MANAGERIAL ECONOMICS

MBAZC416

Sajin John
2020HB58042
MANAGERIAL ECONOMICS 0 SAJIN JOHN
TABLE OF CONTENTS
MODULE 1 – THE NATURE AND SCOPE OF MANAGERIAL ECONOMICS ........................................................................... 4
BASIC CONCEPTS AND PRINCIPLES ..................................................................................................................................................................... 4
Introduction to Economics & its terminologies.................................................................................................................................................... 4
What is Managerial Economics .................................................................................................................................................................................... 4
Basic Economics concepts & principles for managers ...................................................................................................................................... 4
Basic process of decision making................................................................................................................................................................................. 6
Application of Managerial Economics ...................................................................................................................................................................... 7
Application of concepts using case studies ............................................................................................................................................................. 7
OVERVIEW OF MANAGERIAL ECONOMICS .......................................................................................................................................................... 8
Positive and Normative economics ............................................................................................................................................................................. 8
Time Period ............................................................................................................................................................................................................................. 8
Opportunity costs ................................................................................................................................................................................................................. 8
Profit ........................................................................................................................................................................................................................................... 8
Ten Economic Principles for Managers .................................................................................................................................................................... 8
MODULE 2 - THEORY OF THE FIRM AND RELATED CONCEPTS ....................................................................................... 10
THEORY OF THE FIRM: NEOCLASSICAL AND OTHERS .......................................................................................................................................10
The Nature of the firm .................................................................................................................................................................................................... 10
FIRMS : Areas of economic theories ........................................................................................................................................................................ 10
TR, AR AND MR .................................................................................................................................................................................................12
The Basic Profit – Maximizing Model ..................................................................................................................................................................... 12
Measurement of Profit .................................................................................................................................................................................................... 12
TOTAL Revenue .................................................................................................................................................................................................................. 12
Marginal Revenue ............................................................................................................................................................................................................. 12
Average Revenue ............................................................................................................................................................................................................... 12
MODULE 3 – DEMAND ANALYSIS AND ELASTICITIES OF DEMAND ................................................................................ 13
BASICS OF DEMAND, DETERMINANTS OF DEMAND .........................................................................................................................................13
The Circular Flow of Economic Activity ................................................................................................................................................................ 13
Demand in Product/Output markets...................................................................................................................................................................... 13
Supply of Product .............................................................................................................................................................................................................. 17
Market Equilibrium ......................................................................................................................................................................................................... 17
ELASTICITY OF DEMAND ....................................................................................................................................................................................18
Price Elasticity of demand ............................................................................................................................................................................................ 18
Income elasticity of Demand ....................................................................................................................................................................................... 19
Cross elasticity of demand ............................................................................................................................................................................................ 19
Household choice in output markets ...................................................................................................................................................................... 19
MODULE 4 – ECOMOMIC FORECASTING ................................................................................................................................. 21
DEMAND FORECASTING ......................................................................................................................................................................................21
Qualitative Method........................................................................................................................................................................................................... 21
Quantitative Method ....................................................................................................................................................................................................... 22
Limitations of Demand Forecasting ........................................................................................................................................................................ 24
MODULE 5 – PRODUCTION ANALYSIS .................................................................................................................................... 26
PRODUCTION FUNCTIONS ..................................................................................................................................................................................26
Production Functions...................................................................................................................................................................................................... 26
Law of Diminishing Returns ........................................................................................................................................................................................ 27
TOTAL, MARGINAL, AVERAGE PRODUCT (TP, MP, AP) ................................................................................................................................28
Stages of Production........................................................................................................................................................................................................ 28
ISOQUANTS AND MRTS .....................................................................................................................................................................................30
ISOQUANTS .......................................................................................................................................................................................................................... 30
MRTS ........................................................................................................................................................................................................................................ 30
ISOCOSTS ............................................................................................................................................................................................................................... 31
Equilibrium of the producer ........................................................................................................................................................................................ 31
ECONOMIC REGION OF PRODUCTION, EXPANSION PATH ...............................................................................................................................32
Expansion Path................................................................................................................................................................................................................... 32

MANAGERIAL ECONOMICS 1 SAJIN JOHN

 Elasticity of Substitution ............................................................................................................................................................................................... 32
Economic Region of Production and Ridge Lines ............................................................................................................................................. 32
Law of Returns to Scale.................................................................................................................................................................................................. 33
MODULE 6 - COST OF PRODUCTION ........................................................................................................................................ 34
TYPES OF COSTS..................................................................................................................................................................................................34
Cost Function....................................................................................................................................................................................................................... 34
Relation between Production and Cost ................................................................................................................................................................. 35
COSTS IN THE SHORT RUN .................................................................................................................................................................................36
Short-run Cost Analysis.................................................................................................................................................................................................. 36
COSTS IN THE LONG RUN ...................................................................................................................................................................................38
Long-Run Cost Analysis .................................................................................................................................................................................................. 38
Economies of Scale ........................................................................................................................................................................................................... 39
Diseconomies of Scale ..................................................................................................................................................................................................... 39
Learning Curve ................................................................................................................................................................................................................... 40
MODULE 7 – PROFIT AND REVENUE MAXIMIZATION ........................................................................................................ 41
PROFIT MAXIMIZATION......................................................................................................................................................................................41
BREAK EVEN ANALYSIS......................................................................................................................................................................................42
Breakeven Analysis .......................................................................................................................................................................................................... 42
INCREMENTAL PROFIT ANALYSIS .....................................................................................................................................................................43
The Shutdown point......................................................................................................................................................................................................... 43
Incremental Profit Analysis ......................................................................................................................................................................................... 43
MODULE 8 – PERFECT COMPETITION AND MONOPOLY ................................................................................................... 44
PERFECT COMPETITION: MARKET DEMAND AND FIRM DEMAND ................................................................................................................44
Type of Market Structure & Pricing ........................................................................................................................................................................ 44
Firm’s revenue curves under perfect competition ........................................................................................................................................... 45
Price Controls ...................................................................................................................................................................................................................... 46
MONOPOLY AND ITS SETTING ............................................................................................................................................................................47
Characteristics of Monopoly ........................................................................................................................................................................................ 47
Type of Monopoly .............................................................................................................................................................................................................. 47
Firms Revenue curves under Monopoly................................................................................................................................................................. 47
Short-run Equilibrium of a firm ................................................................................................................................................................................ 48
Long-Run Equilibrium of a firm ................................................................................................................................................................................ 48
Price Disrimination .......................................................................................................................................................................................................... 49
MODULE 9 - MONOPOLISTIC COMPETITION AND OLIGOPOLY ....................................................................................... 50
MONOPOLISTIC COMPETITION................................................................................................................................................................50
Characteristics of Monopolistic Competition ..................................................................................................................................................... 50
Advertising............................................................................................................................................................................................................................ 50
short-run EQUILIBRIUM OF A FIRM ....................................................................................................................................................................... 50
Long-Run Equilibrium of a firm ................................................................................................................................................................................ 51
OLIGOPOLY ..........................................................................................................................................................................................................52
CAUSES OF OLIGOPOLY ................................................................................................................................................................................................. 52
CHARACTERISTICS OF OLIGOPOLY......................................................................................................................................................................... 52
DUOPOLY: COURNOT’S MODEL .........................................................................................................................................................................53
Cournot Model .................................................................................................................................................................................................................... 53
SWEEZY’S KINKED DEMAND CURVE MODEL ................................................................................................................................................... 53
Bertrand’s and Edgeworth’s Theories .................................................................................................................................................................... 54
Chamberlin and Duopoly Theory .............................................................................................................................................................................. 54
MODELS OF COLLUSIVE OLIGOPOLY .................................................................................................................................................................55
Cartels ..................................................................................................................................................................................................................................... 55
PRICE LEADERSHIP ......................................................................................................................................................................................................... 56
MODULE 10 - GAMES, INFORMATION AND STRATEGY ...................................................................................................... 57
GAME THEORY ....................................................................................................................................................................................................57
Strategy .................................................................................................................................................................................................................................. 57
Game Theory........................................................................................................................................................................................................................ 57
Prisoner’s dilemma........................................................................................................................................................................................................... 57
MANAGERIAL ECONOMICS 2 SAJIN JOHN
 Repeated Games................................................................................................................................................................................................................. 58
ASYMMETRIC INFORMATION .............................................................................................................................................................................59
Decision-Making Principles ......................................................................................................................................................................................... 59
MODULE 11 - PRICING AND PROFIT ANALYSIS .................................................................................................................... 60
MARK UP PRICING ..............................................................................................................................................................................................60
Two part pricing ................................................................................................................................................................................................................ 60
Bundling................................................................................................................................................................................................................................. 60
JOINT PRODUCT...................................................................................................................................................................................................61
Joint Products...................................................................................................................................................................................................................... 61
Joint products produced in variable proportions ............................................................................................................................................. 61
TRANSFER PRODUCTS ........................................................................................................................................................................................62
Transfer Product PRIcing ............................................................................................................................................................................................. 62
MODULE 12 – PERSPECTIVE OF INDIA ................................................................................................................................... 63
MACROECONOMIC PERSPECTIVE.......................................................................................................................................................................63
National Income ................................................................................................................................................................................................................ 63
Methods of Measuring National Income ............................................................................................................................................................... 64
Inflation .................................................................................................................................................................................................................................. 65
Inflation and Decision Making ................................................................................................................................................................................... 66
Measuring Inflation ......................................................................................................................................................................................................... 66
EMPLOYMENT IN INDIA ......................................................................................................................................................................................67
Type of unemployment ................................................................................................................................................................................................... 67
Measurement of Unemployment ............................................................................................................................................................................... 67

MANAGERIAL ECONOMICS 3 SAJIN JOHN

MODULE 1 – THE NATURE AND SCO PE OF MANAGERIAL ECONOMICS
BASIC CONCEPTS AND PRINCIPLES
INTRODUCTION TO ECONOMICS & ITS
TERMINOLOGIES
FUNDAMENTAL QUESTIONS
• What is Managerial Economics?
• Why Managerial Economics?
• What kind of issues does it help address?
• How can it help managers to make better decisions?
FUNDAMENTAL ECONOMIC PROBLEMS
• Three questions that managers face:
o What to produce? (micro)
o How to produce? (micro)
o How much to produce? (micro)
o For whom to produce? (micro)
o Are resources used optimally? (micro)
o Are resources fully employed? (macro)
o Is the economy Growing? (macro)
o In what phase of business cycle is the economy?
(macro)
o How to distribute?
• Scarcity of resources – the wants are unlimited and
on the other hand, the resources are scarce.
• How does economics answer these questions?
BASIC ASSUMPTIONS
CETERIS PARIBUS –
• Other things remaining equal. It is a Latin word
means ‘with other things (being) the same’
• “The existence of other tendencies is nor denied,
but their disturbing effect is neglected for a time” –
Marshall
RATIONALITY –
• Implies that consumers and produces measure and
compare costs and benefits before taking decisions
• Consumers: Maximising utility and minimising
sacrifice
• Products: Maximising profits and minimising costs
WHAT IS MANAGERIAL ECONOMICS
ECONOMICS: Economics is defined as body of
knowledge or study that discusses how a society tries to
solve the human problems of unlimited wants and scare
resources.
Adam Smit (1723-1790) Father of Economics: Economics is
the study of nature and uses of national wealth.
Economics is the science of making decisions in the
presence of scarce resources. Resources are simply
anything used to produce a good or service to achieve a
goal. Economic decisions involve the allocation of
scarce resources so as to best meet the managerial goal.
MANAGERIAL ECONOMICS
The nature of managerial decision varies depending on
the goals of the manager.
MANAGER: A Manager is a person who directs
resources to achieve a stated goal and he/she has the
responsibility for his/her own actions as well as for the
actions of individuals, machines and other inputs under
the manager’s control.
BUSINESS: Any situation where there is a transaction
between two or more parties.
MANAGERIAL ECONOMICS: The application of
economic theory and methods to business decision-
making.
Managerial economics is that discipline which requires
the application of economics in the complex business
decision-making process to formulate and achieve the
rational managerial objectives.
Managerial economics can be thought of as applied
microeconomics though, to some extent,
macroeconomics is also relevant at some stages.
Managerial economics is the study of how scarce
resources are directed most efficiently to achieve
managerial goals. It is a valuable tool for analysing
business situations to take better decisions.
BASIC ECONOMICS CONCEPTS & PRINCIPLES
FOR MANAGERS
MICROECONOMICS: is a branch of economics, which
analyses the market behaviour and decision-making
process of an individual consumer and a firm.
• Focus on individual consumes and firms
• Theory of the firm
• Theory of consumer behaviour (demand)
• Production and cost theory (supply)
• Price theory
• Market structure and competition theory
MACROECONOMICS: is the study of how the national
economy as a whole grows and the changes which occur
over time.
• Aggregate variable such as GDP, GNP,
Unemployment, Inflation, etc.
MANAGERIAL ECONOMICS: How is it useful?
• While economics attempts to describe how the
economy works, managerial economics speaks to
how the economy should work!
• It prescribes rules for improving managerial
decisions
• It helps managers recognize how economic forces
affect organizations
• It links economic concepts with quantitative
methods to develop vital tools for managerial
decision making.
4 SAJIN JOHN
DISTINCTION BETWEEN MICRO AND MACRO • Forecasting Procedures
ECONOMICS • Game Theory Concepts
Micro Macro • Optimization Techniques
Unit of Individual Aggregate • Information Systems
study Managerial Economics
Method Slicing Lumping • Use of Economics concepts and Quantitative
Subject Study of product Study of National Methods to Solve Management Decision Problems.
matter and factor Income, general level • Provide Optimal Solutions to Management Decision
pricing, etc. of prices, trade cycles, Problems.
etc • Quantity and quality of product
Basis Based on Based on inter- • Price of product
independence dependence • Marketing Management
Advocated Alfred Marshall John Maynard Keynes • Financial Management
by • Research and Development
Vision Worms eye view Birds eye view – forest
– study of a tree as a whole NATURE OF MANAGERIAL ECONOMICS
• Micro-economics
RELATIONSHIP WITH OTHER DISCIPLINES:
Managerial economics is concerned with the
Horizontal/Vertical Linkages
analysis of finding optimal solutions to decision
making problems of businesses/ firms (micro
economic in nature).
• Normative economics
Managerial economics describes, what is the
observed economic phenomenon (positive
economics) and prescribes what ought to be
(normative economics)
• Uses theory of firm
• Managerial economics is a practical subject
therefore it is pragmatic.
• Takes the help of macro-economic
Managerial economics analyses the problems of the
MANAGERIAL ECONOMICS: A tool for Improving firms in the perspective of the economy as a whole
Management Decision Making (macro in nature)
• Aims at helping the management
Economics
Concepts It helps to find optimal solution to the business
Management
Quantitative
problems (problem solving)
Decision
Problems
Methods • A scientific art
• Prescriptive rather than descriptive
Manageral
Economics

SCOPE OF MANAGERIAL ECONOMICS

Management Decision Problems Theory of demand
• Product Selection, Output, and Pricing • Demand Analysis
• Internet Strategy • Demand Theory
• Organization Design Theory of Production
• Product Development and Promotion Strategy • Variable factor of production
• Worker Hiring and Training • Fixed factor of production
• Investment and Financing Theory of exchange or price theory
Economic Concepts Theory of profile
• Majorly, Micro-economics Theory of capital and investment
• Marginal Analysis Environmental issues
• Theory of the firm • Business cycles
• Theory of Consumer Demand • Industrial policy of the country
• Industrial Org. and Firm behavior • Trade and fiscal policy of the country
• Public Choice Theory • Taxation policy of the country
Quantitative Methods • Price and labour policy
• Numerical Analysis
• Statistical Estimation

MANAGERIAL ECONOMICS 5 SAJIN JOHN

BASIC PROCESS OF DECISION MAKING • PPC is a graph that shows the
different combinations of the
quantities of two goods that
WHAT IS THE BEST “CHOICE” can be produced (or
• Understand the economic environment in which consumed) in an economy,
firms operate subject to limited availability
• Consider alternatives or resources.
• Make optimal choices to maximize Concept of Margin
o Profit • The Marginality deals with a unit increase in cost or
o Market share revenue or utility.
o Managerial interests 𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑻𝒐𝒕𝒂𝒍 𝑪𝒐𝒔𝒕
o Government influence 𝑴𝒂𝒓𝒈𝒊𝒏𝒂𝒍 𝑪𝒐𝒔𝒕 =
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑻𝒐𝒕𝒂𝒍 𝑶𝒖𝒕𝒑𝒖𝒕
o National interests 𝒅𝑻𝑪
o Social and environment benefits =
𝒅𝑸
The Incremental Concept
THE DECISION-MAKING PROCESS • A decision is clearly a profitable one if
Managerial decisions in any business area would o It increases revenue more than costs
include: o It decreases some cost to a greater extent than
1. Assessment and evaluation of investible funds it increases others.
2. Selection of business area o It increases some revenues more than it
3. Choice of product to deal with decreases others.
4. Determination of optimum level of output o It reduces costs more than revenues.
5. Determination of price of product Concept of Time Perspective
6. Determination of input-combination, mix and • The time perspective concept states that the
technology decision maker must give due consideration both to
7. Publicity and sales promotion the short run and long run effects of his decisions.
Examine He must give due emphasis to the various time
Establish Identify the possible periods.
objetives problem alternative
solutions • It was Marshall who introduced time element in
economic theory
Equi-Marginal Concept
Analyze • The principle states that an input should be
Implement Perform a
and monitor sensitive
alternatives allocated so that value added by the last unit is the
and select the same in all cases. This generalisation is popularly
the decision analysis
best
called the equi-marginal
• Let us assume a case in which the firm has 100 unit
CONVENTIONAL DECISION RULES of labour at its disposal. And the firm is involved in
Concept of Scarcity: five activities viz., A, B, C, D and E. The firm can
• Everything in this world can’t be used endless increase any one of these activities by employing
• Human wants are unlimited, but human capacity to more labour but only at the cost i.e. sacrifice of
satisfy such wants is limited other activities.
• So, is the case for Business Discounting Concept
• i.e. the wants are unlimited and on the other hand, • This concept is an extension of the concept of time
the resources are scarce. perspective.
• Since future is unknown and incalculable, there is
Concept of Opportunity Cost: lot of risk and uncertainty in future.
• It is the benefit foregone from the • Everyone knows that a rupee today is worth more
alternative that is not selected than a rupee will be two years from now.
• The economist has to make rational • This appears similar worth than two in the bush.
choice in all aspects of business by Risk and Uncertainty
sacrificing some of the alternatives, • Managerial decisions are actions of today which
since resources are scare and wants are unlimited bear fruits in future which is unforeseen.
Production Possibility Curve (PPC) • Future is uncertain and involves risk
• The uncertainty is due to unpredictable changes in
the business cycle, structure of the economy and
government policies.

MANAGERIAL ECONOMICS 6 SAJIN JOHN

APPLICATION OF MANAGERIAL ECONOMICS
Managerial economics can be applied by a firm in
making its business decisions. These decisions include:
Decision Regarding the Price:
• When a firm is planning on its production, it has to
determine the price of the product.
• This will depend on the structure of the market.
• If there exists perfect competition, then the firm will
be just a price taker.
• However, if there is a monopoly, then the firm will
have some controls over the price.
• Hence, the determination of the price involves an
understanding of the different market structures.
Forecasting and Estimation of the Demand for the
Product:
• The firm will have to forecast and estimate the
demand for the product to be able to decide on the
level of output of the product.
• The managers will have to foresee and provide for
the future increases in the demand for the product.
• This involves an understanding of the nature of the
demand and the ability to forecast the demand.
Choice Relating to the Technique of Production:
• The manager will have to make the crucial decision
as to whether to use a labour-intensive technology
or a capital-intensive technology.
• The decision will, to some extent, depend on which
factor of production is more readily available and is
in abundance in the economy.
• This involves an understanding of the cost and
production analysis.
Advertising Expenditures:
• Under imperfect competition, often, to sell its
product, a firm may have to resort to advertising.
• It will have to decide on the amount of expenditure
to incur on advertising, the medium of information
to be used: television, newspapers and other such
decisions.
• This involves an understanding of the optimum
advertising expenditure under the monopoly,
monopolistic competition and oligopoly.
Decisions Relating to Investment:
• In the long run, a firm has to decide on expanding
the production of the product.
• Hence, it has to incur the capital expenditure.
• This involves an understanding of the theory of
capital budgeting.
MANAGERIAL ECONOMICS
APPLICATION OF CONCEPTS USING CASE
STUDIES
MULTINATIONAL PRODUCTION AND PRICING
• How does FORD or GM decide where to produce its
cards (multinational factory locations) and where
to see (multinational markets).
MARKET ENTRY
• How do major bookstores decide where to set up
show, assess demand and profitability, assess and
react to threats from online stores
R & D DECISIONS
• How does a pharma company decide whether to
invest in traditional biochemistry-based research
or to pursue biogenetic approaches (such as gene
splicing)?
WHAT TO PRODUCE? THE COCA COLA WAY
BUILDING A
NEW BRIDGE
Building a bridge is usually a public responsibility (paid
out of public funds raised via taxes)
How might a public planner determine the need for a
new bridge?
How should tolls (if any) be set?
The authority should
- estimate usage of the bridge over its useful life,
- the likely cost of building and maintaining the
bridge, and
- the important side-effects, pro and con –
including positive effects on business activity
and the impacts on air pollution and traffic
congestion.
EURO DISNEY
Which factors most affect the success of the park?
How would you go about collecting and analysing the
information needed to make forecasts regarding these
factors?
Disney should gather information on:
- The likely number of European visitors to the
new park and the amount these visitors will
spend on amusements, food, and lodging
- Cost of operating the park
- Macro-economic forecasts for the European
economy.
7 SAJIN JOHN
OVERVIEW OF MANAGERIAL ECONOMICS
POSITIVE AND NORMATIVE ECONOMICS
This is also referred as is / ought distinction.
POSITIVE STATEMENT
• Factual statements (“what is” or actual)
• It can be verified by empirical study or logic
• These statements are more objective
• E.g.: The distribution of income in India is unequal
NORMATIVE STATEMENT
• Value judgements (“what ought/should to be”)
• It can’t be verified by empirical study or logic
• These statements are more subjective
• E.g.: The distribution of income in India should be
equal
Relevance of the distinction to the study of managerial
economics
Microeconomics has both Positive and normative
statements
Managerial economics are prescriptive in nature and
thus it deals with normative statements.
TIME PERIOD
SHORT RUN – A time period not long enough for
consumers and producers to adjust to a new situation –
K/L (Capital/Land)
LONG RUN – Planning Horizon – A time period long
enough for consumers and producers to adjust to a new
situation – All inputs can be varied – K and L – whether
to change product line, built new plant, etc.
OPPORTUNITY COSTS
• Scarcity and choice are central to the economics
discipline
• In the face of scarcity, we make many decisions
• Follow one course of action and forge some other
course of action
• Opportunity cost is the highest values alternative
forgone whenever a choice is made.
• Opportunity cost is the price that a firm must pay to
factor to prevent it from moving to the next best
alternative use of the factor.
PROFIT
BUSINESS OR ACCOUNTING PROFIT: Total
revenue minus the explicit or accounting cost of
production
Accounting Profit = TR − Explicit Cost
ECONOMIC PROFIT: Total revenue minus the explicit
and implicit costs of production. (𝜋 = TR − TC)
Economic Profit = TR – TC
where, TC = Explicit Cost + Implicit Cost
thus, Economic Profit = Accounting Profit − Implicit Cost
OPPORTUNITY COST: Implicit value of a resource in
its best alternative use.
MANAGERIAL ECONOMICS
THEORIES OF PROFIT
• Risk-Bearing Theories of Profit
o Risks like technology change. in case of Kodak
or Nokia Mobiles
• Frictional Theory of Profit
o Oil (gulf war) cause Profit to other Oil company
o Lenders Bank Entrepreneur
lender Entrepreneur (via P2P/internet)
this cause a loss to Bank
• Monopoly Theory of Profit
o E.g.: Horlicks when initially launched
• Innovation Theory of Profit
o E.g.: Apple
• Managerial Efficiency Theory of Profit
SOCIAL FUNCTION OF PROFIT
• Profit is a signal that guides the allocation of
society’s resources.
• High profits in an industry are a signal that buyers
want more of what the industry produces.
• Low (or negative) profits in an industry are a signal
that buyers want less of what the industry
produces.
TEN ECONOMIC PRINCIPLES FOR MANAGERS
MAKING OPTIMAL DECISIONS
• The role of managers is to make decisions
o Business firms come in all sizes
o No firm has unlimited resources
o Short-run and long-run decisions
• Managerial Economics: How to make decisions that
make sense for the operation of the firm.
DECISIONS ARE ALWAYS AMONG
ALTERNATIVES
• Choices are always among alternatives
• Example-buying a new computer
• A job can be done by many, but some may be better
at it than others-cost differs
DECISIONS ALTERNATIVES ALWAYS HAVE
COSTS AND BENEFITS
• Working vs Pursing further studies
• What we consider when making our decisions?
• Benefits: benefit gained from studying – enhanced
knowledge and capabilities, which lead to better
career opportunities in the future
• Cost: cost of giving up short term promotions and
increments
• Choosing to study – additional benefit gained from
further studies exceeds the additional cost
• Opportunity cost
8 SAJIN JOHN
OBJECTIVE IS TO INCREASE THE FIRM’S VALUE
• Profit is the difference between TR & TC
• Different types of organizations/firms
• Problem – Managers attempt to maximize own
interest while shareholders increase own benefit
• Principal – agent problem.
FIRM’S VALUE IS MEASURED BY ITS EXPECTED
PROFIT
• Example: consider two companies using different
production process
• Which one would be the better company?
• This can be easily evaluated based on excepted
profits
• Present value of the expected future profit stream
FIRMS’ SALES REVENUE DEPENDS ON DEMAND
FOR ITS PRODUCT
• Some goods are highly price sensitive while other
goods are less price sensitive
• Demand for a product is a function of a number of
factors in addition to price.
THE FIRM MUST MINIMIZE COST FOR EACH
LEVEL OF OUTPUT
• TR – TC
• Important factors:
MANAGERIAL ECONOMICS
o Technology of production
o Input prices
o Factors of production
o Different levels of technologies
THE FIRM MUST DEVELOP A STRATEGY
CONSISTENT WITH ITS MARKET
• We will study the various market structures and the
appropriate strategy for each of these situations
• Selling identical products
• Differentiated products
• Example – airline industry, software industry, etc.
GROWTH DEPENDS ON RATIONAL
INVESTMENT DECISIONS
• Decision to invest in new plan or equipment or
develop a new product
• The process of evaluating new investments of the
firm-capital project analysis or capital budgeting
• Capital project – calculating the expected stream of
benefits it will product for the firm
FIRMS DEAL RATIONALLY AND ETHICALLY
WITH LAWS AND REGULATIONS
• Various business laws and regulations
• Case of Enron or closer hope the collapse of Satyam
highlights the consequences of unethical behaviour
9 SAJIN JOHN
MODULE 2 - THEORY OF THE FIRM AND RELATED CONCEPTS
THEORY OF THE FIRM: NEOCLASSICAL AND OTHERS
• Managerial Economics is primarily concerned with
the application of microeconomic principles for the
effective management of business firms
• In order to do this in an effective manner we need
an overarching “Theory of the Firm” that explains
why firms exist, their structure, how they behave,
and what their goals are, etc.
• Firms are complex organizations that are difficult to
model but as with any modelling the key is to focus
on the important factors and eliminate the
unimportant factors
• There are a number of theories (i.e. models) that
attempt to model the business enterprise and we
shall review the key ones in this segment
THE NATURE OF THE FIRM
• Two fundamental questions:
– What are organizations?
– Why do they exist?
• Economic organizations
– Organizations occur at many different
levels
• Business organizations
– Sole proprietorships
– Partnerships
– Joint stock company
A FIRM is an association of individuals who have
organized themselves for the purpose of turning inputs
into output. The firm organizes the factors of
production to produce goods and services to fulfil the
needs of the households. Each firm lays down its own
objectives which is fundamental to the existence of a
firm.
THE MAJOR OBJECTIVES OF THE FIRM ARE:
• To achieve the Organizational Goal
• To maximize the Output
• To maximize the Sales
• To maximize the Profit of the Organization
• To maximize the Customer and Stakeholders
Satisfaction
• To maximize Shareholder’s Return on
Investment
• To maximize the Growth of the Organization
FIRMS : AREAS OF ECONOMIC THEORIES
• Transaction cost theory
– Cost associated with undertaking transactions
in different ways
– One of the first theories developed in this area
– Ronald Coase proposed this in 1937
• Information theory
– Concept of bounded rationality, asymmetric
information
• Motivation theory
MANAGERIAL ECONOMICS
– This examines the underlying factors that
cause people to behave in certain ways
• Agency theory
– Conflict between Principal and Agent
• Property rights theory
– This examines the nature of ownership, and its
relationship with incentives to invest and
bargaining power
• Game theory
– The strategic interaction of different agents
TRANSACTION COST THEORY
• An exchange of goods or services (Transaction)
• It can be performed in three different ways
– Trading in spot markets
– Long-term contracts
– Internalizing the transaction within the
firm
• Transactions costs refer to the costs that are not
directly associated with the actual transaction but
rather enable the transaction to take place
– Acquiring information about a good or
service (e.g., price, availability, durability,
servicing, safety) are transaction costs
• Minimize the external and internal transaction
costs
• An exchange of goods or services (Transaction)
• It can be performed in three different ways
• Trading in spot markets
• Long-term contracts
• Internalizing the transaction within the firm
• Transactions costs refer to the costs that are not
directly associated with the actual transaction but
rather enable the transaction to take place
• Acquiring information about a good or service (e.g.,
price, availability, durability, servicing, safety) are
transaction costs
• Minimize the external and internal transaction
costs
THE AGENCY PROBLEM
• An exchange of goods or services (Transaction)
• It can be performed in three different ways
– Trading in spot markets
– Long-term contracts
– Internalizing the transaction within the
firm
• Transactions costs refer to the costs that are not
directly associated with the actual transaction but
rather enable the transaction to take place
– Acquiring information about a good or
service (e.g., price, availability, durability,
servicing, safety) are transaction costs
• Minimize the external and internal transaction
costs
10 SAJIN JOHN
CONTRACTS AND BOUNDED RATIONALITY VALUE OF A FIRM
• An exchange of goods or services (Transaction) Since both short term as well as long term profits are
• It can be performed in three different ways clearly important, the “theory of firm” now postulates
– Trading in spot markets that the primary goal or objective of the firm is to
– Long-term contracts maximize the wealth of value of the firm.
– Internalizing the transaction within the Future profits must be discounted the present value of
firm all expected future profits of the firm.
• Transactions costs refer to the costs that are not Future profits must be discounted to the present
directly associated with the actual transaction but because a unit of profit in the future is worth less than a
rather enable the transaction to take place unit of profits today.
– Acquiring information about a good or Formally stated value of firm,
service (e.g., price, availability, durability, 𝑇𝑅 −𝑇𝐶
∑𝑛𝑟=1 𝑟 2𝑟
servicing, safety) are transaction costs (1+𝑟)
• Minimize the external and internal transaction Where, TR – Total Revenue
costs TC – Total Cost
r – appropriate discount/rate of return
NATURE OF CONTRACT IN REALITY
PV – Present value of the firm
• An exchange of goods or services (Transaction) FV – Future Value of the firm
• It can be performed in three different ways 𝐹𝑉
– Trading in spot markets 𝑃𝑉 =
(1 + 𝑟)𝑛
– Long-term contracts
Where, r – rate of return
– Internalizing the transaction within the
n – number of period
firm
• Transactions costs refer to the costs that are not 𝑖
directly associated with the actual transaction but 𝐹𝑉 = 𝑃𝑉 × [1 + ( )](𝑛×𝑡)
rather enable the transaction to take place 𝑛
Where, i - the interest rate or other return that can be
– Acquiring information about a good or earned on the money
service (e.g., price, availability, durability, t – the number of years to take its consideration
servicing, safety) are transaction costs n – the number of compounding periods of interest per
• Minimize the external and internal transaction year
costs

MANAGERIAL ECONOMICS 11 SAJIN JOHN

TR, AR AND MR
– The stream of profits over some period of
time
THE BASIC PROFIT – MAXIMIZING MODEL
– Value of the expected future cash flows
The most common objective of the firm – Discounting
• Basic profit-maximizing model:
𝑀𝑅 = 𝑀𝐶
We start by defining, TOTAL REVENUE
𝑃𝑟𝑜𝑓𝑖𝑡 (𝜋) = 𝑇𝑅 − 𝑇𝐶 In any market, the total revenue (TR) received by
Pi is at a maximum when its first derivative produces is calculated as,
with respect to Q is equal to zero 𝑻𝑹 = 𝑷 × 𝑸
𝒅𝝅 𝒅𝑹 𝒅𝑪 𝑻𝒐𝒕𝒂𝒍 𝑹𝒆𝒗𝒆𝒏𝒖𝒆 = 𝑷𝒓𝒊𝒄𝒆 × 𝑸𝒖𝒂𝒏𝒕𝒊𝒕𝒚
= − =𝟎
𝒅𝑸 𝒅𝑸 𝒅𝑸
𝒅𝑹 𝒅𝑪
= MARGINAL REVENUE
𝒅𝑸 𝒅𝑸
• It is the additional revenue added by an additional
𝑴𝑹 = 𝑴𝑪
unit of output.
• Assumptions of basic profit-maximising model
• In other words marginal revenue is the extra
– The firm has a single decision-maker.
revenue that an additional unit of product will bring
– The firm produces a single product.
a firm.
– The firm produces for a single market.
• Marginal revenue is the
– The firm produces and sells in a single location
derivative of total revenue with
– All current and future costs and revenues are
respect to demand
known with certainty.
– Price is the most important variable in the If, the inverse demand equation is,
𝑃 = 100 − 𝑄
marketing mix
∵ 𝑇𝑅 = 𝑃 × 𝑄
∴ 𝑇𝑅 = 100𝑄 − 𝑄2
𝑑𝑇𝑅
MEASUREMENT OF PROFIT 𝑎𝑠, 𝑀𝑅 =
𝑑𝑄
• Two problems associated with the measurement of ∴ 𝑀𝑅 = 100 − 2𝑄
profit So, when Q=60,
– Ambiguity in measurement P=40, TR=2400 & MR=-20
– Restriction to a single time period Example: If the total
• Bankruptcy of Enron in 2001 highlights these issues revenue of
• Restating their earnings producing 10 units
• Accounting profit is an ambiguous term is Rs. 100. And for
– gross profit producing 11 units
– net profit the total revenue is
– operating profit Rs.109 ; then
– earnings before interest Marginal Revenue
– depreciation and tax of producing the
• The above definitions involve estimates rather 11th will be Rs. 9
than precise measures for a number of reasons ∆𝑻𝑹
𝑴𝑹𝒏 = 𝑻𝑹𝒏 − 𝑻𝑹𝒏−𝟏 =
relating to GAAP ∆𝑸

MANIPULATION AVERAGE REVENUE

• Scope for managers to manipulate the firm’s Average revenue refers to the revenue obtained
accounts by the seller by selling the per unit commodity. It is
– boost the share price obtained by dividing the total revenue by total output.
– personal earnings of the managers (CEO 𝑻𝒐𝒕𝒂𝒍 𝑹𝒆𝒗𝒆𝒏𝒖𝒆
and CFO) 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑹𝒆𝒗𝒆𝒏𝒖𝒆 =
𝑼𝒏𝒊𝒕𝒔 𝒐𝒇 𝑶𝒖𝒕𝒑𝒖𝒕 𝑷𝒓𝒐𝒅𝒖𝒄𝒆𝒅
• It is difficult for shareholders to comprehend easily
• an agency problem combined with moral hazard
Average Revenue is equal to price only when the cost of
• Auditing: protect shareholders and potential
every unit remains same.
investors 𝑇𝑅 𝑃 × 𝑄
• Restriction to a single time period 𝐴𝑅 = = =𝑃
𝑄 𝑄
– It is more appropriate to consider the long-
term profits of a firm

MANAGERIAL ECONOMICS 12 SAJIN JOHN

MODULE 3 – DEMAND ANALYSIS AND ELASTICITIES OF DEMAND
BASICS OF DEMAND, DETERMINANTS OF DEMAND
THE CIRCULAR FLOW OF ECONOMIC
ACTIVITY
The individuals own or control resources which are
necessary inputs for the firms in the production
process. These resources (factors of production) are
classified into four types.
• LAND: It includes all-natural resources on the
earth and below the earth. Non-renewable
resources such as oil, coal etc once used will never
be replaced. It will not be available for our children.
Renewable resources can be used and replaced and
is not depleted with use.
• LABOUR: is the work force of an economy. The
value of the worker is called as human capital.
• CAPITAL: It is classified as working capital and
fixed capital (not transformed into final products)
• ENTREPRENEURSHIP: It refers to the individuals
who organize production and take risks.
All these resources are allocated in an effective manner
to achieve the objectives of consumers (to maximize
satisfaction), workers (to maximize wages), firms (to
maximize the output and profit) and government (to
maximize the welfare of the society).
The fundamental economic activities between
households and firms are shown in the diagram.
The circular flows of economic activities are explained
in a clockwise and counter clockwise flow of goods and
services.
The four sectors namely households, business,
government and the rest of the world can also be
considered to see the flow of economic activities.
The circular flow of activity is a chain in which
production
MANAGERIAL ECONOMICS
creates income, income generates spending and
spending in turn induces production.
The major four sectors of the economy are engaged in
three economic activities of production, consumption
and exchange of goods and services.
These sectors are as follows:
• HOUSEHOLDS: Households fulfil their needs and
wants through purchase of goods and services from
the firms. They are owners and suppliers of factors
of production and in turn they receive income in the
form of rent, wages and interest.
• FIRMS: Firms employ the input factors to produce
various goods and services and make payments to
the households.
• GOVERNMENT: The government purchases goods
and services from firms and also factors of
production from households by making payments.
• FOREIGN SECTOR: Households, firms and
government of India purchase goods and services
(import) from abroad and make payments. On the
other hand, all these sectors sell goods and services
to various countries (export) and in turn receive
payments from abroad
DEMAND IN PRODUCT/ OUTPUT MARKETS
A household’s decision about what quantity of a
particular output, or product, to demand depends on a
number of factors, including:
The price of the product in question.
The income available to the household.
The household’s amount of accumulated wealth.
The prices of other products available to the
household.
The household’s tastes and preferences.
The household’s expectations about future income,
wealth, and prices.
QUANTITY DEMANDED
The amount (number of units) of a product that a
household would buy in a given period if it could buy all
it wanted as the current market price
CHANGES IN QUANTITY DEMANDED VS.
CHANGES IN DEMAND
• Changes in the price of a product affect the quantity
demanded per period.
• Changes in any other factor, such as income or
preferences, affect demand.
• Thus, we say that an increase in the price of Coca-
Cola is likely to cause a decrease in the quantity of
Coca-Cola demanded.
• However, we say that an increase in income is likely
to cause an increase in the demand for most goods.
13 SAJIN JOHN
DEMAND Market demand: Demand by all consumers
A relation showing the quantities of a good that
consumers are willing and able to buy at various prices REPRESENTATION OF DEMAND
per period, other things constant. LAW OF DEMAND
Demand is that desire which backed by willingness and
• States, “other things remaining the same quantity
ability to buy a particular commodity
demanded of a commodity is inversely related to its
price”.
Demand for commodity implies:
• As price rises, quantity demanded decreases.
• Desire to acquire it
• As price falls, quantity demanded increases
• Willingness to pay for it 𝟏
• Ability to pay for it 𝑷𝒓𝒊𝒄𝒆 ∝
𝑸𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝑫𝒆𝒎𝒂𝒏𝒅𝒆𝒅
• Demand curves have a negative slope
TYPES OF DEMAND:
• Consumer goods vs. Producer goods DEMAND SCHEDULE OR TABLE
• Firm vs. Industry A table showing how much of a given product a household
• Autonomous vs. Derived would be willing to buy at different prices.
• Durable vs. Perishable PRICE (PER CALL) QUANTITY DEMANDED
• Short-term vs. Long-term $ (CALLS PER MONTH)
0 30
Consumer Direct .50 25
3.50 7
7.00 3
Capital Derived 10.00 1
Goods 15.00 0

Consumable Recurring DEMAND CURVE/GRAPH

A graph illustrating how much a given product a
household would be willing to buy at different prices.
Durable Replacement The relationship between price (P) and quantity
demanded (Qd) presented graphically is called a demand
curve.
Direct or Autonomous and Derived Demand
Direct demand is for the goods as they are such
as Consumer goods
Derived demand is for the goods which are
demanded to produce some other commodities;
e.g. Capital goods
Recurring and Replacement Demand
Recurring demand is for goods which are
consumed at frequent intervals such as food
items, clothes.
Durables are purchased to be used for a long
period of time
Complementary and Competing Demand
Some goods are jointly demanded hence are EQUATIONS
complementary in nature, e.g. software and 𝑄 = 𝑓(𝑃)
hardware, car and petrol. 𝑄 = 𝑓(𝑃, 𝐴, 𝑌, 𝑃𝑠 , … )
Some goods compete with each other for A linear demand function.
demand because they are substitutes to each 𝑄 = 𝑎 − 𝑏𝑃
other, e.g. soft drinks and juices. Here, -b is due to the negative slope.
Demand for Perishable and Durable Goods
Durables: Last for a relatively long time and can
be consumed multiple times EXCEPTIONS TO THE LAW OF DEMAND
Demand can be postponed Law of demand may not operate due to the following
Non-durables: Perishable, Non-perishable. reasons:
Individual and Market Demand Giffen Goods: Sir Robert Giffen, Ireland
Individual demand: Demand for an individual o Once it so happened in England that when the
consumer price of bread declined the demand for bread

MANAGERIAL ECONOMICS 14 SAJIN JOHN

 also declined and when price of bread increased
the demand for bread also increased.
o Sir Robert Giffen said that in case of bread,
which is an inferior good of a special kind, when
price of bread declined, the real income of the
consumer increased and out of this increase in
real income, the consumers decided to consume
more of some other commodities, instead of
demanding more of bread.
o This explanation came to be called the Giffen’s
Paradox, which is an exception to the law of
demand.
Snob Appeal: Veblen Goods, Thorstein Veblen
Demonstration Effect: Fashion
Future Expectation of Prices (Panic buying)
Addiction
Price-illusions
o Consumers are, in modern world, governed
more by price-illusions
o E.g.: the consumed strongly believes that
‘higher the price, better the product’, and thus
greater is the demand for it.
Neutral goods
o Lifesaving drugs
o Salt
Goods with no substitute
DETERMINANTS OF DEMAND
Price of the product
o Single most important determinant
o Negative effect on demand
Income of the consumer
o Normal goods: demand increases with increase
in consumer’s income
o Inferior goods: demand falls as income rises
Price of related goods
o Substitutes
If the price of a commodity increases,
demand for its substitute rises.
o Complements
If the price of a commodity increases,
quantity demanded of its complement falls.
Tastes and preferences
o Very significant in case of consumer goods
Expectation of future price changes
o Gives rise to tendency of hoarding of durable
goods
o If the Consumers expect that there will be a rise
in prices in future, he may buy more at the
present price and so his demand increases.
Population
o Size, composition and distribution of
population will influence demand
Advertisements and salesmanship
o Very important in case of competitive markets
o In modern markets the demand for a product
can be created through appropriate
advertisements and salesmanship.
Climatic conditions
MANAGERIAL ECONOMICS
o Demand for commodity is also influenced by
climate changes.
Psychology of the consumers
o Demand for a good depends also on the
psychological behavior of the consumer.
o There is the possibility that as more and more
consumers possess a particular good, others are
also psychologically activated to buy that good.
This is commonly called the Bandwagon effect.
o On the other hand, some consumers display
opposite attitude. Just because others demand a
particular good, they would not like to demand
that good. They may prefer to have something
which is not commonly demanded by others.
This is called Snob effect.
Government policy (taxation)
o High taxes will increase the price and reduce
demand, while low taxes will reduce the price
and extend the demand.
FACTORS DETERMINING DEMAND
Interdependence between demand for a product and its
determinants can be shown in a mathematical
functional form
Dx = f(Px, Y, Py, T, A, N) …….. [Multivariate fx]
Independent variables: Px, Y, Py, T, A, N
Dependent variable: Dx
Px: Price of x
Y: Income of consumer
Py: Price of other commodity
T: Taste and preference of
consumer
A: Advertisement
N: Macro variable like inflation, population growth,
economic growth
Example: Demand Curve
15 SAJIN JOHN
 Substitutes
Goods that can serve as replacements for one
another; when the price of one increase, demand for the
other increases.

CLASSIFICATION OF GOODS
Normal goods
Goods for which demand goes up when income
Complements or Complementary goods
is higher and for which demand goes down when
Goods that “go together”; a decrease in the price
income is lower.
of one result in an increase in demand for the other and
vice versa.

Inferior goods
Goods for which demand tends to fall when
income rises.

MANAGERIAL ECONOMICS 16 SAJIN JOHN

SUPPLY OF PRODUCT o Transport: Better transport facilities will increase
the supply.
Firms build factories, hire workers, and buy raw
o Price: If the prices are high, the sellers are willing to
materials because they believe they can sell the
products they make for more than it costs to produce supply more goods to increase their profit.
them. o Price of other goods: The price of other goods is
more than ‘X’ then the supply of ‘X’ will be
QUANTITY SUPPLIED
increased.
The amount of a particular product that a firm would be
willing and able to offer for sale at a particular price
during a given time period. SHIFT OF SUPPLY VERSUS MOVEMENT ALONG A
SUPPLY SCHEDULE SUPPLY CURVE
A table showing how much of a product firms will sell at When the price of a product changes, we move along the
alternative prices. supply curve for that product; the quantity supplied
LAW OF SUPPLY rises or falls.
The positive relationship between price and quantity of a When any other factor affecting supply changes, the
good supplied: An increase in market price will lead to an supply curve shifts.
increase in quantity
supplied, and a decrease in
market price will lead to a
decrease in quantity
supplied.
A producer will supply more
when the price of output is
higher.
The slope of a supply curve
is positive
Supply is determined by
choices made by firms. MARKET EQUILIBRIUM
When quantity demanded exceeds quantity supplied,
DETERMINANT OF SUPPLY price tends to rise.
Assuming that its objective is to maximize profits, a When the price in a market rises, quantity demanded
firm’s decision about what quantity of output, or falls and quantity supplied rises until an equilibrium is
product, to supply depends on: reached at which quantity demanded and quantity
1. The price of related products. supplied are equal.
2. The cost of producing the product, which in turn
depends on:
■ The price of required inputs (labor, capital,
and land).
■ The technologies that can be used to produce
the product.
o The cost of factors of production: Cost depends on
the price of factors. Increase in factor cost increases
the cost of production and reduces supply.
o The state of technology: Use of advanced technology
increases productivity of the organization and
increases its supply.
o External factors: External factors like weather
influence the supply. If there is a flood, this reduces
supply of various agricultural products.
o Tax and subsidy: Increase in government subsidies
results in more production and higher supply.

MANAGERIAL ECONOMICS 17 SAJIN JOHN

ELASTICITY OF DEMAND
Elasticity of demand is a measure of how much buyers Examples:
and sellers respond to change in the market conditions. Urban India Short Run Long Run
It allows us to analyse demand with greater precision.
Butter 1.478 2.78
Elasticity of Demand measures the degree of
responsiveness of the quantity demanded of a commodity Petrol 0.3 0.9
to a given change in any of the determinants of demand. Tea 0.718 1.14
%𝚫𝑨
𝒆𝒍𝒂𝒔𝒕𝒊𝒄𝒊𝒕𝒚 𝒐𝒇 𝑨 𝒘𝒊𝒕𝒉 𝒓𝒆𝒔𝒑𝒆𝒄𝒕 𝒕𝒐 𝑩 = Coffee 0.292 0.685
%∆𝑩
Types of Elasticity of Demand: Burger 1.49 2.79
• Price elasticity of demand Clothing 1.1 2.88
• Income elasticity of demand
• Cross elasticity of demand Goods/Services Price Elasticity
Brinjals 3.5
PRICE ELASTICITY OF DEMAND
The ratio of the percentage of change in quantity Cabbage 2.8
demanded to the percentage of change in price; measures Health insurance 1.9
the responsiveness of demand to changes in price. Public transport 1.0
% 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝒅𝒆𝒎𝒂𝒏𝒅𝒆𝒅
𝒑𝒓𝒊𝒄𝒆 𝒆𝒍𝒂𝒔𝒕𝒊𝒄𝒊𝒕𝒚 𝒐𝒇 𝒅𝒆𝒎𝒂𝒏𝒅 =
% 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒑𝒓𝒊𝒄𝒆 Electricity for domestic purpose 0.5
%∆𝑸𝒅
𝑷𝑬𝑫 =
%∆𝑷
• Quantity demanded of a commodity in response
to a given change in price CALCULATING ELASTICITIES
• PED is always negative as the relationship 𝒑𝒓𝒊𝒄𝒆 𝒆𝒍𝒂𝒔𝒕𝒊𝒄𝒊𝒕𝒚 𝒐𝒇 𝒅𝒆𝒎𝒂𝒏𝒅 =
% 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝒅𝒆𝒎𝒂𝒏𝒅𝒆𝒅
% 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒑𝒓𝒊𝒄𝒆
between the price and the demand is inverse. %∆𝑸𝒅
𝑷𝑬𝑫 =
%∆𝑷
DEGREE OF PRICE ELASTICITY OF DEMAND Where,
INELASTIC DEMAND (PED<1) 𝑄2 − 𝑄1
Quantity demanded does not %∆𝑄𝑑 = × 100%
𝑄1
respond strongly to price changes. 𝑃2 − 𝑃1
Demand curve is steep %∆𝑃 = × 100%
𝑃1
PED < 1, %∆Qd < %∆P Whereas using Arc Elasticity of demand (or The Midpoint
ELASTIC DEMAND (PED>1) Formula),
Quantity demanded responds 𝑸𝟐 − 𝑸 𝟏
strongly to change in price. %∆𝑸𝒅 = × 𝟏𝟎𝟎%
(𝑸𝟏 + 𝑸𝟐 )/𝟐
Demand curve is flatter 𝑷𝟐 − 𝑷𝟏
PED > 1, %∆Qd > %∆P %∆𝑷 = × 𝟏𝟎𝟎%
(𝑷𝟏 + 𝑷𝟐 )/𝟐
PERFECTLY INELASTIC (PED = 0)
A more precise way of calculating percentages using the
Quantity demanded does not
value halfway between P1 and P2 for the base in
respond to price changes.
calculating the percentage change in price, and the
Vertical Demand Curve
value halfway between Q1 and Q2 as the base for
PED = 0, %∆Qd = 0
calculating the percentage change in quantity
PERFECTLY ELASTIC (PED = ∞)
demanded.
Quantity demanded changes
infinitely with any change in price
Horizontal demand curve DETERMINANTS OF PRICE ELASTICITY OF
PED = ∞, %∆Qd = ∞ or %∆P = 0 DEMAND
UNITARY ELASTIC (PED = 1) • Nature of Commodity
Quantity demanded changes by • Availability and proximity of Substitutes
the same percentage as the price. • Proportion of Income spent on the Commodity
Demand curve is a rectangular • Time frame
hyperbola • Durability of the Commodity
PED = 1, %∆Qd = %∆P
Elastic Unitary Elastic Inelastic
Price rises TR falls No change in TR TR rises
Price falls TR rises No change in TR TR falls

MANAGERIAL ECONOMICS 18 SAJIN JOHN

INCOME ELASTICITY OF DEMAND THE BUDGET CONSTRAINT
Income elasticity measures the responsiveness The limits imposed on household choices by
of quantity demanded to the changes in income, holding income, wealth, and product prices.
the price of the good & all other demand determinants Information on household income and wealth, together
constant. with information on product prices, makes it possible to
% 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝒅𝒆𝒎𝒂𝒏𝒅𝒆𝒅 distinguish those combinations of goods and services
𝑰𝑬𝑫 = that are affordable from those that are not.
% 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒊𝒏𝒄𝒐𝒎𝒆
%∆𝑸𝒅
𝑰𝑬𝑫 = CHOICE SET OR OPPORTUNITY SET
%∆𝑰
𝑸 𝟐 − 𝑸𝟏 The set of options that is defined and limited by a
%∆𝑸𝒅 = × 𝟏𝟎𝟎% budget constraint.
(𝑸𝟏 + 𝑸𝟐 )/𝟐
Possible Budget Choices of a Person Earning $1,000 Per
𝑰𝟐 − 𝑰𝟏
%∆𝑰 = × 𝟏𝟎𝟎% Month After Taxes
(𝑰𝟏 + 𝑰𝟐 )/𝟐
OPTION RENT FOOD OTHER TOTAL AVAILABLE?

• Luxury goods: IED > 1 A 400 250 350 1000 Yes

• Normal goods: 0 > IED > 1 B 600 200 200 1000 Yes
• Inferior goods: IED < 0 C 700 150 150 1000 Yes
o E.g.: Public Transport D 1000 100 100 1200 No
• Neutral goods: IED = 0
o E.g.: Medicine goods

CROSS ELASTICITY OF DEMAND

Cross-price elasticity of demand (EXY)
measures the responsiveness of quantity demanded of
good X to changes in the price of related good Y, holding
the price of good X & all other demand determinants for
good X constant.
% 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒅𝒆𝒎𝒂𝒏𝒅 𝒇𝒐𝒓 𝒄𝒐𝒎𝒎𝒐𝒅𝒊𝒕𝒚 𝑨
𝐄𝒄 =
% 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒑𝒓𝐢𝐜𝐞 𝐨𝐟 𝐜𝐨𝐦𝐦𝐨𝐝𝐢𝐭𝐲 𝐁
%∆𝑸𝑨
𝑬𝒄 =
𝑷𝑩
• Positive: Two goods are substitutes
• Negative: Two goods are complements THE EQUATION OF BUDGET CONSTRAINT
Example: In general, the budget constraint can be written:
Commodity X Commodity Cross-price 𝑃𝑥 𝑋 + 𝑃𝑦 𝑌 = 𝐼
Y elasticity Where, Px – the price of X,
Tea (India) Coffee 0.0385 X – the quantity of X consumed,
(India) Py – the price of Y,
Y – the quantity of Y consumed, &
Tea (India) Coffee 0.3457 (long)
I – household Income
(India)
Entertainment (US) Food (US) -0.72 BUDGET CONSTRAINTS CHANGE WHEN PRICES
Margarine (US) Butter (US) 1.53 RISE OR FALL
The budget constraint is defined by income, wealth, and
prices. Within those limits, households are free to
choose, and the
HOUSEHOLD CHOICE IN OUTPUT MARKETS household’s
Every household must make three basic decisions: ultimate choice
1. How much of each product, or output, to depends on its own
demand? likes and dislikes.
2. How much labor to supply The Effect of a
3. How much to spend today and how much to save Decrease in Price on
for the future? Ann and Tom’s
Budget Constraint:

MANAGERIAL ECONOMICS 19 SAJIN JOHN

THE BASIS OF CHOICE
UTILITY
The satisfaction, or reward, a product yields
relative to its alternatives. The basis of choice.
MARGINAL UTILITY (MU)
The additional satisfaction gained by the
consumption or use of one more unit of something.
TOTAL UTILITY
The total amount of satisfaction obtained from
consumption of a good or service.
LAW OF DIMINISHING MARGINAL UTILITY
The more of any one good consumed in a given
period, the less satisfaction (utility) generated by
consuming each additional (marginal) unit of the same
good.
• Higher price also means “more expensive relative to
substitutes,” and we are likely to buy less of it and
more of other goods (substitution effect).
INDIFFERENCE CURVE
1. We assume that consumers have the ability to
choose among the combinations of goods and
services available.
2. We assume that consumer choices are
consistent with a simple assumption of
rationality (to maximize his satisfaction).
An indifference curve is a set of points, each point
representing a combination of goods X and Y, all of which
yield the same total utility.

• Its slopes downwards from left to right

• It is convex to the origin
• It cannot intersect with another indifference curve
THE UTILITY – MAXIMIZING RULE CONSUMER EQUILIBRIUM
In general, utility-maximizing consumers spread out As long as indifference curves are convex to the origin,
their expenditures until the following condition holds: utility maximization will take place at the point at which
𝑀𝑈𝑥 𝑀𝑈𝑦 the indifference curve is just tangent to the budget
= constraint.
𝑃𝑥 𝑃𝑦
For all pairs of goods.

INCOME AND SUBSTITUTION EFFECTS

THE INCOME EFFECT
When the price of something we buy falls, we
are better off. When the price of something we buy
rises, we are worse off.
THE SUBSTITUTION EFFECT
• Both the income and the substitution effects imply
a negative relationship between price and quantity
demanded—in other words, downward-sloping
demand.
• When the price of something falls, ceteris paribus,
we are better off, and we are likely to buy more of
that good and other goods (income effect).
• Because lower price also means “less expensive
relative to substitutes,” we are likely to buy more of
the good (substitution effect).
• When the price of something rises, we are worse off,
and we will buy less of it (income effect).

MANAGERIAL ECONOMICS 20 SAJIN JOHN

MODULE 4 – ECOMOMIC FORECASTING
DEMAND FORECASTING
Demand forecasting is the scientific and • But personality of one or a few key members in the
analytical estimation of demand for a product (service) panel mat distort the results.
for a particular period of time • If the consulted experts are genuinely reliable, the
It is the process of determining how much of what panel consensus could be the best method of
product is needed when and where. forecasting.
• Group Discussion:(developed by Osborn in 1953)
TECHNIQUES OF DEMAND FORECASTING Decisions may be taken with the help of
• A forecast is an estimation or prediction about brainstorming sessions or by structured
situations which are most likely to occur in near or discussions.
distant future • Delphi Technique: developed by the Rand
• Forecasting demand means predicting the future Corporation at the beginning of the Cold War, to
demand. forecast impact of technology on warfare.
• To reduce the uncertainty in planning the future o Way of getting repeated opinion of experts
production levels, demand forecasting is essential. without their face to face interaction.
• Forecasting of demand is one of the most important o Consolidated opinions of experts are sent for
functions of managers of firms. revised views till conclusions converge on a
Expert Opinion
point.
Method • Merits
o Decisions are enriched with the experience of
Sales Force
Composite competent experts.
o Firm need not spend time, resources in
Qualitative Method Market Simulation collection of data by survey.
o Very useful when product is absolutely new to
Test Marketing
Complete all the markets.
Enumeration
• Demerits
Forecasting Methods

Survey
Customer Survey o Experts’ may involve some amount of bias.
Method Sample Survey o With external experts, risk of loss of
confidential information to rival firms.
Exponential
End-Use Survey
Smoothing

B. MARKET SIMULATION
Time Series
• Firms create “artificial market”, consumers are
Moving Averages
instructed to shop with some money. “Laboratory
experiment” ascertains consumers’ reactions to
Quantitative changes in price, packaging, and even location of the
Method Index Number
product in the shop.
Regression Analysis • Grabor-Granger test (1960s)
• Merits
Econometric
Models
o Market experiments provide information on
consumer behaviour regarding a change in any
Input-Output
Analysis of the determinants of demand.
o Experiments are very useful in case of an
absolutely new product.
QUALITATIVE METHOD • Demerits
• Qualitative (or Subjective) approach seeks to obtain o People behave differently when they are being
information about intentions of the spender. observed.
• Such method relies on human judgment and
opinion. C. TEST MARKETING
• Such approach leads to short term Demand • Involves real markets in which consumers actually
Forecasting. buy a product without the consciousness of being
observed.
A. EXPERT OPINION METHOD • Product is actually sold in certain segments of the
• Advice is obtained from experienced experts in the market, regarded as the “test market”.
field of the product • Choice and number of test market(s) and duration
• This panel consensus provided reliable forecast. of test are very crucial to the success of the results.
• Merits

MANAGERIAL ECONOMICS 21 SAJIN JOHN

 o Most reliable among qualitative methods.
o Very suitable for new products.
o Considered less risky than launching the
product across a wide region.
• Demerits
o Very costly as it requires actual production of
the product, and in event of failure of the
product the entire cost of test is sunk.
o Time consuming to observe the actual buying
pattern of consumers.
D. SALES FORCE COMPOSITE
• Salespersons are in direct contact with the
customers.
• Salespersons are asked about estimated sales
targets in their respective sales territories in a given
period of time.
• Merits
o Cost effective as no additional cost is incurred
on collection of data.
o Estimated figures are more reliable, as they are
based on the notions of salespersons in direct
contact with their customers.
• Demerits
o Results may be conditioned by the bias of
optimism (or pessimism) of salespersons.
o Salespersons may be unaware of the economic
environment of the business and may make
wrong estimates.
o This method is ideal for short term and not for
long term forecasting
E. CONSUMERS SURVEY METHOD
• Consumers survey method is the most direct
method and is valid for short term projections.
• Here, consumers are directly approached with a
questionnaire
• Buyer’s intentions and their views are obtained
about the particular product
• Merits:
o Simple to administer and comprehend.
o Suitable when no past data available.
o Suitable for short term decisions regarding
product and promotion.
• Demerits
o Expensive both in terms of resources and time.
o Buyers may give incorrect responses.
• The survey can take three forms:
COMPLETE ENUMERATIONS
o Such survey covers all consumers like in a
Census data collection
o All possible customers i.e. past, present and
future customers are approached for the survey
o Such survey is absolutely un-biased as all
opinions are obtained.
o But such survey cannot be carried our easily
MANAGERIAL ECONOMICS
o Data obtained will be very large and hence will
be expensive and tedious to be analysed
SAMPLE SURVEY
o Few representative consumers are chosen from
whole population for such survey.
o Demand projected on the basis of response
from this sample.
o As the survey data is small, it makes the analysis
less expensive, tedious and fast to execute.
o The sample chosen needs to be large enough to
be representative and small for handling.
END – USE METHOD
o If a product has several end-uses, it has specific
demand for each use, its own marked segment.
o Customers in each segment convey their
demands well ahead of their production
schedules.
o Such approach works well if number of end
users is limited.
QUANTITATIVE METHOD
• Quantitative methods use mathematical or
simulation models based on historical demand or
relationships between variables.
1. TIME SERIES/TREND PROJECTION METHOD
• Any method used to forecast on a given time series
data, is called a time series forecast.
• Time series data is a collection of data for a pre-defined
internal of time index in a chronological order.
• Used to predict the future values based on past trends.
• This method is based on obtaining the historical
data regarding the demand of the product so as to
project future occurrences on the basis of what has
happened in the past.
• Data indicates secular trend, cyclical fluctuation,
seasonal variation, random fluctuation.
• Only secular trend is used to prepare a forecast.
• Secular trend refers to a long run increase or
decrease in the data series.
• Time series data are composed of:
o Secular trend (T): change occurring
consistently over a long time and is relatively
smooth in its path.
o Seasonal trend (S): seasonal variations of the
data within a year
o Cyclical trend (C): cyclical movement in the
demand for a product that may have a tendency
to recur in a few years
o Random events (R): have no trend of
occurrence hence they create random variation
in the series.
2. MOVING AVERAGES
22 SAJIN JOHN
• Such method is useful when the market demand is
assumed to remain steady over time.
• The moving average for ‘n’ months is found by
simply summing up the demand during the past ‘n’
months and then dividing the total by ‘n’.
𝑴𝒐𝒗𝒊𝒏𝒈 𝑨𝒗𝒆𝒓𝒂𝒈𝒆
𝑫𝒆𝒎𝒂𝒏𝒅 𝒊𝒏 𝒑𝒓𝒆𝒗𝒊𝒐𝒖𝒔 ′𝒏′ 𝒎𝒐𝒏𝒕𝒉𝒔
= determination is to square the correlation of the
𝒏
∑𝒏𝟏 𝒙𝒏
= 𝐸𝑥𝑝𝑙𝑎𝑖𝑛𝑒𝑑 𝑉𝑎𝑟𝑖𝑎𝑡𝑖𝑜𝑛
𝒏 𝑅2 =
3. EXPONENTIAL SMOOTHING
• In this technique more recent data are given more
weightage.
• This is based on the argument that the more recent
data are given relatively more weight than the
earlier observation.
𝑭𝒕+𝟏 = 𝜶𝑨𝒕 + (𝟏 − 𝜶)𝑭𝒕
4. INDEX NOS / BAROMETRIC TECHNIQUES
• The Index numbers offer a device to measure
changes in a group of related variables over a period
of time.
• In case of index numbers, we select a Base year
which is given the value of 100. The subsequent
changes are expressed as a movement of this
number.
• The most commonly used is the Laspeyres’ Price
Index.
• BarometricTechniquealertsbusinessestochangesin
theoveralleconomicconditions.
• Helpsinpredictingfuturetrendsonthebasisofindexof
relevanteconomicindicatorsespeciallywhenthepast
datadonotshowacleartendencyofmovementinapart
iculardirection.
• Indicators may be
o Leading indicators: economic series that
typically go up or down ahead of other series
o Coincident indicators: move up or down
simultaneously with the level of economic
activities
o Lagging series: which moves with economic
series after a time lag.
5. REGRESSION ANALYSIS
• This statistical method is undertaken to measure
the relationship between two variables where
correlation appears to exist.
• E.g.: We can establish a relationship between the
age of the air condition machine and the annual
repair expenses.
• Regression analysis is a way to find the relationship
between a dependent variable and one or more
independent variables based on the historical trend
or relationship
o Dependent variable is the one whose value is
being forecasted or predicted
MANAGERIAL ECONOMICS
o Independent variables are the underlying
drivers which cause the dependent variable to
change
• The co-efficient of variation measures the fraction
of the total variance in the dependent variable that
is explained by the independent variable.
o The simplest way to calculate the co-efficient of
dependent and the independent variables
𝑇𝑜𝑡𝑎𝑙 𝑉𝑎𝑟𝑖𝑎𝑡𝑖𝑜𝑛
𝑈𝑛𝑒𝑥𝑝𝑙𝑎𝑖𝑛𝑒𝑑
=1−
𝑇𝑜𝑡𝑎𝑙
R squared: The Coefficient of Determination. It tells you
how many points fall on the regression line.
SIMPLE (OR BIVARIATE) REGRESSION
ANALYSIS:
o Deals with a single independent variable that
determines the value of a dependent variable.
o Demand Function:
𝐷 = 𝑎 + 𝑏𝑃
where b is negative.
o If we assume there is a linear relation between
D and P, there may also be some random
variation in this relation.
NONLINEAR REGRESSION ANALYSIS
o Log linear function
log 𝐷 = 𝐴 + 𝐵 log 𝑃 + 𝑒
where A and B are the parameters to be
estimated and e represents errors or
disturbances.
o Linear form of log linear function D* = a + b P* +
e
where D*= log D and P*=log P
MULTIPLE REGRESSION ANALYSIS:
𝐷 = 𝑎1 + 𝑎2 𝑃 + 𝑎3 𝐴 + 𝑒
where A = advertising expenditure incurred
a1, a2 and a3 are the parameters &
e is the random error term (or
disturbance), having zero mean).
o Similar to simple regression analysis, multiple
regression analysis would aim at estimation of
the parameters a1, a2 and a3.
o Choose such values of the coefficients that
would minimize the sum of squares of the
deviations.
6. ECONOMETRIC MODEL
• This statistical method is undertaken to form an
equation or system which seems best to express the
most probable interrelationship between a set of
economic variables.
• Economic models can be quantitatively or
qualitatively formulated.
23 SAJIN JOHN
• Being analytical and process oriented, the method
throws more light on problems of theoretical and
statistical nature.

7. INPUT-OUTPUT ANALYSIS
• This method is based on a set of tables that explain
interrelationship among the variables or various
components of economy.
• The analysis helps us to understand the inter-
industry relationships to provide information about
the total impact on all industries as a result of
changes in demand forecast.
So, the regression equation is:
𝑌𝑡 = 11.9 + 0.394𝑡
LIMITATIONS OF DEMAND FORECASTING
This equation suggests, that if “t” changes by 1 unit then
Opinion survey are simple; but they are Y (i.e. Electricity demand) changes by 0.394 million unit.
subjective. R2 = 53% 53% of the total variation is explained by
Surveys are expensive; samples selected may the regression equation
not be representative. Using this equation, we can forecast the future
Time series analysis is used to forecast cyclical demands.
fluctuations. These cycles have different
intensities and timings. Example 2:
There is difference between field experiments Bicycle Demand Regression Analysis:
and laboratory observations.
Sales
Lack of Experienced Experts
Year (in millions)
Change in Fashion
Consumers’ Psychology 2006 61.63
Lack of Past Data 2007 67.97
2008 69.63
Example 1: 2009 71.49
Electricity Demand Regression Output 2010 89.01
Data – 2011 96.61
Period Time Electricity (million kwh) 2012 108.62
Q1FY12 1 11 2013 111.53
Q2FY12 2 15 2014 115
Q3FY12 3 12 2015 119.6
Q4FY12 4 14
Q1FY13 5 12 Plotting Scatter Plot and adding Linear & Polynomial
Q2FY5 6 17 Trend Line using Excel:
Q3FY5 7 13
Q4FY5 8 16
Q1FY6 9 14
Q2FY6 10 18
Q3FY6 11 15
Q4FY6 12 17
Q1FY7 13 15
Q2FY7 14 20
Q3FY15 15 16
Q4FY15 16 19
Plotting Scatter Plot and adding Linear Trend Line using
excel:

MANAGERIAL ECONOMICS 24 SAJIN JOHN

 MEAN ABSOLUTE PERCENTAGE ERROR (MAPE)

1) Can be used to compare over different

scales of data, as the value is normalized by
its own value.
2) Since we are using Absolute values in
computation, this gives you a clear picture
So, the linear regression equation is: of the difference in the data set. As positive
𝑌𝑠 = 7.1481𝑠 − 14280 and negative values don’t clash out to
With, R² = 0.9599 reduce the overall error.
i.e. 96% of the total variation is explained by the
regression equation.
ROOT MEAN SQUARED ERROR (RMSE)

1) The output value is in the same units as that

of the input value, thus giving a good
relative picture of the variation in the
pattern. (Good preliminary parameter to
check for goodness of fit)
2) RMSE gives more emphasis to large errors
in the model, thereby making it optimum
parameter when implementing control
actions.

MANAGERIAL ECONOMICS 25 SAJIN JOHN

MODULE 5 – PRODUCTION ANALYSIS
PRODUCTION FUNCTIONS
BASIC CONCEPTS
PRODUCTION
Production is a process where inputs (factors of
production) are converted into an output.
o In the simplest terms, production is a process
where inputs (factors of production) are converted
into an output.
o Thus, through production, the resources of a society
are converted into a good or a service.
o In other words, it is a process through which the
consumer is able to avail of the goods and services.
o The process of creation of value or wealth through
the production of goods and services that have
economic value.
o Process of adding value may occur
By change in form (input to output, say steel
into car)
By change in place (supply chain, say from
factory to dealers/retailer)
By changing hands (exchange, say from retailer
to consumer)
o All firms must make several basic decisions to
achieve what we assume to be their primary
objective – maximum profits.
How much output to supply
Which production technology to use
How much of each input to demand
INPUT AND OUTPUT
An input is in the form of a service or a good that
is used in the process of production.
An output is a service or a good that results from
the process of production.
An input or a factor of production includes land, labour,
capital and others.
FIXED AND VARIABLES FACTORS
Inputs or factors of production may be fixed or
variable. A fixed factor is one where the supply is always
inelastic in the short run.
o A variable factor is one where the supply is always
elastic in the short run.
o It is important to note that this classification of
inputs is valid only in the short run.
o In the long run, all inputs or factors of production
are variable.
SHORT RUN AND LONG RUN
The short run is that time in which the supply of
some of the factors of production is inelastic or fixed.
The long run is that time in which the supply of
most of the factors of production is elastic though the
production technology is assumed to remain unchanged.
o Thus, both the fixed and variable factors can be
changed in the long run.
MANAGERIAL ECONOMICS
o The very long run is that time in which the
production technology can also undergo a change.
o Short run: The period of time for which two
conditions hold:
The firm is operating under a fixed scale (fixed
factor) of production, and
Firms can neither enter nor exit an industry.
PRODUCTION TECHNOLOGY
The Quantitative relationship between inputs
and outputs.
LABOR-INTENSIVE TECHNOLOGY
Technology that relies heavily on human labor
instead of capital.
CAPITAL-INTENSIVE TECHNOLOGY
Technology that relies heavily on capital instead
of human labor
PRODUCTION FUNCTIONS
The production function is a technological (or
mathematical) relationship between the physical inputs
and outputs in a particular time given the technology.
The characteristics of a production function are as
follows:
o It depicts a technological relationship between the
inputs and the outputs of a firm.
o It relates to a time where the inputs and the outputs
are flow concepts.
o The state of technology is assumed to be given for
that time.
o Only the technically efficient combinations of the
factors of production are included in the production
process.
o The factors of production are used jointly to
produce the output.
A general production function can be expressed as:
𝑿 = 𝒇(𝑳, 𝑲, 𝑴, 𝑵, 𝑻, 𝑬)
Where, X is output, L is labour, K is capital, M is materials,
N is land, T is technology and E is efficiency parameter.
For sake of convenience, when there are only two
factors of production, the production function is written
as 𝑋 = 𝑓(𝐿, 𝐾) 𝑐𝑒𝑡𝑒𝑟𝑖𝑠 𝑝𝑎𝑟𝑖𝑏𝑢𝑠
Assuming both L and K are homogeneous.
A production function is homogenous if all the factors of
production are increased proportionately and one can
factor out the proportion (n).
𝑋 ∗ = 𝑓(𝑛𝐿, 𝑛𝐾) = 𝑛𝑓(𝐿, 𝐾)
An example of Cobb Doulas production function or
also known as Empirical Production function.
𝑿 = 𝑨𝑳𝜶 𝑲𝟏−𝜶
Where, X is output, A is a positive constant known as
efficient parameter or in other words it shows the factor
productivity, L is labour, K is capital,  is the output
26 SAJIN JOHN
elasticity of labour and (1 – ) is output elasticity of PROPERTIES:
capital. Homogeneous of degree (𝛼 + 𝛽)
This principle can apply to firms using more than two The returns to scale (explained in later section)
inputs and delivering more than one output. is immediately revealed by the sum of two
parameters 𝛼 𝑎𝑛𝑑 𝛽
o Constant Returns to Scale: (𝛼 + 𝛽) = 1
MEASURING PRODUCTION FUNCTION
o Increasing Returns to Scale: (𝛼 + 𝛽) > 1
Linear Production o Decreasing Returns to Scale: (𝛼 + 𝛽) < 1
𝑄 = 𝑎𝐿 + 𝑏𝐾 + 𝑐 Isoquants are negatively sloped and convex to
Production with fixed properties the origin
Taxi and Taxi Driver Elasticity of substitution is equal to 1
Polynomial functions
𝑄 = 𝑎𝐿𝐾 − 𝑏𝐿2 𝐾 2
LAW OF DIMINISHING RETURNS
The Law of diminishing returns is also known as law of
variable proportions or the law of returns to a variable
input.
According to the law as more and more units of the
variable factor is applied to a given amount of the fixed
factors, the output will initially increase at an increasing
rate, then at a constant rate and finally it will increase at
a decreasing rate.
o Thus, when additional units of a variable factor are
added to a given quantity of the fixed factors, the
output of a good will, in the beginning, increase at
an increasing rate, then it will increase at a constant
rate and finally it will increase at a decreasing rate.
Since the marginal increase, which occurs in the
The Cobb-Douglas Function
total output of the good, diminishes eventually it is
also called the law of diminishing marginal returns.
THE COBB-DOUGLAS FUNCTION The law of variable proportions is based on certain
Proposed by Wicksell and tested against statistical assumptions:
evidence by Charles W. Cobb and Paul H. Douglas in o The period under consideration is the short run.
1928 o There is only one variable input. All other inputs are
𝑸 = 𝑨𝑲𝜶 𝑳𝜷 fixed.
Where 𝛼, 𝛽 are constants o As far as the variable input is concerned, its units
A is the technological parameter are all homogenous or are equally efficient in
𝛼 is the elasticity of output with respect to production.
capital o There is a given time involved.
𝛽 is the elasticity of output with respect to o The technology is assumed to be given.
labour o The prices of the factors of production do not
change in the time under consideration.

MANAGERIAL ECONOMICS 27 SAJIN JOHN

TOTAL, MARGINAL, AVERAGE PRODUCT (TP, MP, AP)
TOTAL PRODUCT (TP)
The total product is the total output of a good,
STAGES OF PRODUCTION
which is produced by a firm during a specific time. It can
be increased by applying additional amounts of the We assume there are two factors of productions, land
variable factor. which is fixed while labour which is variable.
Thus, the short-run production function can be written
MARGINAL PRODUCT (MP) as:
The marginal product is the change in the total 𝑋 = 𝑓(𝐿, 𝑁)
product when additional amounts of the variable factor A bar has been inserted over N, which indicates that
are employed. land (N) is fixed and Labour (L) is variable.
∆𝑻𝑷 ∆𝑻𝑷 Now, we analyse
𝑴𝑷 = , 𝑴𝑷𝑳 =
∆𝑽 ∆𝑳 the total product,
marginal product
AVERAGE PRODUCT (AP) and average
The average product is the total product divided product of the
by the amount of variable factor employed to produce the variable factor
output. labour in the three
𝑻𝑷 𝑻𝑷
𝑨𝑷 = , 𝑨𝑷𝑳 = stages of
𝑽 𝑳 production.
OUTPUT ELASTICITY OF VARIABLE FACTOR
The percentage change in output divided by
STAGE 1
percentage change in the quantity of variable factor (like
Labour) This is also called the stage of increasing marginal
%∆𝑻𝑷 𝑴𝑷𝑳 returns to the factor.
𝑬= = It starts from the origin and goes on till the point, where
%∆𝑳 𝑨𝑷𝑳
average product is a maximum.
Example: Calculating MP, AP & E In this stage:
Labour TP MP AP E o Total product initially increases at an increasing
L ∆𝑇𝑃 𝑇𝑃 𝑀𝑃 rate and then once the point of inflexion, Px, is
( ) ( ) ( )
∆𝐿 𝐿 𝐴𝑃 reached, it increases at a decreasing rate. (𝑻𝑷 ↑)
0 0 - - - o Marginal product increases initially, reaches its
3−0 3 3 maximum and then starts decreasing. (𝑴𝑷 ↑)
1 3 =3 =3 =1 o Average product increases all along till it reaches a
1−0 1 3
maximum. (𝑨𝑷𝒎𝒂𝒙 )
8−3
2 8 =5 4 1.25 The reasons why marginal product and average product
2−1 increase are because the fixed factor land is abundant
3 12 4 4 1 and thus underutilized, and also when the employment
4 14 2 3.5 0.57 of labour increases each unit of labour becomes more
5 14 0 2.8 0 specialized.
6 12 -2 2 -1
STAGE 2
This is also called the stage of decreasing (diminishing)
returns to the factor.
It starts from where Average Product is a maximum and
goes on till the point at which Marginal Product
becomes zero and total product is a maximum.
In this stage:
o Total product increases at a decreasing rate and
then reaches its maximum. (𝑻𝑷𝒎𝒂𝒙 )
o Marginal product is decreasing and becomes zero.
(𝑴𝑷 = 𝟎)
o Average product is also decreasing but is
positive. (𝑨𝑷 ↓/+)
All along this stage, average product is greater than the
marginal product.
This is the stage, where a rational producer will operate
because the efficiency of labour is the maximum in this
stage. The reason why marginal product and average

MANAGERIAL ECONOMICS 28 SAJIN JOHN

product decrease is that the labour to land ratio has Also, the specialization of labour has reached its limit
reached beyond the optimal stage and thus the and thus if more labour is employed, it will lead to
efficiency of labour begins to fall. inefficiencies.

STAGE 3
This is also called the stage of negative returns to the
factor.
It starts from where total product after having reached
its maximum starts decreasing. In this stage:
o Total product decreases. (𝑻𝑷 ↓)
o Marginal product is negative. (𝑴𝑷 ↓/−)
o Average product is also decreasing but is positive.
(𝑨𝑷 ↓/+)
This is the stage, where a rational producer will never
operate because the efficiency of labour and land are
decreasing.

MANAGERIAL ECONOMICS 29 SAJIN JOHN

ISOQUANTS AND MRTS
MARGINAL REVENUE PRODUCT OF LABOUR
(MRP)
The extra revenue generated by the use of an
additional unit of labour.
𝑴𝑹𝑷𝑳 = (𝑴𝑷𝑳 )(𝑴𝑹)
MARGINAL RESOURCE COST OF LABOUR (MRC)
The extra cost of hiring an additional unit of
labour.
∆𝑻𝑪
𝑴𝑹𝑪𝑳 =
∆𝑳
Condition (Labour will be hired until) – The extra
revenue generated from the sale of output by employing
additional unit of labour equals the extra cost of hiring
the labour (i.e. MRCL = MRPL)
E.g.: additional revenue Rs. 30 and extra cost is Rs. 20
then fine, but additional revenue Rs. 30 and extra cost is
Rs. 40 then should not consider increasing labour.
ISOQUANTS
An isoquant depicts the various combinations of
two factors of production, for example, labour and
capital, using which a firm can produce the same level of
output.
o It is also called an isoproduct curve or an equal
product curve.
o A producer is indifferent among the different
combinations of labor and capital which lie on the
same isoquant.
o Along an isoquant while the level of output is the
same, the capital labor ratio differs.
o Similar to an indifference schedule, one can have an
isoquant schedule.
o While constructing an isoquant, the following
assumptions are made:
There are only two factors of production.
Technology is given.
There is a continuity in the production function.
CHARACTERISTICS OF ISOQUANTS
o An isoquant is negatively sloped or downward
sloping.
This is because if a producer employs more of
one factor he will have to cut down on the
employment of the other factor if he has to
remain on the same isoquant and his level of
output has to remain the same.
MANAGERIAL ECONOMICS
This implies that the two factors can be
substituted for each other.
o An isoquant is convex to the origin
This is because the marginal rate of technical
substitution diminishes as we move down an
isoquant.
The marginal rate of technical substitution is
the slope of an isoquant. It shows the
substitutability between the factors labour and
capital.
Thus, Marginal rate of technical substitution of
labour of capital,
∆𝐾
𝑀𝑅𝑇𝑆𝐿𝐾 = 𝑆𝑙𝑜𝑝𝑒 𝑜𝑓 𝑎𝑛 𝑖𝑠𝑜𝑞𝑢𝑎𝑛𝑡 =
∆𝐿
o Isoquants cannot intersect each other
With the same combination of capital and
labour, a firm cannot produce two different
output levels.
MRTS
The marginal rate of technical substitution of
labour for capital, MRTSLK, is the quantity of capital that
a firm is ready to give up for an additional unit of labour
so that the level of output remains the same.
o As the quantity of labour with the firm increases
(and that of capital decreases), the marginal rate of
technical substitution of labour for capital
decreases.
∆𝐾
𝑀𝑅𝑇𝑆𝐿𝐾 = 𝑆𝑙𝑜𝑝𝑒 𝑜𝑓 𝑎𝑛 𝑖𝑠𝑜𝑞𝑢𝑎𝑛𝑡 =
∆𝐿
𝑀𝑃𝐿
=−
𝑀𝑃𝐾
o Loss in output as quantity of capital with the firm
decreases = Gain in output as quantity of labour
with the firm increases
−(𝑀𝑃𝐾 )(∆𝐾) = +(𝑀𝑃𝐿 )(∆𝐿)
∆𝑲 𝑴𝑷𝑳
𝑴𝑹𝑻𝑺𝑳𝑲 = =−
∆𝑳 𝑴𝑷𝑲
o When the factors of production, capital and labour
are perfect substitutes, the isoquant is linear.
o When the factors of production, capital and labour
are perfect complements, the isoquant is L shaped.
30 SAJIN JOHN
ISOCOSTS technology represented by the point at which the
isoquant is tangent to an isocost line.
The isocost line represents the various
combinations of the factors, for example, labour and
capital, which the firm can purchase given the total
outlay and the prices of the factors of production. It is also
called the outlay line or factor price line.
Assume that there are only two factors, labour and
capital. The isocost line can be expressed as
𝑪 = 𝑷 𝑳 𝑳 + 𝑷𝑲 𝑲
Where, C is cost or total outlay, PL is price of labour, L is
amount of labour employed, PK is price of capital and K is
amount of capital employed.
Plotting L on X axis
(since K is zero),
𝐿 = 𝐶⁄𝑃
𝐿
Plotting K on Y
axis (since L is
zero), 𝐾 = 𝐶⁄𝑃
𝐾

The producer is in equilibrium at point C.

SLOPE OF ISOCOST LINE At point C, isoquant qx is tangential to the isocost line
The slope of the isocost line is the price ratio of the two with TC=$6.
factors, labour and capital. Thus the slope of isoquant is equal to slope of isocost
Higher is the isocost line, greater is the total outlay or line.
cost. Hence,
∆𝑲 𝑴𝑷𝑳 𝑷𝑳
𝑻𝑪⁄ 𝑴𝑹𝑻𝑺𝑳𝑲 = =− =−
𝑶𝑩 𝑷𝑲 𝑷𝑳 ∆𝑳 𝑴𝑷𝑲 𝑷𝑲
𝑺𝒍𝒐𝒑𝒆(𝑨𝑩) = − =− =− 𝑷𝑳 𝑴𝑷𝑳 𝑴𝑷𝑲 𝑴𝑷𝑳
𝑶𝑨 𝑻𝑪⁄ 𝑷𝑲 ∴ = 𝐎𝐑 =
𝑷𝑳 𝑷𝑲 𝑴𝑷𝑲 𝑷𝑲 𝑷𝑳
i.e., for a producer to be in equilibrium is that he
employs labour and capital such that the ratio of the
marginal products of the factors of production is equal
to the ratio of the factors prices.
Provided, the iso-quant should be convex to the origin.

MAXIMIZATION OF OUTPUT GIVEN THE COST

EQUILIBRIUM OF THE PRODUCER

A producer is in equilibrium when he is using the
optimum (least cost) combination of the factors, labour Here Cost is fixed (AB), the equilibrium is at point E,
and capital, to achieve a given level of output. where the isoquant I2 is tangent to isocost line AB.
Thus, the slope of both isoquant and isocost are equal
𝑷𝑳 𝑴𝑷𝑳 𝑴𝑷𝑲 𝑴𝑷𝑳
MINIMIZATION OF COST GIVEN THE OUTPUT ∴ = 𝐎𝐑 =
𝑷𝑲 𝑴𝑷𝑲 𝑷𝑲 𝑷𝑳
Profit-maximizing firms will minimize costs by
producing their chosen level of output with the

MANAGERIAL ECONOMICS 31 SAJIN JOHN

ECONOMIC REGION OF PRODUCTION, EXPANSION PATH
EXPANSION PATH
The expansion path is a locus of points of the
producer’s equilibrium represented by points of tangency
of successive isoquants with the corresponding isocost
lines.
o A rational producer aims at maximizing his profits
by either maximizing his output given the cost or by
minimizing the cost given the output.
o Thus, in the long run, a producer will choose a factor
combination that is optimum.
o An optimum factor combination exists at the point
of tangency of the isoquant and the isocost line.
o At this point, ratio of the marginal products of the
factors of production is equal to the ratio of the
factors prices.
o In the long run, as firm increases its total outlay,
there is a parallel shift outwards of the isocost lines.
o These isocost lines will be tangential to different
isoquants representing different levels of output.
o Hence, there will be different points at which the
producer is in equilibrium.
ELASTICITY OF SUBSTITUTION
Elasticity of substitution between two factors is a
measure of the degree to which one factor can substitute
the other.
Thus, it is proportionate change in the factor
proportions of between the ratio of the two factors
divided by proportionate change in the marginal rate of
technical substitution
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐾 ⁄𝐿
𝐸𝑠 =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑀𝑅𝑇𝑆𝐿𝐾
∆(𝐾 ⁄𝐿)
(𝐾 ⁄𝐿)
𝐸𝑠 =
∆(𝑀𝑅𝑇𝑆𝐿𝐾 )
𝑀𝑅𝑇𝑆𝐿𝐾
∆(𝑲⁄𝑳) 𝑴𝑹𝑻𝑺𝑳𝑲
𝑬𝑺 =
∆(𝑴𝑹𝑻𝑺𝑳𝑲 ) (𝑲⁄𝑳)
MANAGERIAL ECONOMICS
ECONOMIC REGION OF PRODUCTION AND
RIDGE LINES
If the isoquants are oval shaped. They can be divided
into two ranges:
O EFFICIENT RANGE
Efficient range or the economic region of
production is depicted by the convex part of the
isoquant.
It is the range over which the marginal products
of the factors, for example, labour and capital,
are diminishing but greater than zero or positive.
The production techniques are efficient. In this
range to produce the same output level if a firm
increases the employment of a factor by one
unit, it will have to give up some units of the
other factor.
It represents stage 2, which is the stage of
decreasing (diminishing) returns to the factor.
This is the stage, where a rational producer will
operate because the efficiency of labour is the
maximum in this stage.
O INEFFICIENT RANGE
Inefficient range of production or the
uneconomic region of production is depicted by
the non-convex part of the isoquant where to
produce the same output level a firm uses
increasing amounts of labour and capital.
The production techniques are inefficient.
o The efficient range is separated from the inefficient
range by the ridge lines.
o Ridge lines are the locus of points formed by the
isoquants on which the marginal product of the
factors is zero.
o There are two ridge lines:
Upper ridge line is formed by points like b, d and f.
At these points and other such points, the
marginal product of capital is zero (or MPK = 0).
This implies that capital has been utilized to its
intensive margin.
Thus,
32 SAJIN JOHN
 𝑴𝑷𝑳 A firm experiences decreasing returns to scale because
𝑴𝑹𝑻𝑺𝑳𝑲 = =∞
𝑴𝑷𝑲 of diseconomies of scale.
Lower ridge line is formed by points like a, c and e.
At these points and other such points, the Labo Capi Total
marginal product of labour is zero or (MPL = 0). ur tal Product
This implies that the labour has been utilized to 1 1 10
its intensive margin. 2 2 15
Thus,
𝑴𝑷𝑳
𝑴𝑹𝑻𝑺𝑳𝑲 = =𝟎
𝑴𝑷𝑲
ELASTICITY OF RETURNS TO SCALE
LAW OF RETURNS TO SCALE % 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒕𝒐𝒕𝒂𝒍 𝒑𝒓𝒐𝒅𝒖𝒄𝒕 %∆𝑸
𝑬𝒒 = =
% 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒂𝒍𝒍 𝒊𝒏𝒑𝒖𝒕𝒔 %∆(𝑳)∆(𝑲)
In long run, a change in the scale of operation occurs Eq > 1 then IRTS
when all the factors of production change Eq = 1 then CRTS
simultaneously in the same proportion. Eq < 1 then DRTS
The law which operates in the long run is the law of
returns to scale, which can be depicted with the help of
isoquants.

INCREASING RETURN TO SCALE (IRTS)

Increasing returns to scale occur when all the factors of
production are increased simultaneously in the same
proportion and there is an increase in the output, which
is more than the proportionate.
A firm experiences
increasing returns to scale
because of economies of
scale.
Labo Capi Total
ur tal Product
1 1 10
2 2 25

CONSTANT RETURN TO SCALE (CRTS)

Constant return to scale occur when all factors of
production are increased simultaneously in the same
proportion and there is an increase in the output, which
is in same proportion.
When the economies of scale have reached their limit
while diseconomies of scale have not yet appeared, the
returns to scale becomes a
constant.
Labo Capi Total
ur tal Product
1 1 10
2 2 20

DECREASING RETURNS TO SCALE (DRTS)

Decreasing returns to scale occur when all the factors of
production are increased simultaneously in the same
proportion and there is an increase in the output, which
is less than the proportionate.

MANAGERIAL ECONOMICS 33 SAJIN JOHN

MODULE 6 - COST OF PRODUCTION
TYPES OF COSTS
ACTUAL COST
Actual costs are the costs, which a firm incurs on
raw materials, labour, machinery, advertising and other
such expenses.
OPPORTUNITY COST
Opportunity cost is the cost of the alternative
options, which has been lost by putting the scarce
resources in the present option.
This cost arises because resources of the society are
scarce.
VARIABLE COST
Variable cost is the cost, which varies with the
level of output.
It includes cost of raw material, labour, fuel and
others.
FIXED COST
Fixed cost is the cost, which does not vary with
the level of output.
It includes cost of managerial and administrative
staff, depreciation of building and machinery and
others.
It is also called supplementary cost or overhead
cost.
EXPLICIT COST
Explicit costs are incurred by the firm when it
buys or hires factors, which are required in the process of
production.
These factors are not owned by the firm.
Such costs are depicted explicitly in the expenditure
by the firm. for example, wages and insurance.
IMPLICIT COST
Implicit cost is incurred by the firm when it uses
the factors, which are owned by the firm in the process of
production.
for example, rent and interest on building and
capital owned by the firm.
They are also called the imputed cost.
While calculating the total cost, both the explicit
cost and the implicit cost are included.
PRIVATE COST
Private cost is the monetary cost, which a firm
incurs in the production of a good.
SOCIAL COST
Social cost is the real cost, which the society
incurs in the production of a good.
for example, pollution from a factory, which affects
the health of people adversely.
MANAGERIAL ECONOMICS
SHORT-RUN COST
Short-run costs are those incurred over the short
run, which is that time in which the supply of some of the
factors of production is inelastic or fixed.
for example, machinery.
LONG-RUN COST
Long-run costs are those incurred over the long
run, which is that time in which the supply of most of the
factors of production is elastic.
Thus, all the factors of production can be changed in
the long run.
SUNK COST
A sunk cost refers to money that has already been
spent and which cannot be recovered.
E.g.: R&D on a product which never produced.
HISTORICAL COST
Cost incurred at the time of procurement
CONTROLLABLE COST
Controllable Costs are subject to regulation by
the management of a firm.
E.g.: fringe benefits to employees, cost of quality control
UNCONTROLLABLE COST
Uncontrollable Costs are beyond regulation of
the management.
E.g.: minimum wages determined by gov., price of raw
material by supplier
COST FUNCTION
The cost function is a derived function since it
is obtained from the production function, which is a
technological relationship between the physical inputs
and physical outputs in a particular time, given the
technology.
The element of time is very important in cost
theory.
A short-run cost function can be expressed as:
𝑪 = 𝒇(𝑿, 𝑷𝑭 , 𝑻, 𝑲̅)
𝑤ℎ𝑒𝑟𝑒, 𝐶 𝑖𝑠 𝑐𝑜𝑠𝑡, 𝑋 𝑖𝑠 𝑜𝑢𝑡𝑝𝑢𝑡,
𝑃𝐹 𝑖𝑠 𝑡ℎ𝑒 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑓𝑎𝑐𝑡𝑜𝑟,
𝑇 𝑖𝑠 𝑡𝑒𝑐ℎ𝑛𝑜𝑙𝑜𝑔𝑦 𝑎𝑛𝑑 𝐾 ̅ 𝑖𝑠 𝑓𝑖𝑥𝑒𝑑 𝑓𝑎𝑐𝑡𝑜𝑟, 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
A long-run cost function can be expressed as:
𝑪 = 𝒇(𝑿, 𝑷𝑭 , 𝑻, 𝑲)
SIGNIFICANCE OF COST ANALYSIS
o In order to make wise decisions on how much to
produce and what price to charge, managers need
to understand the relationship between a firm’s
output rate and its costs.
o Cost has multiple impacts:
o Current level of profitability
34 SAJIN JOHN
 o Competitive advantages
o Expansion of output
o Determining the level of output (frequently pose
questions)
o What would be the cost of increasing
production by 25%
o What is the impact on cost of rising input
prices?
o What production changes can be made to
reduce costs?
o Output and costs are interrelated.

COMPARISONS OF COSTS
Type of Cost Relevant to Relevant to
Accountant? Decision
Maker?
Fixed Cost Yes No
Sunk Cost Yes No
Variable Cost Yes Yes
Opportunity Cost No Yes

RELATION BETWEEN PRODUCTION AND

COST
Plotting TP (Total Product - Labour) and TVC (Total
Variable Cost) illustrates that they are mirror images
of each other.
When TP increases at an increasing rate, TVC increases
at a decreasing rate.

MANAGERIAL ECONOMICS 35 SAJIN JOHN

COSTS IN THE SHORT RUN
AVERAGE COST
SHORT-RUN COST ANALYSIS Average cost can be obtained from the total
Short-run costs are those incurred over the cost.
time in which the supply of some of the factors of 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑜𝑠𝑡 =
production is fixed. 𝑂𝑢𝑡𝑝𝑢𝑡
Thus, in the short run while some costs are 𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡
=
fixed, others are variable. 𝑂𝑢𝑡𝑝𝑢𝑡
𝑇𝑜𝑡𝑎𝑙 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡
TOTAL FIXED COST +
Total fixed cost includes those costs, which do not 𝑂𝑢𝑡𝑝𝑢𝑡
vary with the level of output. 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑪𝒐𝒔𝒕 = 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑭𝒊𝒙𝒆𝒅 𝑪𝒐𝒔𝒕
Whatever is the level of output, these costs have to + 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑽𝒂𝒓𝒊𝒂𝒃𝒍𝒆 𝑪𝒐𝒔𝒕
be incurred. The average cost
They include the cost of managerial and curve is shown as U
administrative staff, depreciation of building and shaped.
machinery and Initially, it falls, then
others. reaches a minimum
The total fixed cost and starts rising.
curve is shown as a AVERAGE VARIABLE COST
straight line, which is Average Variable cost can be obtained from
parallel to the X axis. total variable cost.
TOTAL VARIABLE 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑽𝒂𝒓𝒊𝒂𝒃𝒍𝒆 𝑪𝒐𝒔𝒕 =
𝑻𝒐𝒕𝒂𝒍 𝑽𝒂𝒓𝒊𝒂𝒃𝒍𝒆 𝑪𝒐𝒔𝒕
COST 𝑶𝒖𝒕𝒑𝒖𝒕
Total variable cost is the cost, which varies with The average variable cost
the level of output. curve is shown as U shaped.
It includes cost of raw material, labour, fuel and
others.
The total variable AVERAGE FIXED COST
cost curve is Average fixed cost can be obtained from the
shown as inverse total fixed cost.
S-shaped curve. 𝑻𝒐𝒕𝒂𝒍 𝑭𝒊𝒙𝒆𝒅 𝑪𝒐𝒔𝒕
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑭𝒊𝒙𝒆𝒅 𝑪𝒐𝒔𝒕 =
This is due to the 𝑶𝒖𝒕𝒑𝒖𝒕
law of diminishing The average fixed
returns cost curve is shown
as a rectangular
TOTAL COST hyperbola because
Total cost is obtained by adding total fixed cost as the level of output
and total variable cost at the different levels of output.
increases, the fixed
𝑻𝒐𝒕𝒂𝒍 𝑪𝒐𝒔𝒕 = 𝑻𝒐𝒕𝒂𝒍 𝑭𝒊𝒙𝒆𝒅 𝑪𝒐𝒔𝒕
cost per unit
+ 𝑻𝒐𝒕𝒂𝒍 𝑽𝒂𝒓𝒊𝒂𝒃𝒍𝒆 𝑪𝒐𝒔𝒕
decreases.
The total cost curve is shown as a summation of
the total fixed cost and total variable cost at the
different levels of output. MARGINAL COST
The total cost curve Marginal cost is the change in the total cost or
is also an inverse S- total variable cost due to a unit change in the level of
shaped curve like output.
the total variable 𝑴𝒂𝒓𝒈𝒊𝒏𝒂𝒍 𝑪𝒐𝒔𝒕 = 𝑻𝑪𝑵 − 𝑻𝑪𝑵−𝟏
cost curve and is ∆𝑻𝑪
𝑴𝒂𝒓𝒈𝒊𝒏𝒂𝒍 𝑪𝒐𝒔𝒕 =
everywhere higher ∆𝑿
than the total The marginal cost
variable cost curve curve is shown as
by the same amount U shaped.
as the total fixed Initially, it falls as
cost. the variable factor
is used more
efficiently and
then starts rising.

MANAGERIAL ECONOMICS 36 SAJIN JOHN

RELATIONSHIPS BETWEEN THE SHORT-RUN Example:
TC AFC AVC ATC MC
COST CURVES o/p
FC VC FC + 𝐹𝐶 𝑉𝐶 AFC+ ∆𝑇𝐶
X
VC 𝑋 𝑋 AVC ∆𝑋
Relationship Between Total Fixed Cost and Average
0 270 0.0 270.0 - - - -
Fixed Cost
At any point on the total fixed cost curve, the 5 270 157.5 427.5 54.0 31.5 85.5 31.5
average fixed cost is the slope of the line, which joins the 10 270 330.0 600.0 27.0 33.0 60.0 34.5
origin to that particular point on the total fixed cost
15 270 517.5 787.5 18.0 34.5 52.5 37.5
curve.
20 270 720.0 990.0 13.5 36.0 49.5 40.5
Relationship Between Total Variable Cost and
Average Variable Cost 25 270 937.5 1207.5 10.8 37.5 48.3 43.5
At any point on the total variable cost curve, the 30 270 1170.0 1440.0 9.0 39.0 48.0 46.5
average variable cost is the slope of the line, which joins
35 270 1417.5 1687.5 7.7 40.5 48.2 49.5
the origin to that particular point on the total variable
cost curve. 40 270 1680.0 1950.0 6.8 42.0 48.8 52.5

45 270 1957.5 2227.5 6.0 43.5 49.5 55.5

Relationship Between Average Cost and Average
Variable Cost 50 270 2250.0 2520.0 5.4 45.0 50.4 58.5
The average variable cost curve and average 55 270 2557.5 2827.5 4.9 46.5 51.4 61.5
cost curve are both shown as U shaped due to the law of
variable proportions. 60 270 2880.0 3150.0 4.5 48.0 52.5 64.5

However, average variable cost curve reaches its

minimum point before the average cost curve.
Relationship Between Total Cost and Marginal Cost
At any point on the total cost curve, the
marginal cost curve is the slope of the total cost curve at
that point.
Relationship Between Average Cost and Marginal
Cost
Both the average cost curve and the marginal
cost curve are U shaped.
Below figure depicts that
when average cost is falling, marginal cost is also
falling and is below it.
when average cost is rising, marginal cost is also
rising and is above it.
when average cost is at its minimum point, marginal
cost is equal to average cost or the marginal cost
curve intersects the average cost curve.
𝑺𝑴𝑪 = 𝑺𝑨𝑪

If the Cost function can be represented in equation form,

𝐶 = 𝐶(𝑄) = 270 + 30𝑄 + 0.3𝑄2
𝑇𝐶 270
𝑆𝐴𝐶 = = + 30 + 0.3𝑄
𝑄 𝑄
𝑑𝐶
𝑆𝑀𝐶 = = 30 + 0.6𝑄
𝑑𝑄

MANAGERIAL ECONOMICS 37 SAJIN JOHN

COSTS IN THE LONG RUN
LONG-RUN COST ANALYSIS
In the long run, the supply of most of the factors
of production is elastic.
No factors are fixed in the long run. Thus, all the
factors of production can be changed in the long run.
It is important to understand that the long-run
cost curves are formed by the short-run cost curves.
LONG-RUN AVERAGE COST
The long-run average cost is the average per unit
cost of production when all the factors of production are
variable in the long run.
o The long-run average cost curve can be derived
from the short-run average cost curves as it is
tangent to the short-run average cost curves.
o The long-run average cost curve is derived from the
SAC’s (Short-run Average Cost) as the minimum
per-unit cost of producing each level of the output.
It shows the least cost of producing each level of the
output.
o The long-run average cost curve is called the
envelope curve as it envelops the SAC’s.
o The long-run average cost curve is U shaped
because of the law of returns to scale:
Initially, the long-run average costs fall as a firm
experiences increasing returns to scale because
of economies of scale.
When the economies of scale have reached their
limit while diseconomies of scale have not yet
appeared, the long-run average cost curve
reaches its optimum plant producing the
optimum output.
When a firm increases its output beyond its
optimum capacity by changing its scale of
operations, the disadvantages that it
experiences are called the diseconomies of
scale.
LONG-RUN MARGINAL COST
The long-run marginal cost curve can be derived
from the short-run marginal cost curves as in below
figure.
o The long-run marginal cost curve is the locus of
points, which is formed by the point where the
MANAGERIAL ECONOMICS
vertical line, drawn from the point of tangency of
the SAC with the long-run average cost curve,
intersects the corresponding SMC curve.
o By joining all such points, one can draw the long-
run marginal cost curve.
From above figure, we can depict:
o When long-run average cost is falling, long-run
marginal cost is also falling and is below it.
o When long-run average cost is rising, long-run
marginal cost is also rising and is above it.
o When long-run average cost is at its minimum
point, long-run marginal cost is equal to long-run
average cost, or the long-run marginal cost curve
intersects the long-run average cost curve.
o Also, at this point (X2)
𝑳𝒐𝒏𝒈 𝒓𝒖𝒏 𝑨𝒗𝒈 𝑪𝒐𝒔𝒕 = 𝑺𝒉𝒐𝒓𝒕 𝒓𝒖𝒏 𝑨𝒗𝒈 𝑪𝒐𝒔𝒕
= 𝑺𝒉𝒐𝒓𝒕 𝒓𝒖𝒏 𝑴𝒂𝒓𝒈𝒊𝒏𝒂𝒍 𝑪𝒐𝒔𝒕
= 𝑳𝒐𝒏𝒈 𝒓𝒖𝒏 𝑴𝒂𝒓𝒈𝒊𝒏𝒂𝒍 𝑪𝒐𝒔𝒕
𝑳𝑨𝑪 = 𝑺𝑨𝑪 = 𝑺𝑴𝑪 = 𝑳𝑴𝑪
LONG-RUN TOTAL COST
The long-run total cost curve is the minimum
total cost of producing different levels of output from
different plant sizes.
o The long-run total cost curve is derived from the
short-run total cost curves taking the point which
represents the optimum size of the plant.
o The short-run total cost curve begins from the level
of the fixed costs while the long-run total cost curve
begins from the origin since in the long run there
are no fixed costs.
o The long-run total cost curve is inverse S shaped
because of the law of returns to scale.
38 SAJIN JOHN
ECONOMIES OF SCALE
When a firm increases its output by changing its
scale of operations, the benefits that it experiences are
called the economies of scale.
A firm experiences increasing returns to scale
because of economies of scale.
Situation where a firm’s long-run average cost
(LRAC) declines as output increases
INTERNAL ECONOMIES
These economies are not dependent on the
actions of other firms.
An individual firm experiences them when it expands
its production.
It is due to these internal economies that the long-run
average cost curve falls.
They include:
LABOUR ECONOMIES
o When production is on a large scale, each labourer
specializes and is involved in doing the work he is
most suited for.
o Thus, his efficiency increases and there is an
increase in the production.
TECHNICAL ECONOMIES
These arise when a firm grows in size. They include :
o Economies of Superior Technology: Due to its large
size a firm can purchase bigger and specialized
machinery, which may be utilizing the latest
technology and thus may be cost reducing.
o Economies of Linked Processes: Due to an increase
in its size a firm can go for backward integration
(manufacture its inputs) and forward integration
(market its product).
o Economies of Increased Dimensions: As the firm
grows bigger in size, it can operate the different
processes involved in production in its own
premises, thus saving on time and cost.
o Economies of Specialization: A large firm can
subdivide the production process leading to a
greater specialization, which improves the
productive efficiency of the firm.
o Economies in the Use of its Wastes: A large firm can
utilize its wastes and manufacture its by-products.
MARKETING ECONOMIES
o A large firm is in a position to buy the raw materials
and the factors of production at concessional rates
because of its purchase in bulks.
o Similarly as far as selling the product is concerned,
it is able reap economies in its advertising, sales
promotion and others.
MANAGERIAL ECONOMIES
o Unlike a small firm, a large firm is in a position to go
in for a division in its diverse activities,
o for example, production manager, finance manager
and others.
MANAGERIAL ECONOMICS
o This results in an expertise of different people in
different areas leading to an increase in their
efficiency.
FINANCIAL ECONOMIES
o Because of its large asset base and its credit
worthiness in the market, a large firm can raise
finance more easily and at cheaper rates.
RISK-BEARING ECONOMIES
o Large firms are better equipped to bear risks as
compared with small firms because they have a
diversified portfolio of products and also because
they are selling the product in many markets.
EXTERNAL ECONOMIES
These economies occur because of the growth
of the industry as a whole.
They are generated from outside the firm and the
benefit is shared by all the firms in the industry.
It is due to these external economies that the long-run
average cost curve shifts downwards.
They include:
ECONOMIES OF INFORMATION
o All the firms in a particular area can come together
to share the information relating to labour, latest
techniques of production and can even go in for
research and development.
o All the information can be published in journals to
benefit all the firms in the industry and thus
improve their efficiency.
ECONOMIES OF CONCENTRATION
When an industry comes up in an area, they all reap the
advantages from localization like:
— availability of skilled labour.
— availability of cheap and easy finance.
— access to transport and communication facilities.
— access to adequate sources of power.
— access to marketing facilities because of
concentration.
ECONOMIES OF DISINTEGRATION:
o When the industry is concentrated in a particular
area, firms can take advantage of the economies of
disintegration.
o For example, all wastes from the different firms
could be put to use by starting another firm in the
area which utilizes the wastes.
DISECONOMIES OF SCALE
When a firm increases its output beyond its
optimum capacity by changing its scale of operations, the
disadvantages that it experiences are called the
diseconomies of scale.
A firm experiences decreasing returns to scale because
of diseconomies of scale.
Situation where a firm’s LRAC increases as
output increases
The diseconomies of scale are of two types:
39 SAJIN JOHN
INTERNAL DISECONOMIES communication facilities, power and other facilities,
which are limited.
These diseconomies are not in any way
o This leads to bottlenecks and increases in the costs
dependent on the actions of other firms.
It is due to these internal diseconomies that the firm’s of production.
productive efficiency starts falling. Problems relating to DISPOSAL OF TOO MANY
They include: WASTES in a particular area.
While internal economies of scale cause the long-run
TECHNICAL DISECONOMIES
o These diseconomies arise when a firm grows in size average cost curve to fall, the internal diseconomies of
beyond its optimum capacity. scale cause the long-run average cost curve to rise.
o They include increases in the costs of maintenance While external economies of scale cause the long-run
and in the occurrence of accidents. average cost curve to shift downwards, the external
diseconomies of scale cause the long-run average cost
MANAGERIAL DISECONOMIES curve to shift upwards.
o Beyond a limit, if there are too many managers at
different levels, there may be problems relating to
coordination and distortion of information.
o This may have an adverse effect on the decision-
making ability of the managers.
o It may also lead to managerial problems and
increase the inefficiencies in the firm.
FINANCIAL DISECONOMIES:
o We have observed that because of its large asset
base and its credit worthiness in the market, a large
firm can raise finance more easily and at cheaper
rates.
o But if this raising of finance is indulged in beyond a
limit, it may lead to problems relating to
concentration of power and wealth and also in the
repayments of the loan.
RISK-BEARING DISECONOMIES:
o As already discussed, large firms are better
equipped to bear risks as compared with small
firms because they have a diversified portfolio of
products.
o But if this diversification is done beyond the
optimum limit, problems may occur and there may
be a fear of loss in control by the management at the
top.

EXTERNAL DISECONOMIES
These diseconomies occur because of the
growth of the industry as a whole leading to an increase LEARNING CURVE
in the per-unit costs. A learning curve is a concept that graphically
They are generated from outside the firm and the depicts the relationship between the cost and output over
disadvantages are faced by all the firms in the industry. a defined period of time, normally to represent the
It is due to these external diseconomies that the long- repetitive task of an employee or worker.
run average cost curve shifts upwards. T A steeper slope indicates initial learning
hey include: translates into higher cost savings, and subsequent
learnings result in increasingly slower, more difficult
INCREASE IN THE PRICE OF THE FACTORS OF cost savings.
PRODUCTION:
o Due to the growth of the industry, there is an
increase in the demand for the factors of production
leading to an increase in their price.
o Thus, there in an increase in costs of production.
INFRASTRUCTURAL PROBLEMS:
o The expansion of the industry in a particular area
puts pressures on the transport and
MANAGERIAL ECONOMICS 40 SAJIN JOHN
MODULE 7 – PROFIT AND REVENUE MAXIMIZATION
PROFIT MAXIMIZATION

o Total profit for small and large quantity production o Basic profit-maximizing model:
is negative with two zero crossing. 𝑀𝑅 = 𝑀𝐶
o Total Profit is maximum when the two slopes of o We start by defining,
both TR and TC curves are equal and parallel. 𝑇𝑜𝑡𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡
o Slope of the TC curve = Marginal Cost 𝑇𝜋 = 𝑇𝑅 − 𝑇𝐶
o Slope of the TR curve = Marginal Revenue o Profit is at a maximum when its first derivative with
o When both are equal, slope of the total profit is zero. respect to Q is equal to zero
o It states that additional revenue generated from a 𝒅𝑻𝝅 𝒅𝑹 𝒅𝑪
= − =𝟎
unit of output must be equal to the additional cost 𝒅𝑸 𝒅𝑸 𝒅𝑸
of producing it. 𝑴𝑹 − 𝑴𝑪 = 𝟎
𝑴𝑹 = 𝑴𝑪
o And second derivative is negative.
𝒅𝟐 𝑻𝝅 𝒅𝑴𝑹 𝒅𝑴𝑪
= − <𝟎
𝒅𝑸𝟐 𝒅𝑸 𝒅𝑸
Example:
Q P TR TC Tπ MR MC Mπ
0 200 0 200 -200 - - -
5 190 950 1200 -250 190 200 -10
10 180 1800 2050 -250 170 170 0
15 160 2400 2450 -50 120 80 40
20 140 2800 2700 100 80 50 30
25 120 3000 2850 150 40 30 10
30 105 3150 2950 200 30 20 10
35 93 3255 3055 200 21 21 0
40 80 3200 3180 20 -11 25 -36
o Here, there are two points where MR=MC so as per
Profit maximization rule the second derivative is
negative. i.e. at Q=35 will be considered.

MANAGERIAL ECONOMICS 41 SAJIN JOHN

BREAK EVEN ANALYSIS
At the break-even level of output, the total cost is equal
to the total revenue. Assume that the break-even level
BREAKEVEN ANALYSIS
of output is QB.
The break-even level of output is that level of Thus, 𝑇𝑅 = 𝑇𝐶
output at which a firm neither makes profits nor losses. It 𝑃 × 𝑄𝐵 = (𝐴𝑉𝐶 × 𝑄𝐵 ) + 𝑇𝐹𝐶
is the level of output at which total cost is equal to total 𝑄𝐵 (𝑃 − 𝐴𝑉𝐶) = 𝑇𝐹𝐶
revenue. 𝑻𝑭𝑪
o It is also called the cost volume profit analysis or 𝑸𝑩 =
(𝑷 − 𝑨𝑽𝑪)
profit contribution analysis.
Here, (P-AVC) is known as the unit contribution margin.
o It helps a firm in analysing the relationship between
It measures the contribution made by each unit of
total revenue, total cost and total profit.
output to cover the fixed cost.
o With the help of this analytical tool, a firm is able to
Also the equation shows that the break-even level of
differentiate between the ranges of production,
output is determined by the amount of the total fixed
which are profitable from those which are not
cost, per-unit price of good x and average variable cost.
profitable.
If any of these variables change, the break-even level of
o Thus, by using the break-even analysis, a firm is in
output will also change.
a position to find out the level of output, where
EXAMPLE:
revenue and cost break even.
Product Cost is $3.60
o Example:
Product Price is $6.00
Nano: Took four years to break even with an
Total Fixed cost are 60000/month
estimate of 8 lakh units
Using formula finding breakeven point,
Air Asia-(February 2013), Initially, it was 𝑻𝑭𝑪 𝟔𝟎𝟎𝟎𝟎
expected to break even by May or June (Original 𝑸𝑩 = = = 𝟐𝟓𝟎𝟎𝟎
(𝑷 − 𝑨𝑽𝑪) (𝟔. 𝟎𝟎 − 𝟑. 𝟔𝟎)
break-even was in November last year) (Source:
Live Mint, Air Asia India to break even by May Means, break-even point is at 25000 products/month
June, Says CEO, 20th August 2015)
Using graph/table,
TR TVC
Q P AVC TFC TC Tπ
(P*Q) (P*C)
0 6 3.6 0 0 60000 60000 -60000

5000 6 3.6 30000 18000 60000 78000 -48000

10000 6 3.6 60000 36000 60000 96000 -36000

15000 6 3.6 90000 54000 60000 114000 -24000

20000 6 3.6 120000 72000 60000 132000 -12000

25000 6 3.6 150000 90000 60000 150000 0

30000 6 3.6 180000 108000 60000 168000 12000

35000 6 3.6 210000 126000 60000 186000 24000

40000 6 3.6 240000 144000 60000 204000 36000

Break-even analysis is useful when a firm is planning on

its output for targeting a certain level of profits.
Total Profit, 𝑇𝜋 = 𝑇𝑅 − 𝑇𝐶 Suppose, if a firm wishes to earn a specific profit and
But, 𝑇𝑅 = 𝑃 × 𝑄
wants to estimate the quantity it must sell to earn that
And, 𝑇𝐶 = 𝑇𝑉𝐶 + 𝑇𝐹𝐶
profit. Below formula could be used
However, 𝑇𝑉𝐶 = 𝐴𝑉𝐶 × 𝑄 𝑻𝑭𝑪 + 𝝅𝑻
Thus, 𝑇𝐶 = (𝐴𝑉𝐶 × 𝑄) + 𝑇𝐹𝐶 𝑸𝑻 =
(𝑷 − 𝑨𝑽𝑪)

MANAGERIAL ECONOMICS 42 SAJIN JOHN

INCREMENTAL PROFIT ANALYSIS

THE SHUTDOWN POINT INCREMENTAL PROFIT ANALYSIS

A shutdown point is a level of operations at which
a company experiences no benefit for continuing
operations and therefore decides to shut down
temporarily—or in some cases permanently.
o It results from the combination of output and price
where the company earns just enough revenue to
cover its total variable costs.
o The shutdown point denotes the exact moment
when a company’s (marginal) revenue is equal to its
variable (marginal) costs—in other words, it occurs
when the marginal profit becomes negative.
To determine the effect on total profit that will
result from a particular action, given that the firm is
already generating a certain level of profit (based on its
existing business)
- Open a new territory
- Sell on credit
- New technology or Equipment change, etc.
o Identify the relevant costs and revenues for the
various options being considered
o Analyse whether these activities contribute more to
total revenue than to total cost.
o If it contributes more revenue and/or reduces cost
then go ahead with the action as it will result in
increasing the profit

EXAMPLE:
A yoga centre, has a contract to rent space that costs
$10,000/month & marginal cost of hiring yoga teachers
is $15,000/month.
So, here FC = 10000, VC=15000
Scenario 1: No client available.
- If shutdowns now, then he has to pay only the
rent.
- In this case profit,
Profit = TR – (FC + VC) = 0 – 10000 = -$10,000
- Loss of $10,000
Scenario 2: Earns revenue of $10,000/month
- In this case profit,
Profit = 10000 – (10000 + 15000) = -$15,000
- Loss of $15,000
- He has to shut down temporarily as he revenue
is not able to cover the variable cost.
- If he continuous, then the loss keep on
increasing
Scenario 3: Earns revenue of $20,000/month
- In this case profit,
Profit = 20000 – (10000 + 15000) = -$5000
- He should continue the business as the profit is
able to cover the average variable cost and
some part of fixed cost.
- In long run, he will be able to recover the costs
and start earning profit.
MANAGERIAL ECONOMICS 43 SAJIN JOHN
MODULE 8 – PERFECT COMPETITION AND MONOPOLY
PERFECT COMPETITION: MARKET DEMAND AND FIRM DEMAND
No. Freedo
Type No.
Nature of of m of
of of Examples
TYPE OF MARKET STRUCTURE & PRICING market firms
product buye entry &
rs exit
PERFECT COMPETITION

differentiated
Homogeneou
competition

Unrestricted
Very Large

Very Large
There are a large number of buyers and sellers Agricultural

Perfect

(un-
commodities,
of the good. The price of a good is determined in the

)
unskilled labor
market by the demand and the supply. The firm does
not have any discretion in fixing the price of the good.

Differentiated
Monopolistic
competition

Unrestricted
MONOPOLY Retail stores,

Many

Many
There is a single seller of the good in the market FMCG
with no close substitutes for the good. There is very
little competition with the firm exercising a great deal
of control over the price of the good.

differentiated

differentiated
Oligopoly

Restricted
Automobiles,

Many
Few

Un-
MONOPOLISTIC COMPETITION computers,

or
universities
There are a large number of firms, which are
involved in the production of similar goods. Each firm
has some discretion in fixing the price of its product.

Monopoly

Restricted
Indian

Unique
Single

Many
OLIGOPOLY Railways,
There are a few large firms selling similar or Microsoft, Intel

differentiated goods.
There is intense competition between the firms

differentiated

differentiated
Monopsony

Arms

applicable
and often they form cartels with the aim of controlling

Single
Many
manufacturers

Un-

Not
or
the markets. and Defense
Each firm has a control over the price of the industry

good it produces, especially if the good is differentiated.

Number of buyers
One Many
Bilateral
One Monopoly
Number of
suppliers

Monopoly
A few Oligopoly
Monopolistic /
Many Monopsony
Perfect Competition

CHARACTERISTICS OF PERFECT COMPETITION

Perfect competition is a market structure, where there
are a large number of buyers and sellers of a good for
which there is no close substitute, with there being free
entry and exit. Its characteristics are as follows:
1. Large number of buyers and sellers of the good.
There exist such a large number of buyers and
sellers that no single buyer and no single seller can
influence the price of the good. Each is a price taker.
2. Homogenous good. As far as the good is concerned,
each and every unit of the good is similar to the
other unit. For the buyer, each unit of the good is
identical to the other unit irrespective of which firm
has produced the good. Thus, no firm has any
control over the price of the good.

MANAGERIAL ECONOMICS 44 SAJIN JOHN

3. Free entry and exit of firms. Firms are free to enter FIRM’S REVENUE CURVES UNDER PERFECT
or exit the industry without there being any COMPETITION
restrictions or barriers. Also, there is no cost
involved as far as entry and exit are concerned. TOTAL REVENUE CURVE
4. Buyers and sellers have perfect knowledge about Total revenue can be defined as the total
the conditions in the market. Buyers and sellers proceeds earned by a firm from the sale of a certain
have a complete knowledge about the prices amount of the output.
prevailing in the market. There are no uncertainties Under perfect competition, a firm is
in the market about the future conditions. a price taker, the total revenue
5. Factors of production are perfectly mobile. All curve will be a straight line through
factors of production including land, labour and the origin.
capital are perfectly mobile from one place to 𝑻𝑹 = 𝑷 × 𝑸
another and from one occupation to another
AVERAGE REVENUE CURVE
occupation. There are no legal restrictions or
Average revenue can be defined as the average
obstacles in the form of trade unions.
proceeds earned by a firm from the sale of a certain
6. There is no government intervention. There is a
amount of the output.
laissez-faire policy followed by the government in Thus, the average revenue is the price of the good,
the sense that there are no taxes, subsidies, duties,
which is determined by the market demand and supply
etc. imposed by the government.
of the good.
7. There are no costs of transportation. Since it is
The average revenue curve is also the demand curve for
necessary for a single price to exist in all markets, it
the good. It is shown as straight line parallel to the X axis
is assumed that there no costs relating to transport. in Figure depicting that whatever are the quantities sold
8. The goal of the firm is to maximize the profits. Every
the price of the good will remain the same.
firm in the market aims at maximizing its profits. 𝑻𝑹 𝑷 × 𝑸
𝑨𝑹 = = =𝑷
𝑸 𝑸
INDUSTRY SUPPLY AND DEMAND
o At a particular Price, if the demand is low and
supply is high then it results into Surplus
o At a particular Price, if the demand is high and
supply is low then it results into Shortage.
o Equilibrium is attained when the demand and
Supply curve meet each other.

MARGINAL REVENUE CURVE

Marginal revenue is the change in the total
revenue when the output changes by one unit.
The marginal revenue curve is a shown as
straight line parallel to the X. It is important to note that
it coincides with the average revenue curve. Thus,
𝑷 = 𝑨𝑹 = 𝑴𝑹

Short-run Equilibrium of a Firm

For Perfect Competition,
𝐷𝑒𝑚𝑎𝑛𝑑 = 𝑃𝑟𝑖𝑐𝑒 = 𝐴𝑣𝑔. 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
= 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
At Equilibrium,
𝑀𝐶 = 𝑀𝑅
So, Perfectly Competitive firm making Supernormal
At Equilibrium, 𝑄𝑑 = 𝑄𝑠 Profits in Short Run can be shown as
Suppose, 𝑄𝑑 = 625 − 5𝑃
And, 𝑄𝑠 = 175 + 5𝑃
At equilibrium, 625 − 5𝑃 = 175 + 5𝑃
𝑃 = 45
Demand, 𝑄𝑑 = 625 − 5(45) = 400
Supply, 𝑄𝑠 = 175 + 5(45) = 400

MANAGERIAL ECONOMICS 45 SAJIN JOHN

 o When a firm exists a market, the supply in the
market decreases and thus shifts the supply curve
leftwards resulting in an increase in equilibrium
point.
o At the price OP, the firm in the industry will be in
long-run equilibrium earning normal profit. Thus,
there is no incentive for new firms to enter the
industry nor for existing firms to quit the industry.
Both the individual firm and the industry are in
long-run equilibrium
i.e.
at Equilibrium point E, MR meets MC which is where the
firm makes maximum profit.
Here, demand curve is a straight line parallel to X as its
set by the market and firm cannot change it. As Perfectly
Competition firm is a Price taker.
So, area OPEX is total revenue.
Area OABX is total cost.
Thus, area APEB represents the profit earned.

In case of losses, the average cost is more than the Price

set by the market. PRICE CONTROLS
Area APEB represents the lost incurred. Minimum price policies aim at keeping the market price
above the equilibrium price.
o for example, in the case of some agricultural goods
and also under the minimum wage laws, the
government may fix a minimum price for the good
at PMin, which is above the
equilibrium price.
o This will result in an excess
supply of the good, which
the government will have to
purchase.

Long-Run Equilibrium of a Firm

A firm is in the long-run equilibrium when it is Maximum price policies aim at keeping the market price
earning normal profits. This implies that to reach an below the equilibrium price.
equilibrium in the long-run a firm will have to make o for example, when the government wants to control
adjustments the production of a good, the government may fix a
maximum price for the good at PMax, which is below
the equilibrium price OP*.
o This will result in an excess
demand for the good,
which, if not satisfied, may
result in black marketing.

o In long-run, a firm can enter or exit the market and

this will results in shift of Supply in market.
o When a firm enters a market, the supply in the
market increases and thus shifts the supply curve
rightwards resulting in a decrease in equilibrium
point.

MANAGERIAL ECONOMICS 46 SAJIN JOHN

MONOPOLY AND ITS SETTING
Monopoly is a market structure, where there is a
single seller of the good in the market with no close
FIRMS REVENUE CURVES UNDER MONOPOLY
substitutes for the good.
o There is a very little competition, with the firm DEMAND CURVE
exercising a great deal of control over the price of Under monopoly, there exists a single seller
the good. who exercises control over the output of the whole
o Also, there exist barriers to entry. industry.
o Thus, the firm constitutes the industry.
CHARACTERISTICS OF MONOPOLY o Hence, the demand curve of the firm is also the
demand curve of the industry.
SINGLE SELLER OF THE GOOD o Since the firm has control over the price of the good
There exists a single seller, who exercises control over or is a price maker, the demand curve slopes
the output of the whole industry. Thus, the firm downwards.
constitutes the industry. 𝑷 = 𝒂 − 𝒃𝑸
Where, P is per-unit price of the good,
NO GOODS WHICH CAN ACT AS SUBSTITUTES
a is intercept of the demand curve on the Y axis,
As far as the good is concerned, the entire output of the
b is slope of the demand curve and
good is produced by the monopoly firm. There are no
Q is quantity of the good or the output level.
goods, which can substitute for the good. Thus, the firm
has control over the price of the good or is a price TOTAL REVENUE CURVE
maker. Total revenue can be defined as the total
proceeds earned by a firm from the sale of a certain
RESTRICTIONS ON ENTRY
amount of the output.
There exist barriers as far as entry is concerned, for
Under monopoly, the total revenue curve is an inverted
example, patents. This is necessary for a monopoly firm
U-shaped curve.
to survive.
𝑇𝑅 = 𝑃 × 𝑄
MONOPOLIST HAS PERFECT KNOWLEDGE 𝑇𝑅 = (𝑎 − 𝑏𝑄)𝑄
The monopolist has perfect knowledge about the 𝑻𝑹 = 𝒂𝑸 − 𝒃𝑸𝟐
conditions in the market. There are no uncertainties in
AVERAGE REVENUE CURVE
the market about the future conditions.
Average revenue can be defined as the average
GOAL OF THE FIRM IS TO MAXIMIZE THE proceeds earned by a firm from the sale of a certain
PROFITS amount of the output.
The monopolist firm aims at maximizing its profits. 𝑻𝑹 𝑷 × 𝑸
𝑨𝑹 = = = 𝑷 = 𝒂 − 𝒃𝑸
𝑸 𝑸
TYPE OF MONOPOLY Thus, the average revenue is the price of the good. The
average revenue curve is also the demand curve for the
1. NATURAL MONOPOLY where the monopoly
good.
exists due to the existence of natural factors, for
example, the accessibility to some basic raw MARGINAL REVENUE CURVE
materials, which is required for the production of Marginal revenue is the change in the total
the good, climatic suitability for the good and revenue when the output changes by one unit.
economies of scale. 𝝏𝑻𝑹 𝝏(𝒂𝑸 − 𝒃𝑸𝟐 )
2. SOCIAL (REGIONAL) MONOPOLY where the 𝑴𝑹 = = = 𝒂 − 𝟐𝒃𝑸
𝝏𝑸 𝝏𝑸
monopoly is formed by the state or the government 𝑴𝑹 = 𝑻𝑹𝒏 − 𝑻𝑹𝒏−𝟏
for the welfare of the people, for example, railways. Also,
3. LEGAL MONOPOLY where the monopoly is 𝝏𝑻𝑹 𝝏(𝑷 × 𝑸) 𝝏𝑸 𝝏𝑷 𝝏𝑷
created by legal barriers, for example, patents and 𝑴𝑹 = = =𝑷 +𝑸 =𝑷+𝑸
𝝏𝑸 𝝏𝑸 𝝏𝑸 𝝏𝑸 𝝏𝑸
copyrights. Often, a firm may discover a new But, elasticity of demand,
method of producing a good and then may acquire −𝝏𝑸 𝑷
exclusive rights for its production for a certain time. 𝑬𝑷 = ×
𝝏𝑷 𝑸
4. FISCAL (ECONOMIC) MONOPOLY where the 𝝏𝑷 𝟏 𝑷
monopoly is formed by the government, for =− ×
𝝏𝑸 𝑬𝑷 𝑸
example, the printing of currency and the minting of
𝟏 𝑷
coins. 𝑴𝑹 = 𝑷 + 𝑸 {− × }
𝑬𝑷 𝑸
𝟏
𝑴𝑹 = 𝑷 (𝟏 − )
𝑬𝑷

MANAGERIAL ECONOMICS 47 SAJIN JOHN

For relatively inelastic demand, EP<1, MR is negative
For Unitary elastic demand, MR is zero
For Elastic demand, MR is positive.
SHORT-RUN EQUILIBRIUM OF A FIRM
The marginal approach to equilibrium for a monopoly
firm has been depicted diagrammatically
At Equilibrium E is attained at MR=MC. i.e. Maximum
profit, for quantity QE
QE meets Average Cost at B and Average Revenue at C.
So, rectangle OQBA is the total cost, OQCP is total
revenue.
Hence, rectangle ABCP is the supernormal profit (as
AR>AC)
MANAGERIAL ECONOMICS
When Average cost is
more than Average
revenue, firm incurs
loss.
Rectangle APCB is the
loss incurred at
Equilibrium quantity X’.
LONG-RUN EQUILIBRIUM OF A FIRM
In long run, a monopolist is able to expand the firm’s
size so as to be able to increase its profit in the long run.
The marginal approach to equilibrium for a monopoly
firm has been depicted diagrammatically
o The firm is in a short equilibrium at point ES , where
MR = SMC1 and also the short-run marginal cost
curve intersects the marginal revenue curve from
below. The equilibrium price is OPS while the
equilibrium output is OXS. The firm is earning
supernormal profits equal to the rectangle PSLMN.
o The firm is in a long-run equilibrium at point EL,
where MR = LMC and also the long-run marginal
cost curve intersects the marginal revenue curve
from below. The equilibrium price is OPL while the
equilibrium output is OXL. The firm is earning
supernormal profits equal to the rectangle PLACB.
A comparison of the short- and long-run equilibrium of
the monopolist depicts that:
o The long-run equilibrium output OXL is larger than
the short-run equilibrium output OXS.
o The long-run equilibrium price OPL is lower than
the short-run equilibrium price OPS.
o The long-run monopoly profit PLACB is larger than
the short monopoly profit PSLMN.
o Thus, the monopolist produces a larger output at a
lower price and earns larger profits in the long run
than it does in the short run.
48 SAJIN JOHN
PRICE DISRIMINATION sub-markets or blocks charging a different price
from each block.
Price discrimination is a situation when different
o The basis on which
prices are charged from different consumers for the sale
of the same good at the same point in time. the market is
The monopoly firm which goes in for practising price subdivided is
according to the
discrimination is called a discriminating monopoly.
quantity bought in
each market.
CONDITIONS NECESSARY FOR PRICE o The price in each
DISCRIMINATION block is determined
1. There must exist imperfect competition in the by what the
market. Only under a situation like monopoly, it is marginal unit in that
possible for a firm to charge the different prices block is able to pay.
from the different consumers.
THIRD DEGREE PRICE DISCRIMINATION
2. It is necessary that there should exist two or more
o Here, the monopolist divides the consumers of the
markets, which are separated from each other.
good into different sub-markets or different groups
Otherwise, a consumer in one market may indulge
and charges a different price from each one of them.
in reselling the good in the higher-priced market at
o The market may be divided on the basis of some
a higher price.
geographical or demographic features.
3. The price elasticity of demand must be different in
o The important point to note here is that for third
the different markets. This is because if the
degree price discrimination to be possible, the price
elasticity is the same, then the price discrimination
elasticity of demand should be different in each sub-
would lead to a fall in the profits by causing a
market or group.
decrease in demand in the higher-priced market.
4. The marginal revenue in each market should be
greater than the marginal cost of the monopoly
good.

DEGREES OF PRICE DISCRIMINATION

The degree of price discrimination is the limit to
which a firm can make a division of the markets and
extract the surplus from the consumers.
There are three degrees of price discrimination.
FIRST DEGREE PRICE DISCRIMINATION COMPARISON OF PERFECT COMPETITION &
o Here, the monopolist charges the maximum price MONOPOLY
that each consumer is willing to pay for every unit
of the good. POINTS OF PERFECT MONOPOLY
o Thus, he is able to extract the whole of the surplus COMPARISON COMPETITION
from the consumer. Relationship
o The problem that may occur is that often the firm
between AR and AR = MR AR > MR
may not be aware of the maximum price that each
MR
consumer is
Profit in the Supernormal
willing to pay. Normal profits
long run profits
o The minimum
Number of
price, which Large Single
sellers
he would be
Barriers to Free entry and
ready to Strong barriers
entry and exit exit
accept, would
Control on Price The seller is
be OP3 Monopolist is
only the price
determined at the price maker
taker
the level, Nature of
where the marginal cost curve intersects the Perfectly elastic Inelastic
demand curve
demand curve.
Relationship Firm and
Each firm is a
between firm industry are
part of the
SECOND DEGREE PRICE DISCRIMINATION and industry one and the
industry
o This is also called the block pricing method. Here, same
the monopolist divides the different markets into

MANAGERIAL ECONOMICS 49 SAJIN JOHN

MODULE 9 - MONOPOLISTIC COMPETITION AND OLIGOPOLY
MONOPOLISTIC COMPETITION
Monopolistic competition is a market structure,
where there are many firms in the market selling close
substitutes for the good.
o Monopolistic competition is associated with E. H.
Chamberlin and Mrs J. Robinson.
o Both had presented separate models but arrived at
the same solution.
o Chamberlin used the concept of the ‘group’ (instead
of the industry) as the firms produce differentiated
products.
o Monopolistic competition has elements of both
perfect competition and monopoly. I
o t is a market structure, where there are many firms
in the market selling close substitutes (but not
identical) of the good.
o It is one of the most prevalent forms of market
structures that exist in the manufacturing sector in
any economy,
o The demand for the firm’s product is influenced by
three variables: price of the good, quality of the
good when compared with other goods and the
selling costs incurred by the firm.
o for example, in televisions, automobiles and soaps
CHARACTERISTICS OF MONOPOL ISTIC
COMPETITION
1. In the ‘group’, there are a large number of buyers
and sellers of the good. Each single seller has a
limited influence over the price of the good.
2. There exists product differentiation. As far as the
good is concerned, the goods produced by the group
are close substitutes of each other.
3. As far as the firms in the group are concerned, there
exist free entry and exit.
4. All the firms in the group have identical cost and
revenue curves.
5. The goal of the firm is to maximize the profits.
6. Each firm acts independently of the other firm in the
group.
7. Since the goods produced by the group are close
substitutes of each other there exists non-price
competition, for example, advertising, between the
firms.
o D, the proportionate or the actual demand curve of
the firm, depicts the demand for the good of one
firm when all the other firms in the group charge
MANAGERIAL ECONOMICS
the same price and also change the price of their
good simultaneously.
o It can be obtained by dividing Dg, the group or total
demand curve, by the number of firms in the group.
o DP, the perceived demand curve of the firm, depicts
the demand for the good of one firm assuming that
the other firms in the group do not change the price
of their goods.
o DP is more elastic than D because when only one
firm in the group decreases its price, then the
buyers may shift from other firms to this firm who
reduces its price.
o Thus, the firm is able to capture the share of the
other firms in the market.
o The individual firm may perceive its demand curve
to be DP because there are many firms in the group
and may feel that its actions may not be noticed by
the other firms.
ADVERTISING
o The Critique of Advertising
Manipulate people's tastes
Advertising reduces competition because it
increases the perception of product
differentiation
o The Defence of Advertising
Firms use advertising to provide information to
consumers.
Advertising increases competition because it
allows consumers to be better informed about
all of the firms in the market.
Advertising is a complementary good.
Advertising increases the pleasure one gets
from purchasing a good
SHORT-RUN EQUILIBRIUM OF A FIRM
o Each firm faces a downward-sloping demand curve
o The monopolistically competitive firm follows the
monopolist's rule for maximizing profit
It chooses the output level where MR is equal to
MC
It sets the price using the demand curve to
ensure that consumers will buy the amount
produced
o The reason for supernormal profit in short run, is
supplying a product which is differentiated, or at
least perceived to be different by the consumer.
o We may compare price and average total cost to
decide whether a firm is making a profit or loss
If P > ATC , the firm is earning a profit
If P < ATC , the firm is earning a loss
If P = ATC , the firm is earning zero economic
profit
When AR > AC,
50 SAJIN JOHN
Total Revenue: OPBQ LONG-RUN EQUILIBRIUM OF A FIRM
Total Cost: OACQ o When firms make profit, new firms have an
Supernormal Profit: APBC incentive to enter the market
Since OP>OA This increases the number of products from
which consumers can choose
Thus, the demand curve faced by each firm
shifts to the left
o When firms are incurring losses, firms in the
market will have an incentive to exit
Consumers will have fewer products from
which to choose
Thus, the demand curve for each firm shifts to
the right
o The process of exit and entry continues until firms
are earning zero profit
o This means that the demand curve and the average
total cost curve are tangent to each other.

When AR < AC,

Total Revenue: OPBQ
Total Cost: OACQ
Loss: APBC
Since OP<OA

Normal Profit = No loss/No gain; since AR=AC

o Since the firm has some monopoly power, its
demand curves and marginal revenue curve are
downward sloping while the cost curves are U
shaped.
o Each firm perceives that it is maximizing the profits
since the MR equals the MC.
o The firm is earning supernormal profits.
o The firm is earning supernormal profits in the short
run.
o These profits will attract new firms into the group.
o Since the demand curve of the group will now be
divided among more firms, now the proportionate
demand curve of each firm will shift towards the
left.
o The supernormal profits of each firm will be
competed away till every firm faces a no-economic
profit no-loss situation.

MANAGERIAL ECONOMICS 51 SAJIN JOHN

OLIGOPOLY
Oligopoly is a market structure, where there are
a few sellers of the product, which may be homogenous or
CHARACTERISTICS OF OLIGOPOLY
differentiated. Duopoly is a situation, where there are just
two sellers of the product. Oligopoly is characterized by the following:
o Oligopoly may be a pure oligopoly when the o A few dominant firms which produce a major part
product is homogenous or it may be a differentiated of the total industry output.
oligopoly when the product is differentiated. o Since there are only a few firms in the industry, the
o Derived from Greek word: “oligo” (few) “polo” (to actions of one firm influence the other firm in the
sell) industry.
o Few Sellers: small number of large firms compete o The output and price decisions made by one firm in
o Product: Some industries may consist of firms the industry have a significant impact on the profits
selling identical products, while in some other of the other firm in the industry. Thus, there exists
industries firms may be selling differentiated a mutual interdependence between the firms,
products. which provides them with an incentive to go in for
o Entry Barriers: No legal barriers; only economic in a non-price competition in their objective of profit
nature maximization.
o Huge investment requirements o The barrier to entry reduces the threat of entry into
o Strong consumer loyalty for existing brands the industry, thus enabling the firms to maximize
their profits in the long run.
o It is because of this very fact that there is no set
CAUSES OF OLIGOPOLY pattern in an oligopoly. Thus, we cannot define and
1. PRODUCT DIFFERENTIATION: Often construct a demand curve for an oligopolist as in the
consumers may have a preference for a particular other market structures. Hence, there does not exist
variety of a good produced by a firm. In that case, a general theory of oligopoly. There exist many
the firm may be in a position to control a large part models each based on a different set of behavioural
of the sales of the good, thus providing a barrier to assumptions.
entry to the other firms, which would like to enter
the industry.
2. LARGE CAPITAL INVESTMENT: Some
MARKET STRUCTURE IN AN OLIGOPOLY
industries which are capital intensive involve huge
investments, for example, iron and steel and Five Force Model:
shipbuilding. Since not everyone who is interested A model developed by Michael Porter helps us
in setting up a factory can afford such investments, understand the five competitive forces that determine
this again acts as a barrier to entry. the level of competition and profitability in an industry.
3. ABSOLUTE COST ADVANTAGES: In case the
existing firms in the industry have cost advantages,
for example, in purchasing raw materials and in the
techniques of production, a new firm will not find it
easy to enter and operate in the industry.
4. MERGERS BETWEEN FIRMS: Firms in an
industry may often reduce the competition among
themselves by merging with each other. New
entrants to the industry may feel discouraged by the
presence of such mergers.
5. ECONOMIES OF LARGE SCALE: When a firm
goes in for large scale production and reaps the
benefit of the economies of scale, the smaller firms
in the industry, which cannot join the rat race, may
opt out of the industry.

MANAGERIAL ECONOMICS 52 SAJIN JOHN

DUOPOLY: COURNOT’S MODEL
The model was developed by the French economist
Augustin Cournot in 1838.
The assumptions in the model are as follows:
1. There are only two firms, Firm A and Firm B, in the
industry selling spring water, which is assumed to
be a homogenous good.
2. There are constant costs of production.
3. The firms sell their good in a market, where the
demand curve is linear.
4. The behavioural assumption made in this model is
that each firm in its attempt at profit maximization
assumes that the other firm will keep its output
constant.
COURNOT MODEL
• Firm A is the only firm in the market
• Point A is the monopoly situation and TR is
maximum
• Firm B enters the market and assume that A will
continue to sell six units
• Adjustment process
Entry by Firm B reduces the demand for Firm
A’s product
Firm A reacts by reducing output, which
increases demand for Firm B’s product
Firm B reacts by increasing output, which
reduces demand for Firm A’s product
Firm A then reduces output further
This continues until equilibrium is attained
By repeating this exercise with different levels of
output and then by plotting them in graph, one can
arrive at Firm A’s reaction curve.
A reaction curve shows the profit-maximizing
output that a firm will produce expressed as a function of
what it thinks will be produced by the other firm.
Firm A’s reaction curve, QA*(QB) shows the profit-
maximizing output that it will produce expressed as
a function of what it thinks will be produced by Firm
B.
Similarly, Firm B’s reaction curve, QB*(QA) shows
the profit-maximizing output that it will produce
expressed as a function of what it thinks will be
produced by Firm A.
MANAGERIAL ECONOMICS
Cournot equilibrium exists at point C in above Figure,
where the two reaction curves intersect.
At the Cournot equilibrium, each firm is correct in its
assumption about the other firm’s output and thus it
maximizes its profits according to that output.
This equilibrium is a stable equilibrium.
SWEEZY’S KINKED DEMAND CURVE MODEL
• Paul Sweezy (1939) introduced concept of kinked
demand curve to explain ‘price stickiness’.
• Assumptions
If a firm decreases price, others will also do the
same. So, the firm initially faces a highly elastic
demand curve.
A price reduction will give some gains to the
firm initially, but due to similar reaction by
rivals, this increase in demand will not be
sustained.
If a firm increases its price, others will not
follow. Firm will lose large number of its
customers to rivals due to substitution effect.
Thus, an oligopoly firm faces a highly elastic
demand in case of price fall and highly inelastic
demand in case of price rise.
• A firm has no option but to stick to its current price.
• At current price a kink is developed in the demand
curve
• The demand curve is more elastic above the kink
and less elastic below the kink.
The assumptions in the model are as follows:
The firms recognize their interdependence but do
not collude in any way.
The behavioural assumption is that firms in the
industry match decreases in the price but not any
increases.
A price decrease by one firm in the industry leads
to a decrease in the price by the others and hence
the firm will not benefit in any way.
A price increase by one firm is not matched by a
price increase by the others and hence the firm
would lose its customers.
Thus, there is a non-price competition between the
firms.
53 SAJIN JOHN

o The Oligopoly firm faces the demand curve D1KD2.
o The curve has a kink at K, the currently prevailing
Price P.
o Curve is divided into two parts:
D1K = highly elastic portion of the demand curve
(AR) when rival firms do not react to price rise
KD2 = less elastic portion, when rival firms react
with a price reduction.
o Discontinuity in AR (D1KD2) creates discontinuity in
the MR curve.
o At the kink (K), MR is constant between point S and
T.
o Producer will produce OQ, whether it is operating
on MC1 or MC2, since the profit maximizing
conditions are being fulfilled at points S as well as T.
o If MC fluctuates between S and T, the firm will
neither change its output nor its price.
o It will change its output and price only if MC moves
above S or below T.
o Thus, as long as the marginal cost curve lies in the
discontinuous part of the marginal revenue curve,
the equilibrium output and price will not change.
o Thus, the model explains as to why price remains
rigid or sticky even when there are changes in costs.
MANAGERIAL ECONOMICS
BERTRAND’S AND EDGEWORTH’S THEORIES
• Cournot was criticized by several economists even
in his own time, notable among them being:
BERTRAND: each of the duopolists would
assume that the other’s price would not change
(not quantity); each will cut price to steal
customers until ultimately the price falls to zero
EDGEWORTH: based on productive capacity
(limited capacity); in this model price will be cut
by one firm and in reaction the other will
increase it slightly and this will continue ad
infinitum
• the Bertrand–Edgeworth model of price-setting
oligopoly looks at what happens when there is a
homogeneous product
• consumers want to buy from the cheapest seller
• where there is a limit to the output of firms which
they are willing and able to sell at a particular price.
• This differs from the Bertrand competition model
where it is assumed that firms are willing and able
to meet all demand.
• The limit to output can be considered as a physical
capacity constraint which is the same at all prices
(as in Edgeworth's work), or to vary with price
under other assumptions.
CHAMBERLIN AND DUOPOLY THEORY
• Cournot, Bertrand, and Edgeworth theories are all
based on the assumption of naive behaviour on the
part of the firms.
• Chamberlin argued that the duopolists would
recognize their interdependence and settle on a
price that confirms to the monopolists price and
split the profits between them.
• He stated that an explicit agreement is not required
since the firms would recognize that any other
strategy would lead to worse outcomes.
54 SAJIN JOHN
MODELS OF COLLUSIVE OLIGOPOLY
Under collusive oligopoly, firms cooperate and work
together to determine the output and the price levels in
a particular market. The purpose of the collusion is to
reduce the competition between the firms and to
increase the profits.
CARTELS
A cartel is formed by a group of firms, which are
producing a good and which may explicitly agree to
coordinate their policies to set a price and to increase the
profits of the member firms.
Often quotas may be fixed for each member. The
Organization of Petroleum Exporting Countries (OPEC)
is an international cartel of the oil-producing countries.
CENTRALIZED CARTEL
Formal agreement among member firms to set a
monopoly price and restrict output
A major part of the world’s production of the
good must be controlled by the cartel.
o Four major problems
Difficult to organize if there are more than a few
producers
How to allocate output and profits when firms
face different cost curves
There is a strong incentives for each firm to
remain outside the cartel or cheat on the cartel
by selling more than its quota at the high prices
resulting from the limited output of the other
cartel members
Monopoly profits are likely to attract other
firms into industry and undermine the cartel
agreement
Example: OPEC
• The OPEC –Petroleum exporters
• It was founded in Baghdad, Iraq (1960)
• Aim: increase the petroleum earnings of its
members
• The organization has a total of 12 member
countries
• Founder members: Islamic Republic of Iran, Iraq,
Kuwait, Saudi Arabia and Venezuela

MARKET SHARING CARTEL

o Suppose that there are four firms in the cartel • Collusion to divide up markets
producing a homogenous good. The prices of the • Each member firms agree only on how to share the
input remain constant. market.
o D is the market demand curve while MR is the • Each firm then operates in only one area or region
corresponding marginal revenue curve. agreed upon without encroaching on the others’
o By summing horizontally, the short-run marginal territories
cost curves of the four firms in the industry, one can • Example: Du Pont (American) and Imperial
obtain ΣMC. Chemical (English) made an agreement in the early
o MR intersects ΣMC part of this century
at point E to • Firms decide to divide the market share among
determine the them and fix the price independently.
equilibrium, which • All firms have the same cost functions because they
is a monopoly are producing a homogenous product but have
solution. different demand
o The equilibrium functions.
output is OQ while • Due to different
the equilibrium demand
price is OP. functions, at
o Once the equilibrium total
equilibrium output is determined, it is allocated output = OQA+
among the member firms. OQB, where OQA>
o The profits are also distributed among the members OQB.
depending on the size of the firm. • The quantity of
output produced
o The conditions necessary for a cartel to be and sold would
successful are as follows: depend upon the terms of agreement among the
The member firms should agree on the output firms in the cartel.
and the price to be charged by the cartel.
It is necessary that the demand for the good is
not price elastic.

MANAGERIAL ECONOMICS 55 SAJIN JOHN

FACTORS INFLUENCING CARTELS
• Number of firms in the industry: Lower the
number of firms in the industry, the easier to
monitor the behavior of other members.
• Nature of product: Formed in markets with
homogenous goods rather than differentiated
goods, to arrive at common price. But if goods are
homogeneous, an individual firm may gain larger
market share by cheating, i.e. by lowering the price.
• Cost structure: Similar cost structures make it
easier to coordinate.
• Characteristics of sales: Low frequency of sales
coupled with huge amounts of output in each of
these sales make cartels less sustainable, because in
such cases firms would like to undercut the price in
order to gain greater market share.
– with large number of firms and small size of
the market some firms may deviate from
the cartel price and thus cheat other
member
PRICE LEADERSHIP
Price leadership is another oligopoly model,
where one firm sets the price while the other firms in the
industry follow the firm.
o One firm may be recognized as the leader implicitly
and the other firms in the industry become the price
followers of this firm.
o There are different forms of price leadership. We
here focus on price leadership by a dominant firm.
MANAGERIAL ECONOMICS
o In Figure, there is a dominant firm, which supplies
a large portion of the industry output while the
remainder of the output is supplied by the group of
the smaller firms or the fringe firms.
o The large firm may fix a price at which it maximizes
its profits and then the smaller firms, acting as
perfect competitors, accept the price and determine
its output.
o Dominant Firm:
a leader in terms of market share, or presence
in all segments, or just the pioneer in the
particular product category.
Either a benevolent/ kind firm or an
exploitative firm.
o Benevolent leader
Allows other firms to exist by fixing a price at
which small firms may also sell.
so that it does not have to face allegations of
monopoly creation;
Earns sufficient margin at this price and still
retains market leadership
o Exploitative leader:
fixes a price at which small inefficient players
may not survive and thus it gains large share of
the market.
o Barometric Firm:
has better industry intelligence and can
preempt (being pioneer) and interpret its
external environment in a more effective
manner than others.
No single player is too large to emerge as a
leader, but there may be a firm which has a
better understanding of the markets.
Acts like a barometer for the market.
56 SAJIN JOHN
MODULE 10 - GAMES, INFORMATION AND STRATEGY
GAME THEORY
A dominant strategy (DS) is a strategy that produces
the optimal outcome regardless of what the other
STRATEGY
players do.
o A distinguishing characteristic of rivalrous market Example:
structures is that individual firm managers need to Firm B
take into consideration the reactions of rival firms
Don't
before making key decisions relating to pricing or Advertise
Advertise
profitability of the firm.
Advertise ( 4, 3 ) 5, 1

Firm A
o This is particularly important in an Oligopoly, since
there are only a few firms in the industry, and the Don't
Advertise
2, 5 3, 2
actions of a particular firm can potentially
adversely impact the other firms o Here, Firm A can select ‘Advertise’ irrespective of
o Strategic Behavior: the plan of action or behavior what Firm B selects (as, 4>2 & 5>3).
of an oligopolist, after taking into consideration all o Similarly, Firm B can select ‘Advertise’ irrespective
possible reactions of its competitors of what Firm B selects (as 3>1, 5>2)
o Strategies: changes to product pricing, quantity of
product produced, level of advertising, etc. A dominant strategy equilibrium (DSE) occurs if each
player in a game chooses its dominant strategy.
Example: Selecting (4, 3) in above instance.
GAME THEORY
Game theory was developed by Von Neumann and A Nash equilibrium occurs if every player’s strategy is
Oskar Morgenstern in 1944. optimal given its competitors’ strategies.
It is a mathematical technique, which helps in Firm B
examining the interdependence among the oligopoly Don't
firms and also the uncertainty involved in their decision Advertise
Advertise
making. Advertise 4, 3 5, 1
Firm A

The study of decision making in the context of Don't

Oligopoly is known as Game Theory
The players in the game are like rival firms planning
their strategies under the conditions of uncertainty.
o PLAYERS: decision makers whose behavior we are
trying to explain
o STRATEGY: the choice made by a decision maker
by sacrificing other options (their action)
o PAYOFF: benefit of choosing a particular strategy
o PAYOFF MATRIX: analysis of the payoff from
various choices
TYPE OF GAMES
ZERO-SUM GAMES
Gain of one player is exactly equal to the loss of
the other player
NONZERO-SUM GAMES
Gains or losses of one firm do not come at the
expense of or provide equal benefit to other firms
GAMES IN ECONOMICS
A payoff matrix is a table that describes the outcome
for each player and for each set of strategic choices.
MANAGERIAL ECONOMICS
Advertise
2, 5 6, 2
o Here, Firm B has dominant strategy to ‘Advertise’
o Where, as Firm A doesn’t have a dominant strategy
as its decision would depend on Firm B’s action. i.e.
Firm A need to ‘Advertise’ if B ‘Advertise’ and ‘Don’t
Advertise’ if B ‘Don’t Advertise’ (5 < 6).
o Now, here Firm A has the information about Firm B
(i.e. payoff matrix) and this it can assume that Firm
B’s dominant strategy is ‘Advertise’ and thus A also
goes with ‘Advertise’.
o This is Nash Equilibrium.
o If at least one of the players has a dominant
strategy, then a Nash equilibrium can still occur
o So, all dominant strategy equilibrium is a Nash
equilibrium but not vice-versa.
PRISONER’S DILEMMA
Prisoner’s dilemma is a game theory model, which shows
how rivals could act in a way which could be mutually
disadvantageous to both of them.
The Prisoner’s Dilemma was first presented by Merrill
Flood and Melvin Dresher in the year 1950. Later it was
formalized by Albert W. Trucker. Many articles have
been published about this game.
It is a zero sum game.
It is often applied in situations where there are two
entities who could actually gain if they cooperate with
each other but due to circumstances are not able to do
so.
57 SAJIN JOHN
o Two suspects, A and B, are caught in connection Firm B
with a bank robbery. Enter Do not Enter
o Unless they confess to the crime, the evidence to Enter 7, 7 10, 8

Firm
A
prove them guilty is not sufficient. Do not Enter 8, 10 7, 7
o There is no communication between the two
suspects. Each is interrogated alone and told:
If both the suspects confess, each will go to jail COOPERATIVE GAMES
for five years. o Situation where decisions are made collectively by
If both the suspects do not confess, each will be two or more players
charged with a lesser crime and will go to jail o However, in most countries antitrust laws prohibit
for two years. collusion in decisions relating to pricing, market
If one of the suspects alone confesses, then his share, etc.
sentence will be reduced to just one year while o But the OPEC cartel is an example of a cooperative
the other who does not confess will get a 10 game where there is explicit collusion
year sentence.
REPEATED GAMES
o In many business situations games are not one shot
games but rather played over and over again
o This is particularly true in advertising and pricing
decisions
Given the above situation, it is obvious that there are o In situations where the game may be repeated over
two options before a prisoner: to confess or not confess. and over again (infinitely), a form of collusion called
o Prisoner A might try to reason out that if he does “tacit collusion” may spontaneously occur.
not confess (and if prisoner B confesses), he will go Firm B
to jail for 10 years and if he confesses he will go to High Price Low Price
jail for five years (if prisoner B confesses) and for High Price 20, 20 -20, 60
Firm
A

one year (if prisoner B does not confesses).
o Thus, prisoner A might find it best to confess.
o Similarly, prisoner B might arrive at the same
conclusion and confess to the crime.
o By confessing, each prisoner is trying to get the best
out of the worst possible outcomes.
o Actually, the better strategy for the two would be to
not confess as then both get a sentence of just two
years.
Low Price 60, -20 0, 0
o The Nash equilibrium (one shot) is for both firms to
charge a low price
o However, if both agree to charge a High price then
they will make huge profits (this cannot be done
explicitly)
o However, there is an incentive to defect but since
the game is repeated the defector will be penalized
in the next period due to the presence of a credible
threat

FIRST MOVER ADVANTAGE TREES AND SEQUENTIAL GAMES

If play is simultaneous then the results are
unpredictable, however if we assume that one of the
firms makes the entry first then we can indeed predict
what the other firm will do once it is able to observe the
action of the rival.
This example illustrates the first mover advantage that
accrues to the player who makes the first strategic
choice in a sequential game.
o Sequential games are typically analyzed using a
decision tree analysis method
o A decision tree is a diagram that maps out the
strategy (or game) in the form of a tree with
decision nodes and branches
o Backward induction is used to identify the optimal
decisions by working backwards through the tree
starting from the best outcome for each player.

MANAGERIAL ECONOMICS 58 SAJIN JOHN

ASYMMETRIC INFORMATION
o Information is typically neither free nor complete
o Search costs are the economic costs associated with
searching, obtaining and analyzing information
before we make a decision
o The tools of marginal analysis can be applied to
optimize search costs
o Asymmetric Information is the situation where one
party to a transaction has more information than
the other
o Adverse Selection is the situation where the
information relating to a transaction attracts
undesirable customers
o Moral Hazard is the phenomenon of engaging in
risky behavior by one party of a transaction to the
detriment of the counter party
o Asymmetry and Moral Hazard typically occur when
one party has private information that is relevant
but unavailable to the counterparty
o Monitoring Costs are costs incurred to ensure
compliance to the terms of the agreement
o Signaling is an alternative way of communicating
otherwise unobservable information
MANAGERIAL ECONOMICS
DECISION-MAKING PRINCIPLES
o Under asymmetric information, the decision maker
must take into account the dual problems of
adverse selection and moral hazard.
o Many contractual relationships involve an agent in
possession of superior information taking actions
for another party. The principal must provide
incentives or controls to induce the agent to act in
the principal’s behalf.
o Modern firms divide information and management
responsibilities among a wide group of managers.
o According to the efficiency principle, business firms
will organize to minimize the total cost of
production, including transaction costs.
o Designing an efficient organization involves
determining the boundaries of the firm, assigning
decision responsibilities to managers with the best
information on which to act, and providing control
and incentive systems to minimize agency costs.
59 SAJIN JOHN
MODULE 11 - PRICING AND PROFIT ANALYSIS
MARK UP PRICING
o An item costs Rs 50 to produce and is sold for 𝑷 = 𝑨𝑽𝑪 + 𝒎 (𝑨𝑽𝑪)
Rs 100. Where, m is Proportion of mark-up on cost
o Is this 50 % mark-up or is it 100 % mark-up −𝟏
𝒎=
o That varies by industry and geography 𝑬𝒑 + 𝟏
o MARKUP ON PRICE: proportion of the selling This shows that the profit maximizing mark-up is
price that is added to cost of goods sold (50% in inversely related to price elasticity.
above example) Profit maximizing markup is lower, higher the
o MARKUP ON COST: proportion of cost of goods absolute value of the own price elasticity of demand
sold that represents an amount added to cost of for goods and services
goods sold (100% in above example)
o We use mark-up-on cost approach (as do most Example:
Economics textbooks) Optimal %age Mark-up
o Traditional way of doing business in the United Value of elasticity on Cost
States coefficient −𝟏
o Set price at a level that would allow firms to (Ep) 𝟏𝟎𝟎 × ( )
𝑬𝒑 + 𝟏
achieve a
o certain rate of return (Ex: General Motors) -2 100
o Impact the sales revenue and quantity of goods -3 50
sold -4 33.3
o Important aspects while determining the mark-up -5 25
price -6 12.5
Estimate the elasticity of demand for the
product TWO PART PRICING
Cost minimization strategies
o Using this pricing strategy, to raise profits the
Conduct market research to identify the
seller simply divides the price into two or more
potential demand
parts.
As we learned earlier,
o For example: access fee and price per unit
𝟏
𝑴𝑹 = 𝑷 (𝟏 + ) consumed
𝑬𝑷 o Telephone services that impose a fixed monthly fee
Also, for profit maximization, and additional charge per time unit of use
𝑴𝑹 = 𝑴𝑪 o The underlying idea is to exploit the consumer
If, AVC is a constant and equals to MC, then for surplus
maximizing profits,
𝟏
𝑴𝑹 = 𝑷 (𝟏 + ) = 𝑴𝑪 = 𝑨𝑽𝑪 BUNDLING
𝑬𝑷
𝑨𝑽𝑪 Bundling involves offering a single package price
𝑷= for multiple products. This strategy can be advantageous
𝟏
𝟏+𝑬
𝒑 to the buyer as well.
𝑨𝑽𝑪 𝑨𝑽𝑪 𝑬𝒑 o Bundling works well if there are groups of
𝑷= = = 𝑨𝑽𝑪 ( ) consumers with inversely related preferences.
𝟏 𝑬𝒑 + 𝟏 𝑬𝒑 + 𝟏
𝟏+𝑬 o Total revenue is increased when both groups buy a
𝒑 𝑬𝒑
𝑬𝒑 + 𝟏 − 𝟏 𝟏 package at a higher price than required to entice
𝑷 = 𝑨𝑽𝑪 ( ) = 𝑨𝑽𝑪 (𝟏 − ) them individually to purchase both items
𝑬𝒑 + 𝟏 𝑬𝒑 + 𝟏 separately.
−𝟏
= 𝑨𝑽𝑪 + 𝑨𝑽𝑪 ( )
𝑬𝒑 + 𝟏

MANAGERIAL ECONOMICS 60 SAJIN JOHN

JOINT PRODUCT
MULTI-PRODUCT FIRM
- Technologically related products
- Mergers and Acquisitions
JOINT PRODUCTS
Products that are interdependent in that producing one
necessarily results in the production of the other (by-
product).
In the long-run, move resources from less profitable
product lines into more profitable ones
Fixed vs. variable proportions
JOINT PRODUCTS PRODUCED IN FIXED
PROPORTIONS
o Product A and B are joint products with demand
and MR curves as shown in the diagram
o Both are produced in fixed proportions
o The two MR curves are vertically summed between
the origin and Q*, such that MRJ = MRB + MRA
o If the marginal cost is SMC, then Qe of each product
should be produced.
o If the marginal cost is reduced to SMC’, then Qe’ of
both A and B are produced but (Qe’-Q*) of B will not
be sold.
o The firm should never sell more that Q* of Product
B
MANAGERIAL ECONOMICS
JOINT PRODUCTS PRODUCED IN VARIABLE
PROPORTIONS
o Market prices of A and B are given
o The curved lines represent amounts of A& B
produced for the same total cost. These are referred
to as product transformation curve (sometimes also
called isocost curve)
o The straight lines are isorevenue lines given fixed
prices for A & B.
o How much of each product should the firm
produce?
o Key is to note that the point of tangency is the
optimal output combination
o Point D is the maximum profit point in the upper
graph.
o The three curves in the lower graph reflect three
possible levels of production (shifts).
o Point E is the maximum profit point in the lower
graph.
61 SAJIN JOHN
TRANSFER PRODUCTS

o Firms are vertically integrated

o Or-One division of the firm produces a good that is
an input
o for the product of another division
o Transfer products exist when a firm produces a
product that is also used in another of its products.
o Price determination
If there is no external market for the transfer
product, the price of the transfer product will be
determined internally to maximize profit
Prices are set by market if there is a perfectly
competitive external market for the transfer
products
TRANSFER PRODUCT PRICING
EXTERNAL MARKET FOR THE TRANSFER
PRODUCT
o Under perfectly competitive market for transfer
product.
o The marginal revenue curve of the
o transfer product is flat in this case.
o At the maximum profit point for the transfer
product an excess or shortage exists depending
upon the marginal cost curve of its supplying
division.
o In this case the firm should sell excess or buy
shortage of the transfer product.

NO EXTERNAL MARKET FOR THE TRANSFER

PRODUCT
o Marginal cost is the total of the transfer and final
products.
o Marginal revenue includes only the final product.
o This fixes the quantity of both products.
o The firm can then fix the price of the transfer
product at its marginal cost for that quantity.
o This ensures that the supplying division is
operating at its maximum profit point.

MANAGERIAL ECONOMICS 62 SAJIN JOHN

MODULE 12 – PERSPECTIVE OF INDIA
MACROECONOMIC PERSPECTIVE
𝑵𝑷𝑷(𝑭𝒂𝒄𝒕𝒐𝒓 𝑪𝒐𝒔𝒕)
= 𝑵𝑵𝑷(𝑴𝒂𝒓𝒌𝒆𝒕 𝑷𝒓𝒊𝒄𝒆𝒔)
NATIONAL INCOME
− 𝑰𝒏𝒅𝒊𝒓𝒆𝒄𝒕 𝑻𝒂𝒙𝒆𝒔 + 𝑺𝒖𝒃𝒔𝒊𝒅𝒊𝒆𝒔
National income is defined as the money value of
all the final goods and services produced in an economy REAL AND NOMINAL NATIONAL INCOME
during an accounting period of time, generally one year. National income estimated at the prevailing
o Calculation of national income requires adding prices, is called national income at current prices or
together all final goods and services produced in a Nominal National Income, or Money National Income
country in a given year. or national income at current prices.
o Various goods and services produced in the National income measured on the basis of some
economy cannot be added together in their physical fixed price, say price prevailing at a particular point of
form; hence they need to be converted into time, or by taking a base year, is known as Real
monetary terms. National Income or national income at constant
prices.
o Real GDP measures changes in the physical output
CONCEPTS OF NATIONAL INCOME in an economy, between different time periods, by
GROSS DOMESTIC PRODUCT (GDP) valuing all goods produced in the two periods at the
GDP is the sum of money value of all final goods same prices
and services produced within the domestic territories of a 𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝑮𝑫𝑷
𝑹𝒆𝒂𝒍 𝑮𝑫𝑷 =
country during an accounting year. 𝑮𝑫𝑷 𝒅𝒆𝒇𝒍𝒂𝒕𝒐𝒓
𝑮𝑫𝑷(𝒂𝒕 𝒎𝒂𝒓𝒌𝒆𝒕 𝒑𝒓𝒊𝒄𝒆) = 𝑪 + 𝑰 + 𝑮 + (𝑿 − 𝑴) o GDP deflator is the ratio of nominal GDP in a year to
𝑮𝑫𝑷 (𝒂𝒕 𝒇𝒂𝒄𝒕𝒐𝒓 𝒄𝒐𝒔𝒕) real GDP of that year.
= 𝑮𝑫𝑷(𝒂𝒕 𝒎𝒂𝒓𝒌𝒆𝒕 𝒑𝒓𝒊𝒄𝒆) o GDP deflator measures the change in prices
− 𝑰𝒏𝒅𝒊𝒓𝒆𝒄𝒕 𝑻𝒂𝒙𝒆𝒔 + 𝑺𝒖𝒃𝒔𝒊𝒅𝒊𝒆𝒔 between the base year and the current year.
GROSS NATIONAL PRODUCT (GNP) PER CAPITA INCOME
GNP is the aggregate final output of citizens and The average income of the people of a country in a
businesses of an economy in a year. particular year is called per capita income. In simple
GNP may be defined as the sum of Gross Domestic words it is income per head of a country for a year.
Product and Net Factor Income from Abroad. 𝑵𝒂𝒕𝒊𝒐𝒏𝒂𝒍 𝑰𝒏𝒄𝒐𝒎𝒆
𝑷𝒆𝒓 𝑪𝒂𝒑𝒊𝒕𝒂 𝑰𝒏𝒄𝒐𝒎𝒆 =
𝑮𝑵𝑷 = 𝑮𝑫𝑷 + 𝑵𝑭𝑰𝑨 𝑻𝒐𝒕𝒂𝒍 𝑷𝒐𝒑𝒖𝒍𝒂𝒕𝒊𝒐𝒏
𝑮𝑵𝑷 = 𝑪 + 𝑰 + 𝑮 + (𝑿 − 𝑴) + 𝑵𝑭𝑰𝑨 o Per capita income for the year 2006-07 may be
calculated at the market price prevailing during the
financial year 2006-07, i.e. current prices or at
NET FACTOR INCOME FROM ABROAD (NFIA)
prices of a base year say 1999-2000, i.e. constant
Difference between income received from abroad
prices
for rendering factor services and income paid towards
services rendered by foreign nationals in the domestic PERSONAL DISPOSABLE INCOME
territory of a country Personal income is the total income received by
the individuals of a country from all sources before direct
NET DOMESTIC PRODUCT
taxes in one year.
𝑁𝐷𝑃 = 𝐺𝐷𝑃 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
𝑃𝑒𝑟𝑠𝑜𝑛𝑎𝑙 𝐼𝑛𝑐𝑜𝑚𝑒
NET NATIONAL PRODUCT (NPP) = 𝑁𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝐼𝑛𝑐𝑜𝑚𝑒
𝑵𝑵𝑷 = 𝑮𝑫𝑷 − 𝑫𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏 + 𝑵𝑭𝑰𝑨 − 𝑈𝑛𝑑𝑖𝑠𝑡𝑟𝑖𝑏𝑢𝑡𝑒𝑑 𝐶𝑜𝑟𝑝𝑜𝑟𝑎𝑡𝑒 𝑃𝑟𝑜𝑓𝑖𝑡𝑠
𝑵𝑵𝑷 = 𝑮𝑵𝑷 − 𝑫𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏 − 𝐶𝑜𝑟𝑝𝑜𝑟𝑎𝑡𝑒 𝑇𝑎𝑥𝑒𝑠
Thus, NNP is the actual addition to a year’s wealth and − 𝑆𝑜𝑐𝑖𝑎𝑙 𝑆𝑒𝑐𝑢𝑟𝑖𝑡𝑦 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛𝑠
is the sum of consumption expenditure, government + 𝑇𝑟𝑎𝑛𝑠𝑓𝑒𝑟 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠
expenditure, net foreign expenditure, and investment, + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑜𝑛 𝑃𝑢𝑏𝑙𝑖𝑐 𝐷𝑒𝑏𝑡
less depreciation, plus net income earned from abroad. o Personal Disposable Income is the income which
𝑵𝑵𝑷 = 𝑪 + 𝑰 + 𝑮 + (𝑿 − 𝑴) − 𝑫𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏 can be spent on consumption by individuals and
+ 𝑵𝑭𝑰𝑨 families.
𝑷𝒆𝒓𝒔𝒐𝒏𝒂𝒍 𝑫𝒊𝒔𝒑𝒐𝒔𝒂𝒃𝒍𝒆 𝑰𝒏𝒄𝒐𝒎𝒆
NNP AT FACTOR COST
= 𝑷𝒆𝒓𝒔𝒐𝒏𝒂𝒍 𝑰𝒏𝒄𝒐𝒎𝒆
NNP at Factor Cost is the sum total of income earned
− 𝑷𝒆𝒓𝒔𝒐𝒏𝒂𝒍 𝑻𝒂𝒙𝒆𝒔
by all the people of the nation, within the national
boundaries or abroad
o It is also called National Income.

MANAGERIAL ECONOMICS 63 SAJIN JOHN

METHODS OF MEASURING NATIONAL INCOME
In equilibrium
Output=Income=expenditure
o Hence there are three approaches to the
measurement of GDP:
o Product (or Output) Method: National Income by
Industry of Origin
o Final Product Method
o Value Added Method
o Income Method or National Income by Distributive
Shares
o Expenditure Method
PRODUCT (OR OUTPUT) METHOD
The market value of all goods and services produced in
the country by all the firms across all industries are
added up together.
Process is as follows:
o The economy is divided on basis of industries, such
as agriculture, fishing, mining and quarrying, large
scale manufacturing, small scale manufacturing,
electricity, gas, etc.
o The physical units of output are interpreted in
money terms
o The total values added up. (GDP at market price)
o The indirect taxes are subtracted, and the subsidies
are added. (GDP at factor cost)
o Net value is calculated by subtracting depreciation
from the total value (NDP at factor cost).
LIMITATIONS OF PRODUCT METHOD
o Problem of Double Counting:
unclear distinction between a final and an
intermediate product.
o Not Applicable to Tertiary Sector:
This method is useful only when output can be
measured in physical terms
o Exclusion of Non-Marketed Products
E.g. outcome of hobby or self-consumption
o Self-Consumption of Output
Producer may consume a part of his production.
INCOME METHOD
The net income received by all citizens of a
country in a particular year, i.e. total of net rents, net
wages, net interest and net profits. (GDP at factor cost).
It is the income earned by the factors of
production of a country.
Add the money sent by the citizens of the nation
from abroad and deduct the payments made to foreign
nationals (individuals and firms) (GNP at factor cost) or
Gross National Income (GNI).
Process:
o Economy is divided on basis of income groups, such
as wage/salary earners, rent earners, profit earners
etc.
o Income of all the groups is added, including income
from abroad and undistributed profits.
MANAGERIAL ECONOMICS
o The income earned by foreigners and transfer
payments made in the year are subtracted.
𝑮𝑵𝑰 = 𝑹𝒆𝒏𝒕 + 𝑾𝒂𝒈𝒆 + 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 + 𝑷𝒓𝒐𝒇𝒊𝒕
+ 𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆 𝒇𝒓𝒐𝒎 𝑨𝒃𝒓𝒐𝒂𝒅
− 𝑻𝒓𝒂𝒏𝒔𝒇𝒆𝒓 𝑷𝒂𝒚𝒎𝒆𝒏𝒕𝒔
LIMITATIONS OF INCOME METHOD
o Exclusion of non-monetary income: Ignores the
non-monetized section of economic activities.
Economic activities that contribute to national
income, but due to their non-monetary nature,
they go unrecorded. For e.g. a farmer and family
working in their own field.
o Exclusion of Non-Marketed Services: People
undertake a particular activity that are difficult to
ascertain in money value. E.g. mother’s services to
the family.
EXPENDITURE METHOD
The total expenditure incurred by the society in a
particular year is added together to get that year’s
national income.
Components of Expenditure:
o personal consumption expenditure
o net domestic investment
o government expenditure on goods and services,
and
o net foreign investment
Limitations
o Ignores Barter System
o Affected by Inflation
USES OF NATIONAL INCOME DATA
o National income is the most dependable indicator
of a country’s economic health.
o Difference between GDP and GNP indicates the
contribution of net income earned abroad
o Necessary for Economic planning: useful aid in
judging which sectors should be given more
emphasis
o A measure of economic welfare.
higher aggregate production implies more and
more goods and services being available to
people
o Helps in determining the regional disparities,
income inequality and level of poverty in a country.
o Helps in comparing the situations of economic
growth in two different countries.
64 SAJIN JOHN
DIFFICULTIES IN MEASUREMENT OF
NATIONAL INCOME
o Non monetized transactions: Exchange of goods
and services which have no monetary payments,
like services rendered out of love, courtesy or
kindness are difficult to include in the computation
of national income.
o Unorganized sector: Contribution of unorganized
sector are unrecorded. It is very difficult to identify
income of those who do not pay income tax.
o Multiple sources of earnings: Part time activity
goes unrecognized and such income is not included
in national income.
o Categorization of goods and services: In many
cases categorization of goods and services as
intermediate and final product is not very clear.
o Inadequate data: Lack of adequate and reliable
data is a major hurdle to the measurement of
national income of underdeveloped countries.
- as soon as these checks are removed, inflation
bursts out.
DEFLATION
o just opposite to inflation;
o a state when prices fall persistently.
DISINFLATION
It is a well-planned process to bring down prices
moderately from a very high level.
INFLATIONARY GAP
Represents rise in price due to a gap between
effective demand and supply.
The term was coined by Keynes to describe a situation
when there is an ‘excess of anticipated expenditure over
available output at base prices.
WAGE PRICE SPIRAL
Wages chase prices and prices chase wages and
thus create a wage price spiral.

CAUSES OF INFLATION
INFLATION o Excess Money Supply.
o Demand Pull Inflation.
o It is a state of “too much money chasing too few
Increase in money supply
goods”.
Increase in disposable income
o Two broad categories:
Increase in aggregate spending
price inflation
Increase in population of the country
money inflation
o Cost Push Inflation: An increase in price of any of
o Both have cause and effect relationship, i.e. money
the inputs, will increase in the cost of production.
inflation leads to price inflation.
Any inflationary pressure created i.e. prices
o Money inflation is increase in the amount of
pushed up by cost.
currency in circulation.
o Low Increase in Supply: if supply falls short of
Foreign exchange inflows in the form of capital,
demand, prices will increase.
tourism and other incomes from abroad.
Obsolete technology
Deficient machinery
CONCEPTS OF INFLATION Scarcity of resources
Natural calamities
HEADLINE INFLATION Industrial disputes and external aggressions
Measure of the total inflation within an economy o Built in Inflation: Built in inflation is a type of
o Affected by the areas of the market which may inflation that has resulted from past events and
experience sudden inflationary spikes such as food persists in the present.
or energy. It is also known as hangover inflation.
o Inflationary Spikes occurs when a particular section
of the economy experiences a sudden price rise,
possibly due to external factors.
HYPERINFLATION
Prices increase at such a speed that the value of
money erodes drastically and the economy is trapped
between rising prices and wages.
o This is also known as galloping inflation or runaway
inflation.
STAGFLATION
A typical situation when stagnation and inflation
coexist.
SUPPRESSED INFLATION
When inflationary conditions exist, but the government
makes such policies which temporarily keep prices under
check
MANAGERIAL ECONOMICS 65 SAJIN JOHN
INFLATION AND DECISION MAKING
IMPACT ON CONSUMERS:
o Increase in price of one commodity affects
purchase decisions for many other things of daily
need.
o Changes in consumer prices upset daily budget.
o Increase in price of eatables may force a cut down
on purchase of many other items.
IMPACT ON PRODUCERS (OR SUPPLIERS):
o Higher the prices, higher are their profits.
o The critical aspect is that producers gain as sellers
of the final (or intermediate) goods but when they
have to buy raw material, hire workforce, buy
technology or machine, they are adversely affected
by inflation.
IMPACT ON GOVERNMENT:
o Government is committed to take the economy to
higher levels of growth by encouraging production
and investment,
o It is duty bound to see that taxpayers’ money is not
eroded by hyperinflation.
o It acts as the balancing force between consumers
and sellers.
INDEXATION:
o It is automatic linkage between monetary
obligations and price levels.
o It applies to wages, interest and taxes.
MANAGERIAL ECONOMICS
MEASURING INFLATION
A price index is a numerical measure designed to
help to compare how the prices of some class of goods
and/or services, taken as a whole, differ between time
periods or geographical locations.
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒀𝒆𝒂𝒓𝒔 𝑷𝒓𝒊𝒄𝒆
𝑷𝒓𝒊𝒄𝒆 𝑰𝒏𝒅𝒆𝒙 = × 𝟏𝟎𝟎
𝑩𝒂𝒔𝒆 𝒀𝒆𝒂𝒓𝒔 𝑷𝒓𝒊𝒄𝒆
VARIOUS MEASURES
o Producer Price Index (PPI): measures average
changes in prices received by domestic producers
for their output.
o Wholesale Price Index (WPI): inflation is calculated
on the basis of wholesale prices of a wide variety of
goods (including consumer and capital goods),
o Consumer Price Index (CPI): measures the price of a
selection of goods purchased by a "typical
consumer.”
o Cost of Living Indices (COLI): are similar to the CPI;
these are often used to adjust fixed incomes and
contractual incomes to maintain the real value of
such incomes.
o Service Price Index (SPI): With the growing
importance of service sector across the world,
many countries have started developing services
price indices (SPI).
𝑰𝒏𝒇𝒍𝒂𝒕𝒊𝒐𝒏 𝑹𝒂𝒕𝒆
𝑳𝒂𝒔𝒕 𝒚𝒆𝒂𝒓𝒔 𝑰𝒏𝒅𝒆𝒙 − 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒀𝒆𝒂𝒓𝒔 𝑰𝒏𝒅𝒆𝒙
= × 𝟏𝟎𝟎
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒀𝒆𝒂𝒓𝒔 𝑰𝒏𝒅𝒆𝒙
66 SAJIN JOHN
EMPLOYMENT IN INDIA
Employment is the state of having paid work. When a person is employed on a day-to-day basis,
casual unemployment may occur due to short-term
Unemployment may be defined as “a situation in which contracts, shortage of raw materials, fall in demand,
the person is capable of working both physically and change of ownership etc.
mentally at the existing wage rate but does not get a job
10. Chronic Unemployment:
to work”.
If unemployment continues to be a long-term feature of
a country, it is called chronic unemployment. Rapid
TYPE OF UNEMPLOYMENT growth of population and inadequate level of economic
development on account of vicious circle of poverty are
1. Open Unemployment: the main causes for chronic unemployment.
Open unemployment is a situation where in a large
section of the labor force does not get a job that may
yield them regular income. MEASUREMENT OF UNEMPLOYMENT
The labor force expands at a faster rate than the growth National Sample Survey Organization (NSSO)
rate of economy. 1. Usual Status Unemployment:
• Also known as open unemployment or chronic
2. Disguised Unemployment:
unemployment. This measure estimates the
It is a situation in which more people are doing work
number of persons who remained unemployed
than actually required. Even if some are withdrawn,
for a major part of the year. This measure gives
production does not suffer. In other words, it refers to a
the lowest estimates of unemployment.
situation of employment with surplus manpower in
2. Weekly Status Unemployment:
which some workers have zero marginal productivity.
• The estimate measures unemployment with
3. Seasonal Unemployment: respect to one week.
It is unemployment that occurs during certain seasons 3. Current Daily Status Unemployment:
of the year. In some industries and occupations like • It considers the activity status of a person for
agriculture, holiday resorts, ice factories etc., each day of the preceding seven days.
production activities take place only in some seasons. Normally if a person works for four hours or more
during a day, he or she is considered as employed for
4. Cyclical Unemployment:
the whole day.
It is caused by trade cycles at regular intervals.
Generally capitalist economies are subject to trade
cycles.
5. Educated Unemployment:
Among the educated people, apart from open
unemployment, many are underemployed because
their qualification does not match the job. Faulty
education system, mass output, preference for white
collar jobs, lack of employable skills and dwindling
formal salaried jobs are mainly responsible for
unemployment among educated youths in India
6. Technological Unemployment:
It is the result of certain changes in the techniques of
production which may not warrant much labor.
7. Structural Unemployment:
This type of unemployment arises due to drastic
changes in the economic structure of a country. These
changes may affect either the supply of a factor or
demand for a factor of production.
8. Underemployment:
It is a situation in which people employed contribute
less than their capacity to production. In this type of
unemployment people are not gainfully employed.
For example, a Postgraduate may work as a clerk for
which only S.S.L.C. is enough.
9. Casual Unemployment:

MANAGERIAL ECONOMICS 67 SAJIN JOHN