalton calls it the general
taxation principle. Such services are pure public goods whose benefits cannot be priced for
the reason that they are invisible. It is not possible to identify the individual beneficiaries and
charge them for the services.
 In some cases, the beneficiaries may be identified but they cannot be charged for their
use. For instance, the users of flyover over the railway line can be identified, but it may be
inconvenient to the taxing authority to collect the road tax and for the road users to pay the
tax due for the time involved. The best course is to finance the flyover out of general taxation.
1. In the case of such services where little waste will occur if they are provided free.
2. Where charging a price will restrict the use of the service.
3. Where the cost of collecting taxes is high.
4. Where the pattern of distribution of tax burden on service is inequitable.
These rules are applicable to a few essential public services like education, sewage,
roads etc. But in the case of services other than those included under “pure public goods,”
free services might lead to wastage of resources.
The compulsory cost of service principle whereby the government should charge a
price for the service provided to the people. This is essential for the reason that municipal
services such as sewage, Sweeping Street, street lighting etc are under priced. Every family
of a locality may be asked to pay for them. But since they are public utilities, they may be
charged nominally and the gap between revenues and costs remains. This is met from general
taxation. This is a sort of government subsidy to the users of such services.
Nonetheless, Dalton favours the voluntary price principle for public utilities.
According to this principle the consumers of a public service are required to pay the price
fixed by the Public Sector Enterprises (PSE). The PSE may have a monopoly in a particular
service, such as water or power supply and it may fix a price for it. But the services being a
public utility, it may set a price lower than its cost of production so that the welfare of the
community is not adversely affected.
7. Explain general consideration if pricing. (APRIL 2017)
(i) Competitive Situation:
Pricing policy is to be set in the light of competitive situation in the market. We have to know
whether the firm is facing perfect competition or imperfect competition. In perfect
competition, the producers have no control over the price. Pricing policy has special signifi-
cance only under imperfect competition.
(ii) Goal of Profit and Sales:
The businessmen use the pricing device for the purpose of maximising profits. They should
also stimulate profitable combination sales. In any case, the sales should bring more profit to
the firm.
(iii) Long Range Welfare of the Firm:
Generally, businessmen are reluctant to charge a high price for the product because this might
result in bringing more producers into the industry. In real life, firms want to prevent the
entry of rivals. Pricing should take care of the long run welfare of the company.
(iv) Flexibility:
Pricing policies should be flexible enough to meet changes in economic conditions of various
customer industries. If a firm is selling its product in a highly competitive market, it will have
little scope for pricing discretion. Prices should also be flexible to take care of cyclical
variations.
(v) Government Policy:
The government may prevent the firms in forming combinations to set a high price. Often the
government prefers to control the prices of essential commodities with a view to prevent the
exploitation of the consumers. The entry of the government into the pricing process tends to
inject politics into price fixation.
(vi) Overall Goals of Business:
Pricing is not an end in itself but a means to an end. The fundamental guides to pricing,
therefore, are the firms overall goals. The broadest of them is survival. On a more specific
level, objectives relate to rate of growth, market share, maintenance of control and finally
profit. The various objectives may not always be compatible. A pricing policy should never
be established without consideration as to its impact on the other policies and practices.
(vii) Price Sensitivity:
The various factors which may generate insensitivity to price changes are variability in
consumer behaviour, variation in the effectiveness of marketing effort, nature of the product.
Importance of service after sales, etc. Businessmen often tend to exaggerate the importance
of price sensitivity and ignore many identifiable factors which tend to minimise it.
(viii) Routinisation of Pricing:
A firm may have to take many pricing decisions. If the data on demand and cost are highly
conjectural, the firm has to rely on some mechanical formula. If a firm is selling its product in
a highly competitive market, it will have little scope for price discretion. This will have the
way for routinised pricing.

8. Classify geographical price differentials. (NOV 2014)

1.( Free on Board ) F.O.B. Factory Pricing:
It implies that the buyer pays all the freight and is responsible for the risks occurring
during transport except those that are assumed by the carriers.
Its possible advantages are:
(i) it assures a uniform net price on all shipments regardless of where they go;
(ii) No risk is assumed by the seller; and
(iii) The seller is not responsible for delay in carriage.
2. Postage stamp pricing:
Postage stamp pricing means charging the same delivered price for all destinations
irrespective of buyer’s location. The quoted price naturally includes the estimated average
transport costs. In effect, these prices become discriminatory, in as much as the short-
distance buyers have to pay more for transport than the actual costs involved while long-
distance buyers have to pay less than the actual costs of transporting goods to them.
Postage stamp pricing is most commonly employed for goods of popular brands and having
nation-wide distribution. The basic idea is to maintain a uniform retail price at all places. This
common retail price can also be advertised throughout the country. Bata footwear’s provide
the best example of postage stamp pricing. Other examples are Usha Machines and fans,
radios. Prestige cookers, typewriters, drugs and medicines, newspapers and magazines, etc.

Postage stamp pricing is most suitable in the case of products where transport costs
are significant. It can also be used with advantage by a manufacturer to avoid the
disadvantage of location being far away from the main customers who if charged on the basis
of actual costs might have to pay much more and hence refrain from purchasing. This
advantage is particularly striking in the case of products involving high transport costs. This
pricing gives a manufacturer access to all markets regardless of his location. Market access is
particularly important when products of the rivals are substantially the same.
3. Zone pricing:
Under zone pricing, the seller divides the country into zones and regions and charges
the same delivered price within each zone, but different prices between different zones.
Generally speaking, zone pricing is preferred where the transport cost on goods is too high to
permit their sale throughout the country at a uniform price.
The more significant the transport costs, the greater the number of zones and smaller their
size. Conversely, for products involving lower transport costs, zones are generally few but big
in sizes. In India, zone pricing has been widely used in vanaspati and sugar industries.
4. Basing point pricing:
 A basing point price consists of a factory price plus a transportation charge calculated
with reference to a particular basing point. Under this system, the delivered price may be
computed by using either single basing point or multiple basing points.

Under the single basing point system, all sellers (irrespective of their locations) quote
delivered prices which are the sum of:
(i) The basing point price, and
(ii) Cost of transport from the basing point to the particular point of delivery. Thus the
delivered prices quoted by all sellers for a given point of delivery are uniform regardless of
the point from which delivery is made.
Under the multiple point pricing system, two more producing centers are selected as basing
points, and the seller then quotes a delivered price equal to the factory price plus
transportation costs from the basing point nearest to the buyer.
Basing point pricing has been widely used in the U.S.A. specially in the steel industry where
at first the single basing point system known as Pittsburgh plus was employed. It was
followed by multiple basing point pricing when Pittsburgh plus was declared illegal.

9. What is the significance of pricing? (NOV 15)

1. The planned Market Position for the Service Product:
Market position means the place the service product is intended to take up and does
take up in the customer’s eyes and in comparison with competitors. It refers to the customer’s
perceptual positioning of the service product: in other words how the service product is ‘seen’
in relation to others available.
Clearly price is an important element in the marketing mix influencing this position.
Tangible products may occupy a particular position by virtue of their physical characteristics
(e.g. a grade of industrial steel tubing). Services, on the other hand, are more often
‘positioned’ on the basis of their intangible attributes.
2. The Stages of the life – Cycle of the Service Product:
The price of the service product will also relate to its life – Cycle. For example in
introducing a new service an organization could opt to set low prices to penetrate markets and
gain rapid market share. Alternatively an organization could opt to charge high prices to make
as much profit as possible in a short time (skimming policy). This strategy is only possible if
there is no immediate competition and a high level of buyer need urgency (e.g. windscreen
replacement services).
3. Elasticity of Demand:
The discretion a service organization has to determine its pricing objectives will be
influenced by elasticity of demand in the market. Elasticity of demand refers to the
responsiveness of demand to changes in price. In some markets demand is much influenced
by price changes (e.g. urban bus services) in others this is less so.
Clearly it is vital for a service organization to understand how elastic or inelastic
demand for its services is in response to price change. For example, if a service company
reduces its prices and demand is elastic then the effect would be to reduce margins with no
compensating increase in demand. Elasticity may impose limitations on certain price options.
4. The Competitive Situation:
The strength of competition in the market influences a service organization’s
discretion over its prices. In situations where there is little differentiation between service
products and where competition is intense (e.g. a seaside resorts during a poor tourist season)
then price discretion is limited. Competition of course has number of dimensions apart from
inter-brand or inter-type competition.
 In transport services, for example, there is competition between different modes of
transport (e.g. rail versus road), different brands, as well as alternative uses of the potential
customers’ time and money (e.g. not to travel at all).
Nevertheless a degree of price uniformity will be established in those markets with
little differentiation between service products and strong levels of competition. In other
settings tradition and custom may influence prices charged (e.g. Advertising agencies
commission system).
5. The Strategic Role of Price:
Pricing policies have a strategic role aimed at achieving organizational objectives.
Thus the pricing decision on any particular service product should fit in with strategic
objectives. For example, new holiday company intent upon establishing itself in the package
holiday market might use a deliberate policy of low prices to obtain substantial market share
although this could mean unprofitable trading for some time.
Maximum sales would be won through penetration pricing as a deliberate policy. Any pricing
strategy must of course fit in with the way in which other elements of the marketing mix are
manipulated to attain strategic ends.
6. Price as an Indicator of Service Quality:
One of the intriguing aspects of pricing is that buyers are likely to use price as an
indicator of both service costs and service quality – price is at once an attraction variable and
a repellent. Customers’ use of price as an indicator of quality depends on several factors, one
of which is the other information available to them.
When service cues to quality are readily accessible, when brand names provide
evidence of a company’s reputation, or when level of advertising communicates the
company’s belief in the brand, customers may prefer to use those cues instead of price.
In other situations, however, such as when quality is hard to detect or when quality or price
varies a great deal within a class of services, consumers may believe that price is the best
indicator of quality many of these conditions typify situations that face consumers when
purchasing services.
Another factor that increases the dependence on price as a quality indicator is the risk
associated with the service purchase. In high-risk situations, many of which involve credence
services such as medical treatment or management consulting, the customer will look to price
as a surrogate for quality.
Because customers depend on price as a cue to quality and because price sets
expectations of quality, service prices must be determined carefully. In addition to being
chosen to cover costs or match competitors, prices must be chosen to convey the appropriate
quality signal. Pricing too low can lead to inaccurate inferences about the quality of the
service. Pricing too high can set expectations that may be difficult to match in service
delivery.
Because goods are dominated by search properties, price is not used to judge quality
as often as it is in services, where experience and credence properties dominate. Thus,
services marketer must be aware of the signals that price conveys about its offerings.

10. Explain the price determination process. (NOV 15).

(i) Market Segmentation:
In market segments, marketers will have firm decisions on:
(a) The type of products to be produced or sold.
(b) The kind of service to be rendered.
(c) The costs of operations to be estimated.
(d) The types of customers or market segments sought.
(ii) Estimate Demand:
 Marketers will estimate total demand for the product based on sales forecast, channel
opinions and degree of competition in the market. Prices of comparable rival products can
guide us in pricing our products. We can determine market potential by trying different prices
in different markets.
(iii) The Market Share:
Marketers will choose a brand image and the desired market share on the basis of
competitive reaction. Market planners must know exactly what his rivals are charging. Level
of competitive pricing enables the firm to price above, below or at par and such a decision is
easier in many cases.
Higher initial price may be preferred, in case of smaller market share is anticipated,
whereas, in the expectation of a much larger market share for the brand, marketer will have to
prefer relatively lower price. Proper pricing strategy is evolved to reach the expected market
share either through skimming price or through penetration price or through a compromise,
i.e., fair trading or fair price- to cover cost of goods, operating expenses and normal profit
margin.
(iv) The Marketing Mix:
The overall marketing strategy is based on an integrated approach to all the elements
of marketing mix.
It covers:
(a) Product-market strategy
(b) Promotion strategy
(c) Pricing Strategy
(d) Distribution Strategy
Marketers will have to assign an appropriate role to price as an element of marketing-
mix. Promotional strategy will affect pricing decisions.
The design of marketing mix can indicate the role to be played by pricing in relation
to promotion and distribution policies. Price is critical strategic element of the marketing mix
as it influences the quality perception and enables product or brand positioning. Price is also a
good tactical variable. Changes in price can be made much faster than in any other variable of
marketing mix. Hence, price has a good tactical value.
(v) Estimate of Costs:
Straight, cost-plus pricing is not desirable always as it is not sensitive to demand. Marketing
must take into account all relevant costs as well as price elasticity of demand.
(vi) Pricing Policies:
Pricing policies are guidelines to carry out pricing strategy. Pricing policy may be fixed or
flexible. Pricing policies must change and adopt themselves with the changing objectives and
changing environment.
(vii) Pricing Strategies:
Strategy is a plan of action to adjust with changing condition of the– market place. New and
unanticipated developments such as price cut by rivals, government regulations, economic
recession, changes in consumer demand etc. may take place, and then changes all for special
attention and relevant adjustments in the pricing policies and producers.
(viii) The Price Structure:
Developing the price structure on the basis of pricing policies and strategies is the final step
in price determination prices. The price structure will now define the selling prices for all
products and permissible discounts and allowances to be given to distributor’s co-dealers as
well as various types of buyers.

11. Explain the problems in pricing a new product. (NOV 16)

Pricing Over the Life Cycle of the Product:
Every product has its own life cycle and its sales and profitability change over time.
The product life cycle hypothesis was developed in an attempt to recognize formally distinct
stages in the sales history of representative products.
As the product passes through each of these stages, the strategies and problems of
pricing must be varied accordingly. Figure 19.6 illustrates the most common type of product
life cycle pattern, shown as the S-shaped sales curve. There are four phases of a product’s life
cycle: introduction, growth, maturity and decline. Sales and profit patterns vary during these
stages.

The introducing (or launching) phase is characterized by relatively low levels of sales,
slow rate of growth of sales, and negative or minimal profits. The second growth phase is
characterized by two features — rapid acceleration in sales and considerable improvements in
product profitability.
The third (or maturity phase) involves a slowing down of the sales growth and a
stabilization of profits. The final (or decline) phase is the period during which sales start
falling and profits once again start declining. It is to be noted that there is no clear-cut rule as
to where each of the stages begins or ends, and the exact demarcation of these stages has to
be subjectively determined.
Another important qualification to the model is that all products do not necessarily
exhibit the typical S-shaped product life-cycle as shown in Figure 19.6. Some products (such
as electronic watches or pocket calculators) show quite rapid growth only in their early life;
thereby they move past (or skip) the introductory phase. For other products, there is undue
prolongation of the introductory phase.
Moreover, some products actually pass through several different life-cycles. By stu-
dying 754 drug manufacturers, William E. Cox, Jr., has discovered six different life-cycle
patterns, with the most common pattern being the ‘cycle- recycle’ pattern shown in panel (a)
of Figure
This typical cycle-recycle pattern is justified by the traditional promotion and price
push that is given to many products as they approach the declining phase of their life cycle.
Cox has also noted another common life cycle pattern as in panel (b) in Figure 19.7. The
proximate cause of the scalloped pattern seems to be the implementation of new strategies
with regard to market penetration and development.
Against this backdrop, we may now describe the characteristics and response of the
product life cycle and place price in the context of being one of the several variables that
fluctuate over the life cycle. (See Table 19.2.) As a product passes through each stage, there is
a corresponding change in the applicable pricing decisions.
In the product launching (introductory) phase, the manager in charge of pricing has to
decide whether to adopt a market penetration or a price skimming strategy and, in the growth
phase, management can probably be more aggressive in pricing to improve profits.

However, as a general rule, the maturity and decline stages are characterised by
vigorous competition. Moreover, pricing decisions can lead to the cycle-recycle pattern noted
in Figure 19.6. Thus, the point that emerges from our discussion so far is that pricing
responses required of management vary according to the stage in the product life cycle and
are related to diverse marketing and production decisions.
In his study of 43 products in 7 different markets, Herman Simon identified important
relationships between the price elasticity of demand and product life-cycles. These elasticity
estimates are listed in table 19.3 above. The diverse elasticities give a clear indication that the
pricing strategy has to differ over the entire life cycle of the product.
 The pricing implication of the elasticity values is that there should be low mark-up
during the early phases since demand seems to be more price elastic in these phases. By
contrast, high mark-up may be added to costs in arriving at a price during the maturity and
decline phases when demand appears to be fairly inelastic.
Dean has analysed the problem of choice between a skimming price in case of new
products and a penetration price in case of mature products. In choosing between these two
alternatives, the producers should consider several major factors.
The Rate of Market Growth:
This itself is often influenced by pricing policies. In practice, some products are
inherently less likely to gain rapid market than others. These products are, therefore,
unsuitable for a penetration price policy, involving initially low, and perhaps even negative,
margins.
The Erosion of Distinctiveness:
The second factor is the likely rate of erosion of the distinctiveness of the pioneer
product. This will, in turn, depend upon the number of competitive products entering the
market and the extent to which they can reproduce the characteristics of pioneer products.
The possible lead time enjoyed by the initial producer may be obtained from an analysis of
his strengths and weakness vis-a-vis potential competitors’, in terms of technical know-how
(which may be supported by patents), access to channels of distribution, and the financial
strength of potential rivals.
If the lead time is very long, then a skimming price would be appropriate. But if the
lead time is short, a penetration price might be required “to build up as wide a market as
possible before the onset of the competitive onslaught, especially in those markets, such
as grocery products, where distributors may refuse to handle more than a proportion of
the competing brands. Again if it is felt that the product is one for which considerable
brand loyalty may be built up, a penetration-price strategy would be suggested.”
On the contrary, a skimming price may be more appropriate where buyers are more
concerned about the characteristics of the product, including its price, than with the supplier.
Manufacturers of woolen cloth often complain that they are unable to sustain for a long time
the initial price of a new design of cloth because buyers quickly switch over to new, low cost
source of supply.
The above analysis is based on the assumption that the producer is concerned with
making choice which will yield the highest profits over the foreseeable life of the product.
However, other’ objectives such as increased sales or market share will surely encourage a
penetration policy.
There is also an off-setting consideration: the firm may be interested in improving its
liquidity position in the short-term, and may be unwilling to wait for the longer term rewards
accruing from a penetration policy.
 Finally, “although a pioneer product will not normally compete very strongly with
existing products, some substitution may occur, and if this substitution is likely to encompass
the producer’s existing products, a penetration price will again be less appropriate.”
The Significance of Cost:
The third major factor is the cost structure of the producers. A reduction in average
cost is likely if there is learning effect. In Figure 19.8, AC 1 shows the unit cost of producing
various quantity of a product within a period, say a day.
Average cost is lower with average output of OM than ON per day, due to scale effect.
If we measure cost in a subsequent period, say, after one year, a reduction in real costs (i.e.,
after allowing for changes in input prices) may be expected.
The extent of this reduction would be influenced by the volume of production within the one-
year period. A daily output of ON would be reflected in the cost curve AC 2 and a daily output
of OM would give rise to a cost curve AC 3. This shows the operation of the learning effect. In
general “the greater the scale factor and the learning effect, the more appropriate will a
penetration policy be.”

Post-Skimming Strategies:
Choice of a skimming price is not enough. Subsequent decisions will have to be made about
the timing and size of future reductions from the initial price. In some instances, the
producer’s hand may be tied by the actions of competitors. In other instances, however,
producers may have more discretion.
If it is felt that the ‘top’ of the market has become saturated (i.e., the limited number of
customers who are willing to pay a high price have had the opportunity to buy) it becomes
appropriate to lower the price in order to attract new customers.
Another factor worth consideration is the extent to which the product has gained an image of
exclusivity or prestige. A substantial price reduction may lead to loss of prestige. A series of
small price reductions would be more appropriate.
Mixed Strategies:
Many firms do adopt a strategy which falls between the two extremes of the
skimming and penetration prices. This policy is followed by many large companies in case of
many new products. For example, Du Pont followed a mixed strategy for both nylon and
cellophane.
However, cellophane was nearer the penetration end of the spectrum, apparently
because the cost elasticity of volume of output and the price elasticity of growing demand
were sufficiently high to permit a more rapid rate of expansion than was possible in nylon.
Again, “in the pricing of a major piece of farm machinery such as the cotton picker
(manufactured by International Harvester) the decision settled on was a middle ground
 between the estimated maximum economic value as a replacement for hand labour, and a
sufficiently low price to give assurance of widespread adoption.”
An alternative approach is to use the customer’s estimated savings in operating costs as a
guide to price. This is a special characteristic of industrial goods pricing.
Pricing in Maturity:
Maturity is generally defined in terms of the product’s rate of sales. It is the stage
between the growth period, when sales increases rapidly and the period of decline, when sales
falls sharply. The concept of product life cycle is useful for multi-product firms.
It prevents complacency on the part of firms who have introduced successful products,
alerting them to the need to have additional products ready for launching when sales of their
existing products begin to fall.
Joel Dean appears to be very unsure about the implications for pricing policy. On the
one hand, he suggests that the “first step for the manufacturer whose specialty is about to slip
into the commodity category is to reduce real price as soon as symptoms of deterioration
appear.”
On the other hand, he declares that “this does not mean that the manufacturer should
not declare open price-war in the industry. When he moves into mature competitive stages, he
enters oligopoly relationships where price slashing is peculiarly dangerous and unpopular.
With active competition in prices precluded, competitive efforts move in other directions,
particularly toward product improvement and market segmentation.”
Another deficiency of the product-life-cycle concept is that “it implies that a decline
stage will inevitably succeed maturity, whereas in some markets maturity may be prolonged
for many years by a series of product innovation. In other markets, maturity may be
prolonged because the product fulfils a basic need for which no close substitute exists, for
example, in the case of some minerals and agricultural products”.
Again, it is necessary to take cost conditions into account. If cost continues to fall
with an expansion of output due to the learning effect there will be a pressure for price
reduction, even though the market elasticity of demand may now be low.
Finally, “where there are significant cost differentials, but little scope for cost
reductions, a price reduction implies increased pressure on the margins of the high-cost
producers who may thereby be forced out of the market. Conversely, if the low cost firm
prefers to adopt a live-and-let-live policy it will maintain its prices, perhaps utilizing the
higher short-run profits thus generated for investment in product differentiation activities”.
Pricing Products in Decline:
An analysis similar to the above one can be applied to products whose sales have
begun to decline.

UNIT IV PART - C
1. "Whatever price monopolist fixes and whatever output he decides to produce are determined by
the conditions of demand". Explain. (APRIL 2012)
1.Changing prices of a substitute good
Substitutes are goods in competitive demand and act as replacements for another product
A rise in price of the Apple iPhone will cause a rise in demand for Samsung phones
Higher electricity prices may encourage use alternative sources of energy
Air travel and train services – cheaper flights between London and Glasgow might cause a fall in
demand for rail services between the two cities
 2.Changing price of a complement
Two complements are in joint demand – e.g. DVD players and DVDs, iron ore and steel. A rise in the
price of a complement to Good X should cause a fall in demand for X. An increase in the cost of
flights from London Heathrow to New York would cause a decrease in the demand for hotel rooms in
New York and also a fall in the demand for taxi services both in London and New York. A fall in the
price of a complement to Good Y should cause an increase in demand for Good Y. For example a
reduction in the price of the new iPhone should lead to an expansion in demand for the iPhone and a
complementary increase in demand for download applications.

2. Discuss the general considerations of pricing. (APRIL 2012)

Considerations Involved in Formulating the Pricing Policy:

The following considerations involve in formulating the pricing policy:
(i) Competitive Situation:
Pricing policy is to be set in the light of competitive situation in the market. We have to know whether
the firm is facing perfect competition or imperfect competition. In perfect competition, the producers
have no control over the price. Pricing policy has special significance only under imperfect
competition.
(ii) Goal of Profit and Sales:
The businessmen use the pricing device for the purpose of maximising profits. They should also
stimulate profitable combination sales. In any case, the sales should bring more profit to the firm.
(iii) Long Range Welfare of the Firm:
Generally, businessmen are reluctant to charge a high price for the product because this might result in
bringing more producers into the industry. In real life, firms want to prevent the entry of rivals.
Pricing should take care of the long run welfare of the company.
(iv) Flexibility:
 Pricing policies should be flexible enough to meet changes in economic conditions of various
customer industries. If a firm is selling its product in a highly competitive market, it will have little
scope for pricing discretion. Prices should also be flexible to take care of cyclical variations.
(v) Government Policy:
The government may prevent the firms in forming combinations to set a high price. Often the
government prefers to control the prices of essential commodities with a view to prevent the
exploitation of the consumers. The entry of the government into the pricing process tends to inject
politics into price fixation.
(vi) Overall Goals of Business:
Pricing is not an end in itself but a means to an end. The fundamental guides to pricing, therefore, are
the firms overall goals. The broadest of them is survival. On a more specific level, objectives relate to
rate of growth, market share, maintenance of control and finally profit. The various objectives may
not always be compatible. A pricing policy should never be established without consideration as to its
impact on the other policies and practices.
(vii) Price Sensitivity:
The various factors which may generate insensitivity to price changes are variability in consumer
behaviour, variation in the effectiveness of marketing effort, nature of the product. Importance of
service after sales, etc. Businessmen often tend to exaggerate the importance of price sensitivity and
ignore many identifiable factors which tend to minimise it.
(viii) Routinisation of Pricing:
A firm may have to take many pricing decisions. If the data on demand and cost are highly
conjectural, the firm has to rely on some mechanical formula. If a firm is selling its product in a
highly competitive market, it will have little scope for price discretion. This will have the way for
routinised pricing.

3. Enumerate the objectives of pricing policies. (APRIL 2014)

The pricing policy of the firm may vary from firm to firm depending on its objective. In practice,
we find many prices for a product of a firm such as wholesale price, retail price, published price,
quoted price, actual price and so on. Special discounts, special offers, methods of payment,
amounts bought and transportation charges, trade-in values, etc., are some sources of variations
in the price of the product.
For pricing decision, one has to define the price of the product very carefully. Pricing decision of
a firm in general will have considerable repercussions on its marketing strategies. This implies
that when the firm makes a decision about the price, it has to consider its entire marketing efforts.
Pricing decisions are usually considered a part of the general strategy for achieving a broadly
defined goal.
While setting the price, the firm may aim at the following objectives:
(i) Price-Profit Satisfaction:
The firms are interested in keeping their prices stable within certain period of time irrespective of
changes in demand and costs, so that they may get the expected profit.
(ii) Sales Maximisation and Growth:
A firm has to set a price which assures maximum sales of the product. Firms set a price which
would enhance the sale of the entire product line. It is only then, it can achieve growth.
(iii) Making Money:
Some firms want to use their special position in the industry by selling product at a premium and
make quick profit as much as possible.
(iv) Preventing Competition:
Unrestricted competition and lack of planning can result in wasteful duplication of resources. The
price system in a competitive economy might not reflect society’s real needs. By adopting a
suitable price policy the firm can restrict the entry of rivals.
(v) Market Share:
The firm wants to secure a large share in the market by following a suitable price policy. It wants
to acquire a dominating leadership position in the market. Many managers believe that revenue
maximisation will lead to long run profit maximisation and market share growth.
(vi) Survival:
In these days of severe competition and business uncertainties, the firm must set a price which
would safeguard the welfare of the firm. A firm is always in its survival stage. For the sake of its
continued existence, it must tolerate all kinds of obstacles and challenges from the rivals.
(vii) Market Penetration:
Some companies want to maximise unit sales. They believe that a higher sales volume will lead
to lower unit costs and higher long run profit. They set the lowest price, assuming the market is
price sensitive. This is called market penetration pricing.
(viii) Marketing Skimming:
Many companies favour setting high prices to ‘skim’ the market. DuPont is a prime practitioner
of market skimming pricing. With each innovation, it estimates the highest price it can charge
given the comparative benefits of its new product versus the available substitutes.
(ix) Early Cash Recovery:
Some firms set a price which will create a mad rush for the product and recover cash early. They
may also set a low price as a caution against uncertainty of the future.
(x) Satisfactory Rate of Return:
Many companies try to set the price that will maximise current profits. To estimate the demand
and costs associated with alternative prices, they choose the price that produces maximum
current profit, cash flow or rate of return on investment.

4. Explain the various price leadership models in detail. (APRIL 2014)

The most common types of leadership are:
(a) Price leadership by a low-cost firm.
(b) Price leadership by a large (dominant) firm.
(c) Barometric price leadership.
These are the form of price leadership examined by the traditional theory of leadership as developed
by Fellner and others. The characteristic of the traditional price leader is that he sets his price on
marginalistic rules, that is, at the level defined by the intersection of his MC and MR curves. For the
leader the behavioural rule is MC = MR. The other firms are price-takers who will not normally
maximise their profit by adopting the price of the leader. If they do, it will be by accident rather than
by their own independent decision.

A. The Model of the Low-cost Price Leader:

We will illustrate this model with an example of duopoly. It is assumed that there are two firms which
produce a homogeneous product at different costs, which clearly must be sold at the same price. The
firms may have equal markets (or they may come to an agreement to share the market equally) as in
figure 10.7, or they may have unequal markets (or agree to share the market with unequal shares), as
in figure 10.8. The important condition for this model is that the firms have unequal costs.
The firm with the lowest cost will charge a lower price (P A) and this price will be followed by the
high-cost firm, although at this price firm B (the follower) does not maximize its profits. The follower
would obtain a higher profit by producing a lower output (X Be) and selling it at a higher price (P B).
However, it prefers to follow the leader, sacrificing some of its profits in order to avoid a price war,
which would eliminate it if price fell sufficiently low as not to cover its LAC. It should be stressed
that for the leader to maximize his profit price must be retained at the level P A and he should sell XA.
This implies that the follower must supply a quantity (0X B in figure 10.8, or OX1 = OX2 in figure
10.7) sufficient to maintain the price set by the leader.
Although the price- leadership model stresses the fact that the leader sets the price and the follower
adopts it, it is clear that the firms must also enter a share-of-the-market agreement, formally or
informally, otherwise the follower could adopt the price of the leader but produce a lower quantity
than the level required to maintain the price (set by the leader) in the market, and thus push
(indirectly, by not producing enough output) the leader to a non-profit-maximising position.
In this respect the price follower is not completely passive he may be coerced to adopt the leader’s
price, but, unless tied by a quota-share agreement (formal or informal) he can push the leader to a
non-maximising position.
B. The model of the Dominant-firm Price Leader:
In this model it is assumed that there is a large dominant firm which has a considerable share of the
total market, and some smaller firms, each of them having a small market share. The market demand
(DD in figure 10.9) is assumed known to the dominant firm.

It is also assumed that the dominant leader knows the MC curves of the smaller firms, which he can
add horizontally and find the total supply by the small firms at each price; or at best that he has a fair
estimate, from past experience, of the likely total output from this source at various prices. With this
knowledge the leader can obtain his own demand curve as follows.
At each price the larger firm will be able to supply the section of the total market not supplied by the
smaller firms. That is, at each price the demand for the product of the leader will be the difference
between total D (at that price) and the total S 1. For example, at price P 1 the demand for the product of
the leader will be zero, because the total quantity demanded (D 1) is supplied by the smaller firms.
As price falls below P1 the demand for the leader’s product increases. At P 2 the total demand is D2; the
part P2 A is supplied by the small firms and the remaining AD 2 is supplied by the leader. At P 3 total
demand is D3 and the total quantity is supplied by the leader since at that price the small firms do not
supply any quantity. Below P3 the market demand coincides with the leader’s demand curve.
Having derived his demand curve (d L in figure 10.10) and given his MC curve, the dominant firm will
set the price P at which his MR = MC and his output is 0x. At price P the total market demand is PC,
and the part PB is supplied by the small firms followers while quantity BC = 0x is supplied by the
leader.

The dominant firm leader maximises his profit by equating his MC to his MR, while the smaller firms
are price-takers, and may or may not maximise their profit, depending on their cost structure. It is
assumed that the small firms cannot sell more (at each price) than the quantity denoted by S 1.
 However, if the leader is to maximise his profit, he must make sure that the small firms will not only
follow his price, but that they will also produce the right quantity (PB, at price P). Thus, if there is no
tight sharing-the- market agreement, the small firms may produce less output than PB and thus force
the leader to a non-maximising position.
C. Barometric Price Leadership:
In this model it is formally or informally agreed that all firms will follow (exactly or approximately)
the changes of the price of a firm which is considered to have a good knowledge of the prevailing
conditions in the market and can forecast better than the others the future developments in the market.
In short, the firm chosen as the leader is considered as a barometer, reflecting the changes in
economic environment.
The barometric firm may be neither a low-cost nor a large firm. Usually it is a firm which from past
behaviour has established the reputation of a good forecaster of economic changes. A firm belonging
to another industry may also be chosen as the barometric leader. For example, a firm in the steel
industry may be agreed as the (barometric) leader for price changes in the motor-car industry.
Barometric price leadership may be established for various reasons.
Firstly, rivalry between several large firms in an industry may make it impossible to accept one among
them as the leader. Secondly, followers avoid the continuous recalculation of costs, as economic
conditions change. Thirdly, the barometric firm usually has proved itself as a ‘reasonably’ good
forecaster of changes in cost and demand conditions in the particular industry and the economy as a
whole, and by following it the other firms can be ‘reasonably’ sure that they choose the correct price
policy.

5. “ profit maximisation is the primary objective of the firm” - discuss(ARIL 2017)

Profit Maximisation:
In the conventional theory of the firm, the principal objective of a business firm is profit
maximisation. Under the assumptions of given tastes and technology, price and output of a given
product under perfect competition are determined with the sole objective of maximising profits. The
firm is supposed to act as one of a large number of producers which cannot influence the market price
of the product.
It is the price-taker and quantity-adjuster. Thus the demand and cost conditions for the product of the
firm are determined by factors external to the firm. In this theory, maximum profits refer to pure
profits which are a surplus above the average cost of production. It is the amount left with the
entrepreneur after he has made payments to all factors of production, including his wages of
management.
In other words, it is a residual income over and above his normal profits. It is a necessary payment for
an entrepreneur to stay in the business. The rules for profit maximisation are (1) MC = MR and (2)
MC should cut MR from below.

6. Discuss the different types of price discrimination. (NOV 2012) (NOV 2016)
Price Discrimination Form # 1. First-Degree Price Discrimination:
A firm would wish to charge a different price to different customers.
If it could, it would charge each customer the maximum price that the customer is willing to pay,
which is known as reservation price. The practice of charging each customer his reservation price is
called first-degree price discrimination.
Let us see how it affects the firm’s profit.
We know the profit the firm earns when it charges the single price P* in Fig. 9.8. To find out, we can
add the profit on each incremental unit produced and sold, up to the quantity Q*. This incremental
profit is the MR less MC for each unit. In Fig. 9.8, this MR is highest and MC lowest for the first unit.
For each additional unit, MR falls and MC rises, so, the firm produces the total output Q*, where MR
= MC. Total profit is simply the sum of the profits each incremental unit produced, and it is given by
the area in Fig. 9.8 between the MR and MC curves. Consumer’s surplus, which is the area between
the AR curve and the price P* that consumers pay, is shown by a triangle.
What happens if the firm can perfectly discriminate price? Since each consumer is charged exactly
what he is willing to pay, the MR curve is no longer relevant to the firm’s output decision. In fact, the
incremental revenue earned from each additional unit sold is simply the price paid for that unit, and is,
thus, given by the demand curve.
Since price discrimination does not affect the firm’s cost structure, the cost of additional unit is given
by the firm’s MC curve. Thus, the profit from producing and selling each incremental unit is the
difference between demand and MC. The firm charges each consumer his reservation price, so it is
profitable to expand output to Q**.
When a single price P* is charged, the firm’s variable profit is the area between the MR and MC
curves. With perfect price discrimination, this profit expands to the area between the demand curve
and MC curve. From Fig. 9.8 we can see that total profit is now much larger. Since every customer is
being charged the maximum amount he is willing to pay, all consumer’s surplus has been captured by
the firm.
In practice, perfect first-degree price discrimination is impossible. First, it is not practical to charge
each customer a different price. Second, a firm does not know the reservation price of each customer.
Even if the firm could ask each customer how much he would be willing to pay, it would not receive
honest answers. After all, it is in the customers’ interest not to give the correct answer!
Sometimes, it can discriminate by charging a few different prices based on estimates of customers’
reservation prices. This often happens when professionals — such as doctors, lawyers, accountants,
etc., who know their clients reasonably well — are the firms.
Then, it may be possible to assess the client’s willingness and ability to pay and charge fees
accordingly. For example, a doctor may charge a reduced fee to a low-income patient whose ability
cum willingness to pay is low, but charge higher fees to upper income patients.
Fig. 9.9 shows this kind of imperfect first- degree price discrimination. If only a single price were
charged, it would be P*. Instead, six different prices are charged, the lowest of which, P 5, is just the
point where MC intersects the demand curve.
Those customers who would not have been willing to pay a price of P* or greater, are better- off in
this situation — they are now enjoying at least some consumer’s surplus. If price discrimination
brings enough new customers into the market, consumer welfare can increase, and both consumers
and producers are better-off.
Price Discrimination Form # 2. Second-Degree Price Discrimination:
In some markets, each consumer purchases many units of the good over a given period, and
consumer’s demand declines with the number of units purchased. For example, water, gas and
electricity. Consumers may each purchase a few hundred kilowatt-hours of electricity a month, but
their willingness to pay declines with increased consumption.
In this case, a firm can discriminate according to the quantity consumed. This is called second-degree
price discrimination, and it operates by charging different prices for different quantities or ‘blocks’ of
the same good.
Different prices are charged for different quantities, or “blocks” of the same good. In Fig. 9.10, there
are three blocks, with corresponding prices P 1, P2, P3. There are also economies of scale, and AC and
MC are declining. Second- degree price discrimination can then make consumers better-off by
expanding output and lowering cost.
Fig. 9.10 also shows that if a single price were charged, it would be P 0, and the quantity produced
would be Q0, Instead, three different prices are charged, based on the quantities purchased. The blocks
are sold at P1, P2 and P3.

Price Discrimination Form # 3. Third-Degree Price Discrimination (P. D.):

A liquor company is practising third-degree price discrimination, and it does so because the practice is
profitable. This form of price discrimination divides consumers into two or more groups with separate
demand curve for each group.
This is most prevalent form of price discrimination. In each case, some characteristic is used to divide
consumers into distinct. groups. For example, for many goods, students and senior citizens are
normally willing to pay less on average than the rest of the population and identity can be readily
established.
If third-degree price discrimination is feasible, how should the firm decide what price to charge each
group? Let us think about this in two steps. First, we know that total output should be divided between
the groups of customers, so that the MRs for all groups are equal.
Otherwise, the firm would not be maximising profit. For example, if there are two groups of
customers and the MR for the first group, MR 1, exceeds the MR for the second group, MR 2, the firm
could do better by shifting output from the second group to the first.
It would do this by lowering the price to the first group and raising the price to the second group. So
whatever the two prices are, they must be such that the MR s for the different groups are equal.
Second, we know that total output must be such that the MR for each group of consumers is equal to
the MC of production (MR = MC). If this was not the case, the firm could increase its profit by raising
or lowering total output. For example, suppose the MRs were the same for each group of consumers,
but MR > MC of production.
The firm could increase its profit by expanding the output. It would lower its prices to both groups of
customers, so that the MR for each group falls and equals MC.
Algebraically, let us suppose that the price P 1 is charged to the first group of consumers, P 2 the price
charged to the second group, and TC(Q T) the total cost of producing output Q T = Q1 + Q2. Then, total
profit is given by: π = P1Q1 + P2Q2 – TC(QT)
The firm should increase its sales to each group of consumers, Q 1 and Q2, until the incremental profit
from the last unit is zero, as given below.
The incremental sales to group one:
dr/dQ1 = d(P1Q1)/dQ1 – dTC/dQ1 = 0
Here d(P1Q1)/dQ1 is the incremental revenue from an extra unit of sales to the first group (i.e. MR 1).
The next term, dTC/dQ1, is the incremental cost of producing this output, i.e. MC.
Thus, we have MR1 = MC.
Similarly, for the second group, we have: MR2 = MC.
Bringing them together we get: MR1 = MR2 – MC…………. (1)
The relative prices to each group of consumers must be related to their elasticities of demand. We can
write MR in terms of the elasticity of demand: MR = P(1 + 1/E d) and, so, MR1 = P1(1 + 1/E1) and
MR2 = P2(1 + 1/E2), where E1 and E2 are the elasticities of demand in the first and second markets,
respectively.
Now equating MR1 = MR2 we get the following relationship for the price P 1/P2 = (1 + E2)/(1 + E1)
………(2) As we can expect, higher price will be charged to consumers with lower elasticity. If the
elasticity of demand for consumers in group 1 is -2, and the elasticity of demand for consumers in
group 2 is -4, we will have
P1/P2= (11/4)/(1-1/2) = 3/4/1/2= 1.5. In other words, Price charged to the first group of consumers
should be 1.5 times as high as the price charged to the second group.
 Consumers are divided into two groups, with separate demand curves for each group as in Fig. 9.10.
The optimal prices and quantities are such that the MR 1, = MR2 and equal to the MC. Here, group 1,
with demand curve D1 is charged P1, and group 2, with more elastic demand curve D 2, is charged the
lower price P2.
The total quantity QT is produced where MC = MR and profit is maximised. It may be noted here that
Q1 and Q are chosen so that MR1= MR2 = MC.

7. Enumerate the factors influencing pricing policies. (NOV 2013)

Factors affecting pricing policy
Price determination is a very difficult task as it is affected by a number of factors. Therefore, before
deciding the price the marketer has to keep in mind the factors affecting the price. Factors affecting
pricing policy are divided into two parts:
(I) Internal factors
i) Marketing objectives: the marketing objective of the product must be kept in mind before setting
the price of the product, the product is for high class, middle class or lower class.
ii) Marketing mix: one of the key elements of marketing mix is price. Other elements of marketing
mix also affect the pricing decision. So the marketer must keep in mind the marketing mix while
setting the price.
iii) Cost: A company must keep in mind both fixed as well as variable cost while setting the price.
iv) Organizational set up: price of the product is decided by organizational set up. In large scale
organizations the price is decided by the product manager while in the small organization the price is
decided by the top management.
(II)External factors
i) Market and demand: cost of the product is the lower limit of the price. While the market and
demand set the upper limit of the product. So the marketer must keep in mind the relationship
between cost price and market & demand of the product.
ii) Competition: competition affects the pricing decision of the product. The marketer must have
knowledge about the activities of the competitor. For this sometime the companies go for price
leadership, while other goes for low pricing decision to wipe off the competition from the market.
iii) Other environmental factors: the other environmental factors also affect the pricing decisions
like:
a) Economic conditions of the country like inflation, deflation, boom, recession etc. affect the pricing
policy.
b)Consumer thinking about the product.
c) Distribution channel also affects the pricing policy.
d) Government policies also have an effect on the price of the product.
Therefore, all these are the important factors which affect the pricing policy.

8. Elaborate the price determination process. (NOV 2013)

(i) Market Segmentation:
In market segments, marketers will have firm decisions on:
(a) The type of products to be produced or sold.
(b) The kind of service to be rendered.
(c) The costs of operations to be estimated
(d) The types of customers or market segments sought.
(ii) Estimate Demand:
Marketers will estimate total demand for the product based on sales forecast, channel opinions and
degree of competition in the market. Prices of comparable rival products can guide us in pricing our
products. We can determine market potential by trying different prices in different markets.
(iii) The Market Share:
Marketers will choose a brand image and the desired market share on the basis of competitive
reaction. Market planners must know exactly what his rivals are charging. Level of competitive
pricing enables the firm to price above, below or at par and such a decision is easier in many cases.
Higher initial price may be preferred, in case of smaller market share is anticipated, whereas, in the
expectation of a much larger market share for the brand, marketer will have to prefer relatively lower
 price. Proper pricing strategy is evolved to reach the expected market share either through skimming
price or through penetration price or through a compromise, i.e., fair trading or fair price- to cover
cost of goods, operating expenses and normal profit margin.
(iv) The Marketing Mix:
The overall marketing strategy is based on an integrated approach to all the elements of marketing
mix.
It covers:
(a) Product-market strategy
(b) Promotion strategy
(c) Pricing Strategy
(d) Distribution Strategy
Marketers will have to assign an appropriate role to price as an element of marketing- mix.
Promotional strategy will affect pricing decisions.
The design of marketing mix can indicate the role to be played by pricing in relation to promotion and
distribution policies. Price is critical strategic element of the marketing mix as it influences the quality
perception and enables product or brand positioning. Price is also a good tactical variable. Changes in
price can be made much faster than in any other variable of marketing mix. Hence, price has a good
tactical value.
(v) Estimate of Costs:
Straight, cost-plus pricing is not desirable always as it is not sensitive to demand. Marketing must take
into account all relevant costs as well as price elasticity of demand.
(vi) Pricing Policies:
Pricing policies are guidelines to carry out pricing strategy. Pricing policy may be fixed or flexible.
Pricing policies must change and adopt themselves with the changing objectives and changing
environment.
(vii) Pricing Strategies:
Strategy is a plan of action to adjust with changing condition of the – market place. New and
unanticipated developments such as price cut by rivals, government regulations, economic recession,
changes in consumer demand etc. may take place, and then changes all for special attention and
relevant adjustments in the pricing policies and producers.
(viii) The Price Structure:
Developing the price structure on the basis of pricing policies and strategies is the final step in price
determination prices. The price structure will now define the selling prices for all products and
permissible discounts and allowances to be given to distributor’s co-dealers as well as various types of
buyers.

9. Explain the means of determining advertising outlays. (NOV 2014)

. Percentage of sales method.
2. Objective and task method.
3. Competitive parity method.
4. Affordability method.
1. Percentage of sales method:
It is the most widely used method of appropriation though it has declined in its importance. There are
several variations in the actual application of this method. The percentage may be based on last year’s
sales or on the estimated sales for the coming period or the combination of the two.
Under the method, the advertising funds required are equal to rupee sales multiplied by the expected
percentage. For instance, if the estimated sales are rupees 10 million and the expected percentage is 3,
then the funds earmarked will be of the order of rupees 0.30 million.
The merits of this method are:
(a) It is simple.
(b) It works on affordability.
(c) It is consistent.
The demerits are:
(a) Wrong stressing.
(b) Static in approach.
(c) Ignores long-range planning.
2. Objective and task method:
This method is gaining ground because, it directs the attention to the objectives to be attained by the
marketing programme, the role that the advertising is to play in attaining such objectives and works on the
fact that advertising plays vital role in stimulating demand and is not the result of sales. It decides the
appropriation of advertising funds on the basis of the objectives to be achieved and the tasks involved
therein.
This method involves three steps:
(a) Defining the objectives in quantitative terms.
(b) Outlining the tasks to achieve the goals so set.
(c) Estimating the cost of performing these tasks so outlined.
The merits of this method are:
(a) It is more objective.
(b) It is review based.
(c) It is individualistic.
The demerits are:
(a) It is irrelevant.
(b) Difficulty of converting objectives into tasks.
(c) It is unscientific.
3. Competitive parity method:
In essence, this method consists of setting the appropriation by relating it to the expenditure pattern of the
major competitor or competitors. It is a matter of matching the annual expenditure of the competitor or an
attempt to maintain the same set of relationship between the expenditures of the firm and that of a
competitor.
In other cases, this method may involve the use of average percentage so the sales spent by the firms in
the entire industry and then applying that percentage to the firm’s sales to arrive at the appropriations. For
this purpose, the company must collect relevant, up-to-date and authentic data about competitor’s
appropriations in terms of sales, ratios, percentages of advertising costs and sales.
The merits of this method are:
(a) It respects the superiors.
(b) It kills competitive wars.
(c) It is simple.
The demerits are:
(a) It is not logical.
(b) It is a misfit.
(c) It encourages competitive wars.
4. Affordability method:
What a company can afford to spend is more important than what it thinks in terms of wonderful
ambitious plan of advertising. Here, the company thinks in terms of its ability to spend depending on the
prevailing business conditions and the resources at its command.
This means that the advertising appropriation is possible only when the other more important and urgent
needs is met. Under the method, the advertising expenditure is related to either the company profits or the
assets. Thus, the management may decide say, 15 per cent of its profits or 5 per cent of its liquid assets for
ad programme for the ensuing period.
The merits of this method are:
(a) It is practical.
(b) It is simple.
(c) It is flexible.
The demerits are:
(a) It overlooks opportunities.
(b) It is short-sighted.
(c) It ignores the ability of advertising.
From the foregoing discussion it is crystal clear that each method has its own theme and merits and
demerits. None of these methods says about ‘optimum’ advertising expenditure that a firm should attempt
and get on. Under these circumstances, still the age old economic theory provides us with the best
conceptual frame-work as to how much the firm is going to spend on advertising.
The economic principle involved is that the advertising budget should be raised to that level where the last
rupee spent on advertising just pays for itself in additional profit. In actual practice, it is not that easy to
locate this optimum point.
However, it is generally possible to make a reasonable judgment whether the returns from advertising
would be increased or decreased by changing the amount with respect to any given level of advertising
expenditure. Logically, the advertising expenditure should go up as long as it is in the increasing returns.

10. What are the objectives of the Price discrimination? Write down the conditions required for practicing
price discrimination. (NOV 2015)

Price discrimination is the practice of charging a different price for the same good or service.
There are three of types of price discrimination – first-degree, second-degree, and third-
degree price discrimination.
First degree
First-degree discrimination, alternatively known as perfect price discrimination, occurs when
a firm charges a different price for every unit consumed.
The firm is able to charge the maximum possible price for each unit which enables the firm
to capture all available consumer surplus for itself. In practice, first-degree discrimination is
rare.

Second degree
Second-degree price discrimination means charging a different price for different quantities,
such as quantity discounts for bulk purchases.
Third degree
Third-degree price discrimination means charging a different price to different consumer
groups. For example, rail and tube travellers can be subdivided into commuter and casual
travellers, and cinema goers can be subdivide into adults and children. Splitting the market
into peak and off peak use is very common and occurs with gas, electricity, and telephone
supply, as well as gym membership and parking charges. Third-degree discrimination is the
commonest type.
Necessary conditions for successful discrimination
Price discrimination can only occur if certain conditions are met.
1. The firm must be able to identify different market segments, such as domestic users and
industrial users.
2. Different segments must have different price elasticity (PEDs).
3. Markets must be kept separate, either by time, physical distance and nature of use, such as
Microsoft Office ‘Schools’ edition which is only available to educational institutions, at a
lower price.
4. There must be no seepage between the two markets, which means that a consumer cannot
purchase at the low price in the elastic sub-market, and then re-sell to other consumers in the
inelastic sub-market, at a higher price.
5. The firm must have some degree of monopoly power

UNIT – V PART - A
1. State the meaning of monopolistic competition. (APRIL 2012) or Define
monopolistic competition. (NOV 2016)
A perfect competition exists when there are many small competitors carrying similar
products, giving you plenty of options from which to choose. The opposite of this is
a monopoly, in which there's only one option and, therefore, no choice for the consumer. The
third form of competition, an oligopoly, exists when there are only a few, large competitors in
the market. The fourth and final form of competition is called monopolistic competition.
2. Define imperfect competition. ( APRIL 2013) What is imperfect competition?
(APRIL 2012)
Imperfect competition exists whenever a market, hypothetical or real, violates the abstract
tenets of neoclassical pure or perfect competition. Since all real markets exist outside of the
plane of the perfect competition model, each can be classified as imperfect.
3. Define oligopoly competitions. ( APRIL 2013)
An oligopoly is a market where only a few firms make up the entire industry. These firms
have all the control over important factors like price. Often, the products of all the
dominating firms are extremely alike, which forces the firms to become interdependent and
closely monitor the actions of the other firms they are competing against.
4. Classify markets on the basis of area. (APRIL 2014)
The four basic types of markets are:
1) Perfect competition
2) Monopoly
3) Monopolistic competition
4) Oligopoly

5. State the three characteristics of monopolistic competition. (APRIL 2014)

 Large number of firms
 Differentiated product (ie- Substitutes)
 Freedom of entry and exit
6. What is a perfect competition? (APRIL 2015) (APRIL 2017)
Perfect competition: A market structure in which there are many buyers and sellers, the
product is standardized, and sellers can easily enter or exit the market. In a perfectly
competitive market, each buyer and seller is a price taker.
7. What is duopoly? (APRIL 2015) (APRIL 2016)
A duopoly is the most basic form of oligopoly, a market dominated by a small number of
companies. A duopoly can have the same impact on the market as a monopoly if the two
players collude on prices or output.
8. What is a market? (APRIL 2016) (NOV 2012)
A market in which buyers and sellers have complete information about a particular product
and it is easy to compare prices of products because they are the same as each other etc.
9. What is monopsony? (NOV 2012)
A monopsony, sometimes referred to as a buyer's monopoly, is a market condition similar to a
monopoly except that a large buyer, not a seller, controls a large proportion of the market and
drives prices down. A monopsony occurs when a single firm has market power in employing
its factors of production.
10. When is a market said to be imperfect? (NOV2013)
o Large number of Sellers and Buyers: There are large numbers of sellers in the market.
o Product Differentiation: Another important characteristic is product differentiation.
o Selling Costs.
o Free Entry and exit of Firms.
o Price-makers.
o Blend of Competition and Monopoly.
11. Who is a monopolist? (NOV 2013)
A monopolist market can be defined as one m which there is no perfect substitute for the
product of an individual seller so that there is a separate demand curve for the product of each
seller in the market".
How do you determine the competitive structure of markets? (NOV 2014)
Perfectly competitive market satisfy the following conditions
Fragmented industry consist of many small buyers and sellers

2. Buyers and Sellers are “price takers”:

- Each buyer’s purchases are small and do not effect the market price
- Each seller is small and does not effect the market price
-Each seller cannot effect the price of inputs
3. Firms produce identical products
4. Perfect information about prices
5. All firms have the equal access to inputs, they have the same technology, and there is
free entry
12. State the two kinds of Duopoly. (NOV 2014)
Market in which two firms compete with each other.
13. What is meant by monopoly? (NOV 2015)
Definition: A market structure characterized by a single seller, selling a unique product in the
market. In a monopoly market, the seller faces no competition, as he is the sole seller of
goods with no close substitute.
14. What is oligopoly competition? (NOV 2016)
A competitive oligopoly is a market that is dominated by only a few large firms. These firms
prefer not to compete via price wars and therefore compete in various other ways, such as
advertising, product differentiation and barriers.

UNIT V PART B

1. What are the main features of monopolistic competition? (APRIL 2012)

The main features of monopolistic competition are as under:
1. Large Number of Buyers and Sellers:
There are large number of firms but not as large as under perfect competition. That
means each firm can control its price-output policy to some extent. It is assumed that any
price-output policy of a firm will not get reaction from other firms that means each firm
follows the independent price policy. If a firm reduces its price, the gains in sales will be
slightly spread over many of its rivals so that the extent to which each of the rival firms
suffers will be very small. Thus these rival firms will have no reason to react.
2. Free Entry and Exit of Firms:
Like perfect competition, under monopolistic competition also, the firms can enter or
exit freely. The firms will enter when the existing firms are making super-normal profits.
With the entry of new firms, the supply would increase which would reduce the price and
hence the existing firms will be left only with normal profits. Similarly, if the existing firms
are sustaining losses, some of the marginal firms will exit. It will reduce the supply due to
which price would rise and the existing firms will be left only with normal profit.
3. Product Differentiation:
Another feature of the monopolistic competition is the product differentiation.
Product differentiation refers to a situation when the buyers of the product differentiate the
product with other. Basically, the products of different firms are not altogether different; they
are slightly different from others. Although each firm producing differentiated product has the
monopoly of its own product, yet he has to face the competition. This product differentiation
may be real or imaginary. Real differences are like design, material used, skill etc. whereas
imaginary differences are through advertising, trade mark and so on.
4. Selling Cost:
Another feature of the monopolistic competition is that every firm tries to promote its
product by different types of expenditures. Advertisement is the most important constituent of
the selling cost which affects demand as well as cost of the product. The main purpose of the
monopolist is to earn maximum profits; therefore, he adjusts this type of expenditure
accordingly.
5. Lack of Perfect Knowledge:
The buyers and sellers do not have perfect knowledge of the market. There are
innumerable products each being a close substitute of the other. The buyers do not know
about all these products, their qualities and prices.
Therefore, so many buyers purchase a product out of a few varieties which are offered for
sale near the home. Sometimes a buyer knows about a particular commodity where it is
available at low price. But he is unable to go there due to lack of time or he is too lethargic to
go or he is unable to find proper conveyance. Likewise, the seller does not know the exact
preference of buyers and is, therefore, unable to get advantage out of the situation.
6. Less Mobility:
Under monopolistic competition both the factors of production as well as goods and
services are not perfectly mobile.
7. More Elastic Demand:
Under monopolistic competition, demand curve is more elastic. In order to sell more,
the firms must reduce its price.
2. What are the distinguishing features of an oligopolistic market? (APRIL 2012)
1. Interdependence:
The foremost characteristic of oligopoly is interdependence of the various firms in the
decision making.This fact is recognized by all the firms in an oligopolistic industry. If a small
number of sizeable firms constitute an industry and one of these firms starts advertising
campaign on a big scale or designs a new model of the product which immediately captures
the market, it will surely provoke countermoves on the part of rival firms in the industry.
Thus different firms are closely inter dependent on each other.
2. Advertising:
Under oligopoly a major policy change on the part of a firm is likely to have
immediate effects on other firms in the industry. Therefore, the rival firms remain all the time
vigilant about the moves of the firm which takes initiative and makes policy changes. Thus,
advertising is a powerful instrument in the hands of an oligopolist. A firm under oligopoly
can start an aggressive advertising campaign with the intention of capturing a large part of the
market. Other firms in the industry will obviously resist its defensive advertising.
Under perfect competition advertising is unnecessary while a monopolist may find
some advertising to be profitable when his product is new or when there exist a large number
of potential consumers who have never tried his product earlier. But according to Prof.
Baumol, “under oligopoly, advertising can become a life-and-death matter where a firm
which fails to keep up with the advertising budget of its competitors may find its customers
drifting off to rival products.”
3. Group Behaviour:
In oligopoly, the most relevant aspect is the behaviour of the group. There can be two
firms in the group, or three or five or even fifteen, but not a few hundred. Whatever the
number, it is quite small so that each firm knows that its actions will have some effect on
other firms in the group. In contrast, under perfect competition there are a large number of
firms each attempting to maximise its profits. Similar is the situation under monopolistic
competition. Under monopoly, there is just one profit maximising firm. Whether one
considers monopoly or a competitive market, the behaviour of a firm is generally predictable.
In oligopoly, however, this is not possible due to various reasons:
(i) The firms constituting the group may not have a common goal.
(ii) The group may or may not have a formal or informal organization with accepted rules of
conduct.
(iii) The group may be dominated by a leader but other firms in the group may not follow him
in a uniform manner.
4. Competition:
This leads to another feature of the oligopolistic market, the presence of competition.
Since under oligopoly, there are a few sellers, a move by one seller immediately affects the
rivals. So each seller is always on the alert and keeps a close watch over the moves of its
rivals in order to have a counter-move. This is true competition, “True competition consists of
the life of constant struggle, rival against rival, whom one can only find under oligopoly.”
5. Barriers to Entry of Firms:
As there is keen competition in an oligopolistic industry, there are no barriers to entry
into or exit from it. However, in the long-run, there are some types of barriers to entry which
tend to restrain new firms from entering the industry.
These may be:
(a) Economics of scale enjoyed by a few large firms;
(b) Control over essential and specialized inputs;
(c) High capital requirements due to plant costs, advertising costs, etc.
(d) Exclusive patents; and licenses; and
(e) The existence of unused capacity which makes the industry unattractive.
When entry is restricted or blocked by such natural and artificial barriers the oligopolistic
industry can earn long-run supernormal profits.
6. Lack of Uniformity:
Another feature of oligopoly market is the lack of uniformity in the size of firms.
Firms differ considerably in size. Some may be small, others very large. Such a situation is
asymmetrical. This is very common in the American economy. A symmetrical situation with
firms of a uniform size is rare.
7. Existence of Price Rigidity:
In oligopoly situation, each firm has to stick to its price. If any firm tries to reduce its
price, the rival firms will retaliate by a higher reduction in their prices. This will lead to a
situation of price war which benefits none. On the other hand, if any firm increases its price
with a view to increase its profits; the other rival firms will not follow the same. Hence, no
firm would like to reduce the price or to increase the price. The price rigidity will take place.
8. No Unique Pattern of Pricing Behaviour:
The rivalry arising from interdependence among the oligopolists leads to two
conflicting motives. Each wants to remain independent and to get the maximum possible
profit. Towards this end, they act and react on the price-output movements of one another
which are a continuous element of uncertainty.
On the other hand, again motivated by profit maximisation each seller wishes to
cooperate with his rivals to reduce or eliminate the element of uncertainty. All rivals enter
into tacit or formal agreement with regard to price-output changes.
It leads to a sort of monopoly within oligopoly. They may even recognize one seller as a
leader at whose initiative all the other sellers raise or lower the price. In this case, the
individual seller’s demand curve is a part of the industry demand curve, having the elasticity
of the latter. Given these conflicting attitudes, it is not possible to predict any unique pattern
of pricing behaviour in oligopoly markets.
9. Indeterminateness of Demand Curve:
In market structures other than oligopolistic, demand curve faced by a firm is
determinate. The interdependence of the oligopolists, however, makes it impossible to draw a
demand curve for such sellers except for the situations where the form of interdependence is
well defined. In real business operations, the demand curve remains indeterminate. Under
oligopoly a firm can expect at least three different reactions of the other sellers when it
lowers its prices.
This happened due to the reason:
(i) It is possible that other maintain the prices they had before. In this case, an oligopolist can
hope that its demand would increase substantially as the prices are lowered,
(ii) When an oligopolist reduces his price, the other sellers also lower their prices by an
equivalent amount. In this situation although demand of the oligopolist making the first move
will increase as he lowers his price, the increase itself would be much smaller than in the first
case.
(iii) When a firm reduces its price, the other sellers reduce their prices far more. Under the
circumstances the demand for the product of the oligopolistic firm which makes the first
move may decrease. Thus uncertainty under oligopoly is inevitable, and as a result, the
demand curve faced by each firm belonging to the group is necessarily indeterminate.

3. Describe the characteristics of oligopoly. (APRIL 2013) (APRIL 2016)

The three most important characteristics of oligopoly are: (1) an industry dominated
by a small number of large firms, (2) firms sell either identical or differentiated products, and
(3) the industry has significant barriers to entry.
These three characteristics underlie common oligopolistic behaviour, including
interdependent actions and decision making, the inclination to keep prices rigid, the pursuit
of competition rather than price competition, the tendency for firms to merge, and the
incentive to form collusive arrangements.
Small Number of Large Firms

The most important characteristic of oligopoly is an industry dominated by a small

number of large firms, each of which is relatively large compared to the overall size of the
market. This characteristic gives each of the relatively large firms substantial market control.
While each firm does not have as much market control as monopoly, it definitely has more
than a monopolistically competitive firm.
The total number of firms in an oligopolistic industry is not the key consideration. A
oligopoly firm actually can have a large number of firms, approaching that of any
monopolistically competitive industry. However, the distinguishing feature is that a few of the
firms are relatively large compared to the overall market. A given industry with a thousand
firms, for example, is considered oligopolistic if the top five firms produce half of the
industry's total output.
The hypothetical Shady Valley soft drink market contains 20 firms, but it is
oligopolistic because the four largest firms account for over 60 percent of total industry sales
and the top eight firms account for almost 80 percent.
Identical or Differentiate Products

Some oligopolistic industries produce identical products, like perfect competition in

this regard, while others produce differentiated products, more like monopolistic competition.
This characteristic might seem to be a bit wishy-washy, taking both sides of product
differentiation issue. In actuality it points out that oligopolistic industries general come in two
varieties.
 Identical Product Oligopoly: This type of oligopoly tends to process raw materials or
produce intermediate goods that are used as inputs by other industries. Notable examples are
petroleum, steel, and aluminium.

 Differentiate Product Oligopoly: This type of oligopoly tends to focus on goods sold
for personal consumption. The key is that people have different wants and needs and thus
enjoy variety. A few examples of differentiated oligopolistic industries include automobiles,
household detergents, and computers.
Barriers to Entry

Firms in an oligopolistic industry attain and retain market control through barriers to
entry. The most noted entry barriers are: (1) exclusive resource ownership, (2) patents and
copyrights, (3) other government restrictions, and (4) high start-up cost. Barriers to entry are
the key characteristic that separates oligopoly from monopolistic competition on the
continuum of market structures. With few if any barriers to entry, firms can enter a
monopolistically competitive industry when existing firms receive economic profit. This
diminishes the market control of any given firm. However, with substantial entry barriers
found in oligopoly, firms cannot enter the industry as easily and thus existing firms maintain
greater market control.
Any firm seeking to enter this market is faced with significant barriers.
 First, a new firm must compete with the established Fleet Foot and OmniFast brand
names. At the very least, this requires a substantial amount of expensive
upfront advertising and promotion.

 Second, a new entry has to construct a new factory. With limited initial sales, this new
firm in the market will be unable to take full advantage of decreasing short-run average cost
or long-run economies of scale.

 Third, any new firm has to devise its own production techniques to compete with the
patented techniques used by OmniRun and Master Foot. While a new firm could enter this
oligopolistic market, such a task is significantly more difficult than entering an industry with
fewer barriers.
4. Describe the four types of imperfect competition. (APRIL 2014)
1. Oligopoly
Oligopoly describes a market in which there are a small number of sellers for a particular
product.
For example, think of Amazon and eBay. These ecommerce giants offer a similar service—an
online platform for people to buy and sell products. As these platforms have grown, they’ve
both introduced concepts that have changed the nature of online shopping.
For example, Amazon invented the “Buy It Now” button, which eBay emulates. Both
websites offer product and seller ratings in a 5-star system, making it easy for consumers to
compare products on both platforms before making their choice.
In an oligopoly, you know exactly who your competition is. This means that you can get an
idea of which marketing strategies have been successful and which haven’t. You can learn
from your competitors’ mistakes and avoid making similar ones. Competitors are doing in
terms of their marketing strategies and online presence. Follow their social media accounts,
subscribe to their newsletters and visit their websites regularly. By seeing how the online
community responds to various tactics, you’ll get an idea of which ones work well, and you
can use those insights to guide new approaches of your own.
It is important to watch how consumers are interacting with your competition is that,
generally speaking, there has been a critical shift in the consumer mindset about
trustworthiness. Where once the “corporate to consumer” messaging was trustworthy enough
to shape buyer decisions, today “consumer to consumer” messaging–such as public feedback
or reviews about a product, or forums discussing it–is what shoppers rely on.
2. Monopolistic Competition
A monopolistic market is one in which each seller provides a unique product, so no seller’s
product can be a perfect substitute for another. Many online stores that sell women’s clothing.
Even though the base product is the same, each store offers different styles of shirts, different
prices and different services. Another differentiator is branding and logos; a sport shirt from
Nike might be identical to one from Puma if not for the different logos featured on them.
As another example, compare the clothing stores 6pm, Asos, and Lulus.

Each store targets a similar audience. Searching for the same type of clothing item on
each store’s site, however, yields wildly different results. There’s also differentiation in each
store’s coupons, price ranges, and clothing colors and styles. If you compete in a
monopolistic market, then there needs to be something that makes you stand out. Your
products and services aren’t identical to those of any of your competition. In order to succeed,
your product value must speak for itself and the service you provide must be impeccable.
One of the most important factors for driving your success in a monopolistic market is
your customers and their feedback. Since what you’re offering is unique, you can gain a lot of
knowledge about what works and what doesn’t from the people who are interested in doing
business with you. Put this into use by obtaining as much feedback from your customers and
prospects as you can.
For example, ask your customers to complete a short customer satisfaction survey
after they’ve completed their purchase and/or received the product. Another way to gain
customer feedback is by asking for reviews or testimonials and rewarding customers for
giving them.
You can also obtain feedback from prospects who leave your site without completing
a purchase by presenting them with a pop-up question on their way off your site in exchange
for an offer they’ll find valuable.
3. Monopoly
A market in which there is one seller, but many different buyers. For example, the vast
majority of active blogs on the internet are powered by Word Press, which holds a monopoly
on blog-based websites and is also growing as a host for CMS systems. Other blog platforms
have existed, but no competitor to date has had the same lasting power. This info graphic
shows how Word Press is becoming not only a monopoly for blogging platforms, but for
website CMS platforms as well. The company continues to attract new customers by offering
its base product for free and only charging for hosting and support.
How this affects you: There’s an amusing story about the student who is first to finish an
exam: Either she’s brilliant and knew all of the answers quickly, or she didn’t know any of
the answers at all. The chances of you maintaining a monopoly in online retail are pretty slim.
So, you’ll need to stay ahead of the competition that will pop up and attempt to attract your
customer base away from you. This means it’s up to you to continue giving your customers a
reason to stick with you. You could do this with:
 Personalized incentives
 Impeccable customer service
 A streamlined customer experience
4. Oligopsony
A market in which there are many sellers but few buyers. If you set out to buy
something online for a geeky friend, you will be inundated with stores advertising that they
are “for geeks.” Some examples are Think Geek, Gadgets and Geer, and Firebox. This niche
was once intended only for the few people who could create an online store, but it has grown
to become a huge market. If you do a simple search across different online geek stores, you’ll
find a variety of products at varying prices and qualities. Consumers have the power in this
marketplace and can choose exactly what they want.
When buyers have the power to choose from a wide marketplace, you need to stand
out among your competition. Especially in an oligopsony where there are few buyers whose
attention you’re competing for, there must be something that drives them to choose you.
Perhaps this will be your unique branding, which resonates best with your prospect compared
to your competition. Or maybe it’s your impeccable customer service. What sets you apart,
for some customers, might even be as simple as how easily they found you (another reason
you should always make sure you’re on top of SEO).
Remember that your customers will choose you specifically for the unique niche that
you cater to. Staying dedicated to that niche while offering an array of relevant products your
target audience wants will be your ticket to staying alive in an oligopsony.

For starters, this knowledge will help you understand the nuances of the playing field
in which you’re aiming to become a leader. These defining characteristics will impact the
marketing strategies you adopt and how you execute them. For example, marketers across
fields are now turning to behavioural economics principles to inform their tactics for doing
things like minimizing shopping cart abandonment rates or increasing customer loyalty.
The type of marketplace you’re competing in will also determine which behavioural
economics strategies will be most effective, and the ways it makes most sense for you to do
things like adopt personalization in ecommerce. You’ll find that once you understand both
your market and your customers, you’ll be able to implement the right strategies to help your
online store succeed.

5. Classify goods on the basis of difference in their nature. (APRIL 2014)

1. Free goods and economic goods.
2. Free services and economic services.
3. Consumer goods and producer goods.
4. Consumer services and producer services.
5. Single use goods and durable use goods.
6. Private goods and public goods.
1. Free goods and economic goods
Let us assume that you are in a desert. If you fill a bag with sand, you need not pay
any price. But otherwise in a city, you have to pay for it. This example helps us to
differentiate a free good from an economic good. Free goods are free gifts of nature. They are
available in abundance i.e. in unlimited quantity and the supply is much more than the
demand. You don’t have to pay anything to get them. That is why they are called free goods.
In short we can define free goods as goods which posses utility but which are not scarce.
In our daily life, we use toothpaste, soap, shaving cream, footwear, bread etc. These
goods are man made and their supply is not unlimited. Similarly we use machines, buses,
table, chair, books, fans, television etc. They too are man made and their supply is not
unlimited. We use water for various purposes at home, sand for construction and different
minerals in different forms. Now these are not man made but free gifts of nature. But because
they are scarce i.e. their demand is more than their supply, they command a price and are not
freely available. They are the economic goods.
Economic goods are those goods (manmade or free gifts of nature) whose demand is
more than supply. They command a price and they can be bought in the market. 2. Free
services and economic services In case of services too, there are free services and economic
services. Free services are those, which cannot be bought in the market and which are
rendered due to love, affection etc. For example services of parents for their children. All
those services, which can be bought in the market, are economic services such as services of
doctors, engineers etc. The rest of the classification of goods and services deal only with
economic goods and services.
3. Consumer goods and Producer goods
This classification is based on the purpose for which a particular good is used.
Consumer goods are those goods, which satisfy the want of consumer directly. They are
goods, which are used for consumption. For example bread, fruits, milk, clothes etc. Producer
goods are those goods, which satisfy the want of consumers indirectly. As they help in
producing other goods, they are known as producer goods. For example machinery, tools, raw
materials, seeds, manure and tractor etc are all example of producer goods.
3a. Intermediate goods
Raw materials, power, fuels etc. used by the producers for further production of final
goods and services are also called intermediate goods. Example : Wheat flour is an
intermediate good in the production of bread in the bakery.
4. Consumer’s services and producer’s services
Here too the basis of classification is the same as that of goods. When the consumers
or the households directly use services, they are known as consumer services. For example
services of a tailor stitching your shirt or services of a doctor giving you the treatment or
services of a plumber repairing your leaking tap, etc. Producer services on the other hand are
used to produce other goods and services, which are in turn demanded by the consumers. In
other words producer services satisfy the human wants indirectly. For example a tailor
stitches a shirt for a readymade garment shop, an electrician repairs fault in the electric
supply in a production unit or even a truck transporting raw material to a factory.
5. Single use and durable use goods
All types of goods whether consumer goods or the producer goods are further
classified into single use and durable use goods. Single use goods are those goods, which can
be used only once. They are finished only in one use. For example bread, butter, egg, milk etc
are the single use consumer goods as they are consumed immediately and once for all.
Similarly single use producer goods are exhausted in one production process. For example
coal, raw material, seeds, manure etc. To elaborate it further let us take the example of
production of sugar. Here the raw material is sugarcane, which is used only once.
Durable use goods are those goods, which can be used again and again for a long
period of time. There are durable use consumer goods as well as durable use producer goods.
Durable use consumer goods are cloth, furniture, television, scooter etc. that can be used by
consumer again and again. Durable use producer goods are used in production again and
again for example, machines, tools, tractors and implments etc. this does not mean that
repeated use of these goods does not make any difference to them. In fact the value of these
goods gets depreciated after continuous use.
6. Private goods and public goods
Goods can be classified on the basis of their ownership. All goods that are privately
owned and are exclusively enjoyed by individuals are called private goods. For example all
the goods owned by you are private goods. This includes your watch, pen, scooter, books,
table, chair, bed, clothes etc. If you own a factory then its building, machinery; tools etc are
your private goods.
Public goods are those goods, which are owned and enjoyed by the society as a
whole. For example roads, bridges, park, town hall etc. are all collectively owned. They are
available to all people in a society without any discrimination, i.e. no one is denied from the
consumption of public goods. Both government and private entrepreneurs may produces
public goods.

6. Is monopoly price always high? Explain. (APRIL 2017)

We have seen that monopoly power enables a monopolist to restrict its output
and charge a price higher than the marginal cost. Competitive price tends to equal the
marginal cost. This however, monopoly price is necessarily and invariably higher than
competitive price. Several influences may keep the monopoly price down and in some cases
may bring it to a level lower than what-is would he under competition.
The monopolist to produce an good at a lower cost per unit on account of the
exceptional advantages that it may enjoy as regard the scale of production. In advertising,
marketing expenses and other overhead charges. Thus, even though it may charge a price
higher than its own marginal cost, it may be lower than what would be the marginal
cost under competition. This is the ease especially with industries using large and expensive
indivisible equipment, and the demand for the products of which is elastic. Expansion of
output in such industries reduces cost per unit, and larger output can remunerative, though
low, prices. Normally however monopoly price lower than the price under competition. But
the monopoly price is inordinately a high price. There are serious limitations on the power of
a monopolist. He is not always able to charge price which would theoretically maximize his
profit. Apart from the fact that the monopolist may be ignorant of the level of the price.
Which gives him maximum returns due 10 difficulties of assessing the factors involved, there
are certain considerations which few monopolist can ignore.
Conclusion: Out in spite of these restraining influences, monopoly prices are generally higher
than the competitive prices.

7. Describe the importance of monopoly power. (NOV 2012)

 Research and Development. Monopolies can make supernormal profit; this can be
used to fund high cost capital investment spending. Successful research can be used for
improved products and lower costs in the long term. This is important for industries like
telecommunications, aeroplane manufacture and Pharmaceuticals. Without monopoly power
that a patent gives, there may be less development of medical drugs.
 Economies of scale. Increased output will lead to a decrease in average costs of
production. These can be passed on to consumers in the form of lower prices. Economies of
Scale This is important for industries with high fixed costs, such as tap water and steel
production.

If a monopoly produces at output Q1, average costs (AC 1) are much lower than if a
competitive market had firms producing at Q2 (AC 2).
 International Competitiveness. A domestic firm may have Monopoly power in the
domestic country but face effective competition in global markets. E.g. British Steel. With
markets increasingly globalised, it may be necessary for a firm to have a domestic monopoly
in order to be competitive internationally
 Monopolies can be successful firms. A firm may become a monopoly through being
efficient and dynamic. A monopoly is thus a sign of success not inefficiency. For example –
Google has gained monopoly power through being regarded as best firm for search engines.
Apple has a degree of monopoly power through successful innovation.

8. Determine the essentials of a market.(NOV 2013)

Good or service to be traded.
A SERVICE is an action that a person does for someone else. Examples: Goods are
items you buy, such as food, clothing, toys, furniture, and toothpaste. Services are actions
such as haircuts, medical check-ups, mail delivery, car repair, and teaching. Goods are
tangible objects that satisfy people's wants.
Buyers and sellers
Buyers demand goods and services; sellers supply goods and services. Markets exist
when buyers and sellers interact. This interaction determines market prices and thereby
allocates goods and services. The price is what people pay when they buy a good or service,
and what they receive when they sell a good or service. In market economies there is no
central planning agency that decides how many different kinds of sandwiches are provided
for lunch everyday at restaurants and stores, how many loaves of bread are baked, how many
toys are produced before the holidays, or what the prices will be for the sandwiches, bread,
and toys. Businesses want to sell the goods and services consumers will buy. A market exists
when buyers and sellers exchange goods and services. People’s choices about what goods and
services to buy ultimately determine what producers produce.
Place:
A place, be it with real boundaries or imaginary (like world market) A market,
or marketplace, is a location where people regularly gather for the purchase and sale of
provisions, livestock, and other goods. Some markets operate daily and are said to
be permanent markets while others are held once a week or on less frequent specified days
such as festival days and are said to be periodic markets. The form that a market adopts is
dependent on the population, culture, ambient and geographic conditions of the market's
locality.
In many countries, shopping at a local market is a standard feature of daily life. Given
the market's role in ensuring food supply for a population, markets are often highly regulated
by a central authority. In many places, designated market places have become listed sites of
historic and architectural significance and represent part of a town or nation's cultural assets.
For these reasons, they are often popular tourist destinations.

Contact between buyers and sellers

It is impossible to set up any yardstick for relationship between a buyer and a seller.
No two organizations can have similar set of rules for maintaining relationship. Even if on a
particular occasion a situation prompted a particular behavior, it is not necessary that a
similar behavior is necessary on another occasion. The time, place and group of person might
be the same but behave in different way, though circumstances and situations might be
identical.

To a great extent relationship depends upon the: character of contracting parties. This
is thus a study of human behavior and forms part of the behavioural science. Here the
contracting parties do not mean only those who are in direct contact but also include those
who might be present around. No person is acting in isolation. Therefore, there is always an
influence of surroundings on human behaviour.

A buyer is also a seller. A seller is also a buyer. Both could also be customers. To
make the point clear let us take the example of a trader who buys goods for resale or a buyer
who buys goods and then sells it after value addition. Therefore , you can not show same
behaviour when you are in the role of a buyer as then your priorities are different then when
you are in the role of a seller.

9. What are the factors determining the extent of market? (NOV 15)
1. Nature of Demand:
The extent of the market is greatly influenced by the nature of the demand of the commodity.
The commodities like silver, gold etc. having permanent demand would have a larger size of
the market. On the contrary, if the demand is limited to a particular area then it would have
the small size of the market.
2. Means of Transportation and Communication:
Means of transportation and communication determine the extent of the market. If the means
of transportation and communication are well developed, wide contacts can be easily
established.
3. Nature of the Commodity:
The nature of commodity also influences the extent of the market. To have larger market,
commodity must be durable, portable, etc. Perishable goods have narrow market. In case of
perishable goods, extent of the market is small.
4. Currency and Credit:
The market can be conveniently carried to extensive areas only if the currency and credit
system of the country is well developed, because only the good currency and credit policy
can inspire the confidence of the people.
5. State Policy:
The state policy is another factor to influence the size of the market. If the Government
imposes prohibitive duties and quotas, the size of the market would be narrow. Therefore, we
may say that state policy has its effect on the size of the market.
6. Degree of Division of Labour:
The size of the market is also determined by the division of labour, if there exists greater
division of labour, articles would be cheaper and the market would be wider.
7. Durability:
The extent of market of things, which do not perish quickly, that, is, durable and large. But
the commodities such as fresh vegetables, milk, and eggs etc. which perish quickly have
narrow extent of the market. These cannot be transported from one place to the other.
8. Portability:
The commodity which can be transported from one place to the other has large extent of
market. But the things which are heavy and much expenditure is incurred on their
transportation have limited extent of market. For example, bricks have a local market. If huge
expenditure on its transport is made only then would it be carried to another place.
9. Sampling and Grading:
The commodities which can be sampled and graded have a large extent of market because
customers place orders only on seeing sample or grade of such commodities. They do have
not to go personally to see the commodities. For example, woolen cloth, fountain pen, electric
fans etc. But if the products can neither be sampled nor graded, the customers have to see
them personally. Therefore, their extent of market is limited.
10. Peace, Security and Honesty:
A trader will like to send his products to the country where peace and security exist. As a
result, the extent of market will be large. But a place where there are unrest, poor law and
order situation will not be liked by the businessmen. They will avoid sending their
commodity to that place and there will be limited extent of the market.
11. Number of Substitutes:
The more number of substitutes of an article, the narrower the demand for it and extent of its
market will become less because when a certain article is not available in the market or its
price is high people will purchase an article similar to that and the substitute will serve their
purpose.
12. Modern Methods of Trade:
The extent of market will depend on the modern methods of trade. By using the methods of
propaganda, advertisement, storage etc. size of market expands.

10. Explain the features of perfect completion. (NOV 16)

1. Free and Perfect Competition:
In a perfect market, there are no checks either on the buyers or sellers. They are free to buy or
to sell to any person. It means there are no monopolies.
2. Cheap and Efficient Transport and Communication:
Uniform price for the commodity would not be possible if the changes in the prices are not
quickly adjusted or the commodity cannot be quickly transported. Thus cheap and efficient
means of transport and communication are must.
3. Wide Extent:
Sometimes wide market is regarded as the same thing as the perfect market. For wide market,
the commodity should have permanent and universal demand. The commodity should be
portable. Means of transport and communication should be quick. There should be peace and
security and extensive division of labour.
4. Large number of firms:
In this market, a product is produced and sold by large number of firms. Since there are large
number of firms, therefore each firm is supplying only a small part of the total supply in the
market, thus no one firm has any market power. It implies that no firm can influence the price
of the product rather each must accept the price set by the forces of market demand and
supply. The firms are price-takers instead of price-makers.
5. Large number of buyers:
In a perfectly competitive market, there are large numbers of buyers each demanding a small
part of the total market supply of the product. As a result, no single buyer is in a position to
influence the market price determined by the forces of market demand and supply.
6. Homogeneous Product:
In a perfectly competitive market, all the firms produce and supply the identical products. It
means that the products of all the firms are perfect substitutes of each other. As a result of
this, the price elasticity of demand for a firm’s product is infinite.
7. Free entry and exit:
In a perfectly competitive market, there are no restrictions on the entry of new firms into
market or on the exit of existing firms from the market.
8. Perfect knowledge:
In a perfectly competitive market, the firms and the buyers possess perfect information about
the market. It implies that no buyer or firm is ignorant about the price prevailing in the
market.
9. Perfect mobility of factors of production:
In a perfectly competitive market, the factors of production are completely mobile leading to
factor-price equalization throughout the market.

UNIT V PART - C
1. Describe the market classification on the basis of Area. (APRIL 2013) (NOV
2016)
"Market refers to an arrangement, whereby buyers and sellers come in contact with each
other directly or indirectly, to buy or sell goods."
Thus, above statement indicates that face to face contact of buyer and seller is not necessary
for market. E.g. In stock or share market, the buyer and seller can carry on their transactions
through internet. So internet, here forms an arrangement and such arrangement also is
included in the market.
Classification or Types of Market
The classification or types of market are depicted in the following chart.
Generally, the market is classified on the basis of:
1. Place,
2. Time and
3. Competition.
On the basis of Place, the market is classified into:
1. Local Market or Regional Market.
2. National Market or Countrywide Market.
3. International Market or Global Market.
On the basis of Time, the market is classified into:
1. Very Short Period Market.
2. Short Period Market.
3. Long Period Market.
4. Very Long Period Market.
On the basis of Competition, the market is classified into:
1. Perfectly Competitive Market Structure.
2. Imperfectly Competitive Market Structure.
Both these market structures widely differ from each other in respect of their features, price,
etc. Under imperfect competition, there are different forms of markets like monopoly,
duopoly, oligopoly and monopolistic competition.
1. A monopoly has only one or a single (mono) seller.
2. Duopoly has two (duo) sellers.
3. Oligopoly has little or fewer (oligo) number of sellers.
4. Monopolistic competition has many or several numbers of sellers.
The suffix poly has its origin from Greek word Polus which means many or more than one.

2. Discuss the features of perfect competitions. (APRIL 2013) (APRIL 2015)

(APRIL 2016)
1. A perfect market is one where there is perfect competition. This is a model market. It
implies absence of rivalry.
2. According to Boulding, “the competitive market may be defend as a large number of
buyers and sellers all engaged in the purchase and sale of identically similar commodity, who
are in close contact with one another and who buy and sell freely among themselves”.
Features of Perfect Competition

1. Large number:
In perfect competition, there must be large number of buyers and sellers. Each buyer buys a
small quantity of the total amount. Each seller is so large that no single buyer or seller can
influence the price and affect the market. According to Scitovsky buyers and sellers are price
takers in the purely competitive market. Each seller (or firm) sells its products at the price
determined by the market. Similarly, each buyer buys the commodity at the price determined
by the market.
2. Homogeneous product:
Under perfect competition, the product offered for sale by all the seller must be identical in
every respect. The goods offered for sale are perfect substitutes of one another. Buyers have
no special preference for the product of a particular seller. No seller can raise the price above
the prevailing price or lower the price below the prevailing price.
3. Free entry and exit:
Under perfect competition, there will be no restriction on the entry and exit of both buyers
and sellers. If the existing sellers start making abnormal profits, new sellers should be able to
enter the market freely. This will bring down the abnormal profits to the normal level.
Similarly, when losses will occur existing sellers may leave the market. However, such free
entry or free exit is possible only in the long run, but not in the short-run.
4. Perfect knowledge:
Perfect competition implies perfect knowledge on the part of buyers and sellers regarding the
market conditions. As a results, no buyer will be prepared to pay a price higher than the
prevailing price. Sellers will not charge a price higher or lower than the prevailing price. In
this market, advertisement has no scope.
5. Perfect mobility of factors of production:
The second perfection mobility of factors of production from one use to another use. This
feature ensures that all sellers or firms get equal advantages so far as services of factors of
production are concerned. This is essential to enable the firms and industry to achieve
equilibrium.
6. Absence of transport cost:
Under perfect competition transport, cost does not exist. Since commodities have, the same
price it logically follows that there will be no transport cost. In the event of the presence of
cost of transport, there will be no single price in the market. Transport cost occurs when there
is no perfect knowledge of the market conditions on the part of buyers and sellers.
7. No attachment:
There is no attachment between the buyers and sellers under perfect competition. Since
products of all sellers are identical and their prices are the same a buyer is free to buy the
commodity from any seller he likes. He has no special inclination for the product of any
seller as in case of monopolistic competition or oligopoly. Theoretically, perfect competition
is irrelevant. In reality, it does not exist. So it is a myth.

3. Illustrate how a firm under monopolistic competition determines the price of the
product. (APRIL 2015)

PRICE DETERMINATION UNDER MONOPOLISTIC COMPETITION:

Under monopolistic competition, the firm will be in equilibrium position when marginal revenue is equal to m
revenue is greater than marginal cost, the seller will find it profitable to expand his output, and if the MR is
reduce his output where the MR is equal to MC. In short run, therefore, the firm will be in equilibrium when
MR = MC.

(a) Short Run Equilibrium: Short run equilibrium is illustrated in the following diagram:

Diagram: Monopolistic Competition Short Run Equilibrium

In the above diagram, the short run average cost is MT and short run average revenue is MP. Since the
therefore, the profit is shown as PT. PT is the supernormal profit per unit of output. Total supernormal prof
the supernormal profit to the total output, i.e. PT × OM or PTT’P’ as shown in figure (a). The firm may also
facing AR curve below the AC curve. In figure (b) MP is less than MT and TP is the loss per unit of outp
multiplying loss per unit of output to the total output, i.e., TP × OM or TPP’T’.

(b) Long Run Equilibrium: Under monopolistic competition, the supernormal profit in the long run is dis
into the industry. As the new firms are entered into the industry, the demand curve or AR curve will s
supernormal profit will be competed away and the firms will be earning normal profits. If in the short run fi
in the long run some firms will leave the industry so that remaining firms are earning normal profits.

The AR curve in the long run will be more elastic, since a large number of substitutes will be available in t
run, equilibrium is established when firms are earning only normal profits. Now profits are normal only whe
in the following diagram:
4. Discuss the market classification on the basis of nature of transactions. (APRIL 2016)
(NOV 2012)
Methods of transactions:
Generally in a market there are ‘spot’ transactions. The main characteristic of a spot
transaction is that the goods exist aid the buyers and the sellers do the transactions on the
basis of sane agreed terms and conditions. A market where spot transactions take place is
called an ordinary market. But there are some organised markets where ‘futures’ transactions
also take place.
Under futures transactions goods do not exist but transactions are made by samples and by
descriptions or by both. Goods which satisfy some conditions can be brought under organised
markets. There are different types of organised markets like money market, commodity
market and capital market.

5. Describe broad classification of market. (ARIL 2017)

6. classification of market:
7. 1. Geographical area:
8. From the viewpoint of area covered a market can be local, regional and international.
A local market has a very limited area and generally for perishable daily necessary goods like
fish, vegetables etc. A regional market covers a particular region of a country.
9. Such regional classification is found in a large country. India, for example, is divided
into four regions, east, west, north and south, for all practical purposes. A national market
covers the entire area of a country. An international market means extension of market in
other countries.
10. 2. Unit of sale:
11. Market is commonly classified on the basis of unit of sale. For example, wholesale
market and retail market. The unit of sale in wholesale market is big, while in retail market it
is small and sometimes very small. The price of the same commodity differs in wholesale and
retail markets.
12. 3. Periodicity:
13. Economists classify markets from the viewpoint of time and as such there are
four types of markets:
14. (a) Very short-period:
15. This is a market for perishable goods and the goods have to be sold out by the sellers
in a short time. The supply cannot be adjusted with the demand,
16. (b) Short-Period:
17. This is a market for goods with a limited stock. The supply can be adjusted with the
demand to some extent but not fully,
18. (c) Long-period:
19. In such a market the supply can be adjusted with the demand by changing the scale of
production.
20. (d) Very long-period:
21. In such a market, the length of the period is so long that very big changes take place
to affect the supply and the demand, e.g. change in technique of production, change in
population, change in tastes etc.
22. 4. Nature and degree of competition:
23. In a free economy country there is a competition in the market which may be either
perfect or imperfect and accordingly we get perfect and imperfect markets.
24. A market is perfect when sane conditions are satisfied, e.g:
25. (a) There are large number of sellers and buyers;
26. (b) The products of the sellers are identical;
27. (c) Each buyer and each seller has perfect knowledge of the market;
28. (d) Each seller has equal access to the factors of production; etc.
29. When one or more of the conditions are absent the market is imperfect.
30. Market can be further classified according to the degree of imperfection. The worst
situation is when there is a monopoly (one seller) or a monopsony (one buyer).
31. 5. Methods of transactions:
32. Generally in a market there are ‘spot’ transactions. The main characteristic of a spot
transaction is that the goods exist aid the buyers and the sellers do the transactions on the
basis of sane agreed terms and conditions. A market where spot transactions take place is
called an ordinary market. But there are some organised markets where ‘futures’ transactions
also take place.
33. Under futures transactions goods do not exist but transactions are made by samples
and by descriptions or by both. Goods which satisfy some conditions can be brought under
organised markets. There are different types of organised markets like money market,
commodity market and capital market.
34. 6. Position of sellers:
35. Markets can be further classified according to the position of sellers. Accordingly we
find primary, secondary and terminal markets. The agricultural or industrial goods are sold by
the producers to some middlemen like wholesalers.
36. This is the primary market. In the secondary market the middlemen like the
wholesalers sell the goods to another group of middlemen called the retailers. Ultimately the
goods are sold in the terminal market to the actual consumers.

37. Enumerate the effects of monopolistic competition. (NOV 2014)

The effects of Monopolistic Competition:
38. Many sellers or vendors Different products Enter and exit freedom
39. Cost of sale Undependability on each other Double proportional competition Group
40. Decline of demand curve Many sellers and vendors: Many sellers are producing
different products. Therefore, the competition between them is very enthusiastic. As there is a
large number of sellers so each of them produce a small part of the market supply. In this way
no one can control the price of the product.
41. Difference of the products: In perfect competition all products are same in their
nature. However, in monopolistic competition all producers of the product try to produce a
dissimilar product than others to sustain their product’s identity.
42. Enter and exit freedom: Free entries in the market allow new concerns to come up
with new substitutes. Freedom of entry and exit maintain the profit of the market on normal
level.
43. Cost of sale: Cost of sale is a very unique feature of monopolistic competition. In this
type of market, because of the difference of products, all concerns have to pay some extra
expenses in form of cost of sale. This cost is consist of the expenses of advertisement, payroll
of the staff, promotion etc.
44. Undependability on each other: Every concern has its own marketing and
production policy. Firms are not influenced by each other. Every firm is independent.
45. Double proportional competition: There are two types of competition features
of monopolistic competition
Price competition: price is a base of competition between firms or concern.
Non-price competition: competition of firms or concerns is based on brand, quality, product
and advertisement.
Group: A group is a large number of firms or concerns producing different goods which are
intimately related.
Decline of demand curve: A firm or concern is facing descending slop of demand curve.
Therefore, individual can sell more on low price and vice-versa.
46. Discuss the forms of markets in detail. (NOV 2014)

There are quite a few different market structures that can characterize an economy. However,
if you are just getting started with this topic, you may want to look at the four basic types of
market structures first. Namely perfect competition, monopolistic competition, oligopoly, and
monopoly. Each of them has their own set of characteristics and assumptions, which in turn
affect the decision making of firms and the profits they can make.
It is important to note that not all of these market structures actually exist in reality, some of
them are just theoretical constructs. Nevertheless, they are of critical importance, because
they can illustrate relevant aspects of competition firms’ decision making. Hence, they
will help you to understand the underlying economic principles. With that being said, let’s
look at them in more detail.
Perfect Competition
Perfect competition describes a market structure, where a large number of small firms
compete against each other. In this scenario, a single firm does not have any significant
market power. As a result, the industry as a whole produces the socially optimal level of
output, because none of the firms have the ability to influence market prices.
The idea of perfect competition builds on a number of assumptions: (1) all firms maximize
profits (2) there is free entry and exit to the market, (3) all firms sell completely identical (i.e.
homogenous) goods, (4) there are no consumer preferences. By looking at those assumptions
it becomes quite obvious, that we will hardly ever find perfect competition in reality. This is
an important aspect, because it is the only market structure that can (theoretically) result in a
socially optimal level of output.
Probably the best example of a market with almost perfect competition we can find in reality
is the stock market. If you are looking for more information on perfect competition, you can
also check our post on perfect competition vs imperfect competition.
Monopolistic Competition
Monopolistic competition also refers to a market structure, where a large number of small
firms compete against each other. However, unlike in perfect competition, the firms in
monopolistic competition sell similar, but slightly differentiated products. This gives them a
certain degree of market power which allows them to charge higher prices within a certain
range.
Monopolistic competition builds on the following assumptions: (1) all firms maximize profits
(2) there is free entry and exit to the market, (3) firms sell differentiated products (4)
consumers may prefer one product over the other. Now, those assumptions are a bit closer to
reality than the ones we looked at in perfect competition. However, this market structure will
no longer result in a socially optimal level of output, because the firms have more power and
can influence market prices to a certain degree.
An example of monopolistic competition is the market for cereals. There is a huge number of
different brands (e.g. Cap’n Crunch, Lucky Charms, Froot Loops, Apple Jacks). Most of
them probably taste slightly different, but at the end of the day, they are all breakfast cereals.
Oligopoly
An oligopoly describes a market structure which is dominated by only a small number firms.
This results in a state of limited competition. The firms can either compete against each other
or collaborate. By doing so they can use their collective market power to drive up prices and
earn more profit.
The oligopolistic market structure builds on the following assumptions: (1) all firms
maximize profits, (2) oligopolies can set prices, (3) there are barriers to entry and exit in the
market, (4) products may be homogenous or differentiated, and (5) there is only a few firms
that dominate the market. Unfortunately, it is not clearly defined what a «few» firms means
exactly. As a rule of thumb, we say that an oligopoly typically consists of about 5 dominant
firms.
An example of an oligopoly is the market for gaming consoles. There are only three dominant
players in this market: Microsoft, Sony, and Nintendo. This gives each of them a significant
amount of market power.
Monopoly
A monopoly refers to a market structure where a single firm controls the entire market. In this
scenario, the firm has the highest level of market power, as consumers do not have any
alternatives. As a result, monopilists often reduce output to increase prices and earn more
profit.
The following assumptions are made when we talk about monopolies: (1) the monopolist
maximizes profit, (2) it can set the price, (3) there are high barriers to entry and exit, (4) there
is only one firm that dominates the entire market.
From the perspective of society, most monopolies are usually not desirable, because they
result in lower outputs and higher prices compared to competitive markets. Therefore, they
are often regulated by the government. An example of a real life monopoly could
be Monsanto. About 80% of all corn harvested in the US is trademarked by this company.
That gives Monsanto an extremely high level of market power. You can find
additional information about monopolies our post on monopoly power.
In a Nutshell
There are four basic types of market structures: perfect competition, imperfect competition,
oligopoly, and monopoly. Perfect competition describes a market structure, where a large
number of small firms compete against each other with homogenous products. Meanwhile,
monopolistic competition refers to a market structure, where a large number of small firms
compete against each other with differentiated products. An Oligopoly describes a market
structure where a small number of firms compete against each other. And last but not least a
monopoly refers to a market structure where a single firm controls the entire market.