MBCE701D-Economics & Management Decisions

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) UP
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Course Design
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Advisory Council
Chairman
Mr. Utpal Ghosh
Members
Dr. S J Chopra Dr. Deependra Kumar Jha

Chancellor Vice Chancellor
Dr D N Pandey Dr Kamal Bansal Dr Tabrez Ahmad

Dean-SoB Dean-SoE Dean-SoL
Mr Ashok Sahu
Head-CCE
UP
SLM Development Team
Dr Raju Ganesh Sunder Mr. Aindril De
Head-Academic Unit Head-Operations
Dr. Rajesh Gupta Dr. Meenakshi Sharma Dr. Rakhi Dawar
Mr. Rahul Sharma Mr. Shantanu Trivedi Ms. Aparna
Author
Dr. Rakhi Dawar

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All rights reserved. No Part of this work may be reproduced in any form, by mimeograph or any other
means, without permission in writing from University of Petroleum & Energy Studies.
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Course Code: MBCE 701D
Course Name: Economics & Management Decisions
Version: January 2018

© University of Petroleum & Energy Studies
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Contents
Block–I
Unit 1: Introduction to Managerial Economics...........................................................................3

Unit 2: Ten Principles of Economics............................................................................................9
Unit 3: Tools Used For Economic Analysis................................................................................15
Unit 4: Fundamental Concepts of Managerial Economics.......................................................19
Unit 5: Case Study: A Case On Survey System........................................................................27
Unit 6:
UP Block–II
Theory of Consumer Behaviour.....................................................................................31

Unit 7: Demand Analysis............................................................................................................41
Unit 8: Elasticity of Demand......................................................................................................51
Unit 9: Demand Forecasting......................................................................................................61
Unit 10: Case Study: The Finance Minister’s Dilemma.............................................................69
Block–III
Unit 11: Supply Analysis..............................................................................................................73

Unit 12: Production Concepts and Analysis...............................................................................81
Unit 13: Cost Analysis..................................................................................................................89
Unit 14: Cost Analysis: II.............................................................................................................97
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Unit 15: Case Study: Buying Versus Making............................................................................105

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Block–IV
Unit 16: Monopoly Market.........................................................................................................111

Unit 17: Imperfect Competiton: Monopolistic and Oligopoly...................................................119
Unit 18: Nature and Measurement of Profit.............................................................................127
Unit 19: Pricing Methods and Strategy.....................................................................................131
Unit 20: Case Study: Prices Slashed Down For Medicines......................................................141
Content
iv
Block–V
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Unit 21: Government, Firms, and Markets With Importance To Money................................147
Unit 22: National Income...........................................................................................................159
Unit 23: Inflation and Monetary Policy.....................................................................................165
Unit 24: Fiscal Policy..................................................................................................................171
Unit 25: Case Study: Impact of Technological Advancements on Employment Levels..........177
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UP
BLOCK–I
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Detailed Contents
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UNIT 1: INTRODUCTION TO MANAGERIAL UNIT 4: FUNDAMENTAL CONCEPTS OF
ECONOMICS MANAGERIAL ECONOMICS
UNIT 2: TEN PRINCIPLES OF ECONOMICS UNIT 5: CASE STUDY: A CASE ON

SURVEY SYSTEM
UNIT 3: TOOLS USED FOR

ECONOMIC ANALYSIS
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3
Unit 1 Notes
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___________________
Introduction to Managerial ___________________
Economics ___________________
___________________
Objectives: ___________________
Post completion of this unit, learners shall be capable of:
___________________
\\ Explaining the meaning of managerial economics
___________________
\\ Summarising the nature of managerial economics
\\ Defining the scope of managerial economics ___________________
\\ Identifying the role of managerial economics in making business deci- ___________________

sions
Managerial Economics: Overview

UP ___________________
Economics is described as the study of social aspects and establish-

ments involved in the use of limited resources to produce and allo-
cate products and services which can gratify human needs. Man-
agerial economics establishes the relation between economics and
management applications. Under managerial economics, a manag-
er’s ability to utilize the knowledge of economics in daily life to make
policies for the business is studied. Managerial economics aims to
provide the right resolution of every problem faced by a manager, as
risks are also adequately managed.
Nature of Managerial Economics

Economics can be categorised into two major categories: Microeco-
nomics and Macroeconomics.
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Microeconomics can be described as the study of economic units

at an individual level whereas study of the economy as a whole is
done under Macroeconomics. Variables such as consumer, com-
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modity, industry, and hous ehold are covered under the purview of
Microeconomics whereas, Macroeconomics is explained as the study
of aggregates, such as National Income, General Price Level, etc.
The following figure depicts the different branches of economics.

Economics & Management Decisions
4
Different Branches of Economics
Notes
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___________________ MICROECONOMICS MACROECONOMICS
___________________
Individual decision-making Decision-making at the
and smaller components national level and aggregate
___________________ of the economy economic variables
___________________
Individual income National income
___________________
Individual consumption Aggregate consumption
___________________
Individual savings National savings
___________________
___________________ Individual investment Aggregate investment
___________________ Output of an individual firm National output
___________________
UP Output of an industry
Individual expenditure
Aggregate expenditure
Price of any product/factor General price-level
Demand/supply of any Inflation and deflation

product or a factor
Employment/unemployment Aggregate employment

in any industry or unemployment
Figure 1.1: Branches of Economics
Managerial economics helps managers in the following way:
1. It helps to identify the problems faced by managers and then

work out a solution.
2. It elaborates on policies that should be pursued by any busi-

ness organization for achieving the desired results. This makes
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the managerial economics perspective in nature.
3. Various laws of economics such as the law of demand and pro-

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duction function are used for analysis of business problems.
4. It emphasizes on quantitative analysis. Business decisions

related to the following factors are expressed in numeric and
quantitative terms:
(i) Output to be produced
(ii) Inputs to be utilized

Unit 1: Introduction to Managerial Economics
5
(iii) Prices to be fixed on a level
Notes
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(iv) Estimated costs and revenues along with scheduled timings
___________________
The Scope of Managerial Economics ___________________
Managerial economics takes into consideration all the numeric and ___________________
quantitative aspects of micro and macro parameters. There are some
___________________
important fields that fall under the purview of managerial econom-
___________________
ics, which are stated below.
___________________
● Demand Analysis
___________________
● Production Analysis
___________________
● Cost Analysis
___________________
● Objectives of the Business Organization
● Pricing Policies
● Capital Budgeting
UP ___________________
● Supply Analysis
It is imperative to mention that managerial economics not only cov-

ers business organizations, but also non-profit organizations.
Importance of the Study of Managerial Economics

The study of managerial economics is beneficial and has applica-
tions as a useful tool in different fields. Various purposes that this
subject satisfies are listed as below:
1. Effective decision-making processes
2. Understanding of multiple nuances of business and managerial

problems
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3. Application of conceptual and technical skills
4. Identification of distinct managerial issues, including the root

cause and the effects; as it recommends multiple policies to find
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solutions for
5. Assurance of responsiveness in businesses
6. Maximizationof profits through optimal use of scarce resources
7. Achieving objectives such as becoming an industry leader and

expanding market share
8. Forecasting on various parameters.

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Hence, there is an immense need for managerial economics in every
Notes business scenario.
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___________________
___________________ Role of Managerial Economics in Making

Business Decisions
___________________
___________________ In managerial economics, the proper application of laws of econom-

ics allows for better decision-making.
___________________
___________________ Use of Mathematics in Managerial Economics

___________________ Statistical and other tools of econometrics help managers to work
___________________
out economics in the form of equations. For example, the probability
is used for risk analysis.
___________________
___________________
UP Scarcity, choice and resource allocation
Limited Unlimited demands

resources Scarcity for resources
(finite resources) (infinite demands)
Choices
What to What to How to How to

sacrifice? produce? produce? distribute?
(opportunity cost) (what?) (how?) (for whom?)
System of
resource allocation
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By the state By the state and By the free

(planned the market market
economy) (market-based or (free market
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mixed economy) economy)
Figure 1.2: Basics of Economics
Managerial Economics is a science which makes value judgments.

For example, the behavior of an organization is best expressed
through Calculus and Linear Programming.
Unit 1: Introduction to Managerial Economics
7
Practical Applications of Managerial Economics
Notes
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Scarcity is the phenomenon characterized by non-availability of ___________________
a product or service in the market. Economic activity at both con-
___________________
sumption as well as production levels is affected by choice. The is-
sue of choice emerges when an individual has to decide how much ___________________
time is required to be allocated for work and leisure. Allocation of ___________________

resources refers to the process of selecting resources to ensure their
___________________
proper utilization.
___________________
The following figure depicts the basics of economics in terms of scar-
___________________
city, choice and resource allocation.
___________________
The fundamental problem of scarcity poses three elementary ques-
___________________
tions:
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1. What kind of product or service to be produced and in what
quantity?
___________________
2. How should the production be carried out?
3. For whom the production should be carried out?
Laws of economics are applied by an organization to answer the

above elementary questions.
What to Produce?
The first and foremost question is what kind of products and ser-
vices are to be produced by the firm and in what amount?
Consumer demand decides when new goods can be launched in the

market.
How to Produce?
The second aspect is how the goods and services are going to be pro-
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duced?
Decisions regarding choice of vendors of raw material and capital

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equipment are made. Production and cost figures help managers

with hiring and recruitment of staff.
For whom to Produce?

A decision must be made regarding whom the goods and services are
produced for?
People who are willing to and are able to pay for the necessary goods
and services, command the production of such goods and services.
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Summary
Notes
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___________________ Managerial economics is a part of microeconomics and establishes
a relationship between management and economics. This chapter
___________________
focuses on the formulation of policies for various managers. It also
___________________ encompasses the tools and techniques used in multiple operations
___________________ of businesses.
___________________
Assessment Questions
___________________
1. How does the economic theory help a manager?
___________________
___________________
2. Explain the following statement – “Mathematical tools and
techniques are generally helpful to managers.”
___________________
3. Explain the need for managerial economics for a business orga-
___________________
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Unit 2 Notes
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___________________
Ten Principles of Economics ___________________
___________________
Objectives:
___________________
Upon this unit’s successful completion, the students will be able to:
___________________
\\ Explain the principles of economics
\\ Outline the works of eminent economists ___________________
___________________
Principles of Economics ___________________
Following are the eight essential principles of economics. ___________________

UP
Principle 1: People face trade-offs
In everything a person chooses to do, he must perform some trade-
off either in terms of time or money. For example, if one goes to the
___________________
market to buy something, he or she has to give up the comforts of the

home and spend on the commute, while taking risks during the said
commute. In a broader context, sometimes to remove disparity and
to promote equity, the government chooses to sacrifice efficiency. For
example, the government often redistributes income taxes to finance
unemployment.
Principle 2: What you give up for something, is its cost

As per economic theory, when presented with a choice to select one
from amongst numerous alternatives, we probably always try to
choose the best option. Opportunity Cost is defined as the next pos-
sible best alternative which has to be given up during the selection
process, in order to choose the best one. For example, if we are un-
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well and must choose among medicines, clothes and a movie, we

are most likely to select medicines over the other two options. The
opportunity cost of medicines will be the next best alternative.
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Principle 3: Rational people think at the margin

Economists hold the view that, in order to make rational decisions,
people consider their opportunities and objectives. Sometimes, ra-
tional people make a marginal change to the existing plan of action.
Managers compare the marginal cost and marginal benefit to arrive
at a decision.
10
For example, An airline has 500 passenger seats available for a
Notes
flight.
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___________________
● Cost of 500 tickets: Rs. 2,00,000
___________________
● Average cost per ticket: Rs. 400
___________________
___________________
Should the airline sell a ticket at a price less than Rs. 400?
___________________ Yes. If the plane has 12 empty seats just before flying, the airline
can decide the fare at Rs. 300 to attract the last-minute passengers.
___________________
It makes sense for the airline to sell those 12 tickets at a cost less
___________________ than Rs. 400, as the additional cost of flying these passengers, is
___________________ small. It is the marginal cost of the ticket, that is, a bag of peanuts
___________________
and a little extra fuel that may be needed to fly those last few pas-
sengers.
___________________
UP
Principle 4: Trade can make everyone better off
The result of trading carried out between countries, households,
and people is called Specialisation and Competition. Japanese and
Americans produce the same type of goods, such as cars. They have
healthy competition amongst them to produce better cars to attract
people and establish themselves as trustworthy and consumer-ori-
ented companies.
Principle 5: Markets are usually a good way to organize eco-

nomic activity
People carry out buying and selling of goods and services in markets.
Markets decide the demand and supply of goods and hence, their
prices. In a market economy, the decision-making is in the hand of
millions of buyers and sellers. It is a fact that the government is the
central planning authority in a communist economy, and as such, it
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may not be able to take the best decisions for every buyer and seller.
In a market economy, individuals decide regarding which jobs they
would take up and what they will buy with their income.
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Principle 6: Market outcomes can occasionally be improved by

Governments
According to this principle, If the invisible hand of market forces
had been perfect, there would have been no need for a government.
The government is required in order to form and enforce rules. The
working of market-forces is based on the imposition of rules by the
government. It is also based on how the government maintains the
Unit 2: Ten Principles of Economics
11
related organizations and institutions that are essential for the
Notes
functioning of a market economy.
ES
___________________
Principle 7: A country’s living standard is dependent on its ca-
pability to produce goods and services ___________________
___________________
High productivity in an economy is depicted by a High Standard of
Living. Higher productivity ensures higher living standards. Laws ___________________
for minimum wages and labor unions do not provide for a higher ___________________
standard of living. Policymakers can ensure a better living standard
___________________
by raising productivity, which is dependent on skill development
and thus, the efficiency of the workers. Policymakers can also pro- ___________________
vide access to the best technology to their workers. ___________________
Principle 8: If the Government Prints excess currency, Prices will ___________________

rise
UP
Inflation is a phenomenon characterized by an incessant and per-
sistent increase in prices in the whole economy. The purchasing
___________________
power falls whenever inflation rises, thereby affecting the demand.

Inflation can be caused due to the excess supply of currency by the
government.
High inflation means everything costs more, putting pressure on the

market forces and the economy. Hence, economists generally want
to keep the inflation low.
Three Economists and Their Theories

The most influential economic theories were developed by three of
the most important economists and highly original thinkers - Adam
Smith, John Maynard Keynes, and Karl Marx. These theories have
affected the world’s economies for generations.
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Adam Smith: Theory of invisible hand of capitalism

Adam Smith (1723–1790) is also referred to as the father of eco-
nomics. His book “The Wealth of Nations” was published in 1776.
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He founded the modern economics and the classical economics. He

argued that every person in a society is as an economic man, who
acts rationally in his own interest to maximize his personal utility.
He explored the concept of wealth accumulation, labor market, and
growth productivity.
12
Karl Marx: Exploitation of labor
Notes
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Karl Marx (1818 to 1883) was a German Economist. He was of the
___________________
view that when all the resources of production have been set up by
___________________ the capitalist, all the value created by labor is involved in the pro-
___________________ duction of commodities for capital accumulation of the capitalists. In
his book, Das Kapital (Capital) published in 1867, Marx presented
___________________
his views that the capitalists earn profits when labor is exploited.
___________________
The exploitation of labor by management underlies the class strug-
___________________ gle, which according to Marx, will ultimately destroy capitalism.
___________________
Keynes: Government as a helping hand
___________________
John Maynard Keynes (1883 to 1946) was a British economist. He
___________________ examined the capitalism closely. His argument was that overall
level of economic activity is determined by aggregate demand and
___________________
UP
if the aggregate demand is inadequate, this could result in higher
unemployment for extended periods. To alleviate the hostile effects
of economic downturns and depressions, Keynes had advocated the
use of fiscal and monetary policies.
The most significant aspect of Keynes work during the great depres-
sion was that he put forth his views regarding Government’s role in
a capitalist economy,
The approach of Keynesian economics refers to the economic policy

that keeps the economy stable and growing.
Summary
The chapter discusses the significance of eight principles of Econom-
ics, which help in decision-making. When a decision needs to be tak-
en by individuals, they face trade-offs between their alternate goals.
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The chapter discusses how rational people act to make decisions.

This chapter acquaints us with economists such as Adam Smith,
Karl Marx, and Lord Keynes who are widely recognized for their
work.
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1. Explain the concept of a trade-off?
2. What is deficit financing? Why do economists want to keep in-

flation low?
Unit 2: Ten Principles of Economics
13
3. Give an example of how managers compare marginal cost and
marginal benefit to come to a decision? Notes
ES
___________________
4. How has Keynes contributed to the stable growth of an econo-
my? ___________________
___________________
5. Give an example of a situation that validates Karl Marx’s views
on capitalism. ___________________
___________________
6. Explain as to how the growth of economies is assisted by Prin-
ciple 4 – ‘Trade can make everyone better off’? How can it ___________________
adversely affect markets? ___________________
___________________
___________________
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Unit 3 Notes
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___________________
Tools Used For ___________________
Economic Analysis ___________________
___________________
Objectives: ___________________
After completion of this unit, the learners will be able to:
___________________
\\ List the fundamental principle of economic analysis
___________________
\\ Explain the basic terms of Economics
\\ Identify various graphs, curves, and slopes ___________________
\\ Summarise the importance of a slope ___________________
Introduction:
UP ___________________
Economic theories are made to explain different perspectives. The

relation between two or more variables is defined by these theories.
Mathematical tools are used to explain economic theories, in a pro-
cess called economic analysis. Experts use several tools in economic
analysis.
To solve the complicated aspects of economic theories and models,

the modern economists take help of Matrix, Calculus, and Algebra
and Derivatives, to calculate more precisely and accurately. Graphs
enable to understand economics.
Basic Terms of Economics

Here are a few basic terms used in the application of economic anal-
ysis.
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Variables:
A measurable value is a variable. The magnitude of variables can
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change. At different times or places, a variable can assume differ-

ent values. Variables used in Economics include saving, imports, ex-
ports, etc. Each of these is represented by a symbol.
Ceteris Paribus:
When the relation between two variables is analyzed, we assume all
the other factors remain the same. Ceteris Paribus is a Latin phrase
that implies “other things remain constant.”
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Function:
Notes
ES
The relation between two or more economic variables describes a
___________________
function.
___________________
The demand function for certain goods is expressed as:
___________________
D = f (P, Pr, T, F)
___________________
___________________ Where;
___________________ D = Demand,
___________________ P = Price,
___________________ Pr = Price of similar goods,
___________________ T = Taste and Preferences,
___________________
UP

F = Fashion and
f = Functional relationship.
Equations:
In Economics, there is an expression of functional relationships be-
tween economic variables, which when transformed into algebraic
expressions provides equations.
Each equation shows a relation.
For example, C = a + b Y is the consumption function.
Identities:
An identity is the one that shows an equilibrium condition.
For example, total profit is denoted as:
 = TR – TC
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Where;
π is the total profit,

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TR indicates the Total revenue and
TC is taken as the Total Cost.
Graphs and Diagrams:

A graph shows the relationship between two or more sets of vari-
ables.
For example, figure 3.1 shows a typical graph with its four quad-
rants.
Unit 3: Tools Used For Economic Analysis
17
Notes
ES
Quadrant Quadrant ___________________
2 1
___________________
___________________
___________________
Quadrant Quadrant
3 4 ___________________
___________________
Figure 3.1: Four Quadrants in a Typical Graph ___________________
___________________
Lines and Curves:
___________________
The relationship between different variables can be shown with the
UP
help of a line graph. For example, the relationship between income
and consumption is shown below.
___________________
Y
Consumption
O X
Income
Figure 3.2: Relationship between Income and Consumption
Slope:
)
A slope indicates the change in one variable in response to the

change in another variable. The following figure shows the different
methods of measurement of a slope.
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Y Y
D D
B B C
C
O X O X
(A) (B)
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Y
Notes
ES
___________________
Y1
___________________
a
___________________
___________________
X
O X1
___________________
Figure 3.4: Different Methods of Slope Measurement
___________________
___________________ A slope helps in identifying both steepness and direction. If a line

moves upward when going from left to right, the slope is positive,
___________________
and when, the line moves down when going from left to right, the
___________________
slope is negative.
___________________
UP
Summary
This chapter introduces different concepts of mathematics, which
are useful in analyzing of economics. Equations, slopes, lines, iden-
tities, graphs, diagrams and curves are used in economics. A mea-
surable value is a variable. The magnitude of variables can change.
The relation between two or more economic variables describes a
function. An identity is the one that shows an equilibrium condition.
A graph shows the relationship between two or more sets of vari-
ables. A slope indicates the change in one variable in response to the
change in another variable.
1. What do you mean by a function?
2. How is a slope beneficial to an economist?

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3. What is the importance of a graph in economic analysis?

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Unit 4 Notes
ES
___________________
Fundamental Concepts of ___________________
Managerial Economics ___________________
___________________
Objectives: ___________________
___________________
\\ Explain the marginal principle
___________________
\\ Summarise the Equi-marginal principle
___________________
Introduction: ___________________
UP
We shall now focus on numerous economic decision variables and
processes, given that managerial economics is a concept-based sub-
ject. Scientific management begins with formulating the concept of
___________________
the decision-related problem. This is followed by the derivation of

decision rules and principles to arrive at results using sophisticated
tools and techniques.
Marginal Principle
Firms try to maximize marginal profits. Marginal revenue is the
total increase in revenue from selling one extra unit of output. The
marginal cost is the overall increase in the cost of producing one
additional unit of output. Marginal costs are low at low production
and high as the production increases. It is assumed that a firm max-
imizes the profit by producing a level of output, where the marginal
revenue is same as marginal costs.
)
Equi-Marginal Principle
The Equi-marginal principle defines the behavior of a consumer in
distributing the limited income among various goods and services.
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It states how an individual distributes his income between different

products and services to achieve maximum satisfaction. The buyer
will spend his income on goods such that the value derived from the
last amount of money spent on every good, is equivalent.
20
The concept of Scarcity and Choice
Notes
ES
___________________ The fundamental problem faced during economic decision-making
is the scarcity of resources in relation to unlimited requirement. For
___________________
example, a production manager may have to work around the short-
___________________ age of raw materials, timely supply or skilled labor.
___________________ If there is an excess demand for one commodity, there must be an
excess supply for another commodity. Managers must investigate
___________________
this problem.
___________________
___________________
The concept of Opportunity Cost
___________________ Opportunity cost can be defined as the next best alternative which
has been forgone in order to produce another good. It is the benefit
___________________
given up when one option is chosen over another. Such situation
___________________
UP
may include the decision to outsource, the decision to buy new tech-
nology, and the decision to buy instead of production, etc.
The principle of Time Perspective

Managers must keep in mind the effects of their decisions over time.
A manager must look at past data, locate a problem and define its
impact in the future while making decisions. This can be explained
by the decision to advertise. Such arrangement results in immediate
spending while reaping its benefits in the future.
Discounting
Discounting is both a technique as well as a concept. To understand
this concept better, we will use together with the two concepts stud-
ied earlier. These include the time perspective and opportunity costs.
Rn
PV =
(1 + i )n
)
Where;
PV = present value,
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Rn = amount to be received in future,
i = rate of interest,
n = number of years lapsing between the receipt of R
In the above example, the present value for 1100 at 10% Rate of
Interest (ROI) for a period of 1 year is:
Unit 4: Fundamental Concepts of Managerial Economics
21
Marginal utility of Good X
MRSxy = Notes
ES
Marginal Utility of Good Y
___________________
Thus, the PV is 1000. ___________________
Here, we can note that if the time taken is longer, then the discount ___________________
will also be higher.
___________________
Risk and Uncertainty ___________________
Decision-making is required when situation and environment ___________________

change. Most of the business decisions revolve around costs and ___________________
future revenues, and the future cannot be predicted with complete
___________________
accuracy. Future consists of changes, and there is no surety that
the present situation will repeat itself in future. Changes are not ___________________
similar; they are unpredictable.
UP
The outcome of obvious changes may either be definite or indefinite.
The exact consequence of a known change defines the decision envi-
___________________
ronment of certainty. The result of a known change which is uncer-

tain involves risk. Such risk may be estimated in terms of likelihood
of incidence of events. But if the variations are indefinite and their
consequence is also indefinite, then risk cannot be measured before-
hand. This implies that there can be no guarantee of a risk, which
then creates an environment of uncertainty.
Managerial Economics involves Decision making
Decision making occurs in changing environment

and the changes are not homogenous
)
Known changes Unknown changes

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Definite changes: Indefinite changes: It leads to uncertainly

It leads to It leads to risk. The and the measure of risk
uncertainty. In measure of risk lies is infinite
this, the measure between zero and
of risk is nil. infinity.
Figure 4.1: Decision-Making in Economics

22
Thus, it is implied that risk and uncertainty are two separate no-
Notes tions. The flow chart below gives a more graphic look:
ES
___________________
Measurement of Risk
___________________
Quantitative evaluation of risk depends on the possible outcomes of
___________________ an event, as well as on the probability that each result will occur.
___________________ For instance, a manager must take a decision on a specific invest-
ment that involves certain kinds of risk. It requires two types of
___________________
information;
___________________
● The probability distribution of various results associated with
___________________
risky situations
___________________
● A possible outcome of each situation
___________________
Probability is defined as the chance that a particular outcome will
___________________
UP
occur. The probability calculation of a manager or an analyst can
be based upon market research report or the reports from analysts
about the different situations such as the stock market. It also could
be subjective. The subjective calculation indicates that it depends
upon the observation of the manager regarding the outcome based
on his/her past experience.
Therefore, the notion of risk and uncertainty plays a crucial role in de-
cision-making, along with the statistical theory of the probability. Each
management, while making a policy decision, would like to know the
probability of occurrence of an event; as to whether it will go right or
wrong in future estimates of revenue and cost. Knowledge of degree of
uncertainty and risk helps the managers in making a decision.
Indeed, for different management and organizations, attitudes to-

ward risks and uncertainty would be different.
)
Summary
This chapter discusses the fundamental concepts of managerial
economics, such as the marginalism concept and the equi-marginal
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principle along with their applications. The section also describes

other concepts - discounting the principle and time perspective, and
the concept of uncertainty and risk. Decision-making in a manageri-
al scenario is also discussed.
23
Notes
ES
1 What is an equi-marginal principle? ___________________
2 Distinguish between the concept of risk and uncertainty of ___________________

change? ___________________
3 What does an opportunity cost mean? Explain with an example. ___________________
___________________
___________________
___________________
___________________
___________________
) UP ___________________
(C
24
Case Study: Amazon Spark, the new social network from
Notes
ES
Amazon, has got an uncanny resemblance to Pinterest
___________________
Amazon has a potential game-changer in the form of Amazon
___________________ Spark, an entirely new “Social Network Platform,” developed to en-
tice its existing loyal customers to spend even more money with the
___________________
online giant. Amazon Spark is an exciting combination of some of
___________________ the fantastic features of Amazon Prime, Pinterest, and Instagram.
___________________ The service was launched for the Amazon’s iPhone app on Tuesday,
only after thorough testing, with an Android version in develop-
___________________
ment stages. Right now, this service is exclusively available to Am-
___________________ azon Prime members only, who on payment of a yearly fee of $99
enjoy benefits like free shipping, exclusive video streaming, and
___________________
numerous other perks.
___________________
According to Bob Hetu, Research Director for Retail at Gartner,
___________________
UP Amazon Spark is aimed to connect better with customers by learn-
ing more about them to sell more”. He further suggested that Am-
azon is not pushing spark aggressively as it is not spontaneous to
access Amazon Spark on the Amazon app.
Much like Pinterest, users can share their picture-heavy posts,

which are related to their interests. This option is expected to lead
users to shop more.
In order to access Spark, users need to log on to the app and then
select the “programs and features” option on the menu bar. Firstly,
you will be asked to choose five items of interest. Once you select
your interests, you can expect to see an Instagram like a feed of
pictures of products with shopping bag icons that enlist as to how
many of the pictured products as well as related products can be
bought on Amazon.
On Wednesday when a user selected “travel,” “Food” and “beauty

and grooming” as exciting choices, Spark showed terrific pictures
of travel scenes, kitchen gadgets, and cosmetics. When you click
)
on the images, items which can be purchased on Amazon are high-

lighted with yellow dots, and a single tap on any such dot will take
the user to the actual product page. For, e.g., A user named Kas-
sandra had posted a picture depicting a hand holding a bright red
(C
nail paint bottle. When the user taps on the yellow dot near nail
paint bottle, they are taken to the Smith and Cult Nail Paint prod-
uct page with a price of $18.
Although due to many similarities, Spark has drawn comparisons

to popular social networks like Pinterest and Instagram, it is still
not clear if it will be posing a serious threat to them. In recent times
it has been observed that tech-giants such as Amazon and Face-
book have grown a liking for cloning popular apps from fast-grow-
Contd....
25
ing start-ups. For instance, ever since Facebook failed to acquire
Notes
ES
the youth-oriented Snapchat several years ago, it has been trying
to imitate Snapchat, one way or another. Most of such efforts have ___________________
failed miserably with the exception of Stories, a snapchat-like fea-
___________________
ture on Instagram which has been tremendously popular amongst
users. ___________________
Hetu further added that although it might still be early days to ___________________
comment on the extent of threat Spark poses to Pinterest, it will
___________________
be Amazon’s hold over the retail market that would be the decision
maker in the end. When contacted, Pinterest, which has been in ___________________
existence for seven years and now carries a valuation of appx $12 ___________________
Billion, did not respond.
___________________
___________________
1. What kind of decision would be favorable for Amazon?
) UP
2. Comment on Pinterest’s stake in this development.
___________________
(C
(C
) UP
ES
27
Unit 5 Notes
ES
___________________
Case Study: A Case On ___________________
Survey System ___________________
___________________
Survey Systems, the self-proclaimed “Computer Selling Icon” of the
United Arab Emirates is one of the leading sellers of computers ___________________
and associated peripherals in the country.
___________________
A large number of companies carry out on-going marketing cam- ___________________
paigns. Companies such as Wilger, Serie, and Short market their
packages under their own brand names whereas Bell produces ___________________
custom-order group packages and offers. Large retailers like Sarat ___________________
and Nukons deal in a vast variety of electrical appliances. But Sur-
UP
vey systems has carved a distinct presence for itself on basis of
regular advertisements including full page write-ups in all leading
newspapers.
___________________
There is a unique attribute of the advertisements from Survey Sys-

tems, most of their ads refer to packages being offered at special
prices. These packages mostly include some softwares or hardware
peripherals such as printers and scanners bundled with computers.
The advertised products belong to some of the reputed brands such
as Apple, Sony, Hewlett-Packard, Compaq etc. and are very com-
petitively priced. This aggressive marketing strategy has helped
the company register exponential growth and expand incredibly in
terms of profits as well as size of operations.
Although most of the customers are ecstatic at the great deals they
have managed to grab from Survery Systems but there are some
who complained that the products do not meet their eexpectations
and they ended up paying more than what the product deserved.
There are various reasons to which this can be attributed to:
)
1. Many times, the benefits being offered with the special deals
provide redundant or useless items, this causes the custom-
ers to lose their trust in the company as they believe that the
company is just trying to clear old stocks, which otherwise
(C
was not being sold by bundling them in a package. Sometimes

the packages do not include the additional products that the
consumers really desire such as some of the most sought after
softwares. As such despite being given a perception of getting
a great deal the consumer might have to buy several more
additional items, to get the desired final product.
2. Survey system has also been accused of trying to hard-sell

its extended warranty service. Though it may be beneficial
Contd....
28
to customers, it ends up enhancing the cost of the product by
Notes
ES
3%-4%. Surprisingly, this strategy is being followed in other
___________________ countries also. For instance, in UK electrical appliance re-
___________________
tailers like Dixons and Argos are being investigated for their
excessive profit booking in their activity area, by Mergers
___________________ Commission.
___________________ 3. Another deceptive tool being used by Survey Systems is the
___________________ “so-called” extended interest free credit period. This period
usually ranges from 9 months to 12 months and is highly at-
___________________ tractive to buyers as they can buy products of around $2000
___________________ without having to pay anything for an extended period. This
facility is extended in collaboration with DDC Bank.
___________________
The major issue here is that on expiry of the extended credit period
___________________
the buyers are not intimated, as a result they must pay interest
___________________
UP
from the date of the purchase of the product and that too at ex-
orbitant interest rates of up to 25%. As a result, in the end the
unaware consumers usually end up paying almost twice the cost of
the original product during four years after the purchase has been
made.
1. Discuss about various complementary products which a con-

sumer may consider while he buys a computer system, both
at product level and service level.
2. Compare the situation being faced by Survey Systems to that

of a supermarket chain, in terms of profit maximization of the
product mix.
3. Discuss the role of risk for Survey Systems for surviving in

the market.
)
(C
ES
UP
BLOCK–II
)
(C
Detailed Contents
ES
UNIT 6: THEORY OF CONSUMER UNIT 9: DEMAND FORECASTING
BEHAVIOUR
UNIT 10: CASE STUDY:

UNIT 7: DEMAND ANALYSIS THE FINANCE MINISTER’S DILEMMA
UNIT 8: ELASTICITY OF DEMAND

) UP
(C
31
Unit 6 Notes
ES
___________________
Theory of Consumer ___________________
Behaviour ___________________
___________________
Objectives: ___________________
___________________
\\ Explain the concept of indifference curves
___________________
\\ Demonstrate the consumer’s equilibrium under cardinal and ordinal
utility analysis ___________________
___________________
Introduction
UP
A consumer plans his purchases in accordance with his income and
savings. This is to maximize the satisfaction, which he will experi-
___________________
ence from the consumption of purchased goods and services. Con-

sumers can compare the two patterns of consumption, income, and
savings. There are two possible outcomes:either they prefer one over
the other, or they are indifferent to both the patterns.
In case of a single commodity, a consumer is in equilibrium if;
MUO = PO
● Here, PO denotes the price of commodity O, and MU indicates

the marginal utility derived from commodity O . If the mar-
ginal utility of O is same as its price, the consumer will be in
equilibrium. For example, if X has a number of coupons for the
same item but plans to buy only one such item, then those extra
coupons provide no marginal utility.
)
Indifference Curve
A thorough understanding of Law of Equi-Marginal Utility is re-
(C
quired to explain the nature of indifference curve
Law of Equi-Marginal Utility

This law states that to derive maximum utility, a rational consumer
chooses, foregoes or replaces specific goods. The consumer will spend
his income on goods as such that ,the utility derived from the last
rupee spent on each good is equal.
32
The utility is the ability of a product to satisfy a consumer. The util-
Notes
ity of a product may be different for different consumers.
ES
___________________
Total Utility is explained as the complete satisfaction that a
___________________ customer may get from consumption of a specific quantity of a
___________________ product or service.
___________________ Marginal Utility is explained as the additional/increased utility
___________________ derived from consumption of an extra unit of a product or ser-
vice.
___________________
___________________ According to the law of equi-marginal utility, a consumer is in equi-

librium if the marginal utility derived from each is equal to its price.
___________________
___________________
For equilibrium;
MUE/PE = MUF/PF = MUM

___________________
UP
Where;
MUE is the marginal utility of product E,
MUF is the marginal utility of product F,
PE is the price of E,
PF is the price of F,
MUM is the marginal utility of money.
Explain Through an Example

When a consumer consumes an additional unit of a commodity, the
Total utility increases but at a diminishing rate over a period of
time. Concurrently, the marginal utility reduces. This concept is
illustrated in the figure below.
)
Total utility of good
Marginal
(C
utility of
good
Quantity (M)
Figure 6.1 – Change in Total Utility and Marginal Utility
Unit 6: Theory of Consumer Behaviour
33
Utility Curve and Marginal Utility Curves
Notes
ES
Study of utility and marginal utility curves require the basic under-
___________________
standing of indifference curve analysis.
___________________
Indifference Curve Analysis
___________________
The consumer behavior was explained by Sir John Hicks through
___________________
the indifference curve analysis.
___________________
∆X PX
MRSXY = = ___________________
∆Y PY
___________________
Here, MRSXY is the marginal rate of substitution of the two products,
___________________
X and Y.
___________________
Indifference Curve
UP
An indifference curve shows different combinations of the quantity
of two goods bought by the consumer, which provide similar satisfac-
___________________
tion to the consumer. It is a convex curve.
Example 1: Apples and Bananas

Following is an example of an indifference curve.
Apples
A
14
B
10
C
9 IC1
)
20 26 41 Bananas
Figure 6.2. Example of an Indifference Curve

(C
In the above diagram, the OX-axis displays OX units of the good,

and the OY-axis shows Y units of goods. Joining the points, A, B, and
C, we obtain IC1, which is the indifference curve. All the combina-
tions show the similar level of satisfaction (A, B, C) on the IC1 curve.
Example 2: Shakes and Pizza

The following curve is another example of an indifference curve in-
volving consumption of shakes and pizza.
34
• Differrent combinations
Notes of the two goods that
ES
Shakes
yield the same level of
___________________ C utility.
___________________ D D
A
___________________ B
E
U = 100
___________________
Pizza
___________________
Figure 6.3: Indifference Curve
___________________
___________________
In the above diagram on the OX-axis, we have OX units of the good,
and on the OY-axis we have YO units of goods. Joining the points,
___________________
A, B, and C, we obtain IC1, which is the indifference curve. All the
___________________ combinations show the similar level of satisfaction (A, B, C) on the
IC1 curve.
___________________
UP
Properties of Indifference Curve
Let us now examine the properties of an indifference curve.
1. It is convex to the origin.
In the case when a commodity is preferred over another com-

modity, then for each combination of the two products on an
indifference curve, the curve becomes convex to the origin.
)
C
(C
I
BA
I

I
2. Two indifference curves cannot intersect.
This property suggests that two indifference curves cannot

meet, as the combinations on each curve represent a different
35
level of satisfaction. If one combination coincides with the one
Notes
on the indifference curve, it will be quite absurd.
ES
___________________
Y ___________________
___________________
___________________
GOOD Y S ___________________
B ___________________
F IC2
___________________
IC1
O X ___________________
GOOD X
Figure 6.5: Non-intersecting indifference curves ___________________

UP
3. A higher level of satisfaction is depicted by Higher indifference
curves
___________________
The more distant the indifference curve is from the origin, high-
er would be the units of both goods consumed to achieve those
higher levels of satisfaction. This implies that higher the indif-
ference curve is, higher are the satisfaction levels.
An indifference map is a set of

indifference curves that describes
a person’s preferences for all
combinations of two commodities.
Clothing Each indifference curve in the
(units per map shows the market baskets
week) among which the person is
indifferent.
B A
U3 Market basket A
)
is preferred to B.
U2 Market basket B is
preferred to D.
U1
Food
(units per week)
(C
Figure 6.6 Indifference Curve Indicating Higher Level of Satisfaction
Budget Line or Price Line

A Budget line depicts various combinations of two commodities that
an individual consumer can purchase with his income, at given pric-
es for the two products.
36
The budget line is depicted in the below figure:
Notes
ES
Number of music
___________________ downloads
___________________
___________________
___________________ Budget line

Price of chocolate bar
___________________ Slope = –
Price of download
___________________
___________________
___________________ Number of
chocolate bars
___________________
Figure 6.7: Budget Line
___________________
UP
Consumer’s Equilibrium
The essential condition for the consumer’s equilibrium is:
∆X PX
MRSXY = =
∆Y PY
This is also acknowledged as “The Tangency Solution,” wherein

MRSXY is the marginal rate of substitution amongst commodity X
and commodity Y, PX and PY depict the cost of commodity X and
commodity Y, respectively.
The figure below shows the consumer’s equilibrium.
B
)
IC5
A
IC4
IC3
(C
IC2
IC1
O C X
Figure 6.8:Consumer Equilibrium
On OX axis, we measure good A, and on OY axis, we measure good

B. IC1, IC2, IC3, IC4, IC5 are the indifference curves, and BC is the
37
budget line. Consumer equilibrium is established at Point A, the
point of tangency of the budget line and the indifference curves IC3. Notes
ES
___________________
Consumer Surplus
___________________
The concept of consumer surplus can be efficiently analyzed through
___________________
indifference curve analysis. This analysis demonstrates as to how a
dual price system, can be used by a producer to examine some of the ___________________
consumer surpluses as additional revenue. ___________________
Consumer Surplus is defined as the difference between amounts ___________________

which a consumer wants to pay for a commodity and what he would ___________________
essentially pay. This concept is explained the Figure 6.9, where the
___________________
horizontal axis measure commodity X and the vertical axis measure
the money spent on all other commodities other than X. ___________________
Y3 = A
UP ___________________
Y2
C E
Y1 IC2
IC1
O X1 X2 B D
Quantity of good X
Figure 6.9 Consumer Surplus and Dual Pricing
Instances of Dual Pricing are evident in everyday lives as well, such

as when Power Companies charge lower rates for primary units but
start charging more for units beyond a specific limit.
)
The consumers maximize their satisfaction levels, along with the

budget line AB, on indifference curve IC2, wherein they consume X2
units of good X and spend Y2 on goods other than X. Therefore, Y3 –
(C
Y2 must be spent on X2 units of good X.
How much would the consumer have been willing to spend for
X2 units of X?
In order to observe this concept, an indifference curve should be
drawn which is touching the vertical axis at A. The indifference
curve (IC1) obtained as such, depicts the consumer to be indifferent
to their two available choices, i.e., either spending their whole in-
38
come on other commodities and consuming no units of X, otherwise
Notes they can spend Y1 on other goods and X2 upon commodity X. This
ES
___________________ implies that a consumer would deliberate an expenditure of Y3 – Y1
___________________ on X2 units of X, even though they were only required to spend Y3 –
Y2. It thus implies that consumer surplus is represented by Y2 – Y1,
___________________
which is the difference between the amount that the consumer is
___________________ willing to pay and the amount they actually have to pay.
___________________
In a nutshell, though consumer surplus might represent a potential
___________________ loss to the producer, it indeed represents a bonus for the consumer.
___________________ How can the producer turn some of the consumer surpluses into
___________________ additional revenue?
___________________ There are two alternatives in front of a producer. Firstly, they can
raise the price of commodity X, which would move the budget line
___________________
UP
AB downwards from A but this might result in fewer units being
consumed by the consumer. In such a scenario the total revenue will
increase only if the price elasticity is inelastic.
Otherwise, the producer can adopt a dual pricing strategy wherein

the consumer can buy a certain number of units at a given price and
thereafter additional units can be sold at a lower price. This will
help the producer grab some of the consumer surpluses to increase
its revenue and can maintain levels of consumptions by using the
original price only.
The real-life application of dual pricing is depicted in Figure 6.9,

wherein the initial X1 units are available for purchase at higher
prices (represented by Budget Line AE). Any units beyond X1 are
sold at a lower price and are indicated by budget line ED.
The consumer faces the kinked budget line AED and thus buys X1
)
units at a price indicated by budget line AE. Additionally, more

units are purchased at a lower price depicted by budget line ED.
Therefore, the consumer would have to spend Y3 – Y1 to get X2 units
of commodity X and the producer in-turn grabs the entire consumer
(C
surplus as has been previously identified. (Note that in Figure 6.9

the consumer would be indifferent between purchasing Zero or X2
units of X. But, the consumer will never buy any less than X2 units
and subsequently if the price of additional units were to slightly
reduce, then X would always be bought.)
39
The above-discussed pricing strategy is applicable only to a specific
consumer, i.e., this concept cannot be generalized as different con- Notes
ES
sumers have different preferences and as such different indifference ___________________
maps. But such strategies definitely allow producers to grab more ___________________
consumer surplus and more revenue than what could be achieved by
___________________
setting a single price.
___________________
___________________
Y3 = A
___________________
___________________
___________________
Y2
C E ___________________
Y1
O
UP
X1 X2 B
IC2
IC1
D
___________________
Quantity of good X
Figure 6.10: Consumer Surplus and Dual Pricing
While studying consumer behavior, it is also essential to understand

the meaning of two important terms, cardinal utility, and ordinal
utility.
Cardinal utility
Cardinal utility refers to the utility through which the satisfaction
obtained by consumers from the consumption of products and ser-
vices can be measured in numerical terms.
Ordinal utility
Ordinal utility refers to the level of satisfaction achieved by a con-
)
sumer from the consumption of product or service. It is not possible

to measure such utility in numerical terms.
(C
Summary
This unit provides a theoretical analysis of several determinants of
demand. Different theories, such as the modern indifference curve
techniques, traditional utility approach, and the recently discovered
preference approach, have been covered. A brief outline of the con-
cept of theoretical developments recommends that to analyze the
effect of the demand decision, it is necessary to differentiate between
40
a single and multi-commodity consumer and the nature of the com-
Notes modity. The analysis of the consumer behavior is a challenging task.
ES
___________________
___________________
___________________ 1. What are indifference curves?
___________________ 2. What do you mean by consumer’s equilibrium?
___________________
3. Elaborate on properties of indifference curves?
___________________
4. Why should the indifference curves not intersect?
___________________
___________________
___________________
___________________
) UP
(C
41
Unit 7 Notes
ES
___________________
Demand Analysis ___________________
___________________
Objectives:
___________________
After completion of this unit, the learners will be able to
___________________
\\ Understand demand and related concepts
\\ Understand demand analysis ___________________
\\ List the factors determining demand ___________________
___________________
Demand
___________________
In economic terms, demand is defined as the quantity of products
UP
or service that people are willing to buy at a particular time and at
a particular price.
___________________
Types of Demand
Demand can be broadly categorized into individual demand and
market demand.
An Individual’s demand is the amount of commodity that will be

purchased within a particular time period and at a particular price.
The total of all individual demands is called the market demand.
The following graph illustrates the market demand:

)
(C
Figure7.1: Market Demand
D1 = Demand curve of Consumer 1

Dx = Market demand curve
Ddx1 = Quantity demanded by Consumer 1.
QDx = Quantity demanded by the market
D2 = Demand curve of Consumer 2.
Px = Price of X commodity
Qdx2 = Quantity demanded by individual 2.
42
From the figure in Figure 7. for market demand, it can be summa-
Notes
rized as ‘the market demand is the summation of the all quantities
ES
___________________ demanded by all the individuals of the market at the price.’
___________________
Law of Demand
___________________
According to the law of demand, ceteris paribus, when the price of
___________________ a good rise, quantity demanded falls and when the price of the good
___________________ falls, the quantity demanded rises.
___________________ Price
___________________
___________________ P3
___________________ P3
Contraction
___________________
UP P1
P2
Expansion
Demand
Q3 Q1 Q2 Quantity
Figure 7.2: Law of Demand
Factors Affecting the Law of Demand

The determinants of the law of demand are as follows:
(i) Price: The quantity demanded a good is inversely related to its

own price. When the price of a good increase, its demand falls.
(ii) Price of the substitute goods: Quantity demanded a com-

modity is directly proportional to the worth of the substitute
goods. For example, with an increase in the price of tea, the
quantity demanded coffee in the market will also increase.
)
D3
Price of Coeffee in Pence
D1
(C
D2
D3
D1
D2
O Q
Figure 7.3 Price of substitute goods
Unit 7: Demand Analysis
43
Figure 7.3 elaborates on the relationship between the cost of coffee
Notes
in pence, and its quantity demanded, Q. When the price of coffee de-
ES
creases there is a positive shift in demand from D1 to D2 and whereas ___________________
with an increase in the price of coffee, the demand has a negative ___________________
shift.
___________________
(iii) Price of complementary goods: when there is an increase in
___________________
the price of a commodity, the quantity demanded of a comple-
mentary good will fall. For instance, when there is a fall in de- ___________________
mand for tea, there is a reduction in the demand for milk also. ___________________
(iv) Future Price expectations: If the price expectations in the ___________________
near future are expected to rise, the current quantity demand-
___________________
ed will rise and reverse is also true.
___________________
(v) Consumer’s Income: As income increases, consumers pur-
UP
chase more goods and services and vice versa.
Good A Good B
___________________
O O a b
Disposable income
Figure 7.4 Income of the consumer
The figure shows that when income increases, consumers purchase

more goods and services and vice versa.
Movement Along the Demand Curve

Extension of Demand: The demand of a commodity rises, when
)
there is a fall in its price. Movement along a demand curve is shown

graphically in the Figure 7.2.
Contraction of Demand: The quantity demanded falls when there

(C
is a rise in the price of a commodity. Movement along a demand

curve is shown graphically in Figure 7.2.
Shifts of the Demand Curve

There are two types of shifts of the demand curve.
Increase in demand: In this case, the price of a commodity re-

mains the same, if the quantity demanded increases towards the
44
right. Sometimes in the instance of an increase in prices, quantity
Notes demanded might remain the same due to external factors other than
ES
___________________ the price. This shift is referred to as an increase in demand and can
___________________ be dialyzed in the following figure.
Shift in the Demand Curve
___________________
___________________ P
5
___________________
A A′
4
___________________
3 D2
___________________
2
___________________
1 D1
___________________
10 20 30 40 50 Q
___________________
UP Figure 7.5: Increase in Demand
The decrease in demand: At the same price, if the quantity

demanded a commodity decreases, the demand curve shifts towards
the left. Also, at the lower price, the quantity demanded remains the
same due to change in other factors affecting demand. This shift is
referred to a decrease in demand and can be dialyzed in the follow-
ing figure.
Shift in Demand: Decrease
Price
D1
D2
0 Quantity
)
Figure 7.6: Decrease in Demand
Factors Determining Demand

(C
There are several factors that determine the demand for a commod-
ity. These are internal and external factors, known as the controlla-
ble and uncontrollable factors, respectively. Both of these might be
useful to determine the demand for a commodity. The controllable
factors are controlled by the firm, and the uncontrollable factors are
external factors that might influence or change the demand. The
following figure specifies the various factors that determine the
demand.
45
Controllable Uncontrollable
Notes
ES
Income
Tastes ___________________
Price
Competitive factors ___________________
Government policy ___________________

Product
Demographic factors ___________________
___________________
DEMAND Climatic factors
___________________
Seasonal factors
Promotion Macroeconomic factors ___________________
___________________
Institutional factors
Technological factors ___________________
Place
UP Prices of subtitutes and complements
Expectations of changes
Figure 7.7: Factors Determining Demand

___________________
Controllable Factors
These factors correspond to what is often referred to as the market-
ing-mix variables.
1. Price: The quantity demanded a product is affected by the na-

ture of its price. According to an empirical study, the price af-
fects the psyche of customers, and hence, quantity demanded.
In some cases, a firm might be selling multi-products. In such
cases, as most of the products are either substitutes or comple-
mentary, their prices hold great relevance. For example – The
demand for tea and coffee. Whenever there is an increase in the
price of tea, correspondingly the demand for coffee will rise.
)
2. Product: The quality of products as perceived by a customer,

greatly affects the quantity demanded. In reality, a couple of
problems regarding measurement are found:
● Prejudice being the foremost one for quality is perceived by
(C
customers in varied ways.

● The other problem being dimensions. Products often have
different characteristics. This is predominantly noticeable
for expensive and technical products.
For instance, in case of mobile phones, a buyer looks for multiple
features including a great design good brand name, compact size,
light weight, multiple features, good post-sales service, etc.
46
Not just this, customers when buying an inexpensive product such
Notes as toothpaste, they might look for features like good cleaning, fresh
ES
___________________ breath, prevention of decay and plaque all in a user-friendly pack-
___________________ age. These prove the point that customers seek extra features.
___________________ Multidimensional scaling is employed by researchers and market-

ing professionals, wherein the consumers are requested to rate a
___________________
product across a range of features and also ranking each product.
___________________
Due care needs to be exercised while designing such questionnaires
___________________ to include most relevant factors including assumptions related to
___________________ the subjective importance of such factors according to their impact.
___________________ In some cases, the cost of production of a unit is used to measure the
quality of a product but this may not be a correct indicator for it may
___________________
reflect more on a firm’s efficiency.
___________________
UP
3. Promotion: This refers to the communication that a firm wants
to have with its target customers with an aim to persuade them
to buy their products. Promotion-mix comprises of four differ-
ent components:- “Advertising, Personal Selling, Publicity and
Sales Promotion.” Additionally, other elements such as direct
marketing and packaging are also included separately. They
have a direct relationship with quantity demanded and are
generally measured in terms of expenditure.
4. Place: This factor pertains to selection of distribution channels

as a part of distribution strategy. It is directly related to the
quantity demanded and is measured as an expense.
In a nutshell, it can be said that other than price, marketing

mix’s the remaining components can be considered as a cost. The
price being the only component contributing directly to the reve-
nue and Price elasticity defines its relationship with r evenue.
)
Uncontrollable Factors
This category includes a wide range of factors with varying relative
(C
importance and may be environmental or external:-
1. Income: the single most critical factor affecting demand for a

product. Economists use a number of techniques to measure
this parameter.
The most pertinent parameter for determination of demand is

Personal Disposable Income. Regular publishing of relevant
information on this parameter is done by various agencies of
47
government. But ass these figures have limited application to a
particular nation only, they are applicable only to firms operat- Notes
ES
ing in local markets. ___________________
Average personal disposable income of a market is the most ___________________
relevant parameter for a firm. But in case the market in which ___________________
a firm operates is relatively small, or its area is difficult to iden-
___________________
tify than a pseudo-income variable needs to be used. For in-
stance, in case a firm is operating in a small area of Hong Kong, ___________________
they will have to use the average income of a Hong Kong citizen ___________________
as the most relevant proxy variable. ___________________
As previously discussed, it is the nature of the product, i.e. ___________________
whether it is a superior or inferior quality that will determine
___________________
the relationship of disposable income with the quantity de-
manded.
UP
2. Tastes: As tastes are subject to subjective preferences and can
be multi-dimensional, they are really difficult to measure. As
___________________
such they affect the perceived quality. Some examples of prod-

ucts where preference of taste has caused a great increase in
demands can be computer games, micro-scooters, etc.
3. Government policy: Government policies will always have mi-

cro and macroeconomic effects on a firm. Many times, Govern-
ment formulates policies to either encourage or discourage the
consumers from using particular products in order to increase or
decrease its consumption. For instance, Government regularly
promotes policies to control consumption of harmful substances
such as alcohol, drugs, cigarettes, etc. Then there are products
which are dangerous for the society such as pornography.
There are various policy instruments at government’s dispos-

)
al to control consumption of such products such bans, health

warnings, age restrictions and restrictions on time and place of
consumption. These instruments help control both demand and
supply of such products.
(C
4. Competitive factors: This refers to the marketing-mix of

competitors. This phenomenon where firms compete with each
other based on factors other than price can be observed in Oli-
gopolistic markets only. A most relevant example would be Pep-
si and Coke, both these firms have a virtual “duopoly” over the
cola market, and they compete based on factors other than pric-
es such as distribution and promotion.
48
5. Demographic factors: This factor lays emphasis on the size
Notes of population along with its structure. For instance, an aging
ES
___________________ population will lead to a rise in the demand for medical ser-
___________________ vices, aged care services, pension services, etc. This is bound to
have a great impact on government policies.
___________________
___________________ 6. Climatic factors: Climate also plays an important role in de-

termining the demand for a product. This includes elements
___________________
like temperature, terrain, weather, etc. In a country like India
___________________ with tropical climates, there is great demand for air-condition-
___________________ ers, evaporative coolers, and fans.
___________________ 7. Seasonal factors: Many products demands are governed by

___________________ seasonal demands. For instance, during marriage season there
is going to be great demand for jewelry, expensive clothes, etc.
___________________
UP
Additionally, there could be daily patterns, weekly patterns
and monthly patterns for the demand of products and services.
More so, some services can have hourly patterns such as peak
hour and non-peak hour demand and pricing.
8. Macroeconomic factors: These factors include macroeco-

nomic parameters such as income levels, inflation rates, un-
employment rates and exchange rates, etc. These factors are
generally non-essential to the demand for a particular product.
Government policy does have a bearing on these macroeconom-
ic factors.
For example, when there is a reduction in interest rates, de-

mands are affected because of two reasons:
– Reduction in interest rates will put more discretionary

income in hand of homeowners with a mortgage. This in-
)
come will be used by them for the purchase of non-neces-

sary goods.
– There will be an increase in demand for consumer dura-

(C
bles because in many cases, they are bought on credit and

would now become more affordable with lower interest
rates.
9. Institutional factors: Various parameters such as political, le-

gal, education, infrastructure, religious beliefs and family systems
have a significant impact on demand for a product or service. For
example, in a country with the poor road network, demand for
49
cars will be low. Similarly, with low literacy rates in a country, the
demand for magazines and newspapers will also be low. Notes
ES
___________________
10. Technological factors: Despite the fact that these factors af-
fect the supply side more, there is no denying the fact that these ___________________
will affect the demand side also. For example e upgradation of ___________________
features in mobile phones and smartphones, the demand for
___________________
such smartphones has increased significantly over the last few
___________________
years. What was once a luxury has now become a necessity.
___________________
Demand and Quantity Demanded ___________________
(a) Type of change: Demand ___________________
1. Graphical Representation: Demand curve is shifted ___________________

UP
2. Cause: Apart from price, quantity demanded is affected
due to changes in other factors other than price.
(b) Type of change: Quantity demanded

___________________
3. Graphical representation: Movements along the demand

curve
4. Cause: Changes in cost and changes in supply lead to
changes in price.
P
D S2
S1
B
P2 = 5
P1 = 4 A
Q2 = 8 Q1 = 10 Q
)
Figure 7.8 Change in quantity demanded
Figure 7.8 shows “the change in the quantity demanded. It shows

price on the y-axis and quantity demanded on the x-axis. It shows a
(C
negative shift in the supply from S1 to S2 when the quantity demand-

ed decreases from 10 to 8. Here, the prices increase from 4 to 5”.
Summary
This chapter deals with the concept of the demand. The chapter ex-
plains the law of demand, along with various determinants of de-
mand, which can influence the buying behavior of the consumer.
50
Notes
ES
___________________ 1. Explain the behavior of the consumer under the normal ten-
dencies of life.
___________________
___________________
2. Use examples to explain the law of demand?
___________________ 3. Give examples from daily life to explain any situation that
leads to shifting in demand curve.
___________________
___________________ 4. Does the law of demand hold true during the depression, reces-
sion, or prosperity in an economy?
___________________
___________________
5. How would an economist interpret the factors that affect the
demand for automobiles in India?
___________________
___________________
) UP
(C
51
Unit 8 Notes
ES
___________________
Elasticity of Demand ___________________
___________________
Objectives:
___________________
___________________
\\ Explain different types of elasticity of demand
\\ Do measurement of elasticity of demand ___________________
\\ List down various types of elasticities ___________________

\\ Identify the determinants of elasticity of demand
___________________
___________________
Elasticity of Demand
UP
The elasticity of demand depicts the degree of responsiveness of de-
mand for a product to the corresponding change in its price. Income
___________________
elasticity of demand measures the degree of responsiveness of quan-

tity demanded a product or service to a corresponding change in the
income of a consumer.
Price Elasticity of Demand

“Price elasticity of demand (Ed) explains the responsiveness of the
quantity demanded of a commodity to the corresponding changes in
its price.”
Classification of Elasticities
Price Elasticity of Demand can be categorized into five further cat-
egories:
)
Perfectly elastic demand Perfectly inelastic demand Relatively elastic demand

D
(C
D
D
D
D
Price
Price
Price
D
Demand Demand Demand
Relatively inelastic demand Unity elastic demand
D
D
Price
Price
D
D
Demand Demand
Perfectly elastic demand Perfectly inelastic demand Relatively elastic demand
D
D
D
D
D
Price
Price
Price
D Economics & Management Decisions
Demand Demand Demand
52
Relatively inelastic demand Unity elastic demand
Notes
ES
D
D
___________________
Price
Price
___________________
D
___________________ D
___________________ Demand Demand
___________________ Figure 8.1: Elasticity of Demand
___________________
Perfectly inelastic demand curve: When despite significant
___________________ change in the price of a product, the quantity demanded does not
___________________ change at all.
___________________ Unitary elastic demand curve: When the percentage change in
the price of a product is equal to the percentage change in its de-
___________________
UP
mand.
Elastic demand curve: When the corresponding change in demand

of the product is significantly higher than the respective change in
the price.
Inelastic demand curve: When the proportionate change in the

demand for a product is less than the corresponding change in its
price.
Perfectly elastic demand Curve: When despite a small change in

the price the change in quantity demanded is infinite.
Computation of Coefficients of Elasticity
Numerical Type of price

Description
value elasticity
There is a greater change in demand
)
in response to a percentage or smaller

Perfectly elastic change in the price. For example,
ep = ∞
demand with a little change in the price of a
commodity its demand decreases or
completely stops and vice versa.
(C
Consumers do not respond to a

product with increase or decreases in
Perfectly inelastic
ep = 0 its price. This holds that despite the
demand
change in prices, demand remains the
same.
When the percentage change in the
demand for a product is significantly
Relatively elastic higher than the corresponding change
ep > 1
demand in its price. In such cases, consumers
tend to switch to cheaper alternatives,
due to increase in prices.
Contd....
Unit 8: Elasticity of Demand
53
Numerical Type of price
Description Notes
value elasticity
ES
The percentage change in the
Relatively inelastic ___________________
ep < 1 demand for a product is less than the
demand
percentage change in its price.
___________________
The corresponding change in the
Unitary elastic
ep = 1 demand and price of a product are ___________________
demand
same.
___________________
Table 8.1: Summary of Elasticity of Demands
___________________
___________________
– Coefficients of elasticity can be computed in two ways de-
___________________
pending on the data available and its use. By arc elastici-
ty – It is used to measure changes that can be measured. ___________________
___________________
– By point elasticity – It is used to calculate very small
changes in price.
Arc Elasticity Method

UP ___________________
Arc elasticity of demand (EP) is:
EP = [Q2 – Q1/(Q1 + Q2/2)]
[P2 – P1/(P1 + P2/2)]
Where;
P1 = Initial Price,
Q1 = Initial Quantity,
P2 = New Price,
Q2 = New Quantity.
Measure: It measures the quantity demanded the price between

two points on the demand curve. This method is used, when price
)
elasticity of demand curve between two points has to be calculated.
Point Elasticity Method

(C
This method is used when the change in price is minuscule. ∆q and

∆p can be written as d∆q and d∆p, where d is the derivative of price
and quantity demanded. d∆q/d∆p denotes the rate at which Q chang-
es for a small change in P.
Hence,
dQ P
Ep =
dP Q
54
For example, when there is an increase in price from 40 p to 60 p,
Notes and the number of units falls continuously from 25 to 20, then the
ES
___________________ elasticity of price can be depicted in the following figure.
___________________
D
___________________
___________________ P2 = 60p x
___________________ P1 = 40p
___________________
___________________ D
O Q2 = 20 Q1 = 25 quantity demanded
___________________
Figure 8.2 Price elasticity
___________________
The following table displays the range of values that can be obtained
___________________
UP
for price elasticity of demand.
|PED| Demand Interpretation

>1 Elastic Consumers responsive to price change
<1 Inelastic Consumers not very responsive to price
changes
=1 Unit elastic Intermediate case
∞ Perfectly elastic Infinitely responsive (buy nothing if price
rises)
0 Perfectly inelastic Totally unresponsive (buy the same if price
rise)
Table 8.3: Range of values for price elasticity of demand
In the figure below, different relationships of price elasticity of de-

mand are shown:-
Demand Price Quantity Revenue Costs Profit
Elastic ↑ ↓more ↓ ↓ ?
)
↓ ↑more ↑ ↑ ?
Inelastic ↑ ↓less ↑ ↓ ↑
↓ ↑less ↓ ↑ ↓
Unit elastic ↑ ↓same same ↓ ↑
↓ ↑same same ↑ ↓
(C
↑ = increase; ↓ = more = increases by a larger proportion; ↑less = increases by a

smaller proportion; ↑same = increases by the same proportion; ↓ = decreases; ↓more
= decreases by a larger proportion; ↓less = decreases by a smaller proportion; ↓same
= decreases by the same proportion; ? = unknown without further information
Table 8.4: PED relationships with costs, profits, and revenue
For changing Prices, Price elasticity of demand is calculated by

firms for making forecasts.
55
Q P TR MR PED
0 9 0 0 –∞ Notes
ES
2 8 16 7 –8
___________________
4 7 28 5 –3.5
6 6 36 3 –2 ___________________
8 5 40 1 –1.25
10 4 40 –1 –0.8 ___________________
12 3 36 –3 –0.52
14 2 28 –5 –0.29 ___________________
16 1 16 –7 –0.125
___________________
18 0 0 –9 0
Table8.5: Linear Demand, Price Elasticity of Demand and Revenue ___________________
___________________
Perfectly elastic
9 ___________________
Price, marginal revenue (£ unit)
Elastic ___________________
P2 = 6
P1 = 4.5
UP Unit elastic
MC
Inelastic
___________________
O Q2 = 6 Q1 = 9 16 Perfectly inelastic
MR Quantity (units)
40.5
Total revenue (£)
Total revenue
)
Figure 8.3 Perfectly inelastic demand
Different Types of Elasticities of Demand

(Other than Price)
(C
Following are the two types of elasticities of demand:
Cross Elasticity of Demand

It depicts the degree of responsiveness of demand of a commodity for
change in the cost of a complementary commodity.
Hence,
56
% change in purchase of a goood
Notes Income Elasticity of demand =
ES
% change in income
___________________
EC = ∆QA/∆PB*PB/QA
___________________
For instance if, the changes in price and the quantities demanded
___________________
are large. In this case, measuring the percentage changes are based
___________________ on the midpoint of measuring the elasticity of demand, along with
___________________ the average of initial and subsequent prices and quantities.
___________________ Hence,
___________________ E = [QA2 – QA1/QA2 + QA1] / [PB2 – PB1/PB2 + PB1]
___________________ = [QA2 – QA1/PB2 – PB1*PB2 + PB1/QA2 + QA1]
___________________ = ∆q/∆p *PB2 + PB1/QA2 + QA1
___________________
UP
Cross elasticity of demand is used in decision-making, wherein the
same company produces competing products. For example, Hyund-
ai makes the i10 cars, as well as the Creta cars. Hyundai may sell
more i10s if it increases the price of Creta and as a result, the com-
pany Ford might be able to sell more of Ecosport.
Income Elasticity OF Demand

Income elasticity of demand depicts the degree of responsiveness of
demand of a commodity to a minor variation in the income of a con-
sumer for that commodity.
% change in purchase of a goood

Income Elasticity of demand =
% change in income
Determinants of Elasticity of Demand

Following are the various factors that determine the elasticity of
)
demand.
● Nature of goods: In case of luxury goods, the demand is elas-

tic, while for necessity goods, it tends to be inelastic.
(C
● Percentage of Income: Items that require large income have

more elastic demand than the items that require less income.
● Substitutes: Goods with substitutes have an elastic demand

whereas Goods without Substitutes have an inelastic demand.
● Time: The lengthier the time frame, more elastic is the de-
mand.
57
Summary
Notes
ES
Price elasticity of demand is discussed in detail in this chaoter. It ex- ___________________
plains the degrees of elasticity in detail, which are perfectly elastic,
___________________
perfectly inelastic, unitary elastic, inelastic, and elastic. It further
explains the concept of income and cross elasticity. The various fac- ___________________
tors that affect price elasticity of demand are also dealt with in the ___________________
chapter. Example to Understand Elasticity
___________________
Following is an example to help you understand the concept of elas- ___________________
ticity.
___________________
Marginal Effects and Elasticity ___________________
ABC Private Limited estimates that its demand function is as fol- ___________________
lows:
Where;
UP
Q = 150 – 5.4P + 0.8A + 2. 8Y - 1.2 P*
___________________
Q = Quantity demanded per month (in 1000s),
P = Price of the product (in $),
A = Firm’s advertising expenditure (in $’000 per month),
Y = Per capita disposable income (in $ ’000),
P* = Price of XYZ Private Limited (in $).
Let us find the solution to the following problems.
a. During the next five years, enhancement of $2500 is expected

in the per capita disposable income,500. What would be the im-
pact of this on the sales of the firm?
)
b. If ABC Pvt. Ltd., in order to offset effects of increase in come

by raising its prices, then how much should they increase their
prices?
(C
c. If ABC increase the prices as per the amount calculated, how

will it affect the PED? Explain.
d. Explain what is the relationship of ABC and XYZ?
e. If in the subsequent year ABC wishes to spend $10,000 per

month on promotion and charge $ 15, assuming the per capita
income to be $12,000 and price of XYZ to be $3, compute the
58
income elasticity of demand. What can you determine about the
Notes nature of ABC’s product?
ES
___________________
f. If the advertising budget is enhanced by $1000, what effect
___________________ would it have on profitability, if the cost of production of every
___________________ additional unit is $10?
___________________ Solution:
___________________
a. Use the marginal effect of income on the quantity demanded:
___________________
___________________ Change in Q/Change in Y = 2. 8
___________________ Change in Y = 2.5

___________________ Change in Q/2.5 = 2.8
___________________
UP
Change in Q = 2. 8 * 2. 5 = 7; or 7000 units
b. Use the marginal effect of price on quantity demanded:
Change in Q/Change in Y = –5.4
–7/ change in P = –5.4
Change in P = –7/–5.4= $1.30
c. PED = change in Q/change in P* (p/Q) = P –5. 4P/Q
As P increases and Q stays constant (because of rising income),

Price Elasticity of Demand increases in absolute number,
meaning that demand becomes more elastic.
d. The two companies make complementary products because the

marginal effect of the price of XYZ on the quantity of ABC is
negative.
)
e. YED = change in Q/change in Y *(Y/Q)
= 2:8 * 12/ (150 – 5.4 * 15 + 0:8 * 10 + 2.8 * 12 – 1.2 *3)
= 0.3140 (staple product)

(C
f. If change in A = 1; change in Q = 0. 8 = 800 units; and the

change in R ¼ 800 * 15 = $12000
Change in C = 800 * 10 (production) + Change in A ($1, 000) =

$9.000
Thus, every additional $1,000 spent on advertising increases profit

by $3,000.
59
The capability of a student to differentiate amongst concepts of mar-
ginal effect and elasticity are tested in this problem and they learn Notes
ES
its applications. In question(f), as profit is measured in monetary ___________________
terms it is essential to not use elasticity but rather use the marginal ___________________
effect. It is pertinent for the student to observe that variables are
___________________
measured in which units?
___________________
Summary
___________________
In this chapter, the concept of price elasticity of demand has been
___________________
discussed. Price Elasticity of demand is described as the degree of
responsiveness of demand of a product to corresponding change in ___________________
its price. Price Elasticity of demand can be measured in five degrees ___________________
namely:
___________________
– Perfectly Elastic
– Perfectly Inelastic
UP ___________________
– Unitary Elastic
– Inelastic
– Elastic
Concepts of Cross Elasticity of demand have also been discussed

along with the concept of income elasticity of demand. Various fac-
tors that affect price elasticity of demand have been dealt with in
this chapter.
1. What are the related goods? Give examples.
2. What is the managerial application of the cross elasticity of de-

)
mand (either elastic or inelastic)?
3. Elasticity and marginal revenue – discuss their relationship in

detail?
(C
4. Analyse the demand for luxury goods against basic utility goods.
5. The demand for tickets to the cricket match is given by the

equation:
QD = 450,000 – 800P
The supply of tickets to the event is limited by the capacity of

the ground, which is 170,000. Calculate the equilibrium price of
60
tickets for the event and the elasticity of demand at the equilib-
Notes rium price.
ES
___________________
6. Find the ep of movement from point A to B and from point C to
___________________ D from the table below.
___________________
Point Px Qx
___________________ A 18 0
B 12 1200
___________________ C 11 1400
D 9 1600
___________________
E 7 1800
___________________ F 6 2000
___________________
___________________
___________________
) UP
(C
61
Unit 9 Notes
ES
___________________
Demand Forecasting ___________________
___________________
Objectives:
___________________
___________________
\\ Discuss the demand forecasting concepts
\\ Use different techniques for demand forecasting ___________________
\\ Discuss the constraints of demand forecasting ___________________
___________________
Introduction: Concept of Demand Forecasting
___________________
It is important for a firm to plan for the future. Planning for future
UP
includes forecasting or predicting the likely demand for a product in
the future. Demand forecasting is the process of forecasting custom-
___________________
er demand to drive holistic execution of such demand by corporate

supply chain and business management. It considers various tech-
niques. It is used in production planning, inventory management,
and in assessing future capacity requirements.
Methods Use for Demand Forecasting

There are two approaches to demand forecasting
● Qualitative forecasting: It is used to obtain information about

the intentions of the customer’s expenditures either through
collecting experts’ opinion or by interviewing the consumers.
● Quantitative forecasting: It is used for long-term demand

forecasting and uses consumer’s past experiences and trends to
)
make forecasts.
For demand forecast of existing products, we can use any one or a

mix of the above-stated methods. However, to forecast the demand
(C
for a new product, we have to conduct surveys since historical data

for the new product is not available.
Qualitative Methods (Survey Methods)

Survey Method: For short-term forecasting, information is gained
and collected about consumer behavior. For long-term forecasting,
apart from collecting information on consumer behavior, expert’s
62
opinion or past experiences are also used as a guide with the use of
Notes
statistics.
ES
___________________
Experts Opinion Poll: Experts are asked to provide their feedback
___________________ regarding a commodity. These are experts who deal with same or
___________________ similar products and based on their experience, are able to predict
___________________
the expected sales of a particular product in the future under differ-
ent circumstances.
___________________
Hunch Method: In case the number of experts is large, and ex-
___________________
perience-based reactions given by them are varying, then an aver-
___________________ age-simple or weighted average is found that yields unique fore-
___________________ casts. This method of forecasting is called the hunch method. Some
___________________
companies also ask their salesmen to find the likely sales from re-
tailers and wholesalers.
___________________
UP
Consumer Survey Method or End User Method: The survey
method is mainly used for short-term forecasts and consist of more
than one important tool of forecasting. In order to estimate demands
in the short run, the best direct method is a survey of intentions of
buyers. The consumers are approached directly and are asked to
give their opinions about their likelihood to buy an item. The ques-
tionnaire should be carefully prepared following all the instructions
of a non-biased survey.
Survey of consumers may contain three types of forms:
1. Complete Enumeration Survey
2. Sample Survey
3. End-Use Method
Complete Enumeration Survey: It is like the process of Census

)
Data Collection that covers the entire population. Though this is an

ideal method of survey, a company may not have the resources to
conduct such a large survey especially in case of fast selling goods.
(C
Sample Survey: For sample survey method, a few consumers who

best represent the entire population of consumers of the product are
interviewed. On the basis of the views collected from the sample,
the total probable demand of the product in the market is then cal-
culated.
End-Use Method: A given product may have various end uses. For
example, milk has different end uses, such as chocolates, milk pow-
Unit 9: Demand Forecasting
63
der, sweets, yogurt, etc. Therefore, identification of the various end
users of milk is made. A survey is planned based on the end users, Notes
ES
and their demands estimated from all the sections of the end users ___________________
are added. ___________________
___________________
Quantitative Methods (Statistical Methods)
___________________
Exponential Smoothing is included in the Quantitative Methods of
___________________
demand, Moving Averages, Time Series Analysis, Regression Anal-
ysis, Index Numbers as well as Input-Output Analysis and Econo- ___________________
metric Models. ___________________
The above-mentioned analyses under quantitative methods are used ___________________

to estimate the demand in future. In the Time Series Method, which
___________________
is based on the occurrences in the past, the future demand for the
UP
product is projected. The data compiled at varying points of time
from the population are arranged chronologically.
___________________
Varying fluctuations can be inferenced from the data which can be

categorised into the following:
(i) The secular trend is the long-run decrease or increase in

the series.
(ii) Rhythmic differences in economic series are called cycli-

cal fluctuations.
(iii) Disparities caused by weather patterns and social habits

are called cyclical fluctuations.
(iv) Shocks to the system such as random fluctuations are

irregular and unpredictable, examples could be strikes,
natural catastrophes, wars, etc.
)
Time Series Analysis: When forecasting is done, cyclical, random

and seasonal variations are excluded from the collected data. The
secular trend is then projected which can be a linear or nonlinear
trend. The line-of-best-fit or the least squares method is used if the
(C
trend is linear.
Moving Average: When the market demand is expected to remain

stable over time, this method is used. Calculation of the moving av-
erage for ‘n’ number of months is done by simple summation of the
demand during the past ‘n’ months and then dividing the total by ‘n.’
Moving Average = ℎ
64
Exponential Smoothing: In Exponential smoothing, the data
Notes with recent information is awarded more weight. It is based on the
ES
___________________ discussion that more recent the observation, more impact it has on
___________________ the future, and therefore it is relatively given more weight as com-
pared to the earlier observations.
___________________
Index Numbers: they offer a device for measuring changes in a
___________________
group of related variables over a period of time. In the case of index
___________________
numbers, a base year is selected, which is given the value of 100
___________________ and thereafter all the subsequent changes are expressed in respect
___________________ to the movement of this number. Laspeyres’ Price Index is the most
commonly used Index number.
___________________
Regression Analysis: This is a statistical method, which is used
___________________
to calculate the relation between two variables, where a correlation
___________________
UP
between them appears to exist. For example, we can create a rela-
tionship between the expenses for annual repairs and the lifetime
of the air condition machine. However, it is only based on the sta-
tistical data available regardless of the actual causes of damage for
which the repair expenses have to be incurred.
Econometric Models: It is in the form of either an equation or

set of equations which seems best to express the possible interrela-
tionship among a set of economic variables according to statistical
analysis and economic theory. They can be formulated quantitative-
ly as well as qualitatively. One of the first steps in the construction
of the econometric model is to know all or most of the factors which
influence the series to be forecasted, and then the influence of these
factors, which can be reflected in the form of an equation. These
models are usually used by econometricians. A major limitation of
this technique is that it works under an assumption that relations
that were established in the past shall prevail in future also.
)
When the relationship between two or more variables during the

different time period is studied, it is called a lagged relationship.
A non-lagged relationship is the relationship of variables over time
(C
when both the endogenous and exogenous variables are observed at

the same point in time.
Example:
Trio Corporation makes pencil boxes and has observed the following
pattern of sales over the last 8 months:
65
Jul. Aug. Sep. Oct. Nov. Dec. Jan. Feb
Notes
ES
Sales (units) 380 430 410 420 450 440 480 500
Income ($000) 26 25 27 29 28 31 32 32 ___________________
Table 9.1: Sales and Income of Trio Corporation ___________________
a. Is it appropriate to use a lagged relationship in the above situ- ___________________
ation? Give reasons. ___________________
b. Estimate an appropriate relationship. ___________________
c. Estimate sales in March, stating any relevant assumptions. ___________________
___________________
d. To what extent, variation in sale levels is explained by its rela-
tion to the income level? ___________________
___________________
Solution
UP
a. As the income is usually received at the end of the month, the-
oretically it may deem fit to lag the relationship. To find out if
___________________
it actually fits the case, we need to draw estimates relationship

using lag and see if it suits better as compared to a relationship
without lag. The lagged relationship does, in fact, fit better,
with a Coefficient of Determination (COD) of 94.33% compared
with the non-lagged relationship with a COD of 60.79%.
b. Unlagged linear: Q = 121.9 + 11.02Y, COD = 60.79%
Unlagged power: Q = 41.31Y0.7033, COD = 58.35%
Lagged linear: Q = 98.70 + 12.32Yt–1, COD = 94.33%
Lagged power: Q = 34.32Y0.7682t–1, COD = 93:61%
Therefore, the appropriate relationship is the lagged linear.
c. 493 units, considering that all other factors that affect sales
)
remain the same.
d. 94.33%
(C
Demand Forecasting and its Limitation

Following are the limitations of demand forecasting:
Change in Fashion: In a dynamic business environment, results

from demand forecasting have short-term impacts due to this inher-
ent vice of human nature.
66
Consumers’ Psychology: Understanding human psychology in
Notes itself is an arduous task, and the results of demand forecasting de-
ES
___________________ pend greatly on it.
___________________ Uneconomical: Collection and analysis of huge volumes of data are
___________________ not economically feasible for small business units. Some enterprises
may not be able to afford the time it takes for analysis of the data.
___________________
___________________ Lack of Experienced Experts: Seasoned experts are required for

accurate forecasting results, but they may not be easily available
___________________
Forecasting by less experienced experts may lead to flawed analysis.
___________________
Lack of Past Data: If the product is new, then gathering past data
___________________
related to it is impossible.
___________________
Summary
___________________
UP
For any business to be successful, demand forecast of its products
and services is essential and also to decide upon its appropriate
business strategy. Under the qualitative method of demand fore-
casting, this is done by collecting the data of customers, their choic-
es, incomes, etc. by conducting surveys. For the quantitative meth-
od of demand forecasting, past data on consumption is also used to
forecast the future trends.
The appropriate method for forecasting is decided by the stage of a

product lifecycle. Criteria for selecting a good method are accuracy,
costs, reliability, availability of data, etc. Forecasting is not expect-
ed to provide absolutely correct results; hence more than one meth-
od is used to cross-check forecasts.
)
1. Why is demand forecasting important for managers?

2. What is the benefit of selecting a good method of demand fore-
casting?
(C
3. Explain the Hunch method.

4. What kind of forecasting model would you use before launching
a new shaving cream, a new airline and a spacecraft for Mars?
5. Explain all the forecasting models along with an example of
situations where you would use them.
6. The following data relate to the sales of a product over an eight-
month period:
67
Jan.. Feb. Mar. Apr. May. Jun. Jul. Aug.
Notes
ES
Sales (units) 56 72 70 65 68 75 66 67
Price ($) 75 65 59 69 69 49 59 59 ___________________
___________________
a. Investigate whether sales are affected more by the level of price
or by the change in the price of the product. ___________________
b. Interpret the regression c oefficient of the explanatory variable. ___________________
___________________
c. Draw an appropriate graph of the data and relationship.
___________________
d. Forecast sales in September if the price is $65.
___________________
___________________
___________________
) UP ___________________
(C
(C
) UP
ES
69
Unit 10 Notes
ES
___________________
Case Study: ___________________
The Finance Minister’s Dilemma ___________________
___________________
The FM of the country is a worried man these days. The Govern-
ment’s expenses on defense, salaries, pensions, subsidies are ex- ___________________
panding rapidly. With the existing tax revenue, the Central Gov-
___________________
ernment is finding it difficult to meet the burgeoning expenditure.
Due to the provisions of the Fiscal Responsibility and Budget Man- ___________________
agement Act (FRBM) Act, he is neither allowed to borrow much nor ___________________
is he allowed to create deficits. Concerned over this state of affairs,
he has set up a task force to suggest measures to increase govern- ___________________
ment revenue through taxation.
UP
The task force considered the issue in detail and finally shortlisted
three products; an excise duty on which could be the major source
___________________
of revenue to the Government. These three items are as follows.
● Textiles
● Computers
● Cars
On an average, these products have a before-tax price of Rs. 1000,

Rs. 20,000 and Rs.3,00,000, respectively. The existing tax rates on
the ad valorem basis are 20%, 10 %, and 25 %, respectively. The
units sold for these items are as follows.
● Apparels – 10 Crores p.a.
● Computers – 10 lakhs p.a.
● Cars – 2 lakhs p.a.

)
A study group appointed by the Task Force has estimated that if

the tax rates are uniformly raised by 10% across the board, the sale
of apparels, computers, and cars will decrease by 5, 10, and 20%, re-
spectively. The left parties, supporting the Government, want that
(C
the essential items such as apparels, should not be taxed; while the
luxuries items such as cars can be taxed heavily.
Questions
1. Find out the price elasticity of above-mentioned items.
2. How does an increased tax rate affect revenue generation in

the long run?
Contd....
70
3. Study the price elasticity of essential goods and correspond-
Notes
ES
ing curve for them.
___________________
4. What would you suggest the FM about increasing the tax
___________________ rates on these items?
___________________ 5. According to you which additional items can be taxed further
___________________ without having any impact on demand and revenue generat-
ed? Why?
___________________
___________________
___________________
___________________
___________________
___________________
) UP
(C
ES
UP
BLOCK–III
)
(C
Detailed Contents
ES
UNIT 11: SUPPLY ANALYSIS UNIT 14: COST ANALYSIS: II
UNIT 12: PRODUCTION CONCEPTS AND UNIT 15: CASE STUDY: BUYING
ANALYSIS VERSUS MAKING
UNIT 13: COST ANALYSIS

) UP
(C
73
Unit 11 Notes
ES
___________________
Supply Analysis ___________________
___________________
Objectives: ___________________
___________________
\\ Define supply and its principles
___________________
\\ Understand the law of supply
\\ Explain the concept of elasticity of supply ___________________
___________________
Concept of Supply ___________________

UP
Supply is defined as the total amount of products, goods or services
available in the market at any given price. It is related to the de-
mand for a good at a certain price; given that all else remain con-
___________________
stant. If the price increases, there will be more producers, as the

objective of a business is to make a profit. If the market has buyers
available, there will be producers willing to sell the product. Once
the supply increases, the prices will come down, provided that the
demand remains the same. In an ideal situation, the supply equals
demand.
Price
Supply
80
60
)
500 700 Qyantity

(C
According to the figure, when the price rises from 60 to 80

the quantity increases from 500 to 700.
Figure 11.1: Relationship between Supply and Quantity
Law of Supply
According to the Law of Supply, if the price of a commodity increas-
es, the supply also increases subsequently, keeping other things
74
constant. It further defines the relationship between demand, price,
Notes and quantity.
ES
___________________
Higher prices will lead to higher profits.
___________________
The above diagram shows the supply curve and the movement
___________________
along the same. The change in price results into the increase or
___________________ decrease in supply and this is called “Movement along the supply
___________________ curve.” In the Figure 11.2, the shift in curve shows the increase
and decrease in supply when other factors change and price re-
___________________
mains constant.
___________________
When we add all the individual supply curves, we get the market
___________________
supply curve.
___________________
Price
___________________
UP S3
Decrease in
Supply
S1
Increase in
Supply
S2
P1
Q3 Q1 Q2 Quantity
Figure 11.2: Source: Shifts in Supply Curve
When any factor other than price changes, one witnesses a shift in
the supply curve. A shift towards left indicates that with the decrease
in supply, the produces sell a smaller quantity at the same price.
)
Determinants of Supply
Cost of production: If the factors affecting the cost of production lead
to increase in prices, the supply will decrease; as the producers can’t
(C
afford to produce at the old prices. For example, the cost of building
a house also increases with the increase the cost of its raw materials
like bricks, cement, wood, etc.
● Natural disasters: Floods and other natural calamities re-

duce the supply.
● Taxes and Subsidies: Tax on a firm will increase the cost, as

its supply will decrease.
Unit 11: Supply Analysis
75
● Subsidies: Subsidies are the cash grants given by the govern-
ment to boost production of a certain sector. If subsidies are Notes
ES
provided, cost reduces and supply increases. ___________________
● New Technology: New technologies help to cut down costs for ___________________
the producers, and the prices decrease as well. ___________________
Elasticity of Supply ___________________
Elasticity of supply refers to “the degree of responsiveness of quan- ___________________
tity supplied to the change in price.” ___________________
It is measured as: ___________________
% Change in quality supplied ___________________

Es =
% change in price ___________________
Hence,
Es
= ∆Q Q = ∆Q ∆P × P Q
UP ___________________
∆ P P
Please refer to the following degrees of responsiveness.

Price Elasticity of Supply & Five Elasticity Alternatives of Supply Curve
Price Elasticity of Supply

& Five Elasticity Alternatives of Supply Curve
Price
Alternative Coefficient (E)

Perfectly Elastic E=∞
P0 S
Relatively Elastic 1<E<∞
Unit Elastic E=1
Relatively Inelastic 0<E<1 Quantity
Perfectly Inelastic E=0
Perfectly Elastic
Price
Price
S
S
)
Quantity Quantity
Relatively Elastic Unit Elastic
(C
S
S
Price
Price
Quantity Q0 Quantity
Relatively Inelastic Perfectly Inelastic
Figure 11.3: Types of Elasticity

76
Types of Elasticity of Supply
Notes
ES
Similar to the elasticity of demand, there are five types of elasticity
___________________
of supply.
___________________
● Perfectly Elastic: The elasticity of supply changes to infinity
___________________
but the price change is almost nil. An infinite quantity is sup-
___________________ plied at price P. But there will be no supply of this good, if the
___________________ price falls below this level, even if the fall is very small.
___________________ Price Firms can supply

amount at price P
___________________
___________________ Es = ∞
S1
___________________
___________________
UP Figure11.4: Perfectly Elastic Supply
Quantity
The figure 11.4 shows the supply curve parallel to the horizontal
axis. With the smallest change in price, there is an infinite change
in supply, and this phenomenon is called perfect elasticity.
● Relatively Elastic: The supply is relatively elastic when a

small change in price leads to a large change in quantity. In
other words, the percentage change in price is more than the
percentage change in quantity.
∆Q
Y > 1, because %∆Q > %∆P
∆P
S
) Price
P2
∆P
P1 Es > 1
(C
S
∆Q
X
O
Q1 Q2
Quabtity supplied
Figure 11.5: Relatively Elastic Supply
The figure 11.5 shows the increase in the price from P1 to P2

leads to increase in quantity, Q1 to Q2, thereby increases the
supply, S.
77
● Unit Elastic: When the percentage change in quantity sup-
plied is same as the percentage change in price, it results in a Notes
ES
straight line, starting at the origin, depicting unit elastic sup- ___________________
ply. This indicates that the product has close substitutes. ___________________
∆Q
Y > 1, because %∆Q > %∆P ___________________
∆P
___________________
S
___________________
___________________
Price
P2
∆P ___________________
P1 Es > 1
___________________
S
∆Q
___________________
X
O
UP Q1
Quabtity supplied
Figure 11.6: Unit Elastic Supply

Q2 ___________________
The figure 11.6 depicts that the change in quantity supplied is

same as the change in price.
● Relatively Inelastic: When the change in quantity supplied is

less than the change in price, it results in a relatively inelastic
supply curve. It depicts that a small change in price results in a
smaller change in quantity supplied.
∆Q
Y > 1, because %∆Q > %∆P
∆P
S
P2
Price
∆P Es > 1
)
P1
S ∆Q
O X
(C
Q1 Q2
Quabtity supplied
Figure 11.7: Relatively Inelastic Supply
The figure 11.7 depicts that the change in price is greater than
the change in quantity supplied.
● Perfectly Inelastic: When any change in price results in an

infinite change in supply, it is called perfectly inelastic supply.
78
No effect on supply
Notes
ES
S1 following a change
Price
in price
___________________
___________________
Es = 0
___________________
___________________
O Q Quantity
___________________
Figure 11.8: Perfectly Inelastic Supply
___________________
___________________
Factors Influencing the Elasticity of Supply
___________________
● Time factor: It is only in the long run that the supply is more
___________________ elastic. In the short run, it is somewhat elastic; because the re-
sources need to be reallocated and that takes time. In the long
___________________
UP run, it is more elastic; because the factors of production become
variable in nature. For example, a farmer may grow vegetables
on his land, but the rice fetches him a better price. So, he will
have to wait for the sowing season.
● Ability to store and process the product: If the warehous-

es are easily available, the supply is elastic and vice versa.
Agricultural produce requires proper warehousing, which is
not available in India. Hence, the prices of tomatoes increase
during rainy season as the farmers do not have proper ware-
houses. As a result, they seem to rot very quickly. Henceforth,
it becomes important for the farmers to raise the price of toma-
toes and incur the losses.
● Barriers to entry: If the entry is restricted for the new firms

into the market, the supply will be inelastic. For example, it is
not easy to setup a solar lamp manufacturing factory, as the
)
prices and competition from the Chinese solar lamps are al-
ready very tight.
● Nature of good: Availability of substitutes is the most import-

(C
ant factor because the production of a certain product takes

various kinds of resources. A company may want to shift to
producing organic foods, as there is an increasing demand for
them. However, the raw material required is scarce, as there
are few suppliers and the land needs to be left chemical-free
for 3 years to grow organic produce. Hence, there are no substi-
tutes.
79
Summary
Notes
ES
Supply refers to the quantity of a product in the market at any given ___________________
price.
___________________
According to the Law of Supply, the quantity supplied increase with ___________________
the increase in price and vice versa.
___________________
Other factors of production include time, cost of technology, new
___________________
technology, natural calamity and increase in taxes and subsidies.
___________________
Price Elasticity of Supply refers to the degree of responsiveness of
___________________
the change in quantity supplied to the change in price.
___________________
Different degrees of elasticity of supply include perfectly elastic,
___________________
perfectly inelastic, relatively elastic, relatively inelastic and unity
elasticity.
UP ___________________
1. Why does the supply curve slope upward?
2. Which are the different elasticity of supply? Explain them.
3. Imagine if you are the owner of a firm producing parts for AC

and cars. How would you allocate your resources around the
year?
4. How is the supply affected by production factors in the follow-

ing industries:
a. Semiconductor chips
b. Oil Drills
c. Cereals
)
(C
(C
) UP
ES
81
Unit 12 Notes
ES
___________________
Production Concepts and ___________________
Analysis ___________________
___________________
Objectives: ___________________
___________________
\\ Explain the concept of the production function
___________________
\\ Law of Variable Proportion
\\ Production Function with Two Variable Inputs ___________________
\\ Optimal Factor Combination ___________________

\\
\\
Expansion paths
UP
Importance of Production Function in Managerial Decision Making
___________________
Introduction
Production is the creation of utility as studied under Economics.
Various decisions need to be taken by a firm including how much
production should be done, what proportion of inputs are required
and how much resources need to be hired?
The least cost combination is followed as far the costs of production

are concerned.
Production Function
Production Function refers to the maximum output that can be ob-
tained from the given input.
)
The relationship between Labour (L), Capital (K) and Output (Q), is
as follows:
Q = f (L, K)
(C
Here, Q is the level of output or total product
L is labour
K is capital
The concept of Fixed and Variable Factor
There can be two categories of inputs.

82
(i) Fixed inputs: The input that cannot be varied in one quantity
Notes is known as a fixed input. This input includes the plant of the
ES
___________________ firm.
___________________ (ii) Variable inputs: The inputs that can be changed as and when
___________________ required are known as variable inputs. For example, labour is
a variable input.
___________________
___________________ The concept of Total Product (TP), Marginal Product (MP) and Av-
erage Product (AP)
___________________
___________________ Maximum TP can be obtained from different combinations of inputs

in different quantities, which is shown in the production function.
___________________
There are two concepts that are important:
___________________
● AP
___________________
UP
● MP
The AP is TP (Q) divided by input.
( TP)
AP =
( Amount of input to produce output )
MP is the extra units produced by increasing one extra input.
Here is the equation:
MP = TPn – TPn – 1
Here, MP is the marginal product
TPn is total product

)
TPn-1 is the extra unit produced of the total product
The following table and figure show the examples of calculating TP,
AP, and MP.
(C
Exhibit12.1: Effects of Output on Adding More inputs
Labour Total Marginal Average

input, L output, Q product, MP product, AP
0 0 –
13
1 13 13
14
Contd....
Unit 12: Production Concepts and Analysis
83
Labour Total Marginal Average
input, L output, Q product, MP product, AP Notes
ES
2 27 13.5 ___________________
13 ___________________
3 39 13
___________________
11
___________________
4 50 12.5
___________________
9
___________________
5 59 11.8
___________________
5
6 64 10.7 ___________________
2 ___________________
8
UP 66
64
–2
9.4
8
___________________
70
60
50
Total output, TP
40
30
20
10
0
0 2 4 6 8 10
Labour (number of workers)
15
10
AP
)
MP, AP
5
MP
0
(C
–5
0 2 4 6 8 10
Labour (number of workers)
Exhibit12.2: Total, Marginal, and Average Product
Here is the graphical representation of the relationship between AP,

TP, and MP.
84
Notes TP
ES
Q
___________________ C
B
___________________ TP
A
___________________
___________________
L1 L2 L3 L
___________________
___________________
MP
___________________ AP
Stage I Stage II Stage III

___________________
___________________
___________________
UP L1 L2 L3
Figure 12.3: Relationship between TP, AP, and MP

MP
AP
L
Law of Variable Proportion

If the inputs are more, the TP increases at an increased rate up to
the point of inflexion. Then ,the TP tends to increase at a decreasing
rate, as it reaches the maximum and declines eventually. The figure
12.4 shows the various stages of the Law of Variable Production.
Stages of Production
Following are the three primary stages of production.
Stage 1 – Increasing Returns

This is the stage where the Total Product increases at an increas-
)
ing rate, Marginal Product reaches its maximum, and the Average
Product becomes maximum.
Stage 2- Diminishing Returns

(C
The Total Product increases at a decreasing rate and reaches its

maximum point. Marginal Product falls and becomes zero. Average
product falls.
Stage 3-Negative Returns.

In Stage I and III, no firm will like to operate. In Stage I, still the
fixed factors need to be fully utilized and in Stage III, the nega-
tive returns exist. Profit maximizing producer will like to operate in
85
stage II, because the efficiency of workers is maximum at this stage,
along with the total product. Notes
ES
___________________
Y
H ___________________
___________________
Point of TP ___________________
Inflexion F
Stage Stage ___________________
Output
Stage
2 3
1 ___________________
S
___________________
___________________
AP
___________________
X
O N M
UP
Amount of a variable factor MP
Figure 12.4: Graph of Law of Variable Proportions
___________________
Y
H
Point of TP
Inflexion F
Stage Stage
Output
Stage
2 3
1
S
AP
X
O N M
Figure 12.4(a): Amount of a variable factor
)
Y
H
Point of
(C
TP
Inflexion F
Stage Stage
Output
Stage
2 3
1
S
AP
X
O N M
Figure 12.4(b): Amount of a variable factor
86
Production Function with Two Variable Inputs
Notes
ES
___________________
Isoquants
___________________ An isoquant uses various combinations of two inputs to show all the
possibilities of producing a level of an output.
___________________
___________________ Features of Isoquants:
___________________ The isoquant has the following properties.
___________________ ● The slope of all isoquants are downward towards the right.
___________________ ● It is convex to the origin and is continuous and smooth.
___________________
● These never intersect each other.
___________________
Iso-Cost Line: It shows the total expenditure or cost of the firm when
___________________
UP
only labour and capital is used by the firm.
C = wL + rK
where C = total cost
w = wage rate of labour
Optimal Factor Combination: A firm may maximize its output

and try to work out the combination of total inputs at least cost.
10
L3
8 L2
L1
Capital input (machines)
6
B
5 Q = 100
A
)
4
C
Q = 80
Q = 60
(C
C1 = 3,000 C2 = 4,000 C3 = 5,000
3 5 7.5 10 12.5
Labour input (workers)
Figure 12.5: Equilibrium in Long Run
At point E, the isoquant is tangent to the budget line, depicting the

firm being at equilibrium.
Expansion Paths: Another application of this analysis is to con-

sider the scenarios when the firm’s target output increases. The
87
nalysis also serves to express the situation in terms of its twofold,
a
when the firm’s capital increases. As the firm attains higher output Notes
ES
levels, the optimal combinations of inputs involved will trace an ex- ___________________
pansion path. ___________________
___________________
___________________
___________________
L1 L2 L3
___________________
Capital input (machines)
___________________
Expansion path ___________________

Z
___________________
Q = 100
X
UP
Y
Q = 80
Q = 60
___________________
C1 = 3,000 C2 = 4,000 C3 = 5,000
Labour input (workers)

Figure 12.6: Expansion Path
Importance of Production Function in Managerial

Decision Making
Following are two important principles of management:-
1. A manager can use its resources rationally.
2. The cost of each decision involving the allocation of scarce resourc-

es and the marginal benefits can be finalized by the manager.
)
Summary
Production is the creation of Utility. The short run is the time period
for which only one factor is variable. The long run is the time period
(C
in which no variable is constant, and all the inputs vary. According

to the Law of Variable Proportion, when the quantity of one fac-
tor is increased, keeping the others constant, the Marginal Product
increases at first and then eventually decreases. Then, it increas-
es at a decreasing rate until it reaches the maximum and declines
eventually. A firm is in equilibrium, wherein the isocost line and
isoquants are tangent to each other.
88
Notes
ES
___________________
1. What is the significance of the law of variable proportions?
___________________
2. What do you understand by isoquants?
___________________
3. Explain the importance of isocost line.
___________________
4. When does a firm attain equilibrium?
___________________
___________________
___________________
___________________
___________________
___________________
) UP
(C
89
Unit 13 Notes
ES
___________________
Cost Analysis ___________________
___________________
Objectives:
___________________
___________________
\\ Explain the meaning of cost and its types. Compare different cost con-
cepts ___________________
\\ Use cost in management decisions
___________________
___________________
Introduction
___________________
This chapter will focus on different cost concepts and decision-mak-
UP
ing for managers. Here, major differences between various cost con-
cepts will be made clear. Even the treatment of different costs by
economists and accountants will be seen in this chapter.
___________________
Types of Cost
Costs are of different types. Depending on how it is used in the mar-
ket, the cost can be categorized into explicit cost, implicit cost, fixed
cost, variable cost and opportunity cost. The types of costs are dis-
cussed as below with the help of examples.
Explicit Cost and Implicit Cost

The costs that occur as payments to those factors of production that
exist outside the firm are explicit costs. These are actual cash pay-
ments, for example, salaries, rent, etc.
Implicit costs are not actually paid. These are imputed expenses that
)
the owner himself has incurred for the business. For example, if the
manager runs his own business, he may forgo his salary. This cost is
not shown in the statement of accounts. For example: Salary to the
owner, rent of owner’s building, etc. which do not occur in reality.
(C
Fixed, Variable and Opportunity Costs

Money costs are those, which a producer incurs to purchase raw ma-
terials, labour, rent, etc. The cost incurred at the initial stage of an
organization is known as a fixed cost and the cost incurred at a par-
ticular frequency repeatedly is known as a variable cost.
Both fixed and variable costs are also referred to as accounting costs.
90
Opportunity cost, on the other hand, is known as the next best al-
Notes ternative forgone. For example, Mr. A has to choose between a cor-
ES
___________________ porate job and another job reasonably lower in salary close to his
___________________ native place. Selection of the lower salaried job is the opportunity
cost, the next best alternative.
___________________
___________________ Examples of fixed cost are rent, employee salaries, insurance, etc.
___________________ Examples of variable cost are sales commissions, direct labour costs,
___________________ etc.
___________________ Examples of opportunity cost is the cost of starting one’s own busi-
___________________ ness is the wages given up by working for another company.
___________________ Total cost is generally given by total fixed cost and total variable
cost. Opportunity costs are also called alternative costs.
___________________
UP
Controllable and Non-Controllable Cost
The costs, which are being regulated and controlled by executives
are called controllable costs. These are also used for the evaluation
of the efficiency of executives.
Example: Direct variable cost, wages, advertising and promotion
Non-controllable costs are those costs, which cannot be controlled

by executives.
Example: Rent, interest on a mortgage, real estate taxes
Past and Future Costs

The actual costs that have appeared in the past and are shown in
the inflow statements are called Past Costs. If these are more in
quantity, the management analyses, and searches for the possible
)
reasons.
Example: Wage bill, cost of raw materials

(C
Future costs are defined by the costs, which are anticipated in the
future times. These cannot be absolutely correct, as the future is
unpredictable. Example: Taking pre-advanced order for inventory
A manager needs to decide, how to plan out a reduction in the ex-

penses. Management should estimate the costs for various reasons,
such as control pricing, estimate profits for future and capital bud-
geting decisions.
Unit 13: Cost Analysis
91
Historical and Replacement Costs
Notes
ES
The actual cost incurred, when an asset is initially attained, is the
___________________
historical cost. Replacement cost will be incurred if that item is pur-
chased at present. ___________________
___________________
Example of historical cost: Cost of plant
___________________
Example of replacement cost: Cost of plant and equipment
___________________
Social and Private Costs ___________________
Private costs are also known as individual costs that incurred in ___________________
performing the day to day operations of the business. For example, ___________________
the cost incurred in transporting finished goods from the factory to
___________________
the consumer, packaging cost, advertising cost, etc.
UP
The society bears the social costs. These are external costs. For ex-
ample, if the waste is dumped in the river, the private cost is nil; but
the society has to pay for it; as it is not friendly for the society.
___________________
Relevant and Irrelevant Costs

Relevant costs, or incremental costs, are the costs that are incurred
in lieu of recent changes in technology, industry and other problems.
There are many types of relevant costs, and they include opportu-
nity costs, specific costs, avoidable fixed cost, incremental cost, etc.
Irrelevant costs are those that do not affect the final decision and
have to be incurred while various managerial alternatives are con-
sidered. Various examples of irrelevant costs can be fixed cost, his-
torical cost, sunk cost, committed cost, etc.
Sunk Costs and Additional or Incremental Costs

)
Sunk costs are the expenses, which are already spent or to be spent
in future, according to a contract. For example, the opportunity cost
of expenses for inventory, equipment, and rent is zero. Such costs
(C
are not relevant for economic decisions.
The incremental cost is the total marginal cost of executing a man-

agerial decision.
Any change in the existing process will result in an incremental cost.

Some of the reasons for the additional or incremental cost include
changes in technological advancements, changes in the output of a
product, changes in maintenance, etc.
92
Direct or Indirect Costs
Notes
ES
The costs that are directly incurred for the production purpose are
___________________
known as direct costs. For example, office and administrative ex-
___________________ penses constitute the direct costs.
___________________ Indirect costs are the costs which are not directly incurred for pro-
___________________ duction purpose. These are called overhead costs. The overheads
are variables, as these vary with output. Fixed overhead is one that
___________________
does not fluctuate with the output.
___________________
Total Cost (TC), Average Cost (AC) and Marginal Cost (MC)
___________________
TC is the value of total expenses incurred for a firm. The summation
___________________
of total fixed cost and the total variable cost is known as Total Cost.
___________________
___________________
UP 200
150 –
Unit cost (£)
100
– –
– –
50 –
+ – – + + ++
– – + +
0
0 10 20 30 40 50 60 70
Output (units)
– MC – ATC
+ AVC AFC
)
Figure 13.1: Short-Run Cost Curves
AC is the TC divided by total output (N).

For example,
(C
If TC =Rs. 8000 and N = 800,

Then, AC is Rs. 100.
The change in total cost when an additional unit is produced is
known as Marginal Cost.
For example,
If TC 100 units = Rs. 10,000,
93
TC of producing 101 units is Rs. 10,050 MC at N of 101 units = Rs.50.
Notes
ES
For example, a firm producing coolers will not be able to find out the ___________________
change in cost for 2 units. However, a change in cost can be deter-
___________________
mined by a significant size. Here, the increased cost is the addition-
al cost. ___________________
___________________
Profits are based on total costs, which are also useful in Break-Even
Point (BEP) analysis. If the manager faces any problem, the rele- ___________________
vant costs will be applicable. ___________________
Fixed Cost and Variable Cost ___________________
___________________
Fixed Costs are those costs which are incurred on fixed factors.
These costs do not change with the change in production. For e.g. ___________________
Electricity bill.
UP
Variable costs occur from the variable factors used in production and
change with the change in production.
___________________
TC
Total variable cost (TVC)
Total cost (TC)
x
TC*
b
F TFC
TVC*
O Q1 Q2 Q3
(a)
Output per unit
of time
) Short-run average variable cost (SRAVC)
Short-run average total cost (SRATC)
MC
SRATC
(C
SRAVC
Marginalcost (MC)
AFC
O Q1 Q2 Q3
(b) Output per unit

of time
Figure 13.2: Short Run Total Cost Curve Explanation of the first graph (a):
94
Short Run Total Cost Curve
Notes
ES
___________________ Short Run Total Cost Curves- helps the managerial decisions by
assisting in understanding trends and comprise of various short-run
___________________
curves such as Total cost curve, total variable cost curve, and total
___________________ fixed cost curve. Cost curves will help the managers to decide how
___________________ total variable costs if rising above a certain level, can be reduced.
___________________ In the short run, as the production will increase, the AFC or Aver-
___________________
age Fixed Cost, will diminish continuously since K is constant. The
shape of Average Variable Cost is determined initially by increasing
___________________
and then diminishing marginal returns to various inputs. (conven-
___________________ tionally labor).
___________________ Total Cost curve = Total variable cost curve + Total fixed cost curve
___________________
UP
The graph (a) demonstrates the total cost curve comprising of both
total variable cost curve and total fixed cost curve. Total variable
cost curve starts from the origin, and total cost curve starts where
total fixed cost starts. Total variable cost changes with the output.
Total fixed cost remains constant throughout and therefore is the
horizontal line parallel to the OX-axis.
Output Q
(units)
AP
MP
Stage I Stage II
Labour (workers)
Unit cost
(£) Increasing Diminishing MC
Returns Returns
ATC
AVC
)
AFC
(C
Q1 Q2 Q3 Output Q (units)
Cost TC
(£)
Inflection
points VC
FC
Output Q (units)
Figure 13.3: Relationship between Short-Run Cost Curves

and Production Function
95
The graph (b) shows Average cost curves. Average cost curves com-
prise of average fixed cost curve (AFC), average variable cost curve Notes
ES
(AVC) and average total cost curve(ATC). The average total cost ___________________
curve is the summation of the average variable cost curve and the ___________________
average fixed cost curve. The average total cost curve falls as the
___________________
total fixed cost curve remains the same when the output increases.
Average variable cost is U-shaped due to the law of variable propor- ___________________
tions. ___________________
___________________
With different output, the total cost varies directly.
___________________
Summary
___________________
● Cost is the expenditures incurred in the firm. ___________________
● Types of cost include:

UP
● Explicit cost-Remuneration to factors of production hired from
outside.
___________________
● Implicit cost: the owner of the business himself provides his

personal asset to the business, that value is the estimated cost
or implicit cost.
● Fixed Cost-Cost which do not change with production.
● Variable Cost- It is the cost which changes with production.
● Total cost: Sum of fixed and variable costs.
● Opportunity Costs: It is the next best alternative forgone to

choose the best option.
● Past Costs: Actual Costs which are incurred in the past are the
past costs.
● Future Costs: Future Costs are the anticipated costs.

)
● Historical Cost: Original cost of the asset.
● Replacement Cost: It is the present value of that asset.

(C
● Sunk cost: It is incurred initially as an investment.
● Incremental Costs: It is the total marginal cost of executing a

marginal decision.
● Direct Costs: These costs are incurred directly for the produc-
tion purpose.
● Indirect Costs: These costs are incurred indirectly for the pro-
duction purpose.
● Marginal Cost: The change in total cost to produce one addi-
tional unit.
ES
1. What do you understand by marginal costs and why are these
important?
2. What is the role of total cost in BEP analysis?
3. How does a manager find out the most suitable combination of

resources?
UP
)
(C
97
Unit 14 Notes
ES
___________________
Cost Analysis: II ___________________
___________________
Objectives:
___________________
Post completion of this unit, the learners will be able to demonstrate knowl-
edge of: ___________________
\\ Outlining the economies of scope ___________________
\\ Explanation of economies and diseconomies of scale
___________________
\\ List different types of costs in short run and long run
___________________
___________________
Introduction
UP
The focus of this chapter will be on the relationship between cost
and a producer’s output rate and how it will affect the decision as to
how much output has to be produced and at what price.
___________________
Different Types of Costs

Following are the different types of costs that occur in the short run
and long run.
Short Run Costs

The cost-output relationship in short-run relates to a fixed plant. It
shows the changes in cost over the output with the change in capac-
ity of plants.
Short-Run Total Cost and Output

Cost of fixed factors, such as factories, offices, capital equipment,
)
buildings, etc.is fixed.
Thus, the Total Cost (TC)=Total Fixed Cost (TFC) + Total Variable
Cost (TVC).
(C
The examples of fixed costs are depreciation, depreciation, inter-

est expense, property taxes, rent, salaries, etc. The examples of
variable costs includethe costs of raw material, hourly production,
sales commission, inventory, shipping cost, etc. which differ with
the output.
The law of variable proportions defines the shape of the total vari-
able cost curve.
98
Notes TVC = TC – TFC
ES
Y
Cost of production
___________________
TVC
___________________
___________________
O X
___________________ Output
Figure 14.1: Total Variable Cost

___________________
Curve
___________________
The total variable cost curve depicted in the above figure demonstrat-
___________________ esthe graphical relation amongst aquantity of the output produced
___________________ by a firm and its total cost of production. The shape of the curve
showsthat the marginal returns increase at lesserquantities of out-
___________________
put,whilethe marginal revenue reducesat higheroutput q uantities.
___________________
UP
Short-Run Average Costs and Output
Average Fixed Cost (AFC): To obtain AFC, the total fixed cost
needs to be divided by atotal number of units produced.
Therefore,
TFC
AFC =
Total Output
Here, the Total Fixed Cost (TFC) remains constant throughout,

but along with an increase in the output, the average fixed cost
is reduced as the cost of production is divided over more units of
output.
The shape of the AFC is somewhat similar to that of a rectangular

hyperbola.
)
Similarly,
Average Variable Cost (AVC) = Total Variable Cost (TVC)/Out-

put(Q) and
(C
Average Total Costs (ATC) = Total Cost (TC)/Output(Q)
ATC = AFC + AVC
Marginal Cost (MC): Marginal cost is defined as the increase in

total cost of production of one additional unit.
The mathematical formula for calculating marginal cost is:

Unit 14: Cost Analysis: II
99
Marginal Cost (MC) = Total Costn (TCn) – Total Costn–1(TCn–1)
Notes
ES
___________________
Unit
cost
___________________
___________________
ATC ___________________
___________________
MC = AVC
___________________
Q1 Output
___________________
Cost
TC ___________________
___________________
UP FC
___________________
Output
Figure 14.2: Short Run Cost Curves.
Figure 14.2 shows Average variable cost curve, average fixed cost
curve, Average total cost curve and Marginal cost curve. It shows the
relation between average cost curves and marginal cost curve. Margin-
al cost curve intersects AVC and ATC curves from their lowest points.
Costs in the Long Run

All factors tend to vary in the long run. So, it means that there is no
constant in the long run.
Long run total cost (LTC) is an increasing function of output. It de-

picts the minimum cost at which the specified output can be pro-
duced, keeping all inputs variable.
)
LTC is less than or equal to STC
LTC is never more than STC, at any given point.

(C
LTC= Long run total cost, STC = Short Run total cost
Long Run Cost Curve is from Short Run Cost Curves

Each minimum point of the short-run cost curve is tangent to the
long-run curve at that point. Here, by joining such points, we get
the long-run cost curve. Long-Run Average Cost (LAC) is downward
sloping,because of the economies of scale. Later, it is upward sloping
due to the diseconomies of scale.
100
Notes
ES
___________________
Average variable cost( AVC)

___________________ AVC MC AVC
Marginal cost (MC)

___________________
___________________ MC
___________________
___________________
___________________
___________________
Q1 X Q2 Output per unit
___________________ Figure 14.3: Long Run Production Decision
___________________
UP
The following figures show the difference in short-run and long-run
cost curves.
The figure 14.3 depicts the least cost combination in the long run.
The long-run average cost curve is tangent to the short run average
cost curves. The long-run marginal cost curve intersects the long
run average cost curve from its lowest point. When the cost is mini-
mum, the profits are maximized.
SRATC
MC SRATC
AFC SRAVC AVC
)
MC
(C
AFC
O Q1 X Q2 Output per unit
Figure 14.4: Short Run Production Decision

101
Figure 14.4 depicts the effect of a change in the output from Q1 to Q2
on marginal cost, average fixed cost, short-run average variable cost Notes
ES
and short-run average total cost. ___________________
___________________
Economies of Scale
___________________
Economies of scale refer to the reduction in the per unit cost of a
___________________
product with increased total output, keeping other factors fixed.
There are financial economies, technical economies, marketing econ- ___________________
omies of scale, etc. For example, it is obtained when the cost per unit ___________________
of output decreases with increasing scale as fixed costs are spread
___________________
out over more units of output.
___________________
Diseconomies of Scale ___________________
Diseconomies of scale refer to a situation in which the economies of

UP
scale no longer functions for a firm. In this case, a firm experiences
continued the decrease in costs and increased in output. As a result,
___________________
a firm sees an increase in marginal costs when output is increased.
Unit
cost
SAC1 SAC2 SAC3
U3 C
U2
A B
U1 LAC
Q1 Q2 Output
Figure 14.5: Long-Run Cost Curve in the absence of Economies of Scale

)
Economies of Scope
Economies of Scope refers to the reduced average total cost of pro-
(C
duction when the products are produced in a wide variety. This is

known as economies of scope.
Relationship of Price (Ar) with the Short-Run and

Long-Run Level of Profit to Cost Production Decision
The table below helps in understanding the trade-off between the
short run and the long run production decision.
102
Notes
ES
___________________
___________________ Increasing returns Decreasing returns

to scale to scale
___________________
___________________
SRAC9
___________________ LRMC
___________________ SRAC8
___________________ SRAC7
___________________ SRAC1 SRAC6

SRAC2
___________________ SRAC3 SRAC5
SRAC4
___________________
UP
O Q1 Output per unit
Minimum efficient scale (MES) of time
Figure 14.6: The Short-Run Production Decision
Condition Production Decision Profits

Price (AR) > ATC ● continue production in profit> ‘normal.’
the short run and long
run
Price (AR) = ATC ● continue production in profit = ‘normal.’
the short run and long
run
)
Price (AR) > AVC < ATC ● continue production in profit < ‘normal’ (losses
the short run are less than fixed costs)
● leave theindustry in
the long run
(C
Price (AR) = AVC ● make a loss equal to profit < ‘normal’ (losses
fixed costs whether equal to fixed costs)
producing or not
● leave theindustry in
the long run
Price (AR) < AVC ● stop production in the Profit < ‘normal’ (if the
short run firm produces in the
● leave theindustry in short run, losses are
the long run greater than fixed costs.
Therefore, cease to
produce.)
103
Summary
Notes
ES
● The chapter focuses on Short-Run Cost Curves and Long-run ___________________
cost curves.
___________________
● Short Run Cost Curves are Short Run Average Total Cost Curve, ___________________
Marginal Cost Curve and Short Run Variable Cost Curve
___________________
● Long Run Cost Curves are Long Run Average Total Cost Curve
___________________
and Long Run Marginal Cost Curve. The long-run average cost
___________________
curve is derived from the lowest points of all short-run cost
curves. ___________________
● Long Run Production decision is taken where the Long Run ___________________
Marginal Cost Curve cuts the Long Run Average Cost Curve, ___________________
i.e. at its lowest point
UP ___________________
1. Explain the various types of short-run costs?
2. Why is Long Term Cost Curve U-shaped?
3. What do you mean by economies of scale?
4. Last month Franklin sold 24,000 liters of Liquid Chocolate. The

variable costs were £2.70 per liter and each liter contributed
25% of its revenue to the fixed costs and profits. It was just
found that a new supplier would enable Franklin to both reduce
its cost by £0.40 per liter and to improve its quality. However, it
estimates that it will have to spend another £3,000 on advertis-
ing per month to inform customers of the improvement. Profits
from the last month were £10,000.
a. What is the previous month’s cost function?

)
b. What is the new cost function with the new supplier?
c. How many liters will Franklin have to sell to increase the

(C
profit by 20 percent, assuming the price is kept the same?
d. If Franklin can raise its price by 10%, what difference will

this make to the sales in the scenario given in question C?
(C
) UP
ES
105
Unit 15 Notes
ES
___________________
Case Study: ___________________
Buying Versus Making ___________________
___________________
Shiraz Ltd. has been involved in the business of manufacturing
___________________
of ball bearings for last eight years and has been producing only
a single variety of the ball bearing. With an initial sales level of ___________________
15,000 units per month, they have now risen their production to ___________________
appx. 80,000 units per month. All the raw materials were being
sourced locally,and the whole manufacturing process was carried ___________________
in-house only. ___________________
Now after well establishing their foothold in the market, the com-
UP
pany is planning to expand its operations and add different prod-
ucts to its portfolio. Presently, they are operating from their prem-
ises located at thecitycenter with an area of 55,00 sq. ft. but now
___________________
they are looking to add another 50,000 sq ft of space to handle their

expansion plans. But due to thescarcity of land in the city, the pric-
es have increased to almost double in last 3 years.
The production operations are handled by Mr. Shahbaz, Produc-

tion Head of Shiraz Ltd. His expertise has ensured that the pro-
duction has been increasing on year on year basis. But, there has
been one alarming trend regarding the quality complaints which
have risen up to 0.5% from an average of 0.2% since last two years.
Additionally, there has been high levels of dissatisfaction amongst
the workers regarding their workload as well as salary levels.
Due to thescarcity of workforce, Mr. Shahbaz is unable to take

any strict action against the workers who waste their work time
in socializing and wasteful activities, and the workers are taking
advantage of this fact. In order to keep up with the rising demand
)
and maintain the production levels, Mr. Shahbaz has to employ

workers on overtime. Asaresult, the overtime costs have risen by
threefold.
(C
The aggressive expansion plans of the management have given a

new headache to Mr. Mohan, the Operations Manager of the com-
pany. He is worried that at present the company is facing ashort-
age of workers, from where would he arrange for the new ones to
keep up with the expansion plans. He has sent a request to Mr.
S. Sharma, Director (Operations) to put the expansion plans on
hold and instead focus on improving and consolidating the exist-
ing setup.
Contd....
106
After considering the request, Mr. Sharma called a meeting of all
Notes
ES
the concerned department heads to try and find a solution to the
___________________ problem. In the meeting, the Marketing Manager expressed ex-
___________________ treme sentiments regarding the growth prospects of the compa-
ny. He held the opinion that as the country’s economy is booming,
___________________ the company should also take advantage of that and backed by
___________________ the brand image of the company should go ahead with expansion
plans. The Finance Manager said that expansion of operations
___________________ would help in reducing the costs through economies of scale and
___________________ give a further boost to the profits.
___________________ But, Mr. Mohan expressed his reservations regarding scarcity of

manpower, quality control,and production schedules. At this junc-
___________________ ture, the Marketing Manager discussed the possibility of Produc-
___________________ tion outsourcing. Here Mr. Shahbaz came up with his concerns
regarding the fact that the outside agencies are bound to charge
___________________
UP
more money, straining their profit margins and as well as possible
issues regarding delivery schedules.
Then Mr. Sharma asked the Purchase Manager, Mr. Rajesh to put
forth his views. He said that as the expansion plans would ensure
more business for the suppliers, suppliers would not hesitate and
they company should go ahead with expansion plans as with each
passing day there is apotential loss of business. Here the Finance
Manager came up with his inputs that the cost-benefit analysis
of buying against in-house production shall be done to arrive at a
decision.
After careful deliberation, Mr. Sharma asked Mr. Shahbaz to work

around the future sales projections given by the marketing depart-
ment and work out the cost of production accordingly. HE asked
the purchase manager, Mr. Rajesh to gather the purchase cost of
few key components of the ball bearings with newly increased or-
der quantities.
Later, Mr. Sharma called a review meeting and there Mr. Mo-
)
han,and Mr. Naresh who have collected the necessary data were
asked to present the compiled data.
Firstly, Mr. Suresh (Marketing Head) put forth his sales forecast
wherein he put the future sales estimates at following figures:
(C
1st Year 2nd Year 3rd Year 4th Year 5th Year
300,000 500,000 700,000 900,000 1,000,000
Secondly, Mr. Mohan came up with his report and stated the
following facts:
– A Supervisor at a monthly salary of Rs. 8,000/- and an annual

increment rate of 10%
Contd....
Unit 15: Case Study:
107
– Cost of worker remuneration to be pegged at Rs. 4 per Unit,
Notes
ES
thereafter a 10% reduction in the second year, no change in
the third year and an annual increase of 10% for subsequent ___________________
years.
___________________
– Cost of material to be pegged at Rs. 14/- per unit with anan-
___________________
nual increment rate of 10%
___________________
– Cost of fuel and Power at Rs. 2/- per unit with yearly increase
of 10% ___________________
– Cost of indirectlabor at 50% that of fixed labor. ___________________
___________________
– Purchase of new machinery worth Rs. 60 Lakhs and produc-
tion life of 5 years ___________________
Lastly, Mr. Rajesh came up with the following data: ___________________

UP
– Components from the supplier at a price of Rs. 22 for initial
two years with an annual increment rate of 10% subsequent-
ly.
___________________
– Cost of transportation at Rs. 2 Per unit initially and thereaf-

ter an enhancement of Rs. 0.20 for every year
– Cost of inventory will be fixed at 5% of the material cost.
1. On the basis of above data, what is more, economical for Shi-
raz Ltd. – In-House Production or Outsourcing Manufactur-
ing
2. Are there any other factors that Shiraz Ltd should look for
while taking a decision?
)
(C
(C
) UP
ES
ES
UP
BLOCK–IV
)
(C
Detailed Contents
ES
UNIT 16: MONOPOLY MARKET UNIT 19: PRICING METHODS
AND STRATEGY
UNIT 17: IMPERFECT COMPETITON:

MONOPOLISTIC AND OLIGOPOLY UNIT 20: CASE STUDY: PRICES
SLASHED DOWN FOR MEDICINES
UNIT 18: NATURE AND MEASUREMENT

OF PROFIT
) UP
(C
111
Unit 16 Notes
ES
___________________
Monopoly Market ___________________
___________________
Objectives:
___________________
Post completion of this unit, learners shall be capable of:
___________________
\\ Elucidateon the notion of monopoly
\\ Classify the equilibrium monopoly ___________________
\\ Comparisonamidst the concept ofmonopoly and perfect competition ___________________

\\ Summarise the equilibrium of a firm
___________________
\\ Categorise the discriminating monopoly
___________________
Monopoly: Introduction
UP
In a monopoly market, one seller has the complete control over th
___________________
supply of goods. There is no competition in the monopoly market. We

rarely come across a situation of pure monopoly in real-life except in
the case of government monopolies.
Features of Monopoly
Following are the prominent features of a monopoly market.
● Single Seller: The monopolist is the only person who is selling
goods in the market.
● Price Maker: A monopolist decides the price in the market.
Therefore he is called price maker.
● Profit Maximisation: The monopolist focuses on his aim of mak-
ing maximum profits.
)
● Firm and Industry: As far as the market competition is con-

cerned, there exists no difference between the two. Both are
the same in a monopoly. A monopoly firm has a falling demand
curve.
(C
There are certain conditions that define a monopoly market, major

ones being lack of any substitutes and restrictions on entry and
exit.
Barriers to Entry and Exit

There are two kinds of barriers; structural barriers and the strategic
barriers.
112
Structural barriers: These are natural barriers occurs due to out-
Notes side forces like market prices for raw material supplies, the consum-
ES
___________________ er demand for the finished products, government regulation, etc.
___________________ Strategic Barriers: Monopolists may often apply strategies to de-
___________________ ter other entrants to enter the market. These types of strategies are
known as strategic barriers for the potential entrants. These may
___________________
result in likely change for the market as well. Some of these strate-
___________________
gies may be unethical.
___________________
Equilibrium in Monopoly
___________________
Consider if we describe the market as follows.
___________________
Demand: Q = 16 – 20P,where, P is Price
___________________
Marginal cost: MC = 0:44 + 0:04Q, Where Q is quantity
___________________
UP

Total cost: TC = 0:08 + 0.44Q + 0:02Q2
P = 0.8 - 0.05Q
Revenue: R = PQ = (0.8 – 0.05Q) Q = 0.8Q – 0.05 Q2
Marginal Revenue: MR = 0.8 – 0.1Q
The equilibrium in monopoly can be expressed by the following

graph.
Price
MC
AC
PM
AC1
)
MR D = AR
(C
QM Quantity
Figure 16.1: Equilibrium in Monopoly
In Figure 16.1, AR denotes the demand curve,and MR depicts the

marginal revenue curve of a monopolist. AC is the average cost cur-
ve,and MC is the marginal cost curve. Equilibrium is achieved at
the point where MR and MC meet. At this point, the monopolist
produces output quantity Q and suppliers the same.
Unit 16: Monopoly Market
113
In case of equilibrium;
Notes
ES
MC = MR
___________________
0.44 + 0.04Q = 0.8- 0.1Q
___________________
0.14 Q = 0.36
___________________
Q = 2.57143
___________________
Hence, P = 0.67 ___________________
Here, the price is higher, and the output is lower, compared to the ___________________
perfect competition. This comparison will be developed further in
___________________
subsection.
___________________
Comparison between Monopoly and Perfect Competition ___________________

UP
There are four factors that can be compared here: price, output, prof-
it,and efficiency. It is helpful for analysis if both forms of a market
structure are shown on the same graph, as in Figure 16.2. This gives
___________________
us a long-run perspective. For the sake of simplicity, it is assumed

that long-run marginal costs are constant.
A
Price
PM B C
D E F LMC = LAC
PC
)
MR
D = AR
QM QC Quantity
(C
Figure 16.2: Comparison of Monopoly and Perfect Competition
Figure 16.2 depicts the relationship between price and quantity in a

monopoly and perfect competition. With an increase in price, there
is an increase in the quantity. It shows that long-run marginal costs
are constant and are equivalent to long-run average cost. As demand
is equal to average revenue, Marginal revenue curve and demand
curve are linear and negatively sloped.
114
This indicates that there are constant returns to scale so that LMC
Notes and LAC are equal. PM and QM represent the price and the output
ES
___________________ of the monopolist. PC and QC represent the price and the total
___________________ output of the industry in perfect competition (PC).
___________________ The factors listed above can now be examined in turn.

___________________
a. Price: In a monopoly, the price is generally higher than in
___________________ perfect competition.
___________________
b. Output: In a monopoly, the output is lesser than in perfect
___________________ competition.
___________________
c. Profit: Although it might not always be the case, in a Monopoly,
___________________ there is still an element of super normal profit represented by
the rectangle BCED. But in Perfect Competition, only normal
___________________
UP profits can be made as the price,and long-run average cost are
equal.
Equilibrium of a Firm
We assume that there is a monopoly firm and there is perfect
competition among buyers. Also, there are no close substitutes,and
the goal is to maximize profits. It is the ideal condition when a
customer derives maximum satisfaction. The equilibrium of the firm
can be understanding terms of marginal cost and revenue in short-
term and marginal cost and revenue in the long-term.
Now, let us first understand the concept of short-term marginal

revenue and its relationship with average revenue.
Short Run Equilibrium

As the price of a commodity changes, the revenue from it also
)
changes in the market. There are average revenue and marginal

revenue that are different from each other. Average Revenue curve
is the demand curve, which also depicts price.
(C
The equilibrium conditions are MR = MC.
There may either be excess profits and normal profits. Some time
sin the short run, there may be losses as well. In the figure 16.3, the
equilibrium is found at point E, where marginal revenue curve and
short-term marginal cost curve intersects. The short-term average
cost curve intersects the average revenue curve at point R, where
the price is marked P for output, M.
115
Y Notes
ES
SMC
___________________
COST / REVENUE
R SAC ___________________
P
___________________
E ___________________
AR
MR ___________________
M X
O OUTPUT
___________________
Figure 16.3: Normal Profits in Monopoly
___________________
___________________
At point E, MC = MR and at point R, AR = AC.
___________________
There is no loss no profit situation.
Long Run Equilibrium

UP
Long run equilibrium of a monopolist firm is shown in the figure16.5
___________________
at point E. It shows the relationship between cost and revenue

and output. When the price increases from T to P the firm earns
an economic profit. It is shown as shaded in the figure. The shaded
portion PQRT shows the abnormal profits; a monopolist firm can
earn during along run.
Price MC
AC
G
H
Loss
P2 F
E
)
AR
O Q2 Quantity
MR
(C
Figure 16.4: Losses in Monopoly
The given figure 16.4 shows that at point E, the firm attains
equilibrium. The firm must bear a loss shown by the area HPGF.
After understanding the equilibrium of a firm in the short-

run and long-run, we will study about the discriminating
monopoly.
116
Y Economic
Notes
ES
Profit LMC LAC
SMC
___________________
COST & REVENUE

Q SAC
___________________ P
T H
___________________
E
___________________ AR
___________________ MR
X
O L
___________________ Output
___________________ Figure 16.5: Long Run Equilibrium of a Monopolist Firm
___________________
___________________
Discriminating Monopoly
When a monopolist charges different prices from different custom-
___________________
UP
ers for the same product at the same time, it is known as monopo-
listic firm.
Types/Methods of Price Discrimination

The strategy of a monopolist makes it adopt various methods of
price discrimination. They are as follows.
1. Discrimination according to markets: A commodity can be

sold at higher prices in retail markets and at lower prices in
wholesale markets.
2. Discrimination according to income: A financial agent can

charge higher fees from a big businessman.
3. Discrimination according to time: The prices may vary

based on the demand at the time. For example, at the night
time,the rickshaws often charge a higher fare than at the day-
)
time.
4. Discrimination according to national boundaries: A mo-

nopolist may involve in ‘dumping,’ that is, charging lower price
(C
across boundaries. It can be temporary or persistent.
5. Discrimination according to utility: The prices may vary

based on the number of utilities offered. For example, the first-
class fares in an airplane are higher than the second class, as
the first-class passengers enjoy more comforts.
6. Discrimination according to places: The prices of certain

products or service vary from place to place, depending on their
117
availability at the location. For example, as compared to other
places and shops in India, the cost of specific items, such as pet Notes
ES
bottles, cold drinks, ice cream, biscuits, etc. are higher at the ___________________
railway stations in India. ___________________
7. Discrimination according to uses: Discrimination of price ___________________

helps a monopolist in maximizing the profits. For example, elec-
___________________
tricity charges for domestic use are higher then the industrial use.
___________________
Summary ___________________
Monopoly is different from Perfect Competition. ___________________
___________________
● In a monopoly, there are many buyers in the market compared
to only one seller, whereas in a Perfect Competition there are ___________________
many buyers and sellers.
UP
● A monopolist is the price maker,and in perfect competition, the
sellers are the price takers. Perfect competition is an ideal mar-
___________________
ket and does not exist whereas monopoly market is a part of the
imperfect competition which exists. Output is lesser, and prices
are high in a monopoly market usually. In perfect competition,
this is not the case. In a monopolistic market, there are restric-
tions on entry and exit for firms whereas in a perfect competi-
tion there are no restrictions on entry and exit.
● There are strategic and structural barriers to entry in a monop-

oly.
● Price discrimination in the monopoly is a common feature. Dis-
crimination can be according to markets, time, income, national
boundaries, utility, places,and uses.
)
1. Clarifyregarding the diverse aspects of a monopoly.
2. Give examples of discriminating monopoly.

(C
3. Discuss the conditions of profit maximization.

(C
) UP
ES
119
Unit 17 Notes
ES
___________________
Imperfect Competiton: ___________________
Monopolistic and Oligopoly ___________________
___________________
Objectives: ___________________
___________________
\\ Define the meaning and features of a monopolistic competition
___________________
\\ Define the meaning of Oligopoly
\\ List down the differences between different types of imperfect markets ___________________
___________________
Monopolistic Competition
UP
Monopolistic competition is the market, of which there are too
many independent firms supplying differentiated products. The
___________________
products are being sold by different organizations in the form of

various brands. Burger King and McDonald are one of the most
common examples of monopolistic competition, as both are fast
food companies.
Features of Monopolistic Competition

Monopolistic competition displays the following prominent features:
● A fairly large number of buyers and sellers operate in the mar-

ket.
● The firm is the price taker.
● Due to minimal barriers, the entry and exit of the firms are
)
relatively free.
● Every firm manufactures relatively differentiated products.

(C
● All firms have almost same demand and cost function.
The figure 17.1 shows short-run equilibrium and long-run equilibri-

um of an organization in monopolistic competition.
120
Notes
ES
Price
___________________ MC
___________________ PM AC
___________________ AC1
___________________
D = AR
___________________
MR
___________________ QM Quantity
___________________ Short-run equilibrium for firms in monopolistic competition.
___________________
Price
LMC
___________________
___________________
UP PM LAC
D = AR
MR
QM Quantity
Long-run equilibrium for firms in monopolistic competition.
Figure 17.1: Equilibrium of a monopolistic firm in the

long run and short run
The figure 17.1 has two graphs. The first one shows the abnormal
profits under monopolistic competition in the short run, which is
again shown in the diagram 17.2. Abnormal profits are there when
the average revenue is greater than the average cost. The second
graph shows long-run equilibrium of a monopolistic firm in which
the firm has normal profits. Normal profits occur when the Average
Cost curve is tangent to the Average Revenue Curve.
)
In this figure, two graphs are shown. The first graph shows that the
firm is having abnormal profits because average revenue is higher than
the average cost. The second graph shows that the monopolistic firm
(C
incurs losses when the average cost is more than the average revenue.
Figure 17.3 shows the long-run equilibrium with monopolistic com-

petition, wherein the competition leads to are duction in profits, as
the demand shifts. It shows the relationship between price, cost,and
output produced. It shows marginal revenue and average revenue
as a linear negative sloping curve as price decreases and output pro-
duced increases.
Unit 17: Imperfect Competiton: Monopolistic and Oligopoly
121
a. A monopolistically competitive firm earning b. A monopolistically competitive firm sufferring
short-run profits short-run losses Notes
ES
Profit = $2,000 Marginal cost ___________________
Marginal cost
Losses = $1,000
Average total cost
___________________
Average total cost
A A
___________________
Dollars ($)
Dollars ($)
P0 = $6 ATC = $6
B C
ATC = $5 P1 = $5
C B
___________________
Demand Demand
Marginal revenue ___________________
Marginal revenue
O
q = 2,000
O q = 1,000 ___________________
Units of output Units of output
___________________
Figure 17.2: Short Run Equilibrium of a Monopolistic Competition
___________________
___________________
Long Run Equilibrium with Monopolistic Competition
Price,
Cost
UP
Profits are competed away as demand shifts inwards to AR2
___________________
MC
P2
AR2
MR2
Q2 Output
Figure 17.3: Equilibrium in Monopolistic Competition
Comparison with Perfect Competition and Monopoly

There are four areas where monopolistic firms can be compared with
others.
)
a. Price: In monopolistic competition,prices are generally higher

as compared to the perfect competition and is above the mini-
mum level of average cost, in both short run and the long run.
(C
b. Output: The output tends to be higher in perfect competition

since in a monopoly, firms operate at less than optimal capac-
ity.
c. Productive efficiency: This is lower than in perfect competi-

tion, for the same reasons provided for the output comparison.
d. Allocative efficiency: There is still a net welfare loss, because

of Price> Marginal Cost.
122
It is important to discuss here that when no supernormal profit is
Notes earned by firms in the long run, then there shows no efficiency in the
ES
___________________ productivity. It is neither very profitable. Therefore experts criticise
___________________ this marketing function of firms.
___________________
Oligopoly Market
___________________
An Oligopoly market is a situation, wherein there are few sellers
___________________
and alarge number of buyers, and there is a stiff competition among
___________________ the sellers.
___________________
Example: The automobile industry is a perfect example of Oligopoly
___________________ with a few manufacturers dominating the market in a particular
___________________ country. In the United States, auto market is dominated by compa-
nies such as Ford (F), GMC, and Chrysler.
___________________
UP
Characteristics of Oligopoly Market
1. Few sellers: There are very few sellers in the market. There-
fore, there exists a stiff competition amongst the sellers, for
example, guns and weapons.
2. Homogeneous and differentiated products: Products in

the oligopoly market are homogenous yet differentiated. For
example, there are different brands of soaps in the market such
as Dettol, Lux, Pears, etc.
3. Barriers to entry: As there are only a few sellers in the mar-

ket selling homogenous products, there are barriers to entry in
the form of licensing requirements,etc. for example, a manufac-
turer of guns and weapons.
4. Mutual interdependence: The decisions of every firm are de-

pendent on the rival firm’s decisions, for example, telecommu-
)
nication products.
5. Selling cost: Selling cost is highin the oligopoly market, as

every firm wants to have the edge over the other firm. For ex-
(C
ample, amanufacturer of premium cars, such as Aston Martin,

Bentley.
An Oligopolistfaces a kinked-demand curve due to intense competi-

tion from other Oligopolistsin the market. This implies that when a
seller in an oligopoly increases its selling prices above the equilib-
rium price, then it can be assumed that other sellers will not follow
suit.
123
Kinked Demand Curve
Notes
ES
As the demand curve is dependent on the behavior of rival firms, it ___________________
tends to be kinked and uncertain.
___________________
___________________
A MC2 ___________________
MC
B ___________________
MC1
___________________
Q
___________________
___________________
R ___________________
S C
UP
Figure 17.4: Kinked Demand Curve
Q ___________________
In case of the kinked demand curve, the price and output of an oli-
gopoly firm are stable. With constant price and output, the cost of
the oligopoly firm changes. This results in a change in movement
in the marginal cost curve, without affecting the firm’s output and
price.
The main feature of oligopoly is that the interdependence of firms

is highlighted in the market. The major contribution of oligopoly is
that the market demand curve each oligopolistic faces is determined
by the output and price decision of the other firms in the oligopoly.
One of the major criticisms that the kinked model faces is that the
theory fails to explain how the oligopolist can find the kinked point
in its market.
)
Cartels
In an oligopolistic market, collusion happens often amongst firms as
a part of cooperative behavior. It may be explicit or implicit.
(C
Explicit collusion generally includes the firms making a cartel. This

is a kind of agreement between firms, to control the prices, total in-
dustry output, market shares or the distribution of profits. It may
be of formal or informal nature. Though such kind of agreements
are not legalized in developed countries; they are still practiced
by many firms on an informal basis. It is because the existence of
such agreements is difficult to find out and prove. In some coun-
124
tries, cartels are invigorated and protected by governments, for
Notes example, the various agricultural marketing boards in the UK and
ES
___________________ in other countries. There are also producers’ associations in the
___________________ service sector, for example, representing taxi drivers, who have the
legal right to control entry into the industry; at least in a domestic
___________________
market. On the global scale, the best-known example of a cartel is
___________________ OPEC, the Organization of Petroleum Exporting Countries. OPEC
___________________ has been in existence for decades but with a mixed success rate for
its members.
___________________
___________________
___________________ Price
___________________
___________________
UP P2 = 220
LMC
P1 = 40
= LAC
MR
Q2 = 90 Q1 = 180 Quantity
Figure 17.5: Effects of a Cartel
Figure 17.5 shows the MR and the AR curve as two negatively

sloped linear curves. It shows an increase in the price as quantity
increases. When price P2 is 220 the quantity, Q2 is 90. When price P1
is 40 the quantity, Q1 is 180. A linear curve moving constantly from
P1 shows LMC is equal to LAC.
Factors Affecting the Success of a Cartel

)
The important factors affecting the success of a cartel are as follows.
1. A total number of sellers: If the number of sellers increases,

it is probable that individual firms might not consider the ef-
(C
fects of their pricing and the output on other competitive firms;

since the number will be smaller. If there are a significant num-
ber of firms operating in the market, a reasonable increase in
a firm’s output is not going to affect the industry price consid-
erably. Additionally, more is the number of firms in the mar-
ket, more likely they are to have arguments and disagreements
about pricing and production strategy as they would want to
function with more independence.
125
2. Product differentiation: If the firms are producing homoge-
neous products, then cooperation becomes easier. It is because Notes
ES
in this case, they can only compete in terms of price. With ___________________
differentiated products, the competition is likely to occur over ___________________
a whole product line of similar characteristics. Even with a
___________________
product such as crude oil, there is no complete homogeneity.
Here, there are different grades according to the country of ___________________
origin, as the sellers can also vary with payment terms and ___________________
conditions.
___________________
3. Cost structures: There is another angle to discuss the issue. ___________________

In Capital Intensive industries, co-operation is difficult as fixed
___________________
costs comprise a significant proportion of total cost. This is be-
cause, if firms are not utilizing the total capacity, it is possi- ___________________
cost-cutting.
UP
ble to increase profits considerably, by increasing output and
4. Transparency: If the market is transparent, it will not be pos-

___________________
sible for a firm to undercut its competitors covertly. Cartels

may,therefore, take steps to publicise information regarding
the transactions of members, to prevent them from conduct-
ing secret negotiations. As many of the above characteristics
might not be favorable, many cartels have proved to be un-
stable in practice, and have stayed only for short run. Some
cartels in Europe that have in the past enjoyed the govern-
ment protection, for example, the coal and steel industries, are
now also in trouble. Recent pressures related to competition in
the so-called single market have undone much of this valued
protection.
Different Types of Imperfect Markets and Oligopoly

)
The difference between four types of markets is given below. These

differences are the basis of various parameters that can be present-
ed in a tabular form.
(C
Kind of Number of Part of Degree of Methods

Competition Producers Economy Control of
and Degree Where over Price Marketing
of Product Prevalent
Differentiation
Perfect Many producers, A few None Market

competition Identical products agricultural exchange or
industries auction
Contd....
126
Kind of Number of Part of Degree of Methods
Notes Competition Producers Economy Control of
ES
and Degree Where over Price Marketing
___________________ of Product Prevalent
Differentiation
___________________
Imperfect Many producers, Toothpastes, Some Advertising and
competition Many real Retail trade, quality rivalry,
___________________
May or Fancied Conglomerates Administered
differentiated differences in prices
___________________
sellers product
___________________ Oligopoly Few producers, Steel, Some Advertising and
Little or no Aluminum quality rivalry,
___________________ difference in Administered
product. Autos, prices.
Machinery
___________________ Few producers
Some
___________________ differentiation of
products.
___________________
Complete Single producers, A few utilities Considerable Promotional
___________________
UP
monopoly Unique product
without close
Substitutes
and
Institutional
public-relations
advertising
Table 17.1: Difference between Four Types of Markets
Summary
Monopolistic Competition is defined by the presence of many firms
selling differentiated products. There fore slope of the demand
curve for individual firms is negative. In Perfect Competition price,
a vast variety of substitutes is available for consumers as there is
free entry and exit from the market, as such the Price Elasticity
is high.
1. Explain the equilibrium under monopoly.
)
2. When do we get abnormal profits under monopolistic competi-

tion in the short run?
3. How is perfect competition different from a monopoly?

(C
4. What are the characteristics of an oligopoly market?
5. How is monopolistic market different from oligopoly?
6. Discuss the importance of cartels for developing countries.

127
Unit 18 Notes
ES
___________________
Nature and Measurement ___________________
of Profit ___________________
___________________
Objectives: ___________________
___________________
\\ Define gross profit and net profit
___________________
\\ List down the theories of profit
\\ List the methods of depreciation ___________________
\\ Identify the effect of the choice of depreciation method on profit ___________________
Profit
UP
According to Walker, “Profit is the rent of ability.”
___________________
Profit is the essence of business. Profit is the amount that one indi-
vidual earns after covering his/her costs.
Profit is defined as the excess of revenue over cost. Cost is the gross
profit from the economic view point.
If all the expenses are deducted from gross profit, what remains is
called the net profit. These expenses include the imputed expenses
spent by the entrepreneur.
Theories of Profit
1. Theory of Entrepreneurial Compensation: This theory is based
on the hypothesis that an entrepreneur is an essential parame-
ter of production. He takes a lot of paintoen sure the success of
)
his enterprise. Profit can be regarded as a reward for the labor

and sacrifice of an entrepreneur.
(C
This theory does not hold well these days. Nowadays,the man-
agement is a separate part of an enterprise,and all functions
are performed by the management. A certain amount is paid as
salary to management, as it has nothing to do with a profit of
the enterprise.
2. Theory of Risk and Uncertainty: There is an atmosphere of

risk and uncertainty in every industrial enterprise. For bear-
ing these risk and uncertainties, an entrepreneur should get
128
a reward. According to the given theory, such reward is called
Notes profit. In this case, such reward acts as a force behind the en-
ES
___________________ trepreneur.
___________________ 3. Theory of Innovation: Innovation refers to all those activi-
___________________ ties, which are performed by an entrepreneur while keeping
the costs in mind. Such activities are performed to improve
___________________
the quality of production, to present the product in a different
___________________
form, to improve the selling and distribution efforts, among
___________________ others.
___________________ This process of innovation should continue forever to win over
___________________ the competition every time and, to maintain the profit position
of an enterprise.
___________________
4. Theory of Monopoly and Market Imperfections: As per this the-

___________________
UP ory, an entrepreneur can get profit only under the situation of
monopoly and market imperfections. An entrepreneur can earn
a profit by controlling the supply of his product, by getting the
advantage of the ignorance of consumers and by fixing relative-
ly high price for his product.
Depreciation
Every business enterprise has fixed assets. The useful life of such
fixed assets is limited. Therefore, it becomes necessary to provide
for depreciation, on fixed assets of the business and industrial en-
terprise.
Depreciation means a fall in the value of fixed assets. This fall may
be caused either by their continuous use, by obsolescence, by a
change in their market price or by accident. The book value of fixed
assets decreases because of depreciation. It also affects profit as de-
)
preciation is a charge against profit of the enterprise.
Methods of Depreciation
Some relevant methods of providing depreciation are as follows.
(C
1. Fixed Installment Method or Straight-Line Method: This meth-

od of depreciation is based on the costs. In this method, the
cost of a fixed asset should be apportioned based on its useful
life equally. Here, the scrap value of the fixed asset is subtract-
ed from its real cost and the balance amount is divided by its
useful life. The amount so calculated is the amount of annual
depreciation of the fixed asset.
Unit 18: Nature and Measurement of Profit
129
Scrap Value
Annual Depreciation = Original Cost – Notes
ES
Estimated Service Life in Years
___________________
2. Diminishing Balance Method: Under this Method of de- ___________________
preciation, the amount of depreciation continuously reduces.
___________________
Under this method the depreciation is charged on the Written
Down Value (WDV) of a fixed asset. Therefore the depreciation ___________________
amount reduces every year along with the reduction in value of ___________________
an asset. A fixed rate of depreciation is determined under this
___________________
method,and the rate remains the same for all subsequent years.
The following formula is used for is the calculation of the rate ___________________
of depreciation: ___________________
r = 100*(1-N√s/c) ___________________
Where;
r = Rate of depreciation,
UP ___________________
S = Scrap value of thefixed asset,

C = Original cost of Fixed Assets,
N = Estimated life of Fixed Asset.
This method is suitable for the fixed assets that require heavy
amount of repairs and maintenance every year, for example, ma-
chines, vehicles, etc.
3. Sum of the years’ digit method: This method is similar to

the diminishing balance method. In this method, the number
starts depleting every year. The depreciated amount is calcu-
lated by the following process:
(i) The effective life of thefixed asset is determined.

)
(ii) Estimated life of thefixed asset is written in inverse order.

For example, in case the estimated useful life of 5 years,
the values of 5,4,3,2 and 1will be used as anumerator to
(C
calculate depreciation for a year.
(iii) Estimated life of fixed asset written in inverse order is

added.
(iv) Scrap value of the fixed asset is subtracted from its orig-
inal cost. The balance amount is multiplied by depreci-
ation ratio. The amount so calculated is the amount of
annual depreciation on a fixed asset.
130
Effect of Choice of Depreciation Method on Profit
Notes
ES
Since depreciation is a charge on profit of an enterprise; this amount
___________________
also affects the amount of profit significantly. If one follows the fixed
___________________ installment method, the rate and amount of depreciation remain
___________________ unchanged in all the years where as if one follows the diminishing
balance method and the sum of years’ digits method, the amount of
___________________
depreciation reduces every year along with the value of the asset. As
___________________ a result, profit will increase year after year.
___________________
Summary
___________________
___________________ Profit is the rent of ability.
___________________ Theories of Profit include Theory of Entrepreneurial Compensation,

Theory or Risk,and Uncertainty, Theory of Innovation, Theory of
___________________
UP
Monopoly and Market Imperfection.
Reduction in the value of fixed assets is called depreciation. It can

be calculated by; Diminishing Balance Method, where the amount
of depreciation is based on the written down value of the asset. By
Straight Line Method, where the amount to be depreciated is based
on the original cost of the asset. Sum of years’ digit Method is also
like the reducing balance method.
1. What is the difference between gross profit and net profit?
2. What do you mean by depreciation?
3. How are the three methods of depreciation different from each

other?
)
(C
131
Unit 19 Notes
ES
___________________
Pricing Methods and Strategy ___________________
___________________
Objectives:
___________________
___________________
\\ Explain the sound pricing policy
\\ Apply the concepts of pricing policies in various business decisions ___________________
___________________
Pricing Policy ___________________
Price is the monetary value assigned to f goods or services. Pricing ___________________

UP
policy is of utmost importance, as it has a direct effect on the sales
of a business. Marketers achieve their objectives of pricing through
pricing policies.
___________________
A firm can improve profits by cutting costs, selling more of its prod-
ucts and applying a proper pricing strategy depending on the mar-
ket conditions.
It’s not always about raising the prices, but it’s about making the prod-
uct optimally available for various types of consumers. Many business-
es lose in the market because they price themselves out of the mar-
ketplace. On the other hand, many businesses leave “money on the
table.” One strategy does not fit all, so adopting a pricing strategy is a
learning curve; while studying the needs and behaviors of customers.
Therefore, a sound pricing policy must be adopted to have maximum

sales revenue.
Marginal Cost Pricing

)
The price is determined based on variable cost, as fixed costs are

completely excluded. It concerns with the estimated revenues, ex-
penses and capital expenditures. Each unit of product is considered
(C
individually, and a price is fixed at a level, which is calculated to

maximize its total contribution.
From Economic Theory’s perspective, most profitable prices in a mar-

ket can be decided by following marginal-cost pricing. But as there is
ageneral tendency, The Managers and Owners tend to merge margin-
al costs with other costs like Fixed Cost, Sunk Cost,etc. This makes it
hard for the businessman to calculate marginal costs efficiently.
132
Cost Plus Pricing
Notes
ES
As evident from the name, this technique involves the determina-
___________________
tion of price through the addition of some profit in the cost of the
___________________ product. Full allocated cost includes actual cost, expect cost and
___________________ standard cost. Due to the ease of calculation offered by this tech-
nique, it is one of the widely used methods. Information on demand
___________________
is not easily available,and managers have limited knowledge as far
___________________ as demand is concerned. Also, the procedure for procuring this in-
___________________ formation is costly.
___________________
Cost-plus pricing has some advantages such as it provides a justifi-
___________________ cation for any price change. The mathematical method used in this
___________________
technique is very logical and simple, as it may also contribute to
price change and requires little information.
___________________
UP
Multi-Product Pricing
When the goods are produced together, it is rather economical.
The complementary goods will have negative cross elasticity coeffi-
cient,and the substitute products will have positive cross elasticity
demand coefficient.
The commodities having inelastic demand will be highly priced. The

product having more elastic demand will have low prices.
Now, we shall learn in detail about the strategies used in pricing a

product:
Pricing Strategies
There are various types of strategies that consider pricing as their
prime focus:
)
1. Limit Pricing: Under this method, products are sold by the

producers at prices which are lower than the average cost of
production. Under this strategy, prices are set by a monop-
(C
olist so as to restrict and desist entry of competitors in the

market, although this practice is illegal in numerous coun-
tries. Limit price is that price which a new company in the
market will have to face in case the sitting company does not
reduce the output. Limit Pricing ensures that the prices are
just low enough to dissuade new producers from entering the
market and are often lower than the average cost of produc-
tion.
Unit 19: Pricing Methods and Strategy
133

Price Discrimination: Under this strategy, different custom-
ers are charged different prices by the customer for the same Notes
ES
product or service. ___________________
There are three necessary conditions for price discrimination: ___________________
___________________
(i) The firm must have some control over the prices. A mo-
nopolist is an inappropriate position to exercise price dis- ___________________
crimination. ___________________
(ii) The firm must be able to categorize different markets ac- ___________________
cording to price elasticity of demand. ___________________
(iii) Products cannot be purchased in one market for reselling ___________________

in another market. ___________________

UP
Following are three significant types of price discrimination:-
(i) First-degree price discrimination: This is one of the

most profitable pricing strategies from the point of view
___________________
of a firm as it entails charging a maximum price for each

unit of a product This makes it one of the most extreme
forms of price discrimination. For eg, When a product is
sold through an auction, people bid the maximum amount
they are willing to pay and as such the seller can get the
best price for their products.
(ii) Second-degree price discrimination: This is an im-

perfect form of first-degree price discrimination. Instead
of setting a different price for each unit, it involves pric-
ing based on the quantities purchased by the consumer.
This form is most common in utility pricing. This strategy
plays an important role in determining prices for public
)
utilities such as Gas, Water,and Electricity. For instance,

the first 100 units of electricity consumption have a dif-
ferent charge as compared to the next slab, for example,
100-300 units.
(C
(iii) Third-degree price discrimination: It is one of the

most common price discrimination strategies. It involves
separating the market or consumer in terms of their price
elasticity of demand.
Three conditions must hold for this price strategy:
● Demand must be heterogeneous,

134
● The manager must identify and segregate the different
Notes segments, and
ES
___________________
● The market must be successfully sealed.
___________________
In this case, the producer will charge a high price in a mar-
___________________
ket, where in the demand is inelastic as compared to a market
___________________ with elastic demand. Price Discrimination enables a seller to
___________________ maximize their revenues and profits as they can now extract
the maximum amounts which their customers are willing to
___________________
pay. Although Perfect Price determination is considered ille-
___________________ gal, when a seller sets an optimal price for customers, imper-
___________________ fect price discrimination occurs. For Instance, Movie The at res
charge different prices for a show according to day and time. A
___________________
movie show on a Monday afternoon will cost significantly less
___________________
UPthan a show on a Sunday Evening. This phenomenon is gov-
erned by Elasticity of Demand.
The figure19.1 for price discrimination is given below.
P1 A
P2 E B
P3 MC
F C
D
Q1 Q2 Q3
Figure 19.1: Degree of Price Discrimination
Example to Understand Price Discrimination

)
Sho-Air is a private airline flying on a designated route that has a

seasonal demand.
(C
The total demand for the firm can be defined as:
Q = 600 – 4P
Where Q signifies the number of travelers every year in lakhs, and

P is the fare (in $).
During the peak season, the demand is signified by:
Q H = 320 – 1. 5PH
135
During the off-season, the demand is given by:
Notes
ES
Q L =280 –2. 5PL
___________________
Now it is assumed that fixed costs of Sho-Air are $6 million per year ___________________
with the marginal costs being constant at $60 per passenger.
___________________
The cost function, in turn, is given as:
___________________
C = 6000 + 60Q ___________________
Where C is total costs (in $’000). ___________________
a. Calculate the price where profit is maximized and maximum ___________________
output that can be achieved without price discrimination, along ___________________

with the size of the profit.
___________________
b. Calculate the price where profit is maximized and maximum

UP
output that can be achieved with price discrimination, along
with the size of the profit.
___________________
c. Calculate the elasticities of two segments at prices where prof-

it-maximization is achieved.
Solution:
a. Without price discrimination,
1 P = (600 – Q)/ 4
R = (600Q – Q 2)/4
2 MR = (600 – 2Q Þ)/4
3 At equilibrium MR = MC
(600 – 2Q Þ)/4=60
)
600 – 2Q = 240; 2Q = 360
Q = 180; or 18,00,000 passengers per year
4 P =(600 – 180)/4 = $105

(C
The profit is given by Revenue – cost
Which is R-C
= 105(180,000)– [6,000 + 60( 180)] 1000
= 189,00,000 – 16,800,000
= $ 21,00,000
136
Note: 1P, 2P, 3P, 4P are different price discriminations
Notes
ES
b. With price discrimination,
___________________
___________________ We now find out for separate segments:
___________________ Peak segment (H)

___________________ 1 P= (320 – Q)/1.5
___________________
R = (320Q – Q 2)/ 1.5
___________________
2 MR = (320 – 2Q)/1.5
___________________
3 MR ¼ MC
___________________
(320 – 2Q)/1.5= 60
___________________
320 – 2Q = 90
___________________
UP
Q = 115; or 115, 00, 00 passengers per year
4 P = (320 – 115)/1.5 = $136:67
Off-peak segment (L)
1 P = (280 – Q)/2.5
R = (280Q – Q2)/2.5
2 MR = (280 – 2Q)/2.5
3 MR = MC
(280 – 2Q)/2.5= 60
280 – 2Q = 150
Q = 65, or 65,0000 passengers per year

)
4 P = (280 – 65)/2.5 = $86
To calculate the total profits, firstly total revenue has to be calculat-

ed,and thetotal costs are to be subtracted from it.
(C
Total revenue = RH + RL = 136.67(115,000) + 86(65,000) = $21307,050
Total costs = [6000 + 60(115 +60)]1000 =$168,00,000
Profit = $ 45,07,050
c. The point elasticity formula can be used to obtain each seg-

ment’s demand elasticity:
137
Peak: Price elasticity of Demand =-1.5(136:67/115)
Notes
ES
= –1.783
___________________
Off-peak: Price elasticity of Demand = –2.5(86/65)
___________________
= – 3.308
___________________
By comparing situations after price discrimination and without price
___________________
discrimination, we can draw the following conclusions:
___________________
(i) In both the scenarios, the total output of the firm re-
___________________
mains same. (It has to be noted that if the cost function is
non-linear, this won’t hold true) ___________________
___________________
(ii) Prices set with price discrimination will always differ from
the prices set without price discrimination,i.e., one price ___________________
will be higher, and one price will be lower. This implies
UP
that if a seller caters to two or more market segments, the
price charged for one segment will always be lower than
the other.
___________________
(iii) The section with lower price will have highly elastic de-
mand and vice-versa
(iv) As evident from the above-mentioned example, when con-

sumer surplus is transferred in producer surplus, Profits
are bound to be higher under Price Discrimination.
2. Predatory Pricing: it is a strategy adopted to weed out com-

petition from the market. This involves setting unrealistically
low prices in an attempt to eliminate competition. It is also
known as undercutting,and because of the fact that it exposes
the market to monopolistic tendencies, it has been declared
illegal by anti-trust watchdogs. This has been done to ensure
)
free and fair operations in a market otherwise a seller who

is in a dominating position can resort to illegal techniques to
sabotage the competition or create virtual barriers to stop new
entrants.
(C
3. Penetration Pricing: this strategy involves setting up low

prices initially as compared to market norms, for a product or
service to attract customers to try the new offering. The whole
purpose of this strategy is to attract customers sensitive to price
reduction. Although, initially Penetration Pricing would result
in lower profits for the seller but helps a lot in establishing a
significant market share. As such its use is justified.
138
For example, penetration pricing is commonly used by utilities, es-
Notes pecially phone and cable or satellite services and sometimes, is even
ES
___________________ found in competitive gas and electricity markets as well. Many home
___________________ phone, cellphone, cable and satellite providers offer a discounted
rate for a period of time, for example,the first six months of service,
___________________
to get you to switch to their service.
___________________
4. Price Leadership: This is one of the models for oligopoly mar-
___________________
ket. In this model, one firm is more powerful than the other.
___________________ This firm sets the price,and other competitors follow it. The
___________________ leading firm that initially sets the price is called the dominant
firm. The firms that use the price set by the dominant firm are
___________________
typically smaller in size and are called followers. Steel and Ag-
___________________ ricultural equipment markets generally follow this strategy.
___________________
UP
5. Competitor Based Pricing: When there are many firms op-
erating in a perfect Competition, no one firm has any signifi-
cant power to control the prices. Sellers usually follow the “Go-
ing-Rate” strategy wherein they set the prices similar to what
is being charged by the competitors. This helps in determina-
tion of prices at which the product can be easily sold. This strat-
egy ignores the cost of production and demand from customers
but focuses solely on pricing followed by competitors. Following
this strategy ensures that pricing is never a disadvantage be-
cause of the fact that pricing determined is in sync with what is
followed by other sellers.
Now, we shall learn in detail about the various methods of pric-

ing in detail.
Customer Oriented and Other Pricing Practices
Following are other pricing practices used by many firms:

)
● Market skimming pricing
● Market-oriented pricing
(C
● Psychological pricing
● High low pricing
● Value-based pricing
● Geographic pricing
Pricing is also affected when the firms are publicly owned. Let’s
have a look at the change in pricing under public ownership.
139
Pricing under Public Ownership
Notes
ES
Welfare loss under public ownership can be represented by the fol-
___________________
lowing graphs:
___________________
Price
£ ___________________
___________________
___________________
15
13 AC ___________________
MC
10
___________________
D = AR
___________________
10 12 Quantity (million units per month)
___________________
P
M
PM
F
A
UP MC
H
___________________
PC E
C
B
G J Fixed price
PF
N
D
Q R QM QC QS Q
Figure 19.2: Welfare loss under public ownership
Summary
This chapter gives a viewpoint of pricing decisions which are made
by firms. Firms may adopt some pricing policies or all, whenever it
is required, depending upon the type of competition in the market.
)
(C
1. How is marginal cost pricing different than cost-plus pricing?
2. Explain the methods of pricing.
3. Why is pricing important?
4. Why do firms do price discrimination?

(C
) UP
ES
141
Unit 20 Notes
ES
___________________
Case Study: ___________________
Prices Slashed Down For ___________________
Medicines ___________________
___________________
On the occasion of ending of 20 years of price fixing strategies,
numerous big supermarkets announced amazing discounts and ___________________
significant price reductions across a vast range of medicines, vita-
___________________
mins and energy syrups. From Last night, a vast array of popular
medications like cough remedy, painkillers, indigestion medicines, ___________________
nutritional supplements have witnessed a steep fall of upto 50% in
___________________
their prices and have become significantly cheaper.
UP
The Office of Reasonable Transaction called it superb news for con-
sumers. However, the body representing small retailers in phar-
maceutical sector has said that many might close their business;
___________________
threatening the community services.
There could be seen a rush amongst some of the biggest supermar-

ket chain to offer highest price reductions, which they claim offer
“Millions of pounds worth of savings.” For instance, Tesco offered
an almost 40% reduction in Anadin Extra, which will now
be sold for £1.29 for 16 tablets. Similarly, Nuda is now offering
a 16 pack of Paracetamol for 68p as compared to the earlier price
of £1.95,and a 16’s pack of Nurofen Tablets is now being sold for
£1.10rather than £2.29.
These steep reductions were possible only after opposition toa High
Court Action brought by Office of Fair Trading, was withdrawn
by Community Pharma Action Group, an umbrella organization
of small pharmacies. Under this action, Office of Fair Trading had
sought abolition of resale price maintenance in the pharma indus-
)
try. The resale price maintenance was introduced almost three de-
cades earlier in order to ensure the survival of small pharmacies,
which form almost 66% of the total 13,500 registered pharmacies
in Britain and have been serving both rural communities as well
(C
as local high streets.
The Community Pharma Action Group had to back out after the
Hon’ble Justice Buckley ruled that there is not sufficient proof to
establish that abolition of resale price maintenance would deal a
death blow to local pharmacies or would lead to any reduction in
therange of products being offered. But the Action Group’s Chair-
man, David Sharpe, strongly opposed this decision. He said that
“It is a sad day for Britain as most of the small pharmacists will
Contd....
142
not be able to withstand the might of big Supermarkets, who have
Notes
ES
more buying power and aggressive pricing.” He further added that
___________________ “The biggest sufferers will be the elderly, disabled individuals and
Young mothers, who used to rely on the experience and free ad-
___________________
vice of a local pharmacist in addition to a host of services. Our only
___________________ hope is that they will remain loyal and would give us the power to
fight on”.
___________________
___________________
Over 2500 Over the Counter (OTC) products will come under the
purview of this ruling only,but prescription drugs would continue
___________________ to be sold by pharmacists only. As the competition will intensify,
___________________ the prices are going to fall even further. For instance, in the USA
where the medication prices are unregulated, similar products are
___________________ available at much lower prices.
___________________ According to Mr. Richard Hyman, Chairman of Verdict Retail Con-
sultancy “Medicines and supermarkets are a perfect competition
___________________
UP
because Medicines are small, fit on small shelves and would give
the supermarkets an opportunity to shout out the amazing dis-
counts they are offering. This would make medicines a part of ev-
ery weekly shopping list.”
Whereas the Proprietary Association of Great Britain, there pre-

sentative of medicine and food supplement manufacturers, said
that they were disappointed by this development, John Vickers,
Director General of Fair Trading was really ecsta tic and said that
“This is an excellent news for customers as now they can enjoy the
benefits of more competitive prices of general household medica-
tions. This will help save millions of pounds every year.”
Questions
1. How would you describe the market structure for sale of med-
ications and vitamins?
2. The comment about the barriers to entry for pharma sector.

3. Will the change in law bring about any changes in the struc-
)
ture of the market?
4. Elaborate on the counter-effects of the abolition of resale

price maintenance on the medication industry.
(C
5. Similar concerns as voiced above were raised when RPM was

abolished for book sales in the year 1995, but since then al-
most 10% of bookshops have shut down. Compare this situa-
tion with one being faced by small pharmacies and comment
on their future.
6. Will the rising popularity of internet affect this situation

somehow? Please Elaborate.
Unit 20: Case Study: Prices Slashed Down For Medicines
143
Whisky Still Top Tipple in Indian Market Notes
ES
Case Study ___________________
Whiskey held the major share of Indian Spirits Market and ac- ___________________
counted for 61.2% volume in 2016, with sales witnessing an annual ___________________
growth rate of 3.8% over the period of 2011-16.
___________________
In High Spirits ___________________
The market for whisky grew 30.7% value of Rs. 1.24 trillion ___________________
from 2011 to 2016 while the market for rum contracted by ___________________
9% to Rs. 19,135 crore.
___________________
Rum 2011 2016 Whisky ___________________
435.1 387.2
UP 1,475.6 1,775.5
___________________
21,043.8 94,863.8
19,135.3 1,23,977.1
Source GlobalData
Graphic: Paras Jain/Mint
With no challenger in the vicinity, Whiskey is still the undisputed

favorite spirit for liquor drinkers in India.
According to data from Global Data, a leading consumer research

firm, Whisky held the major share of Indian Spirits Market and ac-
counted for 61.2% volume in 2016, with sales witnessing an annual
)
growth rate of 3.8% over the period of 2011-16. Careful analysis of

the data shows that the Indian Spirits market registered an annu-
al growth rate of 2% from 2011 to 2016, with Whiskey being the
most significant contributor.
(C
According to Apoorva Nema, Consumer Analyst at Global Data

“This amazing growth registered by Whiskies can be attributed to
the fact that a large base of Indian middle-class shifted preferences
to premium whiskeys.”
There are eight major categories of Liquor comprising Spirits

Markets in India, namely: Whisky, Vodka, Tequila and Mezcal,
Contd....
144
Brandy, Gin and Genever, Speciality Spirits, Rum,and Liqueurs.
Notes
ES
Despite the fact that Liquor companies have introduced and pro-
___________________ moted different variants of tequila, rum, gin and other spirits ag-
gressively, but this has had no bearing on the sheer dominance of
___________________
Whisky in the market.
___________________
According to Nema “The decline in consumption of rum can be at-
___________________ tributed to changes in customer taste as well as distribution is-
___________________
sues.”This statement holds significance because,during the period
when whiskey has registered significant growth, consumption of
___________________ alternative spirits has seen a sharp decline. For e.g., Rum consti-
___________________ tutes almost 10% of the Liquor market by volume in 2016 but has
seen a percentage fall of 2.3% per annum during 2011-16. During
___________________ the said period, market for whiskey grew by a whopping 30.7% to
___________________ almost Rs. 1.24 Trillion whereas the market for rum shrunk by
almost 9% and now stands at Rs. 19,135 crores.
___________________
UP
This observation has been backed by data from Euromonitor,
which clearly shows that liquor firms which focussed on whiskey
have registered a steady growth in their market share,but those
who focussed on sales of Rum have not witnessed any growth at all
and have rather seen adecline in their sales. This trend is further
substantiated by the following example
Pernod Richard India Pvt. Ltd., well known for their whiskey
brands Royal Stag and Blender’s Pride has seen its market share,
of total alcohol sales, jump to 7.1% from 5.3% between 2013-2016.
Whereas in comparison, Mohan Meakin Ltd, renowned for their
Old Monk Rum, witnessed a stagnant market share of 2.3% to
2.5% during the same period.
But this does not mean that everything is bleak. According to data
from Global Data, Liquor companies are expected to see growth in
specialized spirits segment. For instance, Mexican Spirits Tequila
and Mezcal, both obtained from Mexican Agave Plant, have seen a
CAGR (Compound Annual Growth Rate) of 11.6% during 2011-16,
)
one of the highest jumps witnessed in the market. But these two
liquors comprise only 0.1% of the total spirits market.
Additionally, no major company in India manufactures Tequila

(C
and Mezcal. Diageo PLC, the parent company of United Spirits

Ltd., has recently acquired a well known premium tequila brand
“Casamigos” from George Clooney for appx $ 1 Billion.
Questions
1. Do you think whiskey is taking monopoly advantage of hav-

ing a different target audience?
2. In which category you can segment the liquor market in?

ES
UP
BLOCK–V
)
(C
Detailed Contents
ES
UNIT 21: GOVERNMENT, FIRMS, UNIT 24: FISCAL POLICY
AND MARKETS WITH
IMPORTANCE TO MONEY
UNIT 25: CASE STUDY: IMPACT OF

TECHNOLOGICAL ADVANCEMENTS ON
UNIT 22: NATIONAL INCOME EMPLOYMENT LEVELS
UNIT 23: INFLATION AND MONETARY POLICY

) UP
(C
147
Unit 21 Notes
ES
___________________
Government, Firms, ___________________
And Markets With ___________________
Importance To Money ___________________
___________________
Objectives: ___________________
After completion of this unit, the learners will be able to: ___________________
\\ Outline the foundation for government intervention in any economy ___________________

\\ Define the rationale, background, and implementation of key govern-
___________________
ment policies, which affect the business community
\\
\\
\\
UP
Identify the role of money in any economy
Explain the money flow in an economy
Market-based economy
___________________
\\ Summarise the importance of central bank
Foundation for Government Intervention

Let’s understand the various key roles that a government can play
in a modern economy, as most of them have already been executed
in various economies. The following tasks are completed by govern-
mental bodies:
● The consumer of resources (for example, employer, landlord)
● Supplier of resources (for example, infrastructure, information/
data)
● The consumer of goods and services (for example, via govern-
ment spending)
)
● Supplier of goods and services (for example, nationalized indus-

tries)
● Regulator of business activity (for example, consumer law, em-
(C
ployment law)
● Redistributor of income and wealth (for example, via the taxa-
tion system)
● The promoter of economic development (for example, via aid to
industry)
● Regulator of the economy (for example, via fiscal and monetary
policy)
148
The government, not only provides support for the operationalizing
Notes private sector but also is a major business by itself. Government
ES
___________________ displays the exclusive capacity to spend large sums of money raised
___________________ mostly through taxation, along with the ability to pass laws and
introduce policies. These policies have an impact on the different
___________________
economic sectors and/or on the economy as a whole.
___________________
The main point of reservation, in this case, is the justification of
___________________
government intervention into businesses.
___________________
The conventional reply offered by economists is that the market
___________________ mechanism, left to its own devices, cannot be withheld. However, it
___________________ always provides the optimum solution to the problem for one person
without withholding them from all. For example, street lighting or
___________________
defense.
___________________
UP
One of the key measures of performance of both firms and the econ-
omy is the economic efficiency. It is deemed to be a characteristic
of competitive markets to the extent that ‘real’ markets may not
always be efficient in either the technical or allocative sense, as they
can be deemed to have failed.
For many economists, this idea of market failure provides a ratio-

nale for government intervention, whether it is for economic and/
or social reasons. The key areas of market failure are well known
but are worth repeating here. Primary concerns regarding market
failure are as follows:
● The lack of willingness of the market to produce unprofitable or
unfeasible goods and services, which are beyond the means of
the private sector. (For instance, Public goods such as Defence,
Infrastructure, Social Services, etc)
● Goods and Services which might be beneficial for the commu-

)
nity are under-provisioned for, such as merit goods like educa-

tion and library services, etc. This fails to consider the external
costs involved and production benefits.
(C
If businesses can be freely bought and sold, this might give rise to
monopolistic powers.
● The output is determined and distributed according to the pay-

ing ability rather than being based on need or equality.
● Economic resources being under-utilized (for instance, unem-

ployment stemming from deficient demand, lack of new tech-
nology, or structural or frictional problems)
Unit 21: Government, Firms, And Markets With Importance To Money
149
The Government Intervention
Notes
ES
On acceptance of the need for government intervention, three perti- ___________________
nent question arises, namely:
___________________
1. In what situation is government intervention necessary? ___________________
2. At what level does and should this intervention take place? ___________________
3. What form(s) should it take? ___________________
___________________
These three questions are considered in this and the subsequent sec-
tions of this chapter. ___________________
Regarding question 1, it can be fairly said that there is an over- ___________________
all agreement on when a situation of spatial imbalance becomes a ___________________

‘problem’ requiring a governmental response. In essence, those ar-
UP
eas which are significantly and persistently under-performing on
a range of socio-economic indicators (especially unemployment, in-
come, and growth), compared to the national average, tend to be
___________________
designated as ‘problem areas’ recommending for government action.

As most of the data on which decisions are made are routinely col-
lected by government agencies, regular comparisons can be made in
performance between different locations. Also, wherever necessary,
adjustments are made in government policy and/or implementation
over time.
The question of the appropriate level of governmental intervention is

arguably more contentious. However, in effect, the choices boil down
to three main possibilities: supranational, national and sub-nation-
al (for example, regional and/or local). What happens in any coun-
try tends to be dictated largely by history, along with politics and
constitutional arrangements, as these can change over time. In the
UK, for instance, the absence (until recently) of a regional system
)
of government has meant that the focus of governmental action has

traditionally been at national and local level.
(C
After learning about government intervention, we shall now learn in

detail about the market-based economy and its features.
Market-Based Economy
In a market-based economy majority of the economic decisions are
taken by private households and firms who interact in free markets
backed by a system of prices to take a decision regarding the alloca-
tion of resources.
150
The key features of this type of such an economic system are as fol-
Notes lows:
ES
___________________
● Resources are privately owned with the individual owners be-
___________________ ing free to utilize the resources as per their liking
___________________
● Privately owned firms are free from government interference
___________________ and are equally free to make decisions regarding production.
___________________
● Production and Consumption are governed by market princi-
___________________ ples and not by any blueprint.
___________________ ● Choices and decisions taken by numerous households and firms
___________________ are automatically co-ordinated to decide on resource allocation
based on a decentralized system of markets and prices.
___________________
● Customers hold the major power and are in a position to dictate

___________________
UP supply patterns and resource allocation.
Consumers
(individuals)
Supply Demand
Income Expenditure
Markets for resources Markets for products

(with prices) (with prices)
Expenditure Income
Demand Supply
)
Producers
(firms)
(C
Figure 21.1:Market Based Economy
In a market-based economy, market forces, operating for productive

services, determine the distribution of output. Individuals who sup-
ply a resource or service such as Labour, receive remuneration in
the form of Income, from entities using their services. This income
is used by individuals to purchase various goods and services in the
market and this, in turn, provides a source of income for firms in-
151
volved in the production of goods and services. This income is used
by the firms for acquiring further resources and services (labor) (see Notes
ES
Figure 21.1). ___________________
In case, the demand for a product or service produced by a resource ___________________

increases, it will, in turn, lead to an increased demand for that par- ___________________
ticular resource and also increase in the price commanded by that
___________________
resource. Ceteris paribus, this will result in shifting of resources
from less rewarding utilization to more rewarding usage to increase ___________________
the product/service output, that could be purchased. ___________________
The working of demand and supply phenomena has been discussed ___________________
in detail in previous chapters. No economy can operate in a manner ___________________
earlier suggested, after all, the decisions taken by firms are influ-
___________________
enced by supply and demand decisions as well as by costs. Rather
that demand.
UP
than simply responding to the particular demand, firms try to shape
Resource allocation is a market-based economy is free from any in-

___________________
tervention by the government. This is evident from the existence of

a public sector which is responsible for significant levels of consump-
tion and production. This Public sector assists with shaping the con-
ditions under which the private sector operates.
To summarise, the Macroeconomic role of the government needs

to be incorporated to study a market-based economy. This must be
done to examine the influence of Government on activities of both
individuals and firms.
Economic Activity can be depicted as the inflow of economic resourc-
es into productive organizations, who use this inflow to produce out-
put for consumption. This inflow gives rise to another flow of pay-
ment from firms to providers of such resources. This continuous flow
)
of resources, income, expenditure, and production is essentially the

depiction of the economy at work.
Private domestic
consumption
(C
Flows Government
Flows of goods consumption
of resources Firms and Consumption
(e.g. labour) services Foreign
consumption
Capital
formation
Figure 21.2: Real Flows in the Economy

152
Private
Notes
ES
___________________ Government
Flow Flows of
of payments expenditure
___________________ for the use Firms on goods Consumption
of resources and services
___________________ Foreign
___________________
Firms
___________________
Figure 21.3: Income Flows in the Economy
___________________
___________________ Private individuals

(domestic households)
___________________
___________________
___________________
UP Flows of
expenditure
on resources
(i.e. income
Flows of
resources
Flows
of goods
and services
Flows of
expenditure
on goods
and services
for firms) (i.e. income
for firms)
Domestic firms
Figure 21.4: Flow of Expenditure and Resources
The charts in Fig. 21.4 shows,
● Levels of income, output, expenditure, and employment in the

economy.
● There is a circular flow of income, in which the income flows

)
around in the economy. It moves from households to firm and

then from firms to households and keeps on moving like that.
● There is a corresponding real flow of resources, goods, and ser-

(C
vices along with the flow of income in the economy.
● Generation of Income in an economy is dependant on expendi-

ture on consumption of goods and services because what is an
income for one group is expenditure for another group.
● Production of goods and services by firms should be related to

expenditure done by households on goods and services. The ex-
penditure by households on goods and services is in turn relat-
153
ed to the income received by households by supplying resources
and services. Notes
ES
___________________
● The usage of resources by households must be related to the ex-
penditure done by households on consumption of products and ___________________
services, based on the condition that those resources are used to ___________________
produce products and services for consumption of households.
___________________
While studying about the various factors in an economy, it is also ___________________
important to know the failures in a market. Let us quickly study
___________________
what is the meaning of market failure and what are its causes.
___________________
Market Failure ___________________
Market failure is a situation which arises when the allocation of ___________________

goods and services is not efficient. There is the probability of another
UP
possible outcome when at least one individual is better off without
making someone else worse off.
___________________
The causes of market failure are:

1. Monopolies
2. Externalities
3. Public Goods
4. Imperfect information
5. Transaction costs
Now, we shall learn about the role of financial institutions.
The Role of Financial Institutions

Interactions in the macroeconomy between governments, business-
es, and consumers take place within an institutional environment
)
that includes many financial intermediaries. These range from

banks and building societies to pension funds, insurance companies,
investment trusts and issuing houses. All of these provide several
(C
services of both direct and indirect benefit to businesses. As part of

the financial system within a market-based economy, these institu-
tions fulfill a vital role in channeling funds from those able and will-
ing to lend, to those individuals and organizations wishing to borrow
to consume or invest. It is appropriate to consider briefly this role
of financial intermediation and the supervision exercised over the
financial system by the central bank, before concluding the chapter
with a review of important international economic institutions.
154
Elements of the Financial System
Notes
ES
___________________ A financial system tends to have three main elements.
___________________ 1. Lenders and borrowers; these may be individuals, organiza-

___________________
tions or governments.
___________________ 2. Financial institutions, of various kinds, which act as intermedi-

aries between lenders and borrowers. These institutions man-
___________________
age their own asset portfolios in the interest of their sharehold-
___________________
ers and/or depositors.
___________________
3. Money and/or other types of asset, including paper assets such
___________________ as shares and stock.
___________________
Secondary markets
___________________
UP
Lending Lending
Financial
Lenders Borrowers
intermediaries
Paper Paper
claims claims
Individuals1 Financial Individuals1

Organisations1 institutions2 Organisations1
Governments1 Governments1
Notes: 1 both domestic and foreign. 2 including retail and wholesale banks, building societies, overseas
banks, pension funds, and so on.
Figure 21.6: Elements of the Financial System
Meaning and Importance of Money

)
How can we define money? One of its definitions is that of Paul Sam-
uelson, who defined the money as the modern medium of exchange
and the standard unit in which prices are measured. Money has also
been defined as an asset, which is used as a medium of exchange,
(C
as a store of value and as a standard for deferred payment or value.
“Money is anything that is acceptable as a legal tender to discharge

responsibilities within a political boundary. It is expressed as a mul-
tiple of some unit, which is regarded as a measure or standard of the
value of things in general. Money can also be defined as anything,
which passes freely from hand to hand and is generally acceptable
in settlement of a debt.”
155
Types of Money
Notes
ES
Traditionally, diverse items as a brass rod, copper wire, cowries, and
___________________
manilas, etc. have functioned as money. Following include the dif-
ferent types of money: ___________________
___________________
1. Coins: Coins are essential ‘convenience money’ that facilitates
to do various expenses and purchases. ___________________
2. Paper money: These are notes issued by the Central Bank. ___________________
The coin and paper money components of the money supply are ___________________
generally initiated by the central bank and further monitored ___________________
and controlled by other commercial banks.
___________________
3. Cashless component: This component is inclusive of cheques
___________________
or bank money (for example, demand deposits).
Functions of Money
UP
Following are the different functions of money:
___________________
1. It is a medium of exchange of goods.
2. It is the most liquid form of storage of value.
3. It is universally accepted measurement of value for goods, and

savings and debts of economic units.
4. It is a discharge of debt, that is, the ultimate way to repay a

loan.
Money and Capital Markets

The relationship between money and the capital markets can be
elaborated as follows:
)
● Financial assets with a maturity period of less than one year

are treated as Financial Assets by Money Market.
● Financial Assets with a maturity period of over one-year are

(C
treated as financial assets by Capital Market.
● These two markets are just a theoretical concept, and they do

not exist in the real world, as financial assets belonging to both
markets are traded by same financial intermediaries.
● Items such as cash, demand deposits, and Treasury bills come

under the purview of money market instruments.
156
● Items such as loans, bonds, and equities come under the pur-
Notes view of capital market instruments.
ES
___________________
Due to their distinct risk and return characteristics, Instruments
___________________ (financial assets) can be used to change the composition of a portfo-
___________________ lio.
___________________ ● The portfolio can be described as the collection of assets of an
___________________ investor.
___________________
DIRECT FINANCE
___________________ Lenders/savers Financial markets Borrowers/spenders
-Households Funds Funds -Households
-Money market
___________________ -Firms -Firms
-Capital market
-Government -Government
___________________
-Non-residents -Non-residents
Funds
___________________
UP Funds
Financial intermediaries
-Credit institutions
-Other financial institutions
Funds
INDIRECT FINANCE
Figure 21.7: Money and Capital Markets
Central Bank
The central bank is also known as the Banker of Banks as it pro-
vides banking services to the Governments as well as other banks.
In India, The Reserve Bank of India is the Central Bank, and it
controls the monetary policy. Reserve Bank reserves the exclusive
rights to issue currency notes and is the solely responsible authority
for the monetary system and monetary policy of the country. It also
controls the monetary base (and inflation).
European Central Bank (ECB) is the central bank under the Eu-
)
ro-system and is a central authority of 16 different central banks

of all the member nations. In the US, Federal Reserve (Fed) is the
central bank comprising of 12-member banks from different states
(C
in the US. Both ECB and Fed operate as a single unit, even though
they are separated into several local units.
Commercial Banks
Commercial banks carry out the following important functions:
● Collection of money through deposits from customers as well as

through issue of bonds and Certificate of Deposits (CDs)
157
● Taking care of payment services for their customers.
Notes
ES
● Earn money by extending interest-bearing loans to consumers
___________________
and investment of money in revenue-generating assets. The
positive difference between income from loans extended and ___________________
payment of interest on deposits is the commission for banks. ___________________
● Using several short-term deposits to extend long-term loans, ___________________
also known as Maturity Transformation. ___________________
● Compiling information pertaining to borrowers and investors ___________________

and catering to their daily needs. ___________________
Financial transactions between economic units ___________________
Loan money ___________________
Money flows:
UP
Bank
Deposit money
Customer
___________________
Document of deposits (assests)

Asset flows:
Document of loans (assests)
Figure 21.8 Financial transaction between economic units
Sale and Purchase of financial instruments and foreign currencies.
Summary
The chapter discusses government intervention in any economy. It
defines the rationale, background, and implementation of key gov-
ernment policies, which affect the business community. It helps
identify the role of money in any economy and explains the money
flow in an economy. It also discusses the market-based economy.
)
1. Explain the role of money in any economy.
(C
2. How does money flow occurs between various customers and

banking units?
(C
) UP
ES
159
Unit 22 Notes
ES
___________________
National Income ___________________
___________________
Objectives:
___________________
___________________
\\ Explain various components of national income
\\ Apply the concepts of national income to define other macroeconomic ___________________
concepts
___________________
___________________
National Income
___________________
To understand national income, there are related concepts that need
UP
to be studied. These include gross domestic product, gross national
product, net national product, personal income and disposable in-
come. These concepts explain the various sectors and macroeconom-
___________________
ic policies.
Gross Domestic Product (GDP)

GDP is one of the most important concepts in national income. It
is the sum total of all goods and services produced in a country in a
given year, measured in terms of monetary value.
We can express it in the following way.
GDP = (P*Q)
Where;
GDP = Gross Domestic Product,

)
P = Price of goods and service,
Q = Quantity of goods and service.
As per the expenditure approach, GDP is described as the sum total

(C
of consumption, Investment, government expenditure and net for-

eign exports of the country during a year.
GDP = C + I + G + (X – M)
Where,
C denotes consumption,
I denotes investment,
160
G denotes government expenditure,
Notes
ES
(X – M) denotes export minus import.
___________________
Types of final goods and services in GDP:
___________________
___________________ GDP comprises of the following final goods and services:
___________________ 1. Consumer Goods and Services

___________________ 2. Gross Private Domestic Investment in Capital Goods
___________________
3. Government Expenditure
___________________
4. Exports and Imports
___________________
___________________ Gross National Product (GNP)

___________________
UP
GNP can be calculated by adding Net Factor Income from Abroad
to the Gross Domestic Product (GDP) or alternatively by arriving at
the sum total of Consumer Goods and services, Investment in Cap-
ital Goods, Government Expenditure, Net Exports and Net Factor
Income from Abroad .
Hence, GNP is the entire amount of the movement of products and

services at market value, consequential from present levels of pro-
duction during a year in a country. The GNP can thus be calculated
by the following equation:
“GNP = GDP + Net Factor Income from Abroad (NFIA)
Or, GNP = C + I + G + (X – M) + NFIA”
Hence, GNP includes the following:
1. Consumer goods and services

)
2. Gross private domestic investment in capital goods
3. Government expenditure
4. Net exports (exports-imports)

(C
5. Net factor income from abroad
Net National Product (NNP)

NNP is the entire amount of movement of products and services at
market value in a country during a year after allowing for depreci-
ation. It is also known as the National Income at market price. Al-
Unit 22: National Income
161
ternatively, NNP can be arrived at by deducting Depreciation from
the GNP. Notes
ES
___________________
Thus,
___________________
NNP = GNP – Depreciation
___________________
Or, NNP = C + I + G + (X – M) + NFIA–Depreciation
___________________
National Income is also known as National Income at factor cost. ___________________

National income at factor cost is the sum of all incomes earned by re-
___________________
sources suppliers for their contribution of land, labor, capital and or-
ganizational ability, which go into the year’s net production. Hence, ___________________
the sum of the income received by factors of production in the form ___________________
of rent, wages, interest, and profit is called National Income.
___________________
Hence,
UP
NI = NNP + Subsidies – Interest Taxes
___________________
Or, GNP = Depreciation + Subsidies – Indirect Taxes
Or, NI = C+G+I+(X-M)+NFIA – Depreciation – Indirect Taxes +

Subsidies
Where;
C denotes consumption,
I denote investment,
G denotes Government expenditure,
(X – M) denotes export minus import,
NFAI denotes Net factor income from abroad.
Therefore, National income is calculated as the total monetary worth

)
of all the final goods and services produced in the national economy
during a year. In order to avoid the problem of the double counting,
value addition is done at each stage of manufacturing of goods and
(C
provision of services.
Definition of National Product, Income, and

Expenditure
National product covers all the final goods and services produced by
the residents of a country.
162
Measures of Aggregate Income
Notes
ES
Let’s apply the concepts of national income to define other macroeco-
___________________
nomic concepts.
___________________
Gross and Net Concept
___________________
Gross means that no allowance has been made for depreciation.
___________________
___________________ Net indicates that the depreciation has been deducted.
___________________ “Net factor income from abroad = Factor income received from
___________________
abroad - Factor income paid abroad.”
___________________ Since factors receive subsidies, they are added, while indirect taxes
are subtracted, as these do not form any part of the factor income.
___________________
“NNP at factor cost = NNP at market prices – Indirect taxes + Sub-
___________________
UP
sidies.”
Personal Income
Personal income is calculated by the following expression:
Personal Income = NNP at factor cost + Transfer payments – (Un-

distributed profits + Corporate taxes)
Disposable Income
After paying direct taxes, the balance left from personal income is
the Disposable Income. It’s the expense incurred by an individual.
DI = PI–Direct Taxes
From consumption approach,
DI = Consumption Expenditure + Savings

)
Per Capita Income (PCI)
PCI of a country can be calculated by dividing the national income

by the total population of the country.
(C
Thus,
PCI = Total National Income/Total National Population
Summary
The chapter discusses the various components of national income. It
tells us about Gross Domestic Product, Gross National Product, and
Unit 22: National Income
163
Net National Product. It also explains the measures of aggregate in-
come and explains the application of the concepts of national income Notes
ES
to define other macroeconomic concepts. It describes the meaning of ___________________
disposable income and per capita income. ___________________
___________________
___________________
1. Define the various aggregates of national income.
___________________
2. What and how the GDP at market prices is calculated?
___________________
3. What is the difference between personal income and personal ___________________
disposable income?
___________________
4. How does PCI affect GDP?
___________________
) UP ___________________
(C
(C
) UP
ES
165
Unit 23 Notes
ES
___________________
Inflation and Monetary Policy ___________________
___________________
Objectives
___________________
___________________
\\ Explain the concept of inflation in detail
\\ Explain the concept of monetary policy and its impact ___________________
\\ Identify the vicious business cycle ___________________
___________________
Introduction ___________________
UP
Inflation is defined as a continued and unremitting rise in price lev-
els or a reduction in the real value of money or purchasing power
of people. Inflation is caused by excessive aggregate demand over
___________________
aggregate supply, rising import prices and the rate at which money
expands.
Types of Inflation
Open Inflation is the result of supply-demand imbalances in a free
market economy because the prices can go up freely without any
checks.
Creeping Inflation, Galloping Inflation, and Hyper-Inflation: On the

basis of severity of inflation, inflation can be categorized into three
major categories, namely:
1. Creeping Inflation: A highly beneficial phenomena for a

growing economy is, Creeping Inflation occurs when there is
a sustained rise of 2 to 3% in annual price levels. Firms are
)
encouraged to enhance their production levels because the mild

price rise leads to growth in industrial output as well as profit
margins.
(C
2. Galloping Inflation: If the price rise is in the range of 20 to

100%, it is called as galloping inflation. It leads to undesired
variation in distribution or purchasing power of various sec-
tions of money earners. Domestic investments are adversely af-
fected, and people start sending their investment funds abroad.
3. Hyperinflation: When the rate of price rise touches absurd

proportions and runs into a thousand, a million or even a billion
166
percent per year, this phenomenon is known as hyperinflation.
Notes It cripples the economy. Hyperinflation occurs when there is a
ES
___________________ war or a political revolution.
___________________ 4. Demand Pull Inflation: When the aggregate demand of com-
___________________ modities in a market exceeds the aggregate supply, the scenar-
io is referred to as demand-pull inflation.
___________________
___________________ Factors influencing inflation on the demand side

___________________
On the demand side, the major inflationary factors include the vol-
___________________ ume of money in the rotation, spendable income and spending by
___________________ consumers, and expenses in business and foreign demand.
___________________ ● Money Supply: A major cause of Inflation is an enhance-
ment in money supply in an economy. This increase in the
___________________
UP supply of money can be attributed to credit created by the
commercial banks.
● Disposable Income: It is the income payments to factors

of production, excluding the personal taxes. As a result of
high disposable income, the amount of consumption ex-
penditure increases in the economy. It adds on to infla-
tion.
● Increase in Expansion of Capital: Business expenditure

increases because of increase in spending on new equip-
ment, plants, excessive inventories, dividends, wages and
other income payments. Increase in the expansion of cap-
ital leads to inflation in the market. Increased Foreign
Demand: Increased demand is also a result of foreign
spending on local products and services.
)
5. Cost-Push Inflation: When the cost of production rises per-

sistently, because of the constant increase of wages, the pro-
ducers transfer their burden of increased cost on customers and
raise their prices, which leads to rising in prices. It is called the
(C
Cost-Push inflation. In this case, wages rise faster than produc-

tivity.
In the above case shown in the graph, if a business unit is running

in heavy profits, then the trade union leaders ask for high wages.
Once the management increases the wages, the cost of production
rises and thus, the prices. Further increase in high profits leads to
wage-price spiral and thus, the cost-push inflation.
Unit 23: Inflation and Monetary Policy
167
AS2
Price level Notes
ES
AS1
___________________
P2 ___________________
P1
___________________
AD ___________________
___________________
O Y2 Y1 Real national output
___________________
Figure 23.2: Cost Push Inflation
___________________
Control of Inflation ___________________
Reserve Bank of India, utilizes Quantitative and Qualitative tools ___________________

of its monetary policy to control Inflation. The Fiscal policy brings
UP
changes in the public revenue, public expenditure, public borrowing
and public debt, as it controls inflation.
___________________
Let’s have a look at the instruments of monetary policy.
Monetary policy consists of the actions of a central bank, currency

board or another regulatory committee that determine the size and
rate of growth of the money supply, which in turn affects the interest
rates.
Monetary Policy
Monetary Policy Instruments
Following Quantitative Techniques comprise the Instruments of
Monetary Policy:
Open Market Operations: As a Policy matter, purchase and sale of

securities are performed by the Central Bank of the country. During
)
periods of inflation, securities are traded in the financial market.

During deflation, the securities are bought from the financial mar-
ket.
(C
Reducing Consumer’s Credit: During inflation, to curb the cred-

it, the value of the first installment of a loan is increased and the
margin, that is, the amount of loan minus the value of the security
is increased. Even the loan is allowed for certain specific purposes
only. It is done so that the people are discouraged to take loans, and
commercial banks create less credit.
168
During deflation, to increase the credit in the market, the value of
Notes the first installment of the loan is decreased and the margin that is,
ES
___________________ the amount of the loan minus the value of the security, is decreased.
___________________ It is done so that the people are encouraged to take loans, and com-
mercial banks create more credit.
___________________
Now let us have a look at the business cycle and its phase.
___________________
___________________ Business Cycle

___________________
A business cycle depicts economic activity fluctuations of an econo-
___________________ my.
___________________
A business cycle has four phases. They are shown in Figure 23.3.
___________________
Peak Trend line
___________________
UP Peak
Recession
Recession
Real Expansion
Expansion
GDP
Trough
Trough
Time
Figure 23.3: Phases of Business Cycle
The four phases are discussed as follows:
1. Expansion: Expansion means development in the economy,

higher prices and higher investment that increases the pur-
)
chasing power of the people, which increases the market de-

mand. There is also an increase in bank deposits and currency.
At the end of the expansion, there is a large growth of fixed

(C
capital. Pressure rises on cost and price, which reduces profits

with increased competition. Costs of all the factors of produc-
tion rise. Shut down occurs, and as a result, the recession be-
gins.
2. Recession: The fall in prices and decline in economic activity

in an economy is called a recession.
Unit 23: Inflation and Monetary Policy
169
3. Depressions/Contraction: A depression is a severe downturn
in economic activity. Notes
ES
___________________
There is a fear of severe losses in future. In a depression, unem-
___________________
ployment increases and the demand decreases.
___________________
4. Recovery/Revival: The recovery starts slowly, as a fresh in-
___________________
vestment is brought in by fresh entrepreneurs. Development
starts gradually. ___________________
___________________
Summary
___________________
Inflation is the ongoing and persistent increase in the price levels in ___________________
a country.
___________________
Inflation can be broadly categorized into three categories namely,
UP
Creeping Inflation, Galloping Inflation and Hyper Inflation.
Demand Pull Inflation occurs when the total demand for goods and
___________________
services is higher than the total supply of goods and services in an

economy.
Cost-Push Inflation is the caused due to the increased cost of produc-

tion resulting in wage-price spiral.
Inflation can be controlled by the Central Bank through many quan-

titative and qualitative measures.
Quantitative Methods include Bank Rate Policy, Open Market Op-

erations, Reducing Consumer’s Credit.
Business Cycle is a trade cycle which shows prosperity, peak, reces-

sion, depression and recovery phases of an economy.
)
1. Explain the concept of a business cycle?
2. How does the Reserve Bank of India use its monetary policy to
(C
curb inflation?
3. How is the economic stability maintained by the government?

(C
) UP
ES
171
UNIT 24 Notes
ES
___________________
Fiscal Policy ___________________
___________________
Objectives:
___________________
___________________
\\ Describe fiscal policy in detail
\\ List the tools a fiscal policy ___________________
___________________
Introduction ___________________
Fiscal policy is the prerogative of the government. In earlier days, ___________________

UP
the government was known as the police state, and the objective
was to maintain law and order. But now, the objectives have a wider
perspective. The government has a great role to play regarding mo-
___________________
bilization and reallocation of resources, balanced regional growth,

increased employment, etc.
Fiscal policy refers to the changes in government expenditure or tax-

es to achieve specific economic goals, such as low unemployment,
price stability, and economic growth.
In other words, the government raises revenues through sources

such as taxes, and these revenues are then spent (government expen-
diture). To generate revenues and incur expenditure, government
frames a budgetary policy or fiscal policy. Such policy is concerned
with the government expenditure and government revenue, and the
role of the government in stabilizing the macroeconomic variables
that in turn results in economic growth.
)
Fiscal policy has the following major functions:

● Distribution of wealth and income
● High employment
(C
● Price stability
● Correcting the balance of payment
● Foreign exchange earnings
● Controlling inflation
● Increasing the national income
● Capital formation
172
Let us now discuss the tools of fiscal policy in detail.
Notes
ES
___________________
Tools of Fiscal Policy
___________________
The tools of fiscal policy are discussed as below:
___________________
___________________ Demand Side Fiscal Policy

___________________
Fiscal policy, through the government spending and taxes, can af-
___________________
fect the aggregate demand(AD). As we mentioned in the previous
___________________ section, a change in consumption, investment, government spend-
___________________
ing, or net exports, can change the aggregate demand and therefore,
shift AD curve. For example, an increase in government purchases
___________________
increases the aggregate demand and shifts the AD curve to its right.
___________________
UP
On the other hand, a decrease in the aggregate demand shifts the
AD curve to its left. A change in taxes can affect consumption and
investment or both, and therefore, can affect the aggregate demand.
A decrease in income taxes increases the disposable income (after
tax) of the consumer and increases the level of consumption that
shifts the AD curve to the right. An increase in taxes decreases dis-
posable income, lowers consumption, and shifts the AD curve to the
left.
Supply Side Fiscal Policy

The effects of fiscal policy can be felt on the supply side, as well as
on the demand side. For example, a reduction in tax may change
an individual’s incentive to work and produce, thus changing the
aggregate supply.
The marginal (income) tax rate is equal to the change in a person’s

)
tax payment divided by the change in the person’s taxable income.
There is a difference in opinion amongst economists regarding the

degree of success of the discretionary measures in fiscal policy. It
(C
does not always work as mentioned theoretically. Some economists

refer to the crowding effect as the reason for that. Crowding out ef-
fect refers to a decrease in private expenditure that occurs as a con-
sequence of increased government spending or the financing needs
of a budget deficit.
UNIT 24: Fiscal Policy
173
Combined Effect of Monetary and Fiscal Policy
Notes
ES
In the real world, monetary and fiscal policies are used in combina- ___________________
tion and measures are undertaken do have any effect on each other.
___________________
In figure 24.1, a rise in G shifts IS. By itself, this fiscal action would ___________________
push r up to r2. Due to crowding out, Y would rise only to Y2. If this
___________________
move is followed by an enhancement in the money supply, LM will
shift rightwards. If the new LM passes through E3, the output will ___________________
rise in Y3 without any rise in r. Here, the crowding out effect is neu- ___________________
tralized by the appropriate monetary action.
___________________
2. Expansionary monetary policy ___________________

further reduces the interest rate
and offsets the decline in output.
___________________
UP ___________________
Real Interest Rate (%)
LM0
LM1
A
r0
B IS0
C 1. Contractionary fiscal
r1 policy lowers the interest
IS1 rate and output.
Y1 Aggregate Output
Figure 24.1 Offsetting policies.
Let’s see another opinion. The government may raise taxes to de-
crease the budget deficit, but the authorities may not want the in-
come to fall. Without any monetary intervention, the tax increas-
es and the consumption also decrease. The downward pressure on
consumption can be neutralized by increasing the supply of money
in an appropriate manner. The final equilibrium after adjustment
)
will be in equilibrium at this case E3, where the level of output is

unchanged at the same consumption unit.
An important point here to keep in mind is that the fiscal and mone-
(C
tary policy may interact with each other and the impact of any policy
change will depend crucially on the interdependence.
Let’s now discuss revenue budget in detail.
Revenue Budget
Revenue Budget comprises of revenue receipts and expenditure.
174
● Revenue Receipts: consists of revenue collected from tax and
Notes other sources
ES
___________________
a. Tax revenue: It comprises of various taxes and duties levied
___________________ by the Central Government.
___________________
b. Other revenue: These types of receipts of the government
___________________ consist of dividends and interest on investment, which
___________________ are made by the government, including receipts and fees
for other services, which the government renders.
___________________
___________________ ● Revenue Expenditure: For daily workings of government de-

partments, this expenditure is required, for example, subsidies.
___________________
It does not add to the capital requirements.
___________________
Capital Budget
___________________
UP
Capital receipts and various payments are included in capital bud-
geting.
● Capital Receipts: encompasses the credit taken by the ad-

ministration from the general public as well as other entities
by way of sale of treasury bills. It also includes money received
from central subjects, foreign government and entities, recov-
ery of loans granted by the Central Government to State Gov-
ernments, Union Territory Governments and any other enti-
ties.
● Capital Payments: are the payments made by the Union Gov-

ernment as loans or in lieu of acquiring assets to other state
governments, Union territory governments, Public Sector Un-
dertakings
)
Taxation
Taxes are imposed in many ways; we can distinguish taxes as;
1. Direct Tax
(C
2. Indirect Tax
Direct taxes are those which are borne by individuals in such a way
that the impact and incidence of taxation is on the same person, for
example, income tax. Indirect taxes are those which are borne by
individuals in such a way that the impact and incidence fall on two
different persons, for example, sales tax.
UNIT 24: Fiscal Policy
175
Fiscal Policy and Economic Growth
Notes
ES
Deficit financing as a tool of fiscal policy helps to increase the effec- ___________________
tive demand during the recession.
___________________
Savings are considered as the initial stage of capital formation and ___________________
are initiated through government’s savings-oriented budgets which
___________________
in turn help with breaking the vicious cycle of poverty.
___________________
Targeted tax concessions in the form of subsidies, tax holidays, high-
___________________
er depreciation allowances are employed by Governments in the
budgetary policy. ___________________
___________________
Public Debt in India
___________________
Public debt implies the money borrowed by the central as well as
UP
state governments. Gross public debt is defined as the gross finan-
cial liability of a government.
___________________
Net public debt is the gross debt minus the value of capital assets of
the government and loans and advances given by the government to
other sectors.
Deficit Financing
Printing of new notes by the government to fill up the deficit budget
is deficit financing.
“Revenue Deficit = Revenue Expenditure – Revenue Receipts
Budget Deficit = Total Expenditure – Total Receipts.”
Total expenditure encompasses both revenue expenditure as well as

capital expenditure, whereas total receipts comprise of both revenue
receipts and capital receipts.
)
Budget Deficit is characterized by an excess of total budgetary ex-

penditure over total revenue generation.
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Budgetary deficit is fiscal deficit minus government borrowings and

other liabilities (public debt receipts).
Fiscal Deficit
The fiscal deficit is calculated using one of the following two expres-
sions:
176
“Fiscal Deficit = R
evenue Receipts (Net tax revenue + non tax rev-
Notes enue) + Capital Receipts (only recoveries of loans
ES
___________________ and other receipts) – Total Expenditure (Plan and
___________________ non-plan)
___________________ OR
___________________ Fiscal Deficit = B
udget Deficit + Government’s market borrowing
___________________ and liabilities.”
___________________
Summary
___________________
Fiscal policy is the policy level decisions by a government to rein in
___________________
inflation. The compensatory fiscal policy helps to control recession.
___________________ This is made possible through the instruments of fiscal policy that
include, public revenue, public debt, public expenditure and Deficit
___________________
UP
financing.
Self-Assessment Questions
1. “Fiscal Policy is the budgetary policy that helps to control infla-
tion.” Explain how.
2. What are the sources of funds of the government?
3. Differentiate between direct taxes and indirect taxes.
4. How can the tax policy of the government affect a manager?

)
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177
Unit 25 Notes
ES
___________________
Case Study: Impact of ___________________
Technological Advancements on ___________________
Employment Levels ___________________
___________________
Technological advancements not only lead to structural unemploy-
___________________
ment but also regional unemployment. Technological advancement
will benefit those locations mostly which have a high concentration ___________________
of large corporations making use of such technology and innova-
___________________
tions such as London and New York. This advancement of a world-
class city such as London leads to drainage of employment oppor- ___________________
tunities from other regions of the United Kingdom. As a result, till
UP
London continues its love affair with technological advancement,
the benefits reaped from such advancement will be infused within
the city itself. But if these benefits do not expand to other cities in
___________________
the region, the capital city might enjoy the benefits but at the cost
of suffering of smaller cities.
Impact of technology on growth varies from country to country.

For developed economies such as the United Kingdom, which is
recovering from the 2008 crisis, growth had been stimulated by an
enhancement in employment opportunities even though the pro-
ductivity levels have been lingering towards the lower end. As a
result, if technological advancement within the country continues
to create regional unemployment, this could ultimately lead to a
slowdown in the growth of the economy as productivity did not play
a major role in the economic recovery of the UK.
Due to the rapid pace of technological advancements, which is be-

yond management by humans sometimes also, there has been a
trend of destruction of jobs in low skill sectors. Simultaneously,
)
smaller cities are always trying to catch up with the technologically

superior cities leading to the creation of regional unemployment.
But it is pertinent to note that, although technological growth
might create structural and regional unemployment, its overall
(C
impact on the long-term employment rate is insignificant.
This is where the role of Technologically advanced cities like Lon-

don becomes more important, for it is up to them to spread the
benefits of this growth to other regional centers by developing in-
frastructure, research, and transportation links. Overall levels of
employment may not register significant fall as fall in demand of
low skilled labor is offset by an increase in other job opportunities
Contd....
178
as well as people changing jobs between other sectors and trades.
Notes
ES
But in the end, there could be a rise in greater inequalities due to
___________________ the polarisation of employment levels within different sectors.
___________________ Assessment Questions
___________________ 1. What will be the impact of technological advancements on

___________________
employment levels?
___________________ 2. Will there be any impact on inflation level of the country?
___________________
___________________
___________________
___________________
___________________
) UP
(C
(C
)U
PE
S

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(C

Mr. Utpal Ghosh

Dr. S J Chopra Dr. Deependra Kumar Jha

Dr D N Pandey Dr Kamal Bansal Dr Tabrez Ahmad

Dr. Rajesh Gupta Dr. Meenakshi Sharma Dr. Rakhi Dawar

Mr. Rahul Sharma Mr. Shantanu Trivedi Ms. Aparna

Dr. Rakhi Dawar

Course Code: MBCE 701D

Course Name: Economics & Management Decisions

Version: January 2018

Unit 1: Introduction to Managerial Economics...........................................................................3

Theory of Consumer Behaviour.....................................................................................31

Unit 11: Supply Analysis..............................................................................................................73

Unit 15: Case Study: Buying Versus Making............................................................................105

Unit 16: Monopoly Market.........................................................................................................111

UNIT 2: TEN PRINCIPLES OF ECONOMICS UNIT 5: CASE STUDY: A CASE ON

UNIT 3: TOOLS USED FOR

\\ Identifying the role of managerial economics in making business deci- ___________________

Managerial Economics: Overview

Economics is described as the study of social aspects and establish-

Nature of Managerial Economics

Microeconomics can be described as the study of economic units

The following figure depicts the different branches of economics.

___________________ Individual investment Aggregate investment

___________________ Output of an individual firm National output

Price of any product/factor General price-level

Demand/supply of any Inflation and deflation

Employment/unemployment Aggregate employment

Figure 1.1: Branches of Economics

Managerial economics helps managers in the following way:

1. It helps to identify the problems faced by managers and then

2. It elaborates on policies that should be pursued by any busi-

the managerial economics perspective in nature.

3. Various laws of economics such as the law of demand and pro-

duction function are used for analysis of business problems.

4. It emphasizes on quantitative analysis. Business decisions

(i) Output to be produced

(ii) Inputs to be utilized

The Scope of Managerial Economics ___________________

It is imperative to mention that managerial economics not only cov-

Importance of the Study of Managerial Economics

1. Effective decision-making processes

2. Understanding of multiple nuances of business and managerial

3. Application of conceptual and technical skills

4. Identification of distinct managerial issues, including the root

5. Assurance of responsiveness in businesses

6. Maximizationof profits through optimal use of scarce resources

7. Achieving objectives such as becoming an industry leader and

8. Forecasting on various parameters.

___________________ Role of Managerial Economics in Making

___________________ In managerial economics, the proper application of laws of econom-

___________________ Use of Mathematics in Managerial Economics

Limited Unlimited demands

What to What to How to How to

By the state By the state and By the free

mixed economy) economy)

Figure 1.2: Basics of Economics

Managerial Economics is a science which makes value judgments.

time is required to be allocated for work and leisure. Allocation of ___________________

2. How should the production be carried out?

3. For whom the production should be carried out?

Laws of economics are applied by an organization to answer the

Consumer demand decides when new goods can be launched in the

Decisions regarding choice of vendors of raw material and capital

MBCE701D-Economics & Management Decisions

MBCE701D-Economics & Management Decisions