BUAD 805-MANAGERIAL ECONOMICS

Module 1: Fundamentals of Managerial Economics

Study Session 1: Introduction to managerial Economics
✓ Economics, on the other hand, is a social science, chiefly concerned with the way society utilizes its limited
resources, which have alternative uses, to produce goods and services for present and future consumption,
and to provide for economic growth. It is obvious from this definition that economics is engaged in
analyzing and providing answers to manifestation of the fundamental problem of scarcity.

✓ Scarcity of resources result from two fundamental facts of life.

Human wants are virtually unlimited and insatiable. Economic resources to satisfy the human wants are
limited. Thus, we cannot have everything we want; we must make choices broadly in regard to the
following.
o What to produce?
o How to produce?
o For whom to produce?
✓ A plethora of definitions are available in connection with the subject matter of economics. These are
broadly divided into;
o Wealth definition (in 1776, when Adam Smith published his famous book “An Enquiry into the
Nature and Cause of Wealth of Nation”.)
o Welfare definition(Alfred Marshal in 1890 claims that economics “is on the one side a study of the
wealth; and the other and more important side, a part of the study of man”)
o Scarcity definition(Lionel Robin in 1932 “Economics is the science which studies human behaviour
as a relationship between ends and scares means which have alternative uses”)
o Growth definition (Lord J.M Keynes. He defines economics as the “study of the administration of
scares resources and the determinants of income and employment”.)
✓ Managerial economics is concerned with the application of business principle and methodologies to the
decision making process, within the firm or organization under the conditions of uncertainty. It seeks to
establish rules and principles to facilitate the attainment of the desired economic aim of management.
These economic aim relates to costs, revenue and profits and are important within both business and non –
business institutions.
✓ Objectives of Managerial Economics
o to integrate economic theory with business practice
o to apply economic concepts and principles to solve business problems
o to allocate the scares resources in the optimal manner
o to make all-round development of a firm
o to minimize risk and uncertainty
o to help in demand and sales forecasting
o to help in profit maximization
o to help to achieve the other objectives of the firm like industry leadership, expansion,
implementation of policies etc.
✓ Importance of Managerial Economics
o It provides tools and techniques for managerial decision making.
o It gives answers to the basic problems of business management.
o It supplies data for analysis and forecasting.
o It provides tools for demand forecasting and profit planning.
o It guides the managerial economist.
o It helps in formulating business policies.
o It assists the management to know internal and external factors influencing the business.
✓ Scope of Managerial / Business Economics (Areas of study)
o Operational/internal issues:
 Issues are those which arise within the business organization and are under the control of the
management like what to produce, how to produce to whom and quantity to produce. Studies
include:
▪ -Demand analysis and forecasting
▪ -Cost analysis
▪ -Pricing Decision
▪ -Profit Analysis
▪ -Capital Budgeting
▪ -Production and Supply Analysis

o Environmental or external issues

It refers to the general business environment in which the firm operates. Studies include:
▪ -Type of economic system in the country
▪ -General trend in income, employment, production, savings and investment
▪ -Trends in financial institutions
▪ -Trends in foreign market
▪ -Gov't policies, etc.
✓ ITQ: What is the basic objective of managerial economics?
✓ ITA: The basic objective of managerial economics is to analyze the economic problems faced by the
business.

Study Session 2: Functions and responsibilities of managerial economist

✓ The following are the important specific functions of managerial economist;
o sales forecasting;
o market research;
o production scheduling;
o economic analysis of competing industry;
o investment appraisal;
o security management analysis;
o advise on foreign exchange management;
o advice on trade;
o environmental forecasting;
o economic analysis of agriculture sales forecasting
✓ The responsibilities of managerial economists are as follows.
o 1. To bring reasonable profit to the company.
o 2. To make accurate forecast.
o 3. To establish and maintain contact with individual and data sources.
o 4. To keep the management informed of all the possible economic trends.
o 5. To prepare speeches for business executives.
o 6. To participate in public debates.
o 7. To earn full status in the business team.
✓ Characteristics of Managerial Economics
o Microeconomic in character, studies business firm and not entire economy
o Uses “Theory of the Firm” or “Economics of the firm”.
o Managerial economics is pragmatic, practical oriented
o Managerial economics is Normative, describes solutions
o It is management oriented
✓ Managerial economics is closely related to certain subjects like statistics, mathematics, accounting and
operations research.
✓ Managerial Economics is a tool for Decision making and Forward Planning
 ✓ Decision making process involves the following elements:
o The identification of the firm’s objectives.
o The statement of the problem to be solved.
o The listing of various alternatives.
o Evaluation and analysis of alternatives.
o The selection of best alternative
o The implementation and monitoring of the alternative which is chosen.
✓ The following are the important areas of decision making;
o selection of product
o selection of suitable product mix
o selection of method of production
o product line decision
o determination of price and quantity
o decision on promotional strategy
o optimum input combination
o allocation of resources
o replacement decision
o make or buy decision
o shut down decision
o decision on export and import
o location decision
o capital budgeting
✓ These resources (factors of production) are classified into four types:
o Land, Labour, Capital and Entrepreneurship
✓ The major four sectors of the economy are engaged in three economic activities:
o Households: Households fulfill their needs and wants through purchase of goods and services from
the firms.
o Firms: Firms employ the input factors to produce various goods and services and make payments to
the households.
o Government: The government purchases goods and services from firms and also factors of
production from households by making payments.
o Foreign sector: Households, firms and government 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.
✓ A firm is an association of individuals who have organised themselves for the purpose of turning inputs into
output.
✓ The major objectives of the firm are:
o to achieve the organisational goal,
o to maximise the output,
o to maximise the sales,
o to maximise the profit of the organisation,
o to maximise the customer and stakeholders satisfaction,
o to maximise shareholder’s return on investment
o to maximise the growth of the organisation.
✓ ITQ: What is decision making?
✓ ITA: Decision making is the process of selecting one action from two or more alternative course of actions.
Resources such as land, labour and capital are limited and can be employed in alternative uses, so the
question of choice is raised.
Study Session 3: Analysis of risk and uncertainty
✓ ITQ: List the types of risk you have studied.
 ✓ ITA: They are economic, government policy, currency, cultural, derivative, liquidity, credit, interest rate,
inflation, market, business and uncertainty
✓ Expected value: The probable payoffs associated with all possible outcomes are called as expected value.
✓ Variability: The extent to which the possible outcomes of an uncertain situation differ. This difference is
called as deviation; it means difference between expected outcome and the actual outcome.
✓ Risk loving: Arises when the payoff is greater than the expected value.
✓ Risk Aversion: Is the behavior of the mangers when the payoff is less than the expected value.
✓ Risk neutral: Behavior takes place when the expected value is equal to the payoff.
✓ Four Ways to Manage the Risk and Uncertainty
o Insurance (Business risks are transferred through Insurance Policies)
o Hedging is a mechanism whereby the expected loss is to be offset by an expected profit from
another contract.
o Diversification is a method of managing the risk where the risk is spread to various investments and
thus the risk is minimised to each investment.
o Adjusting risk is the mechanism whereby the provision is made to offset the expected loss.
✓ Decision under Uncertainty
o The maximax rule: Deals with selecting the best possible outcome for each decision and choosing
the decision with the maximum payoff for all the best outcomes.
o The Maximin rule: Deals with selecting a worst outcome for each investment decision and choosing
the decision with the maximum worst payoff.
o The Minimax rule: Deals with determining the worst potential regret associated with each, decision,
then choosing the decision with the minimum worst potential regret.
✓ ITQ: What is expected value in risk?
✓ ITA: Expected value is the probable payoffs associated with all possible outcomes and are called as
expected value.
Study Session 4: Revenue, cost and profit (relationships)
✓ REVENUE: The total monetary value of the goods or services sold.
✓ COST: The collective expenses incurred to generate revenue over a period of time, expressed in terms of
monetary value, are the cost.
✓ PROFIT: Some cost elements are related to the volume of sales; that is, as sales go up, the expenses go up.
These costs are called variable costs. The difference between the revenue and cost (found by subtracting
the cost from the revenue) is called the profit. When costs exceed revenue, there is a negative profit, or
loss.
✓ Accounting Measurement of Cost, Revenue and Profit
✓ Costs as measured according to accounting principles are not necessarily the relevant measurements for
decisions related to operating or acquiring a business.
✓ Accounting standards dictate that businesses depreciate long-lived assets, like buildings, by spreading the
cost over the life of the asset.
✓ However, from the perspective of the business, the entire expense was incurred when the asset was
acquired.
✓ Likewise, there are other business costs relevant to decision making that may not be considered as costs
from the perspective of accounting standards
✓ The owner/operator of a proprietorship invests time and effort in operating a business
✓ Revenue Function RF = CQ (where C = cost per item)
✓ Cost Function CF = F + CQ ( where F= fixed cost and C = cost per item)
✓ Profit Function PF = RF – CF
✓ Average Cost Function AC = CF/Q
✓ ITQ: How can we determine a breakeven point of a business?
✓ ITA: There are a number of ways to determine a precise value for the breakeven level algebraically. One is
to solve for the value of Q that makes the economic profit function equal to zero: 0 = $1.2 Q − $40,000 or Q
= $40,000/$1.2 = 33,334 units. An equivalent approach is to find the value of Q where the revenue function
 and cost function have identical values. Another way to assess the breakeven point is to find how large the
volume must be before the average cost drops to the price level. In this case, we need to find the value of Q
where AC is equal to $1.50. This occurs at the breakeven level calculated earlier.
Module 2: Applications of Microeconomics Principle
Study Session 5: Managerial application of demand analysis
✓ Demand means the ability and willingness to buy a specific quantity of a commodity at the prevailing price
in a given period of time. Therefore, demand for a commodity implies the desire to acquire it, willingness
and the ability to pay for it.
✓ Law of demand: The quantity of a commodity demanded in a given time period increases as its price falls,
ceteris paribus (I.e. other things remaining constant).
✓ Demand schedule: This refers to a table showing the quantities of a good that a consumer is willing and
able to buy at the prevailing price in a given period.
✓ Demand Curve: This is a curve indicating the total quantity of a product that all consumers are willing and
able to purchase at the prevailing price level, holding the prices of related goods, income and other
variables as constant. A demand curve is a graphical representation of a demand schedule.
✓ Shifts in Demand: Shift of the demand curve occurs when the determinants of demand change. When
tastes and preferences and incomes are altered, the basic relationship between price and quantity
demanded changes (shifts).
✓ Demand function: is a function that describes how much of a commodity will be purchased at the prevailing
prices of that commodity and related commodities, alternative income levels, and alternative values of
other variables affecting demand.
✓ Other factors that affect demand asides price are:
o Changes in Population
o Changes in Fashion
o Changes in Taste
o Changes in Advertising
✓ Change in demand equation:
✓ QdX = f (Px, Pr, Y, T, Ey, Ep, Adv….)
o Where:
o QdX = quantity demanded of good ‘X’
o Px = the price of good X
o Pr = the price of a related good
o Y = income level of the consumer
o T = taste and preference of the consumers
o Ey = expected income
o Ep = expected price
o Adv = advertisement cost
✓ Determinants of Demand:
✓ 1. Price of the good: 2. Price of related goods: 3. Consumer’s income 4. Taste, preference, fashions and
habits: 5. Population 6. Money Circulation 7. Value of money 8. Weather Condition 9. Advertisement and
Salesmanship 10. Consumer’s future price expectation: 11. Government policy (taxation): 12. Credit
facilities: 13. Multiplicity of uses of goods:
✓ Types of demand
o i. Direct and indirect demand(or) producers’ goods and consumers’ goods:
o ii. Derived demand and autonomous demand:
o iii. Durable and non-durable goods demand:
o iv. Firm and industry demand:
o v. Total market and market segment demand:
o vi. Short run and long run demand:
o vii. Joint demand and Composite demand:
 o viii. Price demand, income demand and cross demand: demand for commodities by the consumers
at alternative prices are called price demand. Quantity demanded by the consumers at alternative
levels of income is income demand. Cross demand refers to the quantity demanded of commodity
‘X’ at a price of a related commodity ‘Y’ which may be a substitute or complementary to X.
✓ Price Demand: the ability and willingness to buy specific quantities of a good at the prevailing price in a
given time period.
✓ Income Demand: the ability and willingness to buy a commodity at the available income in a given period of
time.
✓ Market Demand: the total quantity of a good or service that people are willing and able to buy at prevailing
prices in a given time period. It is the sum of individual demands.
✓ Cross Demand: the ability and willingness to buy a commodity or service at the prevailing price of the
related commodity i.e. substitutes or complementary products. For example, people buy more of wheat
when the price of rice increases.
✓ Exceptions of the law of demand
o 1. Giffen good is a special type of inferior good whose demand increases as the price of the good
increases (effective consumer income decreases due to price increase). An example could be rice
which is a staple food of a region and majority of the food consumption is rice that cannot be
substituted.
o 2. Veblen Effect: A few goods like diamonds etc., are purchased by the rich and wealthy sections of
society. The prices of these goods are so high that they are beyond the reach of the common man.
The higher the price of the diamond the higher its prestige value.
o 3. Conspicuous Necessities: like new TV
o 4. Ignorance: a consumer’s ignorance is another factor that at times induces him to purchase more
of the commodity at a higher price.
o 5. Emergencies:
o 6. Future Changes in Prices
o 7. Change in Fashion: old and new versions of goods
o 8. Demonstration Effect: poor people imitating the rich.
o 9. Snob Effect: Acquisition of customized goods for showoff
o 10. Speculative Goods/ Outdated Goods/ Seasonal Goods:
o 11. Seasonal Goods:
✓ Scope of Elasticity:
o Relatively Elastic Demand (ED > 1): small % change in price leads to large % change in Qty
demanded.
o Perfectly Elastic Demand (Ed = ∞): small change in price will change the quantity demanded by an
infinite amount.
o Relatively Inelastic Demand (Ed < 1) a change in price leads to a smaller percentage change in
quantity demanded.
o Perfectly Inelastic Demand (Ed = 0) the quantity demanded does not change regardless of the
percentage change in price.
o Unit Elasticity of Demand (Ed =1) the percentage change in quantity demanded is the same as the
percentage change in price that caused it.
✓ Cross Elasticity: The responsiveness of the quantity of one commodity demanded to a change in the price of
another good is calculated with the following formula.
✓ EC = (%change in demand for commodity A)/(%change in price of commodity B)
✓ Demand Forecasting: The steps to be followed -
Identification of objectives
Nature of product and market
Determinants of demand
Analysis of factors
Choice of technology
 Testing the accuracy
✓ Criteria to choose a method of forecasting are -
o Accuracy, Plausibility, Durability, Flexibility and Availability

✓ Demand forecasting methods

o Survey of buyers’ intension
o Delphi method
o Expert opinion
o Collective opinion
o Naive model
o Smoothing techniques
o Time series / trend projection
o Controlled experiments
o Judgmental approach

✓ Time Series/Trend Projection uses:

o Linear trend Y = a + b X
o Quadratic trend Y = a + bX + cX2
o Cubic trend Y = a + bX + cX2 + dX3
o Exponential trend Y = a e b/x
o Double log trend Y = a Xb
✓ To solve Linear trend Y = a + bX, you must solve the following equations:
o ΣY = na + bΣX ----- (i)
o ΣXY = aΣX + bΣX2 ----- (ii)
o Where X = time period, while Y= demand
✓ Examples of Survey Method are:
o 1. Complete enumeration method: the survey covers all the potential consumers in the market and
an interview is conducted to find out the probable demand.
o 2. Sample survey method: the complete enumeration is not possible always. The forecaster can go
in for sample survey method.
o 3. Expert’s opinion: the experienced people from the same field or from marketing agents can also
be taken into consideration for collecting information about the future demand.
✓ ITQ: List the three elasticity of demand you have study?
✓ ITA: The elasticity of demand may be as follows.
▪ Price Elasticity
▪ Income Elasticity and
▪ Cross Elasticity
Study Session 6: Managerial application of supply analysis
✓ Concept of Supply: Supply of a commodity refers to the various quantities of the commodity which a seller
is willing and able to sell at different prices in a given market at a point in time, other things remaining the
same.
✓ Determinants of Supply
o The cost of factors of production.
o The state of technology.
o External factors: external factors like weather influence the supply.
o Tax and subsidy
o Transport: better transport facilities will increase the supply.
o Price: if the prices are high, the sellers are willing to supply more goods to increase their profit.
o Price of other goods: if the price of other goods is more than ‘X’ then the supply of ‘X’ will be
increased.
✓ Kinds of Supply Elasticity
 o Perfectly inelastic: if there is no response in supply to a change in price,(Es = 0)
o Inelastic supply: the proportionate change in supply is less than the change in price, (Es =0-1)
o Unitary elastic: the percentage change in quantity supplied equals the change in price, (Es=1)
o Elastic: the change in quantity supplied is more than the change in price, (Ex= 1- ∞)
o Perfectly elastic: suppliers are willing to supply any amount at a given price, (Es=∞)
✓ Break Even Analysis: helps to identify the level of output and sales volume at which the firm ‘breaks even’.
It means the revenues are sufficient to cover all costs of production.
✓ Managerial Uses of Break-Even Analysis
o 1. Product planning
o 2. Activity planning
o 3. Profit planning
o 4. Target capacity
o 5. Price and cost decision
o 6. Safety margin
o 7. Price decision
o 8. Promotional decision
o 9. Distribution decision
o 10. Dividend decision
o 11. Make or buy decision

Study Session 7: Managerial application of production function

✓ Factors of Production: These include resource inputs used to produce goods and services:
o Land: Land is heterogeneous in nature. The supply of land is fixed.
o Labor: The supply of labour is inelastic in nature but it differs in productivity and efficiency and it
can be improved upon.
o Capital: is a manmade factor and is mobile but the supply is elastic.
o Organization: the organisation plans, supervises, organises and controls the business activity and
also takes risks.
✓ Production Function indicates to us the maximum amount of commodity ‘X’ to be produced, from various
combinations of input factors.
✓ TP = Total production, AP= average production and MP = marginal product.
✓ The production function assumes that the state of technology is fixed. If there is a change in technology
then there would be change in production function.
✓ Q = f (Land, Labour, Capital, Organisation) ==> Q = f (L, L, C, O)
✓ Cobb Douglas production function: This is a function that defines the maximum amount of output that can
be produced with a given level of inputs.
o Q = f (K, L) where K = capital and L = labor
o Q = A Kα Lβ
o Q = the max rate of output for a given rate of capital (K) and labour (L).
✓ Short Run production function: In the short run, some inputs (land, capital) are fixed in quantity. The output
depends on how much of other variable inputs are used.
✓ Law of Diminishing Returns or the Law of Variable Proportion: used to refer to a point at which the level of
profits or benefits gained is less than the amount of money or energy invested.
✓ When the production function is expressed as an equation it shall be as follows:

✓ Q = f (Ld, L, K, M, T)
o It can be expressed as Q = f1, f2, f3, f4, f5 > 0
o Where,
o Q = Output in physical units of good X
o Ld = Land units employed in the production of Q
 o L = Labour units employed in the production of Q
o K = Capital units employed in the production of Q
o M = Managerial Units employed in the production of Q
o T = Technology employed in the production of Q
o f = Unspecified function
o fi = Partial derivative of Q with respect to ith input.
o This equation assumes that output is an increasing function of all inputs.
✓ ITQ: Identify the factors of production.
✓ ITA: These include resource inputs used to produce goods and services. Economist categorise input factors
into four major categories such as land, labour, capital and organisation.
✓ The Law of Returns to Scale: In the long run the fixed inputs like machinery, building and other factors will
change along with the variable factors like labour, raw material etc. With the equal percentage of increase
in input factors various combinations of returns occur in an organization.
✓ Returns to scale: the change in percentage output resulting from a percentage change in all the factors of
production. They are
o Increasing : +ve change in output
o Constant : same change in output as in input
o Diminishing returns to scale: -ve change in output
✓ ISO-Quants: To understand the production function with two variable inputs, iso-quant curve is used. These
curves show the various combinations of two variable inputs, resulting in the same level of output.
✓ ISO-Cost: different combination of inputs that can be purchased at a given expenditure level.
✓ Optimal input combination: The points of tangency between iso quant and iso cost curves depict optimal
input combination at different activity levels.
✓ Expansion Path: Over a period of time a firm will face various optimum levels, if we connect all points we
derive expansion path of a firm.
✓ ITQ: How do managers use production function?
✓ ITA: Production analysis can be used as aids in decision making because they can give guidance to obtain
the maximum output from a given set of inputs and how to obtain a given output from the minimum
aggregation of inputs.

Study Session 8: Managerial application of cost function

✓ Types of Costs: There are various classifications of costs based on the nature and the purpose of
calculation. But in economics and for accounting purpose the following are the important cost concepts.
o Actual cost/ Outlay cost/ Absolute cost / Accounting cost: incurred for producing or acquiring a
good or service
o Opportunity cost: The revenue which could have been earned by employing that good or service in
some other alternative uses. (E.g. A land owned by the firm does not pay rent. Thus; a rent is an
income forgone by not letting it out).
o Sunk cost: are retrospective (past) costs that have already been incurred and cannot be recovered.
o Historical cost: the price paid for a plant originally at the time of purchase.
o Replacement cost: the price that would have to be paid currently for acquiring the same plant.
o Incremental cost: is the addition to costs resulting from a change in the nature of level of business
activity. Change in cost caused by a given managerial decision.
o Explicit cost: rent paid
o Implicit cost: if the factors of production are owned by a firm then its cost is implicit cost.
o Book cost: costs which do not involve any cash payments but a provision is made in the books of
accounts, in order to include them in the profit and loss account to take tax advantages.
o Social cost: total cost incurred by the society on account of production of a good or service.
o Transaction cost: the cost associated with the exchange of goods and services.
o Controllable cost: costs which can be controllable by the executives are called controllable cost.
 o Shut down cost: cost incurred if the firm temporarily stops its operation. These can be saved by
continuing business.
o Economic costs are related to future. They play a vital role in business decisions as the costs
considered in decision - making are usually future costs. They are similar in nature to that of
incremental, imputed explicit and opportunity costs.
✓ Determinants of Short –Run Cost
o Fixed cost
o Variable cost
o Total cost: the market value of all resources used to produce a good or service.
o Total Fixed cost: cost of production remains constant, whatever the level of output.
o Total Variable cost: cost of production varies with output.
o Average cost: total cost divided by the level of output.
o Average variable cost: variable cost divided by the level of output.
o Average fixed cost: total fixed cost divided by the level of output.
o Marginal cost: cost of producing an extra unit of output.
✓ ITQ: Explain the relationship between marginal cost and average cost curve.
✓ ITA: The marginal cost and average cost curves are U shaped because of law of diminishing returns. The
marginal cost curve cuts the average cost curve and average variable cost curves at their lowest point.
Marginal cost curve cuts the average variable cost from below. The AC curve is above the MC curve when
AC is falling. The AC curve is below the MC when AC is increasing. The intersecting point indicates that
AC=MC and that is the minimum average cost with an optimum output.
✓ Economies of scale exist when long run average costs decline as output is increased.
✓ Diseconomies of scale exist when long run average cost rises as output is increased.

Module 3: Evaluation of Non-monetary Aspects of Projects and Further Issues on Investment

and Project Appraisal
Study Session10: Managerial application of monopoly market
✓ In economics, the market is the study of the demand for and supply of a particular commodity and its
consequent fixing of prices, for instance; the market may be a bullion market, stock market, or even food
grains market.
✓ In economic language, market is a study of demand for and supply of a particular item and its consequent
fixing of prices, example, foreign exchange market or a commodity market like food grains market etc.
✓ The market is broadly divided into two categories like perfect market and imperfect market.
✓ The perfect market is further divided into pure market (which is a myth) and perfect market.
✓ The imperfect market is divided into:
o Monopoly market: a market with only one seller and a large number of buyers.
o Monopolistic competition: a market in which firms can enter freely, each producing its own brand
or version of a differentiated product.
o Oligopoly market: market in which only a few firms compete with one another and entry by new
firms is impeded/restricted.
o Duopoly: market in which two firms compete with each other.
o Monopsony: is a market with only one buyer, and a few/large sellers.
✓ Perfect Market: Perfect competition is a market structure characterized by a complete absence of rivalry
among the individual firms. A perfectly competitive firm is one whose output is so small in relation to
market volume that its output decisions have no perceptible impact on price.
✓ Characteristics Of Perfect Market:
o 1. Large number of buyers and sellers
o 2. Homogeneous product
o 3. Perfect knowledge about the market
o 4. Ruling prices
 o 5. Absence of transport cost
o 6. Perfect mobility of factors
o 7. Profit maximisation
o 8. Freedom in decision making
✓ In perfect market, the price of the commodity is determined based on the demand for and supply of the
product in the market.
✓ Pricing under Perfect Competition: Demand and supply curves can be used to analyze the equilibrium
market price and the optimum output.
o 1. If quantity demanded is equal to quantity supplied at a particular price, then the market is in
equilibrium.
o 2. If quantity demanded is more than the quantity supplied, then market price may not be stable.
i.e., it will rise.
o 3. If quantity demanded is less than quantity supplied, then market price is fixed not in an
equilibrium position.

✓ Classification Of Market By Objective

o Area: family market, local, regional, national and international
o Time: very short period, short period, long period, very long period
o Commodity: produce exchange, bullion market, capital market, stock market
o Nature of Transaction: spot market, forward market and futures market
o Volume of business: whole sale market, retail market
o Importance: primary market, secondary market, territory market
o Regulation: regulated market, unregulated market
o Economics: Perfect market and imperfect market.
✓ Market in economic sense implies:
o presence of buyers and sellers of the commodity,
o establishment of contact between the buyer and seller,
o similarity of the product, and
o Exchange of commodity for a price.
✓ Shut down point: If the market price for the product is below minimum average variable cost, the firm will
cease to produce, if this appears to be not just a temporary phenomenon.
✓ Lessons for Managers
o 1. Important to enter a growing market as far ahead of the competitors as possible.
o 2. When there is fall in supply and increase in prices, take advantage before the new entrants.
o 3. Due to profit, new entrants are willing to offer low price, therefore; a firm should be among the
lowest cost producer to ensure its survival.
o 4. Differentiation offers temporary relief for competition pressure.
o 5. Due to globalisation, firms enjoy advantage of cheap labour and disadvantage of technology up
gradation.
✓ ITQ: What are the consequences of pure competition?
✓ ITA: Perfect competition ensures maximum welfare of the people as a whole. Each firm tends to attain the
most efficient size to expand output and to reduce the average cost of production.

Study Session 11: Managerial application of oligopoly market and price determination
✓ Characteristic Features of Monopoly Market
o A single seller in the market
o There are no close substitutes
o There is a restriction for the entry and exit for the firms in the market
o Imperfect dissemination of information
✓ To maximize profit in monopoly market:
o Maximize the output and the limit the price
 o Limit the production of the goods and services and fix a higher price (market driven price)
✓ Differences between Perfect and Monopoly Market
o 1. Perfect market is unrealistic in practical life. But slowly, certain commodities are moving towards
it. Monopoly market exists in real time.
o 2. Under perfect market only homogenous products are sold but on the other hand, monopoly
market deals with different products.
o 3. Under perfect competition, price is determined by demand and supply of the market. But in
monopoly the seller determines the price of the good.
o 4. Monopolist can control the market price but in perfect competition, the sellers have no control
over the market price.
o 5. There is no advertisement cost in perfect market. In other markets it is essential and it is included
in the cost of production and is reflected in the price.
o 6. Monopolist sell their products higher than the perfect competitors except when there is
government regulation or adverse public opinion.

✓ Lessons for Managers

o The seller has to fix the price based on the marginal revenue and marginal cost instead of focusing
on their profit.
o It is essential to understand the substitutes and their market competition.
o Under monopoly for certain products buyer has more market power.
o Government policies can also change at any time.
o Monopolist in domestic market may face tough competition from imported products.
✓ Monopolistic Competition: The perfect competition and monopoly are the two extreme forms. To bridge
the gap, the concept of monopolistic competition was developed by Edward Chamberlin. It has both the
elements like many small sellers and many small buyers. There is product differentiation. Therefore; close
substitutes are available and at the same time it is easy to enter and easy to exit from the market. Hence, it
is possible to incur loss in this market.
✓ Oligopoly is of different types, among which are:
o Pure and perfect oligopoly: if the firm produced homogeneous products it is perfect oligopoly. If
there is product differentiation then it is called as imperfect or differentiated oligopoly.
o Open and closed oligopoly: entry is not possible. When it is closed to the new entrants then it is
closed oligopoly. On the other hand entry is accepted in open oligopoly.
o Partial and full oligopoly: under partial oligopoly industry is dominated by one large firm who is a
price leader and others follow. In full oligopoly no price leadership.
o Syndicated and organised oligopoly: where the firms sell their products through a centralised
syndicate. On the other hand, firms organise themselves into a central association for fixing prices,
output and quotas.
✓ Characteristic Features of an Oligopoly Market
o Few sellers
o Lack of uniformity in the product
o Advertisement cost is included
o No monopoly competition
o Firms struggle constantly
o There is interdependency
o Experience of group behaviour
o Price rigidity
o Price leadership
o Barriers to entry
✓ Oligopoly Models include the following;
o Cournot oligopoly: there are few firms producing differentiated or homogeneous products and each
firm believes that competitors will hold their output constant if it changes its output.
 o Stackelberg oligopoly: few firms have differentiated or homogeneous product. The leader chooses
an output and others follow.
o Bertrand oligopoly: few firms produce identical product. Firms compete in price and react optimally
to competitor’s prices.
o Sweezy oligopoly: an industry in which there are few firms serving many consumers. Firms produce
differentiated products and each firm believes competitors will respond to a price reduction but
they will not follow a price increase.
✓ ITQ: What is price rigidity?
✓ ITA: Price rigidity: the price will be kept unchanged due to fear of retaliation and prices tend to be strict and
inflexible. No firm would indulge in price cutting as it would eventually lead to a price war with no benefit
to anyone.
✓ Price discrimination means that the producer charges different prices for different consumers, for the same
goods and service.
✓ Types of price discrimination;
o 1. Personal Discrimination
o 2. Place Discrimination
o 3. Trade Discrimination
o 4. Time Discrimination
o 5. Age Discrimination
o 6. Sex Discrimination
o 7. Location Discrimination
o 8. Size Discrimination
o 9. Quality Discrimination
o 10. Special Service
o 11. Use of services
o 12. Product Discrimination
✓ Objectives of Price Discrimination
o 1. To dispose the surpluses
o 2. To develop new market
o 3. To maximise use of unutilised capacity
o 4. To earn monopoly profit
o 5. To retain export market
o 6. To increase the sales
Study Session 12: Theories of profit and profit maximization as business objective.
✓ The Accounting Profit: Accounting profit may be defined as follows -
Accounting Profit = a = TR – (w + r + I + m) where,
TR = Total Revenue; w = wages and salaries; r = rent; i = interest; and m = cost of materials.
✓ Economic profit may be defined as ‘residual left after all contractual costs, including the transfer costs of
management, insurable risks, depreciation, and payments to shareholders have been met. Thus:
EP = TR – EC – IC where,
EC = Explicit Costs; and, IC = Implicit Costs.
✓ PROFIT THEORIES:
o Walker’s Theory of Profit: Profit as Rent of Ability: One of the widely known theories of profit was
stated by F. A. Walker who theorized ‘profit’ as the rent of “exceptional abilities that an
entrepreneur may possess” over others. Profit is the difference between the earnings of the least
and the most efficient Entrepreneurs.
o Clark’s Dynamic Theory: The J. B. Clark’s theory is of the opinion that profits arise in a dynamic
economy, not in a static economy. The major functions of entrepreneurs or managers in a dynamic
environment are in taking advantage of the generic changes and promoting their businesses,
expanding sales, and reducing costs.
 o Hawley’s Risk Theory of Profit: According to Hawley, risk in business may arise due to such reasons
as obsolescence of a product, sudden fall in the market prices, and non-availability of crucial raw
materials. Hawley simply refers to profit as the price paid by society for assuming business risk.
o Knight’s Theory of Profit: Frank Knight treated profit as a residual return to uncertainty bearing, not
to risk bearing as in the case of Hawley’s. Knight divided risk into calculable and non-calculable risks.
o Schumpeter’s Innovation Theory of Profit: profit can be made only by introducing innovations in
manufacturing technique, as well as in the methods of supplying the goods.
✓ The Profit-Maximizing Conditions
o The first-order condition requires that at a maximum profit, marginal revenue (MR) must equal
marginal Cost (MC).
o The second-order condition requires that the first-order condition must be satisfied under the
condition of decreasing marginal revenue (MR) and increasing marginal cost (MC).

✓ Sales revenue maximisation as business objective

o First, salary and other monetary benefits of managers tend to be more closely related to sales
revenue than to profits.
o Second, banks and other financial institutions look at sales revenue while financing business
ventures.
o Third, trend in sales revenue is a readily available indicator of a firm’s performance.
o Fourth, increasing sales revenue enhances, manager’s prestige, while profits go to the business
owners.
o Fifth, managers find profit maximisation a difficult objective to fulfill consistently over time and at
the same level. Profits fluctuate with changing economic conditions.
o Finally, growing sales tend to strengthen competitive spirit of the firm in the market, and vice versa.
✓ Maximisation of Firm’s Growth Rate as an Alternative Objective
✓ A firm’s growth rate is said to be balanced when demand for its product and supply of capital to the firm
increase at the same rate.
✓ Marris translate these two growth rates into two utility functions:
o (i) manager’s utility function (Um), and
o (ii) business owner’s utility function (Uo), where:
o Um = f (salary, power, job security, prestige, status).
o Uo = f(output, capital, market-share, profit, public esteem).
o The maximisation of business owner’s utility (Uo) implies maximisation of demand for the firm’s
product or growth of the supply of capital.
✓ Maximisation of Managerial Utility Function as an Alternative Objective
✓ According to Williamson, manager’s utility function can be expressed as:
o U = f(S, M, ID) where S = additional expenditure on staff
o M = managerial emoluments
o ID = discretionary investments\
✓ Long-run Survival and Market-share as a Business Objective:
K. W. Rothschild proposed the hypothesis of long-run survival and market-share goals. According to the
hypothesis, the primary goal of the firm is long-run survival.
✓ ITQ: Why profit maximisation objective?
✓ ITA: Profit maximisation objective helps in predicting the behaviour of business firms in the real world, as
well as in predicting the behaviour of price and output under different market conditions.
Study Session 13: Managerial application of pricing policy and practices
✓ Meaning of Price:
✓ Price is the monetary value of goods and services. In other words, it is the exchange value of a product or
service in terms of money. To the seller, price is a source of revenue. To the buyer, price is the sacrifice of
purchasing power.
✓ Factors governing prices and pricing decision:
✓ Internal Factors: These are the factors which are within the control of the organisation.
o Cost
o Objectives
o Organisational factors
o Marketing Mix
o Product differentiation
o Product life cycle
o Characteristics of product
✓ External Factors: These factors are beyond the control of organisation.
o Demand
o Competition
o Distribution channels
o General economic conditions
o Government Policy
o Reaction of consumers
✓ Price policies are those management guidelines that control the day to day pricing decision as a means of
meeting the objectives of the firm such as maximisation of profit, maximisation of sales, targeted rate of
return, survival, stability of prices, meeting or preventing competition etc.
✓ Steps in Formulating Pricing Policies
o 1. Selecting the target market or market segment on which marketer would concentrate more.
o 2. Studying the consumer behaviour and collecting information relating to target market selected.
o 3. Studying the prices, promotion strategies etc., of the competitors and their impact on the market
segment.
o 4. Assigning a role to price in the marketing mix.
o 5. Collecting the cost of manufacturing the product at different levels of demand.
o 6. Fixing suitable (strategic) price after determining the price objectives and according to a selected
method of pricing.
✓ Objectives of Pricing Policy:
o Profit maximisation
o Market share
o Target return in investment
o Meet or prevent competition
o Price stabilisation
o Resource mobilisation
o Speed up cash collection
o Survival and growth
o Prestige and goodwill
o Achieving product –quality leadership
✓ Methods of Pricing
o Cost Plus pricing-the price is computed by adding a certain percentage to the cost of the product
per unit
o Target pricing
o Going rate pricing
o Customary pricing
o Follow up pricing
o Differential pricing
o Marginal cost pricing
o Barometric pricing (oligopolistic leader announces price)
✓ Pricing of a New Product (Methods and strategy)
o Skimming price strategy (for people ready to pay high price)
 o Penetration price strategy (low price to gain market share)

✓ Kinds of Pricing (Pricing Strategies)

o Psychological pricing
o Mark up pricing
o Administered pricing

✓ ITQ: What is the role of cost in pricing?

✓ ITA: According to Hall and Hitch, business firms under the conditions of oligopoly and monopolistic
competitive market, do not determine price and output with the help of the principle MC=MR. They
determine price and output on the basis of full average cost of production. Cost of production consists of
fixed and variable costs.