Managerial Economics

MANAGERIAL ECONOMICS
SAURABH GUPTA
Copyright © 2017 SAURABH GUPTA
All rights reserved.
ISBN: 9781521933794
DEDICATION
Thanks to my family for having the patience with me for having taking yet another challenge which
decreases the amount of time I can spend with them.
CONTENTS
Chapters Page Numbers

CHAPTER 1
INTRODUCTION TO ECONOMICS
1.0 What is Economics 1
1.1 Scope of Economics 2
1.2 The Three Problems of Economic Organization 13
1.3 Managerial Economics 13
1.4 Characteristics of Managerial Economics 14
1.5 Importance of Managerial Economics 14
1.6 Nature of Managerial Economics 14
1.7 Scope of Managerial Economics 15
1.8 Fundamental Principles of Managerial Economics 16
1.9 Role of a Managerial Economist 17
1.10 Relationship of managerial economics with other disciplines 18
1.11 Six steps to Decision making 19
CHAPTER 2
The Essentials of Demand
2.0 Demand 21
2.1 Demand Function 21
2.2 Law of Demand 21
2.3 Demand Schedule 21
2.4 Demand Curve 22
2.5 Determinants of (Factors affecting) demand 23
2.6 Types of Elasticity 24
2.6.1. Price Elasticity of Demand 24
2.6.2. Cross Elasticity of Demand 26
2.6.3. Income Elasticity of Demand 27
2.6.4. Promotional (Advertising) Elasticity of Demand 28
2.7 Managerial Uses of Elasticity Concepts 29
2.8 Types of Demand 29
2.9 Demand Forecasting 30
2.9.0 Definition of Forecasting: 30
2.9.1 Uses of Forecasts 30
2.9.2 Steps of Forecasting 31
2.9.3 Advantages of Forecasting 31
2.9.4 Disadvantages of Forecasting 31
2.9.5 Theories of Demand Forecasting 31
2.9.6 Demand Forecasting Methods/Models 33
2.10 Criteria of a Good Forecasting Method 42
CHAPTER 3
The Essentials of Supply
3.1 The Principle of Supply 44
SAURABH GUPTA
3.1.1 Difference between Stock & Supply 44

3.1.2 Factors on Which Supply of a Commodity Depends 44
3.1.3 Law of Supply 45
3.1.4 Elasticity of Supply 46
3.2 Aggregate Supply 48
3.3 Determination of Effective Demand 48
3.4 Importance of Effective Demand 50
3.5 Determinant of Employment 50
3.6 Role of Investment 51
3.7 Price Ceilings 51
3.8 Price Floors 52
CHAPTER 4
PRODUCTION CONCEPT AND ANALYSIS
4.0 Production 53
4.1 Production Function 53
4.1.1 Definition 53
4.2 Assumptions for Production Function 53
4.3 Significance / Importance of Production Function 53
4.4 Short-Term production function 54
4.5 Law of Variable Proportions 54
4.5.1 Meaning 54
4.5.2 Definition 54
4.5.3 Assumptions of the Law 55
4.5.4 Causes of Initial Increasing marginal Returns to a Factor 58
4.5.5 Causes of Diminishing marginal Returns to a Factor 58
4.5.6 Explanation of Negative Marginal Returns to a Factor 60
4.6 The Laws of Returns to Scale 60
4.6.1 Increasing Returns to Scale 60
4.6.2 Decreasing Returns to Scale 61
4.6.3 Constant Returns to Scale 62
4.7 Iso-Quant Curve 63
4.7.1 Iso-Product Schedule 64
4.7.2 Iso-Product Curve 64
4.7.2.1 Properties of Iso-Product Curves 65
4.7.3 Difference between Indifference Curve and Iso-Quant Curve 69
CHAPTER 5
COST CONCEPT AND ANALYSIS
5.0 Cost and Output Relationship 70
5.1 Various Types of Costs 70
5.2 Relationship between Production and Costs 74
5.3 Short-Run Cost Functions 75
5.4 Long-Run Cost Functions 77
5.5 Production Concept and Analysis 78
5.5.1 Production Function 78
5.5.2 Isoquants 79
5.5.3 Total, Average and Marginal Products 80
5.5.4 Elasticity of Production 81
5.6 Profit & Revenue Maximization 82
5.6.1 Profit Maximization 82
5.6.2 Optimal Input Combination 82
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ECONOMICS FOR MANAGERS: BUSINESS DECISION MAKING & FORWARD PLANNING
5.6.3 Unconstrained Optimization: The Profit Function 82

5.7 Economic Optimization 83
5.7.1 Optimization Analysis 83
5.7.2 Optimizing Economic Function 85
CHAPTER 6
MARKET STRUCTURE
6.1 Markets 87
6.2 Classification of Market Structure 87
6.3 Meaning of Firm and Industry 89
6.4 Equilibrium of the Firm 89
6.5 Determination of Equilibrium 89
6.6.Total Cost Revenue Analysis 90
6.7 Long-run Equilibrium of the Firm 91
6.8 Conditions of Equilibrium of the Industry 92
6.9 Monopolistic Competition 94
6.9.1 Price and Output determination in Short Run 94
6.9.2 Price and Output determination in Long Run 94
CHAPTER 7
PRICING STRATEGIES
7.0 Pricing 96
7.1 Pricing strategies and tactics 96
7.1.1 Types of Pricing Strategy 96
7.2 Kinked demand Curve 101
CHAPTER 8
NATIONAL INCOME
8.0 Definition of National Income 105
8.1 Measures of National Income 105
8.2 National Income: Some Accounting Relationships 105
8.3 Methods of measuring National Income 106
8.4 Choice of Methods 107
8.5 Inflation: Meaning 107
8.5.1 Types of Inflation 108
8.5.2 The Inflationary Gap 110
8.5.3 Causes of Inflation 110
8.5.4 Measure to Control Inflation 111
8.5.5 Effects of Inflation 113
8.6 Theories of Profit in Economics 114
8.7 Business Cycle 116
8.7.1 What keeps the Business Cycle Going? 118
8.7.2 Why should you care about the business cycle and economy? 118
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TABLES & FIGURES PAGE NUMBERS
TABLE 1: Demand Schedule 23

TABLE 2: Elasticity of Supply 48
TABLE 3: Supply Schedule 49
TABLE 4: Schedule of Aggregate Demand & Supply 50
TABLE 5: Returns to Labour 56
TABLE 6: ISO-Product Schedule 65
TABLE 7: Total and Average-Cost Schedules 77
TABLE 8: Long run Total, Average & Marginal Cost 79
TABLE 9: Quantity, Capital and Labour 80
TABLE 10: Output and Labour 81
TABLE 11: Total, Average & Marginal Output 82
FIGURE 1: Growth 10
FIGURE 2: Demand Curve 22
FIGURE 3: Elastic Demand 25
FIGURE 4: Inelastic Demand 25
FIGURE 5: Unit Elastic Demand 25
FIGURE 6: Perfectly Elastic Demand 26
FIGURE 7: Cross Elasticity 27
FIGURE 8: Income Elasticity 28
FIGURE 9: Techniques of Demand Forecasting 33
FIGURE 10: Graphical Method 35
FIGURE 11: Law of Variable Proportions 56
FIGURE 12: Increasing Returns to Scale 60
FIGURE 13: Decreasing Returns to Scale 61
FIGURE 14: Constant Returns to Scale 62
FIGURE 15: ISOQUANTS 62
FIGURE 16: ISO-Product Curve 65
FIGURE 17: ISO-Product Map 65
FIGURE 18: ISO-Product Curve 66
FIGURE 19: Horizontal, Vertical, Upward Sloping Curves 66
FIGURE 20: ISO-Quant Curve 67
FIGURE 21: Two ISO-Products Curve 68
FIGURE 22: Higher ISO-Product Curve 68
FIGURE 23: Parallel ISO-Quant Curve 69
FIGURE 24: No two ISO-Quant Curve touches either axis 69
FIGURE 25: Oval Shaped ISO-Quant Curve 70
FIGURE 26: SMC, SAC & AVC Curve 90
FIGURE 27: TC & TR Curve 91
FIGURE 28: SMC, LMC, SAC, LAC Curve 92
FIGURE 29: SMC, SAC, AVC, AR, MR Curve 92
FIGUR 30: Long Run Equilibrium 93
FIGURE 31: LMC, LAC, AR, MR Curve 93
FIGURE 32: Monopolistic Competition 94
FIGURE 33: LRMC, LRAC, MR, AR Curve 95
FIGURE 34: Kinked Demand Curve 101
FIGURE 35: Business Cycle 117
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ACKNOWLEDGMENTS
The past five and a half years I have been a Ph.D. student (U.G.C. NET J.R.F.) in department of
business administration, university of lucknow, with great pleasure. I have carried out my
research in department of business administration, university of lucknow, which contains
researchers from different areas of management. This turned out to be a fertile basis for my
investigations on mathematical techniques. My supervisor, Dr. Nishant Kumar has supported
and advised me in many different ways. I want to thank him for his guidance and, perhaps as
important, confidence. My supervisor realized that a background in sales forecasting and
operations research alone is not necessarily sufficient to perform interesting research on their
combination. Hence, I have been sent to various institutes for participating in workshops/
seminars. I have been visited many places such as Nahan, Tezpur, Haldwani, Hisar, Gwalior,
Udaipur, and many other places and these visits turned out to be very fruitful. I believe that
these visits have been very important for my development. For all this I am very grateful to all
the resource persons. This is an attempt to the integration of statistical techniques with SPSS
environment for the purpose of analyzing the research data in social sciences research.
I take this opportunity to remember with gratitude: my supervisor, my colleagues, my

family members, authors and researchers whose academic competency is my inspiration all
throughout. I take this moment to recollect them with gratitude whose work I have referred,
consulted and quoted. And Also I thank them in advance all those who would pickup this book
and hopefully provide me with this valuable feedback that would be inspiration to move
forward.
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CHAPTER 1
INTRODUCTION TO ECONOMICS
1.0 What is Economics?
Wealth Definition: It is a science of earning and spending wealth as defined by the Father of
Economics Adam Smith in his classic work ‘An enquiry into nature and causes of the Wealth of
Nations.’
Criticism: Smith defined economics only in terms of wealth and not in terms of human welfare.
However, now, wealth is considered only to be a mean to end, the end being the human welfare.
Hence, wealth definition was rejected and the emphasis was shifted from ‘wealth’ to ‘welfare’.
Welfare Definition: In the opinion of Alfred Marshall it was study of mankind in ordinary business
of life.
Criticism: a) Marshall considered only material things. But immaterial things, such as the services of
a doctor, a teacher and so on, also promote welfare of the people.
Lionel Robbins gave us the most accepted scarcity-oriented definition of Economics. He says
Economics is a social science which studies human behavior as a relationship between unlimited wants
and scarce means which have alternative uses.
Criticism: Robbins does not make any distinction between goods conducive to human welfare and
goods that are not conducive to human welfare. In the production of rice and alcoholic drink, scarce
resources are used. But the production of rice promotes human welfare while production of alcoholic
drinks is not conducive to human welfare. However, Robbins concludes that economics is neutral
between ends.
Growth Definition: Prof. Paul Samuelson defined economics as “the study of how men and society
choose, with or without the use of money, to employ scarce productive resources which could have
alternative uses, to produce various commodities over time, and distribute them for consumption, now
and in the future among various people and groups of society”.
Samuelson appears to be the most satisfactory. However, in modern economics, the subject matter of
economics is divided into main parts, viz., i) Micro Economics and ii) Macro Economics.
Economics is, therefore, rightly considered as the study of allocation of scarce resources (in relation to
unlimited ends) and of determinants of income, output, employment and economic growth.
Two major factors are responsible for the emergence of economic problems. They are: i) the existence
of unlimited human wants and ii) the scarcity of available resources. The numerous human wants are
to be satisfied through the scarce resources available in nature. Economics deals with how the
numerous human wants are to be satisfied with limited resources. Thus, the science of economics
centers on want - effort - satisfaction.
WANT
SATISFACTION EFFORT
FIGURE 1: GROWTH
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1.1 SCOPE OF ECONOMICS

Scope means province or field of study. In discussing the scope of economics, we have to indicate
whether it is a science or an art and a positive science or a normative science. It also covers the subject
matter of economics.
i) Economics - A Science and an Art
a) Economics is a science: Science is a systematized body of knowledge that traces the relationship
between cause and effect. Another attribute of science is that its phenomena should be amenable to
measurement. Applying these characteristics, we find that economics is a branch of knowledge where
the various facts relevant to it have been systematically collected, classified and analyzed. Economics
investigates the possibility of deducing generalizations as regards the economic motives of human
beings. The motives of individuals and business firms can be very easily measured in terms of money.
Thus, economics is a science.
Economics - A Social Science: In order to understand the social aspect of economics, we should bear
in mind that labourers are working on materials drawn from all over the world and producing
commodities to be sold all over the world in order to exchange goods from all parts of the world to
satisfy their wants. There is, thus, a close inter-dependence of millions of people living in distant lands
unknown to one another. In this way, the process of satisfying wants is not only an individual process,
but also a social process. In economics, one has, thus, to study social behaviour i.e., behaviour of men
in-groups.
b) Economics is also an art. An art is a system of rules for the attainment of a given end. A science
teaches us to know; an art teaches us to do. Applying this definition, we find that economics offers us
practical guidance in the solution of economic problems. Science and art are complementary to each
other and economics is both a science and an art.
ii) Positive and Normative Economics
Economics is both positive and normative science.
a) Positive science: It only describes what it is and normative science prescribes what it ought to be.
Positive science does not indicate what is good or what is bad to the society. It will simply provide
results of economic analysis of a problem.
b) Normative science: It makes distinction between good and bad. It prescribes what should be done
to promote human welfare. A positive statement is based on facts. A normative statement involves
ethical values. For example, “12 per cent of the labour force in India was unemployed last year” is a
positive statement, which could is verified by scientific measurement. “Twelve per cent unemployment
is too high” is normative statement comparing the fact of 12 percent unemployment with a standard of
what is unreasonable. It also suggests how it can be rectified. Therefore, economics is a positive as
well as normative science.
iii) Methodology of Economics
Economics as a science adopts two methods for the discovery of its laws and principles, viz., (a)
deductive method and (b) inductive method.
a) Deductive method: Here, we descend from the general to particular, i.e., we start from certain
principles that are self-evident or based on strict observations.
Then, we carry them down as a process of pure reasoning to the consequences that they implicitly
contain. For instance, traders earn profit in their businesses is a general statement which is accepted
even without verifying it with the traders. The deductive method is useful in analyzing complex
economic phenomenon where cause and effect are inextricably mixed up. However, the deductive
method is useful only if certain assumptions are valid. (Traders earn profit, if the demand for the
commodity is more).
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b) Inductive method: This method mounts up from particular to general, i.e., we begin with the
observation of particular facts and then proceed with the help of reasoning founded on experience so as
to formulate laws and theorems on the basis of observed facts. E.g. Data on consumption of poor,
middle and rich income groups of people are collected, classified, analyzed and important conclusions
are drawn out from the results.
In deductive method, we start from certain principles that are either indisputable or based on strict
observations and draw inferences about individual cases. In inductive method, a particular case is
examined to establish a general or universal fact. Both deductive and inductive methods are useful in
economic analysis.
iv) Subject Matter of Economics
Economics can be studied through a) traditional approach and (b) modern approach.
a) Traditional Approach: Economics is studied under five major divisions namely consumption,
production, exchange, distribution and public finance.
1. Consumption: The satisfaction of human wants through the use of goods and services is called
consumption.
2. Production: Goods that satisfy human wants are viewed as “bundles of utility”. Hence production
would mean creation of utility or producing (or creating) things for satisfying human wants. For
production, the resources like land, labour, capital and organization are needed.
3. Exchange: Goods are produced not only for self-consumption, but also for sales. They are sold to
buyers in markets. The process of buying and selling constitutes exchange.
4. Distribution: The production of any agricultural commodity requires four factors, viz., land, labour,
capital and organization. These four factors of production are to be rewarded for their services
rendered in the process of production. The land owner gets rent, the labourer earns wage, the capitalist
is given with interest and the entrepreneur is rewarded with profit. The process of determining rent,
wage, interest and profit is called distribution.
5. Public finance: It studies how the government gets money and how it spends it. Thus, in public
finance, we study about public revenue and public expenditure.
b) Modern Approach
The study of economics is divided into: i) Microeconomics and ii) Macroeconomics.
1. Microeconomics analyses the economic behaviour of any particular decision making unit such as a
household or a firm. Microeconomics studies the flow of economic resources or factors of production
from the households or resource owners to business firms and flow of goods and services from
business firms to households. It studies the behaviour of individual decision making unit with regard to
fixation of price and output and its reactions to the changes in demand and supply conditions. Hence,
microeconomics is also called price theory.
2. Macroeconomics studies the behaviour of the economic system as a whole or all the decision-
making units put together. Macroeconomics deals with the behaviour of aggregates like total
employment, gross national product (GNP), national income, general price level, etc. So,
macroeconomics is also known as income theory.
Microeconomics cannot give an idea of the functioning of the economy as a whole. Similarly,
macroeconomics ignores the individual’s preference and welfare. What is true of a part or individual
may not be true of the whole and what is true of the whole may not apply to the parts or individual
decision making units. By studying about a single small-farmer, generalization cannot be made about
all small farmers, say in Tamil Nadu state. Similarly, the general nature of all small farmers in the state
need not be true in case of a particular small farmer. Hence, the study of both micro and
macroeconomics is essential to understand the whole system of economic activities.
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1.2 The Three Problems of Economic Organization: Because of scarcity, all economic choices can
be summarized in big questions about the goods and services a society should produce. These
questions are:
• What to produce?
• How to produce?
• For whom to produce?
What to Produce?
The first question every society faces is what to produce. Should a society build more roads or
schools? Because of scarcity, society cannot build everything it wants. Choices have to be made. Once
a society determines what to produce it then needs to decide how much should be produced. In a
market economy the "what" question is answered in large part by the demand of consumers?
How to Produce?
The next question a society needs to decide after what to produce is how to produce the desired goods
and services. Each society must combine available technology with scarce resources to produce
desired goods and services. The education and skill levels of the citizens of a society will determine
what methods can be used to produce goods and services. For example, does a nation possess the
technology and skills to pick grapes with a mechanized harvester, or does it have to pick the grapes by
hand?
For whom to produce?
The final question each society needs to ask is for whom to produce. Who is to receive and consume
the goods and services produced? Some workers have higher incomes than others. This means more
goods and services in a society will be consumed by these wealthy individuals, and less by the poor.
Different groups will benefit from the different ways that we choose to spend our money.
1.3 Managerial Economics

According to Mansfield, managerial economics is applied microeconomics.
Whether profit or non-profit making organizations and whatever may be their goals, they have all to
face constraints which may be internal & /or external.
In the words of Mc Nair and Merriam,” Managerial Economics consist of use of economic modes of
thought to analyze business situation”.
According to Spencer and Seigelman it is defined as the integration of economic theory with business
practice for the purpose of facilitating decision making and forward planning by the management”.
Economic provides optimum utilization of scarce resource to achieve the desired result. Managerial
Economics’ purpose is to show how economic analysis can be used formulating business planning.
Managerial Economics = Management + Economics
Management deals with principles which helps in decision making under uncertainty and improves
effectiveness of the organization. On the other hand economics provide a set of preposition for
optimum allocation of scarce resources to achieve a desired result. Managerial Economics deals with
the integration of economic theory with business practices for the purpose of facilitating decision
making and forward planning by management. In other words it is concerned with using of logic of
economics, mathematics, and statistics to provide effective ways of thinking about business decision
THE BASIC DECISION-MAKING PROCESS IS SAME FOR ALL FIRMS.
All managerial decision problems are solved with the help of tools, concepts and principles in….a)
Economic theory; b) Managerial economics c) Mathematical economics.
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1.4 Characteristics of Managerial Economics

1. Micro- study level: - the unit of study is a firm it is the problems of a business or which are studied
in it.
2. Problem solution: - It also use for various problem solution like what to produce? How to produce?
For whom to produce?
3. Pragmatic in nature: - it deals with something is based on practical consideration rather than
theoretical ones.
4. Conceptual: - it aim to analysis business problem on the basic of establishment concepts and
market.
5. Normative approach: - managerial economics belongs to normative economics rather than positive
economics. In other words it is persuasive than descriptive.
1.5 Importance of Managerial Economics
1. Helps in decision making
2. Helps in future planning
3. Helps in problem solving
4. Coordinating with different departments
5. Build competent a variety of business decision in a complicated environment
6. Helps in attainment of social & economics welfare
7. Incorporate useful idea from other disciplines.
1.6 Nature of Managerial Economics

1. Managerial economics is science:-
It studies the effects of a change in price of commodity factors and forces on the demand of a
particular product. It also studies the effects and implication of the plans, policies and programmers’ of
a firm on its sales and profit.
2. Managerial Economics requires Art
Managerial economist is required to have an art of utilizing his capability, knowledge and
understanding to achieve the organizational objective. Managerial economist should have an art to put
in practice his theoretical knowledge regarding elements of economic environment.
3. Managerial Economics for administration of organization
Managerial economics helps the management in decision making. These decisions are based on the
economic rationale and are valid in the existing economic environment.
4. Managerial economics is helpful in optimum resource allocation
The resources are scarce with alternative uses. Managers need to use these limited resources optimally.
Each resource has several uses. It is manager who decides with his knowledge of economics that
which one is the preeminent use of the resource.
5. Managerial Economics has components of micro economics
Managers study and manage the internal environment of the organization and work for the profitable
and long-term functioning of the organization. This aspect refers to the micro economics study. The
managerial economics deals with the problems faced by the individual organization such as main
objective of the organization, demand for its product, price and output determination of the
organization, available substitute and complimentary goods, supply of inputs and raw material, target
or prospective consumers of its products etc.
6. Managerial Economics has components of macro economics
None of the organization works in isolation. They are affected by the external environment of the
economy in which it operates such as government policies, general price level, income and
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SAURABH GUPTA
employment levels in the economy, stage of business cycle in which economy is operating, exchange
rate, balance of payment, general expenditure, saving and investment patterns of the consumers,
market conditions etc. These aspects are related to macro economics.
7. Managerial Economics is dynamic in nature
Managerial Economics deals with human-beings (i.e. human resource, consumers, producers etc.). The
nature and attitude differs from person to person. Thus to cope up with dynamism and vitality
managerial economics also changes itself over a period of time.
Managerial Economics is not only applicable to profit-making business organizations, but also to non-
profit organizations such as hospitals, schools, government agencies, etc.
1.7 Scope of Managerial Economics:

The scope of managerial economics is not yet clearly laid out because it is a developing science. Even
then the following fields may be said to generally fall under Managerial Economics:
1. Demand Analysis and Forecasting
2. Cost and Production Analysis
3. Pricing Decisions, Policies and Practices
4. Profit Management
5. Capital Management
These divisions of business economics constitute its subject matter.
Recently, managerial economists have started making increased use of Operation Research methods
like Linear programming, inventory models, Games theory, queuing up theory etc., have also come to
be regarded as part of Managerial Economics.
1. Demand Analysis and Forecasting: A business firm is an economic organisation which is engaged
in transforming productive resources into goods that are to be sold in the market. A major part of
managerial decision making depends on accurate estimates of demand. A forecast of future sales
serves as a guide to management for preparing production schedules and employing resources. It will
help management to maintain or strengthen its market position and profit base. Demand analysis also
identifies a number of other factors influencing the demand for a product. Demand analysis and
forecasting occupies a strategic place in Managerial Economics.
2. Cost and production analysis: A firm’s profitability depends much on its cost of production. A
wise manager would prepare cost estimates of a range of output, identify the factors causing are cause
variations in cost estimates and choose the cost-minimizing output level, taking also into consideration
the degree of uncertainty in production and cost calculations. Production processes are under the
charge of engineers but the business manager is supposed to carry out the production function analysis
in order to avoid wastages of materials and time. Sound pricing practices depend much on cost control.
The main topics discussed under cost and production analysis are: Cost concepts, cost-output
relationships, Economics and Diseconomies of scale and cost control.
3. Pricing decisions, policies and practices: Pricing is a very important area of Managerial
Economics. In fact, price is the genesis of the revenue of a firm ad as such the success of a business
firm largely depends on the correctness of the price decisions taken by it. The important aspects dealt
with this area are: Price determination in various market forms, pricing methods, differential pricing,
product-line pricing and price forecasting.
4. Profit management: Business firms are generally organized for earning profit and in the long
period, it is profit which provides the chief measure of success of a firm. Economics tells us that
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profits are the reward for uncertainty bearing and risk taking. A successful business manager is one
who can form more or less correct estimates of costs and revenues likely to accrue to the firm at
different levels of output. The more successful a manager is in reducing uncertainty, the higher are the
profits earned by him. In fact, profit-planning and profit measurement constitute the most challenging
area of Managerial Economics.
5. Capital management: The problems relating to firm’s capital investments are perhaps the most
complex and troublesome. Capital management implies planning and control of capital expenditure
because it involves a large sum and moreover the problems in disposing the capital assets off are so
complex that they require considerable time and labour. The main topics dealt with under capital
management are cost of capital, rate of return and selection of projects.
1.8 Fundamental Principles of Managerial Economics

Economic principles assist in rational reasoning and defined thinking. They develop logical ability and
strength of a manager. Some important principles of managerial economics are:
1. Marginal and Incremental Principle
This principle states that a decision is said to be rational and sound if given the firm’s objective of
profit maximization, it leads to increase in profit, which is in either of two scenarios-
• If total revenue increases more than total cost.
• If total revenue declines less than total cost.
Marginal analysis implies judging the impact of a unit change in one variable on the other. Marginal
generally refers to small changes. Marginal revenue is change in total revenue per unit change in
output sold. Marginal cost refers to change in total costs per unit change in output produced (While
incremental cost refers to change in total costs due to change in total output). The decision of a firm to
change the price would depend upon the resulting impact/change in marginal revenue and marginal
cost. If the marginal revenue is greater than the marginal cost, then the firm should bring about the
change in price.
Incremental analysis differs from marginal analysis only in that it analysis the change in the firm's
performance for a given managerial decision, whereas marginal analysis often is generated by a
change in outputs or inputs. Incremental analysis is generalization of marginal concept. It refers to
changes in cost and revenue due to a policy change. For example - adding a new business, buying new
inputs, processing products, etc. Change in output due to change in process, product or investment is
considered as incremental change. Incremental principle states that a decision is profitable if revenue
increases more than costs; if costs reduce more than revenues; if increase in some revenues is more
than decrease in others; and if decrease in some costs is greater than increase in others.
2. Equi-marginal Principle
Marginal Utility is the utility derived from the additional unit of a commodity consumed. The laws of
equi-marginal utility states that a consumer will reach the stage of equilibrium when the marginal
utilities of various commodities he consumes are equal. According to the modern economists, this law
has been formulated in form of law of proportional marginal utility. It states that the consumer will
spend his money-income on different goods in such a way that the marginal utility of each good is
proportional to its price, i.e.,
MUx / Px = MUy / Py = MUz / Pz
Where, MU represents marginal utility and P is the price of good.
Similarly, a producer who wants to maximize profit (or reach equilibrium) will use the technique of
production which satisfies the following condition:
MRP1 / MC1 = MRP2 / MC2 = MRP3 / MC3
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Where, MRP is marginal revenue product of inputs and MC represents marginal cost.
Thus, a manger can make rational decision by allocating/hiring resources in a manner which equalizes
the ratio of marginal returns and marginal costs of various use of resources in a specific use.
3. Opportunity Cost Principle
By opportunity cost of a decision is meant the sacrifice of alternatives required by that decision. If
there are no sacrifices, there is no cost. According to Opportunity cost principle, a firm can hire a
factor of production if and only if that factor earns a reward in that occupation/job equal or greater than
it’s opportunity cost. Opportunity cost is the minimum price that would be necessary to retain a factor-
service in it’s given use. It is also defined as the cost of sacrificed alternatives. For instance, a person
chooses to forgo his present lucrative job which offers him Rs.50000 per month, and organizes his own
business. The opportunity lost (earning Rs. 50,000) will be the opportunity cost of running his own
business.
4. Time Perspective Principle
According to this principle, a manger/decision maker should give due emphasis, both to short-term and
long-term impact of his decisions, giving apt significance to the different time periods before reaching
any decision. Short-run refers to a time period in which some factors are fixed while others are
variable. The production can be increased by increasing the quantity of variable factors. While long-
run is a time period in which all factors of production can become variable. Entry and exit of seller
firms can take place easily. From consumers point of view, short-run refers to a period in which they
respond to the changes in price, given the taste and preferences of the consumers, while long-run is a
time period in which the consumers have enough time to respond to price changes by varying their
tastes and preferences.
5. Discounting Principle
According to this principle, if a decision affects costs and revenues in long-run, all those costs and
revenues must be discounted to present values before valid comparison of alternatives is possible. This
is essential because a rupee worth of money at a future date is not worth a rupee today. Money actually
has time value. Discounting can be defined as a process used to transform future dollars into an
equivalent number of present dollars. For instance, $1 invested today at 10% interest is equivalent to
$1.10 next year.
FV = PV*(1+r) t
Where, FV is the future value (time at some future time), PV is the present value (value at t0, r is the
discount (interest) rate, and t is the time between the future value and present value.
1.9 Role of a Managerial Economist

A managerial economist helps the management by using his analytical skills and highly developed
techniques in solving complex issues of successful decision-making and future advanced planning.
The role of managerial economist can be summarized as follows:
1. He studies the economic patterns at macro-level and analysis it’s significance to the specific firm he
is working in.
2. He has to consistently examine the probabilities of transforming an ever-changing economic
environment into profitable business avenues.
3. He assists the business planning process of a firm.
4. He also carries cost-benefit analysis.
5. He assists the management in the decisions pertaining to internal functioning of a firm such as
changes in price, investment plans, type of goods /services to be produced, inputs to be used,
techniques of production to be employed, expansion/ contraction of firm, allocation of capital, location
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of new plants, quantity of output to be produced, replacement of plant equipment, sales forecasting,
inventory forecasting, etc.
6. In addition, a managerial economist has to analyze changes in macro- economic indicators such as
national income, population, business cycles, and their possible effect on the firm’s functioning.
7. He is also involved in advising the management on public relations, foreign exchange, and trade. He
guides the firm on the likely impact of changes in monetary and fiscal policy on the firm’s functioning.
8. He also makes an economic analysis of the firms in competition. He has to collect economic data
and examine all crucial information about the environment in which the firm operates.
9. The most significant function of a managerial economist is to conduct a detailed research on
industrial market.
10. In order to perform all these roles, a managerial economist has to conduct an elaborate statistical
analysis.
11. He must be vigilant and must have ability to cope up with the pressures.
12. He also provides management with economic information such as tax rates, competitor’s price and
product, etc. They give their valuable advice to government authorities as well.
13. At times, a managerial economist has to prepare speeches for top management.
1.10 Relationship of managerial economics with other disciplines:

Managerial economics is closely related to other subjects like micro economic theory, macro-
economic theory, mathematics, statistics, accounting and operations research. Managerial economics,”
as using the logic of economics, mathematics and statistics to provide effective ways of thinking about
business decision problems”.
Managerial economics and micro economics:
Managerial economics is mainly micro economic in character, making use of many of the concepts and
tools provided by micro-economic theory. The concept of elasticity of demand, marginal cost, market
structures, the theory of the firm and the theory of pricing of micro-economics are fully made use of by
managerial economics. Hence the study of micro economics is essential for the better understanding
of managerial economics. All micro economic theories which can be applied in business are made use
of in managerial economics.
Managerial economics and macro-economics:
Macro-economics is concerned with aggregates and macro-economic concepts are used in managerial
economics in the area of forecasting general business conditions. The theory of the firm, pricing
policies etc have to be viewed in the broad frame work of the economic system and it is essential that
the business executives should have some knowledge of the entire economic system. Macro-economic
concepts like national income, social accounting, managerial efficiency of capital, multiplier, business
cycles, fiscal policies etc have to be studied in managerial economics for forecasting the business
conditions.
Both micro and macro-economic are closely related to managerial economics. Managerial economics
draws from micro and macro-economics, so that it can apply these principles to solve the day-to-day
problems faced by businessmen.
Managerial economics and mathematics:

Managerial economics is becoming increasingly mathematical in character. Businessmen deal with
various concepts which are measurable. The use of mathematical logic provides clarity of concepts. It
also gives a systematic frame-work within which quantitative relationship maybe analyzed.
Mathematics, therefore, is of great help to managerial economics. The major problem confronting
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businessmen is to minimize cost or maximize profit or optimize sales. To find out the solution for the
overall problems, mathematical concepts and techniques are widely used. Mathematical techniques
like linear programming, games theory etc help managerial economists to solve many of their
problems.
Managerial economics and statistics:
Statistics is a science concerned with collection, classification, tabulation and analysis of data for some
specified purpose. Managerial economics and statistics are closely related as businessmen deal mainly
with concepts that are quantifiable for example: demand, price, cost of operation etc.
Statistics is useful to managerial economics in many ways:
a. Managerial economics requires marshaling of quantitative data to find out functional relationship
involved in decision-making. This is done with the help of statistics.
b. Statistical methods are used for empirical testing in managerial economics.
c. The business executives have to work and take decisions in an uncertainty frame-work. The theory
of probability evolved by statistics helps managerial economists for taking a logical decision.
Thus statistical methods provides sound base for decision-making and help the businessmen to achieve
the objective without much difficulty. Statistical tools are extensively used in the solution of
managerial problems. Managerial economists make use of various statistical techniques like the theory
of probability, co-relation techniques, regression analysis etc. in various business situations.
Managerial economics and accounting:
Accounting is concerned with recording the financial operations of a business firm. Accounting
information is one of the primary sources of data required for managerial economists for the decision-
making purpose. The information it contains can be used by the managerial economist to throw some
light on the future course of action.
Managerial economics and operations research:

Operations research is the,” application of mathematical techniques in solving business problems”. It
deals with model building that is construction of theoretical-models that help the decision-making
process. Though the roots of operations research lie in military studies, it is now largely used in
business administration, planning and control. Linear programming and allied concepts of operations
research are used in managerial economics.
1.11 Six steps to Decision making
The examples just given represent the breadth of the decisions in managerial economics. Different as
they may seem, each decision can be framed and analyzed using a common approach based on six
steps, as Figure 1.1 indicates.
With the examples as a backdrop, we will briefly outline each step. Later in the text, we will refer to
these steps when analyzing managerial decisions.
Step 1: Define the Problem
What is the problem the manager faces? Who is the decision maker? What is the decision setting or
context, and how does it influence managerial objectives or options?
Step 2: Determine the Objective
What is the decision maker’s goal? How should the decision maker value outcomes with respect to this
goal? What if he or she is pursuing multiple, conflicting objectives?
When it comes to economic decisions, it is a truism that “you can’t always get what you want.” But to
make any progress at all in your choice, you have to know what you want. In most private-sector
decisions, profit is the principal objective of the firm and the usual barometer of its performance. Thus,
among alternative courses of action, the manager will select the one that will maximize the profit of
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the firm.
Step 3: Explore the Alternatives
What are the alternative courses of action? What are the variables under the decision maker’s control?
What constraints limit the choice of options?
After addressing the question “What do we want?” it is natural to ask, “What are our options?” Given
human limitations, decision makers cannot hope to identify and evaluate all possible options. Still, one
would hope that attractive options would not be overlooked or, if discovered, not mistakenly
dismissed. Moreover, a sound decision framework should be able to uncover options in the course of
the analysis.
Step 4: Predict the Consequences
What are the consequences of each alternative action? Should conditions change, how would this
affect outcomes? If outcomes are uncertain, what is the likelihood of each? Can better information be
acquired to predict outcomes?
Depending on the situation, the task of predicting the consequences may be straightforward or
formidable. Sometimes elementary arithmetic suffices. For instance, the simplest profit calculation
requires only subtracting costs from revenues. The choice between two safety programs might be made
according to which saves the greater number of lives per dollar expended. Here the use of arithmetic
division is the key to identifying the preferred alternative.
Step 5: Make a Choice
After all the analysis is done, what is the preferred course of action? For obvious reasons, this step
(along with step 4) occupies the lion’s share of the analysis and discussion in this book. Once the
decision maker has put the problem in context, formalized key objectives, and identified available
alternatives, how does he or she go about finding a preferred course of action?
Step 6: Perform Sensitivity Analysis
What features of the problem determine the optimal choice of action? How does the optimal decision
change if conditions in the problem are altered? Is the choice sensitive to key economic variables about
which the decision maker is uncertain?
In tackling and solving a decision problem, it is important to understand and be able to explain to
others the “why” of your decision. The solution, after all, did not come out of thin air. It depended on
your stated objectives, the way you structured the problem (including the set of options you
considered), and your method of predicting outcomes. Thus, sensitivity analysis considers how an
optimal decision is affected if key economic facts or conditions vary.
Questions
Q1. Define managerial economics? How does it assist manager in decision making?
Q2. Profit maximization remains the most important objective of business firms inspite of the
multiplicity of alternative business objective suggested by modern economist. Comment on this
statement.
Q3. Critically examine the profit maximization goal of a business firm.
Q4. Discuss the role and responsibility of managerial economist.
Q5. Write Short notes on:
(a) Time perspective principle
(b) Opportunity cost principle
Q6. Define managerial economics. Discuss its nature and scope.
Q7. Explain and illustrate the following:
(a) Marginal Principle
(b) Equi-marginal Principle
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CHAPTER 2
The Essentials of Demand
2.0 Demand
Demand for a commodity refers to the quantity of the commodity that people are willing to purchase at
a specific price per unit of time, other factors (such as price of related goods, income, tastes and
preferences, advertising, etc) being constant. Demand includes the desire to buy the commodity
accompanied by the willingness to buy it and sufficient purchasing power to purchase it. For instance-
Everyone might have willingness to buy “Mercedes-S class” but only a few have the ability to pay for
it. Thus, everyone cannot be said to have a demand for the car “Mercedes-s Class”.
Demand may arise from individuals, household and market. When goods are demanded by individuals
(for instance-clothes, shoes), it is called as individual demand. Goods demanded by household
constitute household demand (for instance-demand for house, washing machine). Demand for a
commodity by all individuals/households in the market in total constitutes market demand.
2.1 Demand Function

Demand function is a mathematical function showing relationship between the quantity demanded of a
commodity and the factors influencing demand.
Dx = f (Px, Py, T, Y, A, Pp, Ep, U)
In the above equation,
Dx = Quantity demanded of a commodity
Px = Price of the commodity
Py = Price of related goods
T = Tastes and preferences of consumer
Y = Income level
A = Advertising and promotional activities
Pp = Population (Size of the market)
Ep = Consumer’s expectations about future prices
U = Specific factors affecting demand for a commodity such as seasonal changes, taxation policy,
availability of credit facilities, etc.
2.2 Law of Demand

The law of demand states that there is an inverse relationship between quantity demanded of a
commodity and it’s price, other factors being constant. In other words, higher the price, lower the
demand and vice versa, other things remaining constant.
2.3 Demand Schedule

Demand schedule is a tabular representation of the quantity demanded of a commodity at various
prices. For instance, there are four buyers of apples in the market, namely A, B, C and D.
Demand schedule for apples
PRICE (Rs. Buyer A Buyer B Buyer C Buyer D Market
per dozen) (demand in (demand in (demand in (demand in Demand
dozen) dozen) dozen) dozen) (dozens)
10 1 0 3 0 4
9 3 1 6 4 14
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8 7 2 9 7 25
7 11 4 12 10 37
6 13 6 14 12 45
TABLE 1: DEMAND SCHEDULE
The demand by Buyers A, B, C and D are individual demands. Total demand by the four buyers is
market demand. Therefore, the total market demand is derived by summing up the quantity demanded
of a commodity by all buyers at each price.
2.4 Demand Curve

Demand curve is a diagrammatic representation of demand schedule. It is a graphical representation of
price- quantity relationship. Individual demand curve shows the highest price which an individual is
willing to pay for different quantities of the commodity. While, each point on the market demand
curve depicts the maximum quantity of the commodity which all consumers taken together would be
willing to buy at each level of price, under given demand conditions.
P2
Price
P1
Q2 Q1
Quantity Demanded
FIGURE 2: DEMAND CURVE

Demand curve has a negative slope, i.e., it slopes downwards from left to right depicting that with
increase in price, quantity demanded falls and vice versa. The reasons for a downward sloping demand
curve can be explained as follows-
1. Income effect- With the fall in price of a commodity, the purchasing power of consumer increases.
Thus, he can buy same quantity of commodity with less money or he can purchase greater quantities of
same commodity with same money. Similarly, if the price of a commodity rises, it is equivalent to
decrease in income of the consumer as now he has to spend more for buying the same quantity as
before. This change in purchasing power due to price change is known as income effect.
2. Substitution effect- When price of a commodity falls, it becomes relatively cheaper compared to
other commodities whose price have not changed. Thus, the consumer tend to consume more of the
commodity whose price has fallen, i.e., they tend to substitute that commodity for other commodities
which have not become relatively dear.
3. Law of diminishing marginal utility- It is the basic cause of the law of demand. The law of
diminishing marginal utility states that as an individual consumes more and more units of a
commodity, the utility derived from it goes on decreasing. So as to get maximum satisfaction, an
individual purchases in such a manner that the marginal utility of the commodity is equal to the price
of the commodity. When the price of commodity falls, a rational consumer purchases more so as to
equate the marginal utility and the price level. Thus, if a consumer wants to purchase larger quantities,
then the price must be lowered. This is what the law of demand also states.
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Exceptions to Law of Demand

The instances where law of demand is not applicable are as follows-
1. Conspicuous goods: There are certain goods which are purchased mainly for their snob appeal,
such as, diamonds, air conditioners, luxury cars, antique paintings, etc. These goods are used as status
symbols to display one’s wealth. The more expensive these goods become, more valuable will be they
as status symbols and more will be there demand. Thus, such goods are purchased more at higher price
and are purchased less at lower prices. Such goods are called as conspicuous goods.
2. Giffen goods: The law of demand is also not applicable in case of Giffen goods. Giffen goods are
those inferior goods, whose income effect is stronger than substitution effect. These are consumed by
poor households as a necessity. For instance, potatoes, animal fat oil, low quality rice, etc. An increase
in price of such good increases its demand and a decrease in price of such good decreases its demand.
3. Speculation: The law of demand does not apply in case of expectations of change in price of the
commodity, i.e., in case of speculation. Consumers tend to purchase less or tend to postpone the
purchase if they expect a fall in price of commodity in future. Similarly, they tend to purchase more at
high price expecting the prices to increase in future.
2.5 Determinants of (Factors affecting) demand

Innumerable factors and circumstances could affect a buyer's willingness or ability to buy a good.
Some of the more common factors are:
I. Good's own price: The basic demand relationship is between potential prices of a good and the
quantities that would be purchased at those prices. Generally the relationship is negative meaning that
an increase in price will induce a decrease in the quantity demanded. This negative relationship is
embodied in the downward slope of the consumer demand curve. The assumption of a negative
relationship is reasonable and intuitive. If the price of a new novel is high, a person might decide to
borrow the book from the public library rather than buy it.
II. Price of related goods: The principal related goods are complements and substitutes. A
complement is a good that is used with the primary good. Examples include hotdogs and mustard, beer
and pretzels, automobiles and gasoline. (Perfect complements behave as a single good.) If the price of
the complement goes up the quantity demanded of the other good goes down. Mathematically, the
variable representing the price of the complementary good would have a negative coefficient in the
demand function. For example, Qd = a - P - Pg where Q is the quantity of automobiles demanded, P is
the price of automobiles and Pg is the price of gasoline. The other main categories of related goods are
substitutes. Substitutes are goods that can be used in place of the primary good. The mathematical
relationship between the price of the substitute and the demand for the good in question is positive. If
the price of the substitute goes down the demand for the good in question goes down.
III. Personal Disposable Income: In most cases, the more disposable income (income after tax and
receipt of benefits) a person has the more likely that person is to buy.
IV. Tastes or preferences: The greater the desire to own a good the more likely one is to buy the
good. There is a basic distinction between desire and demand. Desire is a measure of the willingness to
buy a good based on its intrinsic qualities. Demand is the willingness and ability to put one's desires
into effect. It is assumed that tastes and preferences are relatively constant.
V. Consumer expectations about future prices, income and availability: If a consumer believes
that the price of the good will be higher in the future, he/she is more likely to purchase the good now.
If the consumer expects that his/her income will be higher in the future, the consumer may buy the
good now. Availability (supply side) as well as predicted or expected availability also affects both
price and demand.
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VI. Population: If the population grows this means that demand will also increase.
VII. Nature of the good: If the good is a basic commodity, it will lead to a higher demand
VIII. This list is not exhaustive. All facts and circumstances that a buyer finds relevant to his
willingness or ability to buy goods can affect demand. For example, a person caught in an unexpected
storm is more likely to buy an umbrella than if the weather were bright and sunny.
2.6 Types of Elasticity

2.6.1. Price Elasticity of Demand
The responsiveness or sensitivity of consumers quantity demanded to a change in price is measured by
the Price Elasticity of Demand. The price elasticity of demand is a measure of the extent to which the
quantity demanded of good changes when the price of the good changes and all other influences on
buyers’ plans remain the same.
A. Percentage Change in Price
1. The midpoint method uses the average of the initial price and new price in the denominator when
calculating a percentage change. Because the average price is the same between two prices regardless
of whether the price falls or rises, the percentage change in price calculated by the midpoint method is
the same for a price rise and a price fall.
a. Using the midpoint formula, the percentage change in price equals
 New price  Initial price 
  × 100 .
 New price + Initial price  ÷ 2 
B. Percentage Change in Quantity Demanded
Use the midpoint method when calculating the percentage change in quantity.
 New quantity  Initial quantity 
   100 .
 New quantity  Initial quantity   2 
1. Minus Sign
Because a change in price causes an opposite change in quantity demanded, for the price elasticity of
demand we focus on the magnitude of the change by using the absolute value.
C. Influences on the Price Elasticity of Demand
1. Substitution Effect
If good substitutes are readily available, demand is elastic. If good substitutes are hard to find, demand
is inelastic.
2. Three factors determine how easy substitutes are to find:
a. Luxury versus necessity—there are few substitutes for necessities (so demand is price inelastic) and
there are many substitutes for luxuries (so demand is price elastic).
b. Narrowness of definition—the more narrowly defined the good is, the more elastic its demand. The
more broadly defined the good, the less elastic its demand.
c. Time elapsed since price change—the longer the time that has passed since the price change, the
more elastic is demand.
3. Income Effects
The larger the proportion of income spent on the good, the more elastic is demand because a price
change has a large, noticeable impact on the budget. The smaller the proportion of income spent on the
good, the less elastic is demand.
D. Computing the Price Elasticity of Demand
1. The formula used to calculate the price elasticity of demand is:
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SAURABH GUPTA
Percentage change in quantity demanded

Price elasticity of demand = .
Percentage change in price
a. If the price elasticity of demand is greater than 1 (the numerator is larger than the denominator),
demand is elastic.
b. If the price elasticity of demand is equal to 1 (the numerator equals the denominator), demand is unit
elastic.
c. If the price elasticity of demand is less than 1 (the numerator is less than the denominator), demand
is inelastic.
E. Degrees of price elasticity
I. Elastic Demand –demand for a product is elastic if its price elasticity is greater than 1. (Resulting
percentage change in quantity demanded is greater than the percentage change in price)
Price
Quantity Demanded
FIGURE 3: ELASTIC DEMAND

II. Inelastic Demand – demand for a product is inelastic if its price elasticity is less than 1. (Resulting
percentage change in quantity demanded is less than the percentage change in price)
Price
Quantity Demanded
FIGURE 4: INELASTIC DEMAND
II. Unit Elasticity – The elasticity coefficient of demand or supply is equal to 1. (Percentage change in
quantity is equal to percentage change in price)
Price
Quantity Demanded
FIGURE 5: UNIT ELASTIC DEMAND
26
IV. Perfectly Inelastic Demand – Quantity demanded does not respond to a change in price.
Ed = 0
Price
Quantity Demanded
FIGURE 6: PERFECTLY ELASTIC DEMAND
V. Perfectly Elastic Demand – Quantity demanded will go from 0 to infinity at a particular product
price. That is, if the price isn’t right, 0 is demanded, as soon as the price is right, infinite amounts will
be demanded. Ed = INFINTE
Price
Quantity Demanded
FIGURE 6: PERFECTLY ELASTIC DEMAND
F. Determinants of price elasticity of demand
1. Substitutability – the greater the number of substitute goods that are available, the greater the price
elasticity of demand (more substitute goods = demand is more sensitive to price). Example there is not
a good substitute for insulin, therefore it is relatively inelastic demand; however, there are many
substitutes for potato chips, therefore, demand for them is relatively elastic
2. Luxury versus Necessity – The more that a good is considered a luxury rather than a necessity, the
greater is the price elasticity of demand. Example Heating, Food, water are all considered necessities;
therefore demand for them will be rather inelastic.
3. Proportion of Income – The higher the price of a good relative to consumers’ incomes, the greater
the price elasticity of demand. Example: A 100% increase in the price of a two boxes of matches is a
very low fraction of my annual salary, compared to a 100% increase in the price of a bike. So the price
elasticity of demand on the match box will be much more inelastic than on the bike.
4. Time – demand is more elastic the longer the period under consideration. Example if the price of a
Tea goes up, I might not switch to Coffee at first, but the more time I have to pay the higher price, the
more willing I am to try Coffee and to determine whether Coffee or other substitute products are good
enough
2.6.2. Cross Elasticity of Demand

The cross elasticity of demand is a measure of the extent to which the demand for a good changes
when the price of a substitute or complement changes, other things remaining the same.
The formula used to calculate the cross elasticity of demand is:
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Percentage change in quantity demanded of a good

Cross elasticity of demand = .
Percentage change in price of one
of its substitute s or complement s
FIGURE 7: CROSS ELASTICITY
The cross elasticity of demand for a substitute is positive.

The cross elasticity of demand for a complement is negative.
Cross Elasticity
• Demand is also influenced by prices of other goods and services.
• The responsiveness of quantity demanded to changes in price of other goods is measured by cross
elasticity, which is defined as the % change in the quantity demanded of one good caused by a 1%
change in the price of some other good.
• For large changes in the price of Y, Arc cross elasticity is used.
• Point cross elasticity are analogous to the point elasticity
• Cross price elasticity for Substitutes: Negative
• Cross price elasticity for complementary goods is: Positive
Cross Elasticity and Decision Making
• Many large corporations produce several related products. Gillette makes both razors and razor
blades. Kinetic sells several competing makes of automobiles. Where a company’s products are
related, the pricing of one good can influence the demand for another
• Information regarding cross elasticity’s can aid decision-makers in assessing such impacts.
• Cross elasticity are also useful in establishing boundaries between the industries.
2.6.3. Income Elasticity of Demand

The income elasticity of demand is a measure of the extent to which the demand for a good changes
when income changes, other things remaining the same. The formula used to calculate the income
elasticity of demand is:
Percentage change in quantity demanded
Income elasticity of demand = .
Percentage change in income
For a normal good, the income elasticity of demand is positive.
When the income elasticity of demand is greater than 1, demand is income elastic.
When the income elasticity of demand is between zero and 1, demand is income inelastic. For an
inferior good, the income elasticity of demand is less than 0.
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FIGURE 8: INCOME ELASTICITY

Income elasticity and decision making
• During periods of expansion firms selling luxury items find their demand increase at a rate that is
faster than the rate of income growth. At the time of recession demand for these goods decrease
rapidly
• Basic necessities –food/fuel – sellers of it not benefited as much during periods of economic
prosperity, but will also find their markets somewhat recession proof.
That is, the change in demand will be less than that in the economy in general.
• Knowledge of income elasticity’s can be useful in targeting marketing efforts.
• Consider a firm specializing in expensive men’s colognes. Because such goods are luxuries, those in
high-income groups would be expected to be the prime customers. Thus the firms should concentrate
its marketing efforts on media that reach the wealthier segments of the population. E.g., advertising
dollars should be spent on space in Esquire and the New Yorker rather than the National Enquirer and
Wrestling Today.
2.6.4. Promotional (Advertising) Elasticity of Demand

Salient features of relationship between advertising and sales are the following:
• Some sales are possible even if there are no advertising
• Beyond the minimum level of sales, there is a direct relationship between advertising expenditure and
sales (sales increase with increase in advertisement expenditure and decrease with decrease in
advertisement sales)
• Consumers generally need a minimum level of advertisement before they take notice of the presence
of the product. So sales do not respond to the same extent as advertisement expenditure. Beyond this
initial stage of advertising expenditure, the resulting increase in the sales will be more than
proportionate to the increase in advertisement expenditure. As advertisement expenditure is continued
to increase, it will eventually result in less than proportionate increase in sales, and later a stage comes
when no further increase in sales is possible with the help of advertisement. If we plot the amount of
advertisement expenditure and corresponding sales level, we get an S- shaped curve.
How far the demand for a product will be influenced by advertisement and other promotional activities
may be measured by advertising elasticity of demand. Some goods are more responsive to advertising,
e.g., cosmetics. Advertising elasticity of demand measures the response of quantity demand to change
in expenditure on advertising and other sales promotional activities.
The point formula for calculating advertising elasticity of demand is: Ea= dq/q da/a
Arc Formula
Ea = (q2-qi) (a 2+a1) / (q2+q1) (a1-a2)
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SAURABH GUPTA
Factors Influencing Advertising Elasticity of Demand

1. Stage of product Market:
• It is different for new and old products
• Also different for established Market and growing Markets
2. Effect of advertising in terms of time:
• Time lag in response to advertisement varies
• It may be delayed in some cases, depending upon the general economic environment and the media
chosen.
• It may also depend upon type of product; It takes long for the durable articles;
Advertisement by various media and by various firms may have a cumulative effect after some time
3. Influence of advertising by rivals:
 Ea Depends upon effectiveness of advertisement
 How much additional output this firm can sell by resorting to advertisement depends upon its
own media and the level of advertisement vis-à-vis those of its rival.
2.7 Managerial Uses of Elasticity Concepts

Regarding the importance of the concept of elasticity of demand, it must be pointed out that the
concept is useful to the business managers as well as government managers.
Elasticity measures help the sales manager in fixing the price of his product. The concept is also
important to the economic planners of the country. In trying to fix the production target for various
goods in a plan, a planner must estimate the likely demand for goods at the end of the plan. This
requires the use of income elasticity concepts. The price elasticity of demand as well as cross elasticity
would determine the substitution between goods and hence useful in fixing the outputs mix in a
production period. The concept is also useful to the policy makers of the government, in particular in
determining taxation policy, minimum wages policy, stabilization program for agriculture, and price
policies for various other goods (where administered prices are used). The managers are concerned
with empirical demand estimates because they provide summary information about the direction and
proportion of change in demand, as a result of a given change in its explanatory variables. From the
standpoint of control and management of external factors, such empirical estimates and their
interpretations are therefore, very relevant.
2.8 Types of Demand

i) Direct and Derived Demands
Direct demand refers to demand for goods meant for final consumption; it is the demand for
consumers’ goods like food items, readymade garments and houses. By contrast, derived demand
refers to demand for goods which are needed for further production; it is the demand for producers’
goods like industrial raw materials, machine tools and equipments.
ii) Domestic and Industrial Demands:- The example of the refrigerator can be restated to distinguish
between the demand for domestic consumption and the demand for industrial use. In case of certain
industrial raw materials which are also used for domestic purpose, this distinction is very meaningful.
iii) Autonomous and Induced Demand
When the demand for a product is tied to the purchase of some parent product, its demand is called
induced or derived.
For example, the demand for cement is induced by (derived from) the demand for housing.
Autonomous demand is not derived or induced. Unless a product is totally independent of the use of
other products, it is difficult to talk about autonomous demand. In the present world of dependence,
30
there is hardly any autonomous demand. Nobody today consumers just a single commodity; everybody
consumes a bundle of commodities. Even then, all direct demand may be loosely called autonomous.
iv) Perishable and Durable Goods’ Demands
Both consumers’ goods and producers’ goods are further classified into perishable/non-durable/single-
use goods and durable/non-perishable/repeated-use goods. T
v) New and Replacement Demands
If the purchase or acquisition of an item is meant as an addition to stock, it is a new demand. If the
purchase of an item is meant for maintaining the old stock of capital/asset, it is replacement demand.
Such replacement expenditure is to overcome depreciation in the existing stock.
vi) Final and Intermediate Demands
This distinction is again based on the type of goods- final or intermediate. The demand for semi-
finished products, industrial raw materials and similar intermediate goods are all derived demands,
vii) Individual and Market Demands
This distinction is often employed by the economist to study the size of the buyers’ demand, individual
as well as collective. A market is visited by different consumers, consumer differences depending on
factors
viii) Total Market and Segmented Market Demands
This distinction is made mostly on the same lines as above. Different individual buyers together may
represent a given market segment; and several market segments together may represent the total
market.
x) Company and Industry Demands
An industry is the aggregate of firms (companies). Thus the Company’s demand is similar to an
individual demand, whereas the industry’s demand is similar to aggregated total demand. You may
examine this distinction from the standpoint of both output and input.
2.9 Demand Forecasting

2.9.0 Definition of Forecasting:
“A forecast is an estimate of a future event achieved by systematically combining and casting
forward in a predetermined way data about the past.”
Forecasting is essentially the study of internal and external forecast that shape demand and supply.
Forecasting is a common statistical task in business, where it helps in making decisions about
scheduling of production, transportation and personnel, and provides a guide to long-term strategic
planning. Forecasting is about predicting the future as accurately as possible, given all the information
available including historical data and knowledge of any future events that might impact the forecasts.
Forecasting should be an integral part of the decision-making activities of management, as it can play
an important role in many areas of a company. Modern organization requires short, medium and long
term forecasts, depending on the specific application.
 Short- term forecasts are needed for scheduling of personnel, production and transportation.
 Medium-term forecasts are needed to determine future resource requirements in order to
purchase raw materials, hire personnel, or buy machinery and equipment.
 Long-term forecasts are used in strategic planning. Such decisions must take account of market
opportunities, environmental factors and internal resources.
2.9.1 Uses of Forecasts
1. Accounting : Cost/profit estimates
2. Finance : Cash flow and funding
3. Human Resources : Hiring/recruiting/training
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4. Marketing : Pricing, promotion, strategy

5. MIS : IT systems, services
6. Operations : Schedules, workloads, new facility planning
2.9.2 Steps of Forecasting
The recognition that forecasting techniques operate on the data generated by historical events leads to
the identification of the following five steps in the forecasting process:
 Data Collection
 Data reduction or Condensation
 Model building and evaluation
 Model extrapolation (the actual forecast)
 Forecast evaluation
Data Collection: Data collection suggests the importance of getting the proper data and making
sure they are correct. This step is often the most challenging part of the entire forecasting process
and the most difficult to monitor since subsequent steps can be performed on data whether relevant
to the problem or hand or not.
Data reduction or Condensation: Data reduction or condensation is often necessary, since it is
possible to have too much data in the forecasting process as well as too little. Some data may not
be relevant to the problem and may reduce forecasting accuracy. Other data may be appropriate but
in only historical periods.
Model building and evaluation: Model building and evaluation, involves fitting the collected data
into a forecasting model that is appropriate in terms of minimizing the forecasting error. The
simpler the model, the better it is in terms of gaining acceptance of the forecasting process by
managers who must take the firm’s decision.
Model extrapolation: Model extrapolation, consists of the actual model forecast that are generated
once the appropriate data have been collected and possibly reduced and an appropriate forecasting
model has been chosen.
Forecast evaluation: Forecast evaluation, involves comparing forecast values with actual
historical values. In this process, a few of the most recent data values are often held back from the
data set being analyzed.
2.9.3 Advantages of Forecasting
 Helps in effective planning.
 Helps in removing the weakness of organization structure.
 Helps in better co-ordination.
 Achieves co-operation in the enterprises.
 Provides a basis for effective control.
 Important at the national level.
2.9.4 Disadvantages of Forecasting
 Based on assumptions.
 Based on past data.
 Inaccuracy
 Inadequate data
2.9.5 Theories of Demand Forecasting
A theory is a set of interrelated ideas which attempts at explaining some aspects of the real world.
There are mainly two types of theories:
 Normative theory is about the right way to do the things.
32
 Positive theory is concerned with what is actually happening not it what to happen.
It is well known that some certain principles have to be followed for preparing forecasts scientifically.
These principles are some general rules that are followed during the process of forecasting. In case
these principles are not followed then there shall be no uniformity and consistency in the forecasts. For
providing a strong base to forecasting various principles are propounded. There are some assumptions
implied in these principles which are as follows:
 There exists a kind of regularity in data.
 Past values are regularly repeated in future also.
 It is necessary to consider the effect of present situation at the time of preparing future forecasts
on the basis of past trends.
 Forecaster should be unbiased, experienced and competent.
1. Time Lag Theory

Time lag theory is the oldest theory amongst all the prevalent theories for business forecasting.
Besides being oldest, it is also the most commonly used theory. According to this theory, there is
always a tendency of gap or forward-looking approach in commercial data. What we mean by this
statement is that the basic assumption behind this theory is that business changes do not occur
simultaneously but in a certain sequence. It means that if we ignore the irregular and seasonal
fluctuations in time series then the remaining long term changes do not occur simultaneously but
one after another in a chronological order. Hence, there is a certain time lag between their
occurrences. Time of these various changes may be different but they always occur sequentially. If
we are able to know the time gap between these sequential changes then business forecasting can
be done very easily.
2. Action and Reaction Theory
Action reaction theory is a very famous theory in the field of business forecasting. This theory
originated from a very popular rule of physics i.e. third law of Newton. According to this law for every
action there is an opposite and equal reaction. Keeping in view, the standard conditions in the context
of business economic operations, there exists a normal level of entire economic activities related with
the business, which should be implemented under normal conditions. If any activity or action different
from this level occur then the occurrence of the reaction of that action is certain. This fact should be
kept into mind at the time of designing business forecasting.
3. Historical Analogy Theory
Historical analogy theory is a general theory. Basic assumption of this theory is that history repeats
itself. Therefore, it is assumed that repetition of those events in future is possible which have occurred
in those past situations, which are similar with the prevailing current conditions. What does it means
that whatever circumstance are prevailing in the current time, events which occurred when these
similar situations has arisen in the past, will be repeated in future also. Hence, first of all a past period
is selected which is similar with the current conditions. Thereafter forecasting of future is done on the
basis of events occurred after that past period.
4. Cross-Cut Analysis Theory
Cross-cut analysis theory completely contradicts the above mentioned historical analogy theory. This
theory is exactly opposite of the historical analogy theory. The reason for this theory is being opposite
of historical analogy theory is its basic assumption which is ‘history never repeat itself’. According to
this theory, it is not necessary that those same results that have been obtained in the past will be
repeated in future also. Under this theory, much more importance is given to the present situations than
past. Hence at the time of forecasting no study of past trends or events is made. At the time of
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preparing forecasts on the basis of this theory, every element related with the present situation is
studied separately. Under this method, for making forecast, effect of every element is studied
independently instead of studying the total present situation collectively. In this method it is tried to
know, the effect of each individual element on forthcoming results separately. This estimation of
separate individual effect is the basis of cross-cut analysis theory. Its total concentration is on the
present where there is no place for the past events. Therefore minute and detailed analytical study of
every element related with the present situation is essential for getting proper conclusions.
5. Economic Rhythm Theory
Economic rhythm theory is an appropriate theory for long-term forecasts. The underlying assumption
behind this theory is the occurrence of history in a certain sequence and chronological order. This
theory is implemented entirely through the use of statistical methods. In this theory, time series
analysis is used for extrapolation. From the systematical study of time series data, trend is determined.
Therefore, forthcoming trend is determined with the help of algebraic formulas or trend projection on
graph paper. The task of forecasting is done on the basis of this forthcoming trend. In this way, core of
this theory is the estimation of future trend from the statistical study of the inherent mutual relationship
between the data of past period.
2.9.6 Demand Forecasting Methods/Models

Qualitative Techniques Quantitative Techniques
Trend
Jury of Executive Projection
Opinion
Sales Force Regression

Composite Method
Anticipatory Econometric
Survey & Method
Market research
based method
Barometric
Method
Delphi Method
Brainstorming
FIGURE 9: TECHNIQUES OF DEMAND FORECASTING
A. Qualitative Forecasting Methods
Qualitative methods are subjective in nature since they rely on human judgment and opinion. These
methods are used when the condition is vague and little data exist. Judgmental forecast is the most
widely used approach of forecasting (Makridakis, 1989). It is preferable to perform for two reasons,
which are:
(a). Its ability to incorporate expert’s knowledge.
(b). It does not require personnel who are skilled in the use of statistical methods in which is a lacking
resources in many organizations.
Beside its advantages, it should be noted that judgmental forecasting involves general pitfalls that have
been identified by Armstrong (2001) which are:
(a). Inconsistency
(b). Bias
1. Jury of Executive Opinion: This technique consists of corporate executives, generally from sales,
production, finance, purchasing and administrations, sitting around a table and deciding as a group
what their best estimate is for the item to be forecast. Sometimes the executives are provided with
background data or information that might be useful in assessing forecasts.
2. Sales Force Composite Methods: In this method, a forecast is obtained by collecting the forecast
based on the views of individual sales people and sales management. It contains three different types,
which are grass roots approach, the sales management technique and the distributors approach.
In the grass root approach, the process begins with the collection of each salesperson’s estimate of
probable future sales in his or her territory. Once the sales people have made their individual
assessment, the results for the district forecast are put together.
The sales management technique is similar to grass root approach, but the specialized knowledge of
sales executive staff is used rather than assessments by the individual sales persons. It could reduce the
time required to obtain such forecast due to fewer people involved in the forecasting task.
The wholesaler or distributor approach is generally used by manufacturing which distribute their
products through independent channels of distribution rather than through direct contact with the users
of their products. It involves asking each of their distributors for the information about the size and
quantity of the company’s product lines that they expect to sell in let say the next quarter of next yea
3. Anticipatory Surveys and Market Research-Based Assessment
The idea is to sample the population whose behaviour and actions will determine future trends and
activity levels of the items in question. Several surveys based on a sampling of intentions are prepared
on a regular basis.
4. Delphi Method
The Delphi method is the most formalized and studied of the structured group (Wright & Goodwin,
1998)7. This method is aimed to obtain the most reliable consensus of opinion of a group of experts by
a series of intensive questionnaires interspersed with controlled opinion feedback.
5. Brainstorming
Brainstorming is a group technique for generating new, useful ideas and promoting creative thinking.
The basis of the brainstorm is ‘The Problem Statement’ This Problem Statement will be the single
focus of discussions. The problem statement needs to be specific enough to help participants focus on
the objectives of the session, but it must be open enough to allow innovative thinking and it should not
be biased so it favours a particular solution or excludes creative ideas.
Brainstorming is most effective with groups of 6-12 people and works best with a varied group. So
within a firm a brainstorming session should include participants from various departments from
across the organization and with different backgrounds (qualifications, experience etc.). Even when the
brainstorm is supposed to be focused on a specific or even specialist area, outsiders can bring fresh
ideas that can inspire the experts.
B. Quantitative Forecasting Methods
Quantitative forecasting method is a method to predict the future on the basis of the past patterns or
relationships. Quantitative Methods use mathematical models based on historical demand or
relationships between variables. These methods are used when the situation is stable and the historical
data exist.
1. Trend Projection Method: A firm can use its own data of past years regarding its sales in past
years. These data are known as time series of sales. A firm can predict sales of its product by
fitting trend to the time series of sales. A trend line can be fitted by graphical method or by
algebraic equations. Equations method is more appropriate.
(a). Graphical Method: A trend line can be fitted through a series graphically. Old values of sales for
different areas are plotted on a graph and a free hand curve is drawn passing through as many points as
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possible. The direction of this free hand curve shows the trend. The main drawback of this method is
that it may show the trend but not measure it.
207.42
197.42
Forecasted 187.42
177.42
167.42 Actual
157.42 Forecasted
147.42
137.42
127.42
127.42 147.42 167.42 187.42 207.42
Actual
FIGURE 10: GRAPHICAL METHOD
(b). Least Square Method: The least square method is based on the assumption that the past rate of
change of the variable under the study will continue in the future. It is a mathematical procedure for
fitting a line to a set of observed value is minimized. This technique is used to find a trend line which
best fit the available data. This trend is then used to project dependent variable in the future.
Illustration1: The annual demands of a product are as given below:
Year 1980 1981 1982 1983 1984
Demand
(1,000) 50 65 75 52 72
By the method of least squares find the trend values for each of the five years. Also estimate the
annual demand for the year 1985.
Solution:
Deviation
of X from
Year(X) Demand (Y) 1982 (x) x2 xY Yc = a + bx
1980 50 -2 4 -100 56.6
1981 65 -1 1 -65 59.7
1982 75 0 0 0 62.8
1983 52 1 1 52 65.9
1984 72 2 4 144 69
n=5 314 0 10 31
Y= a + bx
a = ΣY/n = 314/5 = 62.80
b = ΣxY/Σx2 = 31/10 = 3.1
Trend value for 1980,
x = -2, Yc = 62.80 + 3.1(-2)
= 56.60
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x = -1, Yc = 62.80 +3.1(-1)

= 59.70
x = 0, Yc = 62.80 + 3.1 (0)
= 62.80
x = 1, Yc = 62.80 + 3.1 (1)
= 65.90
x = 2, Yc = 62.80 +3.1 (2)
= 69.00
For year 1985, the value of x would be 3
Ye = 62.80 + 3.1(3)
= 66.10
Illustration2: Find the trend value for the year 2005:
Year 1998 1999 2000 2001 2002 2003 2004
Sales(1,000) 70 72 85 83 86 91 93
Solution:
Deviation
Sales from
Year (Y) 2001(X) XY X2 Yc
1998 70 -3 -210 9 71.279
1999 72 -2 -144 4 75.136
2000 85 -1 -85 1 78.993
2001 83 0 0 0 82.851
2002 86 1 86 1 86.707
2003 91 2 182 4 90.564
2004 93 3 279 9 94.421
580 0 108 28
Y= a + bx
a = ΣY/n = 580/7 = 82.85
b = ΣxY/Σx2 = 108/28 = 3.857
x = -3, Yc = 82.85 + 3.857(-3)
= 71.279
x = -1, Yc = 82.85 +3.857(-2)
= 75.136
x = 0, Yc = 82.85 + 3.857 (-1)
= 78.993
x = 1, Yc = 82.85 + 3.857 (0)
= 82.85
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x = 2, Yc = 82.85 +3.857 (1)

= 86.707
x = 2, Yc = 82.85 +3.857 (2)
= 90.564
x = 2, Yc = 82.85 +3.857 (3)
= 94.421
For year 2005, the value of x would be 4
Ye = 82.85 + 3.857(4)
= 98.278
(c). Time Series Methods: A time series is a collection of observation made sequentially through
time. Examples include-(i) Sales of a particular product in successive months, (ii) The temperature of a
particular location at noon on successive days and (iii) Electricity consumption in a particular area for
successive one hour periods.
According to W.Z. Hirsch, “A time series is the sequence of values of some variable
corresponding to successive points in time.”
Components of Time series:
Trend: A gradual increase or decrease in the average over time.
Seasonal influence: Predictable short-term cycling behaviour due to time of day, week, month,
season, year, etc.
Cyclical movement: Unpredictable long-term cycling behaviour due to business cycle or
product/service life cycle.
Randomness: Remaining variation that cannot be explained by the other four components.
(I) Simple moving Average: When demand of product is neither growing nor declining
rapidly and if it does not have seasonal characteristics then moving average can be useful in
removing the random fluctuations for forecasting. The method of moving average
eliminates randomness by taking a set of observed values, finding their average and then
using that average as a forecast for the coming period. The actual number of observations
included in the average is specified by the forecaster and remains constant. The term
moving average is used because as each new observation becomes available, a new average
can be computed and used as a forecast.
The general model of Moving Average method is as follows:
Ft + 1 = St = Xt + Xt – 1 + …. + Xt – N + 1 / N = 1/N ∑ i
Where:
Ft+1 = forecast of the series for time (t+1), St = smoothed value of the series at time t, Xi = actual value
of the series at time i, i = time period, N = number of values included in average.
Illustration1: The following series relates to the annual demand in thousand of product during
the period 1975-1990. Find the trend of sales using:
i. 3 yearly moving average
ii. 5 yearly moving average
Year Demand Year Demand
1975 16 1983 25
1976 18 1984 28
1977 15 1985 26
1978 17 1986 22
38
1979 20 1987 28
1980 22 1988 24
1981 25 1989 25
1982 24 1990 30
Solution:
3 yearly periods
Year Demand 3 yearly Moving Total 3 yearly moving average trend value
1975 16 - -
1976 18 49 49/3= 16.33
1977 15 50 50/3=16.67
1978 17 52 52/3=17.33
1979 20 59 59/3=19.66
1980 22 67 67/3=22.33
1981 25 71 71/3=23.66
1982 24 74 74/3=24.66
1983 25 67 67/3=22.33
1984 28 79 79/3=26.33
1985 26 76 76/3=25.33
1986 22 76 76/3=25.33
1987 28 74 74/3=24.66
1988 24 77 77/3=25.66
1989 25 79 79/3=26.33
1990 30 - -
5 yearly periods
Year Demand 5 yearly Moving Total 5 yearly moving average trend value
1975 16 - -
1976 18 - -
1977 15 86 86/5=17.2
1978 17 92 92/5=18.4
1979 20 99 99/5=19.8
1980 22 108 108/5=21.6
1981 25 116 116/5=23.2
1982 24 124 124/5=24.8
1983 25 128 128/5=25.6
1984 28 125 125/5=25.0
1985 26 129 129/5=25.8
1986 22 126 126/5=25.2
1987 28 125 125/5=25.0
1988 24 129 129/5=25.8
1989 25 - -
1990 30 - -
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(II) Weighted moving Average: It allows any weights to be placed on each element providing of
course the sum of all the ones will be equal to one.
Ft = W1Dt-1 + W2Dt-2 + ---------------------------------+ WnDt-n
Where Ft = Forecasted value, Wt = Weight, Dt = Demand.
Illustration1: A company may find that in a four month period in the best forecast is derived by
using a 40% weightage for the demand of the most recent months, 30% for two months ago,
20% for three months ago and 10% for four months ago.
Month 1 2 3 4
Demand 100 90 105 95
Solution:
Forecasted values Ft = 0.40 (95) + 0.30 (105) + 0.20 (90) + 0.10 (100)
= 97.50
(III) Exponential Smoothing: Exponential smoothing is distinguishable by the special way it
weights each past demand. The pattern of weights is exponential in form. Demand for the most recent
period is weighted most heavily; the weights placed on successively older periods decrease
exponentially. In other words, the weights decrease in magnitude the future back in time the data are
weighted; the decrease is non-linear (exponential).
(a). Single Exponential Smoothing: A strong argument can be made that since the most recent
observations contain the most current information about what will happen in the future, thus they
should be given relatively more weight than the older observations. Exponential smoothing satisfies
this requirement and eliminates the need for storing the historical values of the variable likewise in the
moving average method.
The general model of single exponential smoothing forecast is as follows.
Ft = αDt-1 + (1-α) Ft-1
Where Ft is the forecast demand for next period, Dt-1 is the actual demand for period t-1, Ft-1 is the
forecasted demand during period t-1 and α is the parameter of the exponential smoothing.
Illustration1: The demand for disposable plastic tube for September, October was 300 units and
350 units. Last year’s average monthly demand was 200 units. Using 200 units as the September
forecast and a smoothing coefficient of 0.7 to weight recent demand most heavily, find the
forecast for the month of November.
Solution: October would have been:
Ft = αDt-1 + (1-α) Ft-1
= 0.7(300) + (1-0.7)200
=210 + 60
=270
The forecast for November
Ft = αDt-1 + (1-α) Ft-1
= 0.7(350) + (1-0.7)270
= 245 +81
= 326
(b). Double Exponential Smoothing: If a single exponential smoothing is used with a data series that
contains a consistent trend, the forecast will trail behind (lag) that trend. In this case, the Double
Exponential smoothing performs well in handling a consistent trend in data series.
The general model of the Double Exponential Smoothing is as follows:
40
St = αXt + (1 – α)(St – 1 + Tt – 1)
Tt = β(St – St – 1) + ( 1 – β)Tt – 1
Ft + m = St + Ttm
Where:
St = smoothed value of the series at time t, Tt = smoothed value of trend at time t, Ft+m = forecast value
of the series for time (t+m), Xt = actual value of the series at time t, α = smoothing parameter of series,
β = smoothing parameter of trend, m = number of time periods in the future being forecast.
(c) Triple Exponential Smoothing: This is the most versatile method in exponential smoothing
method since it is able to model randomness, trend and seasonality. This method is similar to the
Double Exponential smoothing, yet includes additional parameter to deal with seasonality.
St = α(Xt/ It – L) + (1 – α)(St – 1 + Tt – 1)
Tt = β(St – St – 1) + (1 – β)Tt – 1
It = γ(Xt/St) + (1 – γ)It – L
Ft + m = (St + Ttm)It – L + m
Where:
St = smoothed value of deseasonalized series at time t, Tt = smoothed value of trend at time t, It =
smoothed value of seasonal index at time t, Ft+m = forecast value of the series for time (t+m), Xt =
actual value of the series at time t, α = smoothing parameter of series, β = smoothing parameter of
trend, γ = smoothing parameter of seasonal index, m = number of time periods in the future being
forecast, L = length of seasonality (e.g., number of months of quarters in a year).
2. Regression Method: Under this method a relationship is established between quantities
demanded (dependent variable) and independent variables such as income, price of the good,
prices of the related goods etc. Once the relationship is established, regression equation
assuming relationship to be linear is derived.
Y= na + bX
Illustration1: Find the regression equation from the data given below:
Demand Income Demand Income
(Y) (X) (Y) (X)
44 41 68 94
60 65 84 110
32 50 34 30
51 57 55 79
80 96 48 65
Solution:
Demand Income
(Y) (X) XY X2 Y2
44 41 1804 1681 1936
60 65 3900 4225 1600
32 50 1950 2500 1521
51 57 2907 3249 2601
80 96 7680 9216 6400
68 94 6392 8836 4624
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84 110 9240 12100 7056

34 30 1020 900 1156
55 79 4345 6241 3025
48 65 3120 4225 2304
563 687 42358 53173 34223
Y=na +bX
563= 10a + 687b………………….(1)
ΣXY = aΣX + bΣX2
42358 = 687a + 53173b………….(2)
Solving these equations we get
a= 14.00, b=0.616
Y = a +bXi
Y = 14.00 + 0.616 Xi (Regression equation)
3. Econometric Method: The basic premise of econometric modeling is that everything in the
real world depends on everything else while the major purpose of this model is to test and
evaluate alternative policies and determine their influence on critical values.
Econometric model is a model, which involves linear multiple regression equations, each
includes several interdependent variables. Structural equations are used to predict and explain
the values of two or more dependent variable as function of several other variables.
4. Barometric Method: Many economists used economic indicators as a barometer to forecast
trends in business activities. The basic approach of barometric technique is to construct an
index of relevant economic indicators and to forecast future trends on the basis of movements
in the index of economic indicators.
(a). Leading Indicators: The leading series consists of indicators which move up or down
ahead of some other series e.g. new order for durable goods.
(b). Coincident Indicators: Coincident series on the other hand are the once that move up or
down simultaneously with the level of economic activities e.g. number of employees,
unemployment, gross national product.
(c). Lagging Indicators: Lagging series consists of those indicators which follow a change
after some time lag e.g. Outstanding loans, lending rates for short term loans.
Forecast Accuracy
The forecasting accuracy of each forecasting technique is measured by the root mean squared error
(RMSE), mean absolute deviation (MAD), mean squared error (MSE), mean absolute error (MAE),
and mean absolute percentage error (MAPE).
These measures are frequently considered to evaluate the forecasting accuracy by measuring the
difference between the estimated value from the forecasting model and the actual value observed.
The forecast error is the difference between the actual value and the forecast value for the
corresponding period (t)
Residual error (et) = Yt – Ŷt
Where Yt = Actual value, Ŷt = Forecast value
Error measure has an important role in calibrating a refining forecasting model / method. As the main
aim in forecasting is to increase the accuracy of the forecasts, error measures are very important from a
forecaster‘s point of view. There are varieties of error measures that are used in practice. Some of them
are listed below:
42
n
1. Mean Absolute Deviation (MAD) = 1  |Yt – Ŷ t|
n t 1
n
1
2. Mean squared Error (MSE) =  (Yt – Ŷt ) 2
n t 1
n
3. Mean Percentage error (MPE) = 1 (Yt – Ŷt ) / Yt x 100%
n t 1
n
1
4. Mean Absolute Percentage error =  |Yt – Ŷt| / Yt x 100%
n t 1
(MAPE)
1 n
5. Root Mean Squared Error = [  (Yt – Ŷt ) 2] ½
n t 1
2.10 Criteria of a Good Forecasting Method:

There are thus, a good many ways to make a guess about future sales. They show contrast in cost,
flexibility and the adequate skills and sophistication. Therefore, there is a problem of choosing the best
method for a particular demand situation.
There are certain economic criteria of broader applicability. They are:
(i) Accuracy, (ii) Plausibility, (iii) Durability, (iv) Flexibility, (v) Availability, (vi) Economy, (vii)
Simplicity and (viii) Consistency.
(i) Accuracy:
The forecast obtained must be accurate. How is an accurate forecast possible? To obtain an accurate
forecast, it is essential to check the accuracy of past forecasts against present performance and of
present forecasts against future performance. Accuracy cannot be tested by precise measurement but
buy judgment.
(ii) Plausibility:
The executive should have good understanding of the technique chosen and they should have
confidence in the techniques used. Understanding is also needed for a proper interpretation of results.
Plausibility requirements can often improve the accuracy of results.
(iii) Durability:
Unfortunately, a demand function fitted to past experience may back cost very greatly and still fall
apart in a short time as a forecaster. The durability of the forecasting power of a demand function
depends partly on the reasonableness and simplicity of functions fitted, but primarily on the stability of
the understanding relationships measured in the past. Of course, the importance of durability
determines the allowable cost of the forecast.
(iv) Flexibility:
Flexibility can be viewed as an alternative to generality. A long lasting function could be set up in
terms of basic natural forces and human motives. Even though fundamental, it would nevertheless be
hard to measure and thus not very useful. A set of variables whose co-efficient could be adjusted from
time to time to meet changing conditions in more practical way to maintain intact the routine
procedure of forecasting.
(v) Availability:
Immediate availability of data is a vital requirement and the search for reasonable approximations to
relevance in late data is a constant strain on the forecaster’s patience. The techniques employed should
be able to produce meaningful results quickly. Delay in result will adversely affect the managerial
decisions.
43
SAURABH GUPTA
(vi) Economical:
Cost is a primary consideration which should be weighed against the importance of the forecasts to the
business operations. A question may arise: How much money and managerial effort should be
allocated to obtain a high level of forecasting accuracy? The criterion here is the economic
consideration.
(vii) Simplicity:
Statistical and econometric models are certainly useful but they are intolerably complex. To those
executives who have a fear of mathematics, these methods would appear to be Latin or Greek. The
procedure should, therefore, be simple and easy so that the management may appreciate and
understand why it has been adopted by the forecaster.
(viii) Consistency:
The forecaster has to deal with various components which are independent. If he does not make an
adjustment in one component to bring it in line with a forecast of another, he would achieve a whole
which would appear consistent.
Questions
Q1. Explain various types of demands? Distinguish between (a) extension and increase demand (b)
contraction and decrease demand
Q2. Show the breakup of price effect into income effect and substitution effect, of a price of an inferior
commodity and a Giffen goods?
Q3. What do you mean by price elasticity, income elasticity and cross elasticity of demand? Explain
the factors affecting elasticity of demand.
Q4. Explain the law of demand. Why does demand curve slope downwards from left to right.
Q5. Define elasticity of demand. What are the different types of price elasticity of demand?
Q6. What are the objectives of demand forecasting? Explain steps involved to forecasting.
Q7. Explain the various qualitative methods of demand forecasting.
Q8. What is demand forecasting? Explain the techniques of demand forecasting.
44
CHAPTER 3
The Essentials of Supply
3.1 The Principle of Supply
Friends after knowing the meaning and purpose of demand and law of demand, elasticity of demand, I
think you should know what supply is. Producers are going to produce on the basis of demand only.
Goods are needed to be supplied to meet the demand for the product.
3.1.1 Difference between Stock & Supply
Like the term 'demand', the term 'supply' is also often misused in the ordinary language. Supply of a
commodity is often confused with the 'stock' of that commodity available with the producers. Stock 'of
a commodity, more or less, will equal the total quantity produce during a period less the quantity
already sold out. But we know that the producers do not offer whole of their stocks for sale in the
market. A part of industrial produces is kept back in godown and is offered for sale in the market when
it can fetch better prices. In other words, the amount offered for sale may be less (or at the most in rare
circumstances equal to) than the stocks of the commodity. The term 'supply' shows a relationship
between quantity and price. By supply we mean various quantities of a commodity which producers
will offer for sale at a particular time at various corresponding prices. In simple words, supply (like
demand) refers to the quantity of commodity offered for sale at some price during a given period of
time.
3.1.2 Factors on Which Supply of a Commodity Depends
It is also known as the determinants of supply. The Important determinants of supply can be grouped
together in a supply function as follows:
SN=f (PN,PR, F, T,G )
Supply function describes the functional relationship between supply of a commodity (say N) and
other determinants of supp1y, i.e., price of the commodity (P N), price of a related commodity (PR),
prices of the factors of production (F), technical know-how" (T) and goals or general objectives of the
Producer. Each of the factors influences supply in a different' way. To isolate the effect of other factors
we take these other factors as constant while considering the relationship between supply and one of
the above variables. For example, if we want to study the relationship between price and supply of
commodity, N, we shall assume other factors PR, F, T and G to remain constant or unchanged. We
study below these relationships.
Price of the Commodity: This is expressed as SN ft PN, i. e. other things being equal, supply of
commodity N depends upon the price of commodity N. This sort of relationship is studied in what has'
come to be popularly known as the Law of Supply'. It implies that if the price of a commodity goes up,
its supply shall expand and vice versa.
Prices of Related Goods: This is expressed as SN = f (P R), i. e., other things being equal, supply of
commodity N depends upon the prices of the related goods. If the price of a substitute goes up,
producers would, be tempted to divert their available resources to the production of that substitute.
Prices of Factors of Production: This is expressed as SN f(F), i, e, other things being equal, supply of
a commodity depends upon the prices of factors of production. A rise in the price of one factor of
production, will cause a consequent increase in the cost of producing those commodities which use a
great deal of that factor and only a small increase in the costs of producing those commodities that use
a small amount of the factor.
State of Technology: This is expressed as SN=f (T), i.e., the supply of a commodity depends upon the
45
SAURABH GUPTA
state of technology. Over the time the technical know-how changes. Goals of firms, expressed as SN, i.
e., other things being equal the supply of a commodity depends upon the, goals of firms producing that
commodity. Ordinarily; every firm tries to attain maximum profits.
Natural Factors: The supply of the agricultural' goods to a great extent depends upon the natural
conditions. Adequate rain, fertility of land irrigation facilities, favorable climatic conditions etc., help
in raising the supply of agricultural produce. Contrary to that, heavy rains, floods, drought conditions,
etc., adversely affect the agricultural production.
Means of Transportation and Communication: Proper development of means of transportation and
communication helps in maintaining adequate supply of the commodities. In case of short Supply,
goods can be rushed from the, surplus areas to the deficient areas. But if the developed means of
transportation are used to export goods, it will create scarcity of goods .In the domestic market.
Taxation Policy: Imposition of heavy taxes on a commodity discourages its production, and as a remit
its supply diminishes. On the other, hand, tax concessions of various kinds induce producers to raise
the supply.
Future Expectations of Rise in Prices: If the producers expect, an increase in the price in the near
future, then they will curtail the current supply, so as to offer more goods in future at higher prices.
3.1.3 Law of Supply

It’s different from law of demand. Law of supply explains the relationship between price of a
commodity and its quantity supplied. Price and supply are directly related. A rise in price induces
producers to supply more quantity or the commodity and a fall Prices, makes them reduce the supply.
The higher is the price of the commodity the larger is the profit that can be earned, and, thus the
greater is the incentive to the producer to produce more of the commodity and offer It in the Market.
Likewise at lower prices, profit margin shrinks and hence producers reduce the sale.
Supply Schedule and Supply Curve: Law of supply can be illustrated with the help of a, schedule
and supply curve. A supply schedule is a tabular statement that gives a full account of supply of any
given commodity in a given market at a given time. It states what the volume of goods offered for sale
would be at each of a series of prices. Supply schedule is of two types:
• Individual Supply schedule,
• Market supply schedule.
Individual Supply Schedule: It states the quantities of a commodity a producer would offer for sale at
various prices. Suppose M/s. A.B.C. Ltd. is willing to sell 10,000 units of their product per week at
price of Rs- 4 each. If the price goes up to Rs. 5 each, they may be willing to sell 12,000 units, and at
Rs. 6 each, 15,000 units. With the increase in price, the quantity supplied increases and vice versa. A
market supply schedule furnishes exactly the same information.
A Market Supply Schedule: It is a given commodity is the sum of individual supply for all those firms
which are engaged in the production of a given commodity during a given period. The market supply
curve can be obtained by aggregating the individual supply curves of the commodity. The market
supply curve also shows the same relationship between the price and the quantity supplied the quantity
supplied increases proportionately with the increase in the/price.
Activity
Qs=20p-100
So that at the price Rs. 10/ per unit quantity supplied equals 20 x 10 - 100=100 at the price Rs 9 per
unit 80 units will be supplied; Similarly different quantities corresponding to different prices can be
calculated.
Shift in Supply: Movement along the same supply curve represents contraction or expansion in supply
46
as a result of a change in the price of a commodity. A shift in supply curve occurs when the producers
are wi1ling to offer more or less of a commodity because of reasons other than the price of the
commodity. For example, an innovation or the discovery of a cheap raw material may result in
increased supplies of a given commodity. Increase in the supply of plastic footwear in recent years is
glaring illustration. This change in supply which occurs because of a change in any of the determinants
of supply, other than the price, is known as increase or decrease in supply. Increase in demand also
increases the price the quantity sold and purchased also increases. Fall in demand brings down the
equilibrium price and the quantity sold and purchased also declines.
Increase in Supply: Shift in the supply curve to the right (increase in supply) brings down the
equilibrium price; the amount sold and purchased increases.
Activity:
Mathematically, the effect of the shift in demand can be presented as follows: Suppose, the original
demand equation is Qd =110-l0 p and, the original supply equation is Q=10p-l00.
The equilibrium price and the equilibrium quantity will be 7 and 40 respectively.
Suppose, the new demand equation, exhibiting an increases in demand is
Qd=140 - 10p and the supply equation remains unchanged. The new equilibrium will be determined as
fol1ows:
140 - 10p=20p-100
Or
30p = 240.
p=8
Substituting p=8 to either the demand or supply equation we get the equilibrium quantity as 60.
Mathematically, this effect can be shown as follows: Suppose the supply equation changes to Qs=20p –
40 and the demand equation remains unchanged Qd=110 - 10p
Shift in the supply curve to left (fall in supply) increases the equilibrium price. The quantity sold and
purchased diminishes.
Simultaneous change in the Demand and the Supply: So far we have been discussing the effect of
change either in demand or in supply on the equilibrium price and the quantity sold and purchased. It
is also possible that demand and supply may change simultaneously. We may discuss the change in
both the demand and the supply as follows:
• If the increase or decrease in the demand and the supply is pf equal magnitude, then the price at old
and new equilibrium will remain equal.
• If the increase in the demand is of greater magnitude than in supply, then the new equilibrium price
will be higher than the old equilibrium price, and vice versa.
• If the supply increases in greater proportion than the demand, the new equilibrium price will be lower
than the old equilibrium price.
It may be observed in all the conditions that the price mechanism brings demand and supply in
equilibrium.
The new equilibrium price will be
110-10p=20p-40
Or 30p= 150
Or p=5
Substituting p=5 in either of the equations we get the equilibrium quantity as 60, i.e. increase in supply
leads to a fall in price, but the quantity demanded and supplied increase.
3.1.4 Elasticity of Supply

Like demand, quantity supplied of different commodities responds in different proportions to the price
47
SAURABH GUPTA
changes. For example, if the price of wheat rises the farmers may be tempted to sell more in the
market, and keep less for them. On the other hand, if the price of cars rises, the car manufacturers may
not probably be in a position to offer more cars for sale, because they may not be keeping stocks of
cars. Similarly, supply of cloth may increase in response to the increase in prices and so on. Elasticity
of supply of a commodity measures changes in the quantity supplied as a result of a change in the price
of commodity. Elasticity of supply is measured as a percentage change in amount supplied divided by
the percentage change in price of the commodity. In short,
Es= Percentage change in quantity supplied.
Percentage change in price
Es= (Δq / q) X (p / Δp) OR (Δq/Δp) X (p/q)
Where p and q are the original price and quantity supplied respectively, and Δp and Δq the change in
price and quantity supplied. This method of measurement of the elasticity of supply can be illustrated
as follows:
Suppose, a producer is willing to supply 100 quintals of wheat at the price of Rs. 110 per quintal if the
price increases to Rs. 120 per quintal, he is willing to supply 25 quintals of wheat. Calculate the
elasticity of supply of wheat. Elasticity of supply of wheat will be calculated as fol1ows:
Es= (Δq/Δp) x (p/q) = (25/10) x (110/100) = 2.75
Es=2.75 will mean that if the price of wheat goes up by one per cent supply of wheat will increase by
2.75 per cent. The value of elasticity coefficient varies between zero and infinity. The various results
are tabulated below:
Elasticity of Supply
Elasticity Terminology Description
Perfectly
1. Es=Zero inelastic Quantity supplied does not change.
2. Es<l Less elastic or Quantity supplied changes by a smaller percentage
than unit inelastic change than price.
Quantity supplied changes in the same proportion as
3. Es=l Unit elastic price.
More than unit
4. Es>l elastic
5. Es Perfectly elastic
TABLE 2: ELASTICITY OF SUPPLY
Factors Influencing Elasticity of Supply: Elasticity of supply depends upon a number of factors,
some of which are as follows:
Nature of the Commodity: The first and foremost determinant of the elasticity of supply is the nature
of the commodity. Commodities on the basis of their nature can be classified as (i) Perishable (ii)
Durable. Perishable products cannot be stored, and hence their supply does not respond in an effective
manner to the change in their price. Hence, their supply is inelastic in nature. Durable products, on the
other hand, can be stored; hence, their supply is generally elastic, i.e., 'supply responds to the change in
prices.
Time: Supply of a commodity, in the ultimate analysis, depends upon its production. Production
always involves a time-lag which may. vary from a few days 10 a few years, Moreover, increased
production of a commodity may contemplate a change in the very size (If the plant, which in turn may
be a long, time-consuming process. Hence, supply of a commodity may be less elastic in the short run,
as time progresses supply may become more elastic.
Techniques of Production: Simple techniques of production are, by and large, less expensive in
nature, if demand conditions so require, the production and the supply of such commodities as involve
48
simple: techniques of production could be easily increased.

In other words, supply of such like commodities is generally elastic in nature, on the other hand, if the
technique of production of a commodity is cumbers me, complex and time-consuming in nature it may
not be possible to change the supply in response to varying price-demand conditions. Supply of such
commodities would generally be Jess elastic,
Estimates of Future Prices: Future expectations of price changes may also include supply of a
commodity. If the producers expect the prices to, rise in future they may hold on to the stocks or the
commodities.
3.2 Aggregate Supply

When an entrepreneur gives employment to certain amount of labor, it requires certain quantities of
cooper ant factors like land, capital, raw material, etc. which will be paid remuneration along with
labor. Thus each level of employment involves certain money costs of production including normal
profits which/ the entrepreneur must cover. "At any given level of employment of labor aggregate
supply price' is the total amount of money which all the entrepreneurs in the economy, taken together,
must expect to receive from the sale of the output produced by that given number of men, if it is to be
just worth employing them.” If brief, the aggregate supply price refers to the proceeds necessary from
the sale of output at a particular level of employment. Thus each level of employment in the economy
is related to a particular aggregate supply price and there are different aggregate supply prices for
different levels of employment.
A statement showing the various aggregate supply prices at different levels of employment is called
the aggregate supply price schedule or aggregate supply function. In the words of Prof. Dillard, "The
aggregate supply function is a schedule of the minimum amounts of proceeds required to induce
varying quantities of employment;”
The Table below shows the aggregate supply schedule.
Aggregate Supply Schedule

Level of Employment (N) (in lakh) Aggregate Demand Price (Z) (Rs. crore)
20 215
25 230
30 245
35 260
40 275
40 290
40 305
TABLE 3: SUPPLY SCHEDULE
The above table reveals that the aggregate supply price rises with the increase in the level of
employment. If the entrepreneurs are to provide employment to 20 lakh workers, they must receive Rs
215 crore from the sale of the output produced by them. It is only when they expect to receive the
minimum amounts of proceeds (Rs. 230 crore, Rs 245 crore and Rs. 260 crore) that they will provide-
employment to more workers (25 lakh, 30 lakh and 35 lakh respectively). But when the economy
reaches the level of full employment (at 40 lakh workers) the aggregate supply price (Rs. 275,290 and
305 crore) continues to increase but there is no further increase in employment. According to Keynes,
the aggregate 'supply' function is an increasing function of the level of employment and is expressed.
As Z = φN, where Z is aggregate supply price of the output from employing new men.
The aggregate supply curve can be drawn on the basis of the schedule. It slopes upward from left to
right because as the necessary expected proceeds increase, the level of employment also rises. But
when the economy reaches the level of full employment, the aggregate supply curve becomes vertical.
Even with the increase in the aggregate; supply price, it is not possible to provide more employment as
the, economy has attained the level of full employment.
49
SAURABH GUPTA
3.3 Determination of Effective Demand:

We have studied the two determinants of effective demand separately and now are in a position to
analyze the process of determining the level of employment in the economy. The level of employment
is determined at the point where the aggregate demand price equals the aggregate supply price; In
other words, it is the point where what die entrepreneurs expect to receive equals what they must
receive and their profits are maximized. This point is called the effective demand and here the
entrepreneurs earn normal profits so long as the aggregate demand price is higher than the aggregate
supply price, the prospects of getting additional profits are greater when more workers are provided
employment. The proceeds expected (revenue) rise more than the proceeds necessary (costs). This
process will continue till the aggregate demand price equals the aggregate supply price and the point of
effective demand are reached. This point determines the level of employment and output in the
economy. The point of effective demand is, however, not necessarily one of full employment but of
underemployment equilibrium. If the entrepreneurs try to provide more employment after this point,
the aggregate supply, price exceed the aggregate demand price indicating that the total costs are higher
than the total, revenue and there are losses. So the entrepreneurs will not employ workers beyond the
point of effective demand till the aggregate demand price rises to meet the aggregate supply price at
the, new equilibrium point which may be one of full employment. If the aggregate demand price is
raised still further, it will lead to inflation for no increase in employment and output is possible beyond
the level of full employment.
The following table below explains the determination of the point of effective demand. It shows that so
long as the aggregate demand price is higher than the aggregate supply price, it is profitable for the
entrepreneurs to employ more workers, when the entrepreneurs expect to receive, Rs 230 crore, Rs 240
crore and Rs. 250 crore than the proceeds necessary amounting to Rs 215 crore, Rs 23P crore and Rs
245 crore, they will provide increasing employment to 20 lakh, 25 lakh and 30 lakh workers
respectively: But when the proceeds necessary and proceeds expected equal Rs. 260 crore the level of
employment, rises to 35 lakhs. This is the point of effective demand. If we assume the level of full
employment to be 40 lakh workers in the economy, it will necessitate the drawing up of a new
aggregate demand price schedule as shown in Table III last column.
As a result, the new point of effective demand is 40 lakh workers because both the aggregate demand
price and the aggregate supply price equal Rs. 275 crore. Beyond this point there is no change in the
level of employment which is steady at 40 lakh workers.
Schedule of Aggregate Demand and Aggregate Supply Prices

Level of Employment (N) (in Aggregate Supply Price (Z) (Rs. Aggregate Demand Price
lakhs) crore) (D) (Rs. crore)
20 215 230 235
25 230 240 245
30 245 250 255
35 260 260 265
40 275 270 275
40 290 280 285
40 305 290 295
TABLE 4: SCHEDULE OF AGGREGATE DEMAND & SUPPLY
The above Figure illustrates the where AD is the aggregate demand function and AS the aggregate
supply function. The horizontal axis measures the level of employment in the economy and the vertical
axis the proceeds expected (revenue) and the proceeds necessary (costs). The two curves AD and AS
intersect each other at point E. This is effective demand where ON workers are employed. At this point
the entrepreneur’s expectations of profits are maximized. At any point other than this, the
50
entrepreneurs will either incur losses or earn subnormal profits. At ON level of employment the
proceeds expected (revenue) are more than the proceeds necessary (costs), i.e., RN'> CN'. This
indicates that is profitable for the entrepreneurs to provide increasing employment to workers till ON
level is reached where the proceeds expected and necessary equal at point E. It would not be; however,
profitable for the entrepreneurs to increase employment beyond this to Nf level because the proceeds
necessary (costs) exceed the proceeds expected (revenue), i.e., CfNf > R1Nf and they incur losses. Thus
E, the point of effective demand determines the actual level or employment in the economy which is of
underemployment equilibrium.
Of the two, determinants of effective demand, Keynes regard the aggregate supply function to be given
because, it depends on the technical conditions of production, the availability of raw materials,
machines etc. which do not change in the short run. It is therefore the aggregate demand function
which plays a vital role in determining the level. of employment in the economy. According to
Keynes, the aggregate demand function depends on the consumption function and investment function.
The cause of unemployment may be a fall in either consumption expenditure or investment
expenditure, or both. The level of employment can be raised by increasing either consumption
expenditure or investment expenditure, or both. Thus, it is the aggregate demand function which is the
"effective” element in the principle of effective demand. Prof. Dillard regards this Employment as the
core of the principle of effective demand.
3.4 Importance of Effective Demand:

The principle of effective demand is the most important contribution of Keynes. It is the soul of the
Keynesian theory of employment. Dr Klein attributes the Keynesian revolution solely to the
development of a theory of effective demand.
3.5 Determinant of Employment:

Effective demand determines the level of employment in the economy. When effective demand
increases, employment also increases, and a decline in effective demand decreases the level of
employment Thus unemployment is caused by a deficiency of effective demand. Effective demand
represents the total expenditure on the total output produced at an equilibrium level of employment. It
indicates the value, of total output which equals national income. National income equals national
expenditure. National expenditure consists of expenditure on consumption goods and investment
goods. Thus the main determinants of effective demand and the level of employment arc consumption
and investment. In brief,
Effective Demand=Value of National Output=Volume of Employment=National

income=National Expenditure=Expenditure on consumption goods + Expenditure on investment
goods.
In the Keynesian analysis of effective demand consumption and investment expenditures relate +0 to
the private sector because Keynes considers government expenditure as autonomous. But the post-
Keynesian economists include government expenditure as a component of effective demand. Thus,
effective demand (D) = Private consumption expenditure (C) + Private investment (l) + Government
expenditure (C) on both. We may conclude that the importance of the principle of effective demand
lies in pointing out the cause and remedy of unemployment. Unemployment is caused by a deficiency
of effective demand and it can be removed by an increase in consumption expenditure or/and
investment expenditure and in case the private expenditures and insufficient and ineffective in bringing
about the required level of employment, the same can be achieved by government expenditure. Thus
the principle of effective demand is the basis of the theory of employment.
Repudiation of Say's Law and Full employment Thesis: The principle of effective demand
repudiates Say's Law of Market that supply creates its own demand and that full employment
equilibrium is a normal situation in the economy. This principle points out that underemployment
equilibrium is a normal situation and full employment equilibrium is accidental. In a capitalist
economy supply fails to create its own demand because the whole of the earned income is not spent on
51
SAURABH GUPTA
the consumption of goods and services.

Moreover the decisions to save and invest are made by different people. As a result the existence of
full employment is not a possibility and the point of effective demand at any time represents
underemployment equilibrium. The Pigovian view that full employment can be achieved by a
reduction in money wage-cut is also repudiated by this principle. A money wage-cut will bring about a
reduction in expenditure on goods and services leading to a fall ineffective demand and hence in the
level of employment. Thus the importance of this principle lies in repudiating Say's Law and the
classical thesis of full employment equilibrium.
3.6 Role of Investment:

The principle of effective demand highlights the significant role of investment in determining the level
of employment in the economy. The two determinants of effective demand are the consumption and
investment expenditures.
When income increases consumption expenditure also increases but by less than the increase in
income. Thus there arises a gap-between incofl1e and consumption which leads to decline in the
volume of employ men. This gap can be bridged by an increase find either consumption expenditure or
investment expenditure in order, to achieve full employment level of effective demand in the,
economy. Since the propensity to consume is stable during the, short run, it is not possible to raise the
consumption expenditure.
Therefore, the level of effective demand and, hence of employment can be, raise by, increase in
investment. In this lies the importance of investment.
The Paradox of Poverty in the Midst of Potential Plenty:

The importance of effective demand lies in explaining the paradox of poverty in the midst of potential
plenty in the modern capitalism effective demand is mainly determined by the aggregate demand
function which is composed of consumption expenditure and investment expenditure. A fundamental
principle is that when income increases consumption also increases but less than proportionately (i.e.,
the marginal propensity to consume is less than one). This creates a gap between income and
consumption which must be filled up by the required investment expenditure. If the appropriate
investment is not forthcoming to fill this gap, it leads to a deficiency of effective demand resulting in
unemployment. It follows that in a poor community, the gap between income and consumption is
small because the marginal propensity to consume is high. It will, therefore, have little difficulty in
employing all its resources by filling the gap through small investment, expenditure.
On the contrary, in a wealthy community the gap between income and consumption is very large
because the marginal propensity to consume is low. It will, therefore, require large investment
expenditure to fill the gap between income and consumption in order to maintain a high level of
income and employment. But in a rich community investment demand is not adequate to fill this gap
and there emerges a deficiency of aggregate demand resulting in widespread unemployment. When the
aggregate demand falls the potential wealthy community will be forced to reduce its actual Output
until it becomes so poor that the excess of output over consumption-will be reduced to the actual
amount of investment. Further, in such a community there is an accumulated stock of capital assets
which weakens the inducement to invest because every new investment competes with an already
existing large supply of old capital assets. This inadequacy of investment demand reacts in a
cumulative manner on the demand for consumption and will, in turn, lead to a further fall in
employment, output and income. Thus as Keynes said, "The richer the community, the more obvious
and outrageous the defects of the economic system that lead to unemployment on a mass scale in the
midst of potential plenty because of the deficiency of effective demand."
3.7 Price Ceilings

At various times, and under a variety of circumstances, state and federal governments have found it
necessary to “interfere” in the market. This interference has sometimes involved measures that short-
circuit the price rationing function of markets. Government officials accomplish this by prohibiting
52
price increases to eliminate shortages when they arise. A ban on price increases above a certain level is
called a price ceiling. The rationale underlying the imposition of a price ceiling typically revolves
around the issue of “fairness.” Sometimes such interference is justified, but more often than not price
ceilings result in unintended negative consequences.
The imposition of a price ceiling means shortages will not be automatically eliminated by increases in
price. With price ceilings, the price-rationing mechanism is not permitted to operate. Some other
mechanism for allocating available supplies of consumer goods is required. When shortages were
created by the imposition of price ceilings during World War II, the federal government instituted a
program of ration coupons to distribute available supplies of consumer goods. Ration coupons are
coupons or tickets that entitle the holder to purchase a given amount of a particular good or service
during a given time period. During World War II, families were issued ration coupons monthly to
purchase limited quantities of gasoline, meat, butter, and so on.
3.8 Price Floors

The counterpart to price ceilings is the price floor. Whereas price ceilings are designed to keep prices
from rising above some legal maximum, price floors are designed to keep prices from falling below
some legal minimum. Perhaps the most notable examples of prices floors are agricultural price
supports and minimum wages.
Definition: A price floor is a legally imposed minimum price that may be charged for a good or
service.
Problem: Consider the following demand and supply equations for the product of a perfectly
competitive industry:
a. Determine the market equilibrium price and quantity algebraically.
QD = 25-3P
QS = 10 + 2P
b. Suppose that government regulatory authorities imposed a “price floor” on this product of P =
$4. What would be the quantity supplied and quantity demanded of this product? How would
you characterize the situation in this market?
Solution
a. Equilibrium in this market occurs when, at some price, quantity supplied equals quantity
demanded. Algebraically, this condition is given as QD = QS. Substituting into the equilibrium
condition we get
25 - 3P = 10 + 2P
P*= 15/5 = 3
The equilibrium quantity is determined by substituting the equilibrium price into either the demand or
the supply equation.
QD* = 25 - 3(3) = 25 - 9 = 16
QS * = 10 + 2(3) = 10 + 6 = 16
b. At a mandated price of P = $4, the quantity demanded and quantity supplied can be determined
by substituting this price into the demand and supply equations and solving:
QD = 25 - 3(4) = 25 - 12 = 13
QS = 10 + 2(4) = 10 + 8 = 18
Since QS > QD, these equations describe a situation of excess supply (surplus) of 5 units of output.
QUESTIONS
Q1. State the difference between stock and supply.
Q2. State the supply function and also describe the factors influencing supply.
Q3. What is elasticity of supply? Describe the different types of elasticity of supply.
Q4. What are the factors influencing the elasticity of supply.
Q5. Write short notes on:
a. Price ceiling
b. Price floor
c. Aggregate supply
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CHAPTER 4
PRODUCTION CONCEPT AND ANALYSIS
4.0 Production
Production is concerned with the way in which resources or inputs such as land, labor, and machinery
are employed to produce a firm’s product or output. Production may be either services or goods. To
produce the goods we use inputs. Basically inputs are divided into two types: those are fixed inputs
and variable inputs. Fixed inputs are the inputs that remain constant in short-term. Variable inputs are
inputs, which are variable in both short-term and long-term.
4.1 Production Function

Production function expresses the relationship between inputs and outputs. Production function is an
equation, a table, a graph, which express the relationship between inputs and outputs. Production
function explains that the maximum output of goods or services that can be produced by a firm in a
specific time with a given amount of inputs or factors of production.
Production Function: Q = f (K, L)
We are producing Q quantities of goods by employing K capital and L labor.
Here
Q Represents quantity of goods
K Represents Capital employed
L Represents Labor employed
4.1.1 Definition:
“Production Function” is that function which defines the maximum amount of output that can be
produced with a given set of inputs.
– Michael R Baye
“Production Function” is the technical relationship, which reveals the maximum amount of output
capable of being produced by each and every set of inputs, under the given technology of a firm.
- Samuelson
From the above definitions, it can be concluded that the production functions is more concerned with
physical aspects of production, which is an engineering relation that expresses the maximum amount
of output that can be produced with a given set of inputs.
Production function enables production manager to understand how better he can make use of
technology to its greatest potential.
The production function is purely a relationship between the quantity of output obtained or given out
by a production process and the quantities of different inputs used in the process. Production function
can take many forms such as linear function or cubic function etc.
4.2 Assumptions for Production Function:

1. Technology is assumed to be constant.
2. It is related to a particular or specific period.
3. It is assumed that the manufacturer is using the best technology.
4. All inputs are divisible.
5. Utilization for inputs at maximum level of efficiency.
4.3 Significance / Importance of Production Function:

1. Production function shows the maximum output that can be produced by a specific set of
combination of input factors.
2. There are two types of production function, one is short-run production function and the other is
long-run production function. The short-run production explains how output change is relation to
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input when there are some fixed factors. Similarly, long run production function explains the
behaviors of output in relation to input when all inputs are variable.
3. The production function explains how a firm reaches the most optimum combination of factors so
that the unit costs are the lowest.
4. Production function explains how a producer combines various inputs in order to produce a given
output in an economically efficient manner.
5. The production function helps us to estimate the quantity in which the various factors of
production are combined.
4.4 Short-Term production function

Short-Term production function is a function, which we are producing goods in the short-term by
employing two inputs that are:
Capital (K): It is fixed input which is constant in the short-term.
Labor (L) : It is variable input in the short-term.
 In the short-term we are producing only one product by employing two inputs
 The two inputs are K capital and L is labor.
 In the short term we will increase L input and we will keep K as constant.
4.5 Law of Variable Proportions: Meaning, Definition, Assumption and Stages!

4.5.1 Meaning:
Law of variable proportions occupies an important place in economic theory. This law examines the
production function with one factor variable, keeping the quantities of other factors fixed. In other
words, it refers to the input-output relation when output is increased by varying the quantity of one
input.
When the quantity of one factor is varied, keeping the quantity of other factors constant, the proportion
between the variable factor and the fixed factor is altered; the ratio of employment of the variable
factor to that of the fixed factor goes on increasing as the quantity of the variable factor is increased.
Since under this law we study the effects on output of variation in factor proportions, this is also
known as the law of variable proportions. Thus law of variable proportions is the new name for the
famous ”Law of Diminishing Returns” of classical economics. This law has played a vital role in the
history of economic thought and occupies an equally important place in modern economic theory. This
law has been supported by the empirical evidence about the real world.
4.5.2 Definition:
The law of variable proportions or diminishing returns has been stated by various economists in the
following manner:
As equal increments of one input are added; the inputs of other productive services being held
constant, beyond a certain point the resulting increments of product will decrease, i.e., the marginal
products will diminish,” (G. Stigler)
“As the proportion of one factor in a combination of factors is increased, after a point, first the
marginal and then the average product of that factor will diminish.” (F. Benham)
“An increase in some inputs relative to other fixed inputs will, in a given state of technology, cause
output to increase; but after a point the extra output resulting from the same addition of extra inputs
will become less.” (Paul A. Samuelson)
Marshall discussed the law of diminishing returns in relation to agriculture. He defines the law as
follows: “An increase in the capital and labour applied in the cultivation of land causes in general a
less than proportionate increase in the amount of product raised unless it happens to coincide with an
improvement in the arts of agriculture.”
It is obvious from the above definitions of the law of variable proportions (or the law of diminishing
returns) that it refers to the behaviour of output as the quantity of one factor is increased, keeping the
quantity of other factors fixed and further it states that the marginal product and average product will
eventually decline.
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4.5.3 Assumptions of the Law:

The law of variable proportions or diminishing returns, as stated above, holds good under the
following conditions:
1. First, the state of technology is assumed to be given and unchanged. If there is improvement in the
technology, then marginal and average products may rise instead of diminishing.
2. Secondly, there must be some inputs whose quantity is kept fixed. This is one of the ways by which
we can alter the factor proportions and know its effect on output. This law does not apply in case all
factors are proportionately varied. Behaviour of output as a result of the variation in all inputs is
discussed under “returns to scale”.
3. Thirdly the law is based upon the possibility of varying the proportions in which the various factors
can be combined to produce a product. The law does not apply to those cases where the factors must
be used in fixed proportions to yield a product.
When the various factors are required to be used in rigidly fixed proportions, then the increase in one
factor would not lead to any increase in output, that is, the marginal product of the factor will then be
zero and not diminishing. It may, however, be pointed out that products requiring fixed proportions of
factors are quiet uncommon. Thus, the law of variable proportion applies to most of the cases of
production in the real world.
The law of variable proportions is illustrated in Table and Fig. We shall first explain it by considering
Table Assume that there is a given fixed amount of land, with which more units of the variable factor
labour, is used to produce agricultural output.
Returns to Labour
Units Total Marginal Average
of Products Products Products
Labour (Quintals) (Quintals) (Quintals)
L Q ΔQ/ΔL Q/L
1 80 80 80
2 170 90 85
3 270 100 90
4 368 98 92
5 430 62 86
6 480 50 80
7 504 24 72
8 504 0 63
9 495 -9 55
10 480 -15 48
TABLE 5: RETURNS TO LABOUR
With a given fixed quantity of land, as a farmer raises employment of labour from one unit to 7 units,
the total product increases from 80 quintals to 504 quintals of wheat. Beyond the employment of 8
units of labour, total product diminishes. It is worth noting that up to the use of 3 units of labour, total
product increases at an increasing rate.
This fact is clearly revealed from column 3 which shows successive marginal products of labour as
extra units of labour are used. Marginal product of labour, it may be recalled, is the increment in total
output due to the use of an extra unit of labour.
It will be seen from Col. 3 of Table, that the marginal product of labour initially rises and beyond the
use of three units of labour, it starts diminishing. Thus when 3 units of labour are employed, marginal
product of labour is 100 and with the use of 4th and 5th units of labour marginal product of labour falls
to 98 and 62 respectively.
Beyond the use of eight units of labour, total product diminishes and therefore marginal product of
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labour becomes negative. As regards average product of labour, it raises upto the use of fourth unit of
labour and beyond that it is falling throughout.
Three Stages of the Law of Variable Proportions:
The behavior of output when the varying quantity of one factor is combined with a fixed quantity of
the other can be divided into three distinct stages. In order to understand these three stages it is better
to graphically illustrate the production function with one factor variable.
This has been done in Fig. In this figure, on the X-axis the quantity of the variable factor is measured
and on the F-axis the total product, average product and marginal product are measured. How the total
product, average product and marginal product a variable factor change as a result of the increase in its
quantity, that is, by increasing the quantity of one factor to a fixed quantity of the others will be seen
from Fig 10.
FIGURE 11: LAW OF VARIABLE PROPORTIONS

In the top Danel of this figure, the total product curve TP of variable factor goes on increasing to a
point and alter that it starts declining. In the bottom pane- average and marginal product curves of
labour also rise and then decline; marginal product curve starts declining earlier than the average
product curve.
The behavior of these total, average and marginal products of the variable factor as a result of the
increase in its amount is generally divided into three stages which are explained below:
Stage 1:
In this stage, total product curve TP increases at an increasing rate up to a point. In Fig. from the origin
to the point F, slope of the total product curve TP is increasing, that is, up to the point F, the total
product increases at an increasing rate (the total product curve TP is concave upward upto the point F),
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which means that the marginal product MP of the variable factor is rising.
From the point F onwards during the stage 1, the total product curve goes on rising but its slope is
declining which means that from point F onwards the total product increases at a diminishing rate
(total product curve TP is concave down-ward), i.e., marginal product falls but is positive.
The point F where the total product stops increasing at an increasing rate and starts increasing at the
diminishing rate is called the point of inflection. Vertically corresponding to this point of inflection
marginal product is maximum, after which it starts diminishing.
Thus, marginal product of the variable factor starts diminishing beyond OL amount of the variable
factor. That is, law of diminishing returns starts operating in stage 1 from point D on the MP curve or
from OL amount of the variable factor used.
This first stage ends where the average product curve AP reaches its highest point, that is, point S on
AP curve or CW amount of the variable factor used. During stage 1, when marginal product of the
variable factor is falling it still exceeds its average product and so continues to cause the average
product curve to rise.
Thus, during stage 1, whereas marginal product curve of a variable factor rises in a part and then falls,
the average product curve rises throughout. In the first stage, the quantity of the fixed factor is too
much relative to the quantity of the variable factor so that if some of the fixed factor is withdrawn, the
total product will increase. Thus, in the first stage marginal product of the fixed factor is negative.
Stage 2:
In stage 2, the total product continues to increase at a diminishing rate until it reaches its maximum
point H where the second stage ends. In this stage both the marginal product and the average product
of the variable factor are diminishing but remain positive.
At the end of the second stage, that is, at point M marginal product of the variable factor is zero
(corresponding to the highest point H of the total product curve TP). Stage 2 is very crucial and
important because as will be explained below the firm will seek to produce in its range.
Stage 3: Stage of Negative Returns:
In stage 3 with the increase in the variable factor the total product declines and therefore the total
product curve TP slopes downward. As a result, marginal product of the variable factor is negative and
the marginal product curve MP goes below the X-axis. In this stage the variable factor is too much
relative to the fixed factor. This stage is called the stage of negative returns, since the marginal product
of the variable factor is negative during this stage.
It may be noted that stage 1 and stage 3 are completely symmetrical. In stage 1 the fixed factor is too
much relative to the variable factor. Therefore, in stage 1, marginal product of the fixed factor is
negative. On the other hand, in stage 3 the variable factor is too much relative to the fixed factor.
Therefore, in stage 3, the marginal product of the variable factor is negative.
The Stage of Operation:
Now, an important question is in which stage a rational producer will seek to produce. A rational
producer will never choose to produce in stage 3 where marginal product of the variable factor is
negative. Marginal product of the variable factor being negative in stage 3, a producer can always
increase his output by reducing the amount of the variable factor.
It is thus clear that a rational producer will never be producing in stage 3. Even if the variable factor is
free, the rational producer will stop at the end of the second stage where the marginal product of the
variable factor is zero.
At the end point M of the second stage where the marginal product of the variable factor is zero, the
producer will be maximizing the total product and will thus be making maximum use of the variable
factor. A rational producer will also not choose to produce in stage 1 where the marginal product of the
fixed factor is negative.
A producer producing in stage 1 means that he will not be making the best use of the fixed factor and
further that he will not be utilising fully the opportunities of increasing production by increasing
quantity of the variable factor whose average product continues to rise throughout the stage 1. Thus, a
rational entrepreneur will not stop in stage 1 but will expand further.
Even if the fixed factor is free (i.e., costs nothing), the rational entrepreneur will stop only at the end of
stage 1 (i.e., at point N) where the average product of the variable factor is maximum. At the end point
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N of stage 1, the producer they will be making maximum use of the fixed factor.
It is thus clear from above that the rational producer will never be found producing in stage 1 and stage
3. Stage 1 and 3 may, therefore, be called stages of economic absurdity or economic non-sense. The
stages 1 and 3 represent non-economic regions in production function.
A rational producer will always seek to produce in stage 2 where both the marginal product and
average product of the variable factor are diminishing. At which particular point in this stage, the
producer will decide to produce depends upon the prices of factors. The stage 2 represents the range of
rational production decisions.
We have seen above how output varies as the factor proportions are altered at any given moment. We
have also noticed that this input-output relation can be divided into three stages. Now, the question
arises as to what causes increasing marginal returns to the variable factor in the beginning, diminishing
marginal returns later and negative marginal returns to the variable factor ultimately.
4.5.4 Causes of Initial Increasing marginal Returns to a Factor:

In the beginning, the quantity of the fixed factor is abundant relative to the quantity of the variable
factor. Therefore, when more and more units of a variable factor are added to the constant quantity of
the fixed factor, the fixed factor is more intensively and effectively utilized.
This causes the production to increase at a rapid rate. When, in the beginning the variable factor is
relatively smaller in quantity, some amount of the fixed factor may remain unutilized and therefore
when the variable factor is increased fuller utilization of the fixed factor becomes possible with the
result that increasing returns are obtained.
The question arises as to why the fixed factor is not initially taken in an appropriate quantity which
suits the available quantity of the variable factor. Answer to this question is provided by the fact that
generally those factors are taken as fixed which are indivisible. Indivisibility of a factor means that due
to technological requirements a minimum amount of that factor must be employed whatever the level
of output.
Thus, as more units of variable factor are employed to work with an indivisible fixed factor, output
greatly increases in the beginning due to fuller and more effective utilization of the latter. Thus, we see
that it is the indivisibility of some factors which causes increasing returns to the variable factor in the
beginning.
The second reason why we get increasing returns to the variable factor in the initial stage is that as
more units of the variable factor are employed the efficiency of the variable factor itself increases. This
is because when there is a sufficient quantity of the variable factor, it becomes possible to introduce
specialization or division of labour which results in higher productivity. The greater the quantity of the
variable factor, the greater the scope of specialization and hence the greater will be the level of its
productivity or efficiency.
4.5.5 Causes of Diminishing marginal Returns to a Factor:

The stage of diminishing marginal returns in the production function with one factor variable is the
most important. The question arises as to why we get diminishing marginal returns after a certain
amount of the variable factor has been added to a fixed quantity of the other factor.
As explained above, increasing returns to a variable factor occur initially primarily because of the
more effective and fuller use of the fixed factor becomes possible as more units of the variable factor
are employed to work with it.
Once the point is reached at which the amount of the variable factor is sufficient to ensure the efficient
utilization of the fixed factor, then further increases in the variable factor will cause marginal and
average products of a variable factor to decline because the fixed factor then becomes inadequate
relative to the quantity of the variable factor.
In other words, the contributions to the production made by the variable factor after a point become
less and less because the additional units of the variable factor have less and less of the fixed factor to
work with. The production is the result of the co-operation of various factors aiding each other. Now,
how much aid one factor provides to the others depends upon how much there is of it.
Eventually, the fixed factor is abundant relative to the number of the variable factor and the former
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provides much aid to the later. Eventually, the fixed factor becomes more and more scarce in relation
to the variable factor so that as the units of the variable factor are increased they receive less and less
aid from the fixed factor. As a result, the marginal and average products of the variable factor decline
ultimately.
The phenomenon of diminishing marginal returns, like that of increasing marginal returns, rests upon
the indivisibility of the fixed factor. As explained above, the important reason for increasing returns to
a factor in the beginning is the fact that the fixed factor is indivisible which has to be employed
whether the output to be produced is small or large.
When the indivisible fixed factor is not being fully used, successive increases in a variable factor add
more to output since fuller and more efficient use is made of the indivisible fixed factor. But there is
generally a limit to the range of employment of the variable factor over which its marginal and average
products will increase.
There will usually be a level of employment of the Variable factor at which indivisible fixed factor is
being as fully and efficiently used as possible. It will happen when the variable factor has increased to
such an amount that the fixed indivisible factor is being used in the “best or optimum proportion” with
the variable factor.
Once the optimum proportion is disturbed by further increases in the variable factor, returns to a
variable factor (i.e., marginal product and average product) will diminish primarily because the
indivisible factor is being used too intensively, or in other words, the fixed factor is being used in non-
optimal proportion with the variable factor.
Just as the marginal product of the variable factor increases in the first stage when better and fuller use
of the fixed indivisible factor is being made, so the marginal product of the variable factor diminishes
when the fixed indivisible factor is being worked too hard.
If the fixed factor was perfectly divisible, neither the increasing nor the diminishing returns to a
variable factor would have occurred. If the factors were perfectly divisible, then there would not have
been the necessity of taking a large quantity of the fixed factor in the beginning to combine with the
varying quantities of the other factor.
In the presence of perfect divisibility, the optimum proportion between the factors could have always
been achieved. Perfect divisibility of the factors implies that a small firm with a small machine and one
worker would be as efficient as a large firm with a large machine and many workers.
The productivity of the factors would be the same in the two cases. Thus, we see that if the factors
were perfectly divisible, then the question of varying factor proportions would not have arisen and
hence the phenomena of increasing and diminishing marginal returns to a variable factor would not
have occurred. Prof. Bober rightly remarks: “Let divisibility enter through the door, law of variable
proportions rushes out through the window.”
Joan Robinson goes deeper into the causes of diminishing returns. She holds that the diminishing
marginal returns occur because the factors of production are imperfect substitutes for one another. As
seen above, diminishing returns occur during the second stage since the fixed factor is now inadequate
relatively to the variable factor. Now, a factor which is scarce in supply is taken as fixed.
When there is a scarce factor, quantity of that factor cannot be increased in accordance with the
varying quantities of the other factors, which, after the optimum proportion of factors is achieved,
results in diminishing returns.
If now some factors were available which perfect substitute of the scarce fixed factor was, then the
paucity of the scarce fixed factor during the second stage would have been made up by the increase in
supply of its perfect substitute with the result that output could be expanded without diminishing
returns.
Thus, even if one of the variable factors which we add to the fixed factor were perfect substitute of the
fixed factor, then when, in the second stage, the fixed factor becomes relatively deficient; its
deficiency would have been made up the increase in the variable factor which is its perfect substitute.
Thus, Joan Robinson says, “What the Law of Diminishing Returns really states is that there is a limit
to the extent to which one factor of production can be substituted for another, or, in other words, that
the elasticity of substitution between factor is not infinite.
If this were not true, it would be possible, when one factor of production is fixed in amount and the
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rest are in perfectly elastic supply, to produce part of the output with the aid of the fixed factor, and
then, when the optimum proportion between this and other factors was attained, to substitute some
other factor for it and to increase output at constant cost.” We, therefore, see that diminishing returns
operate because the elasticity of substitution between factors is not infinite.
4.5.6 Explanation of Negative Marginal Returns to a Factor:

As the amount of a variable factor continues to be increased to a fixed quantity of the other factor, a
stage is reached when the total product declines and the marginal product of the variable factor
becomes negative.
This phenomenon of negative marginal returns to the variable factor in stage 3 is due to the fact that
the number of the variable factor becomes too excessive relative to the fixed factor so that they
obstruct each other with the result that the total output falls instead of rising.
Besides, too large a number of the variable factor also impairs the efficiency of the fixed factor. The
proverb “too many cooks spoil the broth” aptly applies to this situation. In such a situation, a reduction
in the units of the variable factor will increase the total output.
4.6 The Laws of Returns to Scale: Production Function with two Variable Inputs!
The laws of returns to scale can also be explained in terms of the isoquant approach. The laws of
returns to scale refer to the effects of a change in the scale of factors (inputs) upon output in the long
run when the combinations of factors are changed in the same proportion.
If by increasing two factors, say labour and capital, in the same proportion, output increases in exactly
the same proportion, there are constant returns to scale. If in order to secure equal increases in output,
both factors are increased in larger proportionate units, there are decreasing returns to scale. If in order
to get equal increases in output, both factors are increased in smaller proportionate units, there are
increasing returns to scale.
The returns to scale can be shown diagrammatically on an expansion path “by the distance between
successive ‘multiple-level-of-output” isoquants, that is, isoquants that show levels of output which are
multiples of some base level of output, e.g., 100, 200, 300, etc.”
4.6.1 Increasing Returns to Scale:

Figure 12 shows the case of increasing returns to scale where to get equal increases in output, lesser
proportionate increases in both factors, labour and capital, are required.
FIGURE 12: INCREASING RETURNS TO SCALE
It follows that in the figure:

100 units of output require 3C + 3L
So that along the expansion path OR, OA > AB > BC. In this case, the production function is
homogeneous of degree greater than one. The increasing returns to scale are attributed to the existence
of indivisibilities in machines, management, labour, finance, etc. Some items of equipment or some
activities have a minimum size and cannot be divided into smaller units. When a business unit
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expands, the returns to scale increase because the indivisible factors are employed to their full
capacity.
Increasing returns to scale also result from specialization and division of labour. When the scale of the
firm expands there is wide scope for specialization and division of labour. Work can be divided into
small tasks and workers can be concentrated to narrower range of processes. For this, specialized
equipment can be installed.
Thus with specialization efficiency increases and increasing returns to scale follow:
Further, as the firm expands, it enjoys internal economies of production. It may be able to install better
machines, sell its products more easily, borrow money cheaply, procure the services of more efficient
manager and workers, etc. All these economies help in increasing the returns to scale more than
proportionately.
Not only this, a firm also enjoys increasing returns to scale due to external economies. When the
industry itself expands to meet the increased long-run demand for its product, external economies
appear which are shared by all the firms in the industry. When a large number of firms are
concentrated at one place, skilled labour, credit and transport facilities are easily available.
Subsidiary industries crop up to help the main industry. Trade journals, research and training centers
appear which help in increasing the productive efficiency of the firms. Thus these external economies
are also the cause of increasing returns to scale.
4.6.2 Decreasing Returns to Scale:

Figure 13 shows the case of decreasing returns where to get equal increases in output, larger
proportionate increases in both labour and capital are required.
FIGURE 13: DECREASING RETURNS TO SCALE

It follows that:
So that along the expansion path OR, OG < GH < HK.
In this case, the production function is homogeneous of degree less than one. Returns to scale may
start diminishing due to the following factors. Indivisible factors may become inefficient and less
productive. Business may become unwieldy and produce problems of supervision and coordination.
Large management creates difficulties of control and rigidities. To these internal diseconomies are
added external diseconomies of scale. These arise from higher factor prices or from diminishing
productivities of the factors. As the industry continues to expand the demand for skilled labour, land,
capital, etc. rises.
There being perfect competition, intensive bidding raises wages, rent and interest. Prices of raw
materials also go up. Transport and marketing difficulties emerge. All these factors tend to raise costs
and the expansion of the firms leads to diminishing returns to scale so that doubling the scale would
not lead to doubling the output.
4.6.3 Constant Returns to Scale:

Figure 14 shows the case of constant returns to scale. Where the distance between the isoquants 100,
200 and 300 along the expansion path OR is the same, i.e., OD = DE = EF. It means that if units of
both factors, labour and capital, are doubled, the output is doubled. To treble the output, units of both
factors are trebled.
FIGURE 14: CONSTANT RETURNS TO SCALE

It follows that:
100 units of output require
1 (2C + 2L) = 2C + 2L
2 (2C + 2L) = 4C + 4L
3 (2C + 2L) = 6C + 6L
The returns to scale are constant when internal economies enjoyed by a firm are neutralized by internal
diseconomies so that output increases in the same proportion. Another reason is the balancing of
external economies and external diseconomies.
Constant returns to scale also result when factors of production are perfectly divisible, substitutable,
homogeneous and their supplies are perfectly elastic at given prices. That is why, in the case of
constant returns to scale, the production function is homogeneous of degree one.
Alternative Method:
We have explained above the three laws of returns to scale separately on the assumption that there are
three processes and each process shows the same returns over all ranges of output. “However, the
technological conditions of production may be such that returns to scale may vary over different
ranges of output. Over some range, we may have constant returns to scale, while over another range
we may have increasing or decreasing returns to scale.”
To explain it we draw an expansion path OR from the origin in Fig. 15 This are divided into segments
by the successive isoquants representing equal increments in output, i.e., 100, 200, 300 and so on. As
we move along the expansion path, the distance between the successive isoquants diminishes; it is a
case of increasing returns to scale.
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FIGURE 15: ISOQUANTS

This stage is shown in the figure from К to M. The distance between KL and Z.M becomes smaller
LM<KL. The firm, therefore, requires smaller increases in the quantities of labour and capital to
produce equal increments of output.
If the segments between two isoquants are of equal length, there are constant returns to scale. If labour
and capital are doubled, the output would also be doubled. Thus, when output increases from 300 to
400 and to 500 units, the isoquants representing these output levels mark off equal distances along the
scale line, up to point P, i.e., MN = NP.
If these are decreasing returns to scale, the distance between a pair of isoquants would become longer
on the expansion path. ST is longer than PS. It shows that to increase output larger increases in
quantities of labour and capital are required. Thus, on the same expansion path from К to M, there are
increasing returns to scale, from M to P, there are constant returns to scale and from P to T, and there
are diminishing returns to scale.
4.7 Iso-Quant Curve: Definitions, Assumptions and Properties!

The term Iso-quant or Iso-product is composed of two words, Iso = equal, quant = quantity or product
= output.
Thus it means equal quantity or equal product. Different factors are needed to produce a good. These
factors may be substituted for one another.
A given quantity of output may be produced with different combinations of factors. Iso-quant curves
are also known as Equal-product or Iso-product or Production Indifference curves. Since it is an
extension of Indifference curve analysis from the theory of consumption to the theory of production.
Thus, an Iso-product or Iso-quant curve is that curve which shows the different combinations of two
factors yielding the same total product. Like, indifference curves, Iso- quant curves also slope
downward from left to right. The slope of an Iso-quant curve expresses the marginal rate of technical
substitution (MRTS).
Definitions:
“The Iso-product curves show the different combinations of two resources with which a firm can
produce equal amount of product.” Bilas
“Iso-product curve shows the different input combinations that will produce a given output.”
Samuelson
“An Iso-quant curve may be defined as a curve showing the possible combinations of two variable
factors that can be used to produce the same total product.” Peterson
“An Iso-quant is a curve showing all possible combinations of inputs physically capable of producing
a given level of output.” Ferguson
Assumptions:
The main assumptions of Iso-quant curves are as follows:
1. Two Factors of Production:
Only two factors are used to produce a commodity.
2. Divisible Factor:
Factors of production can be divided into small parts.

3. Constant Technique:
Technique of production is constant or is known before hand.
4. Possibility of Technical Substitution:
The substitution between the two factors is technically possible. That is, production function is of
‘variable proportion’ type rather than fixed proportion.
5. Efficient Combinations:
Under the given technique, factors of production can be used with maximum efficiency.
4.7.1 Iso-Product Schedule:

Let us suppose that there are two factor inputs—labour and capital. An Iso-product schedule shows the
different combination of these two inputs that yield the same level of output as shown in table 1.
Iso-Product Schedule
Units of Units of Output of

Combination Labour Capital Cloth (metres)
A 1 15 200
B 2 11 200
C 3 8 200
D 4 6 200
E 5 5 200
TABLE 6: ISO-PRODUCT SCHEDULE
The table 6 shows that the five combinations of labour units and units of capital yield the same level of
output, i.e., 200 metres of cloth. Thus, 200 metres cloth can be produced by combining.
(a) 1 units of labour and 15 units of capital
(b) 2 units of labour and 11 units of capital
(c) 3 units of labour and 8 units of capital
(d) 4 units of labour and 6 units of capital
(e) 5 units of labour and 5 units of capital
4.7.2 Iso-Product Curve:

From the above schedule iso-product curve can be drawn with the help of a diagram. An. equal
product curve represents all those combinations of two inputs which are capable of producing the same
level of output. The Fig. 16 shows the various combinations of labour and capital which give the same
amount of output. A, B, C, D and E.
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FIGURE 16: ISO-PRODUCT CURVE

Iso-Product Map or Equal Product Map:
An Iso-product map shows a set of iso-product curves. They are just like contour lines which show the
different levels of output. A higher iso-product curve represents a higher level of output. In Fig. 17 we
have family iso-product curves, each representing a particular level of output.
The iso-product map looks like the indifference of consumer behaviour analysis. Each indifference
curve represents particular level of satisfaction which cannot be quantified. A higher indifference
curve represents a higher level of satisfaction but we cannot say by how much the satisfaction is more
or less. Satisfaction or utility cannot be measured.
FIGURE 17: ISO-PRODUCT MAP

An iso-product curve, on the other hand, represents a particular level of output. The level of output
being a physical magnitude is measurable. We can therefore know the distance between two equal
product curves. While indifference curves are labeled as IC1, IC2, IC3, etc., the iso-product curves are
labeled by the units of output they represent -100 metres, 200 metres, 300 metres of cloth and so on.
4.7.2.1 Properties of Iso-Product Curves:

The properties of Iso-product curves are summarized below:
1. Iso-Product Curves Slope Downward from Left to Right:

They slope downward because MTRS of labour for capital diminishes. When we increase labour, we
have to decrease capital to produce a given level of output.
The downward sloping iso-product curve can be explained with the help of the following figure:
FIGURE 18: ISO-PRODUCT CURVE

The Fig. 18 shows that when the amount of labour is increased from OL to OL1, the amount of capital
has to be decreased from OK to OK1, The iso-product curve (IQ) is falling as shown in the figure.
The possibilities of horizontal, vertical, upward sloping curves can be ruled out with the help of the
following figure 19:
FIGURE 19: HORIZONTAL, VERTICAL, UPWARD SLOPING CURVES

(i) The figure (A) shows that the amounts of both the factors of production are increased- labour from
L to L1 and capital from K to K1. When the amounts of both factors increase, the output must increase.
Hence the IQ curve cannot slope upward from left to right.
(ii) The figure (B) shows that the amount of labour is kept constant while the amount of capital is
increased. The amount of capital is increased from K to K1. Then the output must increase. So IQ
curve cannot be a vertical straight line.
(iii) The figure (C) shows a horizontal curve. If it is horizontal the quantity of labour increases,
although the quantity of capital remains constant. When the amount of capital is increased, the level of
output must increase. Thus, an IQ curve cannot be a horizontal line.
2. Isoquants are Convex to the Origin:

Like indifference curves, isoquants are convex to the origin. In order to understand this fact, we have
to understand the concept of diminishing marginal rate of technical substitution (MRTS), because
convexity of an isoquant implies that the MRTS diminishes along the isoquant. The marginal rate of
technical substitution between L and K is defined as the quantity of K which can be given up in
exchange for an additional unit of L. It can also be defined as the slope of an isoquant.
It can be expressed as:
MRTSLK = – ∆K/∆L = dK/ dL
Where ∆K is the change in capital and AL is the change in labour.
Equation (1) states that for an increase in the use of labour, fewer units of capital will be used. In other
words, a declining MRTS refers to the falling marginal product of labour in relation to capital. To put
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it differently, as more units of labour are used, and as certain units of capital are given up, the marginal
productivity of labour in relation to capital will decline.
FIGURE 20: ISO-QUANT CURVE

This fact can be explained in Fig. 20. As we move from point A to B, from B to C and from C to D
along an isoquant, the marginal rate of technical substitution (MRTS) of capital for labour diminishes.
Every time labour units are increasing by an equal amount (AL) but the corresponding decreases in the
units of capital (AK) decreases.
Thus it may be observed that due to falling MRTS, the isoquant is always convex to the origin.
3. Two Iso-Product Curves Never Cut Each Other:

As two indifference curves cannot cut each other, two iso-product curves cannot cut each other. In Fig.
21, two Iso-product curves intersect each other. Both curves IQ1 and IQ2 represent two levels of
output. But they intersect each other at point A. Then combination A = B and combination A= C.
Therefore B must be equal to C. This is absurd. B and C lie on two different iso-product curves.
Therefore two curves which represent two levels of output cannot intersect each other.
FIGURE 21: TWO ISO-PRODUCTS CURVE

4. Higher Iso-Product Curves Represent Higher Level of Output:
A higher iso-product curve represents a higher level of output as shown in the figure 7 given below:
FIGURE 22: HIGHER ISO-PRODUCT CURVE

In the Fig. 22, units of labour have been taken on OX axis while on OY, units of capital. IQ1
represents an output level of 100 units whereas IQ2 represents 200 units of output.
5. Isoquants Need Not is parallel to Each Other:
It so happens because the rate of substitution in different isoquant schedules need not be necessarily
equal. Usually they are found different and, therefore, isoquants may not be parallel as shown in Fig.
23. We may note that the isoquants Iq1 and Iq2 are parallel but the isoquants Iq3 and Iq4 are not
parallel to each other.
FIGURE 23: PARALLEL ISO-QUANT CURVE

6. No Isoquant can Touch Either Axis:
If an isoquant touches X-axis, it would mean that the product is being produced with the help of labour
alone without using capital at all. These logical absurdities for OL units of labour alone are unable to
produce anything. Similarly, OC units of capital alone cannot produce anything without the use of
labour. Therefore as seen in figure 24, IQ and IQ1cannot be isoquants.
FIGURE 24: NO TWO ISO-QUANT CURVE TOUCHES EITHER AXIS

7. Each Isoquant is Oval-Shaped.
It means that at some point it begins to recede from each axis. This shape is a consequence of the fact
that if a producer uses more of capital or more of labour or more of both than is necessary, the total
product will eventually decline. The firm will produce only in those segments of the isoquants which
are convex to the origin and lie between the ridge lines. This is the economic region of production. In
Figure 25, oval shaped isoquants are shown.
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FIGURE 25: OVAL SHAPED ISO-QUANT CURVE
Curves OA and OB are the ridge lines and in between them only feasible units of capital and labour
can be employed to produce 100, 200, 300 and 400 units of the product. For example, OT units of
labour and ST units of the capital can produce 100 units of the product, but the same output can be
obtained by using the same quantity of labour T and less quantity of capital VT.
Thus only an unwise entrepreneur will produce in the dotted region of the iso-quant 100. The dotted
segments of an isoquant are the waste- bearing segments. They form the uneconomic regions of
production. In the up dotted portion, more capital and in the lower dotted portion more labour than
necessary is employed. Hence GH, JK, LM, and NP segments of the elliptical curves are the isoquants.
4.7.3 Difference between Indifference Curve and Iso-Quant Curve:

The main points of difference between indifference curve and Iso-quant curve are explained below:
1. Iso-quant curve expresses the quantity of output. Each curve refers to given quantity of output while
an indifference curve to the quantity of satisfaction. It simply tells that the combinations on a given
indifference curve yield more satisfaction than the combination on a lower indifference curve of
production.
2. Iso-quant curve represents the combinations of the factors whereas indifference curve represents the
combinations of the goods.
3. Iso-quant curve gives information regarding the economic and uneconomic region of production.
Indifference curve provides no information regarding the economic and uneconomic region of
consumption.
4. Slope of an iso-quant curve is influenced by the technical possibility of substitution between factors
of production. It depends on marginal rate of technical substitution (MRTS) whereas slope of an
indifference curve depends on marginal rate of substitution (MRS) between two commodities
consumed by the consumer.
QUESTIONS
Q1. Explain law of returns to factor and law of return to scale.
Q2. Explain law of variable proportions.
Q3. What is Producer’s equilibrium? How optimum factor combination can be achieved.
Q4. What is Production Analysis? Explain the law of production.
Q5. What are ISO-Quants? Describe the characteristic of ISO-Quants, compare ISO-Quant with the
properties of indifference curve.
CHAPTER 5
COST CONCEPT AND ANALYSIS
5.0 Cost and Output Relationship

Cost and revenue are the two major factors that a profit maximizing firm needs to monitor
continuously. It is the level of cost relative to revenue that determines the firm’s overall profitability.
In order to maximize profits, a firm tries to increase its revenue and lower its cost. While the market
factors determine the level of revenue to a great extent, the cost can be brought down either by
producing the optimum level of output using the least cost combination of inputs, or increasing factor
productivities, or by improving the organizational efficiency.
The firm’s output level is determined by its cost. The producer has to pay for factors of production for
their services. The expenses incurred on these factors of production are known as the cost of
production, or in short cost. Product prices are determined by the interaction of the forces of demand
and supply.
The basic factor underlying the ability and willingness of firms to supply a product in the market is the
cost of production. Thus, cost of production provides the floor to pricing. It is the cost that forms the
basis for many managerial decisions like which price to quote, whether to accept a particular order or
not, whether to abandon or add a product to the existing product line, whether or not to increase the
volume of output, whether to use idle capacity or rent out the facilities, whether to make or buy a
product, etc. However, it is essential to underline here that all costs are not relevant for every decision
under consideration.
The purpose of this topic is to explore cost and its relevance to decision-making. We begin by
developing the important cost concepts, an understanding of which can aid managers in making correct
decisions. We shall examine the difference between economic and accounting concepts of costs and
profits. We shall then consider the concepts of short-run and long-run costs and show that they, in
conjunction with the concepts of production studies in the preceding unit, can give us a more complete
understanding of the applications of cost theory to decision-making.
5.1 Various Types of Costs

There are different types of costs that a firm may consider relevant for decision-making under varying
situations. The manner in which costs are classified or defined is largely dependent on the purpose for
which the cost data are being outlined.
Explicit and Implicit Costs: The opportunity cost (or cost of the foregone alternative) of a resource is
a definition cost in the most basic form. While this particular definition of cost is the preferred baseline
for economists in describing cost, not all costs in decision making situations are completely obvious;
one of the skills of a good manager is the ability to uncover hidden costs for dissimilar purposes.
Traditionally, the accountants have been primarily connected with collection of historical cost data for
use in reporting a firm’s financial behavior and position and in calculating its taxes. They report or
record what was happened, present information that will protect the interests of various shareholders in
the firm, and provide standards against which performance can be judged. All these have only indirect
relationship to decision-making. Business economists, on the other hand, have been primarily
concerned with using cost data in decisions making. These purposes call for different types of cost data
and classification.
Direct and Indirect Costs: There are some costs which can be directly attributed to production of a
given product. The use of raw material, labor input, and machine time involved in the production of
each unit can usually be determined. On the other hand, there are certain costs like stationery and other
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office and administrative expenses, electricity charges, depreciation of plant and buildings, and other
such expenses that cannot easily and accurately be separated and attributed to individual units of
production, except on arbitrary basis. When referring to the separable costs of first category
accountants call them the direct, or prime costs per unit. The joint costs of the second category are
referred to as indirect or overhead costs by the accountants. Direct and indirect costs are not exactly
synonymous to what economists refer to as variable costs and fixed costs.
Private Costs versus Social Costs: Private costs are those that accrue directly to the individuals or
firms engaged in relevant activity. External costs, on the other hand, are passed on to persons not
involved in the activity in any direct way (i.e., they are passed on to society at large). While the private
cost to the firm of dumping is zero, it is definitely positive to the society. It affects adversely the
people located down current who are adversely affected and incur higher costs in terms of treating the
water for their use, or having to travel a great deal to fetch potable water. If these external costs were
included in the production costs of the producing firm a true picture of real or social costs of the output
would be obtained. Ignoring external costs may lead to an inefficient and undesirable allocation of
resources in society.
Relevant Costs and Irrelevant Costs: The relevant costs for decision-making purposes are those
costs which are incurred as a result of the decision under consideration and which are relevant for the
business purpose. The relevant costs are also referred to as the incremental costs. There are three main
categories of relevant or incremental costs. These are the present-period explicit costs, the opportunity
costs implicitly involved in the decision, and the future cost implications that flow from the decision.
For example, direct labor and material costs, and changes in the variable overhead costs are the natural
consequences of a decision to increase the output level. Many decisions will have implications for
future costs, both explicit and implicit. If a firm expects to incur some costs in future as a consequence
of the present analysis, such future costs should be included in the present value terms if known for
certain.
Accounting costs and economic costs: For a long time, there has been a considerable disagreement
among economists and accountants on how costs should be treated. The reason for the difference of
opinion is that the two groups want to use the cost data for dissimilar purposes. Accountants always
have been concerned with firms’ financial statements. Accountants tend to take a retrospective look at
firms finances because they keep trace of assets and liabilities and evaluate past performance. The
accounting costs are useful for managing taxation needs as well as to calculate profit or loss of the
firm. On the other hand, economists take forward-looking view of the firm. They are concerned with
what cost is expected to be in the future and how the firm might be able to rearrange its resources to
lower its costs and improve its profitability. They must therefore be concerned with opportunity cost.
Since the only cost that matters for business decisions are the future costs, it is the economic costs that
are used for decision-making. Accountants and economists both include explicit costs in their
calculations. For accountants, explicit costs are important because they involve direct payments made
by a firm. These explicit costs are also important for economists as well because the cost of wages and
materials represent money that could be useful elsewhere.
Actual costs and opportunity costs: Actual costs are those costs, which a firm incurs while producing
or acquiring a good or service like raw materials, labour, rent, etc. Suppose, we pay Rs. 150 per day to
a worker whom we employ for 10 days, then the cost of labour is Rs. 1500. The economists called this
cost as accounting costs because traditionally accountants have been primarily connected with
collection of historical data (that is the costs actually incurred) in reporting a firm’s financial position
and in calculating its taxes. Sometimes the actual costs are also called acquisition costs or outlay costs.
On the other hand, opportunity cost is defined as the value of a resource in its next best use. For
example, Mr. Ram is currently working with a firm and earning Rs. 5 lakhs per year. He decides to
quit his job and start his own small business.
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Controllable and Non-Controllable costs

Controllable costs are those which are capable of being controlled or regulated by executive vigilance
and, therefore, can be used for assessing executive efficiency. Non-controllable costs are those, which
cannot be subjected to administrative control and supervision. Most of the costs are controllable,
except, of course, those due to obsolescence and depreciation. The level at which such control can be
exercised, however, differs: some costs (like, capital costs) are not controllable at factory’s shop level,
but inventory costs can be controlled at the shop level.
Historical and Replacement costs: The historical cost of an asset is the actual cost incurred at the
time, the asset was originally acquired. In contrast to this, replacement cost is the cost, which will have
to be incurred if that asset is purchased now. The difference between the historical and replacement
costs results from price changes over time. Suppose a machine was acquired for Rs. 50,000 in the year
1995 and the same machine can be acquired for Rs. 1,20,000 in the year 2001. Here Rs. 50,000 is the
historical or original cost of the machine and Rs. 1,20,000 is its replacement cost. The difference of
Rs.70,000 between the two costs has resulted because of the price change of the machine during the
period. In the conventional financial accounts the value of assets is shown at their historical costs. But
for decision-making, firms should try to adjust historical costs to reflect price level changes. If the
price of the asset does not change over time, the historical cost will be the same as the replacement
cost. If the price raises the replacement cost will exceed historical cost and vice versa. During periods
of substantial price variations, historical costs are poor indicators of actual costs Historical costs and
replacement costs represent two ways of reflecting the costs of assets in the balance sheet and
establishing the costs that are used to determine net income. The assets are usually shown in the
conventional accounts at their historical costs. These must be adjusted for price changes for a correct
estimate of costs and profits. Managerial decisions must be based on replacement cost rather than
historical costs. The historical cost of an asset is known, for it is actually incurred while acquiring that
asset. Replacement cost relates to the current price of that asset and it will be known only if an enquiry
is made in the market.
Private Costs and Social Costs: A further distinction that is useful to make - especially in the public
sector - is between private and social costs. Private costs are those that accrue directly to the
individuals or firms engaged in relevant activity. Social costs, on the\ other hand, are passed on to
persons not involved in the activity in any direct way (i.e., they are passed on to society at large).
Consider the case of a manufacturer located on the bank of a river who dumps the waste into water
rather than disposing it of in some other manner. While the private cost to the firm of dumping is zero,
it is definitely harmful to the society. It affects adversely the people located down current and incur
higher costs in terms of treating the water for their use, or having to travel a great deal to fetch potable
water. If these external costs were included in the production costs of a producing firm, a true picture
of real or social costs of the output would be obtained. Ignoring external costs may lead to an
inefficient and undesirable allocation of resources in society.
Relevant Costs and Irrelevant Costs: The relevant costs for decision-making purposes are those
costs, which are incurred as a result of the decision under consideration. The relevant costs are also
referred to as the incremental costs. Costs that have been incurred already and costs that will be
incurred in the future, regardless of the present decision are irrelevant costs as far as the current
decision problem is concerned.
There are three main categories of relevant or incremental costs. These are the present-period explicit
costs, the opportunity costs implicitly involved in the decision, and the future cost implications that
flow from the decision. For example, direct labour and material costs, and changes in the variable
overhead costs are the natural consequences of a decision to increase the output level. Also, if there is
any expenditure on capital equipments incurred as a result of such a decision, it should be included in
full, notwithstanding that the equipment may have a useful life remaining after the present decision has
been carried out. Thus, the incremental costs of a decision to increase output level will include all
present-period explicit costs, which will be incurred as a consequence of this decision. It will exclude
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any present-period explicit cost that will be incurred regardless of the present decision. The
opportunity cost of a resource under use, as discussed earlier, becomes a relevant cost while arriving at
the economic profit of the firm. Many decisions will have implications for future costs, both explicit
and implicit. If a firm expects to incur some costs in future as a consequence of the present analysis,
such future costs should be included in the present value terms if known for certain.
Sunk Costs and Incremental Costs: Sunk costs are expenditures that have been made in the past or
must be paid in the future as part of contractual agreement or previous decision. For example, the
money already paid for machinery, equipment, inventory and future rental payments on a warehouse
that must be paid as part of a long term lease agreement are sunk costs. In general, sunk costs are not
relevant to economic decisions. For example, the purchase of specialized equipment designed to order
for a plant. We assume that the equipment can be used to do only what it was originally designed for
and cannot be converted for alternative use. The expenditure on this equipment is a sunk cost. Also,
because this equipment has no alternative use its opportunity cost is zero and, hence, sunk costs are not
relevant to economic decisions. Sometimes the sunk costs are also called as non-avoidable or non-
escapable costs.
On the other hand, incremental cost refers to total additional cost of implementing a managerial
decision. Change in product line, change in output level, adding or replacing a machine, changing
distribution channels etc. are examples of incremental costs. Sometimes incremental costs are also
called as avoidable or escapable costs. Moreover, since incremental costs may also be regarded as the
difference in total costs resulting from a contemplated change, they are also called differential costs.
As stated earlier sunk costs are irrelevant for decision making, as they do not vary with the changes
contemplated for future by the management.
Separable and Common Costs: Costs can also be classified on the basis of their tractability. The
costs that can be easily attributed to a product, a division, or a process are called separable costs, and
the rest are called non-separable or common costs. The separable and common costs are also referred
to as direct and indirect costs. The distinction between direct and indirect costs is of particular
significance in a multiproduct firm for setting up economic prices for different products.
Fixed and Variable Costs: Fixed costs are those costs which in total do not vary with changes in
output. Fixed costs are associated with the very existence of a firm’s rate of output is zero. Such costs
as interest on borrowed capital, rental payments, a portion of depreciation charges on equipment and
buildings, and the salaries of top management and key personnel are generally fixed costs. On the
other hand, variable costs are those costs which increase with the level of output. They include
payment for raw materials, charges on fuel and electricity, wages and salaries of temporary staff,
depreciation charges associated with wear and tear of this distinctions true only for the short-run. It is
similar to the distinction that we made in the previous unit between fixed and variable factors of
production under the short-run production analysis. The costs associated with fixed factors are called
the fixed costs and the ones associated with variable factors, the variable costs. Thus, if capital is the
fixed factor, capital rental is taken as the fixed cost and if labor is the variable factor, wage bill is
treated as the variable cost.
Short-Run and Long-Run Costs: The short run is defined as a period in which the supply of at least
one element of the inputs cannot be changed. To illustrate, certain inputs like machinery, buildings,
etc., cannot be changed by the firm whenever it so desires. It takes time to replace, add or dismantle
them. Long run, on the other hand, is defined as a period in which all inputs are changed with changes
in output. In other words, it is that time-span in which all adjustments and changes are possible to
realize. Thus, in the short run, some inputs are fixed (like installed capacity) while others are variable
(like the level of capacity utilization); but in the long run all inputs, including the size of the plant, are
variable. Short-run costs are the costs that can vary with the degree of utilization of plant and other
fixed factors. In other words, these costs relate to the variation in output, given plant capacity. Short-
run costs are, therefore, of two types: fixed costs and variable costs. In the short-run, fixed costs
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remain unchanged while variable costs fluctuate with output. Long-run costs, in contrast, are costs that
can vary with the size of plant and with other facilities normally regarded as fixed in the short-run. In
fact, in the long-run there are no fixed inputs and therefore no fixed costs, i.e. all costs are variable.
Both short-run and long-run costs are useful in decision-making. Short-run cost is relevant when a firm
has to decide whether or not to produce and if a decision is taken to produce then how much more or
less to produce with a given plant size. If the firm is considering an increase in plant size, it must
examine the long-run cost of expansion. Long-run cost analysis is useful in investment decisions.
Total Cost, Average Cost and Marginal Cost:

Total cost (TC) of a firm is the sum-total of all the explicit and implicit expenditures incurred for
producing a given level of output. It represents the money value of the total resources required for
production of goods and services. For example, a shoe-maker’s total cost will include the amount
she/he spends on leather, thread, rent for his/her workshop, interest on borrowed capital, wages and
salaries of employees, etc., and the amount she/he charges for his/her services and funds invested in
the business. Average cost (AC) is the cost per unit of output. That is, average cost equals the total cost
divided by the number of units produced (N). If TC = Rs. 500 and N = 50 then AC = Rs. 10. Marginal
cost (MC) is the extra cost of producing one additional unit. At a given level of output, one examines
the additional costs being incurred in producing one extra unit and this yields the marginal cost. For
example, if TC of producing 100 units is Rs. 10,000 and the TC of producing 101 units is Rs. 10,050,
then MC at N = 101 equals Rs.50. Marginal cost refers to the change in total cost associated with a
one-unit change in output. This cost concept is significant to short-term decisions about profit
maximizing rates of output. For example, in an automobile manufacturing plant, the marginal cost of
making one additional car per production period would be the labour, material, and energy costs
directly associated with that extra car. Marginal cost is that sub category of incremental cost in the
sense that incremental cost may include both fixed costs and marginal costs. However, when
production is not conceived in small units, management will be interested in incremental cost instead
of marginal cost. For example, if a firm produces 5000 units of TV sets, it may not be possible to
determine the change in cost involved in producing 5001 units of TV sets. This difficulty can be
resolved by taking units to significant size. For example, if the TV sets produced is measured to
hundreds of units and total cost (TC) of producing the current level of three hundred TV sets is Rs.
15,00,000 and the firm decides to increase the production to four hundred TV sets and estimates the
TC as Rs. 18,00,000, then the incremental cost of producing one hundred TV sets (above the present
production level of three hundred units) is Rs. 3,00,000. The total cost concept is useful in break-even
analysis and finding out whether a firm is making profit or not. The average cost concept is significant
for calculating the per unit profit. The marginal and incremental cost concepts are needed in deciding
whether a firm needs to expand its production or not. In fact, the relevant costs to be considered will
depend upon the situation or production problem faced by the manager.
5.2 Relationship between Production and Costs

The cost is closely related to production theory. A cost function is the relationship between a firm’s
costs and the firm’s output. While the production function specifies the technological maximum
quantity of output that can be produced from various combinations of inputs, the cost function
combines this information with input price data and gives information on various outputs and their
prices. The cost function can thus be thought of as a combination of the two pieces of information i.e.,
production function and input prices.
Now consider a short-run production function with only one variable input. The output grows at an
increasing rate in the initial stages implying increasing retunes to the variable input, and then
diminishing returns to the variable input start. Assuming that the input prices remain constant, the
above production function will yield the variable cost function which has a shape that is characteristic
of much variable cost function increasing at a decreasing rate and then increasing at an increasing rate.
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Relationship between average product and average costs, and marginal product and marginal costs for
example:
TVC = Prices of Accruing Variable Factors of Production = (Pr.V)
∴ AVC = TVC /Q = Pr. V/Q = Pr Q/V
and MC = ΔTC/ΔQ
where Pr stands for the price of the variable factor and V stands for amount of variable factor.
You may note that Pr being given, AVC is inversely related to the average product of the variable
factors. In the same way, given the wage rage, MC is inversely related to the marginal product of
labor. We shall explore this relationship in greater detail subsequently.
Marginal Costs
Marginal Cost in economics is defined as the change in total cost incurred from the production of an
additional unit. Marginal revenue is defined as the change in total revenue brought about by the sale of
an extra good. Since total cost (TC) and total revenue (TR) are both functions of the level of output
(Q), marginal cost (MC) and marginal revenue (MR) can each be expressed mathematically as
derivatives of their respective total functions. Thus,
If TC = TC(Q), then MC = dTC/dQ
And if TR = TR(Q), then MR = dTR/dQ
Example:
1. If TR = 75Q – 4Q2, then MR = dTR/dQ = 75 -8Q
2. If TC = Q2 + 7Q + 23, then MC = dTC/dQ = 2Q + 7.
Example: Given the demand function P = 30 -2Q, the marginal revenue function can be found by first
finding the total revenue function and then taking the derivative of that function with respect to Q.
Thus,
TR = P.Q = (30 – 2Q).Q = 30Q – 2Q2
MR = dTR/dQ = 30 – 4Q
Then, If Q = 4, MR = 30 – 4(4) = 14; if Q = 5, MR = 30 -4(5) = 10.
5.3 Short-Run Cost Functions

During short run some factors are fixed and others are variable. The short-run is normally defined as a
time period over which some factors of production are fixed and others are variable. Needless to
emphasize here that these periods are not defined by some specified length of time but, rather, are
determined by the variability of factors of production. Thus, what one firm may consider the long-run
may correspond to the short-run for another firm. Long run and short run costs of every firms varies.
In the short-run, a firm incurs some costs that are associated with variable factors and others that result
from fixed factors. The former are called variable costs and the latter represent fixed costs. Variable
costs (VC) change as the level of output changes and therefore can be expressed as a function of output
(Q), that is VC = f (Q). Variable costs typically include such things as raw material, labor, and utilities.
In Column 3 of Table 1, we find that the total of variable costs changes directly with output. But note
that the increases in variable costs associated with each one-unit increase in output are not constant. As
production begins, variable costs will, for a time, increase by a decreasing amount, this is true through
the fourth unit of the output. Beyond the fourth unit, however, variable costs rise by increasing amount
for each successive unit of output. The explanation of this behavior of variable costs lies in the law of
diminishing returns.
Total and Average-Cost Schedules for an Individual Firm in the Short-Rum

(Hypothetical Data in Rupees)
76
Total cost data, per week Average-cost data, per week

Marginal
cost MC =
Average CHANGE
Total cost fixed cost Average total IN TC/
Total Total Fixed Cost Total variable cost (TC) = TFC + (AFC) = Average variable cost cost ATC = CHANGE
Product (TFC) (TVC) TVC TFC/Q AVC = TVC /Q TC/Q IN Q
0 100 0 100
1 100 90 190 100 90 190 90
2 100 170 270 50 85 135 80
3 100 240 340 33.33 80 113.33 70
4 100 300 400 25 75 100 60
5 100 370 470 20 74 94 70
6 100 450 550 16.67 75 91.67 80
7 100 540 640 14.29 77.14 91.43 90
8 100 650 750 12.5 81.25 93.75 110
9 100 780 880 11.11 86.25 97.78 130
10 100 930 1030 10 86.67 103 150
93
TABLE 7: Total and Average-Cost Schedules
Total Cost: Total cost is the sum of fixed and variable cost at each level of output. It is shown in
column 4 of Table-1. At zero unit of output, total cost is equal to the firm’s fixed cost. Then for each
unit of production (through 1 to 10), total cost varies at the same rate as does variable cost.
Per Unit, or Average Costs: Besides their total costs, producers are equally concerned with their per
unit, or average costs. In particular, average cost data is more relevant for making comparisons with
product price,
Average Cost:
AC =TC/Q
Where TC =total cost;
AC = average cost
Q = quantity
Average Fixed Costs: Average fixed cost (AFC) is derived by dividing total fixed cost (TFC) by the
corresponding output (Q). That is
AFC = TFC/Q
While total fixed cost is, by definition, independent of output, AFC will decline so long as output
increases. As output increases, a given total fixed cost of Rs. 100 is obviously being spread over a
larger and larger output. This is what business executives commonly refer to as ‘spreading the
overhead’. We find in Figure-III that the AFC curve is continuously declining as the output is
increasing. The shape of this curve is of an asymptotic hyperbola.
Average Variable Costs: Average variable cost (AVC) is found by dividing total variable cost (TVC)
by the corresponding output (Q):
AVC = TVC/Q
AVC declines initially, reaches a minimum, and then increases again,
AFC + AVC = ATC
MC = Δ ATC/ ΔQ
Average Total Costs

Average total cost (ATC) can be found by dividing total cost (TC) by total output (Q) or, by adding
AFC and AVC for each level of output. That is:
ATC = TC/ Q = AFC + AVC

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SAURABH GUPTA
Marginal Cost
Marginal cost (MC) is defined as the extra, or additional, cost of producing one more unit of output.
MC can be determined for each additional unit of output simply by noting the change in total cost
which that unit’s production entails:
Change in TC ΔTC
MC = ------------------ = ---------
Change in Q ΔQ
The marginal cost concept is very crucial from the manager’s point of view. Marginal cost is a
strategic concept because it designates those costs over which the firm has the most direct control.
More specifically, MC indicates those costs which are incurred in the production of the last unit of
output and therefore, also the cost which can be “saved” by reducing total output by the last unit.
Average cost figures do not provide this information. A firm’s decisions as to what output level to
produce is largely influenced by its marginal cost. When coupled with marginal revenue, which
indicates the change in revenue from one more or one less unit of output, marginal cost allows a firm
to determine whether it is profitable to expand or contract its level of production.
Relationship of MC to AVC and ATC: It is also notable that marginal cost cuts both AVC and ATC
at their minimum when both the marginal and average variable costs are falling, average will fall at a
slower rate. And when MC and AVC are both rising, MC will rise at a faster rate. As a result, MC will
attain its minimum before the AVC. In other words, when MC is less than AVC, the AVC will fall,
and when MC exceeds AVC, AVC will rise. This means that so long as MC lies below AVC, the latter
will fall and where MC is above AVC, AVC will rise. Therefore, at the point of intersection where
MC=AVC, AVC has just ceased to fall and attained its minimum, but has not yet begun to rise.
Similarly, the marginal cost curve cuts the average total cost curve at the latter’s minimum point. This
is because MC can be defined as the addition either to total cost or to total cost or to total variable cost
resulting from one more unit of output. However, no such relationship exists between MC and the
average fixed cost, because the two are not related; marginal cost by definition includes only those
costs which change with output and fixed costs by definition are independent of output.
Managerial Uses of the Short-Run Cost Concepts: As already emphasized the relevant costs to be
considered for decision-making will differ from one situation to the other depending on the problem
faced by the manager. In general, the total cost concept is quite useful in finding out the break-even
quantity of output. The total cost concept is also used to find out whether firm is making profits or not.
The average cost concept is important for calculating the per unit profit of a business firm. The
marginal and incremental cost concepts are essential to decide whether a firm should expand its
production or not.
5.4 Long-Run Cost Functions

Long-run total costs curves are derived from the long-run production functions in which all inputs are
variable. Such a production function is represented by the five asquint curves showing five different
levels of output. The five cost curves tangent to these is equates at the points A, B, C, D and E
represent total cost on resources. Since the cost per unit of capital (v) and, labor (w) are assumed to be
constant, these five cost curves are parallel to one another, and the distance between them is constant
along the expansion path traced out by A, B, C, D and E.
Unit Costs in the Long-Run: In the long-run, costs are not divided into fixed and variable
components; all costs are variable. Thus, the only long-run unit cost functions of interest are long-run
average cost (LAC) and long-run marginal cost (LMC). These are defined as follows:
LAC = LTC; LMC = ΔLTC; LMC = d (LTC)
------ ----- -----------
78
Q ΔQ dQ
For the long-run total cost, these unit costs can be presented in tabular form as follows:
Long
Run Long Run
Average Marginal
Long Run Total Cost Cost Cost
Output Q (LTC) (LAC) (LMC)
0 0 - -
50 150 3 3
125 200 1.6 0.67
250 250 1 0.67
300 300 1 1
325 350 1.08 2
TABLE 8: LONG RUN TOTAL, AVERAGE & MARGINAL COST
5.5 Production Concept and Analysis

The basis function of a firm is that of readying and presenting a product for sale presumably at a profit.
Production analysis related physical output to physical units of factors of production. In the production
process, various inputs are transformed into some form of output. Inputs are broadly classified as land,
labor, capital and entrepreneurship (which embodies the managerial functions of risk taking,
organizing, planning, controlling and directing resources). In production analysis, we study the least-
cost combination of factor inputs, factor productivities and returns to scale. Here we shall introduce
several new concepts to understand the relationship involved in the production process. We are
concerned with economic efficiency of production which refers to minimization of cost for a given
output level. The efficiency of production process is determined by the proportions in which various
inputs are used, the absolute level of each input and productivity of each input at various levels. Since
inputs have a cost attached, the degree of efficiency in production gets translated into a level of costs
per units of output.
Why to Study Production?

When making the decision of what to produce and what not to produce, the study of production is
needed. The discussion in this lesson covers decision rules for determining the quantity of various
inputs to produce a firm’s output under different circumstances. It also develops a basis upon which
firm’s costs can be constructed. After all, a firm incurs costs because it must pay for productive
factors. Thus an understanding of production helps provide a foundation for the study of cost. Business
firms produce goods or service as a means to an end. Besides meeting of final consumer needs, the end
objective of a firm may be to maximize profits, to gain or maintain market share, to achieve a target
return on investment, or any combination thereof. In case of public goods, the objective may be to
provide a particular service, such as education and health, within the bounds of a budget constraint. In
other words, a firm attempts to combine various inputs in such a way that minimum resources are
committed to produce a given product or that maximum production results from a given input. To
achieve this, persons in the decision-making position should have a basis understanding of the process
of production, and also the time perspective of production.
5.5.1 Production Function

A production function expresses the technological or engineering relationship between the output of
product and its inputs. In other words, the relationship between the amount of various inputs used in
the production process and the level of output is called a production function. Traditional economic
theory talks about land, labor, capital and organization or management as the four major factors of
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SAURABH GUPTA
production. Technology also contributes to output growth as the productivity of the factors of
production depends on the state of technology. The point which needs to be emphasized here is that the
production function describes only efficient levels of output; that is the output associated with each
combination of inputs is the maximum output possible, given the existing level of technology.
Production function changes as the technology changes.
Production function is represented as follows: Q=f (f1, f2…………..f n); Where f1, f2,…..fn are
amounts of various inputs such as land, labor, capital etc., and Q is the level of output for a firm. This
is a positive functional relationship implying that the output varies in the same direction as the input
quantity. In other words, if all the other inputs are held constant, output will go up if the quantity of
one input is increased. This means that the partial derivative of Q with respect to each of the inputs is
greater than zero. However, for a reasonably good understanding of production decision problems, it is
convenient to work with two factors of production. If labor (L) and capital (K) are the only two factors,
the production function reduces to: Q=f (K, L). From the above relationship, it is easy to infer that for
a given value of Q, alternative combinations of K and L can be used. It is possible because labor and
capital are substitutes to each other to some extent. However, a minimum amount of labor and capital
is absolutely essential for the production of a commodity. Thus for any given level of Q, an
entrepreneur will need to hire both labor and capital but he will have the option to use the two factors
in any one of the many possible combinations. For example, in an automobile assembly plant, it is
possible to substitute, to some extent, the machine hours by man hours to achieve a particular level of
output (no. of vehicles). The alternative combinations of factors for a given output level will be such
that if the use of one factor input is increased, the use of another factor will decrease, and vice versa.
5.5.2 Isoquants
Isoquants are a geometric representation of the production function. It is also known as the Iso Product
curve. As discussed earlier, the same level of output can be produced by various combinations of
factor inputs. Assuming continuous variation in the possible combination of labor and capital, we can
draw a curve by plotting all these alternative combinations for a given level of output. This curve
which is the locus of all possible combinations is called Isoquants or Iso-product curve. Each Isoquants
corresponds to a specific level of output and shows different ways all technologically efficient, of
producing that quantity of outputs. The Isoquants are downward slopping and convex to the origin.
The curvature (slope) of an Isoquants is significant because it indicates the rate at which factors K&L
can be substituted for each other while a constant level of output of maintained. As we proceed north-
eastward from the origin, the output level corresponding to each successive isoquant increases, as a
higher level of output usually requires greater amounts of the two inputs. Two Isoquants don’t intersect
each other as it is not possible to have two output levels for a particular input combination.
Marginal Rate if Technical Substitution: It can be called as MRTS. MRTS is defined as the rate at
which two factors are substituted for each other. Assuming that 10 pairs of shoes can be produced in
the following three ways.
Q K L
10 8 2
10 4 4
10 2 8
TABLE 9: QUANTITY, CAPITAL AND LABOUR
We can derive the MRTS between the two factors by plotting these combinations along a curve
(Isoquant).
Measures of Production: The measure of output represented by Q in the production function is the
total product that results from each level of input use. For example, assuming that there is only one
factor (L) being used in the production of cigars, total output at each level of labor employed could be?
Labor (L) Output(Q) Labor(L) Output(Q)
1 3 8 220
80
2 22 9 239
3 50 10 246
4 84 11 238
5 121 12 212
6 158 13 165
7 192 14 94
TABLE 10: OUTPUT AND LABOUR
The total output will be 220 cigars if we employed 8 units of labor. We assume in this example, that
the labor input combines with other input factors of fixed supply and that the technology is a constant.
In additional to the measure of total output, two other measures of production i.e. marginal product and
average product, are important to understand.
5.5.3 Total, Average and Marginal Products

This has reference to the fundamental concept of marginalize. From the decision making point view, it
is particularly important to know how production changes as a variable input are changed. For
example, we want to know if it would be profitable to hire an additional unit of labor for some
additional unit of labor for some additional productive activity. For this, we need to have a measure of
the rate of change in output as labor is increased by one unit, holding all other factors constant. We call
this rate of change the marginal product of labor. In general, the marginal product (MP) of a variable
factor of production is defined as the rate of change in total product (TP or Q). Here the output doesn’t
increase at constant rate as more of any one input is added to the production process. For example, on
a small plot of land, you can improve the yield by increasing the fertilizer use to some extent.
However, excessive use of fertilizer beyond the optimum quantity may lead to reduction in the output
instead of any increase as per the Law of Diminishing Returns. (For instance, single application of
fertilizers may increase the output by 50 per cent, a second application by another 30 per cent and the
third by 20 per cent. However, if you were to apply fertilizer five to six times in a year, the output may
drop to zero).
Average Product: Often, we also want to know the productivity per worker, per kilogram of fertilizer,
per machine, and so on. For this, we have to use another measure of production: average product. The
average Product (AP) of a variable factor of production is defined as the total output divided by the
number of units of the variable factor used in producing that output. Suppose there are factors (X1,
X2…….Xn), and the average product for the ith factor is defined as: APi = TP/Xi. This represent the
mean (average) output per unit of land, labor, or any other factor input. The concept of average product
has several uses. For example, whenever inter-industry comparisons of labor productivity are made,
they are based on average product of labor. Average productivity of workers is important as it
determines, to a great extent, the competitiveness of one’s products in the markets.
Marginal Average and Total Product: A hypothetical production function for shoes is presented in
the Table below with the total average, the marginal products of the variable factor labor. Needless to
say that the amount of other inputs and the state of technology are fixed in this example.
Average
Products
Labor Total Output (TP) (AP = MP = Marginal
Input (L) TP/L) ΔTP/ΔL Product
0 0 0 0
1 14 14 14
2 52 26 38
3 108 36 56
4 176 44 68
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SAURABH GUPTA
5 250 50 74
6 324 54 74
7 392 56 68
8 448 56 56
9 486 54 38
10 500 50 14
11 484 44 -16
12 432 36 -52
13 338 26 -94
14 196 14 -142
TABLE 11: TOTAL, AVERAGE & MARGINAL OUTPUT

The value for marginal product is written between each increment of labor input because those e
values represent the marginal productivity over the respective intervals. In both the table and the
graphic representation, we see that both average and marginal products first increase, reach the
maximum, and eventually decline. Note that MP=AP at the maximum of the average product function.
This is always the case. If MP>AP, the average will be pushed up by the incremental unit, and if
MP<AP, the average will be pulled down. It follows that the average product will reach its peak where
MP=AP.
5.5.4 Elasticity of Production

This is a concept which is based on the relationship between Average Product (AP) and Marginal
Product (MP). The elasticity of production (eq) is defined as the rate of fractional change in total
product, Δ Q/ Δ L
Thus Q/L,
ΔQ/Q Δ Q L ΔQ/ ΔL MPL
eq1 = ---------- ---------. = ------ . ------------- = ----------
ΔL/L Δ L Q Q/L APL
Thus labor elasticity of Production, e q 1 is the ratio of marginal productivity of labor to average
productivity of labor. In the same way, you may find that capital elasticity of production is simply the
ratio of marginal productivity to average productivities of capital. Sometimes, such concepts are
renamed as input elasticity of output. In an estimated production function, the aggregate of input
elasticity’s is termed as the function coefficient.
Elasticity of Factor Substitution: This is another concept of elasticity which has a tremendous
practical use in the context of production analysis. The elasticity of factor substitution, efs, is a measure
of ease with which the varying factors can be substituted for others; it is the percentage change in
factor production. Thus K/L with respect to a given change in marginal rate of technical substitution
between factors (MRTS KL). Thus,
Δ(K/L) (MRTS KL)
efs = -------------. -----------------
(K/L) Δ (MRTS KL)
Δ (K/L) Δ (MRTS KL)
= ------------- . -------------------
Δ (MRTSKL) (K/L)
Δ (K/L) (MPK/MPL)
= --------------- . -------------------
Δ (MPK/MPL) (K/L)
The elasticity coefficient of factor substitution, e1s, differs depending upon the form of production
82
function. You should be able to see now that factor intensity (factor ratio), factor productivity, factor
elasticity and elasticity of factor substitution are all related concepts in the context of production
analysis.
5.6 Profit & Revenue Maximization

5.6.1 Profit Maximization
Although discussion of the production function developed in previous section has intuitive appeal in its
own right, its usefulness to the business manager is in its application to profit maximization. It was
demonstrated, for example, that with precise specification of the production function and a given
output level, infinite input combinations are at least theoretically possible. The specific combination of
inputs used to produce that output level, however, will be that which can be produced at least cost.
Alternatively, given the firm’s operating budget and the prices of productive resources, the perfectly
competitive firm will choose that combination of resources that generates the greatest output level.
5.6.2 Optimal Input Combination

Isocost Line
Given the prices of productive resources and the firm’s operating budget, and assuming only two
factors of production, labor and capital, the various combinations of inputs that a firm can employ in
the production process may be summarized as
TC0 = PLL+ PKK ……….7.1
where TC0 is the firm’s operating budget, or total cost, PL is the rental price of labor (or the wage
rate), and PK is the rental price of capital (or the interest rate). Equation (7.1) is known as the iso-cost
equation. This expression is also known as the firm’s cost constraint in the two-variable input case.
Suppose, for example, that the firm’s weekly operating budget is $1,000, the weekly per worker wage
rate is $100, and the weekly rental price of capital is $150. Expression (7.1), therefore, becomes
1,000 = 100L+ 150K ……..7.2
Equation (7.2) may be solved for K to yield the firm’s iso-cost line,
K = 6.67 - 0.67L ……..7.3
The negative slope coefficient indicates that more capital may be hired only at the expense of fewer
units of labor. In this example, when zero labor is employed, at a rental price of capital of $150, the
total amount of labor that can be hired is 6.67 units (per operating period). Similarly, if no units of
capital are employed, then 10 units of labor may be hired. In general, from Equation (7.1) the iso-cost
line may be written as
K = TC0/PK –(PL/PK)L ……7.4
Equation (7.4) indicates that the rate at which a unit of labor may be substituted for a unit of capital is
given by the ratio of the input prices. In summary, the iso-cost line denotes the various combinations
of inputs that a firm may hire at a given cost.
5.6.3 Unconstrained Optimization: The Profit Function

The objective of profit maximization facing the decision maker may, of course, be dealt with more
directly. The optimality conditions just discussed are all by-products of this more direct approach. The
problem confronting the decision maker is to choose an output level that will maximize profit. We will
begin by defining profit as the difference between total revenue and total cost.
π(Q) =TR(Q) -TC(Q) …….7.10
where TR(Q) represents total revenue and TC(Q) represents total cost, both of which are assumed to
be functions of output. As we discussed in earlier Chapter, Equation (7.10) is an unconstrained
objective function in which the object is to maximize total profit, which in this case is a function of the
output level.
As was discussed in earlier Chapter, to meet the first-order and second-order conditions for a
maximum, the first derivative must be equal to zero and the second derivative must be negative. In this
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SAURABH GUPTA
case, the first- and second order conditions, respectively, are d π /dQ = 0 and d2 π /dQ2 < 0. Applying
these conditions to Equation (7.10), we obtain
d π /dQ = dTR/dQ – dTC/dQ = 0 …..7.11
MR = MC ……..7.12
Equation (7.12) simply says that the first-order condition for the firm to maximize profits is to select
an output level such that marginal revenue (MR= dTR/dQ) equals marginal cost (MC = dTC/dQ).
Alternatively, a first order condition for the firm to maximize profits is to select an output level for
which marginal profit (Mp = dp/dQ) is zero.
To ensure that the solution value for Equation (7.10) maximizes profit, the second-order condition
must also be satisfied. Differentiating Equation (7.10) with respect to Q, we obtain
d2 π /dQ2 = d2 TR /dQ2 - d2 TC /dQ2 < 0…………7.13
OR
d2 TR /dQ2 < d 2 TC /dQ2………….7.14
In economic terms, Equation (7.14) simply says that to ensure that profit is maximized given that the
first-order condition is satisfied, the rate of change in marginal revenue must be less than the rate of
change in marginal cost. Diagrammatically, at the profit-maximizing level of output, where marginal
revenue equals marginal cost, the marginal cost curve would intersect the marginal revenue curve from
below. Alternatively, from Equation (7.13) the second-order condition for profit maximization requires
that at the profit-maximizing level of output Q*, not only must marginal profit be zero but the slope of
the profit function must be falling.
Diagrammatically this would be illustrated as a profit “hill,” where profit is maximized at an output
level (Q*) that corresponds to the top of the profit “hill.”
In two common illustrations of the foregoing concepts, which will be discussed at greater length in
subsequent chapters, the selling price Q is taken to be parametric (P = P0) or is assumed to be a
function of output [P = f (Q)]. The first instance is typical of the market structure known as perfect
competition. The second instance is typical of the market structure known as monopoly.
5.7 Economic Optimization
Many problems in economics involve the determination of “optimal” solutions. For example, a
decision maker might wish to determine the level of output that would result in maximum profit. The
process of economic optimization essentially involves three steps:
1. Defining the goals and objectives of the firm
2. Identifying the firm’s constraints
3. Analyzing and evaluating all possible alternatives available to the decision maker
In essence, economic optimization involves maximizing or minimizing some objective function, which
may or may not be subject to one or more constraints.
5.7.1 Optimization Analysis

The process of economic optimization may be illustrated by considering the firm’s profit function p,
which is defined as
π = TR – TC
Example 1: Suppose that revenue r(x) = 9x and cost c(x) = 3x3 – 7x2 + 23x, where x represent
thousands of units. Find out the production level that maximizes profit.
Solution: We know that Profit p(x) = r(x) – c(x)
= 9x – (3x3 – 12x2 + 23x)
= -3x3 + 12x2 - 16x
Differentiating this profit function with respect to x we get:
p’(x) = -9x2 + 24x – 16
Again differentiating it with respect to x we get:
p’’(x) = -18x + 24x
Now to find the critical point it is assume that the first derivative is equal to zero.
84
p’(x) = 0
p’(x) = -9x2 + 24x – 16 = 0
9x2 – 24x + 16 = 0
9x2 –(12x + 12x) + 16 = 0
9x2 – 12x - 12x + 16 = 0
3x(3x – 4) – 4(3x – 4) = 0
(3x – 4)(3x – 4) = 0
x = ±4/3
p’’(+4/3) = -18(+4/3) + 24(+4/3)
= -24 + 32 = 8
p’’(-4/3) = -18(-4/3) + 24(-4/3)
= +24 – 32 = -8 which is negative hence not to be considered
Thus the profit is maximum at x = 4/3 = 8.
Example 2: Given the following cost function, find the level of output at which cost would be
minimum: C = 40 – 6x + x2
Solution: The first order condition is dC/dx = -6 + 2x = 0
2x = 6, x = 3
The second order condition is d 2C/dx2 = 2 > 0, which means that the curve is convex downwards and
that the extreme point at x = 3 is the minimum cost point.
The total cost C = 40 – 6(3) + (3)2 = 31
Example 3: A firm producing two goods x and y has the profit function
π = 64x – 2x 2 + 4xy – 4y2 + 32y – 14
Find the profit-maximizing level of output for each of the two goods and test to be sure profits
are maximized.
Solution:
1. Take the first-order partial derivatives, set them equal to zero, and solve for x and y
simultaneously:
πx = 64 – 4x + 4y = 0
πy = 4x – 8y + 32 = 0
when solved simultaneously, x = 40 and y = 24
2. Take the second-order direct partial derivatives and make sure both are negative, as is
required for a relative maximum. From eq.(1) and (2),
πxx = -4, πyy = -8
Take the cross partials to make sure πxx πyy > (πxy)2.
From eq.(1) and (2), πxx = 4 = πyy
πxx πyy > (πxy)2
(-4)(-8) > (4)2
32 > 16
Profits are indeed maximized at x = 40 and y = 24. At the point, π = 1650.
Example 4: Find the critical values for minimizing the costs of a firm producing two goods x and
y when the total cost function is C = 8x2 – xy + 12y2 and the firm is bound by contract to produce
a minimum combination of goods totaling 42, that is, subject to the constraint x + y = 42.
Solution: See the constraint equal to zero multiply it by λ, and form the Lagrangian function,
C = 8x2 – xy + 12y2 + λ(42 – x- y)
Take the first-order partials,
Cx = 16x –y –λ = 0
Cy = -x + 24y – λ = 0
Cλ = 42 – x – y =0
Solving simultaneously, x = 25, y =17 and λ = 383, a 1-unit increase in the constraint or production
quota will lead to an increase in cost of approximately Rs.383.
Example 5: The XYZ Company is a perfectly competitive firm that can sell its entire output for $18
per unit. XYZ’s total cost equation is where Q represents units of output.
TC = 6 + 33Q – 9Q2 + Q3
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a. What is the firm’s total revenue function?

b. What are the marginal revenue, marginal cost, and average total cost equations?
c. Diagram the marginal and average total cost equations for values Q = 0 to Q = 10.
d. What is the total profit equation?
e. What is the marginal profit equation?
f. Use optimization techniques to find the profit-maximizing output level.
Solution:
a. Total Revenue is defined as:
TR = P.Q= 18Q
b. Marginal Revenue MR = dTR/dQ = 18
Marginal Cost MC = dTC/dQ = 33 – 18Q + 2Q2
Average Cost AC = TC/Q = 33 – 9Q + Q2 + 6/Q
c. Profit π = TR – TC = 18Q- (6 + 33Q – 9Q2 + Q3) = -6 - 15Q + 9Q2 – Q3
d. Mπ = dπ/dQ = - 15 + 18Q – 3Q2
e. To find the profit-maximizing output level, take the first derivative of the total profit function,
set the results equal to zero (the first-order condition), and solve for Q.
dπ/dQ = - 15 + 18Q – 3Q2 = 0
This equation, which has two solution values, is of the general form
aQ2 + bQ + c = 0
The solution values may be determined by factoring this equation, or by application of the
quadratic formula, which is
Q1,2 = [-b ± (b2 – 4ac)1/2]/2a
= [-18 ± (18 2- 4(-3)(-15))1/2]/2(-3)
= [-18 ± (144) ½] /(-6)
= [-18 ± 12]/(-6)
Q1 = 5, Q2 = 1
The second-order condition for profit maximization is d2π/dQ2 < 0.
Taking the second derivative of the profit function, we obtain
d 2π/dQ2 = -6Q + 18
Substitute the solution values into this condition.
d2π/dQ2 = -6(1) + 18 = 12 > 0, for a local minimum
d2π/dQ2 = -6(5) + 18 = -12 < 0, for a local minimum
Total profit, therefore, is maximized at Q* = 5.
5.7.2 Optimizing Economic Function

The economist is frequently called upon to help a firm maximize profits and levels of physical output
and productivity, as well as to minimize costs, levels of pollution, and the use of scarce natural
resources.
Example: Maximize profits π for a firm, given total revenue R = 4000Q – 33Q2 and total cost C = 2Q3
– 3Q2 + 400Q + 5000, assuming Q > 0.
(a). Set up the profit function: π = R – C
= 4000Q – 33Q2 – (2Q3 – 3Q2 + 400Q + 5000)
= -2Q2 – 30Q2 + 3600Q – 5000
(b). Take the first derivative, set is equal to zero, and solve for Q to find the critical points.
π' = -6Q2 – 60Q + 3600 = 0
= -6(Q2 + 10Q – 600) = 0
= -6(Q + 30)(Q – 20) = 0
Q = -30, Q = 20
(c). Take the second derivative; evaluate it at the positive critical point and ignore the negative critical
point, which has no economic significance and will prove mathematically to be a relative minimum.
Then check the sign for concavity to be sure of a relative maximum.
π'’ = -12Q - 60
π'’(20) = -12(20) – 60 = -300 < 0
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Profit is maximized at Q = 20 where

π(20) = -2(20)3 – 30(20)2 + 3600(20) – 5000 = 39,000
Example: The production function facing a firm is
Q = K.5L.5
The firm can sell all of its output for $4. The price of labor and capital are $5 and $10, respectively.
a. Determine the optimal levels of capital and labor usage if the firm’s operating budget is $1,000.
b. At the optimal levels of capital and labor usage, calculate the firm’s total profit.
Solution:
a. The optimal input combination is given by the expression
b. MPL/PL = MPK/PK
Substituting into this expression we get
(0.5K 0.5L-0.5) / 5 = (0.5K 0.5L-0.5) / 10
K = 0.5L
Substituting this value into the budget constraint we get:
1000= 5L + 10 K
1000= 5L + 10 (0.5L)
L* = 80
1000= 5(80) + 10 K
K* = 40
c. π = TR - TC = P(K L ) - TC = 4[(40) (80)0.4] - 1,000 = -$821.11
0.5 0.5 0.6
QUESTIONS
Q1. What is the cost of production? Also explain the concept of costs.
Q2. Define short run total cost. Also explain the relationship between total cost, variable cost and fixed
cost.
Q3. Define short run average cost or average cost.
Q4. Define marginal cost.
Q5. Define long run cost curves.
Q6. Discuss briefly the various cost concepts relevant to managerial decision regarding planning and
control.
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SAURABH GUPTA
CHAPTER 6
MARKET STRUCTURE
6.1 Markets
Market is a place where buyers and sellers meet and exchange goods or services. And now if we
extend this concept a little more, there are certain conditions which create the structure of a market.
Such conditions can be condensed in the following –
• Number of Buyers
• Number of sellers
• Buyer Entry Barriers
• Seller Entry Barriers
• Size of the firm
• Product Differentiation/ Homogeneous Product
• Market Share
• Competition
In market economies, there are a variety of different market systems that exist, depending on the
industry and the companies within that industry. It is important for small business owners to
understand what type of market system they are operating in when making pricing and production
decisions, or when determining whether to enter or leave a particular industry.
6.2 Classification of Market Structure

As there are lot many factors deciding on the market structure, there are lot many variations as well
determining the particular market structure in the economy. If we try to explore that individually it
might not crystallize our concept.
Thus, let’s look at the following chart to understand the varied market structures –
From the above chart now it’s clear that how the market structure can be defined by the various factors
and their way of exercising certain power over the market. However if we consider the gradual
increase of competition from least to maximum, we will come up to the following conclusions –
1. Monopoly
2. Oligopoly
3. Monopolistic Competition
4. Perfect Competition
1. Perfect Competition
• Perfect competition is a market system characterized by many different buyers and sellers. In the
classic theoretical definition of perfect competition, there are an infinite number of buyers and sellers.
With so many market players, it is impossible for any one participant to alter the prevailing price in the
market. If they attempt to do so, buyers and sellers have infinite alternatives to pursue. Though in
concept perfect competition exists, however in real life only near perfect competition can exist. And
the staple food and vegetables we buy from the market is perfect competition. However when they
start branding they move toward oligopoly.
• In case of Monopsony and Oligopsony there are almost no practical examples though they are just
the opposite of monopoly and oligopoly respectively (buyers rule).
• Perfect competition, a theoretical market structure that features no barriers to entry, an unlimited
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number of producers and consumers, and a perfectly elastic demand curve
2. Monopoly
A monopoly is the exact opposite form of market system as perfect competition. In a pure monopoly,
there is only one producer of a particular good or service, and generally no reasonable substitute. In
such a market system, the monopolist is able to charge whatever price they wish due to the absence of
competition, but their overall revenue will be limited by the ability or willingness of customers to pay
their price. Companies which are state owned and entry for other players are not allowed. If we take
example from Indian perspective there is one example we can think of is Indian railway which is the
monopoly as there is no other contributor exercising in the same market. where there is only one
provider of a product or service.
• Natural monopoly, a monopoly in which economies of scale cause efficiency to increase
continuously with the size of the firm. A firm is a natural monopoly if it is able to serve the entire
market demand at a lower cost than any combination of two or more smaller, more specialized firms.
In which a market is run by a small number of firms that together control the majority of the market
share. Let’s take a common example. Look around your locality. There are some good numbers of
restaurants serving their customers. Though they might be producing same kind of recipes, the
branding would be different. And that’s the catch of monopolistic competition. Many buyers, many
sellers, almost same product but different branding and fierce competition.
3. Monopolistic Competition
Monopolistic competition is a type of market system combining elements of a monopoly and perfect
competition. Like a perfectly competitive market system, there are numerous competitors in the
market. The difference is that each competitor is sufficiently differentiated from the others that some
can charge greater prices than a perfectly competitive firm. An example of monopolistic competition is
the market for music. While there are many artists, each artist is different and is not perfectly
substitutable with another artist
In monopolistic competition, we still have many sellers (as we had under perfect competition). Now,
however, they don’t sell identical products. Instead, they sell differentiated products—products that
differ somewhat, or are perceived to differ, even though they serve a similar purpose. Products can be
differentiated in a number of ways, including quality, style, and convenience, location, and brand
name. Some people prefer Coke over Pepsi, even though the two products are quite similar. But what
if there was a substantial price difference between the two? In that case, buyers could be persuaded to
switch from one to the other. Thus, if Coke has a big promotional sale at a supermarket chain, some
Pepsi drinkers might switch (at least temporarily).
How is product differentiation accomplished? Sometimes, it’s simply geographical; you probably buy
gasoline at the station closest to your home regardless of the brand. At other times, perceived
differences between products are promoted by advertising designed to convince consumers that one
product is different from another—and better than it. Regardless of customer loyalty to a product,
however, if its price goes too high, the seller will lose business to a competitor. Under monopolistic
competition, therefore, companies have only limited control over price.
4. Oligopoly
An oligopoly is similar in many ways to a monopoly. The primary difference is that rather than having
only one producer of a good or service, there are a handful of producers, or at least a handful of
producers that make up a dominant majority of the production in the market system. While oligopolists
do not have the same pricing power as monopolists, it is possible, without diligent government
regulation that oligopolists will collude with one another to set prices in the same way a monopolist
would. In US and other countries people buy their automobiles from different companies. Here the
buyers are many, sellers are few, and competition is high. Oligopoly means few sellers. In an
oligopolistic market, each seller supplies a large portion of all the products sold in the marketplace. In
addition, because the cost of starting a business in an oligopolistic industry is usually high, the number
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of firms entering it is low.

Companies in oligopolistic industries include such large-scale enterprises as automobile companies
and airlines. As large firms supplying a sizable portion of a market, these companies have some
control over the prices they charge. But there’s a catch: because products are fairly similar, when one
company lowers prices, others are often forced to follow suit to remain competitive. You see this
practice all the time in the airline industry: When American Airlines announces a fare decrease,
Continental, United Airlines, and others do likewise. When one automaker offers a special deal, its
competitors usually come up with similar promotions.
6.3 Meaning of Firm and Industry:

It is essential to know the meanings of firm and industry before analyzing the two. A firm is an
organization which produces and supplies goods that are demanded by the people. According to Prof.
S.E. Lands-bury, “Firm is an organization that produces and sells goods with the goal of maximizing
its profits.
In the words of Prof. R.L. Miller, “Firm is an organization that buys and hires resources and sells
goods and services.”
Industry is a group of firms producing homogeneous products in a market. In the words of Prof. Miller,
“Industry is a group of firms that produces a homogeneous product.” For example, Raymond,
Maffatlal, Arvind, etc., are cloth manufacturing firms, whereas a group of such firms is called the
textile industry.
6.4 Equilibrium of the Firm:
a) Meaning:
A firm is in equilibrium when it has no tendency to change its level of output. It needs neither
expansion nor contraction. It wants to earn maximum profits. In the words of A.W. Stonier and D.C.
Hague, “A firm will be in equilibrium when it is earning maximum money profits.”
Equilibrium of the firm can be analyzed in both short-run and long-run periods. A firm can earn the
maximum profits in the short run or may incur the minimum loss. But in the long run, it can earn only
normal profit.
b) Short-run Equilibrium of the Firm:
The short run is a period of time in which the firm can vary its output by changing the variable factors
of production in order to earn maximum profits or to incur minimum losses. The number of firms in
the industry is fixed because neither the existing firms can leave nor new firms can enter it.
It’s Conditions:
The firm is in equilibrium when it is earning maximum profits as the difference between its total
revenue and total cost.
For this, it essential that it must satisfy two conditions:
(1) MC = MR, and (2) the MC curve must cut the MR curve from below at the point of equality and
then rise upwards.
The price at which each firm sells its output is set by the market forces of demand and supply. Each
firm will be able to sell as much as it chooses at that price. But due to competition, it will not be able
to sell at all at a higher price than the market price. Thus the firm’s demand curve will be horizontal at
that price so that P = AR = MR for the firm.
1. Marginal Revenue and Marginal Cost Approach:
The short-run equilibrium of the firm can be explained with the help of the marginal analysis as well as
with total cost-total revenue analysis. We first take the marginal analysis under identical cost
conditions.
This analysis is based on the following assumptions:
1. All firms in an industry use homogeneous factors of production.
2. Their costs are equal. Therefore, all cost curves are uniform.
3. They use homogeneous plants so that their SAC curves are equal.
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4. All firms are of equal efficiency.

5. All firms sell their products at the same price determined by demand and supply of the industry so
that the price of each firm is equal to AR = MR.
6.5 Determination of Equilibrium:

Given these assumptions, suppose that price OP in the competitive market for the product of all the
firms in the industry is determined by the equality of demand curve D and the supply curve S at point
E in Figure 1(A) so that their average revenue curve (AR) coincides with the marginal revenue curve
(MR).
At this price, each firm is in equilibrium at point L in Panel (B) of the figure where (i) SMC equals
MR and AR, and (ii) the SMC curve cuts the MR curve from below. Each firm would be producing
OQ output and earning normal profits at the maximum average total costs QL. A firm earns normal
profits when the MR curve is tangent to the SAC curve at its minimum point.
FIGURE 26: SMC, SAC & AVC CURVE

If the price is higher than these minimum average total costs, each firm will be earning supernormal
profits. Suppose the price rises to 0Рг where the SMC curve cuts the new marginal revenue curve MR2
(=AR2) from below at point A which now becomes the equilibrium point. In this situation, each firm
produces OQ2 output and earns supernormal profits equal to the area of the rectangle P2 ABC.
If the price falls below OP1the firm would make a loss because the SAC would be higher than the
price. In the short-run, it would continue to produce and sell OQ1 output at OP1price so long as it
covers its AVC. S is thus the shut-down point at which the firm is incurring the maximum loss equal to
SK per unit of output. If the price falls below OP1 the firm will close down because it would fail to
cover even the minimum average variable cost. OP1 is thus the shut-down price.
We may conclude from the above discussion that in the short-run each firm may be making either
supernormal profits, or normal profits or losses depending upon the price of the product.
6.6.Total Cost Revenue Analysis:

The short-run equilibrium of the firm can also be shown with the help of total cost and total revenue
curves. The firm is able to maximize its profits at that level of output where the difference between
total revenue and total cost is the maximum. This is shown in Figure 2 where TR is the total revenue
curve and TC total cost curve.
The total revenue curve is an upward sloping straight line curve starting from O. This is because the
firm sells small or large quantities of its product at a constant price under perfect competition. If the
firm produces nothing, total revenue will be zero. The more it produces, the larger is the increase in
total revenue. Hence the TR curve is linear and slopes upward.
The firm will maximize its profits at that level of output where the gap between the TR curve and the
1C curve is the maximum. Geometrically, it is that level at which the slope of a tangent drawn to the
total cost curve equals the slope of the total revenue curve. In Figure, the maximum amount of profit is
measured by TP at OQ output. At outputs smaller or larger than OQ between A and В points, the
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firm’s profits shrink. If the firm produces OQ1 output, its losses are the maximum because the TC
curve is i above the TR curve. At Q1 its profits are zero. Similar situation prevails at Q2.
FIGURE 27: TC & TR CURVE

Since the marginal revenue equals the slope of the total о revenue curve and the marginal cost equals
the slope of the tangent to the total cost curve, it follows that where the slopes of the total cost and
revenue curves are equal as at P and T, the marginal cost equals the marginal revenue. It should be
clear of that the point of maximum profits lies in the region of rising marginal cost (when TC is below
TR) and of maximum loss in the falling marginal cost region (where TC is above TR).
The explanation of the equilibrium of the firm by using total cost-revenue curves does not throw more
light than is provided by the marginal cost-marginal revenue analysis. It is useful only in the case of
certain marginal decisions where the total cost curve is also linear over a certain range of output.
But it makes the equilibrium of the firm a cumbersome and difficult analysis particularly when one has
to compare the change in cost and revenue resulting from a change in the volume of output. Further,
maximum profits cannot be known at once. For this, a number of tangents are required to be drawn
which is a real difficulty
6.7 Long-run Equilibrium of the Firm:
In the long-run, it is possible to make more adjustments than in the short-run. The firm can adjust its
plant capacity and scale of operations to the changed circumstances. Therefore, all costs are variable.
Firms must earn only normal profits. In case the price is above the long-run AC curve firms will be
earning supernormal profits.
Attracted by them, new firms will enter the industry and supernormal profits will be competed away. If
the price is below the LAC curve firms will be incurring losses. As a result, some of the firms will
leave the industry so that no firm earns more than normal profits. Thus “in the long-run firms are in
equilibrium when they have adjusted their plant so as to produce at the minimum point of their long-
run AC curve, which is tangent (at this point) to the demand (AR) curve defined by the market price”
so that they earn normal profits.
It’s Assumptions:
This analysis is based on the following assumptions:
1. Firms are free to enter into or leave the industry.
2. All firms are of equal efficiency.
3. All factors are homogeneous. They can be obtained at constant and uniform prices.
4. Cost curves of firms are uniform.
5. The plants of firm: are equal having given technology.
6. All firms have perfect knowledge about price and output.
Determination:
Given these assumptions, each firm of the industry will be in the following two conditions.
(1) In equilibrium, its short-run marginal cost (SMC) must equal to its long-run marginal cost (LMC)
as well as its short-run average cost (SAC) and its long-run average cost (LAC) and both should be
equal to MR=AR=P. Thus the first equilibrium condition is:
SMC = LMC = MR = AR = P = SAC = LAC at its minimum point, and
(2) LMC curve must cut MR curve from below.
Both these conditions of equilibrium are satisfied at point E in Figure 3 where SMC and LMC curves
cut from below SAC and LAC curves at their minimum point E and SMC and LMC curves cut AR =
MR curve from below. All curves meet at this point E and the firm produces OQ optimum quantity
and sell it at OP price.
FIGURE 28: SMC, LMC, SAC, LAC CURVE

Since we assume equal costs of all the firms of industry, all firms will be in equilibrium m the long-
run. At OP price a firm will have neither a tendency to neither leave nor enter the industry and all
firms will earn normal profit.
Equilibrium of the Industry under Perfect Competition:
6.8 Conditions of Equilibrium of the Industry:

An industry is in equilibrium:
(i) When there is no tendency for the firms either to leave or enter the industry, and (ii) when each firm
is also in equilibrium. The first condition implies that the average cost curves coincide with the
average revenue curve of all the firms in the industry. They are earning only normal profits, which are
supposed to be included in the average cost curves of the firms. The second condition implies the
equality of MC and MR. Under a perfectly competitive industry, these two conditions must be satisfied
at the point of equilibrium, i.e.,
SMC = MR
SAC = AR
P = AR = MR
SMC = SAC = AR = P
Such a situation represents full equilibrium of the industry.
Short-Run Equilibrium of the Industry:
An industry is in equilibrium in the short run when its total output remains steady, there being no
tendency to expand or contract its output. If all firms are in equilibrium, the industry is also in
equilibrium. For full equilibrium of the industry in the short run, all firms must be earning only normal
profits. The condition for this is SMC = MR = AR = SAC. But full equilibrium of the industry is by
sheer accident because in the short run some firms may be earning supernormal profits and some
incurring losses.
FIGURE 29: SMC, SAC, AVC, AR, MR CURVE

Even then, the industry is in short- run equilibrium when its quantity demanded and quantity supplied
are equal at the price which clears the market. This is illustrated in Figure 29, where in Panel (A), the
industry is in equilibrium at point E where its demand curve D and supply curve S intersect which
determine OP price at which its total output OQ is cleared. But at the prevailing price OP some firms
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are earning supernormal profits PE1ST as shown in Panel (B), while some other firms are incurring
FGE2P losses as shown in Panel (C) of the figure.
Long-Run Equilibrium of the Industry:

The industry is in equilibrium in the long run when all firms earn normal profits. There is no incentive
for firms to leave the industry or for new firms to enter it. With all factors homogeneous and given
their prices and the same technology, each firm and industry as a whole are in full equilibrium where
LMC = MR =AR(=p) =LAC at its minimum. Such an equilibrium position is attained when the long-
run price for the industry is determined by the equality of total demand and supply of the industry.
FIGUR 30: LONG RUN EQUILIBRIUM

The long-run equilibrium of the industry is illustrated in Panel (A) where the long-run price op and OQ
output are determined by the intersection of the demand curve d and the supply curve s at point E. At
this price op, the firms are in equilibrium at point A in Panel (B) at OM level of output where LMC
=SMC= MR= p (=AR) =SAC= LAC at its minimum. At this level, the firms are earning normal profits
and have no incentive to enter or leave the industry. It follows that when the industry is in long-run
equilibrium, each firm in the industry is also in long-run equilibrium. If both the industry and the firms
are in long-run equilibrium, they are also in short-run equilibrium.
Even though all firms in a perfectly competitive industry in the long run have the same cost curves, the
firms can be of different efficiency. Firms using superior resources or inputs such as superior
management must pay them higher rewards, otherwise they will shift to new firms which offer them
higher prices.
So the forces of competition will force the more efficient firms to pay superior resources higher prices
at their opportunity cost. As a result, the lac curve of the more efficient firms will shift upwards and
they will benefit in the form of higher output at the higher long-run equilibrium price set by the
industry.
FIGURE 31: LMC, LAC, AR, MR CURVE

Unable to pay higher prices to resources or inputs, less efficient firms will be competed away. New
firms which are able to pay more and attracted by the new higher market price will enter the industry.
But at the new long-run equilibrium price of the industry, all firms will be producing at the minimum
LAC.
This is illustrated in Figure 31 where the industry is in initial equilibrium at point E with price OP m
Panel (A) and the more efficient firms like all other firms are in equilibrium at point A in Panel (B). As
the industry is in equilibrium, the new firms do not exist as they are not in a position to cover their
costs at OP price.
When the more efficient firms pay higher prices to resources or inputs, their LAC curve rises to LAC1
At the new long-run equilibrium price of the industry set at OP 1 the more efficient firms are in
equilibrium where P1 = LAC1 at its minimum point A1 in Panel (B). They are now producing larger
output OM1 even though they earn normal profits. The new firms also earn normal profits at point A2,
as shown in Panel (C). But they produce less output OM2 than OM1 produced by the more efficient
firms.
6.9 Monopolistic Competition

6.9.1 Price and Output determination in Short Run
In monopolistic competition, every firm has a certain degree of monopoly power i.e. every firm can
take initiative to set a price. Here, the products are similar but not identical, therefore there can never
be a unique price but the prices will be in a group reflecting the consumers’ tastes and preferences for
differentiated products. In this case the price of the product of the firm is determined by its cost
function, demand, its objective and certain government regulations, if there are any.
As the price of a particular product of a firm reduces, it attracts customers from its rival groups (as
defined by Chamberlin). Say for example, if ‘Samsung’ TV reduces its price by a substantial amount
or offers discount, then the customers from the rival group who have loyalty for, say ‘BPL’, tend to
move to buy ‘Samsung’ TV sets. As discussed earlier, the demand curve is highly elastic but not
perfectly elastic and slopes downwards.
The market has many firms selling similar products, therefore the firm’s output is quite small as
compared to the total quantity sold in the market and so its price and output decisions go unnoticed.
Therefore, every firm acts independently and for a given demand curve, marginal revenue curve and
cost curves, the firm maximizes profit or minimizes loss when marginal revenue is equal to marginal
cost. Producing an output of Q selling at price P maximizes the profits of the firm.
FIGURE 32: MONOPOLISTIC COMPETITION

In the short run, a firm may or may not earn profits. Figure shows the firm, which is earning economic
profits. The equilibrium point for the firm is at price P and quantity Q and is denoted by point A. Here,
the economic profit is given as area PAQR. The difference between this and the monopoly case is that
here the barriers to entry are low or weak and therefore new firms will be attracted to enter. Fresh entry
will continue to enter as long as there are profits. As soon as the super normal profit is competed away
by new firms, equilibrium will be attained in the market and no new firms will be attracted in the
market. This is the situation corresponding to the long run and is discussed in the next section.
6.9.2 Price and Output determination in Long Run

We have discussed the price and output determination in the short run. We now discuss price and
output determination in the long run. You will notice that the long run equilibrium decision is similar
to perfect competition. The core of the discussion under this head is that economic profits are
eliminated in the long run, which is the only equilibrium consistent with the assumption of low barriers
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to entry. This occurs at an output where price is equal to the long run average cost. The difference
between monopolistic competition and perfect competition is that in monopolistic competition the
point of tangency is downward sloping and does not occur at minimum of the average cost curve and
this is because the demand curve is downward sloping.
FIGURE 33: LRMC, LRAC, MR, AR CURVE

Looking at figure, under monopolistic competition in the long run we see that LRAC is the long run
average cost curve and LRMC the long run average marginal curve. Let us take a hypothetical
example of a firm in a typical monopolistic situation where it is making substantial amount of
economic profits.
Here it is assumed that the other firms in the market are also making profits. This situation would then
attract new firms in the market. The new firms may not sell the same products but will sell similar
products. As a result, there will be an increase in the number of close substitutes available in the
market and hence the demand curve would shift downwards since each existing firm would lose
market share. The entry of new firms would continue as long as there are economic profits.
The demand curve will continue to shift downwards till it becomes tangent to LRAC at a given price
P1 and output at Q1 as shown in the figure. At this point of equilibrium, an increase or decrease in
price would lead to losses. In this case the entry of new firms would stop, as there will not be any
economic profits.
Due to free entry, many firms can enter the market and there may be a condition where the demand
falls below LRAC and ultimately suffers losses resulting in the exit of the firms. Therefore under the
monopolistic competition free entry and exit must lead to a situation where demand becomes tangent
to LRAC, the price becomes equal to average cost and no economic profit is earned. It can thus be said
that in the long run the profits peter out completely.
One of the interesting features of the monopolistically competitive market is the variety available due
to product differentiation. Although firms in the long run do not produce at the minimum point of their
average cost curve, and thus there is excess capacity available with each firm, economists have
rationalized this by attributing the higher price to the variety available. Further, consumers are willing
to pay the higher price for the increased variety available in the market.
QUESTIONS
Q1. Define perfect competition market. Also explain the equilibrium of the firm in the short run and
long run under perfect competition.
Q2. Explain the short run and long run equilibrium of the industry in perfect competition market.
Q3. What do you mean by monopoly? How the price and output are determine under it?
Q4. What is a market structure? Explain the different types of market.
Q5. Explain the concept of firm, industry and price under perfect competition and monopolistic
market.
CHAPTER 7
PRICING STRATEGIES
7.0 Pricing
Pricing is the process of determining what a company will receive in exchange for its products.
Pricing is the manual or automatic process of applying prices to purchase and sales orders, based on
factors such as: a fixed amount, quantity break, promotion or sales campaign, specific vendor quote,
price prevailing on entry, shipment or invoice date, combination of multiple orders or lines, and many
others.
Pricing is one of the four elements of the marketing mix, along with product, place and promotion.
Pricing strategy is important for companies who wish to achieve success by finding the price point
where they can maximize sales and profits. Companies may use a variety of pricing strategies,
depending on their own unique marketing goals and objectives.
7.1 Pricing strategies and tactics

Every firm has to take pricing decisions from time to time depending upon its pricing policies and
conditons prevailing in the market. Some of the important pricing strategies are discussed below :
7.1.1 Types of Pricing Strategy:
Premium Pricing
Premium pricing strategy establishes a price higher than the competitors. It's a strategy that can be
effectively used when there is something unique about the product or when the product is first to
market and the business has a distinct competitive advantage. Premium pricing can be a good strategy
for companies entering the market with a new market and hoping to maximize revenue during the early
stages of the product life cycle.
Penetration Pricing
A penetration pricing strategy is designed to capture market share by entering the market with a low
price relative to the competition to attract buyers. The idea is that the business will be able to raise
awareness and get people to try the product. Even though penetration pricing may initially create a loss
for the company, the hope is that it will help to generate word-of-mouth and create awareness amid a
crowded market category.
Economy Pricing
Economy pricing is a familiar pricing strategy for organizations that include Wal-Mart, whose brand is
based on this strategy. Aldi, a food store, is another example of economy pricing strategy. Companies
take a very basic, low-cost approach to marketing--nothing fancy, just the bare minimum to keep
prices low and attract a specific segment of the market that is very price sensitive.
Price Skimming
Businesses that have a significant competitive advantage can enter the market with a price skimming
strategy designed to gain maximum revenue advantage before other competitors begin offering similar
products or product alternatives.
Psychological Pricing
Psychological pricing strategy is commonly used by marketers in the prices they establish for their
products. For instance, $99 is psychologically "less" in the minds of consumers than $100. It's a minor
distinction that can make a big difference.
Pricing in relation to established product
In pricing a product in relation to its well established substitutes, generally three types of pricing
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strategies are adopted:

i. Pricing below the ongoing price
ii. Pricing at par with the prevailing market price
iii. Pricing above the existing market price
Pricing at Prevailing Price
The strategy is followed to stay in the market because a price above the market price would sharply
bring down sales while a lower price would not significantly increase sales. The products offered by
different producers are substitutes of each other and there is no product differentiation. Pricing at the
prevailing price is aimed at providing price competition.
Stay out Price:
When a firm is not certain about the price at which it will be able to sell its products, it starts with a
very high price. If at this high price quotation it is not able to sell, it then lowers the price of its
product. It will keep on lowering the price till it is able to sell the targeted amount of the product. This
approach helps the firm to ascertain the maximum possible price it can charge from its customers.
Price Lining
Price lining is used extensively by the retailers. The retailers usually offers a good better and best
assortment of merchandise at different price levels. For example a retailer of readymade shirts may sell
shirts at three prices: Rs 190, Rs 360 and Rs. 750. The first price stands for the economy choice, the
second for the medium quality and third for the super-fine quality.
Limit Pricing
A firm may also try to establish a price that reduces or eliminates the threat of entry of new firms into
the industry. This is called limit pricing.
Follow the leader pricing
The pricing policy is generally used under oligopolistic competition where there are a small number of
sellers and any of them operates on such a scale that an increase or decrease in his turnover will
appreciably affect the market price. They charged the prices which are charged by the major producer.
Discriminatory or Dual Pricing
Some business enterprises follow the policy of charging different prices from different customers
according to their ability to pay. This policy is very much popular with the service enterprises. E.g.
legal and medical services
Penetration pricing is the pricing technique of setting a relatively low initial entry price, often lower
than the eventual market price, to attract new customers. The strategy works on the expectation that
customers will switch to the new brand because of the lower price. Penetration pricing is most
commonly associated with a marketing objective of increasing market share or sales volume, rather
than to make profit in the short term.
The advantages of penetration pricing to the firm are:
* It can result in fast diffusion and adoption. This can achieve high market penetration rates quickly.
This can take the competitors by surprise, not giving them time to react.
* It can create goodwill among the early adopters segment. This can create more trade through
word of mouth.
* It creates cost control and cost reduction pressures from the start, leading to greater
efficiency.
* It discourages the entry of competitors. Low prices act as a barrier to entry
* It can create high stock turnover throughout the distribution channel. This can create critically
important enthusiasm and support in the channel.
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* It can be based on marginal cost pricing, which is economically efficient.

The main disadvantage with penetration pricing is that it establishes long term price expectations for
the product, and image preconceptions for the brand and company. This makes it difficult to eventually
raise prices. Some commentators claim that penetration pricing attracts only the switchers (bargain
hunters), and that they will switch away as soon as the price rises. There is much controversy over
whether it is better to raise prices gradually over a period of years
Price penetration is most appropriate where:
* Product demand is highly price elastic.
* Substantial economies of scale are available.
* The product is suitable for a mass market (i.e. enough demand).
* The product will face stiff competition soon after introduction.
* There is not enough demand amongst consumers to make price skimming work.
* In industries where standardization is important. The product that achieves high market
penetration often becomes the industry standard (e.g. Microsoft Windows) and other
products, whatever their merits, become marginalized. Standards carry heavy momentum
Price skimming is a pricing strategy which companies adopt when they launch a new product, in this
strategy while launching a product company sets high price for a product initially and then reduce the
price as time passes by so as to recover cost of a product quickly.
Example
An example of price skimming would be mobiles which are have some added features are sold at
higher prices and then prices began to decline as time passes by, another example of price skimming
would be 3D televisions which are right now being sold. Given below are some of the advantages and
disadvantages of price skimming –
Advantages of Price Skimming
 High profit margin. The entire point of price skimming is to generate an outsized profit
margin.
 Cost recovery. If a company competes in a market where the product life span is short, price
skimming may be the only viable method available for ensuring that it recovers the cost of
developing products.
 Dealer profits. If the price of a product is high, then the percentage earned by distributors will
also be high, which makes them happy to carry the product.
 Quality image. A company can use this strategy to build a high-quality image for its products,
but it must deliver a high-quality product to support the image created by the price.
Disadvantages of Price Skimming
The following are disadvantages of using the price skimming method:
 Competition. There will be a continual stream of competitors challenging the seller's extreme
price point with lower-priced offerings.
 Sales volume. A company that uses price skimming is limiting its sales, which means that it
cannot lower costs by building sales volume.
 Consumer acceptance. If the price point remains very high for too long, it may defer or
entirely prevent acceptance of the product by the general market.
 Annoyed customers. Early adopters of the product may be highly annoyed when the company
later drops its price for the product, thereby generating bad publicity and a very low level of
customer loyalty.
 Cost inefficiency. The very high profit margins engendered by this strategy may cause a
company to avoid making the cost cuts required to keep it competitive when it eventually
lowers its prices.
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Average Cost Pricing: Average cost pricing is also known as “mark up pricing,””cost plus pricing” or
“full cost pricing”. The average cost pricing is the most common method of pricing used by
manufacturing firm. The general practice under this method is to add a fair percentage of profit
margins to the average variable cost (AVC). The formula for setting the price is given as:
P = AVC + AVC (m)
P = Price
AVC = Average Variable Cost
m = Mark up percentage
AVC (m)= Gross Profit margin(GPM)
The mark up percentage m is fixed so as to cover average fixed cost(AVC) and a net profit margin
(NPM). Then
AVC (m) = AFC + NPM
NPM: The fair percentage of profit margin is usually determined on the basis of firm’s past experience
and the practice of the rival firm.
Procedure for arriving at AVC and price fixation:
The procedure for arriving at AVC and price fixation may be summarized as follows:
1. The first step in price fixation is to estimate the average variable cost. For this the firm has to
ascertain the volume of its output for a given period of time, usually one accounting year. To
ascertain the output the firm’s uses figure of its planned and budgeted output or takes into
account its normal level of production. If a firm is in a position to compute its optimum level of
output or the capacity output, the same is used as standard output in computing the average
cost.
2. The next step is to compute the total variable cost of the standard output. The total variable cost
includes direct cost i.e.
a) Cost of labour
b) Cost of raw material
c) Other variable cost
These cost added together give the total variable cost. The average variable cost is then
obtained by dividing the total variable cost by standard output (Q) i.e.
AVC = TVC/Q
After AVC is obtained, a mark-up of some percentage of AVC is added to it as profit margin
and the price is fixed. While determining the mark-up firm always takes into account what the
market will bear and the competition in the market.
Average cost pricing can be recommended for the following reasons:

1. In case of multiple products with large common cost, average cost if far easier to calculate than
the marginal cost.
2. Since nobody pays more than the actual cost of production of the goods, average cost pricing
does not result in exploitation.
3. Average cost pricing ensures that the entire expenditure of the undertaking is covered, thereby
ensuring the viability and the autonomy of the production unit.
Limitations of Average Cost Pricings

1. First, average cost pricing assumes that a firm’s resources are optimally allocated and the
standard cost of production is comparable with the average of the industry. In reality however it
may not be so and cost estimates based on these assumptions may be an overestimate or under
estimate.
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2. Second, in average cost pricing, generally historical cost rather than current cost data are used.
3. Third, if variable cost fluctuates frequently and significantly, average cost pricing may not be
an appropriate method of pricing.
4. Finally it is also alleged that average cost pricing ignores the demand side of the market and is
solely based on supply conditions.
Peak load Pricing:
It is a form of price discrimination where the monopolist charges a higher price for peak use than for a
non peak use. Peak load pricing is more usually practiced by Public utilities like electricity companies,
telephones etc. Public utilities produce non storable services their output is consumed the very moment
it is produced. These are demanded in varying amounts in day and night times. Consumption of
electricity reaches its peak in day time. It is called peak load time. It reaches its bottom in the night.
This is called off peak time. Electricity consumption peaks in day times because all establishments,
offices and factories come into operation. It decreases during nights because most business
establishments are closed and household consumption falls to its basic minimum.
Another example of peak and off peak demand is of railways services. During festival and summer
holidays the demand for railway services rises to its peak.
A technical feature of such product is that they cannot be stored. Therefore their production has to be
increased in order to meet the peak load demand and reduced to off peak level when demand
decreases.
Generally a double price system is adopted. A higher price called peak load price is charged during
the peak load period and a lower price is charged during the off peak period.
Limit Pricing:
A firm may also try to establish a price that reduced or eliminates the threat of entry of new firms into
the industry. This is called limit pricing.
Suppose that the existing firm in the industry operate at the scale represented by the short period
average cost curve SRAC1 and price their product at P1. If the new firms could be expected to enter
the industry even at the scale represented by SRAC1, they could potentially make a profit by
producing and competing at the established price P1. Now if the existing firm set the price lower, say
at P2 potential entrants would incur economic loss by entering the industry.
If the entry appears initially any firm which plans entry must also consider the effect of the entry on
price. With entry the total supply and demand for the already existing firm’s output is going to be
affected.
The price must consequently fall and the new entrant may ultimately find that price has fallen below
SRAC1 and he has therefore made a wrong decision.
Thus, if the existing firms set their price closer to average cost there will be less incentive for new
entrants, though also lower short run profits for the existing firms.
Multiple Product Pricing:
The price theory or micro economics models of price determination are based on the assumption that a
firm produces a single, homogenous product. In actual practice however a production of a single
homogenous product by a firm is an exception rather than a rule. Almost all firms have more than one
product in their line of production. For example the various models of refrigerators, TV sets, radio and
car models produced by the same company may be treated as different product for atleast pricing
purposes. The various models are so differentiated that consumers view them as different product and
in some cases as perfect substitutes for each other.
It is therefore not surprising that each model or product has different AR and MR curves and that one
product of the firm competes against the other product. The pricing under these conditions is known as
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multi product pricing or product-line pricing.

The major problem in pricing multiple products is that each product has a separate demand curve. But
since all of them are produced under one organization by interchangeable production facilities, they
have only one inseparable marginal cost curve. That is while revenue curves AR and MR are separate
for each product, cost curves AC and MC are inseparable. Therefore the marginal rule of pricing
cannot be applied straightway to fix the price of each product separately. The problem however has
been provided with a solution by E.W. Clements. The solution is similar to the one employed to
illustrate third degree price discrimination. As a discriminating monopoly tries to maximize its revenue
in all its market, so does a multi product firm in respect of each of its product.
Transfer Pricing
The large size firms divide their operation very often into product divisions or subsidiaries. Growing
firms add new divisions or departments to the existing ones. The firms then transfer some of their
activities to other divisions. The goods and services produced by the new divisions are used by the
parent organization. In other words the parent divisions buy the product of its subsidiaries. Such firms
face the problem of determining an appropriate price of the product transferred from one division or
subsidiary to the other. Specially the problem is of determining the price of a product produced by one
division of the same firm. This problem become much more difficult when each division has a separate
profit function to maximize. Price of intra firm transfer product is referred to as transfer pricing. One
of the most systematic treatments of the transfer pricing technique has been provided by Hirshlerifer.
7.2 Kinked demand Curve:
 Samuelson immortalized it.
 The “young” oligopoly case.
 The industry starts out with price wars and gravitates toward “sticky prices.”
 There are two sets of demand curves: one where competitor’s respond to our initiative and one
where they don’t. So we draw two sets of revenue curves.
 With the blue revenue curves, our competitors do respond.
 With the pink revenue curves, our competitors do not respond
FIGURE 34: KINKED DEMAND CURVE

 We start with a price at the intersection of the blue and pink demand curves.
 To the left of that point (also Q), when we raise our price, we act alone – nobody follows our
increase.
 When we reduce our price, competitors will follow and sales fall off rapidly.
Not an appealing outcome!
FIGURE 35: KINKED DEMAND CURVE

We can simply erase the dotted segments of the respective revenue curves, since they are not
relevant to the outcome.
KINKED DEMAND CURVE

To the left of Q, only D2 and MR2 are relevant, so erase D1+MR1 to the left of Q.
To right of Q, only D1 and MR1 are relevant, so erase D2 and MR2 to the right of Q.
KINKED DEMAND CURVE

Sweezy observed:
At the intersection of D1+D2 (the “kink”), we are in equilibrium.
If we raise the price: Nobody follows us!
If we reduce the price: everybody does!
SAURABH GUPTA
KINKED DEMAND CURVE

Note the discontinuous segment of the firm’s MR curve!
The MR curve becomes vertical at Q, so that there is no incentive to change the output, Q, or the
price as long as the MC curve intersects the MR at that output.
KINKED DEMAND CURVE

Notice here that the MC cuts the MR at the discontinuous segment of the MR curve
KINKED DEMAND CURVE

Notice that this gold MC curve could be shifting up gradually without changing Q or P.
KINKED DEMAND CURVE

KINKED DEMAND CURVE
Unfortunately, the model does not show us what causes a new equilibrium price and quantity to be
achieved, and how that happens.
KINKED DEMAND CURVE
QUESTIONS
Q1. Explain price discrimination.
Q2. Write notes on Average Cost pricing.
Q3. Write notes on Peak load pricing.
Q4. Write a note on limit pricing.
Q5. Write a note on pricing strategies and tactics.
Q6. Write a note on transfer pricing
Q7.
SAURABH GUPTA
CHAPTER 8
NATIONAL INCOME
8.0 Definition of National Income
National income is the final outcome of all economic activities of a nation valued in terms of money.
National income is the most important macroeconomic variable and determinant of the business level
and environment of a country. The level of national income determines the level of aggregate demand
for goods and services. Its distribution pattern determines the pattern of demand for goods and
services, i.e., how much of which good is demanded. The trend in national income determines the
trends in aggregate demand, i.e., the demand for the goods and services, and also the business
prospects. Therefore, business decision makers need to keep in mind these aspects of the national
income, especially those having long-run implications. National income or a relevant component of it
is an indispensable variable considered in demand forecasting. Conceptually, national income is the
money value of the end result of all economic activities of the nation. Economic activities generate a
large number of goods and services, and make net addition to the national stock of capital. These
together constitute the national income of a ‘closed economy’—an economy which has no economic
transactions with the rest of the world. In an ‘open economy’, national income includes also the net
results of its transactions with the rest of the world (i.e., exports less imports).
8.1 Measures of National Income

Gross National Product (GNP) Of the various measures of national income used in national income
analysis, GNP is the most important and widely used measure of national income. It is the most
comprehensive measure of the nation’s productive activities. The GNP is defined as the value of all
final goods and services produced during a specific period, usually one year, plus incomes earned
abroad by the nationals minus incomes earned locally by the foreigners. The GNP so defined is
identical to the concept of gross national income (GNI). Thus, GNP = GNI. The difference between
the two is only of procedural nature. While GNP is estimated on the basis of product-flows, the GNI is
estimated on the basis of money income flows, (i.e., wages, profits, rent, interest, etc.).
Gross Domestic Product (GDP) The Gross Domestic Product (GDP) is defined as the market value of
all final goods and services produced in the domestic economy during a period of one year, plus
income earned locally by the foreigners minus incomes earned abroad by the nationals. The concept of
GDP is similar to that of GNP with a significant procedural difference. In case of GNP the incomes
earned by the nationals in foreign countries are added and incomes earned locally by the foreigners are
deducted from the market value of domestically produced goods and services. In case of GDP, the
process is reverse – incomes earned locally by foreigners are added and incomes earned abroad by the
nationals are deducted from the total value of domestically produced goods and services
Net National Product (NNP) NNP is defined as GNP less depreciation, i.e.,
NNP = GNP – Depreciation. Depreciation is that part of total productive assets which is used to
replace the capital worn out in the process of creating GNP. Briefly speaking, in the process of
producing goods and services (including capital goods), a part of total stock of capital is used up.
‘Depreciation’ is the term used to denote the worn out or used up capital. An estimated value of
depreciation is deducted from the GNP to arrive at NNP. The NNP, as defined above, gives the
measure of net output available for consumption and investment by the society (including consumers,
producers and the government). NNP is the real measure of the national income. NNP = NNI (net
national income). In other words, NNP is the same as the national income at factor cost. It should be
noted that NNP is measured at market prices including direct taxes. Indirect taxes are, however, not a
point of actual cost of production. Therefore, to obtain real national income, indirect taxes are
deducted from the NNP. Thus, NNP–indirect taxes = National Income.
8.2 National Income: Some Accounting Relationships

1. Accounting Indentifies at Market Price
A) GNP ≡ GNI (Gross National Income)
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B) GDP ≡ GNP less Net Income from Abroad

C) NNP ≡ GNP less Depreciation NDP (Net Domestic Product) ≡ NNP less net income from abroad
2. Some Accounting Identities at Factor Cost
A. GNP at factor cost ≡ GNP at market price less net indirect taxes
B. NNP at factor cost ≡ NNP at market price less net indirect taxes
C. NDP at factor cost ≡ NNP at market price less net income from abroad
D. NDP at factor cost ≡ NDP at market price less net indirect taxes
E. NDP at factor cost ≡ GDP at market price less Depreciation
8.3 Methods of measuring National Income

For measuring national income, the economy through which people participate in economic activities,
earn their livelihood, produce goods and services and share the national products is viewed from three
different angles.
(1) The national economy is considered as an aggregate of producing units combining different sectors
such as agriculture, mining, manufacturing, trade and commerce, etc.
(2) The whole national economy is viewed as a combination of individuals and households owning
different kinds of factors of production which they use themselves or sell factor-services to make their
livelihood.
(3) The national economy may also be viewed as a collection of consuming, saving and investing units
(individuals, households and government).
Following these notions of a national economy, national income may be measured by three different
corresponding methods:
(1) Net product method—when the entire national economy is considered as an aggregate of producing
units;
(2) Factor-income method—when national economy is considered as combination of factor-owners
and users;
(3) Expenditure method—when national economy is viewed as a collection of spending units. The
procedures which are followed in measuring the national income in a closed economy—an economy
which has no economic transactions with the rest of the world—are briefly described here. The
measurement of national income in an open economy and adjustment with regard to income from
abroad will be discussed subsequently.
Net Output or Value-Added Method The net output method is also called the value added method. In
its standard form, this method consists of three stages: (i) Estimating the gross value of domestic
output in the various branches of production;
(ii) Determining the cost of material and services used and also the depreciation of physical assets; and
(iii) Deducting these costs and depreciation from gross value to obtain the net value of domestic
output…” The net value of domestic product thus obtained is often called the value added or income
product which is equal to the sum of wages, salaries, supplementary labour incomes, interest, profits,
and net rent paid or accrued.
Factor-Income Method This method is also known as income method and factor-share method. Under
this method, the national income is calculated by adding up all the “incomes accruing to the basic
factors of production used in producing the national product”. Factors of production are conventionally
classified as land, labour, capital and organization. Accordingly, the national income equals the sum of
the corresponding factor earning. Thus, National income = Rent + Wages + Interest + Profit. Thus, the
total factor-incomes are grouped under three categories:
(i) Labour Incomes included in the national income have three components:
(a) Wages and salaries paid to the residents of the country including bonus and commission, and
social security payments;
(b) Supplementary labour incomes including employer’s contribution to social security and
employee’s welfare funds, and direct pension payments to retired employees
(c) Supplementary labour incomes in kind, e.g., free health and education, food and clothing, and
accommodation, etc. Compensations in kind in the form of domestic servants and such other free-of-
cost services provided to the employees are included in labour income.
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(ii) Capital Incomes According to Studenski, capital incomes include the following capital earnings:
(a) dividends excluding inter-corporate dividends;
(b) undistributed before-tax profits of corporations;
(c) interest on bonds, mortgages, and saving deposits (excluding interests on war bonds, and on
consumer-credit);
(d) interest earned by insurance companies and credited to the insurance policy reserves;
(e) net interest paid out by commercial banks
(iii) Mixed Incomes.;. Mixed Income. Mixed incomes include earnings from
(a) farming enterprises,
(b) sole proprietorship (not included under profit or capital income); and
(c) other professions, e.g., legal and medical practices, consultancy services, trading and transporting
etc.
Expenditure Method The expenditure method, also known as final product method, measures national
income at the final expenditure stages. In estimating the total national expenditure, any of the two
following methods are followed: first, all the money expenditures at market price are computed and
added up together, and second, the value of all the products finally disposed of are computed and
added up, to arrive at the total national expenditure. The items of expenditure which are taken into
account under the first method are
(a) private consumption expenditure;
(b) direct tax payments;
(c) payments to the non-profitmaking institutions and charitable organizations like schools, hospitals,
orphanages, etc.; and
(d) private savings.
8.4 Choice of Methods

There are three standard methods of measuring the national income, viz., net product (or value added)
method, factor-income or factor cost method and expenditure method. All the three methods would
give the same measure of national income, provided requisite data for each method is adequately
available. Therefore, any of the three methods may be adopted to measure the national income. But all
the three methods are not suitable for all the economies simply for non-availability of necessary data
and for all purposes. Hence, the question of choice of method arises. The two main considerations on
the basis of which a particular method is chosen are:
A) the purpose of national income analysis, and B) availability of necessary data. If the objective is to
analyse the net output or value added, the net output method is more suitable. In case the objective is
to analyse the factor-income distribution, the suitable method for measuring national income is the
income method. If the objective at hand is to find out the expenditure pattern of the national income,
the expenditure or final products method should be applied. However, availability of adequate and
appropriate data is a relatively more important consideration is selecting a method of estimating
national income. Nevertheless, the most common method is the net product method because: (i) this
method requires classification of the economic activities and output thereof which is much easier than
to classify income or expenditure; and (ii) the most common practice is to collect and organize the
national income data by the division of economic activities. Briefly speaking, the easy availability of
data on economic activities is the main reason for the popularity of the output method. It should be
however borne in mind that no single method can give an accurate measure of national income since
the statistical system of no country provides the total data requirements for a particular method. The
usual practice is, therefore, to combine two or more methods to measure the national income. The
combination of methods again depends on the nature of data required and sectoral break-up of the
available data.
8.5 Inflation: Meaning

Inflation is a highly controversial term which has undergone modification since it was first defined by
the neo-classical economists. They meant by it a galloping rise in prices as a result of the excessive
increase in the quantity of money. They regarded it “as a destroying disease born out of lack of
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monetary control whose results undermined the rules of business, creating havoc in markets and
financial ruin of even the prudent.” Inflation is fundamentally a monetary phenomenon. In the words
of Friedman, “Inflation is always and everywhere a monetary phenomenon…and can be produced only
by a more rapid increase in the quantity of money than output.’” But economists do not agree that
money supply alone is the cause of inflation. As pointed out by Hicks, “Our present troubles are not of
a monetary character.” Economists, therefore, define inflation in terms of a continuous rise in prices.
Johnson defines “inflation as a sustained rise”4 in prices. Brooman defines it as “a continuing increase
in the general price level.”5 Shapiro also defines inflation in a similar vein “as a persistent and
appreciable rise in the general level of prices.” Demberg and McDougall are more explicit when they
write that “the term usually refers to a continuing rise in prices as measured by an index such as the
consumer price index (CPI) or by the implicit price deflator for gross national product.”
However, it is essential to understand that a sustained rise in prices may be of various magnitudes.
Accordingly, different names have been given to inflation depending upon the rate of rise in prices.
8.5.1 Types of Inflation

1. Creeping Inflation:
When the rise in prices is very slow like that of a snail or creeper, it is called creeping inflation. In
terms of speed, a sustained rise in prices of annual increase of less than 3 per cent per annum is
characterized as creeping inflation. Such an increase in prices is regarded safe and essential for
economic growth.
2. Walking or Trotting Inflation:
When prices rise moderately and the annual inflation rate is a single digit. In other words, the rate of
rise in prices is in the intermediate range of 3 to 6 per cent per annum or less than 10 per cent. Inflation
at this rate is a warning signal for the government to control it before it turns into running inflation.
3. Running Inflation:
When prices rise rapidly like the running of a horse at a rate or speed of 10 to 20 per cent per annum, it
is called running inflation. Such an inflation affects the poor and middle classes adversely. Its control
requires strong monetary and fiscal measures, otherwise it leads to hyperinflation.
4. Hyperinflation:
When prices rise very fast at double or triple digit rates from more than 20 to 100 per cent per annum
or more, it is usually called runaway ox galloping inflation. It is also characterized as hyperinflation by
certain economists. In reality, hyperinflation is a situation when the rate of inflation becomes
immeasurable and absolutely uncontrollable. Prices rise many times every day. Such a situation brings
a total collapse of monetary system because of the continuous fall in the purchasing power of money.
The speed with which prices tend to rise is illustrated in Figure 1. The curve С shows creeping
inflation when within a period of ten years the price level has been shown to have risen by about 30
per cent. The curve W depicts walking inflation when the price level rises by more than 50 per cent
during ten years. The curve R illustrates running inflation showing a rise of about 100 per cent in ten
years. The steep curve H shows the path of hyperinflation when prices rise by more than 120 per cent
in less than one year.
5. Semi-Inflation:
According to Keynes, so long as there are unemployed resources, the general price level will not rise
as output increases. But a large increase in aggregate expenditure will face shortages of supplies of
some factors which may not be substitutable. This may lead to increase in costs, and prices start rising.
This is known as semi-inflation or bottleneck inflation because of the bottlenecks in supplies of some
factors.
6. Open Inflation:
Inflation is open when “markets for goods or factors of production are al¬lowed to function freely,
setting prices of goods and factors without normal interference by the authori¬ties. Thus open inflation
is the result of the uninterrupted operation of the market mechanism. There are no checks or controls
on the distribution of commodities by the government. Increase in demand and shortage of supplies
persist which tend to lead to open inflation. Unchecked open inflation ultimately leads to
hyperinflation.
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7. Suppressed Inflation:
Men the government imposes physical and monetary controls to check open inflation, it is known as
repressed or suppressed inflation. The market mechanism is not allowed to function normally by the
use of licensing, price controls and rationing in order to suppress extensive rise in prices. So long as
such controls exist, the present demand is postponed and there is diversion of demand from controlled
to uncontrolled commodities. But as soon as these controls are removed, there is open inflation.
Moreover, suppressed inflation adversely affects the economy.
8. Stagflation:
Stagflation is a new term which has been added to economic literature in the 1970s. It is a paradoxical
phenomenon where the economy expedience’s stagnation as well as inflation. The word stagflation is
the combination of‘ stag’ plus ‘flation’ taking ‘stag’ from stagnation and ‘flation’ from inflation.
Stagflation is a situation when recession is accompanied by a high rate of inflation. It is, therefore, also
called inflationary recession. The principal cause of this phenomenon has been excessive demand in
commodity markets, thereby causing prices to rise, and at the same time the demand for labour is
deficient, thereby creating unemployment in the economy.
9. Mark-up Inflation:
The concept of mark-up inflation is closely related to the price-push problem. Modem labour
organizations possess substantial monopoly power. They, therefore, set prices and wages on the basis
of mark-up over costs and relative incomes. Firms possessing monopoly power have control over the
prices charged by them. So they have administered prices which increase their profit margin. This sets
off an inflationary rise in prices. Similarly, when strong trade unions are suc-cessful in raising the
wages of workers, this contributes to inflation.
10. Sectoral Inflation:
Sectoral inflation arises initially out of excess demand in particular industries. But it leads to a general
price rise because prices do not fall in the deficient demand sectors.
11. Reflation:
Is a situation when prices are raised deliberately in order to encourage economic activity. When there
is depression and prices fall abnormally low, the monetary authority adopts measures to put more
money in circulation so that prices rise. This is called reflation.
12. Demand-Pull Inflation
Demand-Pull or excess demand inflation is a situation often described as “too much money chasing
too few goods.” According to this theory, an excess of aggregate demand over aggregate supply will
generate inflationary rise in prices. Its earliest explanation is to be found in the simple quantity theory
of money.
The theory states that prices rise in proportion to the increase in the money supply. Given the full
employment level of output, doubling the money supply will double the price level. So inflation
proceeds at the same rate at which the money supply expands.
In this analysis, the aggregate supply is assumed to be fixed and there is always full employment in the
economy. Naturally, when the money supply increases it creates more demand for goods but the
supply of goods cannot be increased due to the full employment of resources. This leads to rise in
prices.
Modem quantity theorists led by Friedman hold that “inflation is always and everywhere a monetary
phenomenon. The higher the growth rate of the nominal money supply, the higher the rate of inflation.
When the money supply increases, people spend more in relation to the available supply of goods and
services. This bids prices up. Modem quantity theorists neither assume full employment as a normal
situation nor a stable velocity of money. Still they regard inflation as the result of excessive increase in
the money supply.
The quantity theory version of the demand-pull inflation is illustrated in Figure 3. Suppose the money
supply is increased at a given price level OP as determined by the demand and supply curves D and S1
respectively. The initial full employment situation OYF at this price level is shown by the interaction
of these curves at point E. Now with the increase in the quantity of money, the aggregate demand
increase which shifts the demand curve D to D1to the right. The aggregate supply being fixed, as
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shown by the vertical portion of the supply curve SS1 the D1 curve intersects it at point E1. This raises
the price level to OP1.
The Keynesian theory on demand-pull inflation is based on the argument that so long as there are
unemployed resources in the economy; an increase in investment expenditure will lead to increase in
employment, income and output. Once full employment is reached and bottlenecks appear, further
increase in expenditure will lead to excess demand because output ceases to rise, thereby leading to
inflation.
8.5.2 The Inflationary Gap

In his pamphlet How to pay for the War published in 1940, Keynes explained the concept of the
inflationary gap. It differs from his views on inflation given in his General Theory. In the General
Theory, he started with underemployment equilibrium. But in How to Pay for the War, he began with a
situation of full employment in the economy.
He defined an inflationary gap as an excess of planned expenditure over the available output at pre-
inflation or base prices. According to Lipsey, “The inflationary gap is the amount by which aggregate
expenditure would exceed aggregate output at the full employment level of income.” The classical
economists explained inflation as mainly due to increase in the quantity of money, given the level of
full employment.
Keynes, on the other hand, ascribed it to the excess of expenditure over income at the full employment
level. The larger the aggregate expenditure, the larger the gap and the more rapid the inflation. Given a
constant average propensity to save, rising money incomes at full employment level would lead to an
excess of demand over supply and to a consequent inflationary gap. Thus Keynes used the concept of
the inflationary gap to show the main determinants that cause an inflationary rise of prices.
8.5.3 Causes of Inflation

Inflation is caused when the aggregate demand exceeds the aggregate supply of goods and services.
We analyze the factors which lead to increase in demand and the shortage of supply.
Factors Affecting Demand
1. Increase in Money Supply:
Inflation is caused by an increase in the supply of money which leads to increase in aggregate demand.
The higher the growth rate of the nominal money supply, the higher is the rate of inflation. Modem
quantity theorists do not believe that true inflation starts after the full employment level. This view is
realistic because all advanced countries are faced with high levels of unemployment and high rates of
inflation.
2. Increase in Disposable Income:
When the disposable income of the people increases, it raises their demand for goods and services.
Disposable income may increase with the rise in national income or reduction in taxes or reduction in
the saving of the people.
3. Increase in Public Expenditure:
Government activities have been expanding much with the result that government expenditure has also
been increasing at a phenomenal rate, thereby raising aggregate demand for goods and services.
Governments of both developed and developing countries are providing more facilities under public
utilities and social services, and also nationalizing industries and starting public enterprises with the
result that they help in increasing aggregate demand.
4. Increase in Consumer Spending:
The demand for goods and services increases when consumer expenditure increases. Consumers may
spend more due to conspicuous consumption or demonstration effect. They may also spend more whey
they are given credit facilities to buy goods on hire-purchase and installment basis.
5. Cheap Monetary Policy
Cheap monetary policy or the policy of credit expansion also leads to increase in the money supply
which raises the demand for goods and services in the economy. When credit expands, it raises the
money income of the borrowers which, in turn, raises aggregate demand relative to supply, thereby
leading to inflation. This is also known as credit-induced inflation.
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6. Deficit Financing:
In order to meet its mounting expenses, the government resorts to deficit financing by borrowing from
the public and even by printing more notes. This raises aggregate demand in relation to aggregate
supply, thereby leading to inflationary rise in prices. This is also known as deficit-induced inflation.
7. Expansion of the Private Sector:
The expansion of the private sector also tends to raise the aggregate demand. For huge investments
increase employment and income, thereby creating more demand for goods and services. But it takes
time for the output to enter the market.
8. Black Money:
The existence of black money in all countries due to corruption, tax evasion etc. increases the
aggregate demand. People spend such unearned money extravagantly, thereby creating unnecessary
demand for commodities. This tends to raise the price level further.
9. Repayment of Public Debt:
Whenever the government repays its past internal debt to the public, it leads to increase in the money
supply with the public. This tends to raise the aggregate demand for goods and services.
10. Increase in Exports:
When the demand for domestically produced goods increases in foreign countries, this raises the
earnings of industries producing export commodities. These, in turn, create more demand for goods
and services within the economy.
8.5.4 Measure to Control Inflation

The various methods are usually grouped under three heads:
Monetary measures, fiscal measures and other measures.
1. Monetary Measures:
Monetary measures aim at reducing money incomes.
(a) Credit Control:
One of the important monetary measures is monetary policy. The central bank of the country adopts a
number of methods to control the quantity and quality of credit. For this purpose, it raises the bank
rates, sells securities in the open market, raises the reserved ratio, and adopts a number of selective
credit control measures, such as raising margin requirements and regulating consumer credit.
Monetary policy may not be effective in controlling inflation, if inflation is due to cost-push factors.
Monetary policy can only be helpful in controlling inflation due to demand-pull factors.
(b) Demonetization of Currency:
However, one of the monetary measures is to demonetize currency of higher denominations. Such a
measure is usually adopted when there is abundance of black money in the country.
(c) Issue of New Currency:
The most extreme monetary measure is the issue of new currency in place of the old currency. Under
this system, one new note is exchanged for a number of notes of the old currency. The value of bank
deposits is also fixed accordingly. Such a measure is adopted when there is an excessive issue of notes
and there is hyperinflation in the country. It is a very effective measure. But is inequitable for it hurts
the small depositors the most.
2. Fiscal Measures:
Monetary policy alone is incapable of controlling inflation. It should, therefore, be supplemented by
fiscal measures. Fiscal measures are highly effective for controlling government expenditure, personal
consumption expenditure, and private and public investment.
The principal fiscal measures are the following:
(a) Reduction in Unnecessary Expenditure:
The government should reduce unnecessary expenditure on non-development activities in order to curb
inflation. This will also put a check on private expenditure which is dependent upon government
demand for goods and services. But it is not easy to cut government expenditure. Though economy
measures are always welcome but it becomes difficult to distinguish between essential and non-
essential expenditure. Therefore, this measure should be supplemented by taxation.
(b) Increase in Taxes:
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To cut personal consumption expenditure, the rates of personal, corpo¬rate and commodity taxes
should be raised and even new taxes should be levied, but the rates of taxes should not be so high as to
discourage saving, investment and production. Rather, the tax system should provide larger incentives
to those who save, invest and produce more.
Further, to bring more revenue into the tax-net, the government should penalize the tax evaders by
imposing heavy fines. Such measures are bound to be effective in controlling inflation. To increase the
supply of goods within the country, the government should reduce import duties and increase export
duties.
(c) Increase in Savings:
Another measure is to increase savings on the part of the people. This will tend to reduce disposable
income with the people, and hence personal consumption expenditure. But due to the rising cost of
living, people are not in a position to save much voluntarily. Keynes, therefore, advocated compulsory
savings or what he called ‘deferred payment’ where the saver gets his money back after some years.
For this purpose, the government should float public loans carrying high rates of interest, start saving
schemes with prize money, or lottery for long periods, etc. It should also introduce compulsory
provident fund, provident fund-cum-pension schemes, etc. compulsorily. All such measures to increase
savings are likely to be effective in controlling inflation.
(d) Surplus Budgets:
An important measure is to adopt anti-inflationary budgetary policy. For this purpose, the government
should give up deficit financing and instead have surplus budgets. It means collecting more in
revenues and spending less.
(e) Public Debt:
At the same time, it should stop repayment of public debt and postpone it to some future date till
inflationary pressures are controlled within the economy. Instead, the government should borrow more
to reduce money supply with the public.
Like the monetary measures, fiscal measures alone cannot help in controlling inflation. They should be
supplemented by monetary, non-monetary and non-fiscal measures.
3. Other Measures:
The other types of measures are those which aim at increasing aggregate supply and reducing
aggregate demand directly:
(a) To Increase Production:
The following measures should be adopted to increase production:
(i) One of the foremost measures to control inflation is to increase the production of essential
consumer goods like food, clothing, kerosene oil, sugar, vegetable oils, etc.
(ii) If there is need, raw materials for such products may be imported on preferential basis to increase
the production of essential commodities.
(iii) Efforts should also be made to increase productivity. For this purpose, industrial peace should be
maintained through agreements with trade unions, binding them not to resort to strikes for some time.
(b) Rational Wage Policy:
Another important measure is to adopt a rational wage and income policy. Under hyperinflation, there
is a wage-price spiral. To control this, the government should freeze wages, incomes, profits,
dividends, bonus, etc. But such a drastic measure can only be adopted for a short period and by
antagonizing both workers and industrialists. Therefore, the best course is to link increase in wages to
increase in productivity. This will have a dual effect. It will control wages and at the same time
increase productivity, and hence increase production of goods in the economy.
(c) Price Control:
Price control and rationing is another measure of direct control to check inflation. Price control means
fixing an upper limit for the prices of essential consumer goods. They are the maximum prices fixed by
law and anybody charging more than these prices is punished by law. But it is difficult to administer
price control.
(d) Rationing:
Rationing aims at distributing consumption of scarce goods so as to make them available to a large
number of consumers. It is applied to essential consumer goods such as wheat, rice, sugar, kerosene
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SAURABH GUPTA
oil, etc. It is meant to stabilize the prices of necessaries and assure distributive justice. But it is very
inconvenient for consumers because it leads to queues, artificial shortages, corruption and black
marketing. Keynes did not favour rationing for it “involves a great deal of waste, both of resources and
of employment.”
8.5.5 Effects of Inflation

Inflation affects different people differently. This is because of the fall in the value of money. When
prices rise or the value of money falls, some groups of the society gain, some lose and some stand in
between. Broadly speaking, there are two economic groups in every society, the fixed income group
and the flexible income group.
People belonging to the first group lose and those belonging to the second group gain. The reason is
that price movements in the case of different goods, services, assets, etc. are not uniform. When there
is inflation, most prices are rising, but the rates of increase of individual prices differ much. Prices of
some goods and services rise faster, of others slowly, and of still others remain unchanged. We discuss
below the effects of inflation on redistribution of income and wealth, production, and on the society as
a whole.
1. Effects on Redistribution of Income and Wealth:
There are two ways to measure the effects of inflation on the redistribution of income and wealth in a
society. First, on the basis of the change in the real value of such factor incomes as wages, salaries,
rents, interest, dividends and profits.
Second, on the basis of the size distribution of income over time as a result of inflation, i.e. whether
the incomes of the rich have increased and that of the middle and poor classes have declined with
inflation. Inflation brings about shifts in the distribution of real income from those whose money
incomes are relatively inflexible to those whose money incomes are relatively flexible.
2. Effects on Production:
When prices start rising, production is encouraged. Producers earn wind-fall profits in the future. They
invest more in anticipation of higher profits in the future. This tends to increase employment,
production and income. But this is only possible up to the full employment level.
Further increase in investment beyond this level will lead to severe inflationary pressures within the
economy because prices rise more than production as the resources are fully employed. So inflation
adversely affects production after the level of full employment.
3. Other Effects:
Inflation leads to a number of other effects which are discussed as under:
(1) Government:
Inflation affects the government in various ways. It helps the government in financing its activities
through inflationary finance. As the money income of the people increases, the government collects
that in the form of taxes on incomes and commodities. So the revenues of the government increase
during rising prices.
Moreover, the real burden of the public debt decreases when prices are rising. But the government
expenses also increase with rising production costs of public projects and enterprises and increase in
administrative expenses as prices and wages rise. On the whole, the government gains under inflation
because rising wages and profits spread an illusion of prosperity within the country.
(2) Balance of Payments:
Inflation involves the sacrificing of the advantages of international specialization and division of
labour. It adversely affects the balance of payments of a country. When prices rise more rapidly in the
home country than in foreign countries, domestic products become costlier compared to foreign
products. This tends to increase imports and reduce exports, thereby making the balance of payments
unfavorable for the country. This happens only when the country follows a fixed exchange rate policy.
But there is no adverse impact on the balance of payments if the country is on the flexible exchange
rate system.
(3) Exchange Rate:
When prices rise more rapidly in the home country than in foreign countries, it lowers the exchange
rate in relation to foreign currencies.
114
(4) Collapse of the Monetary System:

If hyperinflation persists and the value of money continues to fall many times in a day, it ultimately
leads to the collapse of the monetary system, as happened in Germany after World War I.
(5) Social. Inflation is socially harmful:
By widening the gulf between the rich and the poor, rising prices create discontentment among the
masses. Pressed by the rising cost of living, workers resort to strikes which lead to loss in production.
Lured by profit, people resort to hoarding, black-marketing, adulteration, manufacture of substandard
commodities, speculation, etc. Corruption spreads in every walk of life. All this reduces the efficiency
of the economy.
(6) Political:
Rising prices also encourage agitations and protests by political parties opposed to the government.
And if they gather momentum and become unhandy they may bring the downfall of the government.
Many governments have been sacrificed at the alter of inflation.
8.6 Theories of Profit in Economics

In economics, profit is called pure profit, which may be defined as a residual left after all contractual
costs have been met, including the transfer costs of management insurable risks, depreciation and
payment to shareholders, sufficient to maintain investment at its current level.
There are various theories of profit in economics, given by several economists, which are as follows:
1. Walker’s Theory of Profit as Rent of Ability
This theory is pounded by F.A. Walker. According to Walker, “Profit is the rent of exceptional
abilities that an entrepreneur may possess over others”. Rent is the difference between the yields of the
least and the most efficient entrepreneurs. In formulating this theory, Walker assumed a state of perfect
completion in which all firms are presumed to possess equal managerial ability each firm receives only
the wages which in Walker view forms no part of pure profit. He considered wages of management as
ordinary wages thus, under perfectly competitive conditions, there would be no pure profit and all
firms would earn only wages, which is known as normal profit.
2. Clark’s Dynamic Theory
This theory is propounded by J.B. Clark According to him, “Profits arise in a dynamic economy and
not in static economy.”
A static economy and the firms under it, has the following features:
• Absolute freedom of competition.
• Population and capital are stationary.
• Production process remains unchanged over time.
• Homogeneous goods.
• Factors of production enjoy freedom of mobility but do not move because their marginal product
in very industry is the same.
• There is no uncertainly and risk. If there is any risk, it is insurable
• All firms make only normal profit.
A dynamic economy is characterized by the following features:

• Increase in population.
• Increase in capital.
• Improvement in production techniques.
• Changes in the forms of business organization.
The major function of entrepreneurs or managers in a dynamic economy is to take the advantage of all
of the above features and promote their business by expanding their sales and reducing their costs of
production.
According to J.B. Clark, “Profit is an elusive sum, which entrepreneurs grasp but cannot hold. It slips
through their fingers and bestows itself on all members of the society”. This result in rise in demand
for factors pf production and therefore rises in factor prices and subsequent rise in the cost of
production. On the other hand, because of rise in cost of production and the subsequent fall in selling
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SAURABH GUPTA
price of the commodities, the profit disappears. Disappearing of profit does not mean that profit arise
in dynamic economy once only, but it means that the managers take the advantage of the changes
taking place in the economy and thereby making profits.
3. Hawley’s Risk Theory of Profit
The risk theory of profit is propounded by F.B. Hawley in 1893. Risk in business may arise due to
obsolescence of a product, sudden fall in prices, non-availability of certain materials, introduction of a
better substitute by a competitor and risks due to fire, war, etc. Hawley’s considered risk taking as an
inevitable element of production and those who take risk are more likely to earn larger profits.
According to Hawley, Profit is simply the price paid by society assuming business risks. In his opinion
in excess of predetermined risk. They also look for a return in excess of the wags for bearing risk is
that the assumption of risk is irrelevant and gives to trouble and anxiety. According to Hawley, Profit
consists of two part, which are as follows:
• One Part represents compensation for actual or average loss supplementing the various classes of
risk.
• The other part represents a penalty to suffer the consequences of being exposed to risk in the
entrepreneurial activities.
Hawley believed that profits arise from factor ownership as long as ownership involves risk.
According to Hawley, an entrepreneur has to assume risk to earn more and more profit. In case of
absence of risks, an entrepreneur would cease to be an entrepreneur and would not receive any profit.
In this theory, profits arise out of uninsured risks. The amount of reward cannot be determined, until
the uncertainly ends with the sale of entrepreneur products profit in his opinion is a residue and
therefore Hawley theory is also called as Residual theory.
4. Knight’s Theory of Profit
This theory of profit is propounded by frank H. Knight who treated profit as a residual return because
of uncertainly, and not because of risk bearing. Knight made a distinction between risk and uncertainly
by dividing risk into two categories, calculable and non-calculable risks. They are explained as below:
• Calculable risks are those, the prodigality of occurrence of which van be calculated on the basis of
available data. For example risk, due to fire theft accidents etc. are calculable and such risks are
insurable.
• Incalculable risks are those the probability of occurrence of which cannot be calculated. For
Instance there may be a certain elements of cost, which may not be accurately calculable and the
strategies of the competitors may not be precisely assessable. These risk are called includable risks.
The risk element of such incalculable costs is also insurable.
It is in the area of uncertainly which makes decision-making a crucial function for an entrepreneur. If
his decisions prove to be right, the entrepreneur makes profit, Thus according to knight profit arises
from the decisions taken and implemented under the conditions of uncertainly. The profits may arises
as a result of decision related to the state of market such as decision, which increase the degree of
monopoly, decisions regarding holding of stocks that give rise to windfall gains and the decisions
taken to introduce new techniques or innovations.
5. Schumpeter’s Innovation Theory of Profit
Joseph A. Schumpeter developed the innovation theory of Profit. According to Schumpeter, factors
like emergence of interest and profits, recurrence of trade cycles only supplement the distinct process
of economic development. To explain the phenomenon of economic development and profit,
Schumpeter starts from the state of a stationary equilibrium, which is characterized by the equilibrium
in all the spheres. Under these conditions stationary equilibrium, the total receipts from the business
are exactly equal to the cost. This means that there will be no profit. The profit can be earned only by
introducing innovations in manufacturing technique and the methods of supplying the goods
innovations may include the following activities.
• Introduction of a new commodity or new quality goods.
• Introduction of a new method of production.
• Introduction of a new market.
• Finding the new sources of raw material.
• Organizing the industry in an innovative manner with the new techniques.
116
The factor prices tend to increase while the supply of factors remains the same. As a result, cost of
production increase. On the other hand with other firms adopting innovations, supply of goods and
services increases resulting in a fall in their prices. Thus, on one hand, cost per unit of output goes up
and on the other revenue per unit decrease. Finally, a stage comes when there is no difference between
costs and receipts. As a result there are no profits at all. Here, economy has reached a state of
equilibrium, but there is the possibility of existence of profits. Such profits are in the nature of quasi-
rent arising due to some special characteristics of productive services. Furthermore, where profits arise
due to factors such as patents, trusts, etc. they will be in the nature of monopoly revenue rather than
entrepreneurial profits.
8.7 Business Cycle

The Business Cycle allows people to understand the direction the economy (GDP) is going (growing
or shrinking) and plan accordingly.
The economy follows the Business Cycle regularly.
Phases of the Business Cycle

Expansion (Growing)
Peak (Top)
Contraction (Shrinking)
Trough (Bottom)
FIGURE 35: Business Cycle
Expansion
• During a period of expansion:
– Wages increase
– Low unemployment
– People are optimistic and spending money
– High demand for goods

SAURABH GUPTA
– Businesses start
– Easy to get a bank loan
– Businesses make profits and stock prices increase
Peak
• When the economic cycle peaks:
– The economy stops growing (reached the top)
– GDP reaches maximum
– Businesses can’t produce any more or hire more people
– Cycle begins to contract
Contraction
• During a period of contraction:
– Businesses cut back production and layoff people
– Unemployment increases
– Number of jobs decline
– People are pessimistic (negative) and stop spending money
– Banks stop lending money
Trough
• When the economic cycle reaches a trough:
– Economy “bottoms-out” (reaches lowest point)
– High unemployment and low spending
– Stock prices drop
But, when we hit bottom, no where to go but up!
UNLESS….
Recession/Depression
• A prolonged contraction is called a recession (contraction for over 6 months)
• A recession of more than one year is called a depression
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8.7.1 What keeps the Business Cycle Going?
• Four variables cause changes in the Business Cycle:
1. Business Investment
When the economy is expanding, sales and profit keep rising, so companies invest in new plants and
equipment, creating new jobs and more expansion. In contraction, the opposite is true
2. Interest Rates and Credit
Low interest rates, companies make new investments, adding jobs. When interest rates climb,
investment dries up and less job growth
3. Consumer Expectations
Forecasts of an expanding economy fuels more spending, while fear of a recession decreases consumer
spending
4. External Shocks
External Shocks, such as disruptions of the oil supply, wars, or natural disasters greatly influence the
output of the economy
Ex. 1992-2000 was the longest period of expansion in U.S. history. Early in 2001, signs of contraction
appeared, though the Bush administration denied it. The Sept. 11th 2001 terrorist attacks quickly
caused the business cycle to shift into a contraction.
8.7.2 Why should you care about the business cycle and economy?
“Don’t quit that job!”
• If the economy is going into a contraction, jobs will become more scarce. If you quit, you may
not find another job!
• But, if the economy is in a period of expansion, jobs are readily available. It may be a good
time to switch careers.
“Should I make a big purchase?”
• Only if you know that you won’t lose your job in a contraction. So, buy your house during an
expansion.
HOWEVER,
• When the economy starts to slow down (contraction), interest rates will decrease. Wait to buy a
house until the rates drop to a low point, if you are sure you won’t lose your job.
Quick Review!
• What phase of the business cycle do wages go up?
Expansion
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SAURABH GUPTA
• What phase of the business cycle do wages go down?
Contraction
• When are wages at their highest?
Peak
• When are wages at their lowest?
Trough
• When will borrowing decrease?
Contraction
• When will borrowing increase?
Expansion
• When will borrowing be at it’s lowest?
Trough
• When will unemployment be at its lowest?
Peak
• When will business profits be the highest?
Peak
• When should you look for a new job?
Expansion
QUESTIONS
Q1. Explain the method of measuring national income.

Q2. What is inflation? Also explain the types of inflation
Q3. Explain the measures to control inflation.
Q4. Explain business cycle.
Q5. Describe the factors causing inflation.
Q6. Explain the various concept of National Income. Under what circumstances does national
income tend to be under estimated?
Q7. Describe in brief inflation? Also discuss reason for inflation and its effects.
Q8. Explain the profit concept and major theories of profits?
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ABOUT THE AUTHOR
Dr. Saurabh Gupta

Associate Professor
UGC NET-JRF
He has two years teaching and five years research experience in reputed organization. He has
completed his doctorate degree in management from Lucknow University. He has done his post
graduate in management. His areas of interest are human resources, marketing, business
mathematics, managerial economics, quality management, operation research, research
methodology etc. He has published 2 research papers in national journals and 4 research papers in
international journal. He has attended more than 25 national and international conferences. He has
also attended more than seven Faculty development programs and workshops on SPSS and
AMOS sponsored by ICSSR New Delhi. He has guided several graduate and post graduate
students in project work. He has successfully conducted SWACHH BHARAT SUMMER
INTERNSHIP PROGRAM 2018 with the group of post graduate students. Over the years, he has
developed an innovative approach to teaching and conducting research. He has creative and
effective management skills, flexible and efficient working with changing priorities and diverse
audiences. He is able to navigate through complex issues and conceive of solutions leading to
cooperation between disparate groups and individuals.
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Managerial Economics

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Managerial Economics

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MANAGERIAL ECONOMICS

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Chapters Page Numbers

3.1.1 Difference between Stock & Supply 44

5.6.3 Unconstrained Optimization: The Profit Function 82

TABLES & FIGURES PAGE NUMBERS

TABLE 1: Demand Schedule 23

I take this opportunity to remember with gratitude: my supervisor, my colleagues, my

1.1 SCOPE OF ECONOMICS

1.3 Managerial Economics

1.4 Characteristics of Managerial Economics

1.6 Nature of Managerial Economics

1.7 Scope of Managerial Economics:

1.8 Fundamental Principles of Managerial Economics

1.9 Role of a Managerial Economist

1.10 Relationship of managerial economics with other disciplines:

Managerial economics and mathematics:

Managerial economics and operations research:

2.1 Demand Function

2.2 Law of Demand

2.3 Demand Schedule

2.4 Demand Curve

FIGURE 2: DEMAND CURVE

Exceptions to Law of Demand

2.5 Determinants of (Factors affecting) demand

2.6 Types of Elasticity

Percentage change in quantity demanded

FIGURE 3: ELASTIC DEMAND

FIGURE 5: UNIT ELASTIC DEMAND

2.6.2. Cross Elasticity of Demand

Percentage change in quantity demanded of a good

FIGURE 7: CROSS ELASTICITY

The cross elasticity of demand for a substitute is positive.

2.6.3. Income Elasticity of Demand

FIGURE 8: INCOME ELASTICITY

2.6.4. Promotional (Advertising) Elasticity of Demand

Factors Influencing Advertising Elasticity of Demand

2.7 Managerial Uses of Elasticity Concepts

2.8 Types of Demand

2.9 Demand Forecasting

4. Marketing : Pricing, promotion, strategy

1. Time Lag Theory

2.9.6 Demand Forecasting Methods/Models

Sales Force Regression

x = -1, Yc = 62.80 +3.1(-1)

x = 2, Yc = 82.85 +3.857 (1)

84 110 9240 12100 7056

2.10 Criteria of a Good Forecasting Method:

SN=f (PN,PR, F, T,G )

3.1.3 Law of Supply

3.1.4 Elasticity of Supply

simple: techniques of production could be easily increased.

3.2 Aggregate Supply

Aggregate Supply Schedule

3.3 Determination of Effective Demand:

Schedule of Aggregate Demand and Aggregate Supply Prices

3.4 Importance of Effective Demand:

3.5 Determinant of Employment:

Effective Demand=Value of National Output=Volume of Employment=National

the consumption of goods and services.

3.6 Role of Investment:

The Paradox of Poverty in the Midst of Potential Plenty:

3.7 Price Ceilings