Annamalai University

346E1150
178E1150
347E1150
348E1150
349E1150
1 - 24
ANNAMALAI UNIVERSITY
DIRECTORATE OF DISTANCE EDUCATION
Master of Business Administration (M.B.A)

M.B.A. E-Business
M.B.A. Human Resource Management
M.B.A. Marketing Management
M.B.A. Financial Management
First Semester
MANAGERIAL ECONOMICS
LESSONS: 1 – 24
Copyright Reserved
(For Private Circulation Only)
MASTER OF BUSINESS ADMINISTRATION (M.B.A)
M.B.A. E-BUSINESS
M.B.A.HUMAN RESOURCE MANAGEMENT
M.B.A.MARKETING MANAGEMENT
M.B.A.FINANCIAL MANAGEMENT
FIRST SEMESTER
Editorial Board
Chairman
Dr. N. Ramagopal
Dean
Faculty of Arts
Annamalai University
Members
Dr. R. Singaravel
Director Director
D.D.E. Directorate of Academic Affairs
Annamalai University Annamalai University
Dr. G. Udayasuriyan Dr. S. Arulkumar

Professor and Head Associate Professor and Dy. Coordinator
Department of Business Administration Management Wing, DDE
Internals
Dr. S. Partheeban Dr. G. Natarajan
Assistant Professor Assistant Professor
Management Wing, D.D.E. Management Wing, D.D.E.
Annamalainagar. Annamalainagar.
Externals
Dr. R. Thenmozhi Dr. R. Venkatapathy
Professor Professor (Retd)
Department of Management Studies School of Management
Universityof Madras Bharathiyar University
Chepauk, Chennai. Coimbatore.
Lesson Writers
Units: I - III Units: IV - VI
Dr.I. Sundar Dr.S. Roberts
Professor Assistant Professor
Economics Wing, D.D.E. Department of Economics
Annamalai University St. Joseph’s College
Annamalainagar. Tiruchirappalli.
M.B.A. E-BUSINESS
Learning Objectives
The objectives of this course are:
LO1: To understand and learn the economic theories and concepts to be
adapted in business development;
LO2: To impart knowledge in analytical skills enabling the candidates to face
the economic challenges arising in business organisation and
LO3: To provide the candidates to acquire vast knowledge on managerial
economics to become business entrepreneurs.
Course Outcomes
Upon completion of this course the candidates will be able to:
CO1: Understand the role of economic theories and concepts in making
managerial decision making;
CO2: Analyse the internal and external economic environment and challenges
favouring organisation success;
CO3: Apply cost theories to enable cost reduction;
CO4: Handle the micro and macro environment of business ventures and
CO5: Building confidence among candidates to meet economic challenges in
his own business or in his work place.
Teaching Methods
Lecture and Case Method
Unit–I: The scope and Method of Managerial Economics
Introduction to Economics: Nature and Scope of Managerial Economics –
Significance in Decision-Making and Fundamental Concepts - Objectives of a Firm -
Role of Economic Analysis in Managerial Decisions.
Unit–II: Demand Analysis and Forecasting
Meaning - Characteristics and Determinants of Demand - Demand Functions -
Demand Elasticities – Income, Price, and Cost, Elasticity of Demand –
Measurement of Elasticity of Demand - Demand Forecasting and Forecasting
Methods - Uses of Elasticity of Demand for Managerial Decision Making.
Unit–III: Cost Analysis and Production
Cost Concepts – Cost Function – Analysis Distinction between Accounting Cost
and Economics Costs – Determinants of Cost - Cost–output Relationship - Returns
to Scale Concept - Production Concepts; Production Function, Single Variable - Law
of Variable Proportion - Two Variable - Law of Returns to Scale.
Unit–IV: Market Structure and Pricing
Various Forms of Market Structure - Features of Various Types of Market
Structure - Analysis of Firm in an Open Economy. Perfect Competition,
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Monopolistic Market, Oligopolistic Market; Pricing of products under Different
Market Structure - Price Discrimination - Techniques of Pricing - Factors Affecting
Pricing Decision - Joint Product Pricing.
Unit–V: Profit Management
Concept of Profit - Nature and Measurement of Profit - Profit Maximization -
Profit Planning and control – Profit Policies – Cost Volume Profit Analysis.
Unit–VI: National Income and Business Cycle
National Income – Definition, Concepts and Various Methods of its
Measurement – Inflation, Types and Causes - National Income and Economic
Welfare - Business Cycles and Business Forecasting – Measuring Business Cycles
Using Trend Analysis - Recent Topics in Managerial Economics (for discussion
alone).
Text Books
1. Mote, Paul & Gupta, Managerial Economics, Tata McGraw Hill, 2004.
2. Varshney, R.L.Maheswari, K.L, Managerial Economics, Sultan Chand &
sons, 2014.
3. Damodaran Suma, Managerial Economics, Oxford, 2006.
4. Hirschey Mark, Economics for Managers, Thomson, India Edition, 2007.
th
5. Dwivedi D.N., Managerial Economics, 8 Edition, Vikas Publication, 2015.
6. Ahuja, H. L., Managerial Economics, S.Chand, Chennai, 2017.
Supplementary Readings
1. Mark Hirschey, EricBentzen, Managerial Economics, Cengage Learning,
2016.
2. Luke M.Froeb, Brian T.McCann, Michael R. Ward, Shor, Managerial
Economics: A Problem solving Approach, Cengage Learning, 2015.
3. Joel Dean, Managerial Economics, PHI Learning Private Ltd., New Delhi,
2012.
4. Moti Paul S. Gupta, Managerial Economics, Tata McGraw Hill Pub.,
New Delhi, 2013.
5. Mithani, D.M., Managerial Economics, Himalaya Publishing House,
New Delhi, 2014.
Journals and Magazines
1. Journal of Managerial Economics
2. International of Managerial Economics
3. Journal of Economics and Management Studies
4. Journal of Managerial and Decision Economics
5. International Journal of Managerial Economics
6. The Global Journal of Managerial Economics.
Web Resources
1. global.oup.com/us/companion.websites/9780199811786
2. highered.mcgraw-hill.com/sites/.../information_center_view0/
3. wps.prenhall.com/bp_keat_managerial.../0,10878,2398017-,00.html
4. www.pearsonhighered.com/.../Managerial-Economics.../9780136040040.
5. www.wiley.com/WileyCDA/.../productCd-EHEP002067.html
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M.B.A. E-BUSINESS
FIRST SEMESTER
CONTENTS
Lesson Page
Title
No. No.
Unit - I : The Scope and Methods of Managerial Economics
1 Nature and Scope of Managerial Economics 1
2 Principles and Applications of Managerial Economics 16
3 Objectives of Firm 24
4 Application of Managerial Economics in Business Decision Making 35
Unit - II : Demand Analysis and Forecasting
5 Demand Theory 48
6 Elasticity Demand 58
7 Demand Forcasting 71
8 Application of Elasicity of Demand in Managerial Decision Making 91
Unit–III : Cost Analysis and Production
9 Cost Concept 100
10 Cost Accounting 114
11 Production Economics 124
12 Returns to Scale 137
Unit - IV : Market Structure and Pricing
13 Market Structure/Perfect Competition 147
14 Monopoly 152
15 Monopolistic Competition and Oligopoly 155
16 Pricing Policy and Practices 161
Unit – V : Profit Management
17 Profit Policy and Practice 168
18 Social Responsibility of Business 173
19 Profit Planning and Forecasting 175
Unit - VI : National Income and Business Cycle
20 Managerial Uses of Break-even Analysis 182
21 National Product, Income and Expenditure 186
22 Approaches to Measure National Income 195
23 Business Cycle 199
24. Business Forecasting 204
UNIT–I : THE SCOPE AND METHOD OF MANAGERIAL ECONOMICS
LESSON – 1
NATURE AND SCOPE OF MANAGERIAL ECONOMICS
1.1 INTRODUCTION
There is a dispute on the question whether managerial economics is an art
or a science. Some may soft the tone and term it as a social science. Others may
stick to their guns to prove that it is an art. But leaving the debate aside, let’s see
how big names in the field of economics define it: This lessons deals with Nature
and scope of Managerial Economics. It outlines the various definitions of
Managerial Economics and points out the Nature and Scope of Managerial
Economics. This lessons examines the subject matter of Managerial Economics and
relationship between Managerial Economics and other subjects.
1.2 OBJECTIVES
 To study the meaning of Managerial Economics.
 To examine the Nature and scope of the Managerial Economics
 To analyze the subject matter of Managerial Economics
 To understand the relationship between Managerial Economics and other
subjects
1.3 CONTENT
1.3.1 Definitions of Managerial Economics
1.3.2 Meaning of Managerial Economics
1.3.3 Nature of Managerial Economics
1.3.4 Scope of Marginal Economics
1.3.5 Positive versus Normative Economics
1.3.6 Demand Analysis and Forecasting
1.3.7 Cost and Production Analysis
1.3.8 Inventory Management
1. 3.9 Profit Management
1.3.10 Capital Management
1.3.11 Relation to Other Branches of Knowledge
1.3.12 Managerial Economics and Economics
1.3.13 Managerial Economics and Theory of Decision Making
1.3.14 Managerial Economics and Operations Research
1.3.15 Managerial Economics and Statistics
1.3.16 Managerial Economics and Accounting
1.3.17 Managerial Economics and Mathematics
1.3.18 Techniques and Methods of studying Marginal Economics
1.3.1 Definitions of Managerial Economics
There is a dispute on the question whether managerial economics is an art or
a science. Some may soft the tone and term it as a social science. Others may stick
to their guns to prove that it is an art. But leaving the debate aside, let’s see how
big names in the field of economics define it:
2
Mansfield says“managerial economics is concerned with the application of
economic principles and methodologies to the decision process within the
organization. It seeks to establish rules and principles to facilitate the attainment of
the desired economic goals of management.”
Spencer and Siegel man thinkit is “the integration of economic theory with
business practice for the purpose of facilitating decision making and forward
planning by management.”
Joel Dean declares"the purpose of managerial economics is to show how
economic analysis can be used in formulating business policies".
Mcnair & Meriam calculate“managerial economics deals with the use of
economic modes of thought to analyse business situation".
Henry and Hayne say “managerial economics is economics applied in
decision making. It is a special branch of economics. That bridges the gap between
abstract theory and managerial practice.”
E.J.Douglas finds “managerial Economics seeks to establish rules &
principles to facilitate the attainment of the desired economic goals of
management.”
Pappas & Hirschey think “Managerial economics applies economic theory
and methods to business and administrative decision-making.”
Salvatore Terms “managerial economics refers to the application of economic
theory and the tools of analysis of decision science to examine how an organisation
can achieve its objectives most effectively.”
Howard Davies and Pun-Lee Lam define “It is the application of economic
analysis to business problems”
Davis & Chang Say “managerial economics applies the principals and
methods of economics to analyze problems faced by the management of a business,
or other types of organizations and to help and to help find solutions that advance
the best interests of such organizations.”
Best Of all, Prof. Evan J. Douglas defines so“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.”
1.3.2 Meaning of Managerial Economics
Managerial economics is the "application of the economic concepts and
economic analysis to the problems of formulating rational managerial decisions". It
is sometimes referred to as business economics and is a branch of economics that
applies microeconomic analysis to decision methods of businesses or other
management units. As such, it bridges economic theory and economics in practice.
It draws heavily from quantitative techniques such as regression analysis,
correlation and calculus. If there is a unifying theme that runs through most of
managerial economics, it is the attempt to optimize business decisions given the
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firm's objectives and given constraints imposed by scarcity, for example through the
use of operations research, mathematical programming, game theory for strategic
decisions, and other computational methods.
1.3.3 Nature of Managerial Economics
Since the purpose of managerial economics is to apply economics for the
improvement of managerial decisions in an organization, most of the subject
material in managerial economics has a microeconomic focus. However, since
managers must consider the state of their environment in making decisions and the
environment includes the overall economy, an understanding of how to interpret
and forecast macroeconomic measures is useful in making managerial decisions.
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.
The 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
4
establishment of firm’s objectives, identification of problems involved in
achievement of those objectives, development of various alternative solutions, and
selection of best alternative and finally implementation of the decision.
1.3.4 Scope of Marginal Economics
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.
1.3.5 Positive versus Normative Economics
Most of the managerial economists are of the opinion that managerial
economics is fundamentally normative and prescriptive in nature. It is concerned
with what decisions ought to be made.The application of managerial economics is
inseparable from consideration of values or norms, for it is always concerned with
the achievement of objectives or the optimization of goals. In managerial economics,
we are interested in what should happen rather than what does happen. Instead of
explaining what a firm is doing, we explain what it should do to make its decision
effective.
Positive Economics
A positive science is concerned with ‘what is’. Robbins regards economics as a
pure science of what is, which is not concerned with moral or ethical questions.
Economics is neutral between ends. The economist has no right to pass judgment
on the wisdom or folly of the ends itself.He is simply concerned with the problem of
resources in relation to the ends desired. The manufacture and sale of cigarettes
and wine may be injurious to health and therefore morally unjustifiable, but the
economist has no right to pass judgment on these since both satisfy human wants
and involve economic activity.
Normative Economics
Normative economics is concerned with describing what should be the things.
It is, therefore, also called prescriptive economics. What price for a product should
be fixed, what wage should be paid, how income should be distributed and so on,
fall within the purview of normative economics?It should be noted that normative
economics involves value judgments. Almost all the leading managerial economists
are of the opinion that managerial economics is fundamentally normative and
prescriptive in nature.It refers mostly to what ought to be and cannot be neutral
5
about the ends.The application of managerial economics is inseparable from
consideration of values, or norms for it is always concerned with the achievement of
objectives or the optimization of goals.
In managerial economics, we are interested in what should happen rather than
what does happen. Instead of explaining what a firm is doing, we explain what it
should do to make its decision effective. Managerial economists are generally
preoccupied with the optimum allocation of scarce resources among competing
ends with a view to obtaining the maximum benefit according to predetermined
criteria.To achieve these objectives they do not assume ceteris paribus, but try to
introduce policies. The very important aspect of managerial economics is that it
tries to find out the cause and effect relationship by factual study and logical
reasoning. The scope of managerial economics is so wide that it embraces almost all
the problems and areas of the manager and the firm.
1.3.6 Demand Analysis and Forecasting
A firm is an economic organization which transforms inputs into output that is
to be sold in a market. Accurate estimation of demand, by analyzing the forces
acting on demand of the product produced by the firm, forms the vital issue in
taking effective decision at the firm level.A major part of managerial decision
making depends on accurate estimates of demand. When demand is estimated, the
manager does not stop at the stage of assessing the current demand but estimates
future demand as well. This is what is meant by demand forecasting.
This forecast can also serve as a guide to management for maintaining or
strengthening market position and enlarging profit. Demand analysis helps in
identifying the various factors influencing the demand for a firm’s product and thus
provides guidelines to manipulate demand. The main topics covered are: Demand
Determinants, Demand Distinctions and Demand Forecasting.
1.3.7 Cost and Production Analysis
Cost analysis is yet another function of managerial economics. In decision
making, cost estimates are very essential. The factors causing variation in costs
must be recognized and allowed for if management is to arrive at cost estimates
which are significant for planning purposes.The determinants of estimating costs,
the relationship between cost and output, the forecast of cost and profit are very
vital to a firm. An element of cost uncertainty exists because all the factors
determining costs are not always known or controllable. Managerial economics
touches these aspects of cost analysis as an effective knowledge and the application
of which is corner stone for the success of a firm.
Production analysis frequently proceeds in physical terms. Inputs play a vital
role in the economics of production. The factors of production otherwise called
inputs, may be combined in a particular way to yield the maximum
output.Alternatively, when the price of inputs shoots up, a firm is forced to work
out a combination of inputs so as to ensure that this combination becomes the
least cost combination. The main topics covered under cost and production
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analysis are production function, least cost combination of factor inputs, factor
productiveness, returns to scale, cost concepts and classification, cost-output
relationship and linear programming.
1.3.8 Inventory Management
An inventory refers to a stock of raw materials which a firm keeps. Now the
problem is how much of the inventory is the ideal stock. If it is high, capital is
unproductively tied up. If the level of inventory is low, production will be
affected.Therefore, managerial economics will use such methods as Economic
Order Quantity (EOQ) approach, ABC analysis with a view to minimising the
inventory cost. It also goes deeper into such aspects as motives of holding
inventory, cost of holding inventory, inventory control, and main methods of
inventory control and management.
Advertising
To produce a commodity is one thing and to market it is another. Yet the
message about the product should reach the consumer before he thinks of buying
it. Therefore, advertising forms an integral part of decision making and forward
planning. Expenditure on advertising and related types of promotional activities is
called selling costs by economists.There are different methods for setting
advertising budget: Percentage of Sales Approach, All You can Afford Approach,
Competitive Parity Approach, Objective and Task Approach and Return on
Investment Approach.
Pricing Decision, Policies and Practices
Pricing is very important area of managerial economics. The control functions
of an enterprise are not only productions but pricing as well. When pricing a
commodity, the cost of production has to be taken into account. Business decisions
are greatly influenced by pervading market structure and the structure of markets
that has been evolved by the nature of competition existing in the market.Pricing is
actually guided by consideration of cost plan pricing and the policies of public
enterprises. The knowledge of the pricing of a product under conditions of
oligopoly is also essential. The price system guides the manager to take valid and
profitable decision.
1.3.9 Profit Management
A business firm is an organisation designed to make profits. Profits are acid
test of the individual firm’s performance. In appraising a company, we must first
understand how profit arises. The concept of profit maximisation is very useful in
selecting the alternatives in making a decision at the firm level.Profit forecasting is
an essential function of any management. It relates to projection of future earnings
and involves the analysis of actual and expected behaviour of firms, the sales
volume, prices and competitor’s strategies, etc. The main aspects covered under
this area are the nature and measurement of profit, and profit policies of special
significance to managerial decision making.Managerial economics tries to find out
the cause and effect relationship by factual study and logical reasoning. For
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example, the statement that profits are at a maximum when marginal revenue is
equal to marginal cost, a substantial part of economic analysis of this deductive
proposition attempts to reach specific conclusions about what should be done.The
logic of linear programming is deduction of mathematical form. In fine, managerial
economics is a branch of normative economics that draws from descriptive
economics and from well established deductive patterns of logic.
1.3.10 Capital Management
Planning and control of capital expenditures is the basic executive function.
The managerial problem of planning and control of capital is examined from an
economic stand point. The capital budgeting process takes different forms in
different industries.It involves the equi-marginal principle. The objective is to
assure the most profitable use of funds, which means that funds must not be
applied when the managerial returns are less than in other uses. The main topics
dealt with are: Cost of Capital, Rate of Return and Selection of Projects.Thus we see
that a firm has uncertainties to rock on with. Therefore, we can conclude that the
subject matter of managerial economics consists of applying economic principles
and concepts towards adjusting with these uncertainties of the firm.In recent years,
there is a trend towards integration of managerial economics and Operation
Research. Hence, techniques such as linear Programming, Inventory Models,
Waiting Line Models, Bidding Models, Theory of Games, etc. have also come to be
regarded as part of managerial economics.
1.3.11 Relation to Other Branches of Knowledge
A useful method of throwing light on the nature and scope of managerial
economics is to examine its relationship with other disciplines. To classify the scope
of a field of study is to discuss its relation to other subjects. If we take the subject
in isolation, our study would not be useful. Managerial economics has a close
linkage with other disciplines and fields of study.
The subject has gained by the interaction with economics, mathematics and
statistics and has drawn upon management theory and accounting concepts. The
managerial economics integrates concepts and methods from these disciplines and
bringing them to bear on managerial problems.
1.3.12 Managerial Economics and Economics
Managerial Economics has been described as economics applied to decision
making. It may be studied as 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 behavior of the individual units and small
groups of such 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 micro-economic analysis may be undertaken at three levels
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(i) The equalization of individual consumers and produces;
(ii) The equalization of the single market;
(iii) The simultaneous equilibrium of all markets. The problems of scarcity and
optimal or ideal allocation of resources are the central problem in micro-economics.
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 also
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 and Managerial 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.
The chief contribution of macro-economics is in the area of forecasting. The
post-Keynesian aggregative theory has direct implications for forecasting general
business conditions. Since the prospects of an individual firm often depend greatly
on business in general, for-casts of an individual firm depend on general business
forecasts, which make use of models derived from theory. The most widely used
model in modern forecasting is the gross national product model.
1.3.13 Managerial Economics and Theory of Decision Making
The theory of decision making is a relatively new subject that has significance
for managerial economics. In the entire process of management and in each of the
management activities such as planning, organising, leading and controlling,
decision making is always essential. In fact, decision making is an integral part of
today’s business management. A manager faces a number of problems connected
with his/her business such as production, inventory, cost, marketing, pricing,
investment and personnel.
Economist are interested in the efficient use of scarce resources hence they are
naturally interested in business decision problems and they apply economics in
management of business problems. Hence managerial economics is economics
9
applied in decision making. According to M.H. Spencer and L. Siegelman,
“Managerial economics is the integration of economic theory with business practice
for the purpose of facilitating decision making up and forward planning by
management”. Managerial economics is a fundamental academic subject which
seeks to understand and to analyse the problems of business decision making.
The theory of decision making recognises the multiplicity of goals and the
pervasiveness of uncertainty in the real world of management. The theory of
decision making replaces the notion of a single optimum solution with the view that
the objective is to find solution that ‘satisfies’ rather than maximise. It probes into
an analysis of motivation of the relation of rewards and aspiration levels, and of
pattern of influence and authority.Economic theory and theory of decision making
appear to be in conflict, each based on different set of assumptions. Much of the
economic theory is based on the assumption of single goal-maximisation of utility
for the individual or maximisation of profit for the firm.
1.3.14 Managerial Economics and Operations Research
Mathematicians, statisticians, engineers and others teamed up together and
developed models and analytical tools which have since grown into a specialised
subject, known as operation research. The basic purpose of the approach is to
develop a scientific model of the system which may be utilised for policy
making.Much of the development of techniques and concepts such as Linear
Programming, Dynamic Programming, Input-output Analysis, Inventory Theory,
Information Theory, Probability Theory, Queueing Theory, Game Theory, Decision
Theory and Symbolic Logic.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. It is employed when the objective
function is to maximise profit, output or efficiency.
Dynamic programming helps in solving certain types of sequential decision
problems. A sequential decision problem is one in which a sequence of decision
must be made with each decision affecting future decision. It has been applied in
cases of maintenance and repair, financial portfolio balancing, inventory and
production control, equipment replacement and directed marketing.Input-output
analysis is a technique for analysing inter-industry relation. Prof. W.W. Leontief
tries to establish inter industry relationships by dividing the economy into different
sectors. In this model, the final demand is treated as exogenously determined and
the input-output technique is used to find out the levels of activity in the various
sectors of the economic system. It can be used by firms for planning, co-ordination
and mobilisation of resources.
Queueing is a particular application of the statistical decision theory. It is
employed to get the optimum solution. The theory may be applied to such problems
as how to meet a given demand most economically or how to minimise the waiting
10
period or idle time. The theory of games holds out the hope of solving certain
problems concerning oligopolistic interminacy.
When we apply the game theory, we have to consider the following:
(i) The players are the two firms;
(ii) They play the game in the market place;
(iii) Their strategies are their price or output decision; and
(iv) The pay-offs or rewards are their profits. The numerical figures are what is
called payoff matrix. This matrix is the most important tool of game theory.
1.3.15 Managerial Economics and Statistics
Statistics is important to managerial economics. It provides the basis for the
empirical testing of theory. Statistics is important in providing the individual firm
with measures of the appropriate functional relationship involved in decision
making. Statistics is a very useful science for business executives because a
business runs on estimates and probabilities.
Statistics supplies many tools to managerial economics. Suppose forecasting
has to be done. For this purpose, trend projections are used. Similarly, multiple
regression technique is used. In managerial economics, measures of central
tendency like the mean, median, mode, and measures of dispersion, correlation,
regression, least square, estimators are widely used. The managerial economics is
constantly faced with the choice between models ignoring uncertainty and those
that explicitly incorporate probability theory.
Statistical tools are widely used in the solution of managerial problems. For
example, sampling is very useful in data collection. Managerial economics makes
use of correlation and multiple regression in business problems involving some
kind of cause and effect relationship.
1.3.16 Managerial Economics and Accounting
Managerial economics is closely related to accounting. It is concerned with
recording the financial operation of a business firm. A business is started with the
main aim of earning profit. Capital is invested it is employed for purchasing
properties such as building, furniture, etc and for meeting the current expenses of
the business.Goods are bought and sold for cash as well as credit. Cash is paid to
credit sellers. It is received from credit buyers. Expenses are met and incomes
derived. This goes on the daily routine work of the business. The buying of goods,
sale of goods, payment of cash, receipt of cash and similar dealings are called
business transactions.The business transactions are varied and multifarious. They
are too numerous to be kept in one’s memory. This has given rise to the necessity of
recording business transaction in books. They are written in a set of books in a
systematic manner so as to facilitate proper study of their results.
There are three classes of accounts
(i) Personal account,
11
(ii) Property accounts, and
(iii) Nominal accounts.
Management accounting provides the accounting data for taking business
decisions. The accounting techniques are very essential for the success of the firm
because profit maximization is the major objective of the firm.
1.3.17 Managerial Economics and Mathematics
Mathematics is yet another important subject closely related to managerial
economics. For the derivation and exposition of economic analysis, we require a set
of mathematical tools. Mathematics has helped in the development of economic
theories and now mathematical economics has become a very important branch of
the science of economics.
Mathematical approach to economic theories makes them more precise and
logical. For the estimation and prediction of economic factors for decision making
and forward planning, the mathematical method is very helpful. The important
branches of mathematics generally used by a managerial economist are geometry,
algebra and calculus.The mathematical concepts used by the managerial
economists are the logarithms and exponential, vectors and determinants, input-
out tables. Operations research which is closely related to managerial economics is
mathematical in character.
1.3.18 Techniques and Methods of studying Marginal Economics
6 most important methods used by managerial economics to explain and solve
business problems of a firm:
Scientific Method
Scientific method is a branch of study which is concerned with observed facts
systematically classified and which includes trustworthy method for the discovery
of truths. It refers to a procedure or mode of investigation by which scientific and
systematic knowledge is acquired.
The method of enquiry is a very important aspect of science, perhaps this is
the most significant feature. Scientific method alone can bring about confidence in
the validity of conclusions. It concentrates on controlled experiments and
investigates the behaviour of preconceived elements in a highly simplified
environment.The experimental method may be usefully applied to those aspects of
managerial behaviour which call for accurate and logical thinking. The
experimental methods are of limited use to managerial economics. A managerial
economist cannot apply experimental methods to the same extent and in the same
way as a physicist can in physical sciences.
We usually adopt an inductive as well as deductive approach in any analysis of
managerial behaviour. The deductive method begins with postulates and
hypotheses which are arbitrary. For the rationalists, there stands at the head of
the system, a set of self-evident propositions and it is from these that other
propositions (theorems) are derived by the process of reasoning.
12
At the other end are inductionist (empiricists) who believe that science must
construct its axioms from the same data and particularly by ascending continually
and gradually till it finally arrives at the most general axioms.It is often asked what
the method of science is, whether induction or deduction? The proper answer to
this is, both. Both the methods are interdependent and hold an equally important
place in any scientific analysis.
The Statistical Method
Statistical methods are a mechanical process especially designed to facilitate
the condensation and analysis of the large body of quantitative data. The aim of
statistical method is to facilitate comparison, study relationships between the two
phenomena and to interpret the complicated data for the purpose of analysis.Many
a time comparison has to be made between the changes and results which are due
to changes in time, frequency of occurrence, and many other factors. Statistical
methods are used for such comparison among past, present and future estimates.
For example, such methods as extrapolation can be applied for the purpose of
making future forecast about the trends of say, demand and supply of a particular
commodity. The statistical method of drawing inference is mathematical in nature.
It not only establishes causal connection between two variables but also tries to
establish a mathematical relationship between them.Statistical approach is a
quantitative micro-approach. Certain important correlation and association of
attributes can be found with the help of statistics. It is useful for the study of
management, economics, etc. and it is very helpful to bankers, state, planners,
speculators, researchers, etc.
Though statistical methods are the handmaid of managerial economics, they
should be used with care. The most significant peculiarity of the statistical method
is that it helps us to seek regularities or patterns in economic data and permits us
to arrive at generalizations that cannot be reached by any other method.
Method of Intellectual Experiment
The fundamental problem in managerial economics is to find out the nature of
any relationship between different variables such as cost, price and output. The
real world is also invariably complex. It is influenced by many factors such as
physical, social, temperamental and psychological. It is difficult to locate any order,
sequence or law in such a confused and complex structure. In this context, it is
essential for the managerial economist to engage in model building.
At times, to analyze behavior we use models. A model is an abstraction from
reality. A model may be in the form of diagram, a verbal description or a
mathematical description. It can be classified into three categories such as iconic,
analogue and symbolic.Managerial economics may be viewed as economics applied
to problem solving at the level of the firm. The problems relate to choices and
allocation of resources is faced by managers all the time. Managerial economics is
more concrete and situational and mainly concerned with purposefully managed
process of allocation. For this purpose the managerial economist can and does use
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an abstract model of the enterprise.Models are approximate representations of
reality. They help us in understanding the underlying forces of the complex world of
reality through approximation. Model building is more useful in managerial
economics, as it helps us to know the actual socio-economic relationship prevailing
in a firm.Firms have only limited resources at their disposal which they must utilise
to make profit. The managers of these firms must make judgements about the
disposition of their resources and decide which priorities among the various
competing claims they have upon them. Models can guide business executives to
predict the future consequences.
The Method of Simulation
It is an extension of the intellectual experiment. This method has gained
popularity with the development of electronic computers, calculators and other
similar equipment and internet services. We can programme a complex system of
relationship with the help of this method. Computer is not only used for scientific
or mathematical applications, it may also be used for some business applications,
document generations and graphical solutions. Computer is a fast electronic
calculating machine capable of absorbing, processing, integrating, relating and
producing the resultant output information within a short span of time.
A manager has to take numerous decisions in the management of business
which may be minor or major, simple or complex. They have to ensure that once
the decision is taken, it is to be implemented within the minimum time and cost.
The electronic gadgets will enable the manager to understand business problems
in a better perspective and increase his ability to solve the business problems
facing him in the management of business.
The Historical Method
Past knowledge is considered to be a pre-requisite for present knowledge. This
is the main argument for the adoption of historical method in the present day
managerial economics. In order to discover some basis for business activity, the
method becomes generic in character.The main objective of this method is to apply
mind in the matter of various business problems by discovering the past trend
regarding facts, events and attitudes and by demarcating the lines of development
of thought and action. If we have an idea of the past events, we can understand the
current economic problems much better. The wisdom of a particular economic
policy is an inevitable product of its past.The historical method requires experience
not only in collecting data but also in finding out their relations and significance in
the particular context. The managerial economist must take up the analytical view
in order to get perfect control over facts and the synthetic view of facts.He should
be able to find out the relations between events and events and between events and
environment. It is necessary to make an objective approach both in discovering
facts and interpreting them. But in order to be objective, the approach must be
based on relevant, adequate and reliable data.For applying historical method, the
managerial economist should be familiar with the general field of his topic and be
14
clear with regard to his own objective. A good deal of imagination is required to
apply the historical method.
The Descriptive Method
The descriptive method is simple and easily applicable to various business
problems, particularly in developing countries. It is a fact finding approach related
mainly to the present and abstract generalisations through the cross sectional
study of the present situation. This method is mainly concerned with the collection
of data. To some extent, the descriptive method is also concerned with the
interpretation of data. In order to apply the descriptive method, the data should be
accurate and objective and if possible quantifiable.
1.4. REVISION POINTS
1. Content and meaning of Managerial Economics
2. Nature and Scope of Managerial Economics
3. Subject matter of Managerial Economics
4. Relationship between Managerial Economics and other subjects
5. Methods of studying Managerial Economics
1.5 INTEXT QUESTIONS
1. Define managerial Economics
2. Write a note on Nature and Scope of Managerial Economics
3. What are the subject matters covered in Managerial Economics
4. Discuss the relationship between Managerial Economics and other subjects
5. What are the methods and techniques of Managerial Economics Analysis
1.6SUMMARY
It could be seen clearly from above discussion that this lesson gives an overall
picture about the managerial Economics covering the areas relating to definitions of
managerial economics, meaning of managerial economics, nature of managerial
economics, scope of marginal economics, positive versus normative economics,
demand analysis and forecasting, cost and production analysis, inventory
management, profit management, capital management, relation to other branches
of knowledge, managerial economics and economics, managerial economics and
theory of decision making, managerial economics and operations research,
managerial economics and statistics, managerial economics and accounting,
managerial economics and mathematics and techniques or methods of marginal
economics. Thus this lesson gives a broad picture about the nature and scope of
managerial economics.
1.7 TERMINAL EXERCISE
1. Which of the following is the best definition of managerial economics?
Managerial economics is
a) Distinct field of economic theory.
b) A field that applies economic theory and the tools of decision science.
c) A field that combines economic theory and mathematics.
d) None of the above.
15
2. Management decision problems are comprised of three elements. Which of the
following is not one of them?
a) Profitability
b) Alternatives
c) Constraints
d) Objectives
1.8 SUPPLEMENTARY MATERIALS
1. William J. Baumol (1961). "What Can Economic Theory Contribute to
Managerial Economics?," American Economic Review, 51(2), pp. 142-46
2. Carl Shapiro (1989). "The Theory of Business Strategy," RAND Journal of
Economics, 20(1), pp. 125-137
3. Thomas J. Webster (2003). Managerial Economics: Theory and Practice, ch. 13
& 14, Academic Press. Description.
1. 9 ASSIGNMENT
1. Write a note on scope of managerial Economics
2. Explain the relationship between managerial Economics and other subjects
1.10SUGGESTED READINGS
1. Baye, Michael R. (2010) Managerial economics and business strategy. Vol. The
McGraw-Hill series economics. New York: McGraw-Hill/Irwin.
2. Boyes, William J. (2012) Managerial economics: markets and the firm. Boston,
Mass: Houghton Mifflin.
3. Hirschey M. and Bentzen E. (2014) Managerial economics. Andover: Cengage
Learning.
1.11LEARNING ACTIVITIES
1. To conduct a group discussion on positive versus normative aspects of
Managerial Economics.
2. To conduct a workshop on Nature and scope of Managerial Economics.
1.12. KEYWORDS
1. Managerial Economics, Nature and scope of Managerial Economics, positive
versus normative aspects of Managerial Economics.

16
LESSON – 2
PRINCIPLES AND APPLICATIONS OF MANAGERIAL ECONOMICS
2.1. INTRODUCTION
Managerial economics is a science that deals with the application of various
economic theories, principles, concepts and techniques to business management in
order to solve business and management problems. It deals with the practical
application of economic theory and methodology to decision-making problems faced
by private, public and non-profit making organizations. This lesson deals with
principles of managerial economics. It outlines the applications of managerial
economics and role of managerial economics. This lesson points out the importance
of the study of managerial economics.
2.2 OBJECTIVES
 To study the features of managerial economics
 To understand the principles of managerial economics
 To examine the area of the study under managerial economics
 To understand the importance of the study of managerial economics
2.3. CONTENT
2.3.1 Features of managerial Economics
2.3.2 The theories of business and management problems
2.3.3 Principles of managerial economics
2.3.4 Areas covered under the managerial economics
2.3.5 The central concept in managerial economics
2.3.6 Role of Managerial Economics in Business Process
2.3.7 Importance of the study of Managerial Economics
2.3.1 Features of managerial Economics
a) It is a new discipline and of recent origin
b) It is a highly specialized and separate branch by itself.
c) It is basically a branch of microeconomics and as such it studies the
problems of only one firm in detail.
d) It is mainly a normative science and as such it is a goal oriented and
prescriptive science.
e) It is more realistic, pragmatic and highlights on practical application of
various economic
2.3.2 The theories of business and management problems
It is a science of decision-making. It concentrates on decision-making process,
decision-models and decision variables and their relationships.
It is both conceptual and metrical and it helps the decision-maker by providing
measurement of various economic variables and their interrelationships.
It uses various macroeconomic concepts like national income, inflation,
deflation, trade cycles etc to understand and adjust its policies to the environment
in which the firm operates.
17
It also gives importance to the study of non-economic variables having
implications of economic performance of the firm. For example, impact of
technology, environmental forces, socio-political and cultural factors etc.
It uses the services of many other sister sciences like mathematics, statistics,
engineering, accounting, operation research and psychology etc to find solutions to
business and management problems.
2.3.3 Principles of managerial economics
Economic principles assist in rational reasoning and defined thinking. They
develop logical ability and strength of a manager. Some important principles of
managerial economics are discussed here.
Marginal and Incremental Principle
This principle states that a decision is said to be rational and sound if given
the firm’s objective of profit maximization, it leads to increase in profit, which is in
either of two scenarios-
* If total revenue increases more than total cost.
* If total revenue declines less than total cost.
Marginal analysis implies judging the impact of a unit change in one variable
on the other. Marginal generally refers to small changes. Marginal revenue is
change in total revenue per unit change in output sold. Marginal cost refers to
change in total costs per unit change in output produced (While incremental cost
refers to change in total costs due to change in total output). The decision of a firm
to change the price would depend upon the resulting impact/change in marginal
revenue and marginal cost. If the marginal revenue is greater than the marginal
cost, then the firm should bring about the change in price.
Incremental analysis differs from marginal analysis only in that it analysis the
change in the firm's performance for a given managerial decision, whereas marginal
analysis often is generated by a change in outputs or inputs. Incremental analysis
is generalization of marginal concept. It refers to changes in cost and revenue due
to a policy change. For example - adding a new business, buying new inputs,
processing products, etc. Change in output due to change in process, product or
investment is considered as incremental change. Incremental principle states that a
decision is profitable if revenue increases more than costs; if costs reduce more
than revenues; if increase in some revenues is more than decrease in others; and if
decrease in some costs
Equi-marginal Principle
Marginal Utility is the utility derived from the additional unit of a commodity
consumed. The laws of equi-marginal utility states that a consumer will reach the
stage of equilibrium when the marginal utilities of various commodities he
consumes are equal. According to the modern economists, this law has been
formulated in form of law of proportional marginal utility. It states that the
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consumer will spend his money-income on different goods in such a way that the
marginal utility of each good is proportional to its price,
i.e., MUx / Px = MUy / Py = MUz / Pz
Where, MU represents marginal utility and P is the price of good.
Similarly, a producer who wants to maximize profit (or reach equilibrium) will
use the technique of production which satisfies the following condition:
MRP1 / MC1 = MRP2 / MC2 = MRP3 / MC3
Where, MRP is marginal revenue product of inputs and MC represents
marginal cost.
Thus, a manger can make rational decision by allocating/hiring resources in a
manner which equalizes the ratio of marginal returns and marginal costs
Opportunity Cost Principle
By opportunity cost of a decision is meant the sacrifice of alternatives required
by that decision. If there are no sacrifices, there is no cost. According to
Opportunity cost principle, a firm can hire a factor of production if and only if that
factor earns a reward in that occupation/job equal or greater than it’s opportunity
cost. Opportunity cost is the minimum price that would be necessary to retain a
factor-service in it’s given use. It is also defined as the cost of sacrificed
alternatives. For instance, a person chooses to forgo his present lucrative job which
offers him Rs.50000 per month, and organizes his own business. The opportunity
cost (earning Rs. 50,000) will be the opportunity cost of running his own business.
Time Perspective Principle
According to this principle, a manger/decision maker should give due
emphasis, both to short-term and long-term impact of his decisions, giving apt
significance to the different time periods before reaching any decision. Short-run
refers to a time period in which some factors are fixed while others are variable. The
production can be increased by increasing the quantity of variable factors. While
long-run is a time period in which all factors of production can become variable.
Entry and exit of seller firms can take place easily. From consumers point of view,
short-run refers to a period in which they respond to the changes in price, given the
taste and preferences of the consumers, while long-run is a time period in which
the consumers have enough time to respond to price changes by varying their
tastes and preferences.
Discounting Principle
According to this principle, if a decision affects costs and revenues in long-run,
all those costs and revenues must be discounted to present values before valid
comparison of alternatives is possible. This is essential because a rupee worth of
money at a future date is not worth a rupee today. Money actually has time value.
Discounting can be defined as a process used to transform future dollars into an
equivalent number of present dollars. For instance, Rs.1 lakh invested today at
10% interest is equivalent to Rs 1.10 lakhs next year.
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FV = PV*(1+r)t
Where, FV is the future value time at some future time, PV is the present value
at t0, r is the discount interest rate, and t is the time between the future value and
present value.
2.3.4 Areas covered under the managerial economics
Broadly speaking, managerial economics deals with the following topics:
1. Demand analysis and forecasting
2. Cost and production analysis
3. Pricing decisions, policies and practices
4. Profit management
5. Capital management
6. Linear programming and theory of games.
1. Demand analysis and forecasting:
Accurate estimation of demand by analyzing the forces acting on demand of
the product produced by the firm forms the vital issue in taking effective decisions
at the firm level. Demand analysis attempts at finding out the forces of determining
sales. This has two main managerial purposes.
1. Forecasting sales and 2. Manipulating demand.
The demand analysis covers the topics like demand determinants, demand
distinctions and demand forecasting.
Cost and production analysis
In decision-making, cost estimates are very essential. Production planning,
profit planning etc depends upon sound pricing practices and accurate cost
analysis. Production analysis deals with physical terms of the product, while cost
analysis deals with the monetary terms. Cost analysis is concerned with cost
concepts, cost-output relations, economies of scale, production function and cost
control.
Pricing decisions, policies and practices
Pricing forms the core of managerial economics. The success or failure of a
firm mainly depends on accurate price decisions to effectively compete in the
market. The important aspects of the study under this are price determination
under different market conditions, pricing methods and police product line pricing
and price forecasting.
Profit management
All business enterprises are profit making institutions. The success or failure
of a firm is measured only in terms of profit it has made and the percentage of
dividend it has declared. Hence, profit management, profit policies and techniques.
Profit planning like break-even analysis is studied under this category.
Capital management
Capital management is the most troublesome problem for the management of
business involving high-level decisions. Capital management deals with planning
20
and control of capital expenditure. Cost of capital, rate of return and selection of
project etc.
Linear programming and theory of games
Linear programming and theory of games have come to be regarded as part of
managerial economics, as there is a trend towards integration of managerial
economics and operations research.
2.3.5 The central concept in managerial economics
Generally, profits are the primary measure of the success of any business. It
is the acid test of the economic strength of the firm. Economic theory makes a
fundamental assumption that maximizing profit is the basic aim of every firm. This
assumption is by and large true, though in modern society this may not always
hold good. Modern firms pursue multiple objectives such as welfare, obligations to
society and consumers etc. However, profit maximization receives top priority, if
not sole objective. Consequently, profit maximization continues to be the objective
of the firm and the study of firm in managerial economics has centered on the
concept of profit.
The maximization of profits is the main objective of any firm and the survival
of the firm depends on the profits it earns. Profits are the main indicator of a firm’s
success. It is the index of business efficiency. Further, the concept of profit
maximization is very much useful in selecting the alternatives in making a decision
at the firm-level.
Optimization
Another important concept used in managerial economics is ‘optimization’.
This aims at optimizing a given objective. The aim of linear programming is to aid
the process of optimization and choice. It offers numerical solutions to the problem
of making of optimum choices. This point of optimization emerges when they are
constraints optimization is basic to managerial economics in decision-making.
2.3.6 Role of Managerial Economics in Business process
1. To make reasonable profits on capital employed:
He must have strong conviction that profits are essential and his main
obligation is to assist the management in earning reasonable profits on capital
invested by the firm.He should always help the management to enhance the
capacity of the firm to earn profits. If he fails to discharge this responsibility then
his academic knowledge, experience, expertise and business skill will be of no use
to the firm.
2. Successful forecasts:
It is necessary for the managerial economist to make successful forecasts by
making in-depth study of internal and external factors that may have influence over
the profitability or the working of the firm.He must aim at lessening if not fully
eliminating the risk involved in uncertainties. It is his major responsibility to alert
management at the earliest possible time in case he discovers an error in his
forecast, so that the management can make necessary changes and adjustment in
21
the policies and programmes of the firm.A managerial economist is supposed to
forecast the trends in the activities of importance to the firm such as sales, profit,
demand, costs, competition, etc.He must inform the management about the trend
turning point of business activities of the firm.He must be willing to make
considered and fairly positive statement about occurring economic development.
3. Knowledge of sources of economic information’s:
A managerial economist should establish and maintain close contacts with
specialists and data sources in order to collect quickly the relevant and valuable
information in the field.For this purpose he should develop personal relation with
those having specialized knowledge of the field.He should also join professional
associations and take active part in their activities. His success depends on how
quickly he gathers additional information’s to serve best the interest of the firm.
4. Firm Business Status
A managerial economist must earn full status in the business team because
only then he can be really helpful to the management in formulating successful
business policies.He should be ready and even offer himself to take up special
assignments. He is to win continuing support for his professional ideas by
performing his functions efficiently in an atmosphere where his resources and
advice are widely sought and used.He should express his ideas and suggestions in
simple and understandable language with minimum use of technical words, while
communicating with his management executives.
It is clear from the above discussion that managerial economists perform many
and varied functions.However, of these, marketing function, i.e. sales forecasting
and industrial market research has been the most important.For carrying out their
functions, they may have to undertake detailed statistical analysis. Thus,
managerial economists help the management a lot in discharging its function of
making decisions and formulating forward plans.Managerial economist must see
that his responsibilities and functions are successfully discharged.He can give the
firm a profitable growth and his presence should be an effective solution to the
complex problems of the management.
2.3.7 Importance of the study of Managerial Economics
The following points indicate the significance of the study of this subject in its
right perspective.
 It gives guidance for identification of key variables in decision-making process.
 It helps the business executives to understand the various intricacies of
business and managerial problems and to take right decision at the right time.
 It provides the necessary conceptual, technical skills, toolbox of analysis and
techniques of thinking and other such most modern tools and instruments like
elasticity of demand and supply, cost and revenue, income and expenditure,
profit and volume of production etc to solve various business problems.
22
 It is both a science and an art. In the context of globalization, privatization,
liberalization and marketization and a highly competitive dynamic economy, it
helps in identifying various business and managerial problems, their causes
and consequence, and suggests various policies and programs to overcome
them.
 It helps the business executives to become much more responsive, realistic and
competent to face the ever changing challenges in the modern business world.
 It helps in the optimum use of scarce resources of a firm to maximize its
profits.
 It also helps in achieving other objectives a firm like attaining industry
leadership, market share expansion and social responsibilities etc.
 It helps a firm in forecasting the most important economic variables like
demand, supply, cost, revenue, price, sales and profit etc and formulate sound
business polices
 It also helps in understanding the various external factors and forces which
affect the decision-making of a firm.
Thus, it has become a highly useful and practical discipline in recent years to
analyze and find solutions to various kinds of problems in a systematic and rational
manner.
2. 4. REVISION POINTS
1. Features of Managerial Economics
2. Principles of Managerial economics
3. Importance of the study of Managerial Economics
2.5. INTEXT QUESTIONS
1. Discuss the Principles of Managerial Economics
2. Write a note on Role of Managerial Economics in business decision making
process
2.6.SUMMARY
It could be seen clearly from the above discussion that this lesson gives a
broad knowledge and understanding about the principles and applications
ofmanagerial economics with reference to features of managerial economics, the
theories to solve business and management problems, principles of managerial
economics, areas covered under the managerial economics, the central concept in
managerial economics, role of managerial economics and importance of the study of
managerial economics. Thus one can acquire through knowledge about the
principles and applications of managerial economics in business activities.
2.7. TERMINAL EXERCISE
1. Which of the following is the best definition of managerial economics?
Managerial economics is
a) a distinct field of economic theory.
b) a field that applies economic theory and the tools of decision science.
23
c) a field that combines economic theory and mathematics.
d) none of the above.
2. Decision making situations can be categorized along a scale which ranges from:
a) Uncertainty to certainty to risk
b) Certainty to uncertainty to risk
c) Certainty to risk to uncertainty
d) Certainty to risk to uncertainty to ambiguity
2. 8. SUPPLEMENTARY MATERIALS
Economics, 20(1), pp. 125-137
3. Prof. M.S. BHAT, and A.V. RAU.Managerial economics and financial
analysis.Hyderabad.ISBN 978-81-7800-153-1
2.9. ASSIGNMENT
1. Write a note on features of managerial economics.
2. Discuss the major principles of managerial economics.
2.10. SUGGESTED READINGS
1. Thomas, Christopher R. and Maurice, S. Charles (2011) Managerial economics:
foundations of business analysis and strategy. [New York, NY]: McGraw-Hill.
2. Truett, Lila Jean and TRUETT, Dale B. (2004) Managerial economics: analysis,
problems, cases. Hoboken, NJ: Wiley.
3. Wilkinson, Nick (2005) Managerial economics: a problem-solving approach.
Cambridge: Cambridge University Press.
2. 11. LEARNING ACTIVITIES
1. To conduct a group discussion on theories to solve business and management
problems.
2. To conduct a seminar on major principles of managerial economics.
2.12. KEYWORDS
1. Managerial economics, principles of managerial economics, areas of managerial
economics, importance of managerial economics.

24
LESSON – 3
OBJECTIVES OF FIRM
3.1. INTRODUCTION
This lessons deals with objectives of firm it outlines the Economic objectives,
social objectives, human objectives and social and psychological satisfaction of the
employees. This lesson points out the aim of the firm.
3.2. OBJECTIVES
 To study the organic and economic objectives of the firm
 To study the social and human objectives of the firm
 To study the National objectives of the firm
3.3. CONTENT
3.3.1 Organic objectives of the firm
3.3.2 Economic objectives
3.3.3 Social Objectives of the firm
3.3.4 Human Objectives of the firm
3.3.5 National Objectives of the firm
3.3.6 Aims of the Firms
3.3.7 Profit maximizing objectives of the firm
3.3.8 Management vs. Stockholders objectives of the firm
3.3.9 Social Responsibility of the Firm
3.3.1 Organic objectivesof the firm
Organic objectives can also be termed as threefold objective. In order to be
successful, the business organisation has to fulfill its primary objectives i.e. to
survive, to maintain growth and make profit.The Organic objectives of the business
are classified into: Survival, Growth and Prestige
Survival
Profit earning is regarded as a main objective of every business unit. But it is
essential for the survival and growth of every business enterprise. ‘To survive’
means, “to live longer”. Survival is the primary and fundamental objective of every
business firm.The business cannot grow until and unless it survives in a
competitive business world. Due to intense global competition, survival has become
extremely difficult for the organization.
Growth
Growth comes after survival. It is the second major business objective after
survival. Growth refers to an increase in the number of activities of an organization.
It is an important organic objective of an organization. Business takes place
through expansion and diversification. Business growth benefits promoters,
shareholders, consumers and the national economy.
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Prestige/Recognition
Prestige means goodwill or reputation arising from success or achievement.
This is the third organic objective after survival and growth. Business growth
enables the firm to establish goodwill in the market.The business firm has to satisfy
the human wants of the society. Along with profit it business wants to create a
distinct image and goodwill in the market.
3.3.2 Economic objectives

Economic objectives stand at the top most in the hierarchy of business
objectives. Economic objectives of business refer to the objective of earning profit
and others that include creation of customers, regular innovations and best
possible use of available resources.
Profit
The primary objective of every business is to earn profit. Profit is the lifeblood
of business, without which no business can survive in a competitive-market. Profit
is the financial gain or excess of return over investment.
It is the reward for bearing risk and uncertainty in the business. It is a
lubricant, which keeps the wheels of business moving. Profit is essential for the
survival, growth and expansion of the business.
Creating and retaining customers

Consumer is a king of the market. All the business activities revolve around
the consumers. The success of the business depends upon its customers. It is not
only necessary to make customers but also to hold the customers.
Competition is intensely rising. Hence to face this stiff competition, it is
necessary for the businessman to come out with new concepts and products for
attracting the new customers and retaining the old one.
Innovation
Innovation is the act of introducing something new. It means creativity i.e. to
come up with new ideas, new concepts and new process changes, which bring
about improvement in products, process of production and distribution of
goods.Innovation helps in reducing the cost by adopting better methods of
production. Reduction in the cost and quality products increase the sales thereby
increasing the economic gain of the firm. Hence to survive in the competitive world,
the business has to be innovative.
Optimum utilization of the scarce resources

Resources comprises of physical, human and capital that has to optimally
utilize for making profit. The availability of these resources is usually limited. So
the firm should make best possible use of these resources, wastage of the limited
resource should be avoided.
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3.3.3 Social Objectives of the firm
Consumer Suppliers
Employees Business Government
Creditors Environment
Social objective means objective relating to the society. This objective helps to
shape the character of the company in the minds of the society. The obligation of
any business to protect and serve public interest is known as social responsibility
of business.
Society comprises of the consumers, employees, shareholders, creditors,
financial institutions, government, etc. Business has some responsibility towards
the society. Businessmen engage themselves in research for improving the quality
of products; some provide housing, transport, education and health care to their
employees and their families.In some places businessmen provide free medical
facility to poor patients. Sometimes they also sponsor games and sports at national
as well as international level etc.
Towards the Employees
Employee of a business firm contributes to the success of the business firm.
They are the most important resource of the business. Every business is
responsible towards their employees in respect of wages, working conditions, etc.
The interest of the employees should be taken care of. The authorities should not
exploit the employees.
Towards the Consumers
Business has some obligation towards the consumers. No business can
survive without the support of customers. Now-a-days consumers have become
very conscious about their rights. They protest against the supply of inferior and
harmful products.This has made it obligatory for the business to protect the
interest of the consumers by providing quality products at the most competitive
price. They should charge the price according to the quality of the goods and
services provided to the consumers. There must be regularity in supply of goods
and services
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Towards Shareholders
Shareholders are the owners of the company. They provide finance by way of
investment in debentures, bonds, deposits etc. They contribute capital and bear the
business risks. The primary responsibilities of business towards.
It is the responsibility of the business to safeguard the capital of the
shareholders and provide a reasonable dividend. Business and Society are
interdependent. Society depends on business for meeting its needs and welfare,
whereas, Business depends on society for its existence and growth.
Towards the Creditors/financial institutions
Towards the Suppliers
Suppliers supply raw material, spare parts and equipment’s necessary for the
business. It is the responsibility of the business to give regular orders for the
purchase of goods, avail reasonable credit period and pay dues in time. The
business should maintain good relations with the supplier for regular supply of
quality raw material.
Towards the government
Government frame certain rules and regulations with in which the business
has to act.These are the following responsibilities of the business towards
government are:Paying taxes regularlyii. Conducting business in a lawful manner,
setting up business enterprise as per the government guidelines, avoiding
indulgence into monopolistic and restrictive trade practices and avoiding
indulgence into corruption and unlawful practices.
Towards the environment
The business is also responsible towards the environment. It is the
responsibility of the business to keep the environment pollution free by producing
pollution free products. Business is also responsible to conserve natural resources
and wild life and hence promote the culture.
3.3.4 Human Objectives of the firm
Human objective refers to the objectives aimed at well being of the employees
in the organization. It includes economic well-being of the employees and their
psychological satisfaction.Hence the human objectives of the business organization
can be explained with the following points:
Economic well-being of the employees
Employees should be given fair wages and incentives for their work done. They
should also be provided with the benefits of provident fund, pension and other
amenities like medical facilities, housing facilities etc.
Human Resource development
The organization should undertake necessary human resource development
programmes. Employees always want to grow and prosper. Employees to grow, the
firm must conduct proper training and development programmes to improve their
skills and competencies.
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Motivating employees
Employees need continuous motivation to improve their performance in their
job. It is the job of the organization and managers to motivate their employees by
providing them monetary and non-monetary incentives like bonus, increments,
promotions, job-enrichment, proper working conditions, appreciations etc.
motivated employees put efforts and are dedicated towards their job.
Social and psychological satisfaction of the employees
This is the most important objective of the organization towards their
employees. The business should provide social and psychological satisfaction to
their employees. Employees can feel satisfied if they are put on the right job
according to their skill, talent and qualification.The firm should give prompt
attention to the employee grievances and necessary suggestions should be
provided. Psychologically satisfied employees put best efforts in their work.
3.3.5 National Objectives of the firm
The business enterprise contributes for the upliftment of the nation. Every
business has an obligation towards nation to fulfill national goal: and aspirations.
The goal can be increase employment opportunities, earn foreign revenue, promote
social justice etc. The following national objectives are explained in detail:
Employment opportunities
Public benefit is the basic national objective of a business firm. Business
creates employment opportunities directly or indirectly. People can be employed in
production and distribution activities by establishing new business units,
expanding markets, widening distribution channels, transportation, insurance etc.
Developing backward areas
Business undertakes projects in the backward region and thereby develops the
backward areas of the nation. Business also helps in providing infrastructure
facilities in the backward regions of the country like transportation, banking,
communication etc.Opening of small-scale industries in those backward areas also
provide employment opportunities to the people and results into balanced regional
development.
Promoting social justice
The term social justice indicates uniform rights and equality to all the sections
of the society. Business can do justice with the society by providing them better
quality products and services at reasonable prices.They should not undertake any
malpractices and prevent the customers from being exploited. The business should
also provide equal opportunities to all the employees to work and progress.
Raising standard of living
Business can raise the standard of living of the people of the country by
making quality goods and services available at reasonable prices. Consuming
quality products enhances the standard of living of the people.
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Contributes revenue to the government
Business helps in earning more foreign exchange to the government by
undertaking export activities. The revenue of the government also increases by
payment of taxes by the business entities, which can further be used for the
development of the nation.
3.3.6 Aims of the Firms
However, in the real world, firms may pursue other objectives apart from profit
maximisation.
Profit Satisfying
In many firms there is 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, such as 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 and This ‘principal agent’ problem can be overcome, to some extent,
by giving mangers share options and performance related pay although in some
industries it is difficult to measure performance.
Sales Maximization
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.
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.
Growth Maximization
This is similar to sales maximization 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.
Long Run Profit Maximization
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.
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.Many companies who have
adopted such strategies have been quite successful. This has encouraged more
30
firms to consider these over objectives, but a cynic may argue they see it as another
opportunity to increase profits rather than a genuine sacrificing of profits in order
to promote other objectives.
Co-operatives Objectives
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
p
MC
p1
p2 AC
p3
p4
D=AR
Q1 Q2 Q3 Q4
Q1 = Profit maximisation (MR=MC)
Q2 = Revenue Maximisation (MR=0)
Q3 = Marginal cost pricing (P=MC) – allocative efficiency
Q4 = Sales maximisation – maximum sales whilst still making normal profit
(AR=ATC)
3.3.7 Profit maximizing objectives of the firm
We assume that the objective of the firm is to maximize its value to its
shareholders. Value is represented by the market price of the company’s common
stock, which, in turn, is a reflection of the firm’s investment, financing, and
dividend decisions.
Profit Maximization vs. Wealth MaximizationFrequently, maximization of
profits is regarded as the proper objective of the firm, but it is not as inclusive a
goal as that of maximizing shareholder wealth. For one thing, total profits are not
as important as earnings per share. A firm could always raise total profits by
issuing stock and using the proceeds to invest in Treasury bills. Even
maximization of earnings per share, however, is not a fully appropriate objective,
partly because it does not specify the timing or duration of expected returns. Is the
investment project that will produce Rs.100,000 return 5 years from now more
valuable than the project that will produce annual returns of Rs.15,000 in each of
the next 5 years? An answer to this question depends upon the time value of
money to the firm and to investors at the margin. Few existing stockholders would
think favorably of a project that promised its first return in 100 years. We must
take into account the time pattern of returns in our analysis.
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Another shortcoming of the objective of maximizing earnings per share is that
it does not consider the risk or uncertainty of the prospective earnings stream.
Some investment projects are far more risky than others. As a result, the
prospective stream of earnings per share would be more uncertain if these projects
were undertaken. In addition, a company will be more or less risky depending
upon the amount of debt in relation to equity in its capital structure. This risk is
known as financial risk; and it, too, contributes to the uncertainty of the
prospective stream of earnings per share. Two companies may have the same
expected future earnings per share, but if the earnings stream of one is subject to
considerably more uncertainty than the earnings stream of the other, the market
price per share of its stock may be less.
For the reasons above, an objective of maximizing earnings per share may not
be the same as maximizing market price per share. The market price of a firm’s
stock represents the focal judgment of all market participants as to what the value
is of the particular firm. It takes into account present and prospective future
earnings per share, the timing, duration, and risk of these earnings, and any other
factors that bear upon the market price of stock. The market price serves as a
performance index or report card of the firm’s progress; it indicates how well
management is doing in behalf of its stockholders.
3.3.8 Management vs. Stockholders objectives of the firm
In certain situations the objectives of management may differ from those of the
firm’s stockholders. In a large corporation whose stock is widely held, stockholders
exert very little control or influence over the operations of the company. When the
control of a company is separate from its ownership, management may not always
act in the best interests of the stockholders Agency Theory. Managersnotes that
sometimes are said to be "satisficers" rather than "maximizers"; they may be
content to "play it safe" and seek an acceptable level of growth, being more
concerned with perpetuating their own existence than with maximizing the value of
the firm to its shareholders. The most important goal to a management team of
this sort may be its own survival. As a result, it may be unwilling to take
reasonable risks for fear of making a mistake, thereby becoming conspicuous to the
outside suppliers of capital. In turn, these suppliers may pose a threat to
management’s survival.
It is true that in order to survive over the long run, management may have to
behave in a manner that is reasonably consistent with maximizing shareholder
wealth. Nevertheless, the goals of the two parties do not necessarily have to be the
same. Maximization of shareholder wealth, then, is an appropriate guide for how a
firm should act. When management does not act in a manner consistent with this
objective, we must recognize this as a constraint and determine the opportunity
cost. This cost is measurable only if we determine what the outcome would have
been had the firm attempted to maximize shareholder wealth.
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A Normative Goalbecause the principal of maximization of shareholder wealth
provides a rational guide for running a business and for the efficient allocation of
resources in society, we use it as our assumed objective in considering how
financial decisions should be made. The purpose of capital markets is to efficiently
allocate savings in an economy from ultimate savers to ultimate users of funds who
invest in real assets. If savings are to be channeled to the most promising
investment opportunities, a rational economic criteria must exist that governs their
flow. By and large, the allocation of savings in an economy occurs on the basis of
expected return and risk. The market value of a firm’s stock embodies both of these
factors. It therefore reflects the market’s tradeoff between risk and return. If
decisions are made in keeping with the likely effect upon the market value of its
stock, a firm will attract capital only when its investment opportunities justify the
use of that capital in the overall economy.
Put another way, the equilibration process by which savings are allocated in
an economy occurs on the basis of expected return and risk. Holding risk constant,
those economic units (business firms, households, financial institutions, or
governments) willing to pay the highest yield are the ones entitled to the use of
funds. If rationality prevails, the economic units bidding the highest yields will be
the ones with the most promising investment opportunities. As a result, savings
will tend to be allocated to the most efficient users. Maximization of shareholder
wealth then embodies the risk-return tradeoff of the market and is the focal point
by which funds should be allocated within and among business firms. Any other
objective is likely to result in the suboptimal allocation of funds and therefore lead
to less than optimal level of economic want satisfaction.
This is not to say that management should ignore the question of social
responsibility. As related to business firms, social responsibility concerns such
things as protecting the consumer, paying fair wages to employees, maintaining fair
hiring practices, supporting education, and becoming actively involved in
environmental issues like clean air and water. Many people feel that a firm has no
choice but to act in socially responsible ways; they argue that shareholder wealth
and, perhaps, the corporations vary existence depends upon its being socially
responsible. However, the criteria for social responsibility are not clearly defined,
making formulation of a consistent objective function difficult.
3.3.9 Social Responsibility of the Firm
Moreover, social responsibility creates certain problems for the firm. One is
that it falls unevenly on different corporations. Another is that it sometimes
conflicts with the objective of wealth maximization. Certain social actions, from a
long-range point of view, unmistakably are in the best interests of stockholders,
and there is little question that they should be undertaken. Other actions are less
clear, and to engage in them may result in a decline of profits and in shareholder
wealth in the long run. From the standpoint of society, this decline may produce a
conflict. What is gained in having a socially desirable goal achieved may be offset in
whole or part by an accompanying less efficient allocation of resources in society.
33
The latter will result in a less than optimal growth of the economy and a lower total
level of economic want satisfaction. In an era of unfilled wants and scarcity, the
allocation process is extremely important.
Many people feel that management should not be called upon to resolve the
conflict posed above. Rather, society, with its broad general perspective, should
make the decisions necessary in this area. Only society, acting through Congress
and other representative governmental bodies, can judge the relative tradeoff
between the achievement of a social goal and the sacrifice in the efficiency of
apportioning resources that may accompany realization of the goal. With these
decisions made, corporations can engage in wealth maximization and thereby
efficiently allocate resources, subject, of course, to certain governmental
constraints. Under such a system, corporations can be viewed as producing both
private and social goods, and the maximization of shareholder wealth remains a
viable corporate objective.
1. Organic objectives and economic objectives of the firm
2. Social and human objectives of the firm
3. National objectives of the firm
1. What are the Economic objectives of the firm?
2. Write a note on Social and human objectives of the firm
3. Discuss the overall objectives of the firm
3.6. SUMMARY
It could be seen clearly from the above discussion that this lesson gives on
idea about overall objectives of the firm with respect to organic objectives of the
firm,economic objectives,social objectives of the firm,human objectives of the
firm,national objectives of the firm,aims of the firms, profit maximizing objectives of
the firm, management vs. stockholders objectives of the firm and social
responsibility of the firm. It is clear that one can clearly understand the overall
objectives of the firm through this lesson.
1) The appropriate Objective of firm is
a) Maximization of Sales
b) Maximization of Profit
c) Maximization of Owner’s Wealth
d) None of the Above.
2) The objective of the firm is:
a) Revenue maximization
b) Profit maximization
c) Revenue maximization and cost minimization simultaneous
d) None of the above.
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3.8. SUPPLEMENTARY MATERIALS
Economics, 20(1), pp. 125-137
3.9. ASSIGNMENT
1. Write a note on Economic objectives of the firm
2. Discuss the National objectives of the firm
3. Explain the aim of the firm
Learning.
3.11. LEARNING ACTIVITIES
1. To conduct a workshop on Economic objectives of the firm
2. To conduct a group discussion on over all objectives of the firm
3.12. KEYWORDS
1. Economicobjectives, organic objectives, social objectives, human objectives,
national objectives

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LESSON-4
APPLICATION OF MANAGERIAL ECONOMICS IN BUSINESS
DECISION MAKING
4.1 INTRODUCTION
This lessons deals with application of managerial Economic in Business
decision making. Managerial economics applies economic theory and methods to
business and administrativedecision making. Managerial economics prescribes
rules for improvingmanagerial decisions. Managerial economics also helps
managers recognize how economicforces affect organizations and describes the
economic consequences of managerialbehaviour. It links traditional economics with
the decision sciences to developvital tools for managerial decision making. This
lessons deals with various aspects of application of managerial Economics in
Business Decision Making process.
4.2 OBJECTIVES
 To study the Role of Managerial Economics in Decision making
 To understand the Managerial Benefits of Managerial Economics
 To study the application of Managerial Economics in profit maximization of firm
4.3 CONTENT
4.3.1 Application of Economics tools and Techniques
4.3.2 Managerial Economics In Business Decision Making
4.3.3 Benefits of managerial economics to the business manager
4.3.4 Areas of Applications of managerial Economics
4.3.5 Profit maximization versus other motivations behind managerial decisions.
4.3.6 Business versus economic profits oriented Decision Making
4.3.7 Mode of Getting Profit Maximization
4.3.8 The Theory of Consumer Behavior in Business Decision Making
4.3.9 Role of managerial economist in business decision making
4.3.1 Application of Economics tools and Techniques
Managerial economics identifies ways to efficiently achieve goals. For
example,suppose a small business seeks rapid growth to reach a size that permits
efficient useof national media advertising. Managerial economics can be used to
identify pricingand production strategies to help meet this short-run objective
quickly and effectively.Managerial economicsapplies economic tools andtechniques
to business andadministrative decision makingchapter.
36
Management Decision Problem

 Product Price and Output
 Make or buy
 Product technique
 Internet Strategy
 Advertising Media and Intensity
 Investment and Financing
Economics Concepts Decision Sciences
 Frame for decisions
 Tools Techniques of analysis
 Theory of Consumer
 Theory of the firm Numerical Analysis
 Theory of Market  Statistical Analysis
Forecasting
Game Theory
Optimization
Managerial Economics
Use of economics Concept anddecision
Science Methodology to Solve Managerial
DecisionProblems
Optimal Solutions to
Managerial Decision
problems
Similarly, managerial economics provides production and marketing rules that

permitthe company to maximize net profits once it has achieved growth
objectives.Managerial economics has applications in both profit and not-for-profit
sectors.For example, an administrator of a nonprofit hospital strives to provide the
bestmedical care possible given limited medical staff, equipment, and related
resources.Using the tools and concepts of managerial economics, the administrator
can determinethe optimal allocation of these limited resources. In short, managerial
economicshelps managers arrive at a set of operating rules that aid in the efficient
use ofscarce human and capital resources. By following these rules, businesses,
nonprofitorganizations, and government agencies are able to meet objectives
efficiently.
To establish appropriate decision rules, managers must understand the
economicenvironment in which they operate. For example, a grocery retailer may
offer consumersa highly price-sensitive product, such as milk, at an extremely low
markupover cost—say, 1%or 2%—while offering less price-sensitive products, such
as non-prescription drugs, at markups of as high as 40% over cost. Managerial
economics4 PART I Overview of Managerial Economicsdescribes the logic of this
pricing practice with respect to the goal of profit maximization.
Similarly, managerial economics reveals that auto import quotas reduce
theavailability of substitutes for domestically produced cars, raise auto prices, and
37
createthe possibility of monopoly profits for domestic manufacturers. It does not
explainwhether imposing quotas is good public policy; that is a decision involving
broaderpolitical considerations. Managerial economics only describes the
predictable economicconsequences of such actions.
Managerial economics offers a comprehensive application of economic theory
andmethodology to managerial decision making. It is as relevant to the
management ofnonbusiness, nonprofit organizations such as government agencies,
cooperatives,schools, hospitals, museums, and similar institutions, as it is to the
management ofprofit-oriented businesses. Although this text focuses primarily on
business applications,it also includes examples and problems from the government
and nonprofitsectors to illustrate the broad relevance of managerial economics
concepts and tools.
4.3.2 Managerial Economics in Business Decision Making
Since a business organization has available resources, such as, capital, land
and labor, a business manager needs to select the best alternative and employ in
the most efficient manner, so as to attain the desired results. After a particular
decision is made relating to resources, plans about production, pricing and
materials are to be implemented. In this way, decision making and forward
planning go conjointly.
The fact that a business entity is influenced by the conditions is uncertainty
about the future and due to the changes in the business environment resulting
complexities in business decisions. Since no information or the knowledge about
the future sales, profits or the costs is available for a business executive, the
decisions are to be made on the basis of past data as well as the approximations
being forecasted. In order that the decision making process is carried out in such
conditions in an efficient way, economic theory is of great value and relevance, as it
deals with production, demand, cost, pricing etc. This gives rise to understand the
concepts of managerial economics for a business manager, so that he may apply
the economic principles to the business and appraise the relevance and impact of
external factors in relation to the business.
Having been regarded as micro economic as well as the economics of the firm,
managerial economics is related to the economic theory which is to be applied to
the business with the objective of solving business problems and to analyze
business situations and the factors constituting the environment in which a
business is operated. Managerial economics has been defined by Spencer and
Siegelman as, the integration of economic theory with business practice for
the purpose of facilitating decision making and forward planning by
management.
Managerial economics is very much capable of serving various purposes and
useful for managers in making decisions in relation to the internal environment. It
aims at the development of economic theory of the firm while facilitating the
decision making process with regard to sales and profits etc. Moreover, it enables to
38
take decisions about appropriate production and inventory policies for the future. It
is a branch of economics that is applied to analyze almost all business decisions. It
is meant to undertake risk analysis, production analysis that is useful for
production efficiency. Likewise, it is of great use for capital budgeting processes as
well. In the most positive form, it seeks to make successful forecasts with the
objective of minimizing the risks involved. It deals with the aspects as to how much
cash should be available and how much of it should be invested in relation to a
choice of processes and projects while making possible the economic feasibility of
various production lines.
A business produces goods which are in course of time to be sold in the
market on the basis of demand of consumers. Demand may be defined in brief as
the quantity of goods that the consumers are willing to buy at certain prices. In this
pursuit, the decisions related to demand are of much significance for managers, as
the process entails making appropriate estimates with successful forecasts on sales
before the activity of production is to be carried out. It is therefore demand analysis
is essential part of managerial economics since it enables to analyze the demand
determinants and forecasting with a deep involvement of value judgments. Above
and beyond, by considering whether the competitions are likely to increase or
decrease, a business manager with the help of managerial economics applications
is able to asses demand prospects as well as the social behavior that can result in
the expansion or the reduction of the sales of business products.
As regards the pricing of products being produced by a business entity, it is
one of the most critical decisions for a manager to fix the price of particular
products, as it is by means of pricing decisions taken by a manager, the inflow of
revenue is determined. The areas that are to be covered through managerial
economics application in this respect are, price methods, product line pricing and
price forecasting. Furthermore, Managerial economics deals with the cost estimates
that are helpful for management decisions. More to the point, it is important for a
manager to undertake production analysis and to determine economic cost with the
objective of profit planning and cost control processes.
Since the objective of a business entity in general is to generate or earn profits,
profit is the chief measure of success in this way. In respect of this, managerial
economics cover the aspects, such as, Profit policies and the techniques of profit
planning – Break Even Analysis – also called as cost volume profit analysis - that
assists significantly in profit planning and cost control methods with a view to
maximize profits of a business.
Managerial economics plays a significant role in business organizations. It is
very much effective to the management in decision making and forward planning in
relation to the internal operations of a business, as it gives clear understanding of
market conditions as well as analytical tools through which the competitions
prevailing in the markets can be studied, at the same time the market behavior can
be predicted. It enables to analyze the information about the business environment
39
in which a business is managed. It is meant to undertake systematic course of
business plans by making possible forecasts.
In this way, managerial economics contributes to the profitable growth of a
business and effective solutions of business problems by changing the economic
scenario in to the feasible business opportunities for business organizations. It thus
enables managers to optimize business decisions involving them in the activity of
forward planning effectively and efficiently.
4.3.3 Benefits of managerial economics to the business manager
A business manager is essentially involved in the processes of decision making
as well as forward planning. Decision making is an integral part of management.
Management and decision making are to be considered as inseparable. It is the
intellectual process and a purposeful activity which at varied times takes in hands
all the managerial activities, such as, planning, organizing, staffing, directing and
controlling. It is the process wherein an executive, by taking in to consideration
several alternatives reaches at the conclusion about how it should be dealt
successfully in a given situation. Thus, being a continuous activity, decision
making is regarded to be the heart of management. Decision making is nothing but
choice-making and the importance of choice-making emerges due to the fact that a
business faces the changes in the conditions in which it operates and there arise
unforeseen contingencies. The survival and the growth of a business in such
situations is directly determined through decision making process. It can be defined
clearly as selecting one of the best alternatives available - that entails being two or
more alternatives. According to George Terry, Decision making is the selection of a
particular course of action, based on some criteria, from two or more possible
alternatives. Decision making is thus choosing the best course of action out of the
available options while aiming at the achievement of particular organizational
objectives. Since a business organization has the available resources, such as,
capital, land and labor, a business manager needs to select the best alternative
among others and employ in the most efficient manner so as to attain the desired
results. After a particular decision is made relating to resources, plans about
production, pricing and materials are to be implemented. In this way, decision
making and forward planning go conjointly. The fact that a business entity is
influenced by the conditions is uncertainty about the future and due to the changes
in the business environment resulting complexities in business decisions. Since no
information or the knowledge about the future sales, profits or the costs is available
for a business executive, the decisions are to be made on the basis of past data as
well as the approximations being forecasted. In order that the decision making
process is carried out in such conditions in an efficient way, economic theory is of
great value and relevance as it deals with production, demand, cost, pricing etc.
This gives rise to understand the concepts of managerial economics for business
manager so that he may apply the economic principles to the business and
appraise the relevance and impact of external factors in relation to the business.
Having been regarded as micro economic as well as the economics of the firm,
40
managerial economics is related to the economic theory which is to be applied to
the business with the objective of solving business problems and to analyze
business situations and the factors constituting the environment in which a
business is operated. Managerial economics has been defined by Spencer and
Siegel man as, the integration of economic theory with business practice for the
purpose of facilitating decision making and forward planning by management.
Managerial economics is very much capable of serving various purposes and useful
for managers in making decisions in relation to the internal environment. It aims at
the development of economic theory of the firm while facilitating the decision
making process with regard to sales and profits etc. Moreover, it enables to take
decisions about appropriate production and inventory policies for the future. It is a
branch of economics that is applied to analyze almost all business decisions.
4.3.4 Areas of Applications of managerialEconomics
Some examples of managerial decisions have been provided above. The
application of managerial economics is, by no means, limited to these examples.
Tools of managerial economics can be used to achieve virtually all the goals of a
business organization in an efficient manner. Typical managerial decision making
may involve one of the following issues:
 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
It should be noted that the application of managerial economics is not limited
to profit-seeking business organizations. Tools of managerial economics can be
applied equally well to decision problems of nonprofit organizations. Mark Hirschey
and James L. Pappas cite the example of a nonprofit hospital. While a nonprofit
hospital is not like a typical firm seeking to maximize its profits, a hospital does
strive to provide its patients the best medical care possible given its limited staff
(doctors, nurses, and support staff), equipment, space, and other resources. The
hospital administrator can use the concepts and tools of managerial economics to
determine the optimal allocation of the limited resources available to the hospital.
In addition to nonprofit business organizations, government agencies and other
nonprofit organizations (such as cooperatives, schools, and museums) can use the
41
techniques of managerial decision making to achieve goals in the most efficient
manner.
While managerial economics is helpful in making optimal decisions, one
should be aware that it only describes the predictable economic consequences of a
managerial decision. For example, tools of managerial economics can explain the
effects of imposing automobile import quotas on the availability of domestic cars,
prices charged for automobiles, and the extent of competition in the auto industry.
Analysis of managerial economics will reveal that fewer cars will be available, prices
of automobiles will increase, and the extent of competition will be reduced.
Managerial economics does not address, however, whether imposing automobile
import quotas is good government policy. This latter question encompasses broader
political considerations involving what economists call value judgments.
4.3.5 Profit maximization versus other motivations behind managerial decisions.
The present value maximization criterion as a basis for the study of the firm's
behavior has come under severe criticism from some economists. The critics argue
that business managers are interested, at least partly, in factors other than the
firm's profits. In particular, they may be interested in power, prestige, leisure,
employee welfare, community well-being, and the welfare of the larger society. The
act of maximization itself has been criticized; there is a feeling that managers often
aim merely to "satisfice" seek solutions that are considered satisfactory, rather than
really try to optimize or maximize seek to find the best possible solution, given the
constraints. This question is often rhetorically posed as: does a manager really try
to find the sharpest needle in a haystack or does he or she merely stop upon
finding a needle sharp enough for sewing needs?
Under the structure of a modern firm, it is hard to determine the true motives
of managers. A modem firm is frequently organized as a corporation in which
shareholders are the legal owners of the firm, and the manager acts on their behalf.
Under such a structure, it is difficult to determine whether a manager merely tries
to satisfy the stockholders of the firm while pursuing other goals, rather than truly
attempting to maximize the value (the discounted present value) of the firm. It is,
for example, difficult to interpret company support for a charitable organization as
an integral part of the firm's long-term value maximization. Similarly, if the firm's
size is increasing, but profits are not, can one attribute the manager's decision to
expand as being motivated by the increased prestige associated with larger firms, or
as an attempt to make the firm more noticeable in the marketplace? As it is
virtually impossible to provide definitive answers to these and similar questions, the
attempt to analyze these issues has led to the development of alternative theories of
firm behavior. Some of the preeminent alternate models assume one of the
following: (1) a firm attempts primarily to maximize its size or growth, rather than
its present value; (2) the managers of firms aim at maximizing their own personal
utility or welfare; and (3) the firm is a collection of individuals with widely divergent
goals, rather than a single common, identifiable goal.
42
While each of the alternative theories of the firm has increased our
understanding of how a modern firm behaves, none has been able to completely
take the place of the basic profit maximization assumption for several reasons.
Numerous academic studies have shown that intense competition in the markets
for goods and services of the firm usually forces the manager to make value
maximization decisions; if a firm does not decide on the most efficient alternative
(implying the need to seek the minimum costs for each output level, given the
market price of the commodity the firm is producing), others can outcompete the
firm and drive it out of existence. Competition also has its effects through the
capital markets. As one would expect, stockholders are primarily interested in their
returns on stocksand stock prices, which in turn, are determined by the firm's
value (the discounted present value of expected profits). Thus, managers are forced
to maximize profits in order to maximize firm value, an important basis for returns
on common stocks in the long run. Managers who insist on goals other than
maximizing shareholder wealth risk being replaced. An inefficiently managed firm
may also be bought out; in almost all such hostile takeovers, managers pursuing
their own interests will most likely be replaced. Moreover, a number of academic
studies indicate that managerial compensation is closely correlated to the profits
generated for the firm. Thus, managers themselves have strong financial incentives
to seek profit maximization for their firms.
Before arriving at the decision whether to maximize profits or to satisfies,
managers like other economic entities have to analyze the costs and benefits of
their decisions. Sometimes, when all costs are taken into account, decisions that
appear merely aimed at a satisfactory level of performance turn out to be consistent
with value-maximizing behavior. Similarly, short-term firm-growth maximization
strategies have often been found to be consistent with long-term value
maximization behavior, since large firms have advantages in production,
distribution, and sales promotion. Thus, many other goals that do not seem to be
oriented to maximizing profits may be intimately linked to value or profit
maximization—so much so that the value maximization model even provides an
insight into a firm's voluntary participation in charity or other socially responsible
behavior.
4.3.6 Business Versus Economic Profits Oriented Decision Making
As discussed above, profits are central to the goals of a firm and managerial
decision making. Thus, to understand the theory of firm behavior properly, one
must have a clear understanding of profits. While the term profit is very widely
used, an economist's definition of profit differs from the one used by accountants
which is also usually used by the general public and the business community.
Profit in accounting is defined as the excess of sales revenue over the explicit
accounting costs of doing business. This surplus is available to the firm for various
purposes.
An economist also defines profit as the difference between sales revenue and
costs of doing business, but includes more items in figuring costs, rather than
43
considering only explicit accounting costs. For example, inputs supplied by owners
including labor, capital, and space are accounted for in determining costs in the
definition used by an economist. These costs are sometimes referred to as implicit
costs—their value is imputed based on a notion of opportunity costs widely used by
economists. In other words, costs of inputs supplied by an owner are based on the
values these inputs would have received in the next best alternative activity. For
illustration, assume that the owner of the firm works for ten hours a day at his
business. If the owner does not receive any salary, an accountant would not
consider the owner's effort as a cost item. An economist would, however, value the
owner's service to his firm at what his labor would have earned had he worked
elsewhere. Thus, to compute the true profit, an economist will subtract the implicit
costs from business profit; the resulting profit is often referred to as economic
profit. It is this concept of profit that is used by economists to explain the behavior
of a firm. The concept of economic profit essentially recognizes that owner-supplied
inputs must also be paid for. Thus, the owner of a firm will not be in business in
the long run until he recovers the implicit costs also known as normal profit, in
addition to recovering the explicit costs, of doing business.
As pointed out earlier, a given firm attempts to maximize profits. Other firms
do the same. Ultimately, profits decline for all firms. If all firms are operating under
a competitive market structure, in equilibrium, economic profits the excess of
accounting profits over implicit costs would be equal to zero; accounting profits
equal to explicit costs, however would be positive. When a firm makes profits above
the normal profits level, it is said to be reaping above-normal profits.
4.3.7 Mode of Getting Profit Maximization
Let us assume throughout the discussion that a firm uses an economist's
definition of profits. Assume that profit is the excess of sales revenue over cost now
assumed to be composed of both explicit and implicit costs. It can also be assumed, as
discussed above, that the profit maximization is the firm's primary goal. Given this
objective, important questions remain: How does the firm decide on the output level
that maximizes its profits? Should the firm continue to produce at all if it is not
profitable?
A manufacturing firm, motivated by profit maximization, calculates the total cost
of producing any given output level. The total cost is made up of total fixed cost (due to
the expenditure on fixed inputs) and total variable cost (due to the expenditure on
variable inputs) of course, the total fixed cost does not vary over the short run—only
the total variable cost does. It is important for the firm to also calculate the cost per
unit of output, called the average cost. In addition to the average cost, the firm
calculates the marginal cost. The marginal cost at any level of output is the increase in
the total cost due to an increase in production by one unit—essentially, the marginal
cost is the additional cost of producing the last unit of output.
The average cost is made up of two components: the average fixed cost (the
total fixed cost divided by the number of units of the output produced) and the
44
average variable cost (the total variable cost divided by the number of units of the
output produced). As the fixed costs remain fixed over the short run, the average
fixed cost declines as the level of production increases. The average variable cost,
on the other hand, first decreases and then increases; economists refer to this as
the U-shaped nature of the average variable cost. The U-shape of the average
variable cost curve is explained as follows. Given the fixed inputs, output of the
relevant product increases more than proportionately as the levels of variable
inputs used increase. This is caused by increased efficiency due to specialization
and other reasons. As more and more variable inputs are used in conjunction with
the given fixed inputs, however, efficiency gains reach a maximum—the decline in
the average variable cost eventually comes to a halt. After this point, the average
variable cost starts increasing as the level of production continues to increase,
given the fixed inputs. First decreasing and then increasing average variable cost
lead to the U-shape for the average variable cost. The combination of the declining
average fixed cost (true for the entire range of production) and the U-shaped
average variable cost results into an U-shaped behavior of the average total cost,
often simply called the average cost.
The marginal cost also displays a U-shaped pattern—it first decreases and
then increases. The logic for the shape of the marginal cost curve is similar to that
for the average variable cost—both relate to variable costs. But while the marginal
cost refers to the increase in total variable cost due to an increase in the production
by one unit, the average variable cost refers to the average variable cost per unit of
output produced. It is important to notice, without going into finer details, that the
marginal cost curve intersects the average and the average variable cost curves at
their minimum cost points.
In a graphic rendering of this concept there would be a horizontal line, in
addition to the three cost curves. It is assumed that the firm can sell as many units
as it wants at the given market price indicated by this horizontal line. Essentially,
the horizontal line is the demand curve a perfectly competitive firm faces in the
market—it can sell as many units of output as it deems profitable at price "p" per
unit (p, for example, can be $10 per unit of the product under consideration). In
other words, p is the firm's average revenue per unit of output. Since the firm
receives p dollars for every successive unit it sells, p is also the marginal revenue
for the firm.
A firm maximizes profits, in general, when its marginal revenue equals
marginal cost. If the firm produces beyond this point of equality between the
marginal revenue and marginal cost, the marginal cost will be higher than the
marginal revenue. In other words, the addition to total production beyond the point
where marginal revenue equals marginal cost, leads to lower, not higher, profits.
While every firm's primary motive is to maximize profits, its output decision
(consistent with the profit maximizing objective), depends on the structure of the
market it is operating under. Before we discuss important market structures, we
briefly examine another key economic concept, the theory of consumer behavior.
45
4.3.8The Theory of Consumer Behavior in Business Decision Making
Consumers play an important role in the economy since they spend most of
their incomes on goods and services produced by firms. In other words, they
consume what firms produce. Thus, studying the theory of consumer behavior is
quite important. What is the ultimate objective of a consumer? Economists have an
optimization model for consumers, similar to that applied to firms or producers.
While firms are assumed to be maximizing profits, consumers are assumed to be
maximizing their utility or satisfaction. Of course, more goods and services will, in
general, provide greater utility to a consumer. Nevertheless, consumers, like firms,
are subject to constraints—their consumption and choices are limited by a number
of factors, including the amount of disposable income (the residual income after
income taxes are paid for). The decision to consume by consumers is described by
economists within a theoretical framework usually termed the theory of demand.
The demand for a particular product by an individual consumer is based on
four important factors. First, the price of the product determines how much of the
product the consumer buys, given that all other factors remain unchanged. In
general, the lower the product's price the more a consumer buys. Second, the
consumer's income also determines how much of the product the consumer is able
to buy, given that all other factors remain constant. In general, a consumer buys
more of a commodity the greater is his or her income. Third, prices of related
products are also important in determining the consumer's demand for the
product. Finally, consumer tastes and preferences also affect consumer demand.
The total of all consumer demands yields the market demand for a particular
commodity; the market demand curve shows quantities of the commodity
demanded at different prices, given all other factors. As price increases, quantity
demanded falls.
Individual consumer demands thus provide the basis for the market demand
for a product. The market demand plays a crucial role in shaping decisions made
by firms. Most important of all, it helps in determining the market price of the
product under consideration which, in turn, forms the basis for profits for the firm
producing that product.
The amount supplied by an individual firm depends on profit and cost
considerations. As mentioned earlier, in general, a producer produces the profit
maximizing output. Again, the total of individual supplies yields the market supply
for a particular commodity; the market supply curve shows quantities of the
commodity supplied at different prices, given all other factors. As price increases,
the quantity supplied increases.
The interaction between market demand and supply determines the
equilibrium or market price (where demand equals supply). Shifts in demand curve
and/or supply curve lead to changes in the equilibrium price. The market price and
the price mechanism play a crucial role in the capitalist system—they send signals
both to producers and consumers.
46
4.3.9 Role of managerial economist in business decision making
The role of managerial economist can be summarized as follows:
1. He studies the economic patterns at macro-level and analysis its significance
to the specific firm he is working in.
2. He has to consistently examine the probabilities of transforming an ever-
changing economic environment into profitable business avenues.
3. He assists the business planning process of a firm.
4. He also carries cost-benefit analysis.
5. He assists the management in the decisions pertaining to internal functioning
of a firm such as changes in price, investment plans, type of goods /services
to be produced, inputs to be used, techniques of production to be employed,
expansion/ contraction of firm, allocation of capital, location of new plants,
quantity of output to be produced, replacement of plant equipment, sales
forecasting, inventory forecasting, etc.
6. In addition, a managerial economist has to analyze changes in macro-
economic indicators such as national income, population, business cycles,
and their possible effect on the firm’s functioning.
7. He is also involved in advising the management on public relations, foreign
exchange, and trade. He guides the firm on the likely impact of changes in
monetary and fiscal policy on the firm’s functioning.
8. He also makes an economic analysis of the firms in competition. He has to
collect economic data and examine all crucial information about the
environment in which the firm operates.
9. The most significant function of a managerial economist is to conduct a
detailed research on industrial market.
10. In order to perform all these roles, a managerial economist has to conduct an
elaborate statistical analysis.
11. He must be vigilant and must have ability to cope up with the pressures.
12. He also provides management with economic information such as tax rates,
competitor’s price and product, etc. They give their valuable advice to
government authorities as well.
13. At times, a managerial economist has to prepare speeches for top
management.
1. Managerial Economicsin Decision Making process
2. Application of Managerial Economics in various areas of Business
3. Profit Maximizing Decisions
4. Role of Managerial Economist in Business decision making
4. 5. INTEXT QUESTIONS
1. Write a note on Managerial Economic in Business Decision making process
2. What are the areas of application ofManagerial Economicin business decision
making
47
4.6. SUMMARY
It could be seen clearly from above discussion that this lesson gives a broad
view on application ofManagerial Economic in business decision making with
reference to application of economics tools and techniques,managerial economics in
business decision making,benefits of managerial economics to the business
manager,areas of applications of managerial economics,profit maximization versus
other motivations behind managerial decisionsbusiness versus economic profits
oriented decision making,mode of getting profit maximization,the theory of
consumer behavior in business decision making and role of managerial economist
in business decision making. Thus one can acquire wider knowledge about the role
of managerial economics is business decision making process.
1. Which of the following is NOT included in the decisions that every society must make?
a) what goods will be produced
b) who will produce goods
c) what determines consumer preferences
d) who will consume the goods
1. Prof. M.S. Bhat, and A.V. RAU.Managerial economics and financial
2. Alan Hughes (1987). "managerial capitalism," The New Palgrave: A Dictionary of
Economics, v. 3, pp. 293–96.
4.9. ASSIGNMENT
1. Write a note on application of Managerial Economics in Business Decision
Making Process
2. Discuss the benefits of Economic Decisions in Business Management
4.11.LEARNING ACTIVITIES
1. To conduct the seminar on Managerial Decision Making Process
2. To conduct a group Discussion on Application of Managerial Economics in
various Aspects of Business Decision Making
4.12. KEYWORDS
1. Business Decision Making, Managerial Economics, Business Manager.

48
UNIT–II : DEMAND ANALYSIS AND FORECASTING

LESSON – 5
DEMAND THEORY
5.1 INTRODUCTION
People demand goods and services in an economy to satisfy their wants. All
goods and services have wants satisfying capacity which is known as “UTILITY” in
economics. Utility is highly subjective concept; it is different from person to person.
Utility (level of satisfaction) is measured by means of introspection. By demand for
goods and services economists essentially mean is willingness as well as ability of
the consumer in procuring and consuming the goods and services. Thus, demand
for a commodity or service is dependent upon (a) its utility to satisfy want or desire
(b) capability of the prospective consumer to pay for the good or service. In nutshell
therefore we can state that when desire is backed by willingness and ability to pay
for a good ot service then it becomes Demand for the good or service Conceptually,
demand is nothing but consumer’s readiness to satisfy desire by paying for goods
or services. A desire accompanied by ability and willingness to pay makes a real or
effective demand. This lesson deals with Demand theory. It outlines the significance
of the demand, theory of demand and factors determining the demand
5.2 OBJECTIVES
 To study the Significance of the concept of demand
 To examine the law of demand
 To study the factors determining the demand
5.3. CONTENT
5.3.1 Significance of the concept of demand
5.3.2 Law of Demand
5.3.3 Demand Function
5.3.4 Demand Schedule
5.3.5 Demand Curve
5.3.6 Variation in Demand
5.3.7 Demand Function Mathematical form
5.3.8 Factors Determining the Demand
5.3.9 The relationship between the income of a consumer and demand
5.3.10 Related goods and demand
5.3.1 Significance of the concept of demand
Demand is one of the most important decisions making variables in present
globalised, liberlised and privatized economy. Under such type of an economy
consumers and producers have wide choice. There is full freedom to both that is
buyers and sellers in the market. Therefore Demand reflects the size and pattern of
the market. The future of a producer is depends upon the well analysed consumer’s
demand. Even the firm dose not want to make profit as such but want to devote for
‘customer services’ or ‘social responsibilities’. That is also not possible without
49
evaluating the consumer’s tastes, preferences, choice etc. All these things are
directly built into the economic concept of demand.
The survival and the growth of any business enterprise depends upon the
proper analysis of demand for its product in the market. Demand analysis has
profound significance to management for day today functioning and expansion of
the business. Thus the short term and long term decisions of the management are
depend upon the trends in demand for the product. Any rise or fall in demand for
the product has to be to find out reasons and revised production plans, technology
or change in advertisement, packging, quality etc.
The market system works in an orderly manner because it is governed by
certain Fundamental Laws of Market known as Law of Demand and Supply The
demand and supply forces determine the price of goods and services in the market.
The laws of demand and supply plays very important role in economic analysis
.Thomas Carlyle, the famous 19th century historian remarked “It is easy to make
parrot learned in economics; teach a parrot to say demand and supply” The most
important function of microeconomics is to explain the laws of demand and supply,
market mechanism and working of the price system. Here we will discuss the
concept of demand and demand analysis.
5.3.2 Law of Demand
Law of demand states that whenever price of a product increases then the
demand for that product decreases and vice versa provided other things remain
constant. Here these other things are Income of the individual, Price of related
goods, Tastes and preferences, Population, Advertisement etc. While studying the
law of demand the direct relationship between price and demand is studied. This is
because under the economic theory price of a product is considered as the main
determinant of demand in the short run period.
5.3.3 Demand Function
As per the law of demand, demand is function of price provided other things
remain constant
Dx = f (Px) Dx is demand for commodity X, which is dependent variable, and
Px is the price of X, which is independent variable. The demand function if
consideredv as linear or straight line function can be expressed in the form of
following equation:
Dx = a + bPx
Where a and b are constants. 'a' is intercept and 'b' quantifies the relationship
between Dx and Px. The demand price relationship can be both linear and non-
linear. The relationship between demand and the price can also be expressed as
follows:
∆Px→∆Qdx
↑ Px →↓ Qdx
↓ Px →↑ Qdx
50
Here Qdx indicates the change in the quantity of demand if the price
changes and as per the law of demand an inverse or opposite relationship between
price and quantity demanded of a commodity is assumed.In simple words, if the
price of a product is high then its demand will be low and vice versa. This
relationship is also exhibited in the digrammatic representation of the demand
curve. To state more clearly, if we are digrammatically representing demand by
taking demand on the X axis and the price of the product on the Y axis then we
always get a demand curve sloping downwards from the left to right indicating the
price demand relationship as expressed by the law of demand.
5.3.4 Demand Schedule
A demand schedule is the tabular presentation of the different levels of
prices at corresponding levels of quantity demanded of that commodity. It shows at
different levels of prices higher or lower how the quantity demanded is different.
This shows the relationship between price and quantity demanded of a commodity
i. e. law of demand.
Demand Schedule of Note Books
Quantity of Notebooks
Price per Notebook (Px
Demanded (Dx)
25 2
20 4
15 8
10 10
8 12
5.3.5 Demand Curve

Demand curve is the graphical representation of the demand schedule.
Demand curve is obtained by plotting a demand schedule on a graph. As discussed
earlier, demand curve slopes downward from left to right. It has a negative slope. It
shows there is inverse relationship between price and quantity demanded of a
commodity.
Again, as discussed earlier, Demand curve can be both Linear or Non-linear -
If the Demand Curve is Non-linear then the equation of Demand is as follows:
Dx = aPx -b
If Demand Curve is Linear, then the equation of Demand curve is taken as
follows:
Dx = a – bPx
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The diagrammatic representation of the Demand Curve can be as follows:

The Own-Price Elasticity of Demand D
Own-price elasticity of demand
(Continued)
◮Price elasticity demand is symbolized by _.
p
◮0 _ _ _ −1
p1 D
⋆When |_| >1, demand is elastic.
Price
⋆When |_| <1, demand is inelastic.
⋆When |_| = 1, demand is unitary.
Demand curves with zero and infinite
price a Elasticity’s of Demand
0 Q Q1
X
Demand
5.3.6 Variation in Demand
Expansion and Contraction of Demand 0
When demand changes due to change Price

dollars
in price of that commodity then the
phenomenon is known as variation or 15
expansion or contraction in demand
whereas when demand changes due to
other factor, that is known as change in
demand.
When we say the variation in demand
takes place in the market for a particular
product or service means this 0
Quantity
phenomenon occurs (that is rise or fall in
Demand Curve Price Elasticity’s
demand) only because of change in
its price.Here consumer remains on the same demand curve. He shifting up or
down on the same demand curve as shown in dig. Therefore law of demand is
concerned with the phenomenon that is variation in demand which is accompanied
by Rise and Fall in price, or known as expansion and contraction in demand.
Change in Demand
When we say the change in demand takes place in the market for a particular
product or service means due change in its other factors like income, taste,
preferences etc and not because of its price. Thus due to rise or fall in income of a
consumer or change in preferences, taste etc there is rise or fall in demand for a
commodity or services. Here quantity demanded of a commodity is more or less at
same or higher or lower price. Here consumer shift on higher demand curve to the
right or lower demand curve to the left. This phenomenon is known as Change in
Demand which is accompanied by increase and decrease in demand.
52
The reasons behind the law of demand and the shape of demand curve are
following.
Income Effect When price of a commodity falls, real income (i.e. purchasing
power) of a consumer increases in terms of that commodity. So our rational will
consume more of relatively cheaper. Such increase in demand due to increase in
real income is called as income effect, Substitution Effect When price of commodity
falls, its becomes relatively cheaper compare to its other close substitutes Rational
consumer will definitely buy more units of relatively cheaper good than relatively
dearer whose price has remain same to maximize the satisfaction. On account of
this factor is known as substitution effect. Diminishing Marginal Utility This
also responsible for the for the increase in demand for a commodity when its price
falls. When a person buys a commodity he exchanges his money income with the
commodity in order to maximize his satisfaction. He continues to buy goods and
services so long as marginal utility of money is less than marginal utility of
commodity. (MUm < MUx )
Therefore general shape of demand curve is negatively sloping downward from
left to right. It positively slopes upward from left to right in case of inferior, Giffen or
complimentary goods.
5.3.7 Demand Function Mathematical form
Therefore new demand function for long run is:
Dx = f (Px, Py,_Pn, Y , W, A, F ,Zp, T, etc ) Where: Dx = Demand for a
commodity
Px = Price of a commodity
Py = Price of a Y good which is close substitute for X good
Pn = Prices of n number of close substitutes
Y = Income of a consumer and Engle curves
W = Wealth of a consumer
A = Advertisement and Publicity
F = Fashion or demonstration effect
Zp = Size and composition of population of population
T = Taste and Preferences of a consumer
Exp = Expected price and utility at equilibrium
Cr = Existing short- term credit facilities
3.8 Factors Determining the Demand
Price - The law of demand states that when prices rise, the quantity
demanded falls. This also means that, when prices drop, demand will rise. People
base their purchasing decisions on price, if all other things are equal. The exact
quantity bought for each price level is described in the Demand Schedule. It's then
plotted graphically to show the Demand Curve.
If the quantity demanded responds a lot to price, then it's known as elastic
demand. If the quantity doesn't change much, regardless of price, that's inelastic
demand. However, the demand curve can only show the relationship between the
price and quantity. If one of the other determinants changes, the entire demand
curve shifts.
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Income - When income rises, so will the quantity demanded. When income
falls, so will demand. However, even if your income doubles, you won't
necessarily buy twice as much of a particular good or service. There's only so many
pints of ice cream you'd want to eat, no matter how rich you are. That's where the
concept of marginal utility comes into the picture. The first pint of ice cream tastes
delicious. You might have another. But after that the marginal utility starts to
decrease to the point where you don't want any more. (At least until tomorrow.)
Prices of related goods or services - The price of complementary goods or
services raises the overall cost of using the good you demand, so you'll want less.
For example, when gas prices rose to $4 a gallon in 2008, the demand for Hummers
fell. Gas is a complementary good to Hummers. The overall cost of driving a
Hummer rose along with gas prices.The opposite reaction occurs when the price of
a substitute rises. When that happens, people will want less of the good or service.
That's why Apple constantly innovates with its iPhones and iPods. As soon as a
substitute, such as the Droid, appears at a lower price, Apple comes out with a
better product, so now the Droid isn't really a substitute.
Tastes - This is the desire, emotion, or preference for a good or service. When
tastes rise, so does the quantity demanded. Likewise, when tastes fall, it will
depress the quantity demanded. This is what brand advertising is all about.
Buick spent millions to make you think its not only for older people.
Expectations - When people expect that the value of something will rise, then
they demand more of it. This explains the housing asset bubble of 2005. Housing
prices rose, but people bought more because they expected the price to continue to
go up. This drove prices even further, until the bubble burst in 2006. Between 2007
and 2011, housing prices fell 30%. However, the quantity demanded didn't really
improve. Why? People expected prices to continue falling, thanks to record levels of
foreclosures entering the market. Demand didn't improve until people expected
future prices would, too. For more, see Subprime Mortgage Crisis Explained.
Number of buyers in the market - The number of buyers affects overall, or
aggregate, demand. As more buyers enter the market rises, so does the quantity
demanded -- even if prices don't change. This was another reason for the housing
bubble. Low-cost and sub-prime mortgages increased the number of people who
were told they could afford a house. The number of buyers actually increased,
driving up the demand for housing. When they found they really couldn't afford the
mortgage, especially when housing prices started to fall, they foreclosed. This
reduced the number of buyers, and demand also fell.
Price of a Product or Service
Affects the demand of a product to a large extent. There is an inverse
relationship between the price of a product and quantity demanded. The demand
for a product decreases with increase in its price, while other factors are constant,
and vice versa.
For example, consumers prefer to purchase a product in a large quantity when
the price of the product is less. The price-demand relationship marks a significant
contribution in oligopolistic market where the success of an organization depends
on the result of price war between the organization and its competitors.
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ii. Income:
Constitutes one of the important determinants of demand. The income of a
consumer affects his/her purchasing power, which, in turn, influences the demand
for a product. Increase in the income of a consumer would automatically increase
the demand for products by him/her, while other factors are at constant, and vice
versa.
For example, if the salary of Mr. X increases, then he may increase the pocket
money of his children and buy luxury items for his family. This would increase the
demand of different products from a single family. The income-demand relationship
can be analyzed by grouping goods into four categories, namely, essential consumer
goods, inferior goods, normal goods, and luxury goods.
5.3.9 The relationship between the income of a consumer and demand
a. Essential or Basic Consumer Goods:
Refer to goods that are consumed by all the people in the society. For example,
food grains, soaps, oil, cooking fuel, and clothes. The quantity demanded for basic
consumer goods increases with increase in the income of a consumer, but up to a
fixed limit, while other factors are constant.
b. Normal Goods:
Refer to goods whose demand increases with increase in the consumer’s
income. For example, goods, such as clothing, vehicles, and food items, are
demanded in relatively increasing quantity with increase in consumer’s income. The
demand for normal goods varies due to .different rate of increase in consumers’
income.
c. Inferior Goods:
Refer to goods whose demand decreases with increase in the income of
consumers. For example, a consumer would prefer to purchase wheat and rice
instead of millet and cooking gas instead of kerosene, with increase in his/her
income. In such a case, millet and kerosene are inferior goods for the consumer.
However, these two goods can be normal goods for people having lower level
of income. Therefore, we can say that goods are not always inferior or normal; it is
the level of income of consumers and their perception about the need of goods.
d. Luxury Goods:
Refer to goods whose demand increases with increase in consumer’s income.
Luxury goods are used for the pleasure and esteem of consumers. For example,
expensive jewellery items, luxury cars, antique paintings and wines, and air
travelling.
iii. Tastes and Preferences of Consumers
Play a major role in influencing the individual and market demand of a
product. The tastes and preferences of consumers are affected due to various
factors, such as life styles, customs, common habits, and change in fashion,
standard of living, religious values, age, and sex.
A change in any of these factors leads to change in the tastes and preferences
of consumers. Consequently, consumers reduce the consumption of old products
and add new products for their consumption. For example, if there is change in
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fashion, consumers would prefer new and advanced products over old- fashioned
products, provided differences in prices are proportionate to their income.
Apart from this, demand is also influenced by the habits of consumers. For
instance, most of the South Indians are non-vegetarian; therefore, the demand for
non- vegetarian products is higher in Southern India. In addition, sex ratio has a
relative impact on the demand for many products.
For instance, if females are large in number as compared to males in a
particular area, then the demand for feminine products, such as make-up kits and
cosmetics, would be high in that area.
iv. Price of Related Goods
Refer to the fact that the demand for a specific product is influenced by the
price of related goods to a greater extent.
5.3.10 Related goods and demand
a. Substitutes
Refer to goods that satisfy the same need of consumers but at a different price.
For example, tea and coffee, jowar and bajra, and groundnut oil and sunflower oil
are substitute to each other. The increase in the price of a good results in increase
in the demand of its substitute with low price. Therefore, consumers usually prefer
to purchase a substitute, if the price of a particular good gets increased.
b. Complementary Goods
Refer to goods that are consumed simultaneously or in combination. In other
words, complementary goods are consumed together. For example, pen and ink, car
and petrol, and tea and sugar are used together. Therefore, the demand for
complementary goods changes simultaneously. The complementary goods are
inversely related to each other. For example, increase in the prices of petrol would
decrease the demand of cars.
v. Expectations of Consumers
Imply that expectations of consumers about future changes in the price of a
product affect the demand for that product in the short run. For example, if
consumers expect that the prices of petrol would rise in the next week, then the
demand of petrol would increase in the present.
On the other hand, consumers would delay the purchase of products whose
prices are expected to be decreased in future, especially in case of non-essential
products. Apart from this, if consumers anticipate an increase in their income, this
would result in increase in demand for certain products. Moreover, the scarcity of
specific products in future would also lead to increase in their demand in present.
vi. Effect of Advertisements
Refers to one of the important factors of determining the demand for a
product. Effective advertisements are helpful in many ways, such as catching the
attention of consumers, informing them about the availability of a product,
demonstrating the features of the product to potential consumers, and persuading
them to purchase the product. Consumers are highly sensitive about
advertisements as sometimes they get attached to advertisements endorsed by their
favorite celebrities. This results in the increase demand for a product.
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vii. Distribution of Income in the Society
Influences the demand for a product in the market to a large extent. If income
is equally distributed among people in the society, the demand for products would
be higher than in case of unequal distribution of income. However, the distribution
of income in the society varies widely.
This leads to the high or low consumption of a product by different segments
of the society. For example, the high income segment of the society would prefer
luxury goods, while the low income segment would prefer necessary goods. In such
a scenario, demand for luxury goods would increase in the high income segment,
whereas demand for necessity goods would increase in the low income segment.
viii. Growth of Population
Acts as a crucial factor that affect the market demand of a product. If the
number of consumers increases in the market, the consumption capacity of
consumers would also increase. Therefore, high growth of population would result
in the increase in the demand for different products.
ix. Government Policy
Refers to one of the major factors that affect the demand for a product. For
example, if a product has high tax rate, this would increase the price of the
product. This would result in the decrease in demand for a product. Similarly, the
credit policies of a country also induce the demand for a product. For example, if
sufficient amount of credit is available to consumers, this would increase the
demand for products.
x. Climatic Conditions
Affect the demand of a product to a greater extent. For example, the demand of
ice-creams and cold drinks increases in summer, while tea and coffee are preferred
in winter. Some products have a stronger demand in hilly areas than in plains.
Therefore, individuals demand different products in different climatic conditions.
a) Meaning of demand
b) Law of demand
c) Determinants of demand
a) Define demand schedule
b) Explain the law of demand
c) What are the Determinants of demand?
5. 6. SUMMARY
It could be seen clearly from the above discussion that this lesson gives an
idea about law of demand and determinants of demand. This lesson covers the
significance of the concept of demand, relating to law of demand, demand function,
demand schedule, demand curve, variation in demand, demand function
mathematical form, factors determining the demand, the relationship between the
income of a consumer and demand and related goods and demand.
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5. 7. TERMINAL EXERCISE
1. Demand for a commodity refers to
a) Desire for a Commodity
b) Need for a commodity
c) Quantity demanded of that commodity
d) Quantity of the commodity demanded at a certain price during any
particular period of time
2.Demand for a commodity depends on
a) Price of that commodity
b) Price of related commodity
c) Income
d) All of the above
3.Law of Demand establishes
a) Inverse relationship between price and quantity
b) Positive relationship between price and quantity
c) Both
d) None
5. 9. ASSIGNMENT
1. Write a note on Application of Demand Theory in Managerial Economics
2. What are the Determinants of demand?
5.10.SUGGESTED READINGS
Learning.
2. Hirschey, Mark (2008) Fundamentals of managerial economics. Mason, Ohio:
South-Western.
1. To conduct the work shop on factors determining the demand
2. To conduct a group discussion on Application of demand theory
5.12. KEYWORDS
1. Law of demand, demand function, demand schedule, determinants of demand

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LESSON-6
ELASTICITY DEMAND
6.1 INTRODUCTION
Elasticity can be quantified as the ratio of the percentage change in one
variable to the percentage change in another variable, when the latter variable has
a causal influence on the former. A more precise definition is given in terms of
differential calculus. It is a tool for measuring the responsiveness of one variable to
changes in another, causative variable. Elasticity has the advantage of being a
unitless ratio, independent of the type of quantities being varied. Frequently used
elasticities include price elasticity of demand, price elasticity of supply, income
elasticity of demand, elasticity of substitution between factors of production and
elasticity of intertemporal substitution. This lesson deals with Elasticity of Demand.
It outlines the price Elasticity of Demand and income Elasticity of Demand. This
lesson points out the measurement of Elasticity of Demand.
6.2 OBJECTIVES
 To study the Elasticity of Demand
 To understand the price Elasticity of Demand and income Elasticity of
Demand
 To study the factors determining the Elasticity of Demand
6. 3. CONTENT
6. 3.1 Concept of Elasticity of Demand
6. 3.2 Definition of 'Price Elasticity of Demand'
6. 3.3 Price Elasticity of demand along a linear demand curve
6. 3.4 Price Elasticity of demand and revenue
6. 3.5 Need for Price Elasticity of Demand
6. 3.6 Determinants of Price Elasticity Of Demand
6. 3.7 Income Elasticity of Demand
6. 3.8 Diagrammatic representation of income elasticity
6. 3.9 Relationship between nature of commodities and income elasticity
6. 3.10 Measuring Elasticity of Demand
6. 3.11 cross elasticity of demand
6. 3.1 Concept of Elasticity of Demand
Elasticity is one of the most important concepts in neoclassical economic
theory. It is useful in understanding the incidence of indirect taxation, marginal
concepts as they relate to the theory of the firm, and distribution of wealth and
different types of goods as they relate to the theory of consumer choice. Elasticity is
also crucially important in any discussion of welfare distribution, in particular
consumer surplus, producer surplus, or government surplus.
59
Price elasticity of demand is a measure used to show the responsiveness, or
elasticity, of the quantity demanded of a good or service to a change in its price.
More precisely, it gives the percentage change in quantity demanded in response to
a one percent change in price (ceteris paribus, i.e. holding constant all the other
determinants of demand, such as income).
6. 3.2 Definition of 'Price Elasticity of Demand'

A measure of the relationship between a change in the quantity demanded of a
particular good and a change in its price. Price elasticity of demand is a term in
economics often used when discussing price sensitivity. The formula for calculating
price elasticity of demand is:Price Elasticity of Demand = % Change in Quantity
Demanded / % Change in Price
If a small change in price is accompanied by a large change in quantity

demanded, the product is said to be elastic (or responsive to price changes).
Conversely, a product is inelastic if a large change in price is accompanied by a
small amount of change in quantity demanded. Price elasticity of demand
measures the responsiveness of demand to changes in price for a particular good. If
the price elasticity of demand is equal to zero, demand is perfectly inelastic i.e.,
demand does not change when price changes. Values between zero and one
indicate that demand is inelastic this occurs when the percent change in demand is
less than the percent change in price. When price elasticity of demand equals one,
demand is unit elastic the percent change in demand is equal to the percent change
in price. Finally, if the value is greater than one, demand is perfectly elastic demand
is affected to a greater degree by changes in price.
For example, if the quantity demanded for a good increases 15% in response to
a 10% decrease in price, the price elasticity of demand would be 15% / 10% = 1.5.
The degree to which the quantity demanded for good changes in response to a
change in price can be influenced by a number of factors. Factors include the
number of close substitutes (demand is more elastic if there are close substitutes)
and whether the good is a necessity or luxury (necessities tend to have inelastic
demand while luxuries are more elastic).
Businesses evaluate price elasticity of demand for various products to help

predict the impact of a pricing on product sales. Typically, businesses charge
higher prices if demand for the product is price inelastic.
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6. 3.3 Price Elasticity of demand along a linear demand curve
Price Elasticity of Demand on a linear demand curve will fall continuously as
the curve slopes downwards, moving from left to right. PRICE Elasticity of Demand
= 1 at the midpoint of a linear demand curve.
Price
PED>1
P PED=1
PED<1
D=AR
MR
Fig- 1
6. 3.4 Price Elasticity of demand and revenue
There is a precise mathematical connection between PRICE ELASTICITY OF
DEMAND and a firm’s revenue.
There are three ‘types’ of revenue:
1. Total revenue (TR), which is found by multiplying price by quantity sold (P x Q).
2. Average revenue (AR), which is found by dividing total revenue by quantity sold
(TR/Q). Consider these figures and calculate Total, Marginal and Average
Revenue.
3. Marginal revenue (MR), which is defined as the revenue from selling one extra
unit. This is calculated by finding the change in TR from selling one more unit.
PRICE (£) Qd TR MR AR
10 1 2 2 6
9 2 1 3 5
8 3 5 5 8
7 4 6 7 1
6 5 7 10 9
5 6 8 4 3
4 7 4 8 4
3 8 10 6 7
2 9 3 1 2
1 10 9 5 10
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Observations
When TR is at a maximum, MR = zero, and PRICE ELASTICITY OF DEMAND =
price
PED> 1 TR
P PED=1
PED<1
D =AR
Q Quantity
MR
fig-2
Price and AR are identical, because AR = TR/Q, which is P x Q/Q, and cancel
out the Qs to get P.
1. A curve plotting AR (=P) against Q is also a firm’s demand curve.
2. TR increases, reaches a peak and decreases.
6.3.5 Need for Price Elasticity of Demand
There are several reasons why firms gather information about the Price
elasticity of demand of its products. A firm will know much more about its internal
operations and product costs than it will about its external environment. Therefore,
gathering data on how consumers respond to changes in price can help reduce risk
and uncertainly. More specifically, knowledge of Price Elasticity of Demand can
help the firm forecast its sales and set its price.
Sales forecasting
The firm can forecast the impact of a change in price on its sales volume, and
sales revenue (total revenue, TR). For example, if PRICE ELASTICITY OF DEMAND
for a product is (-) 2, a 10% reduction in price (say, from £10 to £9) will lead to a
20% increase in sales (say from 1000 to 1200). In this case, revenue will rise from
£10,000 to £10,800.
Pricing policy
Knowing Price Elasticity of Demand helps the firm decide whether to raise or
lower price, or whether to price discriminate. Price discrimination is a policy of
charging consumers different prices for the same product. If demand is elastic,
revenue is gained by reducing price, but if demand is inelastic, revenue is gained by
raising price.
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Non-pricing policy
When Price Elasticity of Demand is highly elastic, the firm can use advertising
and other promotional techniques to reduce elasticity.
6. 3.6 Determinants of Price Elasticity of Demand
There are several reasons why consumers may respond elastically or in
elastically to a price change, including:
The number and ‘closeness’ of substitutes
A unique and desirable product is likely to exhibit an inelastic demand with
respect to price.
The degree of necessity of the good
A necessity like bread will be demanded in elastically with respect to price.
Whether the good is habit forming
Consumers are also relatively insensitive to changes in the price of habitually
demanded products.
The proportion of consumer income which is spent on the good
The price elasticity of demand for a daily newspaper is likely to be much lower
than that for a new car!
Whether consumers are loyal to the brand
Brand loyalty reduces sensitivity to price changes and reduces price elasticity
of demand
Life cycle of product
Price Elasticity of Demand will vary according to where the product is in its life
cycle. When new products are launched, there are often very few competitors and
Price Elasticity of Demand is relatively inelastic. As other firms launch similar
products, the wider choice increases PRICE ELASTICITY OF DEMAND Finally, as a
product begins to decline in its lifecycle, consumers can become very responsive to
price, hence discounting is extremely common.
The effects of advertising
price Firms may use persuasive advertising by
to win new customers and retain the
loyalty of existing ones.
Advertisers use a range of media,
TR including television, press, and
electronic media. Advertising will shift
P demand to the right, and make demand
less elastic.
There are three extreme cases of Price
D1 Elasticity of Demand
D Perfectly elastic, where only one
price can be charged, Perfectlyinelastic,
where only one quantity will be
purchased, Unit elasticity, where all the
Q
MR Quantity
possible price and quantity combinations
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are of the same value. The resultant curve is called a rectangular hyperbola, Go to:
point elasticity of demand, Try a quiz on Price Elasticity of Demand
3.7 Income Elasticity of Demand
In economics, income elasticity of demand measures the responsiveness of the
demand for a good to a change in the income of the people demanding the good,
ceteris paribus. It is calculated as the ratio of the percentage change in demand to
the percentage change in income. For example, if, in response to a 10% increase in
income, the demand for a good increased by 20%, the income elasticity of demand
would be 20%/10% = 2.
A negative income elasticity of demand is associated with inferior goods; an
increase in income will lead to a fall in the demand and may lead to changes to
more luxurious substitutes
A positive income elasticity of demand is associated with normal goods; an
increase in income will lead to a rise in demand. If income elasticity of demand of a
commodity is less than 1, it is a necessity good. If the elasticity of demand is
greater than 1, it is a luxury good or a superior good.
A zero income elasticity of demand occurs when an increase in income is not
associated with a change in the demand of a good. These would be sticky goods.
Income elasticity of demand can be used as an indicator of industry health, future
consumption patterns and as a guide to firm’s investment decisions. For example,
the "selected income elasticity’s" below suggest that an increasing portion of
consumer's budgets will be devoted to purchasing automobiles and restaurant
meals and a smaller share to tobacco and margarine.
Income elasticity is closely related to the population income distribution and
the fraction of the product's sales attributable to buyers from different income
brackets. Specifically when a buyer in a certain income bracket experiences an
income increase, their purchase of a product changes to match that of individuals
in their new income bracket. If the income share elasticity is defined as the negative
percentage change in individuals given a percentage increase in income bracken the
income-elasticity, after some computation, becomes the expected value of the
income-share elasticity with respect to the income distribution of purchasers of the
product. When the income distribution is described by a gamma distribution, the
income elasticity is proportional to the percentage difference between the average
income of the product's buyers and the average income of the population.
Now let us consider the data given below and calculate the income elasticity of
demand. Income of the consumer =Rs.5000/- Increased income =Rs.6000/-
Original demand for butter = 2 Kg Increased demand for butter =2.50Kg
From the data we get,
∆q = 0.50
∆y = 1000
y=5000
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q=2
Substituting these values in the formula for income elasticity we get,
Ey =(∆q/∆y)(y/q)
=(0.50/1000)(5000/2)
=5/4
=1.25
6.3.8 Diagrammatic representation of income elasticity
Y D1
Income
D1
Y2 Y Income
Y1
Y2
Y1
450
O Q1 Q2 O Q1 Q2
Quantity demanded Ey>1 Quantity demanded Ey>1
ASDASD
D1
Income Y
Y - Income
Y2 Y2
Y1
Y1
O Q1 Q2 O Q X
Quantity demanded Ey<1 Quantity demanded Ey=0
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6. 3.9 Relationship between nature of D
Y Income
commodities and income elasticity D1
Now let us understand the different
possibilities.
Normal good
Normal goods have positive income Y2
elasticity of demand. If with an increase
in the income there is an increase in the Y1
demand for the good, we refers to this as
positive income elasticity of demand.
D
The increase could be large or small.
Hence when the increase is such that
percentage change in demand is less
than the percentage change in income
(income elasticity being greater than zero
but less than one) it represents a O Q1 Q2
necessary good(0<Ey<1).However if the Quantity demanded Ey<0
percentageincrease in demand is more
than percentage increase in income then such commodities are considered as
luxury goodsInferior goods Inferior goods have negative income elasticity of
demand.If with an increase in the income there is a decrease in the demand for the
good, we refers to this as negative income elasticity of demand(Ey<0). When the
income of the consumer increases he finds it below his dignity to purchase some
goods and hence when his income increases he prefers to consume less of the
goods he used to purchase earlier or opts for some other good which according to
him has a better position and are consumed by people belonging to the higher
income group.
Note income elasticity of demand varies across product range.Further over a
longrun period with changes in the taste and preference and consumer’s perception
of commodities elasticity of demand is likely to change.A product which was a
luxury at one point of time becomes a necessity today. Consider the market for
foreign travel.A few decades ago,long distance foreign travel was regarded as a
luxury. Now as real price levels have come down and incomes have grown, a large
number of people are travelling to different places for a short or long period.
Activity
Classify the commodities in your own consumption basket as normal
goods,luxury goods and inferior goods. b.Are the commodities mentioned below
normal goods,luxury goods or inferior goods ? Give reason for your answer.
Salt,camera,fruits,milk,Two wheeler,Cigarettes,medicines,Picasso's painting,Laptop.
The following table gives the quantity of a commodity X that a family would
purchase at various income levels. Find the income elasticity of demand of this
family for Commodity X for various successive levels of this family's income. ii)Over
66
what range of income is Commodity X a Luxury,a necessity,or an inferior good for
this family?
Income(Rs.per month) Quantity(Units per month)
4000 100
6000 250
8000 350
10000 380
12000 450
14000 440
15000 410
16000 380
6. 3.10 Measuring Elasticity of Demand
Demand curves can have many different shapes and so it is important to
derive a way to convey their shape with some precision. For example how would
you describe the difference between the two following curves?
Without a precise means of measuring differences you would be forced to
Conclude that one curve is steeper than the other. Still, people can interpret
the word “steeper” differently. To avoid confusion about the shapes of these curves
a more scientific approach should be taken. To explain the shapes of demand
curves with precision refer to their price
Elasticity of Demandor in simple terms their elasticity. Elasticity is the
responsiveness of a change in one variable to a change in another. Consumers
generally respond to prices changes thus economists call this measurement the
Price elasticity of demand
To calculate the price elasticity of demand this simple formula is used:
Elasticity = the percentage change in quantity demanded divided by the percentage
change in price. Putting this definition into mathematical symbols yields:
E = % Δ in Qd / % Δ in P
Where the % Δ in Qd (the numerator) is calculated by solving Q2-Q1 / Q1, and
similarly the % Δ in P (the denominator) is calculated by P2-P1 / P1. The price
elasticity formula then appears as:
E = Q2-Q1 / Q1 P2-P1 / P1
The “P’s & Q’s” in this formula represent the coordinates for two different
points along a demand curve, After making the appropriate substitutions into this
formula you will note that an elasticity coefficient results. Coefficients will be
greater than one, less than one, or equal to one. Demand and supply curves are
then named based upon their elasticity coefficients. When the coefficient is greater
than one the curve is known as elastic. If the coefficient is less than one the curve
is said to be inelastic. And of unitary elasticitywhen equal to one.
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While calculating elasticity is simple some caution should be exercised when
working with linear demand curves. Due to the construction of the elasticity
formula coefficients will vary depending upon the points selected for the
calculation. Coordinates to the left of the midpoint of the line will always yield a
coefficient greater than one. Based on that coefficient one would be forced to
conclude that the curve is elastic. Coordinates selected to the right of the midpoint
will yield coefficients less than one. This would lead to the conclusion that the
curve is inelastic. Finally, coordinates selected at the midpoint will yield a
coefficient equal to one and a conclusion of unitary elasticity.Thus three entirely
different conclusions could be made about the shape of this one curve based on the
injudicious selection of coordinates. Therefore, if the elasticity measurement is
being used to convey the overall shape of a demand curve then it is important to
select coordinates that are to the left and right of the midpoint.
P Q Elasticity greater than one
Elasticity less than one
Elasticity = one
5. E = 12.90
The curve is considered to be elastic
Goods that have elastic curves show greater price sensitivity. This can
beobserved as you move downward to the right along a demand curve. As the price
declines notice how quantity demanded rises. Now in the above case the
elasticitycoefficient of 12.90 means that for each one percent change in price the
quantity demanded changes by 12.90%. Alternatively, a ten percent change in price
would yield a 67.10% change in quantity demanded.
Goods with inelastic curves are said to be relatively price insensitive. In this
case notice how as price increases the quantity demanded does not decrease
dramatically. This means the consumer was insensitive to that price increase. The
determinants of elasticity are:
Availability of substitutes — the greater the number of substitutes the more
price, sensitive the consumer can be because more choices are available, Whether
they are luxuries or necessities — luxuries tend to cost more making the consumer
more sensitive to their price than the price of necessities, What share of the budget
they represent — the more a product costs the more cautious we become as
consumers because we have limited incomes to satisfy all our desires.
6. 3.11 cross elasticity of demand
There is also a measurement known as the cross elasticity of demand.This is
calculated by taking the percentage change in quantity demanded of good A divided
by the percentage in price of good B. This measurement is used to measure good
A’s sensitivity to changes in the price of good B. If the cross elasticity of demand is
positive, two commodities are substitutes. If the cross elasticity is negative the
68
commodities are complements. Using our understanding about elasticity lets
examine how producers and government may use this information.
Producers
The producers’ concern is to maximize revenues. The sum of all their revenue
or total revenue (TR) is simply price times quantity (PxQ = TR). The question before
us is at what point is total revenue for our product maximized when faced with a
particular demand curve? Given the following demand schedule construct the
curve, calculate its total revenue, and relate your observations to elasticity.
Notice that when the firm reduces its price from $100 to $80 that total revenue
rises. Total revenue again rises when the price falls to $60. Between $100 and $60
the firm is operating in the elastic portion of its demand curve. In this region
consumers are price sensitive. Any decrease in price will be met with an increase in
the volume of sales.
Accordingly the firm reduces its price. Notice however that when the firm
reduces price again to $40 total revenue begins to fall. This implies that the firm is
now operating in the inelastic portion of its demand curve. Therefore, if a firm
wants to maximize its total revenue it will sell its product at the price at which
elasticity of demand is equal to one.
At that level of price and output no change in price can produce greater
revenue. Thus firms are very concerned about how much each unit of output
contributes to total revenue. if an increase in output causes total revenue to
increase it will be continued. If an increase in output causes total revenue to
decline it is likely to be discontinued.
The difference in total revenue that results from a unit change in quantity sold
is called marginal revenue (MR). Using the former table we can calculate marginal
revenue.
P Q TR MR
100 5 500
80 10 800 60
60 15 900 20
40 20 800 -20
20 25 500 -60
If a firm is operating in the area where MR is positive a price reduction will
continue to yield greater total revenue. For firms operating in a price range where
marginal revenue is negative, a price reduction will yield less total revenue.
Now since a firm is interested in maximizing total revenue (TR) it attempts to
effect the demand curve by either shifting the demand curve outward to the right,
or influencing the shape of the demand curve (making it more elastic or inelastic).
69
Government
Government is concerned about the shape of demand curves because it also
must raise revenues. The revenues in this case are in the form of taxes.
Government is interested in maximizing revenues but minimizing the impact of
those taxes on the economy. If the government plans to impose a tax on some
specific item it must consider its demand curve. Taxes imposed on luxury items
(goods to which consumers are price sensitive) will increase their cost while
decreasing the quantity demanded. If the quantity demanded decreases
significantly then instability will enter the market. For this reason you will notice
that taxes are generally imposed on goods with inelastic demand curves.
The price increase associated with the increased taxes in this case does not
dramatically decrease the quantity demanded because the consumer is insensitive
to the price increase.
P8
P6
Q1 Q2
Slight price increases on elastic goods results in dramatic declines in quantity
demanded.
P8
P6
Q1 Q2
1. Understanding the concept of elasticity of demand
2. Price elasticity of demand
3. Income elasticity of demand
4. Factors determining the elasticity of demand
1. What do you mean by elasticity of demand?
2. Discuss the price elasticity of demand and income elasticity of demand
3. What are the factors determining the elasticity of demand
6.6. SUMMARY
idea about elasticity of demand with respect to concept of elasticity of demand,
definition of 'price elasticity of demand', price elasticity of demand along a linear
demand curve, price elasticity of demand and revenue, need for price elasticity of
demand, determinants of price elasticity of demand, income elasticity of demand,
diagrammatic representation of income elasticity, relationship between nature of
commodities and income elasticity measuring elasticity of demand and cross
elasticity of demand.
70
1. Cross Elasticity of Demand between tea & Sugar
a) Positive
b) Negative
c) Zero
d) Infinity
2. Demand for a commodity refers to
a) Desire for a Commodity
b) Need for a commodity
c) Quantity demanded of that commodity
d) Quantity of the commodity demanded at a certain price during any
particular period of time
6.9. ASSIGNMENT
1. Write a note on income elasticity of demand and price elasticity of demand
2. Discuss the factors determining the elasticity of demand.
Learning.
South-Western.
1. To conduct a group Discussion price elasticity of demand
2. To conduct a workshop on income elasticity of demand
6.12. KEYWORDS
1. Elasticity of demand, price elasticity of demand, income elasticity of demand,
factors determining elasticity of demand

71
LESSON – 7
DEMAND FORCASTING
7.1 INTRODUCTION
Forecasts are becoming the lifetime of business in a world, where the tidal
waves of change are sweeping the most established of structures, inherited by
human society. Commerce just happens to the one of the first casualties. Survival
in this age of economic predators, requires the tact, talent and technique of
predicting the future. This lesson deals with demand forecasting, types of demand
forecasting, approaches of demand forecasting and forecasting techniques. It points
out the Mathematical method of demand forecasting and demand forecasting
methods in India.
7.2 OBJECTIVES
 To study the content and meaning of demand forecasting
 To Examine the types and methods of demand forecasting
 To study the demand forecasting approaches in India
 To understand the application of demand forecasting in business decision
making process
7.3 CONTENT
1. Concept of Demand Forecasting
2. Procedure to Prepare Sales Forecast
3. Types of Forecasting
4. Classification of demand forecasting
5. Classification of demand forecasting on the basis of types of products
6. The choice forecasting demand
7. Forecasting Demand for Capital Goods
8. Forecasting Demand for New Products
9. Approaches of demand forecasting
10. Forecasting Techniques
11. Statistical Method of demand forecasting
12. Demand Forecasts in India
13. Criteria of a Good Forecasting Method
14. General Approaches to Forecasting
15. Experimental Approaches to Forecasting
7.3.1 Concept of Demand Forecasting
Forecast is becoming the sign of survival and the language of business. All
requirements of the business sector need the technique of accurate and practical
reading into the future. Forecasts are, therefore, very essential requirement for the
survival of business. Management requires forecasting information when making a
wide range of decisions.The sales forecast is particularly important as it is the
foundation upon which all company plans are built in terms of markets and
72
revenue. Management would be a simple matter if business was not in a continual
state of change, the pace of which has quickened in recent years.
It is becoming increasingly important and necessary for business to predict
their future prospects in terms of sales, cost and profits. The value of future sales is
crucial as it affects costs profits, so the prediction of future sales is the logical
starting point of all business planning.A forecast is a prediction or estimation of
future situation. It is an objective assessment of future course of action. Since
future is uncertain, no forecast can be percent correct. Forecasts can be both
physical as well as financial in nature. The more realistic the forecasts, the more
effective decisions can be taken for tomorrowIn the words of Cundiff and Still,
“Demand forecasting is an estimate of sales during a specified future period which
is tied to a proposed marketing plan and which assumes a particular set of uncon-
trollable and competitive forces”. Therefore, demand forecasting is a projection of
firm’s expected level of sales based on a chosen marketing plan and environment.
7.3.2 Procedure to Prepare Sales Forecast
Companies commonly use a three-stage procedure to prepare a sales forecast.
They make an environmental forecast, followed by an industry forecast, and
followed by a company’s sales forecast, the environmental forecast calls for
projecting inflation, unemployment, interest rate, consumer spending, and saving,
business investment, government expenditure, net exports and other environmental
magnitudes and events of importance to the company.
The industry forecast is based on surveys of consumers’ intention and analysis
of statistical trends is made available by trade associations or chamber of
commerce. It can give indication to a firm regarding tine direction in which the
whole industry will be moving. The company derives its sales forecast by assuming
that it will win a certain market share.
7.3.3 Types of Forecasting
Forecasts can be broadly classified into:
Passive Forecast andActive 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
Short term demand forecasting and 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.
73
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.
External or national group of forecast and 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.
7.3.4 Classification of demand forecasting
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.
7.3.5 Classification of demand forecasting on the basis of types of products
There are different forecasts for different types of products like:
(i) Forecasting demand for nondurable consumer goods,
(ii) Forecasting demand for durable consumer goods,
(iii) Forecasting demand for capital goods, and
(iv) Forecasting demand for new-products.
Non-Durable Consumer Goods:
These are also known as ‘single-use consumer goods’ or perishable consumer
goods. These vanish after a single act of consumption. These include goods like
food, milk, medicine, fruits, etc. Demand for these goods depends upon household
74
disposable income, price of the commodity and the related goods and population
and characteristics. Symbolically,
Dc =f(y, s, p, pr) where
Dc = the demand for commodity с
у = the household disposable income
s = population
p = price of the commodity с
pr = price of its related goods
(i) Disposable income expressed as Dc = f (y) i.e. other things being equal, the
demand for commodity с depends upon the disposable income of the household.
Disposable income of the household is estimated after the deduction of personal
taxes from the personal income. Disposable income gives an idea about the
purchasing power of the household.
(ii) Price, expressed as Dc = f (p, pr) i.e. other things being equal, demand for
commodity с depends upon its own price and the price of related goods. While the
demand for a commodity is inversely related to its own price of its complements. It
is positively related to its substitutes.’ Price elasticities and cross elasticities of non-
durable consumer goods help in their demand forecasting.
(iii) Population, expressed as Dc= f (5) i.e. other things being equal, demand for
commodity с depends upon the size of population and its composition. Besides,
population can also be classified on the basis of sex, income, literacy and social
status. Demand for non-durable consumer goods is influenced by all these factors.
For the general demand forecasting population as a whole is considered, but for
specific demand forecasting division of population according to different
characteristics proves to be more useful.
Durable Consumer Goods:
These goods can be consumed a number of times or repeatedly used without
much loss to their utility. These include goods like car, T.V., air-conditioners,
furniture etc. After their long use, consumers have a choice either these could be
consumed in future or could be disposed of.
7.3.6 The choice forecasting demand
Whether a consumer will go for the replacement of a durable good or keep on
using it after necessary repairs depends upon his social status, level of money
income, taste and fashion, etc. Replacement demand tends to grow with increase in
the stock of the commodity with the consumers. The firm can estimate the average
replacement cost with the help of life expectancy table.
Most consumer durables are consumed in common by the members of a
family. For instance, T.V., refrigerator, etc. are used in common by households.
Demand forecasts for goods commonly used should take into account the number
of households rather than the total size of population. While estimating the number
75
of households, the income of the household, the number of children and sex-
composition, etc. should be taken into account.
Demand for consumer durables depends upon the availability of allied
facilities. For example, the use of T.V., refrigerator needs regular supply of power,
the use of car needs availability of fuel, etc. While forecasting demand for consumer
durables, the provision of allied services and their cost should also be taken into
account.
Demand for consumer durables is very much influenced by their prices and
their credit facilities. Consumer durables are very much sensitive to price changes.
A small fall in their price may bring large increase in demand.
7.3.7 Forecasting Demand for Capital Goods
Capital goods are used for further production. The demand for capital good is
a derived one. It will depend upon the profitability of industries. The demand for
capital goods is a case of derived demand. In the case of particular capital goods,
demand will depend on the specific markets they serve and the end uses for which
they are bought.
The demand for textile machinery will, for instance, be determined by the
expansion of textile industry in terms of new units and replacement of existing
machinery. Estimation of new demand as well as replacement demand is thus
necessary.
Three types of data are required in estimating the demand for capital goods:
The growth prospects of the user industries must be known,the norm of
consumption of the capital goods per unit of each end-use product must be known,
andthe velocity of their use.
7.3.8 Forecasting Demand for New Products
The methods of forecasting demand for new products are in many ways
different from those for established products. Since the product is new to the
consumers, an intensive study of the product and its likely impact upon other
products of the same group provides a key to an intelligent projection of demand.
7.3.9 Approaches of demand forecasting
Joel Dean has classified a number of possible approaches as follows:
(a) Evolutionary Approach:
It consists of projecting the demand for a new product as an outgrowth and
evolution of an existing old product.
(b) Substitute Approach:
According to this approach the new product is treated as a substitute for the
existing product or service.
(c) Growth Curve Approach:
It estimates the rate of growth and potential demand for the new product as
the basis of some growth pattern of an established product.
76
(d) Opinion-Poll Approach:
Under this approach the demand is estimated by direct enquiries from the
ultimate consumers.
(e) Sales Experience Approach:
According to this method the demand for the new product is estimated by
offering the new product for sale in a sample market.
(f) Vicarious Approach:
By this method, the consumers’ reactions for a new product are found out
indirectly through the specialised dealers who are able to judge the consumers’
needs, tastes and preferences.
The various steps involved in forecasting the demand for non-durable
consumer goods are the following:
(a) First identify the variables affecting the demand for the product and
express them in appropriate forms, (b) gather relevant data or approximation to
relevant data to represent the variables, and (c) use methods of statistical analysis
to determine the most probable relationship between the dependent and
independent variables.
7.3.10 Forecasting Techniques:
Demand forecasting is a difficult exercise. Making estimates for future under
the changing conditions is a Herculean task. Consumers’ behaviour is the most
unpredictable one because it is motivated and influenced by a multiplicity of forces.
There is no easy method or a simple formula which enables the manager to predict
the future.
Economists and statisticians have developed several methods of demand
forecasting. Each of these methods has its relative advantages and disadvantages.
Selection of the right method is essential to make demand forecasting accurate. In
demand forecasting, a judicious combination of statistical skill and rational
judgement is needed.
Mathematical and statistical techniques are essential in classifying
relationships and providing techniques of analysis, but they are in no way an
alternative for sound judgement. Sound judgement is a prime requisite for good
forecast.
The judgment should be based upon facts and the personal bias of the
forecaster should not prevail upon the facts. Therefore, a mid way should be
followed between mathematical techniques and sound judgment or pure guess
work.
The more commonly used methods of demand forecasting are discussed below:
The various methods of demand forecasting can be summarised in the form of
a chart as shown in Table 1.
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Table 1
Methods and Forecasting
Opinion Polling Statistical

Method Method
Consumer Sales Force Experts Opinion

Survey Opinion Method
Method Method
Trend Project - Icon Barometric Regression Simultaneous

Method Method Method Equation Method
Complete Sample Survey and End Use

Enumeration Test Marketing
Survey
Fitting Trend Line by Least Squaare Time Series Moving Average Exponential
Observation Regression Analysis Analysis and Annual Smoothing
Difference
Opinion Polling Method

In this method, the opinion of the buyers, sales force and experts could be
gathered to determine the emerging trend in the market.
The opinion polling methods of demand forecasting are of three kinds
Consumer’s Survey Method or Survey of Buyer’s Intentions
In this method, the consumers are directly approached to disclose their future
purchase plans. I has been by interviewing all consumers or a selected group of
consumers out of the relevant population. This is the direct method of estimating
demand in the short run. Here the burden of forecasting is shifted to the buyer. The
firm may go in for complete enumeration or for sample surveys. If the commodity
under consideration is an intermediate product then the industries using it as an
end product are surveyed.
Complete Enumeration Survey
Under the Complete Enumeration Survey, the firm has to go for a door to door
survey for the forecast period by contacting all the households in the area. This
method has an advantage of first hand, unbiased information, yet it has its share of
disadvantages also. The major limitation of this method is that it requires lot of
resources, manpower and time.
In this method, consumers may be reluctant to reveal their purchase plans
due to personal privacy or commercial secrecy. Moreover, at times the consumers
78
may not express their opinion properly or may deliberately misguide
theinvestigators.
Sample Survey and Test Marketing
Under this method some representative households are selected on random
basis as samples and their opinion is taken as the generalised opinion. This method
is based on the basic assumption that the sample truly represents the population.
If the sample is the true representative, there is likely to be no significant difference
in the results obtained by the survey. Apart from that, this method is less tedious
and less costly.
A variant of sample survey technique is test marketing. Product testing
essentially involves placing the product with a number of users for a set period.
Their reactions to the product are noted after a period of time and an estimate of
likely demand is made from the result. These are suitable for new products or for
radically modified old products for which no prior data exists. It is a more scientific
method of estimating likely demand because it stimulates a national launch in a
closely defined geographical area.
End Use Method or Input-Output Method
This method is quite useful for industries which are mainly producer’s goods.
In this method, the sale of the product under consideration is projected as the basis
of demand survey of the industries using this product as an intermediate product,
that is, the demand for the final product is the end user demand of the
intermediate product used in the production of this final product.
The end user demand estimation of an intermediate product may involve many
final good industries using this product at home and abroad. It helps us to
understand inter-industry’ relations. In input-output accounting two matrices used
are the transaction matrix and the input co-efficient matrix. The major efforts
required by this type are not in its operation but in the collection and presentation
of data.
Sales Force Opinion Method
This is also known as collective opinion method. In this method, instead of
consumers, the opinion of the salesmen is sought. It is sometimes referred as the
“grass roots approach” as it is a bottom-up method that requires each sales person
in the company to make an individual forecast for his or her particular sales
territory.
These individual forecasts are discussed and agreed with the sales manager.
The composite of all forecasts then constitutes the sales forecast for the
organization. The advantages of this method are that it is easy and cheap. It does
not involve any elaborate statistical treatment. The main merit of this method lies
in the collective wisdom of salesmen. This method is more useful in forecasting
sales of new products.
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Experts Opinion Method
This method is also known as “Delphi Technique” of investigation. The Delphi
method requires a panel of experts, who are interrogated through a sequence of
questionnaires in which the responses to one questionnaire are used to produce the
next questionnaire. Thus any information available to some experts and not to
others is passed on, enabling all the experts to have access to all the information
for forecasting.
The method is used for long term forecasting to estimate potential sales for
new products. This method presumes two conditions: Firstly, the panellists must
be rich in their expertise, possess wide range of knowledge and experience.
Secondly, its conductors are objective in their job. This method has some exclusive
advantages of saving time and other resources.
7.3.11 Statistical Method of demand forecasting
Statistical methods have proved to be immensely useful in demand
forecasting. In order to maintain objectivity, that is, by consideration of all
implications and viewing the problem from an external point of view, the statistical
methods are used.
The important statistical methods are
Trend Projection Method
A firm existing for a long time will have its own data regarding sales for past
years. Such data when arranged chronologically yield what is referred to as ‘time
series’. Time series shows the past sales with effective demand for a particular
product under normal conditions. Such data can be given in a tabular or graphic
form for further analysis. This is the most popular method among business firms,
partly because it is simple and inexpensive and partly because time series data
often exhibit a persistent growth trend.
Time series has got four types of components namely, Secular Trend (T),
Secular Variation (S), Cyclical Element (C), and an Irregular or Random Variation
(I). These elements are expressed by the equation O = TSCI. Secular trend refers to
the long run changes that occur as a result of general tendency.
Seasonal variations refer to changes in the short run weather pattern or social
habits. Cyclical variations refer to the changes that occur in industry during
depression and boom. Random variation refers to the factors which are generally
able such as wars, strikes, flood, famine and so on.
When a forecast is made the seasonal, cyclical and random variations are
removed from the observed data. Thus only the secular trend is left. This trend is
then projected. Trend projection fits a trend line to a mathematical equation.
The trend can be estimated by using any one of the following methods:
The Graphical Method,the Least Square Method.
Graphical Method
This is the most simple technique to determine the trend. All values of output
or sale for different years are plotted on a graph and a smooth free hand curve is
80
drawn passing through as many points as possible. The direction of this free hand
curve—upward or downward— shows the trend. A simple illustration of this
method is given in Table 2.
Table 2
Sales of Firm
Year Sales (Rs.Crore)
1995 40
1996 50
1997 44
1998 60
1999 54
2000 62
Fig. 1, AB is the trend line which has been drawn as free hand curve passing through the
various points representing actual sale values.
70
60
B
50
40
30 A
20
10
1995 1996 1997 1998 1999 2000
Least Square Method
Under the least square method, a trend line can be fitted to the time series
data with the help of statistical techniques such as least square regression. When
the trend in sales over time is given by straight line, the equation of this line is of
the form: y = a + bx. Where ‘a’ is the intercept and ‘b’ shows the impact of the
independent variable. We have two variables—the independent variable x and the
dependent variable y. The line of best fit establishes a kind of mathematical
81
relationship between the two variables .v and y. This is expressed by the regression
у on x.
In order to solve the equation v = a + bx, we have to make use of the following
normal equations
Σ y = na + b ΣX
Σxy =aΣ x+bΣ x2
(ii) Barometric Technique
A barometer is an instrument of measuring change. This method is based on
the notion that “the future can be predicted from certain happenings in the
present.” In other words, barometric techniques are based on the idea that certain
events of the present can be used to predict the directions of change in the future.
This is accomplished by the use of economic and statistical indicators which serve
as barometers of economic change.
Generally forecasters correlate a firm’s sales with three series: Leading Series,
Coincident or Concurrent Series and Lagging Series:
(a) The Leading Series
The leading series comprise those factors which move up or down before the
recession or recovery starts. They tend to reflect future market changes. For
example, baby powder sales can be forecasted by examining the birth rate pattern
five years earlier, because there is a correlation between the baby powder sales and
children of five years of age and since baby powder sales today are correlated with
birth rate five years earlier, it is called lagged correlation. Thus we can say that
births lead to baby soaps sales.
(b) Coincident or Concurrent Series
The coincident or concurrent series are those which move up or down
simultaneously with the level of the economy. They are used in confirming or
refuting the validity of the leading indicator used a few months afterwards.
Common examples of coinciding indicators are G.N.P itself, industrial production,
trading and the retail sector.
(c) The Lagging Series
The lagging series are those which take place after some time lag with respect
to the business cycle. Examples of lagging series are, labour cost per unit of the
manufacturing output, loans outstanding, leading rate of short term loans, etc.
(iii) Regression Analysis
It attempts to assess the relationship between at least two variables (one or
more independent and one dependent), the purpose being to predict the value of the
dependent variable from the specific value of the independent variable. The basis of
this prediction generally is historical data. This method starts from the assumption
that a basic relationship exists between two variables. An interactive statistical
analysis computer package is used to formulate the mathematical relationship
which exists.
82
For example, one may build up the sales model as

Quantum of Sales = a. price + b. advertising + c. price of the rival products + d.
personal disposable income +u
Where a, b, c, d are the constants which show the effect of corresponding
variables as sales. The constant u represents the effect of all the variables which
have been left out in the equation but having effect on sales. In the above equation,
quantum of sales is the dependent variable and the variables on the right hand side
of the equation are independent variables. If the expected values of the independent
variables are substituted in the equation, the quantum of sales will then be
forecasted.
The regression equation can also be written in a multiplicative form as given below
Quantum of Sales = (Price)a + (Advertising)b+ (Price of the rival products) c +
(Personal disposable income Y + u
In the above case, the exponent of each variable indicates the elasticities of the
corresponding variable. Stating the independent variables in terms of notation, the
equation form is QS = P°8. Ao42 . R°.83. Y2°.68. 40
Then we can say that 1 per cent increase in price leads to 0.8 per cent change
in quantum of sales and so on.
If we take logarithmic form of the multiple equation, we can write the equation
in an additive form as follows
log QS = a log P + b log A + с log R + d log Yd + log u
In the above equation, the coefficients a, b, c, and d represent the elasticities
of variables P, A, R and Yd respectively.
The co-efficient in the logarithmic regression equation are very useful in policy
decision making by the management.
(iv) Econometric Models
Econometric models are an extension of the regression technique whereby a
system of independent regression equation is solved. The requirement for
satisfactory use of the econometric model in forecasting is under three heads:
variables, equations and data.
The appropriate procedure in forecasting by econometric methods is model
building. Econometrics attempts to express economic theories in mathematical
terms in such a way that they can be verified by statistical methods and to measure
the impact of one economic variable upon another so as to be able to predict future
events.
Utility of Forecasting
Forecasting reduces the risk associated with business fluctuations which
generally produce harmful effects in business, create unemployment, induce
speculation, discourage capital formation and reduce the profit margin. Forecasting
is indispensable and it plays a very important part in the determination of various
policies. In modem times forecasting has been put on scientific footing so that the
83
risks associated with it have been considerably minimised and the chances of
precision increased.
7.3.12 Demand Forecasts in India
In most of the advanced countries there are specialised agencies. In India
businessmen are not at all interested in making scientific forecasts. They depend
more on chance, luck and astrology. They are highly superstitious and hence their
forecasts are not correct. Sufficient data are not available to make reliable
forescasts. However, statistics alone do not forecast future conditions. Judgment,
experience and knowledge of the particular trade are also necessary to make proper
analysis and interpretation and to arrive at sound conclusions.
7.3.13 Criteria of a Good Forecasting Method
There are thus, a good many ways to make a guess about future sales. They
show contrast in cost, flexibility and the adequate skills and sophistication.
Therefore, there is a problem of choosing the best method for a particular demand
situation.
There are certain economic criteria of broader applicability. They are:
Accuracy, Plausibility,Durability, Flexibility, Availability, Economy, Simplicity
and (Consistency.
(i) Accuracy
The forecast obtained must be accurate. How is an accurate forecast possible?
To obtain an accurate forecast, it is essential to check the accuracy of past
forecasts against present performance and of present forecasts against future
performance. Accuracy cannot be tested by precise measurement but buy
judgment.
(ii) Plausibility
The executive should have good understanding of the technique chosen and
they should have confidence in the techniques used. Understanding is also needed
for a proper interpretation of results. Plausibility requirements can often improve
the accuracy of results.
(iii) Durability
Unfortunately, a demand function fitted to past experience may back cost very
greatly and still fall apart in a short time as a forecaster. The durability of the
forecasting power of a demand function depends partly on the reasonableness and
simplicity of functions fitted, but primarily on the stability of the understanding
relationships measured in the past. Of course, the importance of durability deter-
mines the allowable cost of the forecast.
(iv) Flexibility
Flexibility can be viewed as an alternative to generality. A long lasting function
could be set up in terms of basic natural forces and human motives. Even though
fundamental, it would nevertheless be hard to measure and thus not very useful. A set
of variables whose co-efficient could be adjusted from time to time to meetchanging
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conditions in more practical way to maintain intact the routine procedure of
forecasting.
(v) Availability
Immediate availability of data is a vital requirement and the search for reasonable
approximations to relevance in late data is a constant strain on the forecasters
patience. The techniques employed should be able to produce meaningful results
quickly. Delay in result will adversely affect the managerial decisions.
(vi) Economy
Cost is a primary consideration which should be weighted against the
importance of the forecasts to the business operations. A question may arise: How
much money and managerial effort should be allocated to obtain a high level of
forecasting accuracy? The criterion here is the economic consideration.
(vii) Simplicity
Statistical and econometric models are certainly useful but they are intolerably
complex. To those executives who have a fear of mathematics, these methods would
appear to be Latin or Greek. The procedure should, therefore, be simple and easy so
that the management may appreciate and understand why it has been adopted by the
forecaster.
(viii) Consistency
The forecaster has to deal with various components which are independent. If
he does not make an adjustment in one component to bring it in line with a
forecast of another, he would achieve a whole which would appear consistent.
7.3.14 General Approaches to Forecasting
All firms forecast demand, but it would be difficult to find any two firms that
forecast demand in exactly the same way. Over the last few decades, many different
forecasting techniques have been developed in a number of different application areas,
including engineering and economics. Many such procedures have been applied to the
practical problem of forecasting demand in a logistics system, with varying degrees of
success. Most commercial software packages that support demand forecasting in a
logistics system include dozens of different forecasting algorithms that the analyst can
use to generate alternative demand forecasts. While scores of different forecasting
techniques exist, almost any forecasting procedure can be broadly classified into one of
the following four basic categories based on the fundamental approach towards the
forecasting problem that is employed by the technique.
1. Judgmental Approaches. The essence of the judgmental approach is to
address the forecasting issue by assuming that someone else knows and can tell
you the right answer. That is, in a judgment-based technique we gather the
knowledge and opinions of people who are in a position to know what demand will
be. For example, we might conduct a survey of the customer base to estimate what
our sales will be next month.
2. Experimental Approaches. Another approach to demand forecasting,
which is appealing when an item is "new" and when there is no other information
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upon which to base a forecast, is to conduct a demand experiment on a small group
of customers and to extrapolate the results to a larger population. For example,
firms will often test a new consumer product in a geographically isolated "test
market" to establish its probable market share. This experience is then extrapolated
to the national market to plan the new product launch. Experimental approaches
are very useful and necessary for new products, but for existing products that have
an accumulated historical demand record it seems intuitive that demand forecasts
should somehow be based on this demand experience. For most firms (with some
very notable exceptions) the large majority of SKUs in the product line have long
demand histories.
3. Relational/Causal Approaches. The assumption behind a causal or
relational forecast is that, simply put, there is a reason why people buy our
product. If we can understand what that reason (or set of reasons) is, we can use
that understanding to develop a demand forecast. For example, if we sell umbrellas
at a sidewalk stand, we would probably notice that daily demand is strongly
correlated to the weather – we sell more umbrellas when it rains. Once we have
established this relationship, a good weather forecast will help us order enough
umbrellas to meet the expected demand.
4. "Time Series" Approaches. A time series procedure is fundamentally
different than the first three approaches we have discussed. In a pure time series
technique, no judgment or expertise or opinion is sought. We do not look for
"causes" or relationships or factors which somehow "drive" demand. We do not test
items or experiment with customers. By their nature, time series procedures are
applied to demand data that are longitudinal rather than cross-sectional. That is,
the demand data represent experience that is repeated over time rather than across
items or locations. The essence of the approach is to recognize (or assume) that
demand occurs over time in patterns that repeat themselves, at least
approximately. If we can describe these general patterns or tendencies, without
regard to their "causes", we can use this description to form the basis of a forecast.
In one sense, all forecasting procedures involve the analysis of historical
experience into patterns and the projection of those patterns into the future in the
belief that the future will somehow resemble the past. The differences in the four
approaches are in the way this "search for pattern" is conducted. Judgmental
approaches rely on the subjective, ad-hoc analyses of external individuals.
Experimental tools extrapolate results from small numbers of customers to large
populations. Causal methods search for reasons for demand. Time series
techniques simply analyze the demand data themselves to identify temporal
patterns that emerge and persist.
Judgmental Approaches to Forecasting
By their nature, judgment-based forecasts use subjective and qualitative data
to forecast future outcomes. They inherently rely on expert opinion, experience,
judgment, intuition, conjecture, and other "soft" data. Such techniques are often
86
used when historical data are not available, as is the case with the introduction of a
new product or service, and in forecasting the impact of fundamental changes such
as new technologies, environmental changes, cultural changes, legal changes, and
so forth. Some of the more common procedures include the following:
Surveys
This is a "bottom up" approach where each individual contributes a piece of
what will become the final forecast. For example, we might poll or sample our
customer base to estimate demand for a coming period. Alternatively, we might
gather estimates from our sales force as to how much each salesperson expects to
sell in the next time period. The approach is at least plausible in the sense that we
are asking people who are in a position to know something about future demand.
On the other hand, in practice there have proven to be serious problems of bias
associated with these tools. It can be difficult and expensive to gather data from
customers. History also shows that surveys of "intention to purchase" will generally
over-estimate actual demand – liking a product is one thing, but actually buying it
is often quite another. Sales people may also intentionally (or even unintentionally)
exaggerate or underestimate their sales forecasts based on what they believe their
supervisors want them to say. If the sales force (or the customer base) believes that
their forecasts will determine the level of finished goods inventory that will be
available in the next period, they may be sorely tempted to inflate their demand
estimates so as to insure good inventory availability. Even if these biases could be
eliminated or controlled, another serious problem would probably remain. Sales
people might be able to estimate their weekly dollar volume or total unit sales, but
they are not likely to be able to develop credible estimates at the SKU level that the
logistics system will require. For these reasons it will seldom be the case that these
tools will form the basis of a successful demand forecasting procedure in a logistics
system.
Consensus methods
As an alternative to the "bottom-up" survey approaches, consensus methods
use a small group of individuals to develop general forecasts. In a “Jury of
Executive Opinion”, for example, a group of executives in the firm would meet and
develop through debate and discussion a general forecast of demand. Each
individual would presumably contribute insight and understanding based on their
view of the market, the product, the competition, and so forth. Once again, while
these executives are undoubtedly experienced, they are hardly disinterested
observers, and the opportunity for biased inputs is obvious. A more formal
consensus procedure, called “The Delphi Method”, has been developed to help
control these problems. In this technique, a panel of disinterested technical experts
is presented with a questionnaire regarding a forecast. The answers are collected,
processed, and re-distributed to the panel, making sure that all information
contributed by any panel member is available to all members, but on an
anonymous basis. Each expert reflects on the gathering opinion. A second
questionnaire is then distributed to the panel, and the process is repeated until a
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consensus forecast is reached. Consensus methods are usually appropriate only for
highly aggregate and usually quite long-range forecasts. Once again, their ability to
generate useful SKU level forecasts is questionable, and it is unlikely that this
approach will be the basis for a successful demand forecasting procedure in a
logistics system.
Judgment-based methods are important in that they are often used to
determine an enterprise's strategy. They are also used in more mundane decisions,
such as determining the quality of a potential vendor by asking for references, and
there are many other reasonable applications. It is true that judgment based
techniques are an inadequate basis for a demand forecasting system, but this
should not be construed to mean that judgment has no role to play in logistics
forecasting or that salespeople have no knowledge to bring to the problem. In fact, it
is often the case that sales and marketing people have valuable information about
sales promotions, new products, competitor activity, and so forth, which should be
incorporated into the forecast somehow. Many organizations treat such data as
additional information that is used to modify the existing forecast rather than as
the baseline data used to create the forecast in the first place.
7.3.15 Experimental Approaches to Forecasting
In the early stages of new product development it is important to get some
estimate of the level of potential demand for the product. A variety of market
research techniques are used to this end.
Customer Surveys are sometimes conducted over the telephone or on street
corners, at shopping malls, and so forth. The new product is displayed or
described, and potential customers are asked whether they would be interested in
purchasing the item. While this approach can help to isolate attractive or
unattractive product features, experience has shown that "intent to purchase" as
measured in this way is difficult to translate into a meaningful demand forecast.
This falls short of being a true “demand experiment”.
Consumer Panels are also used in the early phases of product development.
Here a small group of potential customers are brought together in a room where
they can use the product and discuss it among themselves. Panel members are
often paid a nominal amount for their participation. Like surveys, these procedures
are more useful for analyzing product attributes than for estimating demand, and
they do not constitute true “demand experiments” because no purchases take
place.
Test Marketing is often employed after new product development but prior to
a full-scale national launch of a new brand or product. The idea is to choose a
relatively small, reasonably isolated, yet somehow demographically "typical" market
area. In the United States, this is often a medium sized city such as Cincinnati or
Buffalo. The total marketing plan for the item, including advertising, promotions,
and distribution tactics, is "rolled out" and implemented in the test market, and
measurements of product awareness, market penetration, and market share are
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made. While these data are used to estimate potential sales to a larger national
market, the emphasis here is usually on "fine-tuning" the total marketing plan and
insuring that no problems or potential embarrassments have been overlooked. For
example, Proctor and Gamble extensively test-marketed its Pringles potato chip
product made with the fat substitute Olestra to assure that the product would be
broadly acceptable to the market.
Scanner Panel Data procedures have recently been developed that permit
demand experimentation on existing brands and products. In these procedures, a
large set of household customers agrees to participate in an ongoing study of their
grocery buying habits. Panel members agree to submit information about the
number of individuals in the household, their ages, household income, and so
forth. Whenever they buy groceries at a supermarket participating in the research,
their household identity is captured along with the identity and price of every item
they purchased. This is straightforward due to the use of UPC codes and optical
scanners at checkout. This procedure results in a rich database of observed
customer buying behavior. The analyst is in a position to see each purchase in light
of the full set of alternatives to the chosen brand that were available in the store at
the time of purchase, including all other brands, prices, sizes, discounts, deals,
coupon offers, and so on. Statistical models such as discrete choice models can be
used to analyze the relationships in the data. The manufacturer and merchandiser
are now in a position to test a price promotion and estimate its probable effect on
brand loyalty and brand switching behavior among customers in general. This
approach can develop valuable insight into demand behavior at the customer level,
but once again it can be difficult to extend this insight directly into demand
forecasts in the logistics system.
Relational/Causal Approaches to Forecasting
Suppose our firm operates retail stores in a dozen major cities, and we now
decide to open a new store in a city where we have not operated before. We will
need to forecast what the sales at the new store are likely to be. To do this, we
could collect historical sales data from all of our existing stores. For each of these
stores we could also collect relevant data related to the city's population, average
income, the number of competing stores in the area, and other presumably relevant
data. These additional data are all referred to as explanatory variables or
independent variables in the analysis. The sales data for the stores are considered
to be the dependent variable that we are trying to explain or predict.
The basic premise is that if we can find relationships between the explanatory
variables (population, income, and so forth) and sales for the existing stores, then
these relationships will hold in the new city as well. Thus, by collecting data on the
explanatory variables in the target city and applying these relationships, sales in
the new store can be estimated. In some sense the posture here is that the
explanatory variables "cause" the sales. Mathematical and statistical procedures
are used to develop and test these explanatory relationships and to generate
forecasts from them. Causal methods include the following:
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Econometric models, such as discrete choice models and multiple
regressions. More elaborate systems involving sets of simultaneous regression
equations can also be attempted. These advanced models are beyond the scope of
this book and are not generally applicable to the task of forecasting demand in a
logistics system.
Input-output models estimate the flow of goods between markets and
industries. These models ensure the integrity of the flows into and out of the
modeled markets and industries; they are used mainly in large-scale macro-
economic analysis and were not found useful in logistics applications.
Life cycle models look at the various stages in a product's "life" as it is
launched, matures, and phases out. These techniques examine the nature of the
consumers who buy the product at various stages ("early adopters," "mainstream
buyers," "laggards," etc.) to help determine product life cycle trends in the demand
pattern. Such models are used extensively in industries such as high technology,
fashion, and some consumer goods facing short product life cycles. This class of
model is not distinct from the others mentioned here as the characteristics of the
product life cycle can be estimated using, for example, econometric models. They
are mentioned here as a distinct class because the overriding "cause" of demand
with these models is assumed to be the life cycle stage the product is in.
Simulation models are used to model the flows of components into
manufacturing plants based on MRP schedules and the flow of finished goods
throughout distribution networks to meet customer demand. There is little theory
to building such simulation models. Their strength lies in their ability to account
for many time lag effects and complicated dependent demand schedules. They are,
however, typically cumbersome and complicated.
1. Content and meaning of demand forecasting
2. Classification of demand forecasting
3. Techniques of demand forecasting
1. What do you mean by demandforecasting?
2. Write a note on methods and Techniques of demand forecasting
3. Discuss the application of demand forecasting in Business activities
7.6. SUMMARY
idea about demand forecasting with respect to concept of demand
forecasting,procedure to prepare sales forecast,types of forecasting,classification of
demand forecasting, classification of demand forecasting on the basis of types of
products,the choice forecasting demand, forecasting demand for capital
goods,forecasting demand for new products, approaches of demand
forecasting,forecasting techniques,statistical method of demand forecasting,
90
demand forecasts in India,criteria of a good forecasting method,general approaches
to forecasting and experimental approaches to forecasting.
1. Demand forecasting is important for
a) Price Control
b) Business Planning
c) Competitive Strategy
d) All of Above
2. Demand forecasting is important for
a) Price Control
b) Business Planning
c) Competitive Strategy
d) All of Above
3. Alan Hughes (1987). "managerial capitalism," The New Palgrave: A Dictionary of
Economics, v. 3, pp. 293–96.
7.9. ASSIGNMENT
1. Write a note on Application of Demand Forecasting techniques in managerial
decision making process
2. Discuss the Application of various statistical methods in demand Forecasting
1. Mansfield, Edwin and Mansfield, Edwin (2002) Managerial economics: theory,
applications, and cases. New York: W.W. Norton.
2. Png, Ivan (2012) Managerial economics. Abingdon, Oxon: Routledge.
3. Salvatore D. (2015) Managerial economics: principles and worldwide
applications. New York: Oxford University Press.
1. To conduct a group discussion on demand forecasting techniques
2. To conduct a workshop on application of demand forcasting techniques in
business
7.12. KEYWORDS
1. Demand forcasting,demand forcasting techniques, application of demand
forcasting techniques

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LESSON – 8
APPLICATION OF ELASICITY OF DEMAND IN MANAGERIAL
DECISION MAKING
8.1 INTRODUCTION
Elasticity of demand, or more specifically price elasticity of demand, is a
measure of percentage change in quantity demanded for one percentage change in
price of the good. Thus: Price elasticity of demand = percentage change in quantity
demanded)/in terms of percentage change in price Please note that when price
increases the quantity demanded decreases, and when price decreases the quantity
demanded increases. Because of this, strictly speaking the value of ratio as per the
above equation is negative, but for measuring demand elasticity we take the
positive value. This lesson deals with Application of elasticity of demand in
managerial decision. It outlines the applications of price elasticity of demand and
income elasticity of demand. This lesson points out the effects of elasticity of
demand in managerial applications.
8.2 OBJECTIVES
 To study the application of price elasticity of demand
 To examine the benefits of income elasticity of demand
 To understand the factors determining the price elasticity of demand and
income elasticity of demand
8.3. CONTENT
8.3.1 Explanation of Elasticity of Demand
8.3.2 Application
3.3 3.Importance of Price Elasticity of Demand are Given Below:
8.3.4 Importance price elasticity of demand in International Trade of Price Elasticity
of Demand
8.3.5 Importance of price elasticity of demand in Determination of Factors Prices
8.3.6 Explanation of Paradox of Poverty
8.3.7 Elasticity of demand and Types of Products
8.3.8 Elasticity of demand and Types of Customers
8.3.9 Elasticity of demand and Product Life Cycle
8.3.10 Factors Determining Income Elasticity
8.3.1 Explanation of Elasticity of Demand
When the demand elasticity is more than one, we call the demand elastic. For
such type of demands, a reduction in price results in increase in total revenue.
When the demand elasticity is less than one, we call the demand inelastic. For such
type of demands, a reduction in price results in decrease in total revenue.When the
demand elasticity is more than one, we call the demand unit-elastic. For such type
of demands, the total revenue does not change the total revenue. Analysis of
elasticity of demand helps management to take decisions on pricing of products.
When price elasticity is less than one, any increase in price will reduce the total
revenue, but the costs will increase because of increased production. Therefore, the
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total profits will be reduced. In such cases it is best for management to not to
reduce the price. Rather they may consider increase in price.
When elasticity of demand is more than one, a reduction in price will increase
the total revenue. At the same time,the costs will also increase because of increase
in production volume. If this increase in the total cost is less than the increase in
total revenue then the company can increase its profits by reducing price.
8.3.2 Application of Price Elasticity of Demand
The price elasticity of demand for a certain good or service has considerable
implications for businesses. If an ice cream shop, for example, was to increase the
price of vanilla ice cream by ten percent, and if demand fell by 5 percent as a result,
management would then know that the price elasticity of demand for that
particular good was elastic. But if they also increased the price of their top-selling
flavor, chocolate, by the same amount, and if prices remained the same, then they
would have a relatively inelastic product. Thus, elasticity’s differ with respect to
variety of product in question. Businesses must therefore make pricing decisions
based on these elasticity assumptions.
Impact on Business Management Problems
Price elasticity of demand affects a business's ability to increase the price of a
product. Elastic goods are more sensitive to increases in price, while inelastic goods
are less sensitive. Assuming that there are no costs in producing the product,
businesses would simply increase the price of a product until demand falls. Things
become more complicated, however, after introducing costs. Let's say that the cost
of vanilla flavoring increases as a result of short market supply. As profits equal
revenue minus costs, this would lower the ice cream shop's profits. If costs were
close to the price of vanilla ice cream, profits would be almost zero. As vanilla ice
cream is elastic, the shop manager would be unable to increase the price without
damaging demand. Some businesses, therefore, sell some goods that have little to
no profit margin. Their main profits come from products in higher demand. In this
case, the ice cream shop would increase the price of the more inelastic good,
chocolate ice cream, in order to compensate for the loss in profits.
The concept of price elasticity of demand has important practical applications
in managerial decision-making. A business man has often to consider whether a
lowering of price will lead to an increase in the demand for his product, and if so, to
what extent and whether his profits would increase as a result thereof. Here the
concept of elasticity of demand becomes crucial.Knowledge of the nature of the
elasticity of demand for his products will help a business to decide whether he
should cut his price in a particular case. Such knowledge would also help a
businessman to determine whether and to what extent the increase in costs could
be passed on to the consumer. In general for items those whose demand is elastic it
will pay him to charge relatively low prices, while on those whose demand is elastic,
it would be better off with a higher price. A monopolist would not be able to
increase his price if the demand for his product is elastic.
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In practice, an accurate estimate of the probable response of volume of sales to
price changes is extremely difficult. Moreover, the cost of the statistical analysis
required may in some cases, exceed the benefit especially when uncertainty is great
or when the volume is too small to provide a reason also return on the amount
spend on research. The subjective judgment of certain managers, beyond on years
of experience, sometimes exceeds in accuracy the best of the present statistical
techniques. Uses of price elasticity can be point out as below:Price distribution: A
monopolist adopts a price discrimination policy only when the elasticity of demand
of different consumers or sub-markets is different. Consumers whose demand is
inelastic can be charged a higher price than those with more elastic demand.
Public utility pricing: In case of public utilities which are run as monopoly
undertakings e.g. elasticity of water supply railways postal services, price
discrimination is generally practiced, charging higher prices from consumers or
users with inelastic demand and lower prices in case of elastic demand.Joint
supply: Certain goods, being products of the same process are jointly supplied, e.g.
wool and mutton. Here if the demand for wool is inelastic compared to the demand
for mutton, a higher price for wool can be charged with advantage.
Super Markets
Super-markets are a combined set of shops run by a single organization
selling a wide range of goods. They are supposed to sell commodities at lower prices
than charged by shopkeepers in the bazaar. Hence, price policy adopted is to
charge slightly lower price for goods with elastic demand.
Use of Machine: Workers often oppose use of machines out of fear of
unemployment. Machines need not always reduce demand for labor as this
depends on price elasticity of demand for the commodity produced. When machines
reduce costs and hence price of products, if the products demand is elastic, the
demand will go up, production will have to be increased and more workers may be
employed for the product is inelastic, machines will lead to unemployment as lower
prices will not increase the demand.
Factor Pricing: The factors having price inelastic demand can obtain a higher
price than those with elastic demand. Workers producing products having inelastic
demand can easily get their wages raised.
International Trade: (a) A country benefits from exports of products as have
price inelastic demand for a rise in price and elastic demand for a fall in price. (b)
The demand for imports should be inelastic for a fall in price and elastic for a rise
in price. (c) While deciding whether to devalue a country’s currency or not, price
elasticity of demand for a country’s exports would be an important factor to be
taken into consideration. If the demand is price elastic, it would lead to an increase
in the country’s exports and devaluation would fail to achieve its objective.
Shifting of Tax Burden: It is possible for a business to shift a commodity tax
in case of inelastic demand to his customers. But if the demand is elastic, he will
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have to bear the tax burden himself, otherwise demand for his goods will go down
sharply.
Taxation Policy: Government can easily raise tax revenue by
taxingcommodities which are price inelastic.
8.3.3 Importance of Price Elasticity of Demand in Determination of price policy
While fixing the price of this product, a businessman has to consider the
elasticity of demand for the product. He should consider whether a lowering of
price will stimulate demand for his product, and if so to what extent and whether
his profits will also increase a result thereof. If the increase in his sales is more
than proportionate, to the reduction in price his total revenue will increase and his
profits might be larger. On the other hand, if increase in demand is less than
proportionate to fall in price, his total revenue we will fall and his profits would be
certainly less.Therefore, knowledge of elasticity of demand may help the
businessman to make a decision whether to cut or increase the price of his product
or to shift the burden of any additional cost of production on to the consumers by
charging high price. In general, for items having inelastic demand, the producer
will fix a higher price and items whose demand is elastic the businessman will fix a
lower price.
Price Discrimination
Price discrimination refers to the act of selling the technically same products
at different prices to different section of consumers or in different in sub-markets.
The policy of price-discrimination is profitable to the monopolist when elasticity of
demand for his product is different in different sub-markets. Those consumers
whose demand is inelastic can be charged a higher price than those with more
elastic demand.
Shifting of Tax Burden
To what extent a producer can shift the burden of indirect tax to the buyers by
increasing price of his product depends upon the degree of elasticity of demand. If
the demand is inelastic the larger part of the indirect tax can be shifted upon
buyers by increasing price. On the other hand if the demand is elastic than the
burden of tax will be more on the producer.
Taxation and Subsidy Policy
The government can impose higher taxes and collect more revenue if the
demand for the commodity on which a tax is to be levied is inelastic. On the other
hand, in ease of a commodity with elastic demand high tax rates may fail to bring
in the required revenue for the government. Govt should provide subsidy on those
goods whose demand is elastic and in the production of the commodity the law of
increasing returns operates.
8.3.4 Importance price elasticity of demand in International Trade
The concept of elasticity of demand is of crucial importance in many aspects
of international trade. The success of the policy of devaluation to correct the
adverse balance of payment depends upon the elasticity of demand for exports and
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imports of the country. The policy of devaluation would be beneficial when demand
for exports and imports is price-elastic. A country will benefit from international
trade when: (i) it fixes lower price for exports items whose demand is price elastic
and high price for those exports whose demand is inelastic (ii) the demand for
imports should be inelastic for a fall in price and inelastic for arise in price.
The terms of trade between the two countries also depends upon the elasticity
of demand of exports and imports of two countries. If the demand is inelastic, the
terms of trade will be in favour of the seller country.
8.3.5 Importance of price elasticity of demand in Determination of Factors Prices
Factor with an inelastic demand can always command a higher price as
compared to a factor with relatively elastic demand. This helps the trade unions in
knowing that where they can easily get the wage rate increased. Bargaining
capacity of trade unions depend upon elasticity of demand for workers services.
Determination of Sale Policy for Supper Markets
Super Markets is a market where in a variety of goods are sold by a single
organization. These items are generally of mass consumption. Therefore, the
organization is supposed to sell commodities at lower prices than charged by
shopkeepers in the other bazars. Thus, the policy adopted is to charge a slightly
lower price for items whose demand is relatively elastic and the costs are covered by
increased sales.
Pricing of Joint Supply Products
The goods that are produced by a single production process are joint supply
products. The cost of production of these goods is also joint. Therefore, while
determining the prices of these products their elasticity of demand is considered.
The price of a joint supply product is fixed high if its demand is inelastic and low
price is fixed for that joint supply product whose demand is elastic.
Effect of Use of Machines on Employment
Ordinarily it is thought that use of machines reduced the demand for labour.
Therefore, trade unions often oppose the use of machines fearing unemployment.
But this fear is not always true because use of machines may not reduce demand
for labour. It depends on the price elasticity of demand for the products.The use of
machines may reduce the cost of production and price. If the demand of the
product is elastic then the fall in price will increase demand significantly. As a
result of increased demand the production will also increase and more workers will
be employed. In such cases concept of elasticity of demand help the management to
pacify the trade unions. But if the demand of the product is inelastic than use of
more machines will cause unemployment.
Public Utilities
The nationalization of public utility services can also be justified with the help
of elasticity of demand. Demand for public utilities such as electricity, water
supply, post and telegraph, public transportation etc. is generally inelastic in
nature. If the operation of such utilities is left in the hand of private individuals,
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they may exploit the consumers by charging high prices. Therefore, in the interest
of general public, the government owns and runs such services.
The public utility enterprises decide their price policy on the basis of
elasticity of demand. A suitable price policy for public utility enterprises is to
charge from consumers according to their elasticity of demand for public utility.
8.3.6 Explanation of Paradox of Poverty
Exceptionally good harvest brings poverty to the farmers and this situation is
called ‘Paradox of Poverty’. This paradox is easily explained by the inelastic nature
of demand for most farm products. Since the demand is inelastic, prices of farm
products fall sharply as a result of large increase in their supply in the year of
bumper crops. Due to sharp fall in prices, the farmers get less income even by
selling larger quantity.This paradox of poverty is the basis of regulation and control
of farm products prices. Government fixes the minimum prices of farm products
because the demand for farm products is inelastic. Thus, the concept of elasticity of
demand helps the government in determining its agricultural policies.
Output Decisions
The elasticity of demand helps the businessman to decide about production. A
businessman chooses the optimum product- mix on the basis of elasticity of
demand for various products.The products having more elastic demand are
preferred by the businessmen. The sale of such products can be increased with a
little reduction in their prices. From the above discussion it is amply clear that
price elasticity of demand is of great significance in making business decisions.
Income elasticity measures the relationship between sales and consumers'
incomes, according to business expert, Graeme Pietersz, at Moneyterms.co.uk.
Small-business sales are likely to fall when consumers' incomes fall. This can be
highly evident during economic recessionary periods. People have less disposable
income during recessions. Some may not have jobs at all. Hence, companies need
to center their marketing strategies and decision making around the statuses of
consumers' incomes.
8.3.7 Elasticity of demand and Types of Products
Certain types of products are more affected by income elasticity. Consumers
usually take care of their basic needs when income elasticity is high. For example,
people need food, water, shelter and personal-care items. However, consumers
often cut back on luxury items when their incomes are limited. Consequently,
marketers of sports cars, vacations and computers may need to offer extra
incentives to spur sales, including discounts, long-term payments or "no money
down" deals. Food companies and restaurants are not exempt from income
elasticity. Small food companies may need to lower prices to compete with generic
brands, items consumers often buy during tough economic periods. When a
company's production costs get too high, it may also cut portions or sizes of their
brands, or use cheaper paper in packaging.
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8.3.8 Elasticity of demand and Types of Customers
A strategy for a small company is to focus marketing efforts on higher-income
consumers when consumer income elasticity is high. These individuals may be less
sensitive to price changes. Marketers may also target certain types of consumers
known for being the first to buy new products. "Innovators" are the consumers who
are first to buy new products. They typically represent about 2 percent of a
company's market, according to The Business Journal online. Adopters are the next
group of consumers to buy new products, representing about 15 percent of a
company's customers. Savvy small companies may stand to earn higher revenues
and profits by selling their products in locations innovators and adopters typically
shop. For example, a small manufacturer may start selling more to specialty stores
if this is where the innovators and adopters shop.
8.3.9 Elasticity of demand and Product Life Cycle
Income elasticity also comes into play with product life-cycle management.
Overall demands for products are usually higher during their introduction and
growth stages. The challenge comes as a product ages and more substitutes
become available. This usually happens in the maturity or decline stages of the
product life cycle. A small company may need to diversify its product line to attract
consumers with less disposable income. One way to accomplish this is to provide
new features, flavors or fragrances for the products while keeping prices the same.
A small company may also need to find new uses for their products to attract
customers with more disposable income. For example, a consumer soap
manufacturer may find that its products also sell well among workers in plants and
factories. The plants and factories would be the new market -- one that may be less
sensitive to price changes. And these entities would foot the bill for the products
instead of the consumers.
8.3.10 Factors Determining Income Elasticity
An easy way to determine income elasticity is through marketing research
surveys. Companies may divide users up into different income groups, and then
determine how their incomes impact their purchases. The surveyor could list
certain types of products and determine price ranges for which people are willing to
pay. Business owners could then use the information to determine the price ranges
for their entire product line.Income elasticity shows fluctuations in demand for
goods or services as precipitated by changes in the purchasing power of consumers.
Consumers adjust their spending habits along with changes in their disposable
income. The higher the disposable income, the greater the ability of consumers to
afford expensive items, and vice versa. This may either enhance or diminish your
business prospects depending on your industry of specialization. As such, your
business decisions should be sensitive to the impact of income elasticity on your
particular industry.
Coefficients of Elasticity
A coefficient is a metric that expresses the income elasticity of demand for a
particular product or service. To calculate your coefficient of income elasticity,
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divide the percentage change in the quantity of demand for a product by the
percentage change in income. This formula may yield either a positive or negative
elasticity.
Positive Elasticity
Positive income elasticity is a situation where the demand for a particular
product increases with growth in income levels and decreases with decline in
income. This type of elasticity is associated with superior products. McConnell Brue
Flynn, author of the online edition of Economics, identifies restaurant meals,
automobiles and housing as some examples of superior goods. Positive elasticity
prevails during periods of economic prosperity because consumers earn more
money from their employment or business activities.
Negative Elasticity
Negative income elasticity prevails when the demand for certain products,
usually referred to as inferior goods, decline as a result of rising income. The
demand for these products increases with dipping income levels. These goods are
essential, and consumers must have them by all means, regardless of a fall in
income levels. As such, consumer preferences for inferior goods rise during periods
of economic decline. For example, consumers may opt to use public transport
instead of driving when oil prices rise as a result of inflation. This means that
higher demand for bus tickets would have been occasioned by falling income levels
among consumers.
Economic Growth
The dynamics of income elasticity reflect the trends of economic growth.
Income levels increase with economic growth and decrease with economic decline. It
is imperative to adjust your small-business activities according to changes in
economic conditions. For example, when incomes fall as a result of economic
downturn, demand for non-essential items such as jewelry and luxury vacations
drops. One has to be cautious and produce or stock fewer non-essential items
during such periods of economic decline.
1. Application of Elasticity of demand
2. Application of price Elasticity of demand
3. Importance of price Elasticity of demand
4. Determinants of Elasticity of demand
1. What are the applications of Elasticity of demand in managerial decision making?
2. Write a note on benefits of Income Elasticity of demand in Managerial Applications
8. 6. SUMMARY
It could be seen clearly from the above discussion that this lesson gives a broad
knowledge about the price Elasticity of demand with respect to explanation of
elasticity of demand, application 3.3 importance of price elasticity of demand are
given below, importance price elasticity of demand in international trade of price
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elasticity of demand, importance of price elasticity of demand in determination of
factors prices, explanation of paradox of poverty, elasticity of demand and types of
products, elasticity of demand and types of customers, elasticity of demand and
product life cycle and factors determining income elasticity. In nutshell one can
benefit from the subject matter coverage in this lesson.
8. 7. TERMINAL EXERCISE
1. Which of the following is NOT included in the decisions that every society must
make?
a) what goods will be produced
b) who will produce goods
c) what determines consumer preferences
d) who will consume the goods
Economics, 20(1), pp. 125-137
8. 9. ASSIGNMENT
1. Write a note on areas of application of price elasticity of demand
2. Discuss the types of managerial decisions to be taken through income elasticity
of demand
8. 10. SUGGESTED READINGS
8. 11. LEARNING ACTIVITIES
1. To conduct a workshop on application of price elasticity of demand
2. To conduct a group discussion on benefits of income elasticity of demand
8. 12. KEYWORDS
1. Price elasticity of demand, income elasticity of demand, managerial decision
making.

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UNIT–III : COST ANALYSIS AND PRODUCTION
LESSON – 9
COST CONCEPT
9.1 INTRODUCTION
In production, research, retail, and accounting, a cost is the value of money
that has been used up to produce something, and hence is not available for use
anymore. In business, the cost is one of acquisition, in which case the amount of
money expended to acquire it is counted as cost. In this case, money is the input
that is gone in order to acquire the thing. This acquisition cost may be the sum of
the cost of production as incurred by the original producer, and further costs of
transaction as incurred by the acquirer over and above the price paid to the
producer. Usually, the price also includes a mark-up for profit over the cost of
production. This lesson deals with cost concept relating to various types of cost and
cost curves. This lesson points out the output and cost.
9.2 OBJECTIVES
 To study the various components of cost
 To measure the cost components
 To understand the output and cost relationship
9.3. CONTENT
9.3.1 Money Cost and Real Cost
9.3.2 Accounting Cost and Economic Cost
9.3.3 Accounting Profit = Sales Income - Accounting Cost
9.3.4 Private Cost and Social Cost
9.3.5 Fixed Cost, Variable Cost, Average Cost and Marginal Cost
9.3.6 Economic Cost
9.3.7 Types of Economic Costs
9.3.8 Cost measurement
9.3.9 Cost Curves for a Firm
9.3.10 Long-Run Cost with Constant Returns to Scale
9.3.11 Opportunity Cost
9.3.12 Output and cost
9. 3.1Money Cost and Real Cost
Money Cost of production is the actual monetary expenditure made by
company in the production process. Money cost thus includes all the business
expenses which involve outlay of money to support business operations. For
example the monetary expenditure on purchase of raw material, payment of wages
and salaries, payment of rent and other charges of business etc can be termed as
Money Cost.
Real Cost of production or business operation on the other hand includes all
such expenses/costs of business which may or may not involve actual monetary
expenditure. For example if owner of a business venture uses his personal land and
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building for running the business venture and he/she does not charge any rent for
the same then such head will not be considered/included while computing the
Money Cost but this head will be part of Real Cost computation. Here the cost
involved is the Opportunity Cost of the land and building. If the promoter of the
company had not used the land and building for the business venture then the
land and building could have been used elsewhere for some other enture and could
have generated some income for the promoter. This income/rent which could have
been earned under the next best investment option is the opportunity cost which
needs to be considered while calculating the Real Cost for the firm.
9.3.2 Accounting Cost and Economic Cost
Accounting Cost includes all such business expenses that are recorded in the
book of accounts of a business firm as acceptable business expenses. Such
expenses include expenses like Cost of Raw Material, Wages and Salaries, Various
Direct and Indirect business Overheads, Depreciation, Taxes etc. When such
business expenses or accounting expenses are deducted from the Sales income of
any firm the accounting profit is obtained. Such Accounting/Business expenses or
costs are also termed as Explicit Costs.
Accounting Cost: Various allowed business expenses. Such as Cost of Raw
Material, Salaries and Wages, Electricity Bill, Telephone Charges, Various
Administrative Expenses, Selling and Distribution Expenses, Production Overhead
Expenses, Other Indirect Overhead Expenses etc.
9.3.3 Accounting Profit = Sales Income - Accounting Cost
 Economic Cost on the other hand includes all the accounting expenses as well
as the Opportunity cost of a business firm. Economic Cost and Economic
Profit is thus calculated as follows:
 Economic Cost = Accounting Cost (Explicit Costs) + Opportunity Cost
 Economic Profit = Total Revenues - (Accounting Cost + Opportunity Cost)
9.3.4 Private Cost and Social Cost
The actual expenses of individuals/ firms which are borne or paid out by the
individual or a firm can be termed as Private Cost. Thus for a business firm this
may include expenses like Cost of Raw Material, Salaries and Wages, Rent, Various
Overhead Expenses etc.
On the other hand Private Cost for an individual will be his or her private
expenses such as expense on food, rent of house, expenses on clothing, expenses
on travel, expenses on entertainment etc.
Social Cost on the other hand includes Private Cost and also such costs which
are not borne by the firm but by the society at large. For example the cost of
damage or disutility caused by the operations of a firm in an economy may not be
borne by the firm in question but it impacts the society at large and thus such cost
is added to the Private Cost to find the Social Cost of producing the product. Such
Cost (that is cost not borne or paid out by the firm) is also known as External Cost.
Another example of external cost can be the cost of providing the basic
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infrastructure facilities like good roads, sewage system or network, street lights etc.
Cost of such facilities is not borne by a business firm even though the firm is
benefits from such facilities. Such External Costs are thus added to the Private
Cost to find the Social Cost of producing a product or good.
Above can be understood by following example: If a Tannery firm (A firm
processing animal skins) releases its toxic wastes in the river flowing nearby its
factory premises then this act of the Tannery firm results in water pollution and
environmental damage. The Cost of such damage/loss (also known as External
Cost) is added to the private costs of the tannery firm to get fair idea of Social cost
involved in the production of the product in question. Social Cost of an individual
will include his private cost and the cost of damage on account of his actions that
has resulted in doing harm/damage to the environment/society at large.
9.3.5 Fixed Cost, Variable Cost, Average Cost and Marginal Cost
Fixed Cost is that cost which does not change (that is either goes up or goes
down) irrespective of whether the firm is operating or not. For example on account
of Strike on account of Lockout in Maruti-Suzuki’s Manesar plant the production
process stands still. Even when the plant is not operating the Firm still has to bear
such expenses which are indirect in nature. For Example Rent of the factory
premises, Wages of administrative employees etc. In other Fixed cost is not related
direct production/manufacturing expenses.
Variable Cost on the Other hand is directly proportional to the production
operations. As the size of production at any business grows, along with that grow
the variable expenses. As the name suggests, the variable expenses vary with the
business operations. When the firm is not operating on account of Strike/Lockout
etc, then the variable cost of the firm is Zero. Average Cost is the cost that is
obtained after dividing Total Cost with the number of units produced.
9.3.6 Economic Cost
Economic cost is the gains and losses in money, time and resources of one
course of action compared to another. The comparison includes the gains and losses
precluded by taking a course of action, as the those of the course taken itself.
Economic cost differs from accounting cost because it includes opportunity cost.
Example As an example considers the economic cost of attending college. The
accounting cost of attending college includes tuition, room and board, books, food,
and other incidental expenditures while there. The opportunity cost of college also
includes the salary or wage that otherwise could be earned during the period. So for
the two to four years an individual spends in school, the opportunity cost includes
the money that one could have been making at the best possible job. The economic
cost of college is the accounting cost plus the opportunity cost.
Thus, if attending college has a direct cost of Rs.20,000 a year for four years,
and the lost wages from not working Rs.25,000 a year, then the total economic cost
of going to college would be Rs.180,000 (Rs.20,000 x 4 years + the interest of
Rs.20,000 for 4 years + Rs.25,000 x 4 years).
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9.3.7 Types of Economic Costs
Variable cost: Variable costs are the costs paid to the variable input. Inputs
include labour, capital, materials, power and land and buildings. Variable inputs
are inputs whose use varies with output. Conventionally the variable input is
assumed to be labor. Total variable cost (TVC) total variable cost is the same as
variable costs. Fixed cost (TFC) fixed costs are the costs of the fixed assets those
that do not vary with production.
Total fixed cost (TFC)
Average cost (AC) average cost is total costs divided by output. AC = TFC/q +
TVC/q Average fixed cost (AFC) = fixed costs divided by output. AFC = TFC/q. The
average fixed cost function continuously declines as production increases.
Average variable cost (AVC) = variable costs divided by output. AVC =TVC/q. The
average variable cost curve is typically U-shaped. It lies below the average cost curve
and generally has the same shape - the vertical distance between the average cost
curve and average variable cost curve equals average fixed costs. The curve normally
starts to the right of the y axis because with zero production, Marginal cost (MC)
COST THEORY
9.3.8 Cost measurement
n Accounting Cost Consider only explicit cost, the out of pocket cost for such
items as wages, salaries, materials, and property rentals n Economic Cost.
Considers explicit and opportunity cost. –Opportunity cost is the cost associated
with opportunities that are foregone by not putting resources in their highest
valued use. n Sunk Cost An expenditure that has been made and cannot be
recovered--they should not influence a firm’s decisions.
Cost in the Short Run
Total output is a function of variable inputs and fixed inputs. nTherefore, the
total cost of production equals the fixed cost (the cost of the fixed inputs) plus the
variable cost (the cost of the variable inputs)- Fixed costs do not change with
changes in output-Variable costs increase as output increases.n Marginal Cost
(MC) is the cost of expanding output by one unit. Since fixed cost has no impact
on marginal cost, it can be written as
∆ ∆
= =
∆ ∆
nAverage Total Cost (ATC) is the cost per unit of output, or average fixed cost
(AFC) plus average variable cost (AVC).
This can be written: n = + = +
The Determinants of Short-Run Cost
The relationship between the production function and cost can be exemplified
by either increasing returns and cost or decreasing returns and cost.
Increasingreturns and cost–With increasing returns, output is increasing
relative to input and variable cost and total cost will fall relative to output.
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Decreasing returns and cost– With decreasing returns, output is
decreasing relative to input and variable cost and total cost will rise relative to
output.
Cost in the Short Run
For Example: Assume the wage rate (w) is fixed relative to the number of
workers hired. Then: MC-Marginal Cost, VC-Variable cost, VC-Average variable
cost
∆Variable cost
Marginal Cost = Variable cost =
∆
∆
∆Variable cost = ∇ Marginal Cost = ∆ Marginal Cost =
Conclusion: A low marginal product (MP) leads to a high marginal cost (MC)
and vise versa.AVC and the Production Function
Average variable cost
If a firm is experiencing increasing returns, average production is increasing

and Average variable cost will decrease. If firms are experiencing decreasing
returns, average production is decreasing and Average variable cost will
increase.The production function (marginal production&average production) shows
the relationship between inputs and output. The cost measurements show the
impact of the production function in dollar terms.
9.3.9 Cost Curves for a Firm
TC
VC
400
Price ($ per unit)
B
300
200
A
100
0 1 2 3 4 5 6 7 8 9 10 11 13
Output (unit per year)
Fig-1
105
In drawn from the origin to the tangent of the variable cost curve Fig-1:Its
slope equals AVCthe slope of a point on VC equals MC
Therefore, MC = AVC at 7 units of output (point A). The line drawn from the
origin to the tangent of the total cost curve: The slope of a tangent equals the
slope of the point.ATC at 8 units = MCOutput = 8 units.
Cost Curves for a Firm
MC
100
75
Price ($ per unit)
50
Marginal
decrease initially
then increases
25
ATC
AVC
AFC
0 1 2 3 4 5 6 7 8 9 10 11 12 13
Unit Costs, AFC f

fig-2
106
Continuously, When MC<AVC or MC<ATC, AVC&ATC decrease,When MC > AVC or
MC > ATC, AVC & ATC increase
Fig-2:Reveals that MC = AVC and ATC at minimum AVC and ATC,

MinimumAVCoccurs at a lower output than minimum ATC due to FC, Long-Run
Versus Short-Run Cost Curves, Long-Run Average Cost (LAC), Constant Returns to
Scale, If input is doubled, output will double and average cost is constant at all
levels of output, Increasing Returns to Scale, If input is doubled, output will
more than double and average cost decreases at all levels of output.
Decreasing Returns to Scale
If input is doubled, the increase in output is less than twice as large and
average cost increases with output.
Long-Run Versus Short-Run Cost Curves
Long-Run Average Cost (LAC), In the long-run, Firms experience. Increasing

and decreasing returns to scale and therefore long-run average cost is “U” shaped.
Long-Run Average Cost (LAC)
Long-run marginal cost leads long-run average cost: If LMC < LAC, LAC will
fall, If LMC > LAC, LAC will rise, Therefore, LMC = LAC at the minimum of LAC
Long-Run versus Short-Run Cost Curves
The Relationship Between Short-Run and Long-Run CostWe will use short and
long-run cost to determine the optimal plant size.
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9.3.10 Long-Run Cost with Constant Returns to Scale
SAC1 SAC3
SAC2
SMC1 LAC=LMC
Price ($ per unit of out put)
SMC2 SMC3
Q1 Q2 Q3

fig-3
Observation
The optimal plant size will depend on the anticipated output (e.g. Q1 choose
SAC1,etc), Fig-3The long-run average cost curve is the envelope of the firm’s short-
run average cost curves, Question, What would happen to average cost if an
output level other than that shown is chosen?
108
Long-Run Cost with Constant returns to Scale
LAC
SAC2
SMC3
LMC SMC2
Q1 Output
Fig-4
What is the firms’ long-run cost curve?
Firms can change scale to change output in the long-run, The long-run cost
curve is the dark blue portion of the SAC curve which represents the minimum cost
for any level of output.
Observations
The LAC does not include the minimum points of small and large size plants?
LMC is not the envelope of the short-run marginal cost, Breakeven Analysis,
1.Linear Breakeven Analysis, Profit= TR – TC, = (PQ)-[(Q*AVC)+FC]Example 7-4 on
page 263
9.3.11 Opportunity Cost
The resources of any firm operating in the market are limited and investment
options are many. The firm therefore has to decide or select only those investment
opportunities/options which provide the firm with the best return or best income
on investment. This means that if a firm can invest money/ resources only in one
investment option then the firm will select that investment option which promises
best return on investment to the firm. In other words while doing so the firm gives
up/rejects the next best option for investing the funds. The opportunity cost of a
company is thus this income/ return which the firm could have earned on the next
best investment alternative.
This can also be understood by a simple example - Let us assume that an
individual has two job offers in hand. One job offer is promising him a salary of Rs.
30, 000 per month while the other job offer will ensure salary of Rs. 25, 000 per
month. If the job profile and other factors related to the job offers are more or less
109
same then it can be easily expected that the individual will select the job offer
which will provide him with higher salary that is salary of Rs. 30, 000 per month.
Thus, in this case, the opportunity cost is the return involved in the next best
alternative i.e; Salary of Rs. 25, 000 in the next best job offer.
Concept of opportunity cost is closely related to the concept of Economic profit
or Economic Rent. A firm earns or makes Economic profit only when besides
covering various costs of operation, a firm is also able to earn more than its
opportunity cost (or its possible earnings under the next best investment
alternative). Opportunity Cost is also termed as Implicit Cost.
9.3.12 Output and cost
Production decision time frame
Short run is the time span between one where the quantity of no input is
variable and where the quantities of all inputs are variable. Simply put, at least one
input is fixed. Long run is a frame in which the quantities of all inputs can be
changed. Put another way, there is no fixed input in the long run.
Sunk cost
We use concept of sunk cost to describe such investment-the cost already
incurred which cannot be recovered regardless of future vents. When a firm makes
production decisions, it should ignore sunk cost. The only relevant costs that
influence its decisions are the cost of changing variable inputs and the long-run
cost of changing its plant.
Short-run production
The production function is a table, a graph, or an equation showing the
maximum product output achieved from any specified set of inputs. The function
summarizes the characteristics of existing technology at a given time.
Average product (AP) is the ratio of total to the quantity of an input used to
produce the product. For example, the average product of labour is
AP=, holding K constant
Marginal product (MP) is the change in output that results from one additional
unit of a factor of production, all other factors remaining constant. For example, the
marginal product of labour is
MP= or MP= holding K constant
The general relation between marginal product and average product is:
MP<AP AP declines
MP>AP AP rises
MP=AP AP is maximized
This average-marginal relation for production is closely tied to the law of

diminishing marginal returns, which refers to how the marginal of an input usually
decreases as more the input is used.
110
Isoquants
An isoquant is a graph of all possible combination of inputs that result in the
production of a given level of output. Isoquants have several properties: 1) the
father the isoquant is from the origin, the grater the output it represents; 2)
isoquants are always downward-sloping and convex to the origin; 3) two different
isoquants can never cross; 4) any combination of inputs above or to the right of an
isoquant results in more output than any point on the isoquant.
If the distance between isoquants increase as output increase, the firm’s
production function is exhibiting decreasing returns to scale; if the distance is
decreasing as output, the firm is experiencing increasing returns to scale.
Short-run cost
We need to analyze three cost concepts: fixed, variable, and total. Total fixed
cost (TFC) is the cost of production that does not changes with changes in the
quantity of output produced by a firm in the short run. Total variable cost (TVC) is
the cost of production that varies directly in proportion to the number of units
produced. Variable cost often includes labour expenses and raw material cost. Total
cost (TC) is the sum of total fixed and variable cost.
Total foxed cost can be represented by a horizontal line. Variable costs start at
original point, increase with output at a decreasing rate and then increase with
output at an increasing rate. The total cost curve is the vertical summation of the
fixed cost curve the total variable cost curve.
Average fixed cost (AFC) is the total fixed costs divided by the quantity (Q) of
units produced. Average fixed cost is a per-unit measure of fixed costs. Average
variable cost (AVC) is a firm’s variable costs divided by the quantity (Q) of total
units of output. Initially, average variable cost decrease as output increases.
However, as output increases, at some point of increased production, average
variable cost rise,
AVC= TVC/Q=w*L/Q
Where L is the number of variable inputs used in the production, and w is per
unit cost of L. We defined average product as:
AP=Q/L
Therefore AP is the inverse of L/Q. Now we can rewrite AVC as
AVC+W*1/AP
So we can think AVC as the inverse of average product times the cost per unit
of Input. Since average product initially increase with output, reaches a maximum,
and then beings to decline. Given the inverse relationship between AVC and AP,
AVC mirrors the behaviour of AP- when AP increase, AVC decreases; when AP
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decrease, AVC increases. So we expect AVC to initially decrease, hit a minimum,
and then increase.
Average total (ATC) is total cost divided by output. ATC can also be derived by
the sum of AVC and AFC,
= = = + = +
The marginal cost (MC) of an additional unit output is the cost of the
additional inputs needed to produce that output. Mathematically, the marginal cost
is the derivative of total production costs with respect to the level of output.
IfTVC is the change in total variable costs resulting from a change in output
ofQ and if TFC is the changes in total fixed in total costs resulting from a
changes in output of Q then,
∆ +∆
=
∆
But TFC is constant in the short-run, which means that TFC is zero; therefore
∆ ∆
= = ∗
∆ ∆
Recall that we defined MP as
∆
=
∆
Therefore we can rewrite MC as
1
= ∗
Average total cost and average variable cost initially decreases, reach a
minimum, and then increase as output increases. The average total cost curve is
the vertical summation of the average fixed cost and the average variable cost at
their minimum level. Moreover, when marginal cost is above the average cost,
average cost rises. Average total cost because the increase in average variable cost
are, up to a point, more than offset by decreases in average fixed cost.
Further discussion in cost curves
There are two reasons for the U shape of the average total cost curve,
1. As output increase, the total fixed cost is spread over a larger quantity of output
and thus the average fixed cost declines.
2. The production will eventually enter the Phase of diminishing returns.
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The position of a firm’s short-run cost curves may vary with the following two factors:
1) Technology.
Cost Curves Product Curves
2) Prices of inputs. AP
AP and MP
Diagram
MP
Phase A: rising MP and falling MC; rising
AP and falling AVC
Phase B: falling MP and rising MC; rising 0 Variable input
AP and falling AVC
Cost
Phase C: falling MP and rising MC; falling
AP and rising AVC
A firm that seeks to maximize its
profit will choose to organize production
at Phase B.
0
Phase A Phase B Output
Phase c

1. Money cost and real cost
2. Accounting cost and economic cost
3. Opportunity cost
4. Measurement of cost Output and cost
1. What are the different components of cost?
2. Distinguish between money cost and real cost
3. Discuss the short run cost, and long run cost
4. Write a note on application of cost concept in managerial decision making process
9.6. SUMMARY
It could be seen clearly from above discussion that this lesson gives an idea
about cost concepts and their applications in business with reference to money cost
and real cost, accounting cost and economic cost, accounting profit = sales income
- accounting cost, private cost and social cost,fixed cost, variable cost, average cost
and marginal cost,economic cost, types of economic costs, cost measurement,cost
curves for a firm,long-run cost with constant returns to scale,opportunity cost and
output and cost relationship.
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1. Fixed Cost is known as
a) Special Cost
b) Prime Cost
c) Direct Cost
d) Overhead Cost
2. Production function relates to
e) Cost to input
f) Cost to output
g) Wages to profit
h) Input to output
Economics, 20(1), pp. 125-137
9.9. ASSIGNMENT
1. Write a note on private cost and social cost
2. Discuss the content and meaning of fixed cost, variable cost, average cost and
managerial cost.
1. Salvatore, Dominick (2003) Managerial economics in a global economy.
Cincinnati, Ohio: South-Western.
2. Adams, John and Juleff, Linda (2003) Managerial economics for decision making.
Houndmills, Basingstoke: Palgrave Macmillan.
1. To conduct a group discussion on opportunity cost
2. To conduct a seminar on short run cost and long run cost
9.12. KEYWORDS
1. Cost, moneycost, real cost, opportunity cost, short run cost and long run cost

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LESSON – 10
COST ACCOUNTING
10.1INTRODUCTION
Cost accounting is a process of collecting, analyzing, summarizing and
evaluating various alternative courses of action. Its goal is to advise the management
on the most appropriate course of action based on the cost efficiency and capability.
Cost accounting provides the detailed cost information that management needs to
control current operations and plan for the future. This lesson deals with cost
accounting. It outlines the financial accounting, and cost accounting procedures and
mode of calculating cost. It outlines the costing methods.
10.2 OBJECTIVES
 To study the financial accounting, and cost accounting procedure
 To understand the cost accounting methods
 To examine the costing procedure
10.3. CONTENT
10.3.1Need for cost Accounting
10.3.2 Origin of cost accounting
10.3.3 Cost Accounting vs Financial Accounting
10.3.4 Types of cost accounting
10.3.5 Classification of costs
10.3.6 Decision Making Cost
10.3.7 Relevant Cost
10.3.8 Capacity Cost
10.3.9 Business development of throughput accounting
10.3.10 Activity-based costing
10.3.11 Integrating EVA and Process Based Costing
10.3.12 Lean accounting
10.3.13 Marginal costing
10.3.14 Contribution Margin Ratio
10.3.15 Implicit Costs
10.3.16 Explicit Costs
10.3.17 Accounting Profit
10.3.1Need for cost Accounting
Since managers are making decisions only for their own organization, there is
no need for the information to be comparable to similar information from other
organizations. Instead, information must be relevant for a particular environment.
Cost accounting information is commonly used in financial accounting information,
but its primary function is for use by managers to facilitate making decisions.
Unlike the accounting systems that help in the preparation of financial reports
periodically, the cost accounting systems and reports are not subject to rules and
standards like the Generally Accepted Accounting Principles. As a result, there is
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wide variety in the cost accounting systems of the different companies and
sometimes even in different parts of the same company or organization.
10.3.2 Origin of cost accounting
All types of businesses, whether service, manufacturing or trading, require
cost accounting to track their activities. Cost accounting has long been used to help
managers understand the costs of running a business. Modern cost accounting
originated during the industrial revolution, when the complexities of running a
large scale business led to the development of systems for recording and tracking
costs to help business owners and managers make decisions.
In the early industrial age, most of the costs incurred by a business were what
modern accountants call "variable costs" because they varied directly with the
amount of production. Money was spent on labor, raw materials, power to run a
factory, etc. in direct proportion to production. Managers could simply total the
variable costs for a product and use this as a rough guide for decision-making
processes.
Some costs tend to remain the same even during busy periods, unlike variable
costs, which rise and fall with volume of work. Over time, these "fixed costs" have
become more important to managers. Examples of fixed costs include the
depreciation of plant and equipment, and the cost of departments such as
maintenance, tooling, production control, purchasing, quality control, storage and
handling, plant supervision and engineering. In the early nineteenth century, these
costs were of little importance to most businesses. However, with the growth of
railroads, steel and large scale manufacturing, by the late nineteenth century these
costs were often more important than the variable cost of a product, and allocating
them to a broad range of products led to bad decision making. Managers must
understand fixed costs in order to make decisions about products and pricing.
For examplea company produced railway coaches and had only one product.
To make each coach, the company needed to purchase $60 of raw materials and
components, and pay 6 laborers Rs.40 each. Therefore, total variable cost for each
coach was Rs.300. Knowing that making a coach required spending Rs. 300,
managers knew they couldn't sell below that price without losing money on each
coach. Any price above Rs.300 became a contribution to the fixed costs of the
company. If the fixed costs were, say, Rs.1000 per month for rent, insurance and
owner's salary, the company could therefore sell 5 coaches per month for a total of
Rs.3000 (priced at Rs.600 each), or 10 coaches for a total of Rs.4500 (priced at
Rs.450 each), and make a profit of Rs.500 in both cases.
10.3.3 Cost Accounting vs Financial Accounting
Cost Accounting vs Financial AccountingFinancial Accounting aims at finding
out results of accounting year in the form of Profit and Loss Account and Balance
Sheet. Cost Accounting aims at computing cost of production/service in a scientific
manner and facilitates cost control and cost reduction.Financial accounting reports
the results and position of business to government, creditors, investors, and
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external parties.Cost Accounting is an internal reporting system for an
organization’s own management for decision making.In financial accounting, cost
classification based on type of transactions, e.g. salaries, repairs, insurance, stores
etc. In cost accounting, classification is basically on the basis of functions,
activities, products, process and on internal planning and control and information
needs of the organization.
Financial accounting aims at presenting ‘true and fair’ view of transactions,
profit and loss for a period and Statement of financial position (Balance Sheet) on a
given date. It aims at computing ‘true and fair’ view of the cost of
production/services offered by the firm.
10.3.4 Types of cost accounting
The following are different cost accounting approaches:Standard cost
accountingLean accountingActivity-based costingResource consumption
accountingThroughput accountingLife cycle costingEnvironmental
accountingTarget costingElements of cost[edit]Basic cost elements are:Raw
materialsLaborexpenses/overheadMaterial (Material is a very important part of
business) Direct material/Indirect materialLabor Direct labor/Indirect
laborOverhead (Variable/Fixed) Production or works overheadsAdministration
overheadsSelling overheads. Distribution overheadsMaintenance &
RepairSuppliesUtilitiesOther Variable ExpensesSalariesOccupancy
(Rent)DepreciationOther Fixed Expenses(In some companies, machine cost is
segregated from overhead and reported as a separate element)
10.3.5 Classification of costs
Classification of costs Classification of cost means, the grouping of costs
according to their common characteristics. The important ways of classification of
costs are:
By Element: There are three elements of costing i.e. material, labor and
expenses, By Nature or Traceability:Direct Costs and Indirect Costs. Direct Costs
are directly attributable/traceable to Cost Object. Direct costs are assigned to Cost
Object. Indirect Costs are not directly attributable/traceable to Cost Object. Indirect
costs are allocated or apportioned to cost object, 3.By Functions:
production,administration, selling and distribution, R&D, by Behavior: fixed,
variable, semi-variable. Costs are classified according to their behavior in relation to
change in relation to production volume within given period of time. Fixed Costs
remain fixed irrespective of changes in the production volume in given period of
time. Variable costs change according to volume of production. Semi-variable costs
are partly fixed and partly variable, By control ability: controllable, uncontrollable
costs. Controllable costs are those which can be controlled or influenced by a
conscious management action. Uncontrollable costs cannot be controlled or
influenced by a conscious management action.
By normality: Normal costs and abnormal costs. Normal costs arise during
routine day-to-day business operations. Abnormal costs arise because of any
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abnormal activity or event not part of routine business operations. E.g. costs
arising of floods, riots, and accidents etc, By Time: Historical Costs and
Predetermined costs. Historical costs are costs incurred in the past. Predetermined
costs are computed in advance on basis of factors affecting cost elements. Example:
Standard Costs.
10.3.6 Decision Making Cost
By Decision making Costs: These costs are used for managerial decision
making, Marginal Costs: Marginal cost is the change in the aggregate costs due to
change in the volume of output by one unit.Differential Costs: This cost is the
difference in total cost that will arise from the selection of one alternative to the
other.Opportunity Costs: It is the value of benefit sacrificed in favor of an
alternative course of action.
10.3.7 Relevant Cost
Relevant Cost: The relevant cost is a cost which is relevant in various decisions
of management, Replacement Cost: This cost is the cost at which existing items of
material or fixed assets can be replaced. Thus this is the cost of replacing existing
assets at present or at a future date, Shutdown Cost: These costs are the costs
which are incurred if the operations are shut down and they will disappear if the
operations are continued.
10.3.8 Capacity Cost
These costs are normally fixed costs. The cost incurred by a company for
providing production, administration and selling and distribution capabilities in
order to perform various functions.
Other Costs
In modern cost account of recording historical costs was taken further, by
allocating the company's fixed costs over a given period of time to the items
produced during that period, and recording the result as the total cost of
production. This allowed the full cost of products that were not sold in the period
they were produced to be recorded in inventory using a variety of complex
accounting methods, which was consistent with the principles of GAAP (Generally
Accepted Accounting Principles). It also essentially enabled managers to ignore the
fixed costs, and look at the results of each period in relation to the "standard cost"
for any given product.
For example: if the railway coach company normally produced 40 coaches per
month, and the fixed costs were still $1000/month, then each coach could be said
to incur an Operating Cost/overhead of $25 =($1000 / 40). Adding this to the
variable costs of $300 per coach produced a full cost of $325 per coach.
This method tended to slightly distort the resulting unit cost, but in mass-
production industries that made one product line, and where the fixed costs were
relatively low, the distortion was very minor.
For example: if the railway coach company made 100 coaches one month, then
the unit cost would become Rs.310 per coach (Rs.300 + (Rs.1000 / 100). If the next
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month the company made 50 coaches, then the unit cost = Rs.320 per coach
(Rs.300 + (Rs.1000 / 50), a relatively minor difference.
An important part of standard cost accounting is a variance analysis, which
breaks down the variation between actual cost and standard costs into various
components including volume variation, material cost variation, labor cost
variation, etc. so managers can understand why costs were different from what was
planned and take appropriate action to correct the situation.
10.3.9 Business development of throughput accounting
As business became more complex and began producing a greater variety of
products, the use of cost accounting to make decisions to maximize profitability
came into question. Management circles became increasingly aware of the Theory of
Constraints in the 1980s, and began to understand that "every production process
has a limiting factor" somewhere in the chain of production. As business
management learned to identify the constraints, they increasingly adopted
throughput accounting to manage them and "maximize the throughput dollars" (or
other currency) from each unit of constrained resource. Throughput accounting
aims to make the best use of scarce resources (bottle neck) in a JIT environment.[4]
Mathematical formula
throughput=sales revenue-totally variable costs
throughput accounting ratio=
10.3.10 Activity-based costing

Activity-based costing (ABC) is a system for assigning costs to products based
on the activities they require. In this case, activities are those regular actions
performed inside a company. "Talking with customer regarding invoice questions" is
an example of an activity inside most companies.
Companies may be moved to adopt activity based costing by a need to improve
costing accuracy, that is, understand better the true costs and profitability of
individual products, services, or initiatives. Activity based costing gets closer to true
costs in these areas by turning many costs that standard cost accounting views as
indirect costs essentially into direct costs. By contrast, standard cost accounting
typically determines so-called indirect and overhead costs simply as a percentage of
certain direct costs, which may or may not reflect actual resource usage for
individual items.
Under activity based costing, accountants assign 100% of each employee's
time to the different activities performed inside a company many will use surveys to
have the workers themselves assign their time to the different activities. The
accountant then can determine the total cost spent on each activity by summing up
the percentage of each worker's salary spent on that activity.
A company can use the resulting activity cost data to determine where to focus
their operational improvements. For example, a job-based manufacturer may find
that a high percentage of its workers are spending their time trying to figure out a
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hastily written customer order. Via activity based costing, the accountants now
have a currency amount pegged to the activity of "Researching Customer Work
Order Specifications". Senior management can now decide how much focus or
money to budget for resolving this process deficiency. Activity-based management
includes (but is not restricted to) the use of activity-based costing to manage a
business.
While activity based costing may be able to pinpoint the cost of each activity
and resources into the ultimate product, the process could be tedious, costly and
subject to errors.
As it is a tool for a more accurate way of allocating fixed costs into product,
these fixed costs do not vary according to each month's production volume. For
example, an elimination of one product would not eliminate the overhead or even
direct labor cost assigned to it. Activity based costing better identifies product
costing in the long run, but may not be too helpful in day-to-day decision-making.
10.3.11 Integrating Economic value Added and Process Based Costing
Recently, Mocciaro Li Destri, Picone and Minà (2012) proposed a performance
and cost measurement system that integrates the Economic Value Added criteria
with Process Based Costing (PBC). The Economic Value Added -Process Based
Costing methodology allows us to implement the Economic Value Added
management logic not only at the firm level, but also at lower levels of the
organization. Economic Value Added -Process Based Costing methodology plays an
interesting role in bringing strategy back into financial performance measures.
10.3.12 Lean accounting
Lean accounting has developed in recent years to provide the accounting,
control, and measurement methods supporting lean manufacturing and other
applications of lean thinking such as healthcare, construction, insurance, banking,
education, government, and other industries.
There are two main thrusts for Lean Accounting. The first is the application of
lean methods to the company's accounting, control, and measurement processes.
This is not different from applying lean methods to any other processes. The
objective is to eliminate waste, free up capacity, speed up the process, eliminate
errors & defects, and make the process clear and understandable. The second (and
more important) thrust of Lean Accounting is to fundamentally change the
accounting, control, and measurement processes so they motivate lean change &
improvement, provide information that is suitable for control and decision-making,
provide an understanding of customer value, correctly assess the financial impact
of lean improvement, and are themselves simple, visual, and low-waste. Lean
Accounting does not require the traditional management accounting methods like
standard costing, activity-based costing, variance reporting, cost-plus pricing,
complex transactional control systems, and untimely & confusing financial reports.
These are replaced by:
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Financial reports that are timely and presented in "plain English" that
everyone can understandradical simplification and elimination of transactional
control systems by eliminating the need for themdriving lean changes from a deep
understanding of the value created for the customerseliminating traditional
budgeting through monthly sales, operations, and financial planning processes
(SOFP)value-based pricingcorrect understanding of the financial impact of lean
changeAs an organization becomes more mature with lean thinking and methods,
they recognize that the combined methods of lean accounting in fact creates a lean
management system (LMS) designed to provide the planning, the operational and
financial reporting, and the motivation for change required to prosper the
company's on-going lean transformation.
10.3.13 Marginal costing
See also: Cost-Volume-Profit Analysis and Marginal costThe cost-volume-profit
analysis is the systematic examination of the relationship between selling prices,
sales, production volumes, costs, expenses and profits. This analysis provides very
useful information for decision-making in the management of a company. For
example, the analysis can be used in establishing sales prices, in the product mix
selection to sell, in the decision to choose marketing strategies, and in the analysis
of the impact on profits by changes in costs. In the current environment of
business, a business administration must act and take decisions in a fast and
accurate manner. As a result, the importance of cost-volume-profit is still
increasing as time passes.
Contribution of Margin
A relationship between the cost, volume and profit is the contribution margin.
The contribution margin is the revenue excess from sales over variable costs. The
concept of contribution margin is particularly useful in the planning of business
because it gives an insight into the potential profits that a business can generate.
The following chart shows the income statement of a company X, which has been
prepared to show its contribution margin:
Sales Rs.1,000,000
(-) Variable Costs Rs.600,000
Contribution Margin Rs.400,000
(-) Fixed Costs Rs.300,000
Income from Operations Rs.100,000
10.3.14 Contribution Margin Ratio
The contribution margin can also be expressed as a percentage. The
contribution margin ratio, which is sometimes called the profit-volume ratio,
indicates the percentage of each sales dollar available to cover fixed costs and to
provide operating revenue. For the company Fusion, Inc. the contribution margin
ratio is 40%, which is computed as follows:
Contribution Margin ratio=(Sales-variable Costs)/Sales
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The contribution margin ratio measures the effect on operating income of an
increase or a decrease in sales volume. For example, assume that the management
of Fusion, Inc. is studying the effect of adding Rs.80,000 in sales orders.
Multiplying the contribution margin ratio (40%) by the change in sales volume
(Rs.80,000) indicates that operating income will increase Rs.32,000 if additional
orders are obtained. To validate this analysis the table below shows the income
statement of the company including additional orders:
Sales Rs.1,080,000
Economic cost is a more comprehensive idea that accounting costs.Accounting
costs only include what economists call "explicit costs." These are the amounts
that a firm actually pays out to other people in the process of producing their
product. So, if you open a business selling cosmetics from your home, the
accounting costs would include things like the price of the cosmetics, the money
you spend on advertising, if any, and the amount that it costs you to go around
selling your product.
Economic costs include "implicit costs," which are the same as opportunity
costs. In the example mentioned above, the economic costs of starting this
business would also include the value of whatever else you could have been doing
with your time. Economic costs would also include, then, the wages that you could
have been getting if you had gone to work instead of opening this business.
The accounting cost reveals the expenses with production, while the economic
costs may be evaluated as the total of accounting costs and opportunity costs.The
opportunity cost is associated with every decision or action and it represents the
value of a resource that is given in exchange of something else.The account books
do not comprise the opportunity costs but they are emphasized when computing
the expenditure required in acquiring an asset.
Hence, the difference between the economic cost and accounting cost is that
the economic cost comprises the opportunity cost, while the accounting cost does
not.Although the accounting costs are very important to company owners, the
economists are mainly focused on economic costs rather than accounting costs.The
internal and external company reports do include the accounting costs, while the
economic costs are only revealed in internal accounting reports.
10.3.15 Implicit Costs
Unlike accounting costs, economic costs consider both the explicit and implicit
costs to the company that occur during the fiscal year. Implicit costs are associated
with resources that are provided to the company with no price tag. For example, if a
company operates out of a building it owns, it experiences an implicit cost from the
rent it could earn from leasing the building to another company. The building could
earn Rs.3,000 a month from a commercial renter, so the company has an implicit
cost of Rs.3,000 to add to its economic costs.
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10.3.16 Explicit Costs
Accounting costs come from the total explicit costs of the company during the
fiscal year. Accounting costs do not include implicit costs resulting from unused
resources. Explicit costs with defined monetary values are factored into the
accounting costs of the company to calculate net income at the end of the fiscal
year. For example, if the company spends Rs.100,000 on employee wages,
Rs.50,000 on equipment purchases and Rs.20,000 on inventory, the total
accounting costs are Rs.170,000 for the year.
10.3.17 Accounting Profit
To calculate the accounting profit for the fiscal year, accountants look only to
the accounting costs and profit of the company. Accountants do not need economic
cost information to create their income statement. For example, accountants are
not concerned if the company could have made Rs.3,000 per month from leasing its
building for a total of Rs.36,000 during the fiscal year -- the Rs.36,000 does not
come out of the gross profit for the company.
Recording
Economic costs are not typically recorded in the accounting books of
companies. Accountants focus on the hard, explicit costs from operations during
the year when creating financial reports. Economic costs are usually considered
when a company must make a strategic decision involving opportunity. For
instance, if a company wants to close an operating location and rent it out to
another business, the company must consider the economic cost of losing that
operation versus the accounting profit from rent.
1. Content and meaning of Cost Accounting concept
2. Cost Accounting procedure
3. Activity based costing
1. What do you mean by cost accounting?
2. Discuss the types of cost accounting
3. Write a note on application of Cost Accounting in business development
10.6. SUMMARY
It could be seen clearly from the above discussion that this lesson gives a
broad knowledge and understanding on cost accounting with respect to need for
cost accounting, origin of cost accounting, cost accounting vs financial accounting,
types of cost accounting, classification of costs classification, decision making cost,
relevant cost, capacity cost, business development of throughput accounting,
activity-based costing,integrating eva and process based costing, lean accounting,
marginal costing, contribution margin ratio and implicit costs Explicit Costs
Accounting Profit. Thus in brief one can understand the application of cost
accounting in business management.
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1. Implicit cost is equal to
a) Business profit minus economic profit.
b) Business profit plus economic profit.
c) Economic profit minus business profit.
d) Economic profit minus explicit cost.
2. An important relationship between production and costcan be represented by
which of the followingstatements:-
a) When average or marginal products are increasing, average or marginal
costs are increasing
b) When average or marginal products are increasing, average or marginal
costs are decreasing
c) When average or marginal products are decreasing, average or marginal
products are decreasing.
d) There is no relationship between production and cost.
Economics, 20(1), pp. 125-137
2. thomas J. Webster (2003). Managerial Economics: Theory and Practice, ch. 13 &
14, Academic Press. Description.
10.9. ASSIGNMENT
1. Discuss the importance of cost accounting in business management
2. Write a note on costing procedure for different activities
Learning.
South-Western.
3. Mansfield, Edwin and Mansfield, Edwin (2002) Managerial economics: theory,
applications, and cases. New York: W.W. Norton.
1. To conduct a workshop on cost accounting methods
2. To conduct a group discussion on costing procedures for different business
activities
10.12. KEYWORDS
1. Cost accounting, cost accounting procedure, costing methods types of costing

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LESSON – 11
PRODUCTION ECONOMICS
11.1 INTRODUCTION
Production is a process of combining various material inputs and immaterial
inputs in order to make something for consumption. It is the act of creating output,
a good or service which has value and contributes to the utility of individuals.
Economic well-being is created in a production process, meaning all economic
activities that aim directly or indirectly to satisfy human needs. The degree to which
the needs are satisfied is often accepted as a measure of economic well-being. In
production there are two features which explain increasing economic well-being.
They are improving quality-price-ratio of goods and services and increasing incomes
from growing and more efficient market production .This lesson deals with types of
production, production stakeholders and main process of production. It outlines
the production growth and business performance production models and
production function.
11.2 OBJECTIVES
 To study the types of production
 To understand the typed of production stakeholders
 To study the production process and production performance
 To understand the concept of production function
11.3. CONTENT
11.3.1 Need for Production
11.3.2 Stakeholders of Production
11.3.3 Producer Community
11.3.4 Purpose of Production
11.3.5 Production Growth and Performance
11.3.6 Absolute and Average Income from production
11.3.7 Production Models
11.3.8 The procedure for formulating objective production functions
11.3.9 Production Function
11.3.10 The Short-Run Production Function
11.3.11 The Long-Run Production Function
11.3.1 Need for Production
The most important forms of production are market production, public
production andhousehold production .In order to understand the origin of the
economic well-being we must understand these three production processes. All of
them produce commodities which have value and contribute to well-being of
individuals.
The satisfaction of needs originates from the use of the goods and services
which are produced. The need satisfaction increases when the quality-price-ratio of
the goods and services improves and more satisfaction is achieved at less cost.
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Improving the quality-price-ratio of goods and services is to a producer an essential
way to enhance the production performance but this kind of gains distributed to
customers cannot be measured with production data.
Economic well-being also increases due to the growth of incomes that are
gained from the growing and more efficient market production. Market production
is the only production form which creates and distributes incomes to stakeholders.
Public production and household production are financed by the incomes generated
in market production. Thus market production has a double role in creating well-
being, i.e. the role of producing goods and services and the role of creating income.
Because of this double role market production is the “primus motor” of economic
well-being and therefore here under review.
The economic well-being depends on production of goods and services. In
principle there are two main activities in an economy, production and consumption.
Similarly there are two kinds of actors, producers and consumers. Well-being is
made possible by efficient production and by the interaction between producers and
consumers. In the interaction, consumers can be identified in two roles both of
which generate well-being. Consumers can be both customers of the producers and
suppliers to the producers. The customers’ well-being arises from the commodities
they are buying and the suppliers’ well-being is related to the income they receive
as compensation for the production inputs they have delivered to the producers.
11.3.2 Stakeholders of Production
Stakeholders of production are persons, groups or organizations with an
interest in a producing company. Economic well-being originates in efficient
production and it is distributed through the interaction between the company’s
stakeholders. The stakeholders of companies are economic factors which have an
economic interest in a company. Based on the similarities of their interests,
stakeholders can be classified into three groups in order to differentiate their
interests and mutual relations. The three groups are as follows:
Interacting contribution of a company’s stakeholders
 Customers
 Suppliers
 Producers.
The interests of these stakeholders and their relations to companies are
described briefly below. Our purpose is to establish a framework for further
analysis.
Customers
The customers of a company are typically consumers, other market producers
or producers in the public sector. Each of them has their individual production
functions. Due to competition, the price-quality-ratios of commodities tend to
improve and this brings the benefits of better productivity to customers. Customers
get more for less. In households and the public sector this means that more need
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satisfaction is achieved at less cost. For this reason the productivity of customers
can increase over time even though their incomes remain unchanged.
Suppliers
SUPPLIERS COMPANY CUSTOMERS
· Materials
Market
· Energy · Households
· Capital Production · Public Production
· Services · Producers
PRODUCER
COMMUNITY
· Employees
· Society
The suppliers of companies are typically producers of materials, energy,

capital, and services. They all have their individual production functions. The
changes in prices or qualities of supplied commodities have an effect on both
actors’ viz company and suppliers production functions. We come to the conclusion
that the production functions of the company and its suppliers are in a state of
continuous change.
11.3.3 Producer community
The incomes are generated for those participating in production, i.e., the
labour force, society and owners. These stakeholders are referred to here as
producer communities or, in shorter form, as producers. The producer
communities have a common interest in maximizing their incomes. These parties
that contribute to production receive increased incomes from the growing and
developing production.
The well-being gained through commodities stems from the price-quality
relations of the commodities. Due to competition and development in the market,
the price-quality relations of commodities tend to improve over time. Typically the
quality of a commodity goes up and the price goes down over time. This
development favourably affects the production functions of customers. Customers
get more for less. Consumer customers get more satisfaction at less cost. This type
of well-being generation can only partially be calculated from the production data.
The situation is presented in this study. The producer community including labour
force, society, and owners earns income as compensation for the inputs they have
delivered to the production. When the production grows and becomes more
efficient, the income tends to increase. In production this brings about an increased
ability to pay salaries, taxes and profits. The growth of production and improved
productivity generate additional income for the producing community. Similarly the
high income level achieved in the community is a result of the high volume of
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production and its good performance. This type of well-being generation – as
mentioned earlier - can be reliably calculated from the production data.
11.3.4 Purpose of production
A producing company can be divided into sub-processes in different ways; yet,
the following five are identified as main processes, each with a logic, objectives,
theory and key figures of its own. It is important to examine each of them
individually, yet, as a part of the whole, in order to be able to measure and
understand them. The main processes of a company are as follows:
Money Market
Mar ket value process
Distribution Distribution Consumer

Productive process process goods
goods Real Process market
market
Monetary
process
Monetary Market
Main process of a producing company

 Real process.
 income distribution process
 production process.
 monetary process.
 market value process.
Production output is created in the real process, gains of production are
distributed in the income distribution process and these two processes constitute
the production process. The production process and its sub-processes, the real
process and income distribution process occur simultaneously, and only the
production process is identifiable and measurable by the traditional accounting
practices. The real process and income distribution process can be identified and
measured by extra calculation, and this is why they need to be analyzed separately
in order to understand the logic of production and its performance.
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Real process generates the production output from input, and it can be
described by means of the production function. It refers to a series of events in
production in which production inputs of different quality and quantity are
combined into products of different quality and quantity. Products can be physical
goods, immaterial services and most often combinations of both. The
characteristics created into the product by the producer imply surplus value to the
consumer, and on the basis of the market price this value is shared by the
consumer and the producer in the marketplace. This is the mechanism through
which surplus value originates to the consumer and the producer likewise. It is
worth noting that surplus values to customers cannot be measured from any
production data. Instead the surplus value to a producer can be measured. It can
be expressed both in terms of nominal and real values. The real surplus value to
the producer is an outcome of the real process, real income, and measured
proportionally it means productivity.
The concept “real process” in the meaning quantitative structure of production
process was introduced in Finnish management accounting in 1960´s. Since then it
has been a cornerstone in the Finnish management accounting theory.
Income distribution process of the production refers to a series of events in
which the unit prices of constant-quality products and inputs alter causing a
change in income distribution among those participating in the exchange. The
magnitude of the change in income distribution is directly proportionate to the
change in prices of the output and inputs and to their quantities. Productivity gains
are distributed, for example, to customers as lower product sales prices or to staff
as higher income pay.
The production process consists of the real process and the income
distribution process. A result and a criterion of success of the owner is profitability.
The profitability of production is the share of the real process result the owner has
been able to keep to himself in the income distribution process. Factors describing
the production process are the components of profitability, i.e., returns and costs.
They differ from the factors of the real process in that the components of
profitability are given at nominal prices whereas in the real process the factors are
at periodically fixed prices.
Monetary process refers to events related to financing the business. Market
value process refers to a series of events in which investors determine the market
value of the company in the investment markets.
11.3.5 Production Growth Performance
Production growth is often defined as a production increase of an output of a
production process. It is usually expressed as a growth percentage depicting growth
of the real production output. The real output is the real value of products
produced in a production process and when we subtract the real input from the
real output we get the real income. The real output and the real income are
generated by the real process of production from the real inputs.
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The real process can be described by means of the production function. The
production function is a graphical or mathematical expression showing the
relationship between the inputs used in production and the output achieved. Both
graphical and mathematical expressions are presented and demonstrated. The
production function is a simple description of the mechanism of income generation
in production process. It consists of two components. These components are a
change in production input and a change in productivity.
T2
1
Value of Growth
caused by
productivity increase
T1 P2
P1
Production Function
The figure 11.3.5.1 illustrates an income generation process (exaggerated for

clarity). The Value T2 (value at time 2) represents the growth in output from Value
T1 (value at time 1). Each time of measurement has its own graph of the production
function for that time (the straight lines). The output measured at time 2 is greater
than the output measured at time one for both of the components of growth: an
increase of inputs and an increase of productivity. The portion of growth caused by
the increase in inputs is shown on line 1 and does not change the relation between
inputs and outputs. The portion of growth caused by an increase in productivity is
shown on line 2 with a steeper slope. So increased productivity represents greater
output per unit of input.
The growth of production output does not reveal anything about the
performance of the production process. The performance of production measures
production’s ability to generate income. Because the income from production is
generated in the real process, we call it the real income. Similarly, as the
production function is an expression of the real process, we could also call it
“income generated by the production function”.
The real income generation follows the logic of the production function. Two
components can also be distinguished in the income change: the income growth
caused by an increase in production input (production volume) and the income
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growth caused by an increase in productivity. The income growth caused by
increased production volume is determined by moving along the production
function graph. The income growth corresponding to a shift of the production
function is generated by the increase in productivity. The change of real income so
signifies a move from the point 1 to the point 2 on the production function (above).
When we want to maximize the production performance we have to maximize the
income generated by the production function.
The sources of productivity growth and production volume growth are explained
as follows. Productivity growth is seen as the key economic indicator of innovation. The
successful introduction of new products and new or altered processes, organization
structures, systems, and business models generates growth of output that exceeds the
growth of inputs. This results in growth in productivity or output per unit of input.
Income growth can also take place without innovation through replication of
established technologies. With only replication and without innovation, output will
increase in proportion to inputs. (Jorgenson et al. 2014,2) This
11.3.6 Absolute and Average Income from production
 Real output / real input.
The absolute income of performance is obtained by subtracting the real input
from the real output as follows:
 Real income (abs.) = Real output – Real input
The growth of the real income is the increase of the economic value which can
be distributed between the production stakeholders. With the aid of the production
model we can perform the average and absolute accounting in one calculation.
Maximizing production performance requires using the absolute measure, i.e. the
real income and its derivatives as a criterion of production performance.
The differences between the absolute and average performance measures can be
illustrated by the following graph showing marginal and average productivity. The
figure is a traditional expression of average productivity and marginal productivity. The
maximum for production performance is achieved at the volume where marginal
productivity is zero. The maximum for production performance is the maximum of the
real incomes. In this illustrative example the maximum real income is achieved, when
the production volume is 7.5 units. The maximum average productivity is reached
when the production volume is 3.0 units. It is worth noting that the maximum average
productivity is not the same as the maximum of real income.
Figure above is a somewhat exaggerated depiction because the whole production
function is shown. In practice, decisions are made in a limited range of the production
functions, but the principle is still the same; the maximum real income is aimed for.
An important conclusion can be drawn. When we try to maximize the welfare effects of
production we have to maximize real income formation. Maximizing productivity leads
to a suboptimum, i.e. to losses of incomes.
A practical example illustrates the case. When a jobless person obtains a job in
market production we may assume it is a low productivity job. As a result average
productivity decreases but the real income per capita increases. Furthermore the
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well-being of the society also grows. This example reveals the difficulty to interpret
the total productivity change correctly. The combination of volume increase and
total productivity decrease leads in this case to the improved performance because
we are on the “diminishing returns” area of the production function. If we are on
the part of “increasing returns” on the production function, the combination of
production volume increase and total productivity increase leads to improved
production performance. Unfortunately we do not know in practice on which part of
the production function we are. Therefore, a correct interpretation of a performance
change is obtained only by measuring the real income change.
11.3.7 Production Models
A production model is a numerical description of the production process and is
based on the prices and the quantities of inputs and outputs. There are two main
approaches to operationalize the concept of production function. We can use
mathematical formulae, which are typically used in macroeconomics (in growth
accounting) or arithmetical models, which are typically used in microeconomics and
management accounting.
We use here arithmetical models because they are like the models of management
accounting, illustrative and easily understood and applied in practice. Furthermore
they are integrated to management accounting, which is a practical advantage. A major
advantage of the arithmetical model is its capability to depict production function as a
part of production process. Consequently production function can be understood,
measured, and examined as a part of production process.
There are different production models according to different interests. Here we
use a production income model and a production analysis model in order to
demonstrate production function as a phenomenon and a measureable quantity.
Period 1 period 2
Quantity Price Value Quantity Price Value
210.00 7.20 1512 247.25 7.10 1755

Product 1
200.00 7.00 1400 195.03 7.15 1394
Asdasd
Period 1 period 2
Quantity Price Value Quantity Price Value
100.00 7.50 750 115.00 7.70 886
80.00 8.60 688 79.20 8.50 673
Product 2
400.00 1.50 600 428.00 1.55 663
160.00 3.80 608 164.80 3.90 643
2646 1865
Input : Surplus Value (abs.) 266.00 285.12
Surplus Value (rel.) 1.101 1.100
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The scale of success run by a going concern is manifold, and there are no
criteria that might be universally applicable to success. Nevertheless, there is one
criterion by which we can generalise the rate of success in production. This
criterion is the ability to produce surplus value. As a criterion of profitability,
surplus value refers to the difference between returns and costs, taking into
consideration the costs of equity in addition to the costs included in the profit and
loss statement as usual. Surplus value indicates that the output has more value
than the sacrifice made for it, in other words, the output value is higher than the
value (production costs) of the used inputs. If the surplus value is positive, the
owner’s profit expectation has been surpassed.
INCOME FORMATION-Changes between two periods
Income generation Income distribution
+/- Productivity +41.12 = Real income +58.12
-/- Volume +17.00 +/- Customers +9.00
=real income +58.12 +/- Suppliers -28.00
=producers income 39.12
-Labour compensation -20.00
-Taxes N/a
Total Generation 58.12
=Owner income +19.12
Total Distribution 58.12
Summary of objective function formulations

11.3.8 The procedure for formulating objective productionfunctions
The procedure for formulating different objective functions, in terms of the
production model, is introduced next. In the income formation from production the
following objective functions can be identified:
Maximizing the real income
Maximizing the producer income
Maximizing the owner income.
These cases are illustrated using the numbers from the basic example. The
following symbols are used in the presentation: The equal sign (=) signifies the
starting point of the computation or the result of computing and the plus or minus
sign (+ / -) signifies a variable that is to be added or subtracted from the function. A
producer means here the producer community, i.e. labour force, society and
owners.Objective function formulations can be expressed in a single calculation
which concisely illustrates the logic of the income generation, the income
distribution and the variables to be maximized.
The calculation resembles an income statement starting with the income
generation and ending with the income distribution. The income generation and the
distribution are always in balance so that their amounts are equal. In this case it is
58.12 units. The income which has been generated in the real process is
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distributed to the stakeholders during the same period. There are three variables
which can be maximized. They are the real income, the producer income and the
owner income. Producer income and owner income are practical quantities because
they are addable quantities and they can be computed quite easily. Real income is
normally not an addable quantity and in many cases it is difficult to calculate.
The dual approach for the formulation
Here we have to add that the change of real income can also be computed from
the changes in income distribution. We have to identify the unit price changes of
outputs and inputs and calculate their profit impacts (i.e. unit price change x
quantity). The change of real income is the sum of these profits impacts and the
change of owner income. This approach is called the dual approach because the
framework is seen in terms of prices instead of quantities.
The dual approach has been recognized in growth accounting for long but its
interpretation has remained unclear. The following question has remained
unanswered: “Quantity based estimates of the residual are interpreted as a shift in
the production function, but what is the interpretation of the price-based growth
estimates?”. We have demonstrated above that the real income change is achieved
by quantitative changes in production and the income distribution change to the
stakeholders is its dual. In this case the duality means that the same accounting
result is obtained by accounting the change of the total income generation (real
income) and by accounting the change of the total income distribution.
11.3.9 Production Function
Attributes of Production Function
The following are the important attributes of production function: The production
function is a flow concept, A production function is a technical relationship between
inputs and outputs expressed in physical terms, The production function of a firm
depends on the state of technology and inputs, From the economic point of view, a
rational firm is interested not in all the numerous possible levels of output but only in
that combination which yields maximum outputs and The short run production
function pertains to the given scale of production. The long run production function
pertains to the changing scale of production.
11.3.10 The Short-Run Production Function
In the short run, the technical conditions of production are rigid so that the
various inputs used to produce a given output are in fixed proportions. However, in
the short run, it is possible to increase the quantities of one input while keeping the
quantities of other inputs constant in order to have more output. This aspect of the
production function is known as the Law of Variable Proportions. The short-run
production function in the case of two inputs, labour and capital, with capital as
fixed and labour as the variable input can be expressed as
Q=f (L,K)
where K refers to the fixed input.
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This production function is depicted in
Figure 2 where the slope of the curve shows
the marginal product of labour. A movement Q=f (K,L)
along the production function shows the
increase in output as labour increases, given
Q=f (K,L1)
the amount of capital employed K;. If the
Out Put
amount of capital increases to K, at a point of
time, the production function Q = f (L, K 1)
shifts upwards to Q = f (L,K2 ), as shown in
the figure.
On the other hand, if labour is taken
as a fixed input and capital as the
variable input, the production function Labour
takes the form Q =f (KL)
Fig 11-2
This production function is depicted in Figure 2 where the slope of the curve
represents the marginal product of
capital. A movement along the
Q=f (K,L)
production function shows the increase
in output as capital increases, given the
Out Put
quantity of labour employed, L2 If the Q=f (K,L1)

quantity of labour increases to L2 at a
point of time, the production function Q =
f (K,L 1) shifts upwards to Q=f(KL2).
11.3.11 The Long-Run Production Function 0
In the long run, all inputs are Capital
variable. Production can be increased by Fig 11-3
changing one or more of the inputs. The firm can change its plants or scale of
production. Equations (1) and (2) represent the long-run production function. Given
the level of technology, a combination of
the quantities of labour and capital
produces a specified level of output.The
long-run production function is depicted
in Figure 3 where the combination of OK B
K
of capital and OL of labour produces 100
Capital
A
Q. With the increase in inputs of capital 1
200Q
and labour to OK1 and OL1, the output
increases to 200 Q. The long-run 100Q
production function is shown in terms of
an isoquant such as 100 Q. In the long
run, it is possible for a firm to change all 0
Labour L
inputs up or down in accordance with its
scale. Fig 11-4
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This is known as returns to scale. The returns to scale are constant when output
increases in the same proportion as the increase in the quantities of inputs. The
returns to scale are increasing when the increase in output is more than
proportional to the increase in inputs. They are decreasing if the increase in
output is less than proportional to the increase in inputs.
Let us illustrate the case of constant returns to scale with the help of our
production function.
Q = (L, M, N, К, T)
Given T, if the quantities of all inputs L, M, N, K are increased n-fold, the
output Q also increases и-fold. Then the production function becomes nQ –f (nL,
nM, nN, nK).
This is known as linear and homogeneous production function, or a
homogeneous function of the first degree. If the homogeneous function is of the Kth
degree, the production function is nk.Q = f (nL, nM, nN, nK) If k is equal to 1, it is a
case of constant returns to scale; if it is greater than 1, it is a case of increasing
returns of scale and if it is less than 1, it is a case of decreasing returns to scale.
Thus a production function is of two types
Linear homogeneous of the first degree in which the output would change in
exactly the same proportion as the change in inputs. Doubling the inputs would
exactly double the output, and vice versa. Such a production function expresses
constant returns to scale,
Non-homogeneous production functions of a degree greater or less than one.
The former relates to increasing returns to scale and the latter to decreasing
returns to scale.
1. Types of production
2. Stockholders of production
3. Purpose of production
4. Production function
1. What are the factors determining the production
2. Write a note on Stockholders of production
3. Discuss the process of production and production models
11.6. SUMMARY
It could be seen clearly from the above discussion that this lesson gives on
idea about production economics with reference to need for productionStakeholders
of production, producer community, purpose of production, production growth and
performance, absolute and average income from production, production models, the
procedure for formulating objective production functions, production function, the
short-run production function and the long-run production function
136
1. Production Theory is also called __________________.
a) Micro Economics
b) Positive Science
c) Normative Science
d) Theory of Firm
2. Production refers to
a) Destruction of utility
b) Creation of utility
c) Exchange value
d) None
Economics, 20(1), pp. 125-137
2. thomas J. Webster (2003). Managerial Economics: Theory and Practice, ch. 13 &
14, Academic Press. Description.
11.9. ASSIGNMENT
1. Write a note on production function.
2. Discuss the various production models.
Houndmills, Basingstoke: Palgrave Macmillan
1. To conduct a workshop on process of production in a company
2. To conduct a group discussion on types of production
11.12. KEYWORDS
1. Production economics, production function, production stockholders,
production process, production models.

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LESSON – 12
RETURNS TO SCALE
12.1 INTRODUCTION
In economics, returns to scale and economies of scale are related but different
terms that describe what happens as the scale of production increases in the long
run, when all input levels including physical capital usage are variable (chosen by
the firm). The term returns to scale arises in the context of a firm's production
function. It explains the behaviour of the rate of increase in output (production)
relative to the associated increase in the inputs (the factors of production) in the
long run. In the long run all factors of production are variable and subject to
change due to a given increase in size (scale). While economies of scale show the
effect of an increased output level on unit costs, returns to scale focus only on the
relation between input and output quantities. This lesson deals with law of returns
to scale it outlines the definition of law of returns to scale and types of law of
returns to scale. This lesson points out the causes of law of returns to scale and
application of law of returns to scale.
12.2 OBJECTIVES
 To study the law of returns to scale
 To understand the concepts of increasing returns to scale, diminishing
returns to scale and constant returns to scale
 To examine the application of law of returns to scale in production process
12.3 CONTENT
12.3.1 Concept of Law of Returns to Scale
12.3.2 Definitions of Returns to Scale
12.3.3 Law of Returns to Scale
12.3.4 Increasing Returns to Scale
12.3.5 Constant Returns to Scale
12.3.6 Diminishing Returns to Scale
12.3.7 Causes of Increasing Returns to Scale
12.3.8 Causes of Diminishing Returns to Scale
12.3.9 Economies of Scale: Internal and External Economies
12.3.10 Types of Technical economies
12.3.1 Concept of Law of Returns to Scale
The laws of returns to scale are a set of three interrelated and sequential laws:
Law of Increasing Returns to Scale, Law of Constant Returns to Scale, and Law of
Diminishing returns to Scale. If output increases by that same proportional change
as all inputs change then there are constant returns to scale (CRS). If output
increases by less than that proportional change in inputs, there are decreasing
returns to scale (DRS). If output increases by more than that proportional change
in inputs, there are increasing returns to scale (IRS). A firm's production function
could exhibit different types of returns to scale in different ranges of output.
Typically, there could be increasing returns at relatively low output levels,
138
decreasing returns at relatively high output levels, and constant returns at one
output level between those ranges.
In mainstream microeconomics, the returns to scale faced by a firm are purely
technologically imposed and are not influenced by economic decisions or by market
conditions (i.e., conclusions about returns to scale are derived from the specific
mathematical structure of the production function in isolation).When all inputs
increase by a factor of 2, new values for output will be: Twice the previous output if
there are constant returns to scale (CRS) Less than twice the previous output if
there are decreasing returns to scale (DRS) More than twice the previous output if
there are increasing returns to scale (IRS)
Assuming that the factor costs are constant that is, that the firm is a perfect
competitor in all input markets, a firm experiencing constant returns will have
constant long-run average costs, a firm experiencing decreasing returns will have
increasing long-run average costs, and a firm experiencing increasing returns will
have decreasing long-run average costs. However, this relationship breaks down if
the firm does not face perfectly competitive factor markets.In this context, the price
one pays for a good does depend on the amount purchased. For example, if there
are increasing returns to scale in some range of output levels, but the firm is so big
in one or more input markets that increasing its purchases of an input drives up
the input's per-unit cost, then the firm could have diseconomies of scale in that
range of output levels. Conversely, if the firm is able to get bulk discounts of an
input, then it could have economies of scale in some range of output levels even if it
has decreasing returns in production in that output range.
12.3.2 Definitions of Returns to Scale
Formally, a production function is defined to have:
 Constant returns to Scale if (for any constant a greater than 0) ( , ) =
( , )
 Increasing returns to scale if (for any constant a greater than1) ( , ) >
( , )
 Decreasing returns to scale if (for any constant a greater than1) ( , ) <
( , )
Constant returns to scale if (for any constant a greater than 0) Increasing
returns to scale if (for any constant a greater than 1) Decreasing returns to scale if
(for any constant a greater than 1) where K and L are factors of production—capital
and labour, respectively.
In a more general set-up, for a multi-input-multi-output production processes,
one may assume technology can be represented via some technology set, call it,
which must satisfy some regularity conditions of production theory. In this case,
the property of constant returns to scale is equivalent to saying that technology set
is a cone, i.e., satisfies the property. In turn, if there is a production function that
will describe the technology set it will have to be homogeneous of degree 1.
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12.3.3 Law of Returns to Scale
Definition and Explanation
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.
12.3.4 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 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.
12.3.5 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.
12.3.6 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.
The three laws of returns to scale are now explained with the help of a graph
below:
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Output
q=8
C c d Decreasing returns to scale

V
q=6
a b Constant returns to scale
q=3
q=1 a Increasing returns to scale
1 2 4 8
Input
Fig-12-1
The figure 12.3.6 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.
The Law of Returns to Scale
The law of returns to scale describes the relationship between outputs and
scale of inputs in the long-run when all the inputs are increased in the same
proportion. In the words of Prof. Roger Miller, “Returns to scale refer to the
relationship between changes in output and proportionate changes in all factors of
production. To meet a long-run change in demand, the firm increases its scale of
production by using more space, more machines and labourers in the factory’.
Assumptions
This law assumes that:All factors (inputs) are variable but enterprise is fixed, A
worker works with given tools and implements, Technological changes are absent.
There is perfect competition, The product is measured in quantities.
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Explanation
Given these assumptions, when all inputs are increased in unchanged
proportions and the scale of production is expanded, the effect on output shows
three stages: increasing returns to scale, constant returns to scale and diminishing
returns to scale.
Increasing Returns to Scale
Returns to scale increase because the increase in total output is more than
proportional to the increase in all inputs. In the beginning with the scale of
production of (1 worker + 2 acres of land), total output is 8. To increase output
when the scale of production is doubled (2 workers + 4 acres of land), total returns
are more than doubled. They become 17. Now if the scale is trebled (3 workers + о
acres of land), returns become more than three-fold, i.e., 27. It shows increasing
returns to scale. In the figure RS is the returns to scale curve where R to С portion
indicates increasing returns.
Increasing Returns
Constant returns
Marginal returns
C D
Diminishing
Returns
0
Scale of Production
Fig12-2
2.3.7 Causes of Increasing Returns to Scale
Returns to scale increase due to the following reasons
Indivisibility of Factors
Returns to scale increase because of the indivisibility of the factors of
production. Indivisibility means that machines, management, labour, finance, etc.
cannot be available in very small sizes. They are available only in certain minimum
sizes. When a business unit expands, the returns to scale increase because the
indivisible factors are employed to their maximum capacity.
Specialisation and Division of Labour
Increasing returns to scale also result from specialisation and division of
labour. When the scale of the firm is expanded there is wide scope of specialization
and division of labour. Work can be divided into small tasks and workers can be
concentrated to narrower range of processes. For this, specialised equipment can
be installed. Thus with specialisation, efficiency increases and increasing returns to
scale follow.
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Internal Economies
As the firm expands, it enjoys internal economies of production. It may be able
to install better machines, sell its products more easily, borrow money cheaply,
procure the services of more efficient manager and workers, etc. All these
economies help in increasing the returns to scale more than proportionately.
External Economies
A firm also enjoys increasing returns to scale due to external economies.
When the industry itself expands to meet the increased long-run demand for its
product, external economies appear which are shared by all the firms in the
industry.
When a large number of firms are concentrated at one place, skilled labour,
credit and transport facilities are easily available. Subsidiary industries crop up to
help the main industry. Trade journals, research and training centres appear which
help in increasing the productive efficiency of the firms. Thus these external
economies are also the cause of increasing returns to scale.
Constant Returns to Scale
Returns to scale become constant as the increase in total output is in exact
proportion to the increase in inputs. If the scale of production in increased further,
total returns will increase in such a way that the marginal returns become
constant. In the table, for the 4th and 5th units of the scale of production, marginal
returns are 11, i.e., returns to scale are constant.
Causes of Constant Returns to Scale
Returns to scale are constant due to internal economies and diseconomies.
But increasing returns to scale do not continue indefinitely. As the firm expands
further, internal economies are counterbalanced by internal diseconomies. Returns
increase in the same proportion so that there are constant returns to scale over a
large range of output.
External Economies and Diseconomies
The returns to scale are constant when external diseconomies and economies
are neutralised and output increases in the same proportion, Divisible Factors.
When factors of production are perfectly divisible, substitutable, and homogeneous
with perfectly elastic supplies at given prices, returns to scale are constant.
Diminishing Returns to Scale
Returns to scale diminish because the increase in output is less than
proportional to the increase in inputs. The table shows that when output is increased
from the 6th, 7th and 8th units, the total returns increase at a lower rate than before
so that the marginal returns start diminishing successively to 10, 9 and 8.
12.3.8 Causes of Diminishing Returns to Scale
A constant return to scale is only a passing phase, for ultimately returns to
scale start diminishing. Indivisible factors may become inefficient and less
productive. Business may become unwieldy and produce problems of supervision
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and coordination. Large management creates difficulties of control and rigidities. To
these internal diseconomies are added external diseconomies of scale.
These arise from higher factor prices or from diminishing productivities of the
factors. As the industry continues to expand, the demand for skilled labour, land,
capital, etc. rises. There being perfect competition, intensive bidding raises wages,
rent and interest. Prices of raw materials also go up. Transport and marketing
difficulties emerge. All these factors tend to raise costs and the expansion of the
firms leads to diminishing returns to scale so that doubling the scale would not
lead to doubling the output.
For the management increasing, decreasing or constant returns to scale reflect
changes in production efficiency that result from scaling up productive inputs. But
returns to scale is strictly a production and cost concept. Management’s decision
on what to produce and how much to produce must be based upon the demand for
the product. Therefore, demand and other factors must also be considered in
decision making.
12.3.9 Economies of Scale: Internal and External Economies
An economy of scale exists when larger output is associated with lower per
unit cost. Economies of scale have been classified by Marshall into Internal
Economies and External Economies. Internal Economies are internal to a firm
when it expands its size or increases its output.
They “are open to a single factory or a single firm independently of the action
of other firms. They result from an increase in the scale of output of the firm, and
cannot be achieved unless output increases. They are not the result of inventions of
any kind, but are due to the use of known methods of production which a small
firm does not find worthwhile.” (A.K. Caimcross).
External Economies are external to a firm which is available to it when the
output of the whole industry expands. They are “shared by a number of firms or
industries when the scale of production in any industry or group of industries
increases. They are not mono-polised by a single firm when it grows in size, but are
conferred on it when some other firms grow larger”.Modern economists distinguish
economies of scale in terms of real and pecuniary internal and external economies.
Real Internal Economies
Real internal economies are “associated with a reduction in the physical
quantity of inputs, raw materials, various types of labour and various types of
capital (fixed or circulating) used by a large firm.”Real internal economies which
arise from the expansion of a firm are the following:
Labour Economies
As the firm expands, it achieves labour economies with increased division of
labour and specialisation. When a firm expands in size, this necessitates division of
labour whereby each worker is assigned one particular job, and the splitting of
processes into sub-processes for greater efficiency and productivity.
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This, in turn, leads to the increase in the dexterity (skill) of every worker, the
saving in time to produce goods, and to the invention of large number of labour-
saving machines, according to Adam Smith. Thus division of labour and
specialisation lead to greater productive efficiency and reduction in per unit cost in
a large firm.
Technical Economies
Technical economies are associated with all types of machines and
equipment’s used by a large firm. They arise from the use of better machines and
techniques of production which increase output and reduce per unit cost of
production.
12.3.10 Types of Technical economies
Economies of Indivisibility
Mrs. Joan Robinson refers to economies of factor indivisibility. Fixed capital is
one such factor. It is indivisible in the sense that a machine, equipment or a plant
must be used in a fixed minimum size or capacity to justify its use. Such machines
can be most efficiently used at a fairly large output than at small outputs because
they cannot be divided into smaller units.
For example, an automated car assembly plant is not a viable proposition, if
the number of cars to be assembled is small because much of the plant would
remain idle. But a large firm assembling a large number of cars may be able to
utilise the plant to its full capacity and achieve lower per unit cost. Prof. Caimcross
gives a five-fold classification of technical economies.
Economies of Superior Technique
It is only a large firm which can afford to pay for costly machines and install
them. Such machines are more productive than small machines. The high cost of
such machines can be spread over a larger output which they help to produce.
Thus the per unit cost of production falls in a large firm which employs costly and
superior plant and equipment and thereby enjoys a technical superiority over a
small firm.
Economies of Increased Dimensions
The installation of large machines itself brings many advantages to a firm. The
cost of operating large machines is less than that of operating small machines.
Even the cost of construction is relatively lower for large machines than for small
ones.
The cost of manufacture of a double-decker bus is lower as compared to the
manufacture of two single-decker buses. Moreover, a double-decker carries more
passengers than a single-decker and at the same time requires only a driver and a
conductor like the latter. Thus its operating costs are relatively lower.
Economies of Linked Processes
A large firm is able to reduce it’s per unit cost of production by linking the
various processes of production. For instance, a large sugar manufacturing firm
may own its sugarcane farms, manufacture sugar, pack it in bags, transport and
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distribute sugar through its own transport and distribution departments. Thus by
linking the various processes of production and sale, a large firm saves the
expenses incurred on intermediaries thereby reducing unit cost of production.
Economies of the Use of By-products
A large firm possesses greater resources than a small firm and is able to utilise
its waste material as a by-product. For example, the molasses left over after
manufacturing sugar from the surgarcane can be used for producing spirit by
installing a plant for the purpose.
1. Law of increasing return, Law of constant return, and Law of diminishing return
2. Causes of return to scale
3. Application of return to scale in production process
12.5. INDEX QUESTIONS
1. Discuss the Law of increasing return, Law of constant return, and Law of
diminishing return
2. Write a note on application of Law of return to scale in production decision
making process
12.6. SUMMARY
It could be seen clearly from above discussion that this lesson gives a broad
knowledge and understanding about the Law of return to scale with respect to
concept of law of returns to scale,definitions of returns to scale,law of returns to
scale,increasing returns to scale,constant returns to scale,diminishing returns to
scale,causes of increasing returns to scale,causes of diminishing returns to scale,
economies of scale: internal and external economies and types of technical
economies.
1. The Manager tries to produce at ………………………Scale.
a) Minimum
b) Maximum
c) Optimum
d) Ideal
2. Production Theory is also called __________________.
a) Micro Economics
b) Positive Science
c) Normative Science
d) Theory of Firm
1. Lafontaine, Francine, and Kathryn L. Shaw. "Targeting Managerial Control:
Evidence fromFranchising." The Rand Journal of Economics, vol. 36, no. 1
(Spring 2005), 131-150.
2. Lazear, Edward P. “Balanced Skills and Entrepreneurship.” The American
Economic Review, vol.94, no. 2 (May 2004), 208.
146
12.9. ASSIGNMENT
1. Write a note on return to scale
2. What are the causes of increasing return to scale and diminishing return to
scale in production process?
Houndmills, Basingstoke: Palgrave Macmillan.
1. To conduct a workshop on increasing returns to scale
2. To conduct a group discussion on reasons for increasingreturns to scale and
diminishing returns to scale
12.12. KEYWORDS
1. Increasingreturns to scale, diminishing returns to scale, constant returns to
scale, causes of returns to scale

147
UNIT - IV : MARKET STRUCTURE AND PRICING
LESSON - 13
MARKET STRUCTURE/PERFECT COMPETITION
13.1 INTRODUCTION
The determination of price of any product is an important managerial function.
Price affects profit through its effect on revenue and cost. Profit is concerned with
the difference between cost and the revenue. It always depends on cost and volume
of sales. Therefore the management always tries to find out the optimum
combination of price and output which offers the maximum profit to the firm. Thus
pricing occupies on important place in economic analysis of firms.
The knowledge of market and market structure with which a firm operates is
more helpful in price output decisions. Market in economic term means a meeting
place where buyers and sellers deal directly or indirectly. Market structures are
different market forms based on the degree of competition prevailing in the market.
Broadly the market forms are classified into two types:
Perfectly competitive market
Imperfectly competitive market
13.2 OBJECTIVE
This unit aims at making the reader to understand the prevailing types of
various market types avail in an open economy. And this lesson aims at explaining
price output decision taken under perfect competition at different periods.
13.3 CONTENTS
i) Perfect Competition
The term perfect competition is used in wider sense. Perfect competition
means all the buyers and sellers in the market are aware of price of products. The
following are the characteristics of perfectly competitive market
1. Large number of buyers and sellers in the market
2. Homogeneous product
3. Free entry or exit
4. All the buyers and sellers in the market have perfect knowledge about the
market conditions.
5. Perfect mobility of factors of production
6. Absence of transportation costs.
When the first three assumptions are satisfied there exists pure competition.
Competition becomes perfect only when all the assumptions are satisfied. In perfect
competition, the demand for the output for each producer is perfectly elastic. With
the larger number of firms and homogeneous products, no individual firm is in a
position to influence the price.
ii) Equilibrium Price
The demand curve normally slopes downwards showing that more quantity of
commodity will be demanded at a lower price than at higher prices. Similarly
supply curve showing an upward trend where the producers will offer to sell a
148
larger quantity at a higher price than at a lower price. Thus the quantity demanded
and quantities supplied vary with price. The price that tends to settle down or
comes to stay in the market (where both buyers and sellers are satisfied) is at
which quantity demanded equals quantity supplied. The point so formed is known
as equilibrium point and price is known as equilibrium price.
iii) Effect of time on supply
According to Marshall Time has great influence on the determination of price.
The following are the market periods based on time i.e market period, short period
and long period.
1. Very short period (Market period)
2. Short period
3. Long period
Market period or very short period may be only a day or very few days. Change
in supply is not possible where the period is very short and quantity demanded will
be the determining factor in this period Further, supply curve in the market period
is remain fixed showing vertical straight line.
The short period is a period not sufficient to make any changes in the existing
fixed plant capacity. Increase in supply in the short period is possible by increasing
the variable factors of production only the supply curve slopes upward to right
showing that some increase in supply is possible when the price increases.
Long period is a time long enough to adjust the supply to any changes in
demand. The long run supply curve is less steep then short run supply curve
showing increase in quantity supplied when price changes.
iv) Equilibrium under perfect competition
In perfect competition the market
price of a commodity is determined by its
demand and supply. The price of a Y
D S
commodity determines at the point where
quantity demanded equates quantity
M N
supplied. It can be explained through the P1
following diagram. Price
P E
In the above diagram, DD denotes
the demand curve and SS denotes the P2 R
L
supply curve. Demand and supply curves
slopes in opposite direction. In this S D
diagram OP is the equilibrium price
where the demand curve equates with the O Q X
Quantity demanded and supplied
supply curve.
Diagram – 13.1
In this figure, the point E determines the equilibrium price and OQ is the
equilibrium quantity. From the diagram it can be noted that if the price increases to
OP1, the demand will be P1M and supply will be P1N.So MN will be excess supply.
149
Under this circumstance, the firm will be forced to lower the price in order to sell
the excess supply under this circumstance; the firm will be forced to lower the price
in order to sell the excess stock. It the firm can minimizes the price, the profit will
be low. Thus we can say that at the point of equilibrium firm can derive maximum
profit. At the point of equilibrium, there are two conditions to be satisfied.
MC = MR where MC = marginal Cost (Cost of producing an additional unit) MR
– marginal Revenue realized from the sale of an additional unit
MC Curve Cuts MR curve from below that is MC Curve should have positive
slope. Under perfect competition, the following equations are satisfied.
MC = MR, MR = AR Price = AR = AC
There fore, Price = MR = MC = AR = AC.
The equations can be satisfied with the following diagrams
When the firm is OS quantity of MC

Y
goods, the MC curve cuts the AC curve at AC
its lowest. At the lowest point the AC
curve is tangential to the demand (ie
AC=MC=AR) curve. Thus the price OU is Price
equal to the marginal cost (ST) which is U D
again equal to average cost (ST). The
firms under perfect competition will be
the cost efficient size or optimum size
O S X
which gives the lowest possible average
Quantity
cost of production per unit.
Diagram – 13.2
a) During the Market period

In very short period, supply is Y D1
inelastic, thus the price depends on S
changes in demand. The supply curve will D
be vertical straight line parallel to y-axis. D2

P1
In the above diagram, SP is the
supply curve, It means where ever the P
price is, the fixed supply is to be sold in
P2
the market. Here DD is the demand D1
curve. The supply is SQ. The Point of D
equilibrium is at ‘S’ so the equilibrium is D2
OP. Here the demand alone determines O Q X
the price because supply is fixed. Diagram – 13.3
If the demand increases to D1D1, the price will increase from OP to OP1 and
vice versa, ie, if the demand decreases to D2D2, the price will decrease to OP2.
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If the commodity is non-perishable, It can be stored. the seller does not sell the
goods if the price is low. But the price is high he will sell whole stock. The curve will
be curved at beginning; then it will become a straight line. Under very short period,
the demand alone determines the price.
b) During short period
In this period, the firm can make slight changes in their supply of goods
without changing the capacity of plant.
In this diagram, DD is the demand
D1 s
curve and SS is the supply curve. At Y
point ‘E’ the demand curve equals the D
supply curve, the equilibrium price is OP. D2
If te demand is increased to D1D1 the P1
E1
equilibrium price will be OP1 and if the P E
demand decreased to D2D2, the
P2 E2
equilibrium will be OP2. But the quantity
D1
will be decreased form OQ to OQ2. The
firm in the short run can produce output D
S D2
by increasing the variable inputs. A firm O Q2 Q Q1 X
gets maximum profit where MC = MR. Diagram – 13.4
The price determination by the industry is given in the following diagram.
In the above diagram, it can be Y
revealed that the price is determined by
the industry OP. when the demand is D
shifted to D1D1 then the quantity S
D1
demanded is decreased from OQ to OQ1
and also price decreases form OP to OP1. In
the case of a firm, MR = AR, thus
Price
P E
demand = AR = MR = price
c) In the long run
P1
In the long run, the firms in the
industry are eager to get super normal DC
profits. The price determination is S D1
explained through the diagram given O Q1 Q X
below; In output decision making long Quantity demanded and supplied
run Diagram – 13.5
Average Cost (LAC) and Long run Marginal Cost (LMC) are to be taken in to
consideration under this condition, the firm is in equilibrium.
When AR = MR = LAC = LMC.
In below diagram. (1) DD is the long run. Demand curve and S1S1 short run
supply curve. The price is determined at OP. In the figure 2, the equilibrium output
is at point E At this point. AR1=MR=LMC
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Y LMC
SMC
SAC
D S1 AR1=MR1
P1
S P LAC
Price
S2
P1 P1 PB AR=MR
P P
P2 AR2=MR2
P2 S1 P2
S D
S2 O Q2 Q Q1 X
O Q X Out put
Diagram – 13.6 Diagram – 13.6
13.4 REVISION POINTS
It should be understood the possibilities and impossibilities in a business
during market, short and long period. Supply curve is adjusted accordingly.
13.5IN TEXT QUESTIONS
1. Who is a price taker? Why?
2. Discuss the price output determination under perfect competition.
3. What is meant by equilibrium? bring out the conditions for equilibrium.
13.6 SUMMARY
The lesson clarified that in short run the firm entertains either profit or loss.
Loss making firms can not enter in to long run. Due to many number of sellers
and the product is homogeneous, the profit would be very less in long run.
Analyse the price of homogeneous type ceiling fans produced by reputed
companies. Reader may not find much price difference in that.
13.8 ASSIGNMENT
1. Take IT sector as on example and analyse their equilibrium level. Note that IT
sector is producing services.
13.9 SUGGESTED READING
1. Micro Economics, KPM sundharam & EN Sundharam, sukar & chond
Publication.
13.10 SUPPLEMENTARY READING
1. Reader many go through tutorials through browsing and PPT Presentations
available through them.
13.11 LEARNING ACTIVITY
1. Compare the Price, demand and supply of same type of small cars available in
India. Prepare a list of above data for five continuous years.
13.12 KEY WORDS
1. Perfect competition, equilibrium.

152
LESSON -14
MONOPOLY
14.1 INTRODUCTION
Monopoly means ‘single ‘selling. In brief, monopoly is a market situation in
which there is only one seller or producer of a product for which no close
substitution is available. As there is only one firm under monopoly, that single firm
constitutes the whole industry. The monopolist can fix price of his product and can
pursue an independent price policy. A monopolist can take the decision about the
price of his product. For ex: electricity, water supply companies etc.
14.2 OBJECTIVE
 To make the reader to understand the concept of private monopoly by using
diagrams
14.3 CONTENTS
a) Features
The following are the important features of monopoly
1. One seller and a large number of buyers.
2. No close substitutes for the product.
3. Monopolist is not the price taker and the price maker.
4. Monopolist can control the supply.
5. No entry of new firm to the market.
6. Firm and industry are the same
b) Causes of Monopoly
1. Legal restrictions
2. Exclusive ownership or control over the raw materials.
3. Economics of large scale production
4. Exclusive knowledge of a production technique.
c) Price Determination under Monopoly
A monopoly firm has complete control over the entire supply. It can sell
different quantities at different prices. It can sell more if it cuts down its price. Thus
the monopoly firm faces a downward sloping demand curve of the monopoly firm
and the industry will be the same. But under perfect competition the firm’s demand
curve is a horizontal straight line, but the industry’s demand curve slopes down
wards. Since average revenue falls when more units of output are sold marginal
revenue will be less than average revenue. MR curve thus declines at a greater rate
than. AR curve and it falls below AR curve.
Though the monopolist has the freedom to fix any price he will prefer a price
output combination that gives him maximum profit. He goes on producing so long
as additional units add more to revenue than to cost He will stop at that point
beyond which additional units of producti0on add more to cost than to revenue. In
other word he will be in equilibrium position at the output level at which MR equal
MC and MC cuts MR from below.
153
d) Short Run Monopoly Equilibrium
The monopolist will be in short run Y
equilibrium where the output having MR
equal MC.
In the following figure the
monopolist will be in short run
Price cost
equilibrium at output OM where MR
MC
equal to the short run marginal cost AC
P1
curve MC. P
At an output OM, MP’ is the average T L
revenue (price) and ML is the average cost
of production Therefore P1L is the MR
AR
monopoly profit per unit. The total profit
O M
is equal to product of profit per unit with X
Out put
total output.
Diagram – 14.1
The following are the result of monopoly operation in the market
 If AR greater than AC-results super normal profit
 If AR equals AC results normal profit
 If AR less than AC that results loss to the firm
e) Long run Monopoly Equilibrium
The monopolist is the single producer Y
and the new firms cannot cuts the industry
which enables the monopolist to continue
to earn super profit in the long run. In the
figure the long run equilibrium of the
Price cost
monopolist will be at the output where the LMC

long run marginal cost curve MC Intersects
P1
LAC
the marginal revenue curve MR. P
The shaded rectangle ‘PP’LI’ had T

shown the long run monopolist profit. In
long run. If the cost is at an increasing MR
Demand/AC
trend he will fix a high price and sell a
O
large quantity. This will help him to make Out put X
maximum profit. Diagram – 14.2
f) Difference between perfect competition and Monopoly
1. Under perfect competition there are many sellers but in the case of monopoly,
there is only one seller
2. Individual seller has no control over the market supply in the case of perfect
competition. But in the case of Monopoly individual seller controls the supply.
3. Products are identical in the case of perfect competition, but there is only one
product in the case of Monopoly.
154
4. Under perfect competition, there are free entry and exit of firms. But the
Monopolist blocks the entry.
5. The Monopolist discriminates the price but there is uniform price in perfect
competition.
6. Firm and Industry is different in the case of perfect competition, they are same
in the case of Monopoly.
1 4.4 REVISION POINTS
Monopoly’s only aim is to earn huge abnormal profit at the present
infrastructure. Reader can understand the danger of monopoly. Monopoly will
not bring any technical advancement.
14.IN TEXT QUESTIONS
1. Discuss the features of monopoly
2. Who is a price maker? Why?
3. Discuss the equilibrium under monopoly
14.6 SUMMARY
Either long run or short run equilibrium will bring only profit to the monopoly.
Consumer welfare is no where in a monopoly. Monopoly makes his desired price
from the consumer’s pocket.
14.7TERMINAL EXERCISE
Indian Railway is a state monopoly aims at public welfare. Compare and
contrast the monopoly characters with Indian Railways.
14.8 ASSIGNMENT
1. Distinguish the characters at private and state monopoly.
1. Micro Economics, KPM sundharam & EN sundharam, Sultan & chand & sons,
14.10 SUPPLEMENTARY MATERIAL
1. Reader may browse for tutorials and PPT presentations for understanding more
about monopoly.
14.11 LEARNING ACTIVITIES
Analyse the characters of price taking of a perfect competitor and price making
by monopoly.
14.12 KEY WORDS
Monopoly, State monopoly.

155
LESSON-15
MONOPOLISTIC COMPETITION AND OLIGOPOLY
15.1 INTRODUCTION
In the present World market, it can be seen that there is no monopoly and
there is no real competition. There is a mix up of the two. this situation is generally
known as Monopolistic competition. According to Prof. E. H Chemberlin of America,
Monopolistic Competition means a market situation In which competition is
imperfect. The products of the firms under monopolist competition are mainly close
substitutes to each other. And another form of market we can witness is oligopoly
where there will be few sellers and large number of buyers. Only these two
structures are functioning in the real economy.
15.2 OBJECTIVE
 To illustrate the equilibrium of a monopolist by using cost and revenue curves
and similarly of oligopoly.
15. CONTENTS
a) Features/Assumptions of Monopolistic Competition.
1. The following are the important features of Monopolistic Competition.
2. There are large numbers of producers or sellers
3. It deals with differentiated products.
4. There are free entry and exit of firms to the markets.
5. The selling cost determines the demand for the products.
6. there is no association of firms]
7. There is no price competition.
8. There is lack of knowledge of the market.
b) Price and Output decisions under Monopolistic Competition
i) Short run period
In short run, each existing firm is a monopolist having a downward sloping
demand curve for its product. In order to maximize its profit the firm will produce
that level of output at which MC=MR if price is more than MR, there will be
abnormal profit.
ii) Long-Run Period
In the long period, normal profits AC
will disappear. New firms will enter the Y

industry and consequent expansion of MC
output will decrease the price and only P

normal profit are made by the firms.
Profit are normal only when Average Cost
Price/Cost
O
(AC) equals the Average Revenue (AR).
Then the equilibrium output will be at AC
and MC = MR.
In the above diagram, the
equilibrium output is OM where MC = MR AR
and AC = AR Abnormal profit disappears MR
because TC = TR. (Total cost = Total O M X
Quantity demanded and supplied
Revenue)
Diagram – 15.1
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Difference between Perfect Competition and Monopolistic Competition
Perfect Competition Monopolistic Competition
1) Products are identical 1) Products are differentiated
2) It is not a real concept 2) It is real concept.
3) Large Number of buyers and sellers 3) Buyers and Sellers are not so large
4) Perfect knowledge of market 4) Lack of perfect knowledge of
Condition market Condition
5) Selling Cost do not play any role. 5) Selling cost has an important role.
6) They are price takers 6) They are price markets.
7) Demand curve is horizontal 7) Demand curve is downward sloping
8) AR,. MR curves are parallel to x axis 8) 8) Price = demand = AR = But MR < AR.
and price = demand = AR = MR
Oligopoly
Oligopoly is a situation in which there are so few sellers that each of them is
conscious of the results upon the price of the supply inwhich he individually places
upon the market. According to J. Stigler ‘Oligopoly is that situation in which a firm
bases its market policy in part on the expected behaviour of a few close revels’.
Further, they may produce homogeneous or differentiated products.
a) Characteristics
1. Oligopoly is a distinct market condition. It has the following features:
2. The firms are interdependent in decision making.
3. Advertising should be effective.
4. Firms should have group behavior.
5. Indeterminateness of demand curve.
6. The number of firms or producers or sellers are very small
7. Product are identical or close substitutes to each other
8. There is an element of Monopoly
b) Price Determination under Oligopoly
Pricing many be in condition of independent pricing, Pricing under price
leadership and pricing under collusion.
i) Independent pricing (Kinked Demand Model or Price rigidity Model)
Kinked demand curve was first introduced by prof Paul M Sweezy to explain
price rigidity under oligopoly. An oligopolist always guesses about his competitor’s
reaction. They assume that if one decides to decrease the price, the others will also
reduce the price. the assumption behind the kinked curve is that each oligopolist
will act and react in a way that keep condition tolerable for all the members of the
industry. If one firm reduces the price of the product, the others will not increase
the price. The firms in Oligopoly don not increase the prices due to the possibility of
losing the customers to rivals who do not increase the prices due to the possibility
of losing the customers to rivals who do not raise their prices. Firms usually do not
change their price in response to small changes in costs.
157
The kinked demand curve has two segments i.e.(i) the relatively elastic portion
of the demand curve and (ii) the relatively inelastic portion of the demand curve.
The following diagram will give you the clear idea:
P M
Price
O Q X
Output
Diagram – 15.2
Kinked demand curve DD with a kink at point M. The price prevailing in the
market is OP and the firm produces OQ output. Here .D, M is the relatively elastic
of the demand curve and MD Is the relatively inelastic protion. This difference in
elasticity of demand due to the particular competitive reaction pattern assumed by
the kinked demand Curve hypothesis.
ii) Pricing under Price Leadership
The price leadership means the leading firm determines the price and others
follow it. All the firms in the industry adjusts, the price fixed by the price leader.
The large firm, who fixes the price, is known as the price maker and the firms,
who follow it are known as price – takers. The price leadership may be four types.
They are:
1. Dominant price leadership: In this situation, there exist many small firs and one
large firm and the large firm fixes the price and the small firms in the market
accept that price.
2. Barometric Price Leadership: Under this situation one reputed and experienced
firm fixes the price and others may follow it.
3. Aggressive Price Leadership: Under this market condition, one dominating firm
fixes the price and they compel all others in the industry to follow the price.
4. Effective Price Leadership: Under this condition, there are small number of
firms in the industry.
iii) Price-Output determination Under Price Leadership
In order to determine the price and output under price leadership,we have to
make two assumptions. They are,
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1. There are two firms – L and F, in which the cost of production of L is less than
that of F and
2. Product are identical
The following diagram will give the clear picture of price output determination.
Y
MCF
MCL
P2 R
P1
E
2
P/D/AR
E1
MR
O Q Q X
2 1
Diagram – 15.3
In the above diagram, MC and MC1 are the marginal cost curves of the firms F
and L respectively. By analysing this diagram it can be known that the firm L will
fix at point E2, where MC = MR. The price of the firms F and L are OP1 and OP2 and
the output are Oq1 and OQ2 respectively.
iv) Pricing under Collusive Oligopoly
The term Collusion means ‘to play together’. To avoid the competition among
the firms, monopolistic firms arrive at a formal agreement called cartel. it is
common sales agency formed to eliminate competition and fix such a price and
output that will maximize profit of member firms. The firms output and price are
determined by this cartel. The following diagram will give the idea more clearly or to
make an assumption that there are only two firms viz. firm S and firm T.
In the Below diagram, MC denotes the marginal cost curve of industry and
MC1 and MC2 are the MC for the firm S and T. MR is Marginal Revenue Curve. The
industry is in equilibrium at point E and equilibrium output is OQ and the price is
OP. The equilibrium output of two firms are determined based on this own MC
curve. The share of output of each firm will be obtaining by drawing a parallel line
through E to the X axis.
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Firms S Firms T Industry
MC
MC MC
1
P
1
P2 C ac1 e1 ac2
1
C2 E
C2
MR PD=AR
O Q o Q2 O
1 Q X
Diagram – 15.4
The points E1 and E2 determine the level of output for the firm S and the firm
T respectively. OQ1 and OQ2 determine the market share of firms and Firm T
respectively Here, we can say that, OQ1+OQ2=OQ, OP1+OP2=OP
c) Price Discrimination
A monopolist is in a position to fix the price of his product. He enjoys the
control of supply of the product. A monopolist is able to charge different price for
his products to the different customers. This is known as price discrimination.
According to Mrs. John Robinson ‘the act of selling the same article, produced
under single control at different prices to different buyers is known as price
discrimination. This is also known as differential pricing
i) Types of Price Discrimination
1. Price relatively elastic portion of the demand curve of the first degree-
charging different price for different persons for the same product.
2. Price discrimination of the second degree – Under this, the buyers are
classified into different divisions.
3. Price discrimination of the third degree – Here, the markets are divided
according to elasticity of demand
ii) Conditions of Price Discrimination
1. There must be more than one separate market
2. The markets must have different elasticity of demand
3. The market should be such that no buyer of the market may enter the other
market and vice versa
iii) Dumping
When monopolist works in home market as well as foreign market, he is able
to discriminate the price between these two markets. If he has monopoly in home
market, and he faces competition in to foreign market, he will be able to charge
higher prices for his products in home market. This practice is known as ‘Dumping’
or ‘price dumping’
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Reader must differentiate the equilibrium under independent pricing and price
leadership pricing under price leadership does not bring equilibrium to price
followers. And this may lead to monopoly.
15.5 IN TEXT QUESTIONS
1. Explain the concept “price leadership”
2. Discuss equilibrium under price leadership
3. Discuss equilibrium under independent pricing
4. Explain types of price discrimination.
5. Discuss equilibrium under monopolistic competition.
15.6 SUMMARY
Oligopoly will lead to monopoly at one day. Many small firms will be swallowed
by the big firms. Cut throat competition exists in oligopoly. Small firms will find
if difficult to complete with big firms.
15.7Terminal exercise
Analyse how many mobile service providing companies are merged with big
companies in India during the last ten years.
15.8 ASSIGNMENT
Take Indian passenger car making companies and analyse who is the leader
and what are the reasons for that.
Micro Economics, KPM sundharam & EN Sundharam, Sultan chand & sons.
Reader many browse tutorials and PPT from internet sources.
15.11 LEARNING ACTIVITIES
Learner can witness price wars among various competitors dealing
homogeneous products. Through advertisements they will try to show their
product as superior and unique. Costume products can be considered by the
learner for understanding the concept more in detail.
15.12 KEY WORDS
Monopolistic competition, Oligopoly, price leadership, price follower, kinked
demand curve.

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LESSON -16
PRICING POLICY AND PRACTICES
16.1 INTRODUCTION
Formulating price policies and setting the price are the most important aspects
of managerial decision making. Price in fact, is the source of revenue which the firm
seeks to maximize. Again, it is the most important device a firm can use to expand
the market. If the price is set too high, a seller may price himself out of the market.
If it is too low, his income may not cover costs, or at best, fall short of what it could
be. In other words, if the Company prices too much, it will make fewer sales. If it
charges too little, it will sacrifice profits. So the price must be fixed judiciously.
16.2 OBJECTIVE
 To make the reader to understand various types of pricing methods and
policy framing.
16.3 Contents;
a) Meaning of price
Price is the money value of the goods and services. In other words, it is the
exchange value of a product or service in terms of money. To the seller, price is a
source of revenue. To the buyer, price is the sacrifice of purchasing power.
b) Factors governing prices and pricing decision
Price is very important to both the buyer and the seller. In this connection, it
may be noted that in economic theory, two parties should be generally emphasized
i.e. buyers and sellers. In practice, however, as pointed out by Oxenfeldt, certain
other parties are also involved in the pricing process, i.e. rival seller, potential
rivals, middlemen & government. All these parties also exercise their influence in
price determination.
Factors governing prices may be divided into external factors and internal
factors.
Internal Factors
These are the factors which are within the control of th organization. Various
internal factors are as follows.
1. Cost : The price must cover the cost of production including materials, labour,
overhead, administrative and selling expenses and a reasonable profit.
2. Objectives: While fixing the price, the firm’s objectives are to be taken into
consideration. Objectives may be maximum sales, targeted rate of return,
stability in prices, increase market share, meeting or preventing competition,
projecting image etc.
3. Organizational factors: Internal arrangement of the organization.
Organizational mechanism is to be taken into consideration while deciding the
price.
4. Marketing Mix: Other element of marketing mix, product, place, promotion,
pace and politics are influencing factors for pricing. Since these are
interconnected, change in one element will influence the other.
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5. Product differentiation: One of the objectives of product differentiation is to
charge higher prices.
6. Product life cycle: At various stages in the Product Life Cycle, vaious strategic
pricing decisions are to be adopted, eg. at the introduction stage. Usually firm
charges lower price and in growth stage charges maximum price.
7. Characteristics of product: Nature of product, durability, availability of
substitute etc. will also influence the pricing.
External Factors
1. These factors are beyond the control of organization. The following are the main
external factors.
2. Demand: If the demand for a product is Inelastic it is better to fix a higher price
and if demand is elastic, lower price may be fixed.
3. Competition: Number of substitutes available in the market and the extent of
competition and the price of competition etc. are to be considered while fixing a
firm price.
4. Distribution channels: Conflicting interest of manufacturers and middleman is
one of the of the important factor that affect the pricing decision. Manufacturer
would desire that middleman should sell the product at a minimum mark up.
5. General economic conditions: During inflation a firm forced to fix a higher price
and in deflation forced to reduce the price.
6. Government Policy: While taking pricing decision, a firm has to take into
consideration the taxation policy, trade policies etc. of the Government.
7. Reaction of consumers: If a firm fixes the price of its product unreasonably high,
the consumer may boycott the product.
c) Pricing Policies
Price must not be too high or too low. Price setting is a complex problem. The
pricing decision is critical not only in the beginning but it must be reviewed and
reformulated from time to time. Price policies provide the guidelines within which
pricing strategy is formulated and implemented. It represents the general frame
work within which pricing decision are taken. Price policies are those management
guidelines that control the day to day pricing decision as a means of meeting the
objectives of the firm such as maximization of profit, maximization of sales, targeted
rate of return, survival, stability of prices, meeting or preventing competition etc.
d) Steps in formulating pricing policies
1. Selecting the target market or market segment on which marketer would
concentrate more.
2. Studying the consumer behavior and collecting information relating to target
market selected.
3. Studying the prices, promotion strategies etc. of the competitors and their
impact on the market segment.
4. Assigning a role to price in the marketing mix.
5. Collecting the cost of manufacturing the product at different levels of demand.
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6. Fixing suitable (strategic) price after determining the price objectives and
according to a selected method of pricing.
e) Objectives of pricing policy
Pricing decisions are usually considered a part of the general strategy for
achieving a broadly defined goal. Before determining the price itself, the
management should decide the objectives. while setting the price, the firm may aim
at one or more of the following objectives.
1. Profit maximization: Since the primary motive of business is to earn
maximum profit, pricing always aim at maximization of profit through
maximization of sales.
2. Market share: For maximizing market share a firm may lower its price in
relation to the competitor’s product.
3. Target return in investment: The firm should fix the price for the product in
such a way that it will satisfy expected returns for the investment.
4. Meet or prevent competition: In order to discourage competition a firm may
adopt a low price policy.
5. Price stabilization: Another objective of pricing is to stabilize the product
prices over a considerable period of time.
6. Resource mobilization: Company may fix their prices in such a way that
sufficient resources are made available for the firms expansion, developmental
investment etc.
7. Speed up cash collection: Some firms try to set a price which will enable
rapid cash recovery as they may be financially tight or may regard future is
too uncertain to justify patient cash recovery.
8. Survival and growth: An important objective of pricing is survival and
achieving the expected rate of growth. Profit is less important than survival.
9. Prestige and goodwill: Pricing also aims at maintaining the prestige and
enhancing the goodwill of the firm.
10. Achieving product – quality leadership: Some Companies aim at
establishing product quality leader through premium price.
11. Methods of pricing
12. Cost Plus pricing.
13. Target pricing.
14. Going rate pricing.
15. Customary pricing.
16. Follwo up pricing.
17. Differential pricing.
18. Marginal cost pricing.
19. Barometric pricing.
1. Cost plus pricing: This is the most common method used for price. Under
this method, the price is fixed to cover all costs and a predetermined percentage of
profit. ie, the price is computed by adding a certain percentage to the cost of the
product per unit. this method is also known as margin pricing or average cost
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pricing or full cost pricing or mark up pricing. the business firm under oligopoly
and monopolistic market are following this pricing policy.
2. Target pricing: This is variant of full cost pricing. Under this method, the
cost is added with the predetermined target rate of return on capital invested. In
this case the company estimates future sales, future cost and calculates a targeted
rate of return on capital invested. This is also called as rate of return pricing.
3. Marginal cost pricing: Under the marginal cost pricing, the price is
determined on the basis of marginal cost or variable cost. In this method, fixed
costs are totally excluded.
4. Differential pricing: Under this method, the same product is sold at
different prices to different customers, in different places, and at different periods.
this method is called discriminatory pricing or price discrimination. Examples,
Cinema theater, telephone bills etc..
5. Going rate pricing: under this method, prices are maintained at par with
the average level of prices in the industry. I.e., under this method a firm charges
the prices according to what competitors are charging. Thus firm accepts the price
prevailing in the industry in order to avoid price war. This method is also called
acceptance pricing or parity pricing.
6. Customary pricing: in the case of some commodities the prices get fixed
because they have prevailed over along period of time. Example, price of a cup of
tea or coffee. In short the prices are fixed by custom.
7. Follow up pricing: this is the most popular price policy. Under this, a firm
determines the price policy according to the price policies of competitors. If the
Competitors reduce the price of the product; the firm also reduces the price of
its product. If the competitors increase the price, the firma also follow the same.
8. Barometric pricing: this is the method of leadership pricing. In this type of
price leadership, there is no leader firm. but one firm among the oligopolistic firms
announces a price change first. This is followed by other firms in the industry. The
barometric price leader need not be a dominant firm with the lowest cost or even
the largest firm in the industry but they responds to changes in business
environments rapidly. On the basis of a formal or informal tacit agreement, the
firms in the industry accept a firm as price leader who may act firstly upon the
environmental or market changes.
g) Pricing of a new product. (Methods and strategy)
In pricing a new product, generally two types of strategies are suggested. They
are;
1. Skimming price strategy
This is done with a basic idea of gaining a premium from those buyers who
always ready to pay a much higher price than others. Accordingly a product is
priced at a very high level due to incurring large promotional expenses in the early
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stages. Thus skimming price refers to the high initial price charged when a new
product is introduced in the market. Reasons for charging this price are;
1. When the demand of new product is relatively inelastic.
2. When there are no close substitutes
3. Elasticity of demand is not known.
4. When the buyers are not able to compare the value and utility.
5. To recover early the R&D and promotional expenses.
6. To recover early the R&D and promotional expenses.
7. When the product has distinctive qualities, luxuries etc.,
2. Penetration price strategy
This is the practice of charging a low price right forms the beginning to
stimulate the growth of the market and to capture large share of it. Since the price
is lower, the product quickly penetrates the market, and consumers with low
income are able to purchase it. Reasons for adopting this policy are:
1. Product has high price elasticity in the initial stage.
2. The product is accepted by large number of customers.
3. Economies of large scale production available to firm.
4. Potential market for the product is large.
5. Cost of production is low.
6. To introduce product into market.
7. To discourage new competitors.
8. Most of the prospective consumers are in low income class.
h) Kinds of pricing (pricing strategies)
Pricing policy means a policy determined for normal conditions of the market.
Pricing strategy is a policy determined to face a specific situation and is of
temporary nature. Simply pricing policies provide guidelines to carry out pricing
strategy. Following are the important pricing strategies.
Psychological pricing: Here manufacturers fix their prices of a product in the
manner that it may create an impression in the mind of consumers that the prices
are low. E.g. Prices of Bata shoe as Rs. 99.99. This is also called odd pricing.
Mark up pricing. This method of pricing is followed by wholesalers and
retailers. When the goods are received, the retailers add a certain percentage of the
wholesaler’s price.
Administered pricing: here the pricing is done on the basis of managerial
decisions and not on the basis of cost, demand, competition etc.
Other pricing strategies: Geographical pricing, base point pricing, zone
pricing, dual pricing, product line pricing etc. are some other pricing strategies.
i) Roles of Cost in Pricing
Most of the wholesale and retail organizations add some percentage of profit or
mark up total cost per unit to arrive at selling price. According to Hall and Hitch,
business firms under the conditions of oligopoly and monopolistic competitive
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market do not determine price and output with the help ofthe principle MC = MR.
they determine price and output on the basis of full average cost of production.
Cost of production consists of fixed and variable costs. Inthe short run the firm may
nto cover the fixed cost but it must cover at least variable cost. In long run all costs
must be covered. if the entire cost is not recovered, the firm will incur losses, and
the firm must stop their production. Thus costs provide the basis for pricing. If the
cost increase price also increases. Cost represents a resistance point for lowering of
price, i.e., below which pricing should not be done. Cost also determines the profit
margin at various level of output.
j) Role of Demand factor in pricing
In the case of pricing of a product, demand plays a significant role. In some
cases demand occupies a vital role than cost. The demand is the factor which
determines the sales and profit. We know as per law of demand, demand and price
have inverse relationship. To increase the demand,, the firm has to reduce the
price. Similarly to decrease the demand the firm has to increase the price. The
elasticity of demand is to be considered in determining the price of the product. If
the demand for the product is elastic, the firm can fix lower price. If the demand is
inelastic, the firm can fix a higher price.
k) Consumer Psychology and Pricing
While fixing the price of product, the management should give importance to
consumer psychology. Actually demand of the product is based upon the behavior
of consumers. Some consumer may buy a product of high quality even though the
products are highly priced. Consumers think that highly priced products are of
high quality. If the price of product is less, consumer will think that such product is
of low quality. If the price is too high, the consumer may boycott the product and
they will go for substitute product of low price. If the price is too low the consumers
think that the goods are of inferior quality. They will not buy it. The important
elements that influence the consumer psychology are; price of the product, after
sales service, advertisement and sales promotion, personal income, fashions. So
consumer are many types, they follow different approaches to firms product. So in
case of price determination, the consumer psychology must given due weightage.
In global scenario pricing of any product is a challenge, faced by the firms.
Reader must understand the sociological reasons which influence the pricing.
16.5IN TEXT QUESTIONS:
1. Define ‘Price’
2. Explain the factors influence pricing decisions
3. Discuss various types of pricing policy.
4. Discuss methods of pricing.
16.6 SUMMARY
Reader must go through the pros and cons of various pricing policies adopted
by the firms. There is no standard successful pricing policy could be
suggested.
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Analyse the pricing policy of a new product and redesigned product. Also note
the pricing policy of a most needful product with others.
16.8 ASSIGNMENT
Take any innovative product and find out how it is priced. Analyse the product
unique features and its relationship with pricing.
Micro Economics, KPM sundharam & EN Sundharam, Suthan chand and
sons.
16.10 SUPPLEMENTARY READING
Reader may browse for tutorial and PPT to acquire more depth knowledge.
Reader may find the method of pricing has direct nexus with the necessity of
the product. Pricing policy adopted for food itens can not be implemented for
cars.
16.12 KEY WORDS
Kind of prices, pricing policy.

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UNIT-V :. PROFITMANAGEMENT
LESSON - 17
PROFIT POLICY AND PRACTICE
17.1 INTRODUCTION
Profit is necessarily a residual sum. Land, labour and capital are frequently
used under contracts whereby they receive a predetermined return. Net profit is a
sum over and above the ordinary costs of business including such contractual
outlays. Nobody contracts to pay the entrepreneur the residual sum which
constitutes net profit. Business profits are, therefore, especially contingent upon
successful management of risk. Business is faced with a number of uncertainties.
(i) technical uncertainties-those relating to the physical process of production, (ii)
cost uncertainties either due to change in the prices of raw materials, wages, rent,
etc. or due to technology changes, (iii) demand uncertainties either due to changes
in consumer preferences or due to innovation of new products1 and obsolescence of
the existing products, and (iv) market uncertainties-those relating to the future
price of the product and the volume of sales. The entrepreneur receives a reward for
combining the factors of production to meet the economic needs of a world faced
with uncertainties. He takes a risk which others are unwilling to bear, and if he
successfully manages the risk, he receives profits. This means that a businessman,
in order to earn profits, has to do two things. (1) select the risks which he wishes to
bear, and (2) manage them successfully. The selection of risk is made at almost
every step of a businessman’s career. His important problem is the selection of
business in which he wishes to engage himself. In fact, success of profit would
depend upon the ability to foresee the future and prepare for it so that when
opportunity arises, it can be fully availed of. But even after, selection of a business,
many risks arise. Some of them he may have to bear even though he would rather
nor; others he may transfer to people more willing to bear them (or unable to
escape them); still others he may shift by insurance.
Profits vary from industry to industry and from businessman to businessman.
The greater the risk and uncertainty in business or industry, the greater are the
opportunities for large profits. Similarly, those businessmen who are
temperamentally cautious and are not willing to assume large risks get a smaller
margin of profit as compared to those who are more confident and adventurous.
Since risks, and, therefore, profits (and losses) appear because of changes and
uncertainties in a dynamic society, profits vary from year to year as well.
Profits are likely to be high in industries in which methods of production are
constantly changing so that there is continuous adoption of new techniques; in
nascent industries the prospects of which are rather uncertain; in industries in
which there is a large gestation period; and in industries in which resources are
irrevocably committed to narrowly specialised tasks.
Profits are also affected by the level of business activity. If business is brisk
and firms are operating at their maximum capacity, their average costs would be
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reduced to the minimum while their sales would be the maximum. This would lead
to higher profits. Profits would be reduced if the business activity is at a low ebb.
17.2 OBJECTIVE
 To make the reader to understand the concept of profit and policies very
clearly.
17.3 CONTENTS
The basic function of profit is to provide businessman with an incentive to
produce what consumers want, when and where they want it at the lowest feasible
cost. This includes innovation of new products and new methods. In fact, the profit
motive is the kingpin of private enterprise, nay, of every business activity. In
addition, as pointed out by peter Drucker, profit serves three main purposes.
(1) Measure of Performance
It measures the net effectiveness and soundness of a business effort. A higher
profit is an indicator that the business is being run successfully and effectively.
It is true that profit is far from being a perfect measure of business efficiency but
it is probably the best indicator of the general efficiency of a firm. It is certainly the only
one which allows quick and easy comparison of performance of various firms.
(2) Premium to cover costs of staying in Business
Profit is the premium that covers the costs of staying in business-replacement,
obsolescence, market and technical risk and uncertainty. Seen from this point of
view, it may be argued that there is no such thing as profit; these are only the costs
of being and staying in business. The management of a business has to provide
adequately for these costs by generating sufficient profit.
(3) Ensuring Supply of Future capital
Profit ensures the supply of future capital for innovation and expansion, either
directly, by providing the means of self-financing out of retained profits, or
indirectly, through providing sufficient inducement for new external capital which
will optimise the company’s capital structure and minimise its cost of capital.
The primary goal of a business firm is to ensure its own survival. From this
point of view, the firm must make a profit because profits are indispensable to
remaining viable and to remain alive. Again, the firm must have growth because
that is the only way it can perpetuate itself as an institution. And profits are a
natural concomitant of the growth and development of business over time. In fact,
“Profits are essential as a means to an end; they are not an end in themselves,
although essential for the continuity and growth of the firm.”
a) PROFITEERING AND PROFIT – EARNING
Profiteering has to be understood as distinct from profit-earning. Where the
amount of profit made exceeds a socially acceptable limit by questionable methods,
it is a case of profiteering. Profiteering is often done by creation of artifical
shortages through hoarding or curtailing production.
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b) Accounting Profit and Economic Profit
In the accounting sense, profit is regarded as the revenue realised during the
period minus the cost and expenses incurred in producing the revenue. This
concept of profit is also known as the Residual Concept.
The economist, however, does not agree with the accountant’s approach to
profit. The accountant would only deduct the explicit or actual costs from the
revenues to determine profit. The economist points out that in addition to the
deduction of explicit costs, imputed costs, e.g., the cost that would have been
incurred in the absence of the employment of self-owned factors, should also be
deducted. The example are (1) entrepreneur’s wages (which he could earn by
working for someone else), (2) rental income on self-owned land and building
employed in the business (which the owner could have earned by letting it on hire
to some other firm), and (3) interest on self-owned capital (which could have been
earned by investing it elsewhere). The profit arrived at by deducting imputed costs
form accounting profit can be called as economic profit. (Economic profit =
Accounting profit – Imputed costs).
From the managerial point of view, economic profits are more important than
accounting profits because they alone would reflect the true profitablility of the
business. A firm while making accounting profits may be incurring economic
losses. Such a firm would have to withdraw from business in the long run.
c) Measuring Economic Profits
Illustration
Lala Jugal kishore of Aminabad, Lucknow, prepared the following Trading and
profit and Loss Statement for his shop of jeweler and gold ornaments.
TRADING AND PROFIT AND LOSS ACCOUNT
For the Year Ending DECEMBER 31, 2001
Rs Rs
To Opening stock 5.00,000 By Sales 63,50,000
To Purchases 55,00,000 By closing Stock 6,00,000
To Inward Parcel Postage 50,000
To Gross Profit 9,00,000
69,50,000 69,59,000
To Salaries and Wages 2,50,000 By Gross Profit 9,00,000
To Advertisement 50,000
To Boxes and Wrappings 30,000
To Office Supplies and Postage 10,000
To Light and power 25,000
To Insurance, Taxes and Repairs of Building 70,000
To Telephone 20,000
To Depreciation 50,000
To Interest on Borrowings 1,00,000
To Misc. Expenses 75,000
To Net Profit 2,20,000
9,00,000 9,00,000
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The above statement was given to a managerial economist for this comments.
On enquiry, Lala jugal kishore supplied the following additional information.
1. His drawings during the year amounted to Rs. 1,80,000.
2. Up to the year 2000, he worked as manager of another jewellery shop where
he was getting a salary of Rs. 10,000 per month. Since then, he left the service
and started his own retail shop.
3. The building in which the retail shop is housed is a two-storey building owned
by Lala jugal kishore. The building is located in Aminabad which is the
busiest market place situated in the heart of the town. The building can
readily be let out any time for Rs. 8,000 per month.
4. Lala Jugal Kishore invested his own capital of the order of Rs. 20,00,000. If
borrowed, it would have been obtained at 15 per cent per annum.
The managerial economist made certain adjustments as follows to arrive at
another estimate of profits.
Rs
Net Profit 2,20,000
Add: Insurance, taxes and repairs of building 70,000
2,90,000
Less: Proprietor’s Salary 1,20,000
Building rent 96,000
Interest on owned capital 3,00,000 5,16,000
Net Loss 2,26,000
1. Which of the above figure (of profit and loss) truly represents the working result
of the business?
2. Lala jagal Kishore when told that he is actually running the business at a loss
was surprised and argued as follows.
a) “I do not actually draw any salary from the business. Moreover, I am not
working for salary but for profits.”
b) “I own the building myself. The item of rent, therefore, is adequately taken
care of by the expenses incurred in connection with the building such as
taxes, insurance, etc.”
c) “ I do not actually charge interest on my owned capital. In fact, I have
worked to put this business in a position where there would be no need for
borrowing money. I think there is a great difference if a person puts his own
capital rather then be continually in debt to banks and moneylenders.”
Do you agree with the above arguments of Lala jugal Kishore? What economic
functions did he perform? Is he a successful businessman? Should he close down
his business?
Solution
The profit 2,20,000 as shown by the Trading and profit and Loss account is
accounting profit representing the total revenue realised during the year minus the
costs and expense actually incurred in producing this revenue. The net loss of Rs.
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2,26,000 however, takes into account the opportunity cost of proprietor’s labour,
the imputed cost of owned capital and the imputed rent of his own building. Thus it
reflects much more truly the profitability or otherwise of the firm, because in the
absence of self-employed factors, these costs would also have been incurred.
The arguments given by Lala Jugal Kishore are more sentimental than
economic. Basides acting as an entrepreneur, he is performing other functions of
land, labour (or organisation) and capital. The accounting profit of Rs. 2,20,000
includes rewards for performing these functions as well. To arrive at the true
profitability of the business, implicit costs for these functions must be excluded. On
that basis, the business is show to run at a loss. Lala Jugal Kishore, therefore,
cannot be considered a successful businessman. He should not, however, close
down his business immediately but rather improve it. If he closed down his
business, the may not immediately be able to get employment, lend his capital or
let his building on hire.
Readers should understand the nature of the product and its relevance in profit
policy. Reader should capable of illustrating economic and accounting profit.
17.5IN TEXT QUESTIONS
1. Define the term profit.
2. What is meant by profit management?
3. Illustrate Economic profit with an example.
4. Distinguish accounting and Economic profit.
5. Discuss the need for profit analysis.
17.6 SUMMARY
Profit making is not an easy way in the global competition today. Also that there
are more number of substitutes are available today. A firm survives only with a
successful profit policy.
1. Take a small Industry of Reader’s choice and suggest them a suitable profit policy.
17.8 ASSIGNMENT
1. Write an essay on profit management includes factors governing profit
management.
1. Managerial Economics, R. Sharam, Lakshmi Narain Agarwal publication.
Learner can visit a small or cottage industry and analyse the problems faced by
them in fixing prices practically and may find solutions.
1. Tutorials could be browsed and PPT preparations could be witnessed to acquire
more knowledge regarding pricing policy.
17.12 KEY WORDS
1. Profit, remuneration to the firm, payment to entrepreneur, profit management.

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LESSON - 18
SOCIAL RESPONSIBILITY OF BUSINESS
18.1 INTRODUCTION
Though the basic goal of business is to earn a profit, yet business does not
operate in a social vacuum and it is argued that business has a social responsibility
as well. We are, therefore, presenting in a nutshell the various areas of social
responsibility of a business. The phrase social responsibility of business, refers to
the business responsibility for the well-being of the society and the total
environment in which it operates. The concept of social responsibility of business
has many connotations. First, business is responsible for performing its economic
function in the most effective and efficient manner. Secondly, in making its
decisions, it should give appropriate weightage to considerations of public interest.
Thirdly, business should keep into consideration the national priorities. Fourthly,
business should assume responsibility for solving the many social and ecological
problems created by industrial operations like urban congestion. Environmental
pollution, industrial discharges into water, depletion of natural resources, etc.
Fifthly, business should take an active interest in contributing to the solution of
general socio-economic problems like poverty, unemployment, and training facilities
for the unemployed. Finally, it should pay due regard to the goals and interests of
the other sections of the society. A firm can demonstrate its commitment to social
responsibility by being a good corporate citizen. The social responsibility of
business to the various sections of the society is outlined below.
Customers
(a) To provide wholesome products and services on a sustained and regular
basis at reasonable prices. (b) To avoid false advertisement and to provide truthful
information to them on the technical and utilitarian aspects of the products and
services. (c) To ensure continous product improvement through research and
development to enhance customer satisfaction. (d) To establish sound and ethical
business practices.
18.2 OBJECTIVE
 To make the readers to understand the corporate social responsibility (CSR).
18.3 CONTENTS
i) Investors
(a) To maintain the productive and operational capacity and solvency of the
enterprise on a sound basis. (b) To provide timely, factual and full information on
the performance of the enterprise. (c) To safeguard the assets and interest of the
enterprise. (d) To sustain the profit generating capacity of the enterprise. (e) To
search for and take advantage of the opportunities for long-range profitability.
ii) Employees
(a) To formulate fair and sound employment policies to attract and retain
qualified and competent employees. (b) To encourage and inspire them to sharpen
and utilise their knowledge and skills towards fulfillment of organisational and
individual goals. (c) To motivate them to do their best by monetary and other
incentives and to enhance their morale in general. (d) Enlist employee co-operation
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and commitment to the organisation through the process of their participation in
management.
iii) Suppliers
(a) To deal fairly, ethically and legally with them. (b) To establish sound
business relations with them on a reciprocal basis.
iv) Competitors
(a) To compete fairly and ethically. (b) To adopt a policy of live and let live. (c)
To avoid indulging in collusive and restrictive trade practices.
v) Government
(a) To adhere to plan priorities. (b) To abide by the various rules and
regulations. (c) To pay taxes honestly and in time. (d) To co-operate and collaborate
with the Government in various nation-building activities, as for example, by
increasing exports.
In the United States and other western countries, concept of social
responsibility of business has received a lot of emphasis. In our country, however,
the level of social consciousness in trade and industry is rather low, though some
business houses have definite awareness of their social responsibilities.
18.4 REVISION POINT
Reader must note the growing awareness in ecology and the government insists
the corporate on their social responsibility.
18.5IN TEXT QUESTION
1. Discuss the role of corporate in social responsibility.
2. Suggest measures to strengthen CSR.
18.6 SUMMARY
CSR is a concept of the day and each firm has to spend 3% of their profit for
social activities. Thus, reader must understand the need for the hour of this
growing awareness with regard to CSR.
1. Analyse the services rendered by the CSR wing of reputed blue chip companies
in India.
18.8 ASSIGNMENT
1. Write an essay on the measures taken by India to strengthen CSR.
1. Managerial Economics, R.L. Varshney & KL Maheswari, Sultan Chand & sons.
1. Reader may read schedule 7 of the Indian constitution in order to understand
the activities assigned in CSR activities.
18.11 SUPPLEMENTARY MATERIAL
1. Reader may go through the details of foundations; trusts run by the corporate
and acquire more knowledge about CSR.
18.12KEY WORDS
CSR, Indian constitution.
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LESSON- 19
PROFIT PLANNING AND FORECASTING
19.1 INTRODUCTION
The signs of a healthy business include making a profit consistent with the
various risks that it has to face. A firm is faced with a number of uncertainties.
These uncertainties are created by the dynamic nature of consumer needs, the
diverse nature of competition, the uncontrollable nature of most elements of cost,
and the continuous technological developments.
So far as demand is concerned, save for the basic needs essential for survival,
consumer preferences are highly subjective and, therefore, most unpredictable. The
uncertainty about the pattern and quantum of consumer demand for a particular
product increases the degree of risk faced by the firm.
The nature of competition may be related to either product or price or to both
simultaneously. Product competition is more important till the product reaches the stage
of maturity stage. During the growth stage, the risk of product obsolescence and hence
shortening of the product life cycle is great. Again, if the scope of market segmentation
and product differential is great, the risk of product obsolescence increases; if such a
scope is less, the risk of price competition increases. It is said that normally, the degree
of risk involved in product competition is greater than in price competition.
In a period of continuously rising prices, no firm can be certain of its own
internal cost structure, for it does not have any control over the prices of raw
materials, the wages it would have to pay and the prices of other inputs including
the elements susceptible to indirect taxation.
Continuous technological improvements may make today’s established commercial
production completely obsolete in course of time. If an improved process is available, a
firm can limit its risk by discarding its fixed investment. However, if it does not have
access to the improved process, it may have to go out of business altogether.
Unless a firm is prepared to face the uncertainties created by these risks, its
profits would be left to chance. Naturally, the firm will have to plan for profits. In
this respect, a thorough understanding of the relationship of costs, price and
volume is extremely helpful to business executives. The most important method of
determining the cost-volume-profit relationship is that of Break-even Analysis, also
known as cost-volume-profit (C-V-P) analysis.
19.2 OBJECTIVE
This lesson aims at explaining the concept of break even to the readers and
makes them to understand the significance in business.
19.3 CONTENTS
Break-Even Analysis
Break-even Analysis involves the study of revenues and costs of a firm in
relation to its volume of sales and specifically the determination of that volume at
which the firm’s costs and revenues will be equal. The Break-even Point (BEP) may
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be defined as that level of sales at which total revenues equal total costs and the
net income is equal to zero. This is also known as no-profit no-less point. The main
objective of the break-even analysis is not simply to spot the BEP, but to develop an
understanding of the relationships of cost, price and volume within a company’s
practical range of operations. The break-even chart is an “excellent instrument
panel for your guidance in controlling your business.
Determination of the Break-even point
It may be determined either in terms of physical units or in money terms, i.e.,
sales value in rupees.
Break-even Point in Terms of Physical Units
This method is convenient for the single-product firm. The break-even volume
is the number of units of the product which must be sold to earn enough revenue
just to cover all expenses-both fixed and variable. The selling price of a unit covers
not only its variable cost but also leaves a margin (contribution margin) to
contribute towards the fixed costs (costs remaining fixed irrespective of the volume).
The break-even point is reached when sufficient number of units have been sold so
that the total contribution margin of the units sold is equal to the fixed costs. The
formula for calculating the break-even point is:
Fixed cos ts
BEP 
Contribution m arg in per unit
where the contribution margin is: Selling Price-Variable costs per unit.
Example 1
Suppose the fixed costs of a factory are Rs. 10,000 per year, the variable costs
are Rs. 2.00 per unit and the selling price is Rs. 4.00 per unit. The break-even
point would be:
10, 000
BEP   5, 000
4  2 units.
In other words, the company would not make any loss or profit at a sales
volume of 5,000 units as shown below:
Sales Rs. 20,000
Cost of goods sold
Variable cost @ Rs. 2.00 Rs. 10,000
Fixed costs Rs. 10,000 Rs. 20,000
Net profit Nil
Break-even point in Terms of Sales value
Multi-product firms are not in a position to measure the break-even point in
terms of any common unit of product. They find it convenient to determine to
determine their break-even point in terms of total rupee sales. Here, again, the
break-even point would be the point where the contribution margin (Sales value –
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Variable costs) would equal the fixed costs. The contribution margin, however, is
expressed as a ratio to sales. For example, if the sales are Rs. 200 and the variable
costs of these sales is Rs. 140, the contribution margin ratio is (200 - 140)/200, i.e,
0.3.
The formula for calculating the break-even point is:
Fixed cos ts
BEP 
Contribution m arg in ratio
Example 2
Sales Rs. 10,000
Variable costs Rs. 6,000
Fixed costs Rs. 3,000
The contribution margin ratio is (10,000 – 6,000)/10,000 = 0.4
Fixed cos ts 3, 000
BEP    Rs.7,500
Contribution m arg in ratio 0.4
It will be clear from the following calculation that at the sales value of
Rs.7,500 (BEP), there is no-profit no-loss.
Sales value Rs. 7,500
Less: Variable costs (0.6  7,500) Rs. 4,500
Fixed Costs Rs. 3,000 Rs. 7,500
Net profit Nil
Example 3
Sales were Rs. 15,000 producing a profit of Rs. 400 in a week. In the next
week, sales amount to Rs. 19,000 producing a profit of Rs. 1,200. Find out the
BEP.
Solution
Increase in sales 19,000 – 15,000 = Rs. 4,000
Increase in profit 1,200 – 400 = Rs. 800
Increases in variable costs 4,000 – 800 = Rs. 3,200
Over sales of Rs. 4,000, variable costs are Rs. 3,200.
Hence VC per rupee of sale is 3,200  4,000 = 0.80.
Hence, given sales of Rs. 15,000, fixed costs will be as under:
VC = 15,000  0.80 12,000
Profit 400
VC + Profit 12,400
Sales Value 15,000
Fixed Cost 2,600
Now, contribution margin ratio
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S  V 15, 000  12, 000 3, 000

   0.2
S 15, 000 15, 000
FC 2, 600
Now, BEP    Rs.13, 000
Contribution m arg in ratio 0.2
Break-even Point as a Percentage of Full Capacity
Full capacity can be defined as the maximum possible volume attainable with
the firm’s existing fixed equipment, operating policies and practices. Break-even
point is usually expressed as a percentage of full capacity. Supposing the full
capacity of the firm in Example 1 is 10,000 units, the break-even point at 5,000
units can be expressed as 50 per cent of full capacity.
Multi-product Manufacturer and Break-even Analysis
Most manufactures produce more than one type of product. the determination
of BEP in such cases is a little complicated and is illustrated below:
Example 4
A manufacturer makes and sells tables, lamps and chairs. The cost accounting
department and the sales department have supplied the following data.
Selling price per % of rupee sales

Product VC per unit
unit Rs. volume Rs.
Tables 40 30 20
Lamps 50 40 30
Chairs 70 50 50
Capacity of the firm – Rs. 1,50,000 of total sales value.
Annual fixed cost – Rs. 20,000
Calculate (1) BEP, and (2) Profit if firm works at 80 per cent of capacity.
Solution
The contribution towards fixed cost in each case is:
Table .............. Rs. 10
Lamps ............ Rs. 10
Chairs............Rs. 20
Now, these contributions are to be converted into percentages of selling prices,
the formula being:
Selling price  VC
Contribution percentage   100
Selling price
Thus, the contribution percentage for individual items is:
40  30 1
Table -  100   100  25 per cent
40 4
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50  40 1
Lamp -  100   100  20 per cent
40 5
70  50 2
Chair -  100   100  28.57 per cent
70 7
Now, we multiply the contribution percentage of each of the products by the
percentage of sales volume for particular product and add the figures so obtained.
This gives the total contribution per rupee of sales volume for table, lamps and
chairs:
Contribution % % of Sales
Tables 25.00  20 = 5.00
Lamps 20.00  30 = 6.00
Chairs 28.57  50 = 14.28
25.28 % or say 25 %
This 25 per cent is the total contribution per rupee of overall sales given the
present product sales mix.
1.BEP
The BEP of the firm may now be calculated as under:
Fixed cos ts 20, 000
BEP    80, 000
Contribution m arg in ratio 25%
2. Profit
Calculation of profit or loss at various volumes can also be made easily. If the
firm produces at 80 per cent of capacity (assuming the same product mix), the
profit will be calculated as under:
Profit=Total revenue – Total costs
=80% of (1,50,000) – Fixed costs – Variable costs
=1,20,000 – 20,000 – 75% of (1,20,000)
=1,20,000 – 20,000 – 90,000 = Rs. 10,000
Break – even charts
Break-even analysis is very commonly presented by means of break-even
charts, also known as profit-graphs. A break-even chart prepared on the basis of
Example 1 above is given in Fig. 1. Units of product are shown on the horizontal
axis OX and revenues and costs are shown on the vertical axis OY. The fixed costs
of Rs. 10,000 are represented by a straight line parallel to the horizontal axis.
Variable costs are then plotted over and above the fixed costs. The resultant line is
the total cost line, combining both variable and fixed costs. There is no variable cost
line in the graph; variable costs are represented by the vertical distance between
the fixed cost and the total cost lines. The total cost at any point is the sum of Rs.
10,000 plus Rs. 2.00 per unit of variable cost multiplied by the number of units
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sold at that point. Total revenue at any point is the unit price of Rs. 4.00 multiplied
by the number of units sold. The break-even point corresponds to the point of
intersection of the total revenue and the total cost lines. Projecting a perpendicular
from the BEP to the horizontal axis shows the break-even point in units of the
product. Dropping a perpendicular from BEP to the vertical axis shows the break-
even sales value in rupees. Below the BEP (or to the left of it), total costs are more
than total revenue and the firm would suffer a loss. Above the BEP (or to its right),
total revenue exceeds total costs and the firm would be making profits. Since profit
or loss occurs between them is known as the profit zone (to the right of the BEP)
and the loss zone (to the left of the BEP).
Where the BEP is measured in terms of sales value rather than in physical
units, the break-even chart remains basically the same as in Fig.1. The only
difference is that the volume on the X-axis is measured in terms of sales value. In
that case, a perpendicular from the point BEP to either axis would show the break-
even rupee sales value. The same type of chart can be used to depict the BEP in
relation to full capacity; in this case, the horizontal axis would represent the
percentage of full capacity, instead of physical units or the sale value.
1. Reader must know TR, TC curves, BEP point and break even quantity, FC &
AC curves. It has to be understood why graphically FC is parallel to x axis and
why TR starts from the origin. Understanding the diagram will make the
reader to learn the topic easily.
19.5.IN TEXT QUESTION
1. Illustrate BEP with an example
2. Discuss the usage of estimating BEP.
19.6. SUMMARY
1. BEP is the point where the firm enjoys no profit or no loss. After attaining BEP
quantity the firm starts earning profit. In long run this is the condition of any
profit making firm. Diversification of products of a multi product firm is more
conveniently achieves BEP. For example ITC was producing only cigarettes on
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those days but now they produce goods for all levels of customers and thus
enjoy a comfortable position.
1. Prepare a list of items produced by ITC and examine how many products they
manufacture.
19.8. ASSIGNMENT
1. Evaluate a list of fixed and variable costs incurred by a firm.
19.9. SUGGESTED READING
1. Managerial Economics by Varshney and Maheswari, Sultan and Chands, New
Delhi publications.
1. Arrange a group discussion on this topic among readers.
19.11. SUPPLEMENTARY READING
1. BEP slide shows and pdf files are plenty available as web sources. Tutorials
are also available in internet.
10.12. KEY WORDS
1. Break even analysis, BEP, & breakeven point.

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UNIT - VI : NATIONAL INCOME AND BUSINESS CYCLE
LESSON- 20
MANAGERIAL USES OF BREAK-EVEN ANALYSIS
20.1. INTRODUCTION
To the management, the utility of break-even analysis lies in the fact that it
present a microscopic picture of the profit structure of a business enterprise.
Break-even analysis not only highlights the areas of economic strength and
weaknesses in the firm but also sharpens the focus on certain leverages which can
be operated upon to enhance its profitability. Ever-changing contributions are
characteristic of modern business life and through break-even analysis, it is
possible for the management to examine the profit vulnerability of a business firm
to the possible changes in business conditions, for example, sales prospects,
changes in cost structure, etc. Through break-even analysis, it is possible to devise
managerial actions to maintain and enhance profitability of the firm. The break-
even analysis can be used for the following purposes.
20.2. OBJECTIVE
 This lesson aims at explaining the usage of BEP in business decisions.
20.3. CONTENTS
1. Safety Margin
The break-even chart can help the management to know at a glance the profits
generated at the various levels of sales. But while deciding upon the volume at
which the firm would operate, apart from the demand, the management should
consider the ‘Safety Margin’ associated with the proposed volume. The safety
margin refers to the extent to which the firm can afford a decline in sales before it
starts incurring losses. The formula to determine the safety margin is:
Safety Margin =
Sales  BEP  100
Sales
2. Volume Needed to Attain Target Profit
Break-even analysis may be utilised for the purpose of determining the volume
of sales necessary to achieve a target profit. The formula is:
Fixed cos ts  T arg et profit
Target sales volume =
Contrbution m arg in per unit
3. Change in Price
The management is often faced with a problem whether to reduce prices or
not? Before taking a decision on this question the management will have to
consider a number of points. A reduction in price leads to a reduction in the
contribution margin. This means that the volume of sales will have to be increases
even to maintain the previous level of profit. The higher the reduction in the
contribution margin, the higher is the increase in sales needed to ensure the
previous profit. However, reduction in price may not always lead to a
commensurate increase in the volume of sales which is affected by the elasticity of
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demand. But the information about elasticity of demand may not be easily
available. Assuming that the present conditions continue, break-even analysis will
help the management to know the required volume of sales to maintain the
previous level of profit. And on the basis of its knowledge and experience, it will be
much easier for the management to judge whether the required increase in sales
will be feasible. The formula for determining the new volume of sales to maintain
the same profit, given a reduction in price, would be as under:
FC  P
Q
SPn  VC
Where, Qn = New volume of sales, FC = Fixed cost, P = Profit
SPn = New selling price
VC = Variable Cost per unit, (n denotes new)
4. Change in Costs
A. If Variable Costs Change
An increase in variable costs leads to a reduction in the contribution margin.
Therefore, a common question which arises when increases in costs are expected or
imminent, is what total sales volume do we need to maintain our present profits
without any increase in price or, in the alternative, what price should be set to
maintain our present profit without any change in sales volume. The formulae to
determine the new quantity (Qn) or the new selling price (SPn), given a change in
variable costs, are:
FC  P
(a) Q n 
SP  VC n
(b) SPn  SP   VC n  VC 
5. To Expand Capacity or Not

The management might often be interested in knowing whether to expand
production capacity or not through the installation of additional equipment.
Through break-even analysis, it would be possible to examine the various
implications of this proposal.
6. Effect of Alternative Prices
The break-even chart can be modified to show the pricing executive what his
profit position would be at different price levels under assumed conditions of
demand and costs. Fig. 5 shows the profit position at alternative prices for the firm
in Example 1. As can be seen from the figure, the break-even point becomes lower
with every increase in price. But it is not necessary that the profit potential at
higher prices may actually be realised by the firm. A price of Rs. 4 per unit with a
demand at 7,000 units will given a higher profit than a price of Rs. 5 with a
demand at 4,000 units.
It is not feasible to take every conceivable price into consideration. In choosing
a trial price, the analyst must rely largely upon experience and judgement.
Customary price is one such price. Feel of the market and hunch also matter.
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7. Drop and/or Add Decision
A business manager is often confronted with the following questions:
1. Should a new product be added in view of its estimated revenue and cost?
2. Should a particular item be dropped from the product-line and what would
be its consequent effects on revenue and cost?
8. Make or Buy Decision
Many business firms often have the option of making certain components or
ingredients which are part of their finished products or purchasing them from
outside suppliers. For instance, an automobile manufacturer can make spark plugs
or buy them. Break-even analysis can enable the manufacturer to decide whether
to make or buy.
9. Choosing Promotion-mix
Sellers often use several modes of sales promotion, e.g., personal selling,
advertising and the like. However, the proportion of various modes in the
promotion-mix varies from seller to seller. A retail shop may have to consider
whether or not to employ a certain number, say, five additional salesmen. Or, a
manufacturer may have to decide if he should spend an additional sum of Rs.
20,000 on advertising his product. Break-even analysis enables him to take
appropriate decisions by showing how these additional fixed costs would influence
the break-even points.
10. Equipment Selection
Break-even analysis can also be used to compare different ways of doing jobs.
For instance, simple machines, though slow, are usually best for small quantities.
But when bigger quantities are to be produced, faster but usually costlier machines
are to be employed. Sometimes, one has to choose between three or more methods,
each of which is most economical over a certain range of output.
Reader must understand the concepts used in this lesson. Ex; target profit,
promotion mix, safety margin etc.
20.5 IN TEXT QUESTION
1. Illustrate safety margin of a firm by using diagram.
2. Discuss the managerial uses of breakeven analysis.
20.6. SUMMARY
After attaining breakeven point it is required to estimate safety margin. Safety
margin helps the firm to breathe better and move towards positively. A firm
below the safety margin is almost like a cat on the wall.
Prepare a case study from Indian scenario on a significant business decision
taken by any firm using above studied concepts.
20.8. ASSIGNMENT
Identify the safety margin for a small business at your home town and help
that entrepreneur in decision making.
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Managerial Economics by Varshney and Maheswari, Sultan and Chand
publications, New Delhi.
20.10. LEARNING ACTIVITY
Arrange a group discussion among students to discuss a firm decision during
time of crisis published in dailies.
Browsing for ppt and pdf files will add more to the text. Reading books on
experiences of leading business men during crisis will make the reader to earn
more knowledge.
20.12. KEY WORDS
Target profit, safety margin, and add drop decisions.

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LESSON - 21
NATIONAL PRODUCT, INCOME AND EXPENDITURE
21.1. INTRODUCTION
Macroeconomics is concerned with the determination of the economy’s total
output, the price level, the level of employment, interest rates and other variables. A
necessary step in understanding how these variables are determined is “national
income accounting”.
The national income accounts give us regular estimates of GNP- the basic
measure of the economy’s performance in producing goods and services.
National income is the most comprehensive measure of the level of the
aggregate economic activity in an economy. It is the total income of a nation as
against the income of an individual but the term national income is not as simple
and self-explanatory as the concept of individual income maybe. For example, not
all the income received by individuals during a given period can be included in the
national income, similarly not all the income that is generated in the process of
production in an economy during a given period is received by the individuals in
the economy.
21.2. OBJECTIVE
This lesson is intended to study the fundamental of national income
accounting and methods to estimate national income. After studying this lesson
you will be able to:
 Define national income, gross and net domestic products, gross and net
national products.
 describe national income identities
 Explain three methods of measuring national income.
21.3. CONTENTS
National product by definition is a measure in monetary terms of the volume of
all goods and service produced by an economy during a given period of time
accounted for without duplication. The measures of services are not directly added.
An important characteristic of this measure is its comprehensiveness. The measure
covers all the final goods and services produced by the residents of a country. Thus,
the goods cover all possible items produced, as for example, agricultural crops,
livestock products, forest products, mineral products, manufacturing of various
consumer items for consumption, machinery, transport equipment, defense
equipment, etc., construction of building, roads, dams, bridges, etc. The service
similarly cover a wide spectrum including medical and educational services,
defense services, financial services, transport and trading services, sanitary
services, goverment services, etc.
All the final goods and services produced during the period have to be included
whether they are marketed, that is exchanged for money or bartered or produced
for own use. For example some of the products of agriculture and forestry and
fishing are used for own consumption of producers and therefore imputed values of
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these products are also to be included. Similarly, account must also be taken of the
rental of buildings, which are owned and occupied by the owners themselves. Own
account construction activities are also similarly to be included. However, certain
other activities like services of housewives are excluded from production mainly due
to the problems of measurement. Also excluded are illegal activities such as
smuggling, black marketing, etc.
Another important feature of the measure is that it is an unduplicated value of
output or in other words only the value added at each stage of processing is taken
into account while measuring the total, i.e., in the measurement of national output.
A distinction is made between final and intermediate products and unduplicated
total is one that is confined to the value of the final products and excludes all
intermediate products. For example, if the production process during the year
involves the production of wheat, its milling into flour and the baking of bread
which is sold to consumers, then the value of the national output should equal the
final value of the bread and should not count the separate value of the wheat and
flour which have been used in the course of producing bread. Thus the national
product is not the total value of goods and services produced, but only final
products excluding the value of inputs of raw materials and services used in the
process of production. Thus value added by the activities in an enterprise during an
accounting period is an important national income concept. We illustrate the
computation of the value added in the case of a bakery. The following are the
relevant data:
Rs
Gross value of the output of the bakery in 1999-2000 2,25,000
Value of flour and other intermediate inputs 1,20,000
Depreciation 20,000
Gross value added = 2,25,000 – 1,20,000= 1,50,000
Net value added = Gross value added – depreciation
=(1,05,000-20,000) = Rs. 85,000/-
The national product measures value of all final goods and services arising out
of economic activity while the national income is the sum of all incomes generated
as a result of the economic activity. These two are synonymous. Since the
production of goods and services is the result of the use of primary factors of
production namely capital and labour along with the raw material and other
intermediate inputs, the process automatically generates income. This income is in
the form of rewards for capital and labour used in the production process. For
example, the total product originating in a firm making steel could be obtained by
adding the value of the final products and then deducting the value of intermediate
inputs to obtain the value added. The value added of this firm consists of the
income that accrues in the course of production, namely wages and salaries and
operating surplus. The surplus includes rent and interest, rewards for the factors of
production land and capital respectively. Thus total income is given by rent + wages
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/ salaries + interest + profits. Hence, the unduplicated production (value added) is
equivalent to the income which accrues to the factors of production. In other words,
national income of a country can also be viewed in terms of the income flowing form
the producing units to factors of production. National income is not simply an
aggregate of all incomes. It includes only those incomes which are derived directly
from the current production of goods and services called factor incomes. Other
forms of income such as old age pensions, educational grants, unemployment
benefits, etc., cannot be regarded as payments for current services to production.
They are paid out of factor incomes and are called transfer payments. Payments for
which no goods or services are received in return are transfer payments.
The production within the economy over a given period of time is spent either
for consumption of its members or for additions to fixed assets or for additions to
the stock of existing productive assets within the country. Hence, production can
also be measured by considering the expenditure of those who purchase the
finished or final goods and services.The national expenditure is the sum of
expenditure of all economic agents namely. household enterprises and government.
Here, is also it necessary to include only the expenditures on final use in order to
avoid duplication, i.e., one has to omit the network of intermediate sales of all
products needed in further production. The expenditure of final goods and services
may be purely for consumption purposes like consumption of food, clothing,
shelter, services, etc., or for capital formation such as addition to buildings, plant,
machinery, transport equipment, etc. Some goods may not be immediately sold and
may be kept aside as stocks. These goods which are added to stocks are also
accounted for as final expenditure (inventory investment). it is clear from the above
discussion that the national income of a country can be measured in three different
ways-from the angle of production, from the angle of income generation and from
final utilization. The significance of each arises from the fact that they reflect total
operations of an economy at the levels of three basic economic functions, namely,
production, distribution and disposition.
MEASURES OF AGGREGATE INCOME
For the purpose of measurement and analysis, national income can be viewed
as an aggregate of various component flows. To begin with let us consider the most
comprehensive and broad-based measure of aggregate income widely known as
Gross National product at market prices or GNP at market prices.
Two important words are “gross” and “national”. Similarly the phrase “at
market prices” is also significant because it specifies the criterion of valuation. The
main alternatives to these three specifications are ‘net’, ‘domestic’ and at ‘falter
cost’.
i) Gross and Net concept
 Gross emphasizes that no allowance for capital consumption has been made or that
depreciation has yet to be deducted.
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 Net indicates that provision for capital consumption has already been made or that
depreciation has already been deducted.
 Thus the difference between the gross aggregate and the net aggregate is depreciation.
 i.e., GNP at market price/factor cost = NNP at market price/factor cost + depreciation.
National and Domestic Concepts
The term national denotes that the aggregate under consideration represents
the total income which accrues to the normal residents of a country due to their
participation in world production during the current year. Thus, the term ‘national’
is used to emphasize that the aggregate under consideration covers all types of
factor incomes accruing to normal residents of a country irrespective of whether the
factors of production supplied by them are located at home or abroad.
As against this, it is also possible to measure the value of the total output or
income originating within the specified geographical boundary of a country known
as “domestic territory”. The resulting measure is called “domestic product”.
In other words, the distinction between “national” and “domestic” aggregates
lies in the frame of reference-the former takes the normal residents of a country;
the latter takes a given “geographical area”. Here, national product differs from
domestic product by the amount of net factor income from abroad.
 GNP at market price/factor cost = GDP at market price/factor cost + Net factor income from
abroad.
 NNP at market price/factor cost = NDP at market price/factor cost + Net factor income from
abroad.
 Net factor income from abroad = Factor income received from abroad – Factor income paid
abroad.
Market Prices and Factor Costs
The valuation of the national product at market prices indicates the total
amount actually paid by the final buyers while the valuation of national product at
factor cost is a measure of the total amount earned by the factors of production for
their contribution to the final output.
GNP at market price = GNP at factor cost + indirect taxes-Subsidies.
NNP at market price = NNP at factor cost + indirect taxes – Subsidies.
And vice Versa.
Category A Category B
Type 1 GNP at market price GDP at market price
NNP at market price NDP at market price
Type 2 GNP at factor cost GDP at factor cost
NNP at factor cost NDP at factor cost
 Difference between the aggregates in category A and aggregates in category B is
net factor income from abroad.
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 Difference between the aggregates of type 1 and aggregates of type 2 is indirect
taxes less subsidies.
 The difference between the two aggregates of each type in each category is
depreciation.
ii) Gross National Product and Cross Domestic Product
For some purposes we need to find the total income generated from production
within the territorial boundaries of an economy, irrespective of whether it belongs to
the inhabitants of that nation or not. Such an income is known as Cross Domestic
Product (GDP) and found as:
GDP = GNP – Net factor income from abroad
Net factor income from abroad = Factor income received from abroad – Factor
income paid abroad.
For example, if in 1986 the GNP is Rs 8,00,000 million, the income (including
tax on such incomes) received from and paid abroad Rs 60,000 million, and Rs 70,
000 million respectively, then, the GDP in 1986 would be:
(Rs. 8,00,000 – 70,000 + 60,000) million = Rs 7,90,000 million
iii) GNP as a Sum of Expenditures on Final Products
Expenditure on final products in an economy can be classified into the
following categories:
 Personal consumption expenditure (c):- The sum of expenditure on both the
durable and non-durable goods as well as services for consumption purposes.
 Gross Private Investment (Ig) is the total expenditure incurred for the
replacement of capital goods and for additional investment.
 Government expenditure (G) is the sum of expenditure on consumption and
capital goods by the government, and
 Net Exports (Exports – Imports) (X-M) constitute the difference between the
expenditure or rest of the world on output of the national economy and the
expenditure of the national economy on output of the rest of the world.
 GNP is the aggregate of the above mentioned four categories of consumption
expenditure. That is,
GNP = C + Ig + G + (X – M)
iv) GNP as the total of factor Incomes
As mentioned above, national product gives a measure of a nation’s productive
activity, irrespective of the fact whether this activity takes place at home or abroad.
When national income is calculated after excluding indirect taxes like excise duty,
sales tax, etc. and including subsides we get GNP at factor cost as this is the
amount received by all the factors of production (indirect taxes being the amount
claimed by the government and subsidies becoming a part of factor income).
GNP at factor cost = GNP at market prices – Indirect taxes + Subsidies
v) Net National product
The NNP is an alternative and closely related measure of the national income.
It differs from GNP in only one respect. GNP is the sum of final products. It includes
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consumption goods plus gross investment plus government expenditures on goods
and services plus net exports, Here gross investment (Ig) is the increase in
investment plus fixed assets like buildings and equipment and thus exceeds net
investment (In) by depreciation.
GNP = NNP + Depreciation
NNP includes net private investment while GNP includes gross private domestic
investment.
We know that during the process of production, assets get consumed or
depreciated. So, during a year the net contribution to output is the production of
goods and services minus the depreciation during the year. This is known as NNP
at market prices because it is the net money value of final goods and services
produced at current prices during the year after depreciation.
NNP at Factor Cost (Or National Income)
Goods and services are produced with the help of factors of production.
National income or NNP at factor cost is the sum of all the income payments
received by these factors of production.
NI = GNP – Depreciation – Indirect taxes + Subsidies
Since factors receive subsidies, they are added while indirect taxes are
subtracted as these do not form part of the factor income.
NNP at factor cost = NNP at market prices – Indirect taxes + Subsidies
vi) Personal Income
National income is the total income accruing to the factors of production for
their contribution to current production. It does not represent the total income that
individuals actually receive. Personal income is calculated by subtracting from
national income those types of incomes which are earned but not received and
adding those types which are received and adding those types which are received
but not currently earned. So Personal Income = NNP at factor cost – Undistributed
profits – Corporate taxes + transfer payments.
vii) Disposable Income
Disposable income is the total income that actually remains with individuals to
dispose off as they wish. It differs from personal income by the amount of direct
taxes paid by individuals.
Disposable Income = Personal Income – Personal taxes
Value Added
The concept of value added is a useful device to find out the exact amount that
is added at each stage of production to the value of the final product. Value added
can be defined as the difference between the value of output produced by that firm
and the total expenditure incurred by it one the materials and intermediate
products purchased from other business firms. Thus, value added is obtained by
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deducting the value of material inputs or intermediate products from the
corresponding value of output.
Value added = Total sales + Closing stock of finished and semi-finished goods –
Total expenditure on raw materials and intermediate products – Opening stock of
finished and semi-finished goods.
The table below summaries the relationship among all of the above concepts:
Less: Depreciation or Capital Consumption Allowances Gross National product (GNP)
Less: Indirect Taxes plus Subsidies Net National Product (NNP)
Less: government income from property and National Income (NI)
entrepreneurship
Social security taxes
Corporate profit taxes
Retained earnings
Less: Plus Transfer Payments Personal Income (PI)
Personal Taxes Disposable Personal Income (DPI)
Which is available for
Personal consumption expenditure
National income Identities
There are many important concepts and measures in national income
accounts. National income identities are formulated in terms of these concepts and
measure. For Proper understanding of macroeconomic theory one is to be clear
about the distinction between identity and an equation or an equilibrium condition.
Several national income identities can be identified which are very useful in
macroeconomic discussions. National income accounting is also referred to as
social accounting. The identities explained below take care of national income and
other social accounts.
1. Net National Product (NNP) at market price = NNP at factor cost (or National
income) + Indirect taxes – Subsidies.
2. The above identity explains the relationship between NNP at factor cost and
NNP at market price.
3. Market price of a unit of a commodity = factor cost per unit + net indirect
taxes, net indirect taxes being indirect taxes minus subsidies.
4. Net National Disposable Income = NNP at market prices + Other current
transfer from rest of the world.
5. Net Domestic product at Market Price = NNP at market prices – Net factor
income from abroad.
6. Net Domestic Disposable Product at market = Net National disposable income –
Net factor income from abroad minus other current transfers from rest of the
world.
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7. Net Domestic Product at factor cost = Net domestic product at market prices –
indirect taxes + Subsides.
8. Private income = Income accruing to private sector from domestic product +
Interest on public dept + Current transfers from goverment administrative
departments + other current transfers from rest of the world + Net factor
income from abroad.
9. Personal income = Private income – Saving of private corporate sector net of
retained earnings of foreign companies – Corporation tax.
10. Personal Disposable income = Personal income – Direct taxes paid by
households – Miscellaneous receipts of government administrative
departments.
11. When is gross national product (GNP)? The following identity tells us about
GNP.
12. GNP = NNP + depreciation
13. Thus GNP is gross of depreciation and the NNP is net of depreciation. As there
are no ways to determine precisely the amount of depreciation, the usual
national income measure used is GNP. For similar reasons gross domestic
product (GDP) is used instead of NDP.
14. GDP at market prices = NDP at factor cost + Consumption of fixed capital +
(indirect taxes - subsidies)
15. Expenditure on GDP = Government final consumption expenditure + Private
consumption expenditure + Gross fixed capital formation + change in stocks +
exports of goods and services – imports of goods and services + statistical
discrepancies = GDP.
16. Appropriation of disposable income = Government final consumption
expenditure + Private final consumption expenditure + Saving + statistical
discrepancy.
17. Disposable income = NDP at factor cost + Compensation of employees from the
rest of the world (Net) + Property and entrepreneurial income + indirect taxes –
subsidies + other current transfers from the rest of the world (net).
18. Gross accumulation = Domestic saving + Consumption of fixed capital + capital
transfers from the rest of the world (net).
19. Value of current transactions = Exports of goods and services + compensation
of employees from the rest of the world + property and entrepreneurial income
from the rest of the world + other current transfers from the rest of the world +
adjustment or merchandise exports to the change of ownership basis.
20. Disposal of current receipts = imports of goods and services + compensation of
employees to the rest of the world + Property and entrepreneurial income to the
rest of the world + other current transfers to the rest of the world + adjustment
of merchandise imports to the change of ownership basis – surplus of the
nation on current account.
21. Capital receipts = surplus of the nation on current account + capital transfers
form the rest of the world (net) + net incurrence of foreign liabilities.
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22. Capital account disbursements = purchases of intangible assets from the rest
of world (net) + acquisition of foreign financial assets.
1. Reader must familiar with the components of National Income parameters like
GNP, NNP, Disposable income etc.
21.5. IN TEXT QUESTIONS
1. Elaborately discuss identities of national income.
2. Explain various needs for National Income estimation.
3. Explain the nexus between National Income and economic development.
21.6. SUMMARY
1. Estimation of National Income involves so many identities explained in the
lesson. Read carefully and understand the illustrations. As National Income is
the indicator of growth of a county, this study becomes vital.
2.7.TERMINAL EXERCISE
1. Find out factors not included in estimation of national Income and suggest
measures to get rid of that.
21.8. ASSIGNMENT
1. Prepare an essay to show the growth of National Income in various sectors
after globalization.
1. Macro Economics, ML Jhingam, Vrinda Publication.
1. Students can arrange a group discussion to discuss the concepts of national
income.
1. Browse for the concept and see PPT available in order to deeper the
knowledge.
21.12. KEYWORDS
National Income, GNP, NNP, Disposable income.

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LESSON -22
APPROACHES TO MEASURE NATIONAL INCOME
22.1 INTRODUCTION
It is evident that the measurement of national income involves the
measurement of the size of the circular flow. Basically there are three ways of
looking at the circular flow of income. It arises out of the process of activity chain in
which production creates income, income generates spending and spending in turn
induces production. Accordingly there are three different ways in which we can
measure the size of the circular flow. We can measure it either at the production
stage by measuring the value of output or at the income accrual stage by
measuring the amount of factor income earned or at the expenditure stage by
measuring the size of total expenditure incurred in the economy.
22.2. OBJECTIVE
 This lesson aims at explaining various approaches in calculating national income.
22.3. CONTENTS
 Product Approach
 Income Approach
 Expenditure Approach
i) Product Approach
According to this method, the sum of net value of goods and services produced
at market prices is found. Three steps are involved in calculation of national income
through this method.
 Gross product is calculated by sensing up the money value of output in the
different sectors of the economy.
 Money value of raw material and services used and the amount of
depreciation of physical assets involved in the production process are
summed up.
 The net output or value added is found by subtracting the aggregate of the
cost of raw material, services and depreciation form the gross product found
in first step.
This approach is used to estimate gross and net value added in the following
sectors of the Indian economy.
 Agriculture and allied activities (e.g., animal husbandry)
 Forestry and Logging
 Fishing
 Mining and Quarrying
 Registered Manufacturing
ii) Income Approach
This approach is also known as the income-distributed method. According to
this method, the incomes received by all the basic factors of production used in the
production process are summed up. The basic factors for the purposes of national
income are categorized as labour and capital. We have three incomes.
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 Labour income which includes wages, salaries, bonus, social security and
welfare contributions.
 Capital income which includes dividends, pre-tax retained earnings, interest
on saving and bonus, rent, royalties and profits of government enterprises.
 Mixed income, i.e., earnings from professions, farming enterprises, etc.
These three components of income are added together to get national income.The
approach is used for following activities.
 Railways
 Electricity, gas and water supply
 Transport, storage and communication
 Banking, finance and insurance
 Real estate
 Public administration and defence
For the first three groups almost complete data are available from annual
accounts. Such data are also available for parts of letter three-the part that is in the
organized sector. For the rest the indirect approach has to be employed.
Database is the weakest for unorganized sectors of the economy such as
unregistered manufacturing, trade, hotels and restaurants and a variety of personal
services. For these sectors rough and ready estimates based sometimes on
production approach, sometimes on income approach are used. Most often
estimates are obtained for a benchmark year during which a major survey had been
conducted and then these benchmark estimates are brought up to date using a
variety of indicators.
Constant price estimates using the income approach are obtained by updating
the base year estimates using some physical indices such as amount of electricity
sold, tonnekilometres of freight transport, etc.
iii) Expenditure Approach
This method is known as the final product method. According to this method,
the total national expenditure is the sum of the expenditure incurred by the society
in a particular year. The expenditures are classified personal consumption
expenditure. net domestic investment, government expenditure on goods and
services and net foreign investment (imports-exports).
These three approaches to the measurement of national income yield identical
results. They provide three alternative methods of measuring essentially the same
magnitude. If we follow the product approach or the expenditure approach, we are
in effect trying to measure national income by the size of the income flow in the
upper half of the circle. As against this if we follow income approach, we are
actually trying to measure the flow in the lower half of the circle.
iv) Real vs. Money National Product
Measurement of national income depends upon two types of factors: (a)
quantities of different products actually produced during the given year, and (b) the
corresponding set of money prices used for converting diverse physical quantities
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into standardized values for aggregation. If the latter also relates to the same year
as the former, the resulting aggregate is called national product at current prices or
money national product (money NNP). If one has the figures for two years, say 1960
and 1970, a direct comparison of the two figures will show the direction and
magnitude of change in the aggregate flow of factor incomes originating in the
economy between 1960 and 1970. However, it will not give us any indication
regarding magnitude and direction of change in volume of physical output
produced between 1960 and 1970. Both the types of factors determine money NNP.
Physical output and money price might have undergone a change between 1960
and 1970. To measure the change in the physical output, we should eliminate the
effect of changes in the price levels.
The measure that is devised for the purpose of comparing the volume of
physical output produced during different years is known as Real National product
(Real NNP). This is desired by “deflating” the money NNP with an “index number of
prices”. Deflation is the procedure by which the effect of variations in the
measuring rod of money prices is “eliminated”.
The formula is
Money NNP
Real NNP =  100
Pr ice Index
c) Problem of Computation of per capita Income
Per capita income is arrived at by dividing GNP by the total population. It is
actually the per head average share in national income.
Increase in per capita income is determined by
rate of increase in GNP and
rate of growth of population
In case growth rate of GNP is lower than that of the growth of population, an
increase in GNP does not necessarily mean increase in per capita income. Per
capita income is given emphasis as a better measure of individual economic welfare
than GNP, which does not take into account the distribution aspect. Growth in GNP
cannot be used as an indicator of economic welfare since welfare is to be related to
individual’s share in the national cake, namely, the per capita disposable income.
1. Reader must familiar with the components of National Income parameters like
GNP, NNP, Disposable income etc.
22.5. IN TEXT QUESTIONS
1) Elaborately discuss GNP and NNP.
2) Explain various approaches on National Income estimation.
3) Explain the nexus between National Income and economic development.
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22.6. SUMMARY
Estimation of National Income involves so many technical aspects explained in
the lesson. Read carefully and understand the illustrations. As National Income is
the indicator of growth of a county, fool proof estimation of National income
becomes vital.
22.7.TERMINAL EXERCISE
1. Find out factors affecting the estimation of national Income and suggest
measures to get rid of theat.
22.8. ASSIGNMENT
1. Prepare an essay to show the growth of National Income in India offer
independence.
1. Macro Economics, ML Jhingam, Vrinda Publication.
1. Students can arrange a group discussion to discuss above studied
approaches.
1. Browse for the concept and see PPT available in order to deeper the
knowledge.
22.12. KEYWORDS
1. National Income, GNP, NNP, Disposable income.

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LESSON - 23
BUSINESS CYCLE
23.1. INTRODUCTION
The economic progress the world has been achieved is not a steady and
continuous movement forward. Economic activities faced fluctuations at more or
less regular intervals. There were upward swings and downward swings. A period of
prosperity was generally followed by a period of depression. These ups and downs
in the economic activity moving like a wave at regular intervals is known as
business cycle. Business cycle simply means the whole course of business activity
which passes through the phases of prosperity and depression.
23.2. OBJECTIVE
 To make the students to understand the conupt of business cycle very
clearly.
23.3. CONTENTS
a) Phase of business cycle
i) Boom
This is also known as prosperity phase. The products in this phase fetch an
above normal price which is above higher profit. This attracts more and more
investors. The existing production capacity is utilized at its full capacity. More and
more new machines are made use of the business of the capital goods industry also
shoots up. The price of the factors of production increases. Additional workers are
employed at higher wage rate. The increasing cost tendency of the factors of
production leads to a continuous increase in product cost. The fixed income group
on the salaried class found it difficult to cope with this increase in prices. The
income dose not increases accordingly and they ate now compelled to reduce
consumption. The demand is now more or less stagnant or it even decreases. Thus
boom or prosperity reaches its peak.
ii) Recession
Once the economy reaches the peak, the course changes a downward tendency
in demand is observed but the producers who are not aware of it go on producing
further. The supply now exceeds demand. Now the producers come to notice that
their stock piling up. They are compelled to give up the future investment plans.
The order for new equipments and raw materials are cancelled. A business even
cuts down its existing business. Workers are retrenched capital goods producers
who lose orders. Bankers insist on repayment stock accumulate and Business
failure increase investment ceases and unemployment leads to fall in income,
expenditure, prices, profits and industrial and trade activities. Desire for liquidity
increases all around producers are compelled to reduce price so that they can find
money to meet their obligations consumers who expect a still further decline in
prices postpone their consumption stock goes on piling up. some firms are forced
into bankruptcy. The failure of one firm affects other firm with whom it has
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business connections. There is a general distress. This phase of the business cycle
is known as the Recession. It is the period of utmost-suffering for a business.
iii) Depression
Underemployment of both men and material is the characteristics of this
phase. General demand falls faster than production. Producers are compelled to see
their goods at a price which will not even cover the full cost. Manufactures of both
producer’s goods and consumers goods are forced to reduce the volume of
production. As a result workers are thrown out. The remaining workers are poorly
paid. The demand for bank credit is at its lowest which results in idle funds. The
interest rates also decline. The firms that cannot pay of their debts are wound up.
Prices of shares and securities fall down.
Pessimism prevails in the economy the less confident investors are not ready
to take up new investment projects the aggregate economic activity is at its bottom.
iv)Recovery
Depression phase does not continue indefinitely. Depression contains in itself
the gems of recovery. The rule workers now come forward to work at low wages. As
the prices are at its lowest the consumers, who postponed their consumption
expecting a still further fall in price, now starts consuming. The banks, with
accumulated cash reserves, now come forward to gives loans at easier terms and
lower rates. As demand increases the stock of goods become insufficient. The
economic activity now starts picking up. Investment pick up. Employment and
output slowly and steadily begins to rise. Increased income increases demand,
resulting in rise in prices, profits investment, employment and incomes. The wave
of recovery one initiated soon begins to feed upon Itself. Stock markets become live
thus hastening the revival. Optimism develops among the entrepreneurs. Bank
loans and demand for credit starts rising. the depression phase at its through then
given way to recovery.
Characteristics of a business cycle
1. The cycle is synchronic. The upward and downward movements tend to occur
at all the same period in all industries. The wave of prosperity or depression
generates a wave in other industries. When industry picks up to provides
more employment, more income etc. to workers and it given new orders for
raw materials and capital goods. This help other firms also to prosper.
2. A business cycle is a wave-like movement. The period of prosperity and
depression can be alternately seen in a cycle.
3. Cyclical fluctuations are recurring in nature. The various phases are repeated
is followed by depression and the depression again in followed by a boom.
4. Business cycle is cumulative and self-reinforcing in nature. Each movement
feeds on itself and keeps up the movement in the same direction. Once booms
starts it goes on growing till forces accumulate to reverse the direction.
5. There can be no indefinite depression or eternal boom period. Each phase
contain in itself the seed for other phase. The boom, when it reaches its peak,
turns to recession.
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6. Business cycles are pervasive in their effects. The cyclical fluctuations affect
each and every part of the economy. Depression or prosperity felt in one part
of the economy makes its impact in other part also. The cyclical movement is
even international in character. The mechanism of international trade makes
the boom or depression in one country shared by other countries also.
7. Presence of a crisis. The up and down movements are not symmetrical. The
downward movements are not symmetrical. The downward movement is more
sudden and violent than the upward movement.
8. b) Types of Business Cycle
9. Prof. James Arthur classified business cycle into 3 parts as follows:
10. Major and Minor Trade Cycles: Major trade cycles are those the period of
which is very large. Minor trade cycles are those which occur during the
period of a major cycle. Prof. Hanson determines the period of a major cycle
between 8 years and 33 years. Two or three minor cycles occur during the
period of a major cycle. Period of a minor cycle is 40 months.
11. Building Cycle: Building Cycles are those trade cycles which are related with
construction industry. period of such cycle range from 15 to 20 years.
12. Long Waves: Period of a long wave is of 50 years. It was discovered by a
Russian economist kondratief. One or two major trade cycle occur during the
period of a long wave.
c) Schumpeter distinguished 3 types of trade cycle as follows
1. Short Kitchin Cycle: The period of this cycle is very short, approximately 4
months duration.
2. Longer juglar cycle: This cycle has average 9.5 years duration.
3. Very long Kondratief Wave: If takes more than 50 years to run its course.
d) Causes of Business Cycle
Two kinds of element or forces bring about business cycle. They are internal
and external. Internal forces are elements within the very sphere of business
activity itself and include such things as production, income, demand, credit,
interest rates, and inventories. External forces are elements outside the normal
scope of business activity and include population growth, wars, basic changes in
the nation’s currency and national economic policies. Also floods, droughts and
other catastrophes that have effect on business activity.
Important causes giving birth to business cycle may be summarized as follows.
1. Expansion of loans and contraction of loans by banks.
2. Monetary disequilibrium
3. Change in the volume of investment or decrease in the marginal efficiency of
capital
4. under consumption or excessive saving
5. Lack of adjustment between demand and supply
6. Dealings of entrepreneurs
7. Innovation
8. Seasonal fluctuations.
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e) Control of Business cycle
The business cycle leads to greater unemployment and poverty. The various
steps that can be taken to achieve economic stability are (i) monetary policy and (ii)
fiscal policy.
i) Monetary Policy
Monetary policy refers to the programs adopted by the central bank to control
the supply of money. The central bank may resort to open market operations,
changes in bank rate or changes in the variable reserve ratio. The open market
implies the purchase and sale of government bonds and securities. In the boom
period the central bank sells government bonds and securities to the public which
helps to withdraw money form the public. During periods of depression the central
bank purchases government securities which increase the cash supply in the
economy. This helps to increase investment. The central bank purchase
government securities which increase the cash supply in the economy. This helps
to increase investment. The central bank may change the bank rate or rediscount
rate. The bank rate is the rate at which commercial banks borrow from central
bank. When the central bank increases the bank rate the commercial banks in turn
will raise their discount rates for the public. This discourages public borrowing and
it reduces investment. During the depression the bank rate is lowered which will
end up the increased investment. The central bank can regulate the money supply
by changing the variable reserve ratio. When the central bank wants to reduce the
credit creation capacity of commercial banks, it will increase the ratio of the
deposits to be held by the commercial bank as reserve with the central bank.
ii) Fiscal Policy
This implies the variation in taxation and public expenditure programme by
the government to achieve certain objectives. Taxation helps to withdraw cash from
the public. An increase in tax results in reduction of private disposable income.
Taxes should be reduced during the depression will stimulate private sector. During
boom periods public expenditure must be curtailed, so that cash flow can be
reduced. The fiscal policy of the government to regulate purchasing power to control
business cycle is known as counter the cyclical fiscal policy. Counter-cyclical fiscal
policy in the boom period implies a reduction in the public expenditure and heavy
taxes and a surplus budget. The budget surplus can be used to eliminate previous
deficits. This implies an increase in public expenditure, reduction in taxation and
deficit budgeting during the depression. The monetary policy proves more effective
to control boom than to depression. A proper mix of fiscal and monetary policy will
be more fruitful in the control of business cycles.
1. Fiscal and monetary policy is both money related policies. Prior related to
union government and later related to Reserve Bank of India.
23.5.IN TEXT QUESTION
1. Define the concept business cycle.
2. Explain various phases of business cycle.
203
3. Mention the causes for business cycles.
4. Discuss the methods to control business cycle.
5. Distinguish monetary and fiscal policy.
23.6. SUMMARY
In order to control the money supply during the phases of trade cycle, the
union government and Reserve Bank of India use tools to control them.
23.7.Terminal exercise
1. Watch the inflation level day to day, and see what type of monetary policy is
announced by the finance minister and RBI governor.
23.8, ASSIGNMENT
1. Analyse inflation control measures adopted by RBI and union finance
ministry.
1. Managerial Economics, R. Sharma, Lakshmi Narayan Agarwal publication.
1. Arrangement can be made for a group discussion to discuss the topic.
1. Browsing for material and PPT will help the reader to get deep knowledge in
the subject.
23.12. KEY WORDS
1. Business cycle, Fiscal policy, monetary policy.

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LESSON - 24
BUSINESS FORECASTING
24.1. INTRODUCTION
A forecast of sales of depends upon economic forecasts. This is because the
sales of almost every firm are affected by the state of general business. Periods of
depression and boom have an influence on the sales value. Sales may be at an
increase during the prosperity but might decline during the depression. The
businessman should take into consideration the business cycle he is facing so that
he can have an effective forecast of sales. The important methods of forecasting are
(1) Trend projection (2) Leading Indices, and (3) Econometric Models.
24.2 OBJECTIVE
 To make the readers to understand the requirement of business forecasting in
business.
24.3 CONTENT
a) Trend projection
A graph showing the actual movement of a series is constructed and the
apparent trend of the data on future is projected (extrapolated). This is based on
the assumption that those forces which contributed past will continue to have the
same effect.
b) Leading Indices
The ‘Leading indices’ refer to certain sensitive series which tend to turn
upward or downward in anticipation of other series. If one knows a series which
would reliably lead say, commodities, price indices etc. It would not be difficult to
purchase raw materials in advance if prices are expected to rise. Certain important
Leading Indices are (1) New orders for durable goods; (2) Building contracts; (3)
Number of new incorporations; (4) Whole sale prices of basic commodities, New
order placed with manufactures, building contractors etc have early reflection of the
coming demand for products, raw materials, labour loans, and capital.
c) Econometric Models
Econometrics combines Economics and mathematics. It is the science of
economic measurement. Econometrics explains past economic activity by deriving
mathematical equations that will express the most probable inter-relationship
between asset of economic variable. By combining the relevant variable the
econometricians proceed to predict the future course of one or more of these
variables on the basis of established relationship.
d) Techniques of Economic Forecasting
There are several methods or techniques of economic and business
forecasting, Important methods may be briefly discussed as follows.
1. Naive Method: This is one of the oldest and crudest methods of forecasting
business situation. This method neither is nor based on any scientific
approach. Projection is made purely by guesswork and sometimes by
mechanical interpretation of historical data. This method includes such
205
techniques as tossing the coin, simple correlation and even some other simple
mathematical techniques.
Advantages of Naive Method
a. It is simple method.
b. It is less costly
c. It is suitable small firms
Disadvantage of Naive Method
a. It is not a scientific method.
b. It is not always reliable
2. Survey Techniques: One of the simplest forecasting devices is to survey
business firms or individuals and to determine what they believe will occur is
survey techniques. Under survey techniques, interviews and mailed questionnaires
are used for forecasting tools. These are helpful in making short-term forecasts.
These techniques may be used for forecasting the overall level of economic activity
or some special portion of it or they may be used within the firm for forecasting
future sales.
Advantages
a. This method is simple and less costly.
b. These techniques provide substantial amount of qualitative information that
may be useful in economic and business forecasting.
c. These techniques are usually used to supplement other quantitative forecasting
methods.
Disadvantage
a. When the opinions differ it will create problem
b. Not useful for long term forecasts
3. Expert opinion method
It is a qualitative technique. Under this method an expert or informed
individual uses personal or organizational experience as a basis for developing
future expectations.
4. Trend Projection method
Under this method historical data is used to predict future business activity.
Here actual data are presented on a graph and forecasts for the future are prepared
on the basis of analysis of trend of this data.
Advantages
a. Very simple and less expensive
b. More reliable
Disadvantage
When sudden fluctuations in data occur, this method will not be suitable.
Similarly it requires considerable technical skill and experience.
206
5. Smoothing techniques (Exponential smoothing)
Under this method smoothed average of several past observations are
considered say, moving average, exponential smoothing average etc. This method is
very cheap and inexpensive. But it cannot provide accurate forecasts.
6. Barometric Techniques
In this method present events or developments are used for predicting the
future. Further, here we apply certain selected economic and statistical indicators
in time series to predict variables. They are leading, lagging and coincident
indicators. If changes in one series of data consistently occur prior to changes in
another series-leading indicators can be shown, If changes in one series of data
consistently occur after changes in another series-there is lagging indicators, if two
series of data frequently increase or decrease at the same time and one series may
be regarded as a coincident indicator of the other-there is coincidental indicators.
This method is the most complex and scientific one.
7. Econometric Methods
Econometrics is the combination of “econo” and “metrics” which means
measurement of economic variables. This method combines the economic theory,
statistical tools and mathematical model building to analyse economic relations. It
predicts the future activity on past economic activity by using mathematical and
statistical techniques.
a. These methods are more reliable,
b. It is possible to compare forecasts with actual results. The model can modify to
improve future forecasts.
c. These methods indicate both direction and magnitude of change in the
variables.
d. These methods have the ability to explain economic phenomena.
8. Input Output Table Method
This is another approach of economic forecasting. This method enables the
forecaster to trace the effects of increase in demand for one product to other
industries. An increase in the demand for automobiles will first lead to an increase
in the output of the auto industry. This, in turn, will lead to an increase in the
demand for steel, glass, plastics, rubber and upholstery fabric. In addition,
secondary impact will occur as the increase in the demand for upholstery fabric.
Economic Forecasting for Business
Businessmen must plan ahead. Every business decision is based on some
assumption about the future, whether right or wrong, implicit or explicit. And as
business plans and decisions have to be based either directly or indirectly on the
outlook of the national economy, economic projections or forecasts are increasingly
becoming a vital part of managerial decision-making.
Economic forecasting consists of making forecasts of general business or
economic activity such as movements of national income, aggregate industrial
production or employment, and total exports or imports. Economic forecasting may
207
be distinguished from business forecasting which relates more directly to the activity of
the particular firm and comprises short and long-term forecasts of sales and price
forecasts for raw materials and equipment. However, the distinction between economic
forecasting and business forecasting is not always clear-cut. For example, from the
viewpoint of a firm which is one of many such firms in an industry, a sales forecast for
the entire industry would be somewhere between a forecast of general business
activity and of activity pertaining to the firms.
Why are Accurate Economic Forecasts Possible?
Though future is uncertain, there are several factors which explain why a fairly
accurate forecast of general business activity is possible:
1. The current economic situation contains many clues to the future; economic
events are not entirely capricious and haphazard but are caused largely by
ascertainable factors. Hence a detailed examination of the current economic
situation provides significant clues to what will take place in times ahead.
2. Many of the future economic developments result from the commitments which
have already been made in the past. The commitments are often publicly know,
e.g., in case of government appropriations, plans of government industrial
projects, unfilled orders of government departments or undertakings, etc.
3. Many business developments are part of a process which takes time. Once
forces have been set in motion, the process conforms to a fairly stable pattern.
Hence, the process having begun, the forecaster can project about future with
reasonable accuracy. For example, increases in sales after a while result in
increases business inventories; and increases in the number of hours worked
tend to be followed by an increase in the number of workers employed in
manufacturing. Also, when inventories become excessive, a fairly regular and
predictable process of inventory liquidation begins.
Uses of economic forecasts
Predicting Firm’s Sales
The most important single use of an economic forecast is to have a reasonable
basis for predicting the firm’s sales volume. A firm’s sales forecasts must rest upon
economic forecasts for the simple reason that almost every firm’s sales are affected by
the state of general business. It is true that sales of certain firms might have risen
during depression; or conversely, sales of others might have declined during
prosperity. But almost invariably, the rise in sales would have been larger in the former
case and the fall in sales steeper in the latter, had the general business condition not
been changing. Moreover, because every firm’s decisions about production, raw
material purchases, plant expansion, sales quotas, borrowing, etc., hinge on its sales
forecast, an economic forecast can be said to have its greatest signal value as the
basis of sales forecast.
As such, the economic forecast is the necessary first step in predicting a firm’s
sales. The next step is a forecast of the industry’s total sales. Based on theses, a firm
can estimate its own sales, say, by a projection of its market share. Different
industries vary in their sensitivity to changes in general business conditions and in
the speed with which they are affected by such changes. Hence, it is also necessary
208
to determine the turning and amplitude of changes in its own industry’s activity in
relation to changes in general business conditions.
Again, the economic forecast contains a prediction of several segments of the
economy. For example, it will given an estimate of gross national product,
consumer spending, wholesale and retail prices, employment, interest rates,
exports and the like. In practice, the business firms many be far more concerned
with certain segments of the economic forecast than with others. For example,
sellers of consumer goods will be affected much more by changes in consumer
expenditure and savings than by changes in government expenditure. In other
words, in building a sales forecast for one’s own firm or industry, one finds certain
segments of an economic forecast more relevant than others.
Other Uses
Besides facilitating a sales forecast, and economic forecast has several uses for an
average business firm:
1. Labour
An economic forecast may tell about the severity of competition for labour and the
likely pressure on wages. Hence it is especially useful to those entrusted with labour
negotiations, training and recruitment. Often workers have to be trained before they
are useful to a firm.
2. Raw Materials
An economic forecast also suggests the likely intensity of competition for raw
materials which may be in short supply. Hence knowledge of general business outlook
will indicate when to place orders for raw materials and how much inventory to hold.
3. Finance
The economic forecast also indicates the response it will get in borrowing from
banks or public and the likely rates of interest it will have to pay. As such, it may
considerably help in planning the timing of a capital expansion programme.
4. Inventory and Investment
A forecast of price movements can be used with great advantage as a basis of
inventory and investment policy. Normally, an expected price increase will make it
advantageous to build up stocks in advance of the price rise, provided carrying costs
are not excessive.
5. Plant Expansion or Contraction Plans
These plans have to be bases on a long-term forecast of the demand for the firm’s
output. Hence, a forecast should cover the period during which fixed capital equipment
is normally amortized.
Selecting a forecast
Several guidelines may be indicated with a view to choose among available
forecasts and use them effectively:
1. Prefer forecasts which are explicit about what is expected and in the reasoning
underlying the forecast, against those which are categorical and declaratory.
2. Disregard forecasts which lack qualifiers. Future is uncertain and if the
forecaster does not explain the assumption on which his predictions rest, his
209
analysis may be shallow and it will be difficult to interpret his forecasts if
conditions change.
3. Examine the records of the reliability of various forecasts made in the past.
Such an examination should thoroughly see why the forecasts proved right or
wrong one should specially beware of the forecasters who have been right but
for wrong reasons.
4. Use several different forecasts which have good records of reliability. The
selected forecasts should be such as to have been prepared by forcasters
having different biases, and by employing different techniques of construction.
5. Reject a forecast if the forecaster has injected himself too strongly as an
individual into his forecast. In particular, one should beware of forecasters
who are given to sensationalism.
Business forecasting involves factors involving social, economical, Political,
psychological and other factors. Reader must get aware of forecasting techniques
from this lesson.
24.5. INTEXT QUESTION
1. Bring out the need for business forecasting.
2. Explain how economic models help in business forecasting.
3. Discuss various methods of business forecasting.
4. Explain econometric models in forecasting.
5. Discuss the role of forecasting in global scenario.
24.6. SUMMARY
1. Business forecasting many turn failed even in case of reputed companies.
Innovations place an important role in affecting forecasting.
1. Analyse a Firm’s business forecasting and its relevance to their progress in
technology and other areas.
24.8. ASSIGNMENT
1. Out of your own experience find out the reasons for product failure even in
case with leading experienced companies.
1. Managcrial Economics, RL varshney & KL maheswari, Sulthan chand & sons.
1. Arrange a group discussion to discuss a suitable business forecasting which
have taken a firm to the new heights.
1. Browsing the tutorials and PPT will help the reader to understand the concept
more clearly.
24.12. KEY WORDS
1. Business forecasting, techniques of forecasting.
346E1150
ANNAMALAI UNIVERSITY PRESS: 2021 – 2022

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346E1150

Master of Business Administration (M.B.A)

Dr. G. Udayasuriyan Dr. S. Arulkumar

MASTER OF BUSINESS ADMINISTRATION (M.B.A)

3.3.2 Economic objectives

Creating and retaining customers

Optimum utilization of the scarce resources

3.3.3 Social Objectives of the firm

Employees Business Government

Management Decision Problem

Similarly, managerial economics provides production and marketing rules that

UNIT–II : DEMAND ANALYSIS AND FORECASTING

Demand Schedule of Note Books

5.3.5 Demand Curve

The diagrammatic representation of the Demand Curve can be as follows:

When demand changes due to change Price

6. 3.2 Definition of 'Price Elasticity of Demand'

If a small change in price is accompanied by a large change in quantity

Businesses evaluate price elasticity of demand for various products to help

6. 3.9 Relationship between nature of D

Opinion Polling Statistical

Consumer Sales Force Experts Opinion

Trend Project - Icon Barometric Regression Simultaneous

Complete Sample Survey and End Use

Opinion Polling Method

For example, one may build up the sales model as

Average variable cost

If a firm is experiencing increasing returns, average production is increasing

Cost Curves for a Firm

Unit Costs, AFC f

Fig-2:Reveals that MC = AVC and ATC at minimum AVC and ATC,

Decreasing Returns to Scale

Long-Run Versus Short-Run Cost Curves

Long-Run Average Cost (LAC), In the long-run, Firms experience. Increasing

Long-Run Average Cost (LAC)

Long-Run versus Short-Run Cost Curves

Output (unit per year)

This average-marginal relation for production is closely tied to the law of

Further discussion in cost curves

AP and falling AVC

Phase B: falling MP and rising MC; rising 0 Variable input

AP and falling AVC

AP and rising AVC

A firm that seeks to maximize its

profit will choose to organize production

9.4. REVISION POINTS

10.3.10 Activity-based costing

The suppliers of companies are typically producers of materials, energy,

Mar ket value process

Distribution Distribution Consumer

Main process of a producing company

The figure 11.3.5.1 illustrates an income generation process (exaggerated for

210.00 7.20 1512 247.25 7.10 1755

Summary of objective function formulations

quantity of la­bour employed, L2 If the Q=f (K,L1)

C c d Decreasing returns to scale

When the firm is OS quantity of MC

a) During the Market period

be vertical straight line parallel to y-axis. D2

monopolist will be at the output where the LMC

The shaded rectangle ‘PP’LI’ had T

will disappear. New firms will enter the Y

output will decrease the price and only P

quantity of labour employed, L2 If the Q=f (K,L1)