MAM 053 Block-1

MAM-053
Managerial Economics
and Finance in
Agribusiness
BLOCK 1: MANAGERIAL ECONOMICS
Unit 1 : Introduction to Managerial Economics
Unit 2 : Microeconomic Theory and Initial Applications
Unit 3 : Market Equilibrium
Unit 4 : Principles of Farm Management and Pricing Practices
Unit 5 : Equilibrium Condition
BLOCK 2 : FUNDAMENTALS OF ACCOUNTING
Unit 6 : Introduction to Accounting
Unit 7 : Accounting Records and Systems
Unit 8 : Preparation of Accounts
Unit 9 : Understanding Financial Statements
Unit 10 : Fund Flow Statement
Unit 11 : Analysis of Financial Statements
BLOCK 3 : AGRICULTURAL FINANCE AND RISK MANAGEMENT
Unit 12 : Source of Agricultural Finance
Unit 13 : Agricultural Risk and Insurance

MAM-053 M ANAGERIAL ECONOMICS AND
FINANCE IN AGRIBUSINESS
The course on Managerial Economics and Finance in Agribusiness has

been purposively designed to make you understand the nature and scope of
managerial economics and its role in facilitating the decision-making process to
make the organizations profiteering one. The microeconomic theory and initial
applications including the concepts of demand and supply will elaborate the
concepts like price elasticity, income elasticity, cross elasticity, and elasticity of
substitution. On the other hand, the course will also educate you about consumer
surplus, demand forecasting methods, reasons for fluctuating demand for
agricultural commodities, and market equilibrium. The aspects related to farm
management principles and pricing practices will guide us on basic principles
involved in making rational farm management decisions such as the Principle of
variable proportions or laws of returns, Cost principle, Principle of substitution
between inputs, Equi-marginal returns principle or opportunity cost principle,
Principle of substitution between products and Principle underlying decisions
involving time and uncertainty. In addition, the concept of profit maximization,
supply curve derivations, price discrimination, and welfare effects will also
make us understand the market forces and the models like monopoly and
oligopoly. In the second part of the course, you will explore the concepts of
the double entry system, cash book, ledger, trial balance, trading account, and
preparation of financial statements. The general purpose of exposing you to the
financial statements is to make you proficient in providing information about
the results of operations, financial position, and cash flows of an organization.
This information will help you as managers to make decisions regarding the
allocation of resources. At a more refined level, there is a different purpose
associated with each of the financial statements. The income statement informs
the managers about the ability of a business to generate a profit. In addition, it
reveals the volume of sales, and the nature of the various types of expenses,
depending upon how expense information is aggregated. After going through
the fundamentals, you may be able to prepare the layout of the balance sheet
and income statement, how transactions are recorded, and how to prepare these
statements. By the end of this module, you will have a solid understanding
of how to construct a balance sheet and income statement. Under the third
component of the course which is attributed to agricultural finance and risk
management, you will learn about the risks involved in agriculture and how
these risks can be mitigated by using several risk management options. The
concerned units will make you learn about what can be done at the farm, local
area/community, and national levels to manage risks in agriculture.
The course assessment as per IGNOU norms will be through assignments

and term-end examination. You must prepare the assignments based on your
understanding of the contents of this course and the application of the same to
the proposed business activity.
MAM-053
and Finance in
Agribusiness
BLOCK
1
MANAGERIAL ECONOMICS
Unit 1
Introduction to Managerial Economics
Unit 2
Microeconomic Theory and Initial Applications
Unit 3
Market Equilibrium
Unit 4
Principles of Farm Management and Pricing
Practices
Unit 5
Equilibrium Condition
PROGRAMME DESIGN COMMITTEE
Prof. R. P. Das, PVC, Dr. Leena Singh, Assistant Professor,

IGNOU SOMS, IGNOU
Prof. S.K. Yadav, Director, SoA, IGNOU Prof. Sunil Gupta, SOMS, IGNOU
Dr. B.K. Sikka, Former Dean, College of Dr. P. Vijayakumar, Associate Professor,
Agribusiness Management, GBPUAT SoA, IGNOU
Dr. V.C. Mathur, Former Professor and Dr. Mita Sinhamahapatra

Head, Div. of Agri. Econ. IARI Associate Professor, SoA, IGNOU
Dr. Pramod Kumar, Principal Scientist Dr. Mukesh Kumar, Assistant Professor,
(Agri. Econ.) IARI SoA, IGNOU
Prof. M. K. Salooja, School of Agriculture, Dr. P. K. Jain, Associate Professor and

IGNOU Programme Coordinator, SoA, IGNOU
Dr. Anjali Ramtake, Associate Professor,

SOMS, IGNOU
Programme Coordinator: Dr. Praveen Kumar Jain

BLOCK PREPARATION TEAM
Unit Writers Editors

Unit 1 & 4: Dr. D.D. Chaturvedi, New Delhi Dr. M.L. Sharma, Professor,
Agricultural Economics, GBPUAT,
Unit 2: Dr. Ranjit Kumar, NAARM, Hyderabad Pantnagar (Uttrakhand)
Unit 3: Dr. D.K. Bharati, CIPHET, Ludhiana
Dr. Praveen Kumar Jain, SoA,
Unit 5: Dr. Chhotan Singh, New Delhi IGNOU
Course Coordinator: Dr. Praveen Kumar Jain
MATERIAL PRODUCTION
June, 2022
© Indira Gandhi National Open University
ISBN:
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any other means, without permission in writing from the copyright holder.
The University does not warrant or assume any legal liability or responsibility for the academ-
ic content of this course provided by the authors as far as the copyright issues are concerned.
Further information on the Indira Gandhi National Open University courses may be obtained
from the University’s office at Maidan Garhi, New Delhi-110 068 or the official website of
IGNOU at www.ignou.ac.in.
Printed and published on behalf of Indira Gandhi National Open University, New Delhi by the
Director, School of Agriculture.
Laser typeset by
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BLOCK 1 MANAGERIAL ECONOMICS
The block on managerial economics will expose you to the basic concepts and
scope of managerial economics and its role in managerial decision-making. The
first unit under this block will familiarize us with macro and microeconomics,
economic goals, and choices. The second unit on microeconomic theory
and initial applications will educate us on the concept of utility, demand,
and supply functions including demand elasticity, income elasticity, price
elasticity, and cross elasticity. You will also learn about consumer surplus
and demand forecasting techniques for agricultural commodities. The third
unit on the market equilibrium consists of cardinal and ordinal hypotheses of
consumer behavior, the law of demand, and links to demand and elasticity.
Exposure to market equilibrium will help you to determine the minimal point
of equilibrium that ideally every company needs to attain. It will also help you
to numerically determine the minimum equilibrium point of every industry and
for all companies. The fourth unit on-farm management principles and pricing
practices will illustrate how farm management is one of the most important
resources in operating farms. Under this unit, you will learn how the farm-life
will be organized, resources allocated and activities performed so that a farm
can be made productive, sustainable, resistant, and profitable. The concepts like
factor-product relationship, an overview of production and cost theory, different
cost curves and their mutual relationship, cost-plus pricing, etc are exhaustively
described in this unit.
The last unit of the block on equilibrium condition will make you learn how an
oversupply of goods or services causes prices to go down, which results in higher
demand, while an under-supply or shortage causes prices to go up resulting
in less demand. We will also come to know the characteristics of equilibrium
conditions in this unit part from the concepts like price discrimination, welfare
effects, monopoly, duopoly, and oligopoly conditions.
The material provided in this block is supplemented with various examples and
activities to make the learning process simple and interesting. We have also
provided Check Your Progress questions for the self-test at a few places in these
units which invariably lead to possible answers to the questions set in those
exercises. What perhaps you ought to do, is to go through units and jot down
important points as you read, in the space provided in the margin. This will help
you in assimilating the content. A list of reference books has been provided at
the end of each unit for further detailed reading.
UNIT 1 INTRODUCTION TO
MANAGERIAL ECONOMICS
Structure
1.0 Objectives
1.1 Introduction
1.2 Meaning and Nature of Managerial Economics
1.3 Scope of Managerial Economics
1.4 Managerial Economics in Decision Making
1.4.1 Decision Areas
1.4.2 Steps in Decision Making
1.5 Definition, Concepts and Basic Principles of Economics

1.5.1 Microeconomic Concepts
1.5.2 Macroeconomic Concepts
1.6 Economic Goals and Choices

1.7 Let Us Sum Up
1.8 Keywords
1.9 Suggested Further Readings/References
1.10 Check Your Progress: Possible Answers
1.11 Unit End Questions
1.0 OBJECTIVES
After completion of this unit, you are expected to:
• explain the meaning of managerial economics;
• describe the nature and scope of managerial economics;
• establish the role of managerial economics in decision making; and
• appraise concepts and principles associated with micro and macro
economics.
1.1 INTRODUCTION
The basic function of business managers is to make appropriate decisions on
business matters and strive to secure and make optimum use of the available
resources to achieve the predetermined business goals. In today’s world,
business decision-making has become a cumbersome task due to the ever-
growing complexities of the business world. The dominant feature of the
modern business environment is the ever-increasing inter-firm and inter-
industry competition among both domestic and international corporations. In 9
Managerial Economics this competitive era, managers are not only required to focus their efforts on
achieving the business goals but also to endeavor for the survival and growth
of the business firms. Appropriateness of the business decisions and their
effective implementation are two success pillars in today’s business. In the
recent past, the techniques and processes of business decision-making have
transformed tremendously. For arriving at an appropriate and feasible business
decision, one of the prominent elements of the modern techniques of business
decision making is the growing application of economic logic, methodologies,
concepts, theories, and economic analytical tools. Therefore, sound knowledge
of economic science has become inevitable for managers. In this unit, we shall
discuss the various steps involved in the decision-making process and the uses
of managerial economic tools for management decisions. We shall learn basic
concepts of micro and macroeconomics and equip ourselves for handling the
challenges of the business world.
1.2 MEANING AND NATURE OF MANAGERIAL

ECONOMICS
Economics is the study of behavioural patterns and the economic actions
of economic entities. These entities may operate either individually (under
microeconomics) or collectively (under macroeconomics). However, the
emergence of managerial economics as a separate branch of economic study is
a recent phenomenon and can be attributed to the following three factors:
i) Growing complexities in the business decision-making process due to the
rapid expansion of business, changing market conditions and business
environment,
ii) Application of economic theory, logic, concepts, and analytical tools for
decision making, and
iii) Growing demand for professionally trained managerial manpower.
Business managers apply economic theories, concepts, and analytical tools

to find out solutions to problems in conformity with the goals or objectives
of a business. A clear understanding of the business environment e.g. nature
and degree of competition, market fundamentals, etc. are essential for
making the right decision, especially under the varied conditions of risk and
uncertainties. Therefore, a comprehensive analysis of market conditions with
respect to products, inputs, and prevailing financial markets has now become
inevitable. The basic function of economics is to offer a logical analysis and
systematic interpretation of the business world. The application of economic
theories, logic, and tools of analysis for the assessment and prediction of
market conditions are of great importance in making a befitting business
decision. This section of economics has emerged as a separate and specialized
branch of study, known as ‘managerial economics’. It is, therefore, a body of
knowledge consisting of economic concepts, logic and reasoning, economic
laws and theories, and tools and techniques for analyzing economic phenomena,
evaluating economic options, and for optimizing the allocation of resources. A
look at some representative definitions of managerial economics would help in
comprehending what managerial economics is about.
10
“Managerial economics is the integration of economic theory with business Introduction to
practices for the purpose of facilitating decision making and forward planning Managerial Economics
by management.”
- Spencer and Seigelman
“Managerial economics is concerned with the application of economic
principles and methodologies to the decision-making process within the firm
or organization under the conditions of uncertainty. It seeks to establish
rules and principles to facilitate the attainments of desired economic goals of
management.”
- Evan.J.Douglas
“Managerial economics applies the principles and methods of economics to
analyze problems faced by the management of a business or other types of
organizations and to help find solutions that advance the best interest of such
organizations.”
- Davis and Chang
“Managerial economics refers to the application of economic theory and
the tools of analysis of decision science to examine how an organization can
achieve its aim or objective most effectively.”
- Salvatore
These definitions give a broader view of the nature of managerial economics.
Based on these definitions, it can be understood, more comprehensively, that
managerial economics analyses business conditions with the objective of
finding an appropriate solution to business problems.
Activity 1.1:
Identify the differences between managerial economics and pure economic

theory.
………………………………………………………………………………
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.……………………………………………………..………………………
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………………………………………………………………………………
……………………………………………………………………..…………
1.3 SCOPE OF MANAGERIAL ECONOMICS

Demand analysis and forecasting help the firm in demand decisions by choosing
the product and planning its output levels. After determining the best level of
output, the firm takes the input-output decisions by choosing the least cost
11
Managerial Economics input mix and technology. Here, a correct pricing policy under different market
structures makes a firm successful, while an incorrect one may lead to its
elimination. Further, product competition like advertising, product design, etc.,
helps the firm to survive and grow. In the investment analysis, a firm evaluates
its investment decisions besides its pricing and cost aspects. Finally, the role of
risk and uncertainty analysis is in no way less important for the planned rate of
growth.
1. Demand analysis and forecasting: The demand function gives the relation
between the quantity demanded and the factors affecting it. In general,
quantity demanded is a function of the price of the good or service, the
price of other related goods or services, income, taste, and preferences. For
example, if you want to book an Indian Airlines ticket, the factors that will
govern your purchasing would be:
(i) Price of the Indian Airlines ticket.
(ii) Price of the ticket of other airlines.
(iii) Price of air-fuel.
(iv) Your personal disposable income.
Other factors like your preference for travelling by air, etc.

These factors themselves will depend on your age. For example, if you are
a student or a senior citizen, you will get a concession. All these factors will
be studied under demand analysis. To analyze demand, one has to estimate
the demand function. This is the process of finding the current values for
the coefficients of all the factors affecting the demand function. The most
common method of estimating demand is the ‘regression technique’.
Demand forecasting is the process of finding the values for demand in
the future time period. Current values are needed to make optimal current
pricing and promotional policies, while future values are necessary
for planning future production inventories, new product development,
etc. Correct estimates of demand are essential for decision making,
strengthening market position, and improving profits. There are various
techniques used for demand forecasting. Broadly they can be categorized
as qualitative methods like market surveys or expert’s opinion methods;
and quantitative methods like regression method, time series method,
simultaneous equation model, etc. Regression analysis is one of the most
common methods of estimating an economic variable. It is concerned with
the study of the dependence of one variable (the dependent variable) on
various other explanatory variables, with the view to estimate and predict
the average (of the population from which the data has been collected)
value of the dependent variable.
2. Cost and production analysis: Cost and production are the two sides of
the same coin. Production deals with the physical aspect of the business
investment. It is the process whereby inputs are transformed into outputs.
Since we pay a price for these resources or inputs, efficient production
means producing in a least-cost way as the degree of efficiency in
production translates into a level of costs per unit of output. The efficiency
12
of production depends on the ratios in which various inputs are employed, Introduction to
the absolute level of each input, and the productivity of each input. Managerial Economics
A production function is a relation that gives us the technically efficient

way of producing the output, given the inputs. Actually, the cost is the
monetary side of the production. Consider the assembly process for an
automobile. There are certain inputs like land, building, computerized
plant, and equipment to manufacture and assemble the car. All these
inputs cannot be changed on short notice. These are fixed in the short run
and hence costs associated with these are called fixed costs. However,
management can vary the number of workers to some extent depending on
the level of production. Thus, human input is a variable input and the cost
associated with it is called variable cost. The distinction between fixed and
variable costs is crucial for production and cost analysis. Other examples
of variable inputs are raw material, power, fuel, etc.
Given the production function, one can go for cost estimation and
forecasting. While the former refers to the present period cost levels, cost
forecasting refers to the levels of cost in a future period. The firm must
undertake cost estimation and forecasting to judge the optimality of the
present output level and assess the optimal level of production in the future.
3. Market structure and pricing policies: In a layman’s language, a market
is a place where buying and selling take place. There are two sides to every
market: supply and demand. These two building blocks are put together
to form the market. The market is a dynamic concept, where the aim is
generally to achieve equilibrium. Equilibrium is a situation where supply
is equal to demand. Continuous changes are taking place to achieve
equilibrium. The mechanism which will bring about this equilibrium is the
price of the good.
Economists call price the invisible hand in the market, which clears a
situation of excess supply (price will fall) and excess demand (price
will rise) to bring about market equilibrium. The success of a business
firm depends on the correctness of price decisions. Price theory works
according to the nature of the market. Depending on the number of sellers,
demand conditions, etc., there are four types of market structures: perfect
competition, monopolistic competition; oligopoly, and monopoly. Firms
under perfect competition are called price takers. Here, producers can
change only the output level. Under other forms of market structure, firms
are called price makers. In other words, they can adjust the price structure
to achieve their goal.
Perfect competition is very rare to get, but still, our textile industry
and agricultural sector are examples of perfect competition. Industries
like the detergent industry, cigarette industry, and pen industry fall
under monopolistic competition. Monopoly industries are solely under
Government control, public sector enterprises like Indian Oil, Bharat
Petroleum, and Hindustan Petroleum are the few examples of monopoly
industries. With the advent of a new economic policy of liberalization
and privatization, competition among Government enterprises (Govt.
monopoly organizations) is becoming unavoidable.
13
Managerial Economics The most common market structure is an oligopoly. Marketing of products
from cosmetics to the automobile industry is ruled by oligopolists.
Formulation of an effective pricing policy in a highly competitive market
structure is a real challenge for a firm. Competitor firms are mutually
dependent on each other’s actions. Firms face conjectural variation which
is defined as the expected percentage change in the rival’s strategic variable
such as price over the contemplated percentage change in the firm’s own
strategic variable. Conjectural variation is zero, when the firm expects
rivals to do nothing in reaction to its action, unity if the firm expects rivals
to exactly match its action, and more than (or less than) unity if rivals are
expected to adjust their strategic variables by greater (or lesser) percentage.
4. Investment analysis: It is one of the most troublesome tasks for business
firms. It involves planning and control of capital expenditure. In an attempt
to make a profit, whether or not to invest funds in the purchase of assets
or other resources and how to choose among competing uses of funds are
studied under the investment analysis. Investment projects may replace
or expand existing plants and equipment or diversify the firm’s activities
or mount a major advertising campaign and so on. In general, investment
projects will aim at revenue generation or cost reduction, or a combination
of both. As far as a choice among competing uses of funds objective is
concerned, it deals with various criteria, based on which an investment
project is accepted or rejected.
Budgeting one’s capital, to decide to invest or not to invest, depends on
various decision processes like payback period, the average annual rate
of return, net present value, profitability index, and internal rate of return
criteria.
5. Risk and uncertainty analysis: The decision environment of business
firms involves changes, which may be known or unknown. While a
definite outcome associated with known changes results in ‘certainty’,
the indefinite outcome associated with known changes involves ‘risk’.
Some risks are calculable and can be insured. However, if the changes
are unknown and their outcome is indefinite, the risk element cannot be
measured. This world of uncertainty can not be insured. Thus, there exists
a difference between risk and uncertainty (non-calculable risks).
The business firm operates under risk and uncertainty, and the decision
making and planning become difficult. If the knowledge of the future
is perfect, planning can be done without any error, and no need for
subsequent revision. However, business firms rarely have adequate
information on future demand, cost, profit, etc. Decisions are made and
plans are formulated on the basis of past data, current information and
future expectations/predictions. Consequently, plans have to be revised
in the light of new scenario that emerges over time. Hence, firms are
continuously engaged in the appraisal of their business plan so that
appropriate adjustments are based on variations in demand, factor prices,
behaviour of rival firms, and so on. Managerial economics involves the
usage of techniques/ theories from economics, mathematics, statistics, and
econometrics, suitably adjusted/ modified to suit the business problems at
hand.
14
Check Your Progress 1.1 Introduction to
Note: a) Attempt the following questions and write your answers in the
given space.
b) Check your answers with the answers given at the end of the unit.
1) Choose the correct answer.
The application of managerial economics requires the knowledge of
(a) Microeconomics only
(b) Macroeconomics only
(c) Both micro and macroeconomics
(d) None of the above
2) Fill in gaps with the appropriate term.
i. Firms under …………………… are called price takers. Under this
situation, producers can change only the …………. .
ii. Under the market conditions, when firms are price makers, they can
adjust the ……………….. to achieve their goal.
iii. Under …………… forms of market structure, firms face conjectural
variation, which is defined as the expected percentage change in the
rival’s strategic variable such as price over the contemplated percentage
change in the firm’s own strategic variable.
iv. Conjectural variation is …………., when the firm expects rivals to do
nothing in reaction to its action, ……….. if the firm expects a rival
to exactly match its action and more than (or less than) …………. if
rivals are expected to adjust their strategic variables by a greater (or
lesser) percentage.
v. ………………….. helps business managers to estimate an economic
variable.
3) Give examples of monopoly and monopolistic forms of market.
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1.4 MANAGERIAL ECONOMICS IN DECISION

MAKING
Decision-making by management is truly economic in nature since it involves
a choice from among a set of alternatives (alternative courses of action) and the
limited nature of the resources. A finance manager chooses the sources and uses 15
Managerial Economics funds for expansion or renovation programme. A personnel manager chooses
the staffing pattern. A sales manager chooses the market segment (domestic or
international) using aggressive or defensive marketing techniques. A purchase
manager chooses the quality of materials. The choice of each manager is
dictated by his objectives and constraints. Optimal decision-making is an act of
optimal economic choices, considering these objectives and constraints.
Managerial economics is concerned with the decision process, decision model,

and decision variables at the firm level. The managers within the firm consider,
take and execute decisions, either individually or collectively. These decisions
may be scientific or intuitive, strategic or tactical, certain or uncertain, major
or minor, hard or soft. All the decisions involve some degree of choice. Hence,
these are economic in nature and attempt towards a solution to the problem.
Managerial economist assists the managers in using specialized skills and
sophisticated techniques to solve the difficult problem for successful decision
making and forward planning. Managerial decisions can be classified into
various categories depending upon the functional areas of the managers.
(a) Financial decisions: These managerial decisions related to costing,
budgeting, accounting, auditing, tax planning, portfolio composition,
capital structure, dividend distribution, etc. In deciding among different
courses of action, the manager should consider the differential revenues
and costs of the various alternatives.
(b) Production decisions: Such decisions relate to the quantity of raw materials
as well as products, inventory control, choice of technology, technicians,
plant location and layout, production scheduling, maintenance, pollution
control, etc.
(c) Personnel decisions: These decisions relate to recruitment, selection,
training, development, placement, promotion, transfer, retirement, or
retrenchment of staff, etc.
(d) Marketing decisions: Such decisions may relate to target group/territory,
sales volume, salesforce, sales promotion, price discount, market research,
packaging, advertising, after-sales service, new product positioning, etc.
(e) Miscellaneous decisions: This category includes decisions such as
information systems, data processing, public relations, etc.
1.4.1 Decision Areas

Business decision-making is influenced not only by economic considerations
but also by human, behavioural, technological, and environmental factors
due to growing public awareness. Managers generally do not take decisions
purely on the basis of economic logic. They have often to compromise and
adopt a modified decision in the light of several non-economic considerations.
Economic rationality might suggest a strong case for a price rise, yet, the
managers may refrain from raising the price due to fear of social and political
hostility.
Decision-making and processing information are the two important tasks of

managers. In order to make good decisions, managers must be able to obtain,
16
process, and use information in real-time. Managerial economics helps Introduction to
managers in getting the information, required for decision making. Managerial Managerial Economics
economics has therefore gained increasing importance in recent times. It can be
very useful for a successful manager in intelligent decision-making. Managerial
economics is useful in the following five decision areas.
1. Demand Forecasting: A firm has to rely on demand forecasting for making
future production plans. To the extent forecast is wrong, planning exercise
becomes futile. These forecasts are based on past data and whatever
current information is available. As more information becomes available,
the forecasts are revised.
Forecasting the demand is essential for any business house to enable it to
produce the required quantities at the right time and arrange in advance
for the various factors of production (raw materials, equipment, machine,
etc.). Economic forecasting aims to reduce the risk that the firm faces in its
short-term operational decision-making and in planning for its long-term
growth.
Modern management employs a number of demand forecasting techniques
to cope with real-world business problems. They can be broadly classified
under two heads. For new products and for those products for which
sufficient historical data is unavailable, survey methods of forecasting
are used. In case, sufficient historical data is available, then one can use
statistical methods of forecasting.
There are two types of forecasts: qualitative and quantitative. Some firms
use one type, while some use the other. But, in practice, a combination or
blending of the two styles is usually most effective. Qualitative forecasts
incorporate important factors such as decision makers’ intuition, emotions,
personal experiences, and value systems in reaching a forecast. While
quantitative forecasts employ a variety of mathematical models that use
historical data and/or casual variables to forecast demand.
2. Production Planning and Cost / Revenue Decision: The production
function is a technological relationship between the output and various
inputs used in production. The inputs used in production could be land,
labour, capital, or technology. The output is a function of all the factor
inputs. The production function gives the maximum output which can
be obtained from a given level of inputs. Alternatively, it indicates the
minimum amount of various inputs, which are required to produce a given
level of output.
All the factor inputs are not equally important in different productive
activities. For example, in the case of an agriculture production function,
the land is a very important factor input. On the other hand, in the case of
an industrial production function, labour or technology may be important.
Therefore, the problem for a manager is to choose various combinations
of factors of production in such a way to produce the maximum possible
output with a given budget constraint or to choose the factors of production
in such a way to minimize the cost of producing a given level of output.
In agro-based industries, maintenance of the supply chain, and warehousing
for raw materials and finished goods become more important due to their 17
Managerial Economics perishable nature. Therefore, budgeting for these facilities may somehow
get intertwined with the development of infrastructural facilities (power
supply, transportation, cold storage, etc.) in the country.
Cost and revenue are the two major factors with which the profit-maximizing
firms need to deal with more judiciously. They jointly determine the
overall profitability. From the decision-making point of view, cost is more
important than revenue because the firm can influence cost more easily than
revenue. Cost is one of the most important factors, which is also considered
for future decisions. Further, a manager has to analyze the planning as well
as short-term plans.
3. Study of Economic Environment: Economic environment is an important
ingredient of the business environment describing the overall economic
situation of the country. It influences the survival as well as the success
of the business organization. The economic environment of an industry
depends on the following two factors:
(a) Economic Conditions and Policy: The production in the agriculture
and industrial sectors, employment and per capita income trends, the
pattern of saving, expenditure, and income distribution, price level, etc.
affect the general economic conditions in the country. The economic
environment of a country is also affected by the prevailing industrial
conditions as well as policies of the Government.
(b) Availability of Resources for Production: Land, labour, capital
equipment, and managers are the inputs or resources required for
production.
Table 1.1 examines the economic environment of the country through statistical
indicators describing different economic goals.
Table 1.1: Statistical Indicators of Economic Goals
S. No. Economic goal Statistical Indicator
1. High level of aggregate GNP, GDP/GVA
output and income
2. Rapid growth of income Average annual rate of growth of GNP,
GDP
3. Greater equality in income Gini coefficient
distribution
4. More equality in income Distribution of labour force by indus-
distribution trial and occupational classification and
income
5. Lower International Foreign trade and international payment
dependence proportions in total output
6. Price stability Price indices
7. Greater regional balance Gross regional product per capita
Source: Adapted from David P. Louchs, Planning for Multiple Goals in C.
Blitzer, P. Clark and L. Taylor (eds.): Economywide Models and Development
18 Planning (OUP, London, 1975), p. 214.
4 Pricing and Related Decisions: The price-output decisions are taken under Introduction to
various market structures. The structure of a market refers to the degree Managerial Economics
of competition in the market for the firm’s goods and services, where the
market consists of all the firms and individuals, who are willing and able to
sell or buy a particular product. There are four important market structures,
namely, perfect competition, monopoly, monopolistic competition, and
oligopoly.
Cost-plus pricing, marginal cost pricing, dual pricing, price discrimination,
going rate pricing, sealed bid pricing, price penetration, price skimming,
etc., are the pricing practices followed in these market forms.
5 Investment Decisions: Business firms invest large money in their projects.
Therefore, capital expenditure for different project proposals competes
within themselves for their claim on the scarce resources. In the business
sector, individual firms compete for access to financial resources. The
business sector has also to compete for its share against the major claim in
resources of the investing individuals. The capital expenditure decisions
are important as they are not easily reversible. They generally involve large
sums of money, they are highly futuristic (and we all know that the future is
full of uncertainties), and they have long gestation periods. It is, therefore,
essential that careful financial appraisal of each and every project involving
large investments is carried out before acceptance of a project. Due to these
reasons, capital expenditure decisions fall in the category of decisions,
which are generally reserved for consideration by the highest level of
management. These investment decisions of a firm are popularly known
as capital budgeting decisions, though alternative terms like investment
analysis, analysis of capital expenditure, or equipment replacement policy
can also be used.
Generally, the firm may be confronted with three types of capital budgeting
decisions:
(a) Accept or reject decisions: Basically, all those proposals which give
a better rate of return than the required rate of return or cost of capital
are accepted and others are rejected. This is more applicable for
independent projects that do not compete with one another.
(b) Mutually exclusive project decision: When projects compete with one
another and acceptance of one will exclude the acceptance of another,
they are called mutually exclusive projects as only one project is
chosen and accepted. In such cases, all these projects must, on their
own qualify as independent projects, which means that the one giving
the best returns should be accepted.
(c) Capital rationing decisions: The earlier two cases involve the
availability of unlimited funds. But, there are occasions, when the
firm has only limited funds available for investment proposals being
considered. This situation gives rise to the need for capital rationing.
Under a capital rationing situation, acceptable projects are ranked
based on some predetermined criterion, say, rate of return, or any
other desirable criterion. The top-ranked project is taken up first. If
resources are available, the second and then third-best (and so on) are
considered for investment. 19
Managerial Economics 1.4.2 Steps in Decision Making
Managerial economics is concerned with decision-making at the level of the
firm. These decisions have far-reaching effects on the firm. Systematic efforts
are required to be made to arrive at the right decision at the right time. Delay
in taking decisions or implementing decisions might turn opportunities into
threats. Various steps in the decision-making by a business firm are shown
below in Figure 1.1.

Fig. 1.1: Steps in Decision Making

1. Defining business problem: The first step in any business decision is
to clearly understand the problem. A key part of problem definition is to
understand the content. For example, if there is a private power producer
in the country, he has to understand not only the demand-supply scenario
in the country but also the role of state government and the SEB (state
electricity board), its role in power distribution, Government’s policy, etc.
2. Determining objectives: Determination of the objective or goal of the
organization is definitely the second step in any economic decision-
making. The most probable answer will be profit maximization. But, in the
modern corporate sector, profit maximization may not be the only goal, or
sometimes, may not even be the most important goal, as goals like sales
maximization or growth maximization take the centre stage. Sometimes,
organizations have multiple goals like sales maximization along with
customer satisfaction by going for price minimization. Some goals are
mutually beneficial for most of the people within the organisation. Say,
if the goal is ‘market share maximisation’. This will make not only the
sales and marketing departments happy, but the public esteem of that
organisation also goes up. Achieving such a goal will make the shareholders
and managers too happy. A crucial factor in determining the objective
is the time horizon set to achieve the goal. Further, the presence of risk
and uncertainty, which makes the process of determining the objectives a
challenging job, should be seriously considered.
3. Exploring available alternatives: The third step is to ask the question
‘what are the various options available?’ In other words, one has to explore
the alternatives. Ideally speaking, the decision-maker should explore all
possible alternatives and choose the best one. But, that is practically not
possible due to time, cost, and resource constraints. For example, in this
20 era of globalization, there is a firm seeks to modernize its technology. It
has various alternatives to choose from. Either it indigenously develops the Introduction to
suitable one with its own Research and Development (R & D), or, it gets Managerial Economics
into a joint venture with a known internationally famed company or gets
into a technical collaboration.
4 Assessing consequences of various alternatives: Each of these alternatives
has its benefits (opportunities) and limitations (constraints) that bring us
to the fourth step, i.e., predicting the consequences of these alternative
options available. If the firm goes for developing its own R & D, it will
definitely be cost-effective, but the time horizon might be lengthened,
which is crucial in a modern competitive world. On the other hand, the use
of a known name in the business may get the firm started within no time.
But, one has to see what price the firm has to pay before going in for a joint
venture. Alternatively, the firm can simply buy or borrow the technical
expertise.
5. Choosing the best alternative: The most important step, i.e., the fifth
step of decision making (after exploring the alternatives), the decision-
maker has to choose one of the alternatives, which is the optimal and
given objectives and the constraints. Varieties of tools are used to reach
the ‘optimal’ decision, like marginal analysis, linear programming, game
theory, etc.
6. Performing sensitivity analysis: Keeping the uncertainty about the future
in mind, one must always be prepared for the situation, “how should one
change his optimal decision or how will the optimal decision change if
one or some of the factors affecting the decision undergo change?” This is
precisely the sensitivity analysis and is the sixth step in decision making.
For example, an automobile company has entered into a joint venture
with a known name in the international field with the objective of sales
maximisation. A vital sensitivity analysis will be what happens, if there is
a recession in the economy and per capita real income of the middle-class
Indians falls, leading to a fall in the demand for passenger cars. Further, it is
important to note that even after implementing the project; its performance
must be monitored vis-à-vis expectations, so that projection errors are
minimized in the future.
Activity 1.2:
(a) Consider a typical private firm. Classify the various decisions taken by
different managers according to their functional areas.
....................................................................................................................
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21
(b) As manager of a company, you have to take many decisions. If right
decisions are not taken at appropriate time, many opportunities are lost.
Such decision making also facilitates in converting weaknesses into
strengths as well as threats into opportunities. Point out various steps in
decision making in the light of this information.
....................................................................................................................
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Check Your Progress 1.2

given space.
i) …………………… is a statistical indicator of the economic goal of
price stability.
ii) Gini coefficient is a measure of …………………………..
iii) ……………………………………………… are the few analytical
tools available to business managers to arrive at optimal decisions.
2) Enumerate the steps involved in decision-making process.
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1.5 DEFINITION, CONCEPTS AND BASIC

PRINCIPLES OF ECONOMICS
Managerial economics is concept-based and technique-oriented. The use of
concepts and techniques helps us in developing the analytical rigor of the subject.
They aid logical reasoning and precise thinking to managerial economists.
Following concepts are important for the analysis of business problems.
1.5.1 Microeconomic Concepts

Micro economics or price theory (the theory of resource allocation) is that branch
22 of economics that study the behaviour and economic actions of individual units
of the economies, such as particular consumer, particular firm, or small group Introduction to
of individual units like industries. Some important microeconomic concepts Managerial Economics
and principles are explained below.
1. Opportunity cost: Life is full of choices but resources are scarce. With
the given time, should one study managerial economics or visit a friend?
With the given money, should one buy a car or travel abroad? In each of
these cases, one is required to give up some other thing to have the desired
thing. In other words, getting something costs us the opportunity of doing
something else. The foregone alternative is called ‘opportunity cost’. It is
also called the alternate cost. Suppose budgetary allocation for a certain
remote region which is lacking electricity as well as paved roads is INR.
500 crores. It is decided to set up a thermal power station. The opportunity
cost of the money spent on the power station is number of good roads. A
farmer can cultivate either wheat or gram in his field. The opportunity cost
of gram produced will be the cost of wheat foregone.
If a machine can produce 2 units of product ‘X’ or 10 units of product
‘Y’, then the opportunity cost of 1 unit of product ‘X’ is equal to 5 units
of product ‘Y’. If no information about quantities is available, then the
opportunity cost can be calculated in terms of the ratio of their respective
prices, i.e. Px/Py.
All decisions involving choice have some opportunity cost. For optional
allocation of resources, a manager should consider the opportunity costs of
using resources, human or non-human. By choosing one course of action,
he sacrifices the other alternative courses. It is possible to evaluate the
chosen course of action in terms of the other (next best) alternative, which
is sacrificed. Economists use many ‘trade-off’ concepts such as indifference
curves, isoquants, Phillips curve, etc., which are based on opportunity cost
reasoning.
Most of us consciously or otherwise employ the concept of opportunity
cost. A self-employed person feels that he should earn as much or more than
the income he gets if he is to work for someone else. The opportunity cost
of a decision is the cost of sacrificing the alternatives to that decision. For
example, the opportunity cost of holding Rs. 10,000 for one year in cash is
the interest, which could have been earned. In a given situation, if there are
no sacrifices, then there is no opportunity cost. Thus, the opportunity cost of
resources having no alternative use is zero. Further, opportunity cost may
be real or monetary, implicit or explicit, non-quantifiable or quantifiable.
2. Marginalism, equi-marginalism and incrementalism: As resources
are scarce, each and every additional unit of each of the resources
are to be utilized by the managers with utmost care. A decision about
additional investment is taken on the basis of the additional return from
that investment. An investment is worthwhile, if it causes total revenue
(return) to raise more than the total cost or if it causes total revenue (return)
to decline less than the total cost. Similarly, in a decision to employ an
additional worker or machine, one needs to know the additional output
expected from an additional expenditure thereon. Resources should be
allocated or hired in such a way that the ratio of marginal returns and
23
Managerial Economics marginal costs of various uses of a given resource or various resources
in a given use is the same. In other words, the value added by the last
unit of the resource is the same in all cases. This concept (known as the
equi-marginal principle) is used in capital budgeting, where the limited
resources of the firm have to be allocated in a rational manner. If the
said equity were not established, there will be scope to add to his utility/
profit by reshuffling his resources/inputs. In economics, we use the term
‘marginal’ for such an additional magnitude of return of output. Terms like
marginal return on investment, marginal product of labour, the marginal
product of a machine, marginal sales of advertisement, the marginal cost
of production, marginal revenue from output sold, and the marginal utility
of consumption are some examples. The corresponding concept dealing
with equilibria of more than one commodity or factor is called as equi-
marginalism. Equi marginal principal for a multi-commodity consumer
(MU1 = MU2 = ……. = MUN), multi-factor employer (MP1 = MP2 = …….
= MPN), multi-plant monopolist (MC1 = MC2 = ……. = MCN), multi-
market seller MR1 = MR2 = ……. = MRN) and multi-product firm (Mπ1
= Mπ2 = ……. = MπN) can be easily explained after reading relevant
subsequent units.
The marginal concept measures the change in the dependent variable
(cost, revenue, or profits) with respect to a unit change in the independent
variable. However, many times, the independent variable may be subject
to ‘chunk changes’. For example, the output may change because of a
change in process, pattern, or a combination of factors, which may not be
measured in unit terms. In such a situation, the concept of ‘marginalism’
has to be replaced by ‘incrementalism’. The incremental concept involves
the estimation of the impact of a decision. Two fundamental concepts
in this connection are incremental revenue and incremental cost. The
additional revenue earned by a business firm through computerization
may be termed as ‘incremental revenue’, while the additional cost of
installing computer facilities may be termed as ‘incremental cost’. Indeed,
all marginal concepts are incremental concepts particularly when the
changes in the independent variable are very small – say to the tune of
one unit. The implication of these concepts is that incremental benefits
must be higher than incremental costs for a decision to be profitable.
3. Law of diminishing returns: The law holds that as one uses a certain
input, after obtaining some initial quantity, the successive dose of an extra
unit of that input gives lesser and lesser yield. It applies to consumer
behaviour as well. If you keep on having ice cream, initially one extra ice
cream gives you a lot of pleasure, But, as the consumption is continued,
extra satisfaction received by the consumer decreases (even if one does
not catch a cold). This will be termed as the law of diminishing utility
in consumer behaviour theory. The law has a significant role to play in
production also. With a given piece of land, say, 10 acres, and say one
tractor but no labour, we cannot produce any wheat. Let us see what
happens if we keep on adding one unit of labour in every successive
period (with no change in the size of the plot or number of tractors). It is
observed that ultimately, marginal product (MP) diminishes as shown in
Table 1.2.
24
Table 1.2: Law of Diminishing Returns in Production of Wheat Introduction to
4. Concept of equilibrium: The concept of equilibrium is an important tool

for economic analysis. Equilibrium stands for a position of rest, a position
from which there is no incentive for change, or a position of maximum
gain. Though equilibrium implies a state of rest, it does not mean a state of
inactivity. The forces affecting a particular condition keep on changing with
time, but, chances are such that they cancel each other out. Thus, despite
changes in the powerful forces, the original position of the equilibrium
does not change. An economic variable (say, the price of the commodity)
is subject to various forces trying to pull it in different directions. When
these forces are in balance, the value of variable price stops changing and
it comes to equilibrium.
Like demand, supply, income, etc., the concept of equilibrium always
has also a reference to a certain period of time. This equilibrium can be
analyzed from the point of view of a consumer, a firm, an industry, or a
factor of production. A consumer is said to be in equilibrium when he is
able to maximise his satisfaction from his fixed income and other resources
at his disposal. Any departure from this equilibrium position through
redistribution of the income among his purchases cannot raise his level
of satisfaction. Similarly, the firm attains the equilibrium by selling its
goods at a price that maximizes the profits. Once this equilibrium point is
reached, any further movement through variation in output or technique of
its production will only reduce the level of profits. Likewise, an industry is
in equilibrium, when there is no incentive for old firms to leave it and for
new firms to enter. Finally, a factor is in equilibrium, when at the current
compensation, there is no inducement for it to offer more or less of its
productive services to this or the other industries. An industry can, thus,
decide the least-cost combination of the factors for maximum profits.
However, in actuality, the equilibrium is seldom obtained. When the market
tends towards equilibrium through economic forces, disturbances occur
due to dynamic changes that always take place in the economy preventing
equilibrium from being attained. For example, if the demand for a good
rises suddenly at a particular point in time, it will not be possible to meet
it immediately. This will result in a disequilibrium between demand and
supply raising the price of the good. In course of time, the producers may
be in a position to expand production in response to increased demand.
Therefore, whether equilibrium is obtained at the micro-level or at the
25
Managerial Economics macro level, it is generally a short-run equilibrium.
The concept of equilibrium is important both in micro-economics and
macro-economics. In micro-economics, the prices and quantities of
individual products and factors determined in the market are equal to their
equilibrium value. There is neither surplus nor shortage at the equilibrium.
The price which will come to prevail in the market is one at which quantity
demanded is equal to quantity supplied, or it is the price at which the market
is cleared. This price is usually called equilibrium price, and the quantity
demanded and supplied at this price is called equilibrium quantity. So long
as demand and supply remain unchanged, equilibrium price or quantity will
not change. Similarly, in macro economics, the levels of national income,
output, employment, and general price level are equal to their equilibrium
values.
Equilibrium literally means the state of rest or absence of change. Like
many other concepts in Economics, the concept of equilibrium is also
borrowed from Physics (to be precise, mechanics). It is a position where
the opposing forces impinging on a body or affecting a particular condition
cancel each other, such that the system is at rest (or moves steadily). The
concept of equilibrium does not imply the absence of movements, since
an absence of movements would mean a collapse of the economic system.
The only requirement is that there should be, in general, no change in the
rate of movements. In Economics, equilibrium is just treated as a tendency
for the market forces of demand and supply to balance them in course of
time. Any disturbance in the original equilibrium situation by some change
in market conditions will set in motion forces, which cause a return to that
equilibrium. It is called unstable equilibrium if after a small disturbance
it does not come back to the original equilibrium position (and instead it
moves away from it). In a free-market economy, any disturbance is self-
correcting, as if by an invisible hand. Price will have a tendency to rise if
the quantity demanded is more than the quantity supplied of a good and
vice-versa. In the words of Marshall, “When the demand price is equal
to the supply price, the amount produced has no tendency either to be
increased or to be decreased; it is in equilibrium”. All the sellers manage
to sell the entire quantity of the commodity, which they offer for sale in the
market at the equilibrium price.
(a) Partial Equilibrium: To attain the state of stable equilibrium defined
by the optimal economic choice, the economic problem may be
analyzed part by part, one at a time, assuming other things remain the
same. For example, given the budget, the price, and the technology,
the advertising manager has to decide the amount to be spent on
advertising. Under a partial equilibrium approach to the pricing,
price determination of a commodity assumes constancy of prices of
other commodities and independence of various commodities. This
approach is not useful when a significant interrelationship exists
between commodities and factors.
(b) General Equilibrium: The partial equilibrium analysis fails to yield
true results when changes in the price of a commodity or a factor have
important repercussions on the demand for other commodities or factors.
26
Here, we should use general equilibrium analysis by considering the Introduction to
simultaneous equilibrium of all markets and taking into account all Managerial Economics
effects of change in price in one market over others. For example, a rise
in the price of petrol has an important effect on the demand and price
of automobiles as well as the cost of transportation of all the goods in
the economy. It also changes the commuting costs of the workers. In
such cases of interrelation and mutual interdependence of the markets
for commodities (complements or substitutes) and services, general
equilibrium analysis should be preferred. Here, the quantity demanded
of each commodity (Qid) is a function of the prices of all commodities
(Pi), while the quantity supplied of each commodity (Qjs) is a function
of the prices of all factors of production (fj). That is,
Qid D=
i ( p1 , p2 , p3 ,........., pi ,........., pn ), (i 1, 2, 3,........., n)
Q sj S=
j ( f1 , f 2 , f 3 ,........., f j ,........., f n ), ( j 1, 2, 3,, ........, n)

A change in the demand or supply of any commodity or factor would
cause changes in the prices and quantities of all commodities and
factors. This will begin a process of adjustment and readjustment in
demand, supply, and prices of other commodities and factors till the
new general equilibrium is established.
1.5.2 Macroeconomic Concepts

Macroeconomics or income theory (theory of money, income, and price level),
also known as aggregative economics studies the economy as a whole and its
large aggregates or averages such as national income, output, employment,
aggregate demand as well as supply, and general price level. It determines
the level, composition, fluctuations, and trends in overall economic activity.
Macroeconomics also seeks the causes as well as cures for unemployment,
inflation, and balance of payment deficits.
Analysis of macroeconomic environment requires the understanding of the

concepts of ‘stocks’ and ‘flows’. The term stock refers to something that exists
at a point in time, while by flow; we refer to something which circulates over a
period of time. Both of these concepts are of wide applicability.
The national capital, human capital, national wealth, total employment,

inventories, mineral resources, etc., are some stock concepts. We often hear
about the depletion of stocks of crude oil, forests, and other national resources
of the country. We also need to consider the stock of raw materials available in
the factory or the stock of unsold finished products piled up in the godown of
a business firm.
Consumption, investment, and income are some important flow concepts, though
we can also talk about flows of sales revenue, advertisement expenditure, etc.
Money is both stocks as well as the flow concept. The representative examples
are discussed here.
1. Consumption: Consumption (C) is an important flow of expenditure.
Household consumption expenditure and government consumption
27
Managerial Economics expenditure are two main components of this expenditure.
2. Saving: Income not consumed is actually saved. Saving (S) is also a form
of an expenditure flow. An accumulated flow of savings over a period of
time can be used to acquire assets like land, building, farmhouses, gold
ornaments, etc. which constitute the stock of wealth. In this way, flows can
be converted into stocks.
3. Investment: It is a flow of expenditure on the acquisition and maintenance
of fixed capital stock (K). Symbolically,
It = Kt – Ko = ∆ Kt
Here, ∆ Kt is the change in the capital stock over a given time period ‘t’.
Kt stands for the capital stock at the end of the period ‘t’ and Ko stands for
the capital stock at the beginning of the period. The positive difference is
treated as an investment (I), while a negative difference would indicate dis-
investment.
4. Income: Income (Y) is the money value of output produced in a given year
in an economy. It is equal to expenditure on materials, manpower, etc. to
produce a flow of goods and services in the economy from the productive
system to the ultimate consumers. It can be estimated as a flow by three
different methods.
5. Money: The Central Bank and government of a country put a given stock
of money into circulation in the form of currency with the public. However,
money not only serves as a store of value and as a measure of value but also
serves as a medium of exchange and as a standard of deferred payments.
Thus, money can be stock as well as flow. We can think of the nominal value
of money or real value by adjusting the nominal value to a price deflator.
Activity 1.3:
a) Give practical examples from real life where concepts of marginalism,
equi-marginalism, incrementalism, opportunity cost, diminishing returns,
stocks, flows are applied.
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b) Can opportunity cost be ever zero? Why the opportunity cost of one is
always the opportunity gain for the other?
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28 ....................................................................................................................
Check Your Progress 1.3 Introduction to
given space.
i. If a machine produces product ‘X’ and is sold at price Px, the machine
can also produce product ‘Y’ and which can be sold at price Py, then the
opportunity cost can be calculated by the formula …………………
ii. By choosing one course of action, a manager sacrifices the other
available alternative. In order to optimize the business goal, he
would prefer to evaluate the opportunity costs of various available
options by using mathematical application tools like ……………..,
…………………………., …………………………. Which are based
on ………………..concept.
2) State whether the following statements are true/false.
i. Opportunity cost can never be equal to zero.
ii. Partial equilibrium assumes that ‘other things remain the same.
iii. National income is a flow concept.
3) When a business firm has to change a process, pattern, or technique of
production, which of the following concepts is most relevant for decision
making?
(a) Marginalism
(b) Equi-marginalism
(c) Incrementalism
(d) Discounting principle
1.6 ECONOMIC GOALS AND CHOICES

Every firm is a coalition of different vested groups and thus has a multitude of
objectives. Output, sales, or growth maximization are some of the economic
goals. However, the profit-maximization goal as suggested by the traditional
theory of firm continues to be the guiding principle for all business decisions.
This goal dominates the other objectives. In the long run, only profit remains
a motivational force. Further, the maximization of profit is inherent there in
almost all the goals, sometimes as a constraining target variable or otherwise.
Actually, all other objectives are related directly or indirectly to the profit goal
and maximization of profit is not always inconsistent with the pursuit of other
objectives. It will be easier for a firm to achieve other objectives if it is able to
maximize profits first.
Fulfillment of economic goals helps in the optimal allocation of resources through

their appropriate choices for relatively profitable uses. It is indispensable for the
survival, viability, and success of the business firm. Achievement of economic
goals is an indicator of effective business strategy and efficient business tactics. 29
Managerial Economics Consequently, the operational efficiency and financial performance of the
firm are improved. Economic goals facilitate resources to finance expansion,
innovation, replacement and discharge of social responsibilities. They enable
the firm to bear risk and uncertainty. Such goals indicate the areas of planning,
control, and management. They also facilitate inter-firm, inter-industry, and
product line comparisons.
given space.
i. According to the traditional theory of firm …………………………….
is the guiding principle for business decisions.
ii. …………………………………. improves operational efficiency,
ensures optimal resource allocation, and increases the risk &
uncertainty bearing capacity of a firm.
iii. The accomplishment of the economic goals is a normative indicator of
……………………..
1.7 LET US SUM UP

Every day a number of decisions are made by individuals or business firms.
Such decisions are no longer made on intuition or hunch. These decisions may
relate to demand, supply, stock, price, input, output, profit, finance, etc. The
solution to all such problems is now provided by managerial economics rather
than pure economic theory. Managerial economics is primarily micro, partial
equilibrium type, prescriptive in nature, comparative static, and normative in
approach. However, business firms, have to operate within the broad framework
of the economic environment known as macro economic conditions like level
as well as the growth rate of national income, business cycles, international
trade, government policy, tax, tariff, exchange rate, etc. Firms have to adjust
themselves to the changes in these conditions to survive and grow. Managerial
economists must possess complete knowledge about various techniques for
decision making regarding the least-cost input mix, product mix, production
technique, level of output, price of the product, investment decision, amount of
advertising outlay as well as its distribution between different media, etc.
1.8 KEYWORDS
Diminishing returns : As the consumption/production process is
continued, the successive units give/yield
lesser and lesser satisfaction/productivity.
Economic policy : Policy of the government to influence the
macroeconomic environment of the country
to achieve desired goals like growth,
stability, distributive justice, etc.
30
Equilibrium : It is a state of rest or no change from where Introduction to
there is no tendency for movement. Managerial Economics
General equilibrium : Equilibrium takes into account the effects of

all changes simultaneously.
Incrementalism : When the independent variable changes
significantly in a big way, we need to modify
the idea of marginal product/revenue/
cost, etc. to incremental product/revenue/
cost respectively. It represents a change in
respective dependent magnitude as a result
of a ‘big’ change in the independent variable
input.
Managerial economics : It is the study of economic theories, concepts,
logic, and tools of analysis that are used
in analyzing business conditions to find an
appropriate solution to business problems.
Marginalism : Measuring the change in the dependent
variable (cost, revenue, or profits) with
reference to a unit change in the independent
variable.
Opportunity cost : The cost associated with the next best
alternative foregone.
Partial equilibrium : Arriving at equilibrium, assuming that other
things remain constant.
1.9 SUGGESTED FURTHER READINGS/

REFERENCES
1. Chaturvedi, D.D. & Gupta, S.L. (2013), Business Economics: Theory
and Application, International Book House.
2. Chaturvedi, D.D. & Gupta, S.L. (2013), Managerial Economics: Text
and Cases, International Book House.
3. Chaturvedi, D.D. (2014), Micro Economics I, Kitab Mahal.
4. David P. Louchs, Planning for Multiple Goals in C. Blitzer, P. Clark
and L. Taylor (eds.): Economywide Models and Development Planning
(OUP, London, 1975), p. 214.
5. Dean, Joel (1976), Managerial Economics, Prentice Hall of India.
6. Gupta, G.S. (1974) Forecasting Techniques, Management Annual, Vol.
IV, November Issue, pp 8-21.
7. http://application.dbuglobal.com/assets/Pu18ME1002/CPu18ME1002/
UNIT 1 THE NATURE AND SCOPE OF MANAGERIAL ECONOMICS.
pdf
31
1.10 CHECK YOUR PROGRESS: POSSIBLE
ANSWERS
1. C
2. i. Perfect competition; output level,
ii. Price structure,
iii. Oligopoly,
iv. Zero; Unity; Unity,
v. Regression analysis.
3. Monopoly: Public sector enterprises like Indian Oil, Bharat Petroleum,
etc.
Monopolistic: Detergent Industry, Cigarette Industry, etc.

1. i. Price indices
ii. Greater equality in resource distribution,
iii. Managerial analysis, linear programming, game theory
2. Defining business problems, determining objectives, exploring
available alternatives, assessing consequences, choosing best
alternatives, and sensitivity analysis.

1. i. Px/Py
ii. Indifference curves, isoquants, Phillips curve, ………….tradeoff.
2. i. False; ii. True; iii. True.
3 C

1. (i) Profit maximization goal
(ii) Economic Goal
(iii) Effective business strategy.
1.11 UNIT END QUESTIONS

Short Answer Questions:
1) Managerial economics is prescriptive rather than descriptive in nature.
Examine.
2) Discuss the significance and meaning of managerial economics.
3) Is macro economics useful in business decision-making?
32
4) How does marginalism influence decision-making? Introduction to
5) Explain the significance of the law of diminishing returns.
Essay Types Questions:

6) “Managerial economics consists of the use of economic models of
thought to analyze the business situation.” Elaborate.
7) “Managerial economics bridges the gap between abstract theory and
business practice. It uses tools of economic analysis in classifying
problems, in organizing and evaluating information, and in comparing
alternative courses of action.” Outline the nature and scope of
managerial economics in the light of this statement.
8) Explain the various decision areas of managerial economics. How
does its study help a manager in decision-making?
9) Discuss the various steps in decision-making.
10) Explain the fundamental concepts one should study under managerial
economics.
33
34
UNIT 2 MICROECONOMIC THEORY AND
INITIAL APPLICATIONS
Structure
2.0 Objectives
2.1 Introduction
2.2 Concept of Utility
2.3 Demand Functions
2.3.1 Demand Schedule and Demand Curve
2.3.2 Market Demand
2.3.3 Derived Demand
2.3.4 Ordinary Demand Function
2.3.5 Compensated Demand Function
2.4 Elasticity of Demand

2.4.1 Price Elasticity
2.4.2 Income Elasticity
2.4.3 Cross Elasticity
2.5 Elasticity of Substitution

2.6 Supply Function
2.7 Supply Elasticity
2.8 Concept of Equilibrium
2.9 Economic Surplus
2.9.1 Consumer’s Surplus
2.9.2 Producer’s Surplus
2.10 Forecasting of Demand for Seasonal Agri-products

2.10.1 Concept of Forecasting
2.10.2 Need for Demand Forecasting
2.10.3 Purpose of Short Term Forecasting
2.10.4 Purpose of Long Term Forecasting
2.11 Methods of Forecasting

2.11.1 Simple Survey Method
2.11.2 Complex Statistical Methods
2.12 Let Us Sum Up

2.13 Keywords
2.14 Suggested Further Readings /References
35
Managerial Economics 2.15 Check Your Progress: Possible Answers
2.0 OBJECTIVES
After reading this unit, you will be able to:
• explain some of the basic terminologies widely used in the micro-
economics;
• describe the change in demand for two commodities are different even
with equal changes in their prices;
• determine the effect of technological change in production on the
society;
• highlight the concept of elasticity of demand and supply; and
• examine the relevance of consumer surplus.
2.1 INTRODUCTION
Most of the issues studied in economics are related to the use of scarce resources
to satisfy human wants. Resources are employed to produce goods and services,
which are used by consumers to satisfy their wants. While the details of the
theory of consumer behaviour and theory of production are discussed under
other units of this block and some units of other blocks, this unit is a general
introduction to the subject matter of microeconomics.
The scarcity of resources and commodities is the fundamental economic fact

of every society. Economics deals with the allocation of scarce resources/
commodities for alternative use to satisfy human wants. Similarly, microeconomic
theory studies the economic behaviour of individual decision-making units
such as individual consumers, resource owners, and business firms as well as
the operation of the individual market. The price of the resources/ commodities
plays a pivotal role in their judicious uses. On the one hand, price is decided
in the market according to the demand for and supply of a commodity in the
market; on the other hand, it also determines the demand and supply of the
commodity. The extent of their effects on each other depends on the elasticity.
Similarly, with the technological improvement in the production process, it is

expected that there will be a benefit to the producer as well as the consumer.
The producer gets to benefit from lowering down per-unit cost of production,
while a consumer benefits from the lower price of the final goods. Economic
decisions aim to maximize satisfaction to the consumer and net benefits to the
producer.
This is all, we will discuss in the forthcoming sections in detail.
2.2 CONCEPT OF UTILITY

A few important concepts which are useful in understanding the consumer
behaviour are given below:
36
Satisfaction: Microeconomic Theory
and Initial Applications
The purpose of economic activity is to seek satisfaction in the most economic
manner possible. Even if the money price offered by a person is supposed
to represent accurately the intensity of its wants or desire for a particular
commodity, it is hardly possible to measure ‘satisfaction’, - a mental state, by
means of a money price. Not all men have got the same capacity for receiving
satisfaction, and not all men get the same amount of satisfaction,- by ‘amount’
we mean both ‘quality’,- and ‘ intensity, -from the same commodity. The whole
matter is so extremely complex because of the variety of psychological factors
involved that it is well –nigh impossible to measure it accurately. In any case,
the measuring rod of money is a very crude instrument for measuring either
‘desire’ or ‘satisfaction’, both of which refer to mental states and are not capable
of any quantitative measurement at all.
Utility:
The term “utility” implies in economics either satisfaction or want- satisfying

power. The utility is taken to be correlative to Desire or Want. A commodity
that is wanted or desired is supposed to possess utility. There is no ethical or
prudential connotation in the economic concept of utility. If there is demand
for cheese and if cheese is not available in abundance like air and water, cheese
possesses economic utility quite as much as a house in Delhi. A utility like want
is measured by money price. If I am prepared to pay, say, Rs.4 for a commodity,
that commodity is supposed to possess for me Rs. 4 worth of utility.
Law of Diminishing Utility:
On account of the satiability of a particular want, the utility of a commodity

for an individual diminishes with every increase in his stock of the same
commodity. Since utility is measured by money price, the law of diminishing
utility is started with an example. A person may be prepared to pay Rs.500 for
the first kg. of tea which measures the intensity of his desire for the minimum
quantity of tea. For the second kg of tea, however, he will have a somewhat
lesser degree of utility and he will not be prepared to pay more, say more than
Rs.400/-. For third and succeeding kg. of tea, he will be prepared to pay lower
and still lower prices measuring his diminishing utility for successive kg. of
tea. The law of diminishing utility is one of the fundamental laws discovered by
economic science. It is rooted in human nature. It may, therefore, be regarded as
a psychological law. This law is, however, based on certain assumptions and is
subject to certain limitations which will be discussed later on in this unit.
2.3 DEMAND FUNCTIONS

The amount of a product that consumers wish to purchase is called the quantity
demanded. You can notice two things in this concept. First, the quantity
demanded is desired quantity. It is how much consumers wish to purchase,
not necessarily how much they actually succeed in purchasing. Second, the
mere desire for a commodity does not constitute a demand for it. The desire
must be backed by the ability to pay. Thus, by demand, we mean the quantity
of any commodity that ‘buyers are willing and have the ability to buy. Take an
37
Managerial Economics example, if a poor farmer who hardly manages both squares of meals for his
family, wishes to have a car, his wish or desire will not constitute the demand
for the car because he can’t afford to pay for it.
In fact, demand for a good is determined by several factors. Five main variables
that influence the quantity of any product demanded by any individual consumer
are:
a. Price of the product;
b. Price of other (substitute & complementary) products;
c. Income of the consumer;
d. Taste & preferences of the consumer; and
e. Various sociological factors
You may present the relationship between the quantity of a commodity

demanded and their influencing factors in functional form like:
Qid = D (pi, pj, Y, T)
Where, Qid is the quantity demanded for the ith commodity, pi is the price
of the ith commodity, pj is the price of jth commodity, Y is the income of the
consumer, and T is the taste, preferences, and other sociological factors like
family composition, weather condition, place of residence, etc. This functional
relationship is called as demand function.
The demand function is just a shorthand way of saying that the quantity demanded
depends on the variables listed on the right-hand side, while the form of the
function determines the sign and the magnitude of that dependence. Moreover,
it is very difficult to determine the effect of each factor simultaneously on the
quantity demanded. To avoid this difficulty, we consider the influence of one
variable at a time and, among all the variables, the most important variable
is the price of that commodity. This means, we study the effect of changes
in the price of that commodity, say pi, assuming that all other factors remain
unchanged or ceteris paribus (which means ‘other things remaining same’).
It is assumed that by now you must be in a position to understand the meaning

of demand for any commodity, in general.
2.3.1 Demand Schedule and Demand Curve

A demand schedule is one way of showing the relationship between quantity
demanded and price. Table 2.1 is an individual’s hypothetical demand schedule
for carrots. At arbitrarily chosen prices, the quantity of carrots an individual
consumer is expected to demand, is explained by the schedule. The schedule
shows that as the price goes on falling (from Rs 12 to Rs 2 per kg), the quantity
demanded goes on increasing (from 5 to 30 kg per month).
We can now plot the data from Table 2.1 to Figure 2.1, with a price on the
vertical and quantity on the horizontal axis. This curve is called the demand
curve for carrots. It shows the number of carrots that the consumer would like
38 to buy at every possible price. Its negative slope indicates that the quantity
demanded increases as the price falls. Thus, the demand curve is a graphic Microeconomic Theory
presentation of quantitie of a good which will be demanded by the consumer at and Initial Applications
various possible prices at a given point in time.
Table 2.1: An individual consumer’s demand schedule for carrot
Price Quantity demanded (kg per month)

(Rs/ kg)
12 5
10 7
8 10
6 15
4 25
2 30
Fig. 2.1: An individual Consumer’s Demand Curve
In fact, in the real world, such an inverse relationship between the quantities
demanded at the various prices exists for every normal good. This relationship is
explained by the law of demand, which states, "Ceteris paribus, the quantity of
a good demanded will rise (expand) with every fall in its price and the quantity
of a good demanded will fall (contract) with every rise in its price." It is due to
this law of demand that the demand curve slopes downward to the right.
The price of the product (and the change in it) plays an important part in
determining its demand. A change in the quantity demanded is indicated with
movement along the demand curve (up or down accordingly). This change is
subject to the ceteris paribus condition and is also referred to as an extension
in demand. On the other hand, other factors like the price of other products,
the income of the consumer, etc. are also likely to alter the quantity demanded.
This causes a shift in the demand curve, which may be upward or downward,
and is known as the change in demand.
Initially, the law of demand was based on the principle of diminishing marginal
utility (DMU). But in that case, it was implied that utility is cardinally or
absolutely measurable. There were other practical difficulties in the DMU
approach as well. Therefore recently attempts have been made to place the law
of demand on an empirical and realistic basis. One such attempt is in the form 39
Managerial Economics of Indifference Curve (IC) analysis. Under the IC approach, it is enough to
measure utility in ordinal or relative terms.
2.3.2 Market Demand

So far we have discussed how the quantity of a commodity demanded by one
consumer depends on the commodity’s price. To explain market behaviour, we
need to know the total demand of all consumers. To obtain market demand, we
sum the quantities demanded by each consumer at a particular price to obtain
the total quantity demanded at that price.
Suppose the market consists just of two people. How do we get from the two
individuals' demand curves the market demand curve? The answer is we sum
horizontally the two demand curves.
Fig. 2.2: Market Demand Curve
In Figure 2.2, the two individual demand curves (d1 and d2) are added to
give the market demand curve, D. At p = 1, individual demands are 2, and
market demand is 4. At p = 2, individual demands are 6 and 4, and market
demand is 10. The principle is the same for more than two consumers, just
add horizontally. Obviously, any change which affects the consumer's demand
curve will affect the market demand curve. Thus, market demand (curve) is
the horizontal sum of the individual demand (curves) of all consumers in the
market.
2.3.3 Derived Demand

The demand for any commodity may be either for consumption purposes or
for the production of some other commodity. Take an example of a potato.
Every household buys different quantities of potatoes at different prices for its
consumption, while the same potato may be purchased by some chips-making
firms also. The demand for potato by an individual consumer is called direct
demand, on the other hand, demand by the firm will be called derived demand.
Firms require inputs not for their own sake but as a means to produce goods
and services. For example, demand for carpenters and building materials rises
and falls as the amount of housing construction rises and falls.
Firms require the services of land, labour, capital, and natural resources to be
40 used as inputs. Demand for any input is derived from the demand for the goods
and services that it helps to produce; for this reason, the demand for a factor Microeconomic Theory
of production is called derived demand. Thus, derived demand provides a link and Initial Applications
between the markets for output and the markets for inputs.
By going through the above section, you must have understood the nature of the
demand curve and its relationship with the law of demand, and the repercussion
of change in the influencing factors on the demand curve. You must also
understand the difference between individual consumers’ demand and market
demand as well.
2.3.4 Ordinary Demand Function

This is also called as Marshallian demand function or simply demand function.
It gives the quantity of a commodity that the consumer will buy as a function of
commodity prices and his income. It is derived from the analysis for maximizing
utility with the given budget constraint.
Ordinary demand functions are homogeneous to a degree zero in prices and

income.
2.3.5 Compensated Demand Function

Assume that the Government imposes some taxes or provides some subsidy
to a consumer in such a way that the real income of the consumer remains the
same and, the utility derived from the consumption of commodities remains
unchanged after a change in the price of commodities. Thus, the consumer’s
compensated demand function gives the quantities of the commodities that he
will buy as a function of commodity prices only. It is derived by minimizing
the consumer’s expenditure subject to the constraint that his utility is at a fixed
level.

Note: a) Use the spaces given below for your answers.
b) Check your answers with those given at the end of the unit.
1. Differentiate between desire and demand.
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2. List the major factors influencing the demand for any commodity.
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41
Managerial Economics ......................................................................................................................
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3. What do you mean by ceteris paribus and why is it important in the context
of demand for any commodity?
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4. How do different factors influence the demand curve differently?
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5. How the demand for inputs is different than that for final goods?
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2.4 ELASTICITY OF DEMAND

Elasticity is a measure of the sensitivity of one variable to a change in
another. This is a different concept than the rate of change in demand to
change in price. Elasticity is the ratio of relative rates of change -- percent
of change -- not just the ratio of changes (derivative). Consider an example:
How does the quantity demand for good X change if the price of good X
increases by 1%? This is the Price – elasticity of demand for good X. It
is also called own-price elasticity because it refers to a change in demand
driven by a change in its own price.
Similarly, how does the quantity demanded for good Y change if the price
of good X increases by 1%? This is the Cross-price elasticity of demand for
goods X and Y, as it measures the cross-effects of a change in price on one
of the goods on the other good’s demand.
42
There are many kinds of elasticities: Microeconomic Theory
Price Income Cross-price
Demand Price-Elasticity of Income-Elasticity of Cross Price
Demand, or Own-Price Demand Elasticity of
Elasticity of Demand Demand
Supply Price-Elasticity of Supply, Cross Price

or Own-Price Elasticity of Elasticity of
Supply Supply
2.4.1 Price Elasticity

We saw that in principle demand rises when the price of a good falls and
demand falls when the price of that good increases. Sometimes, we wish to
know how the responsiveness of one product changes over time, or we may
wish to compare the responsiveness of several products. For example, although
we can’t easily compare the absolute changes in tonnes of wheat and barrels
of petrol with changes in their prices, but we can compare their percentage
changes.
These considerations lead us to the concept of the Price Elasticity of Demand

(ep), which is defined as a percentage change in quantity demanded due to a
percentage change in the price of a good. It is a pure number, therefore free
from scale.
q q q p ln q
ep
p p p q ln p
where, q is the quantity demanded for the product Q and p is the price of the
good Q.
The first term on the RHS is the slope of the demand curve. For an ordinary
good, the demand curve is downward sloping, i.e., the slope is negative. It
means the price and the quantity will always change in opposite directions,
making the price elasticity always negative. Therefore, while comparing the
price elasticities of two goods, you should consider their absolute and not their
algebraic value. For example, if good X has a price elasticity of -0.5, while good
Y has an elasticity of -1.5, you should say that Y has greater elasticity than X.
The value of ep ranges from zero to infinity (Remember we always consider

only absolute value). Elasticity depends on the slope of the demand curve and
the point at which the measurement is made. The elasticity of a downward-
sloping straight-line demand curve varies from infinity (∞) at the price axis to
zero at the quantity axis. Why it is so? A straight line has a constant slope, i.e.
∆q/∆p is constant, but the ratio of price and quantity (p/q) changes along the
demand curve.
In Fig 2.3, you may see that although the slope of the linear demand curve is
constant along the line, but ep is different at different points. Price elasticity at 43
Managerial Economics lower segment
a point on the demand curve equals to . Therefore, ep =1 at the
upper segment
mid-point, infinity at the price axis, and zero at the quantity axis.
Fig 2.3: Price elasticity measured on a linear demand curve
Box 2.1: Different levels of price elasticity and their interpretation

Price elasticity of Absolute value Description
demand of ep
Quantity demanded doesn’t change as
Perfectly inelastic ep = 0
price changes
Quantity demanded changes by a
Inelastic 1> ep>0
smaller percentage than does the price
Quantity demanded changes by
Unit elasticity ep = 1 exactly the same percentage than does
the price
Quantity demanded changes by a
Elastic ∞> ep>1
larger percentage than does the price
Consumers are prepared to buy all
Perfectly or
ep = ∞ they can at a little lower price and
infinitely elastic
none at all at a little higher price
Now, the question arises, what determines the price elasticity of demand? The
determinants of price elasticity of demand can be summarized as follows:
●● Availability of Substitutes
More Substitutes : More Elastic
●● Importance
Smaller Expense : Less Elastic
●● Durability
More Durable : More Elastic
44
●● Time Microeconomic Theory
More Time to adjust : More Elastic
Box 2.2: Relationship between Price Elasticity (ep) and Total

Expenditure (TE)
Price Elastic Demand Inelastic Demand Unitary Elastic

Change
(ep>1) (ep<1) (ep=1)
Price falls TE increases TE decreases No change in TE
Price rises TE decreases TE increases No change in TE
2.4.2 Income Elasticity

L
The demand for a good can rise or fall when income goes up. If it goes up,
the good is a normal good. Otherwise, it's an inferior good. To measure how
demand responds to income, we use the income elasticity of demand (η).
Income elasticity of demand shows the degree of responsiveness of quantity
demanded of a good to a change in income of the consumer. It is defined as
a percentage change in quantity demanded due to a percentage change in the
income of the consumer.
q / q q y ln q
η=
y / y y q ln y
Where, q is the quantity demanded for the product Q and y is the income of the
consumer.
For most of the products, an increase in income leads to an increase in quantity

demanded, and income elasticity, therefore, is positive.
Box 2.3: Classification of goods according to income elasticity
Type of goods Absolute val- Description

ue of η
Quantity demanded increases as income

Normal good η>0
increases
Quantity demanded decreases as income

Inferior good η<0
increases
Necessary Quantity demanded increases but less

0<η<1
good than in proportion to income increases
Quantity demanded increases but more

Luxury good η >1
than in proportion to income increases
45
Managerial Economics 2.4.3 Cross Elasticity
Many times, demands for two goods are so related to each other that when the
price of any of the changes, the demand for the other goods also changes, even
if their own price remains the same. Such responsiveness between two goods
is determined by Cross Elasticity or Cross Price Elasticity. For example, you
will realize that if the price of coffee increases then the demand for tea also
increases. However, when the price of milk or sugar increases significantly, the
demand for tea as well as coffee decreases.
Cross elasticity (εxy) is the percentage change in quantity demanded due to

a percentage change in the price of some other product. It is used to define
products that are substitutes for one another (positive cross-elasticity) and
products that complement one another (negative cross-elasticity).
qx
qx qx p y ln qx
xy
p y p y qx ln p y
py
Where, qx is the quantity demanded for product X and py is the price of product
Y.
Box 2.4: Classification of goods according to cross elasticity
Type of goods Absolute value Description

of εxy
Quantity demanded of one good and

Substitute good εxy > 0 the price of a substitute good are
positively related
Quantity demanded of one good and

Complementary
εxy < 0 the price of a complement good are
good
negatively related
The absolute value of the cross elasticity of demand measures the degree of
substitution or complementarity. For example, if εxy between coffee and tea
is found to be larger than that between coffee and hot chocolate, this means
that coffee and tea are better substitutes than coffee and hot chocolate. If εxy is
close to zero, X and Y are independent commodities, like mobile phones and
computers, car and television, and so on.
One thing, you must keep in mind is that the value of εxy need not equal the
value of εyx because the responsiveness of Qx to a change in Py need not equal
the responsiveness of Qy to a change in Px. For example, a change in the price of
coffee is likely to have a greater effect on the quantity of sugar demanded than
the other way round, since coffee is the more important of the two in terms of
total expenditure.
46
Check Your Progress 2.2 Microeconomic Theory
1. Enumerate a different kinds of elasticities of demand.
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2. Classify the commodities according to the income and cross elasticities of
demand.
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3. Price elasticity of demand varies along the straight line downward sloping
demand curve, explain.
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4. When the price of any commodity changes, its effect on consumers’
expenditure depends on the price elasticity of that commodity, explain.
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2. 5 ELASTICITY OF SUBSTITUTION
Sometimes, the students may come across another kind of elasticity viz.
elasticity of substitution (σ). The term is however used in the theory of
production, where factors of production substitute each other. The elasticity
of substitution is defined as the proportionate rate of change of the input ratio
47
Managerial Economics divided by the proportionate rate of change of the marginal rate of technical
substitution (MRTS).
d ( x2 / x1 ) ( MRTS x1x2 ) d ln ( x2 / x1 )

d ( MRTS x1x2 ) ( x2 / x1 ) d ln ( MRTS x1x2 )
Where xi = factors of production. The elasticity of substitution varies from zero

to infinity.
2.6 SUPPLY FUNCTION

Just as goods are demanded by consumers, they are supplied by manufacturers
or sellers. The amount of a product that firms are able and willing to offer for
sale is called the quantity supplied. At any point in time quantity supplied by the
firms is a function of the market price of the good. Several such prices can be
related to the relevant quantities supplied: this would give the supply schedule.
Supply curves represent the output firms will supply for given prices. Supply
curves are usually upward sloping (the higher the price, the more products a
firm will produce) while demand curves are usually downward sloping (the
higher the price, the fewer units are demanded).
There are four major factors determining the quantity supplied of any good:
1. Price of the good
2. Price of factors of production
3. Goals of the firm
4. State of technology
This you can write in function form like;
Qis = f (Pi) [T, R, P] const.
The quantity of a commodity supplied is thus a function of its own price

(Pi). There exists a direct relationship between the quantity supplied and the
price of a commodity. It is subject to the condition that other things should
remain constant. In this case ‘other things’ include mainly two things. These
are technical conditions or methods of production (T) and the prices and
quantities of the resources supplied (RP). With improvement in technical
conditions, a firm can increase supply at the same old price, since the cost
of production reduces. Similarly with an enhanced supply of resources and a
reduction in the prices of resources such as land, labor, raw materials, etc. an
increasing quantity of the commodity can be supplied at a constant or even
falling price. The positive slope of the supply curve reflects the fact that higher
prices must be paid to producers to cover rising marginal costs and thus induce
them to supply greater quantities of the commodity.
Like demand, supply has also a universal law, which states that "Ceteris paribus,
the quantity of a good supplied will rise (expand) with every rise in its price and
the quantity of a good supplied will fall (contract) with every fall in its price".
48
Microeconomic Theory
2.7 SUPPLY ELASTICITY and Initial Applications
As in the case of demand elasticity, the elasticity of supply measures the

response of quantity supplied to changes in any of the factors that influence it.
The price elasticity of supply or supply elasticity is defined as the percentage
change in quantity supplied divided by the percentage change in price.
qs q s qs p ln qs
Supply elasticity (ε) =
p p p qs ln p
where, qs is the quantity supplied for the product Q and p is the price of the
good Q.
What determines the response of producers to a change in the price of the

product that they supply?
• First, the size of the response depends in part on how easily
producers can shift from the production of other products to the one
whose price has risen. If agricultural land and labour can be readily
shifted from one crop to another, the supply of any one crop will be
more elastic than if labour can’t easily be shifted.
• Second, elasticity is strongly influenced by how input costs respond
to output changes.
By now, you must be in a position to differentiate between different facets of

demand and supply.
2.8 CONCEPT OF EQUILIBRIUM

Both demand and supply function independently but serve important
functions together. The concept of equilibrium can be defined as a point of
equality or agreement between buyers and sellers. Since both demand and
supply quantities are shown in the schedule forms these indicate the mutual
willingness of consumers and producers to purchase or sell respectively,
varying quantities at varying prices. The schedules do not yet explain the
actual market price at which deals take place. This can be possible only when
the quantities demanded and supplied are exactly equal at some uniform
price. So long as this has not been achieved, some buyers or sellers are
yet dissatisfied and may attempt to raise or lower the price. In this sense
equilibrium is a point of complete satisfaction of the given behaviour
of buying and selling and hence an act of fulfillment of a given economic
activity.
Therefore only at the point of intersection (E) between demand and supply
curves can equilibrium be attained. In other words, equilibrium price
represents the price at which buyers are willing to buy the good and sellers
are willing to sell it. This is the point of satisfaction for both groups. (Fig
2.4)
49
Fig 2.4: Point of equilibrium

1. Enumerate the factors influencing the supply of any commodity.
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2. What do you mean by the elasticity of supply?
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3. What is the point of equilibrium of demand and supply curves?
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2.9 ECONOMIC SURPLUS

Economic surplus comprises two components: Consumer surplus and producer
surplus. If the total consumers’ and producers’ surplus is not maximized, the
50 industry’s output could be altered to increase that total. The additional surplus
could be used to make some consumers better off without making any others Microeconomic Theory
worse off. Let’s now discuss what are these surpluses meant for? and Initial Applications
2.9.1 Consumer’s Surplus

The doctrine of consumer surplus is a deduction from the law of diminishing
marginal significance. The price that we pay for a thing measures only its
marginal significance. Only on the marginal unit, which a man is just induced
to buy the price is exactly equal to the satisfaction that he expects to get from
the unit. But on other units that he buys, he enjoys some extra amount of
satisfaction. He would be willing to pay higher prices for these units than what
he actually pays for them. The difference between the amounts of satisfaction
that a consumer obtains from purchasing things over that which he foregoes
by paying money for them is the economic measure of a consumer’s surplus.
It represents the excess of satisfaction that he secures, the excess is equal
to the difference between the prices of the goods acquired and those of the
goods sacrificed. Had he been deprived of the commodity, he would then
have been forced to spend the money on the purchase of other commodities
from which he does not deprive of the same amount of satisfaction as before.
A consumer’s surplus is then measured by the difference between the total
sum a household would be willing to pay and the price per unit multiplied by
the number of units purchased. The amount of surplus satisfaction depends,
in the words of Marshall, on our opportunities, or conjuncture.
Difficulties in measuring consumer surplus
Certain difficulties have to be faced in measuring consumer surplus in

terms of money. This difficulty is real and limits the utility of the doctrine.
J.R.Hicks in his Value and Capital has suggested a solution for this difficulty.
According to him the best way of looking at the problem is to conceive of
a consumer’s surplus in the nature of a gain in money income caused by
the fall in the price of a commodity. The negative slope of demand curves
shows that all consumers pay less than they would be willing to pay for the
total amount of any product that they consume. The difference between the
total value that consumers place on all the units consumed of some product
and the payment that they actually make for the purchase of that product is
called consumer surplus. In other words, the difference between what the
consumer would be willing to pay- which is the value of the total utility that
they derive from consuming the product- and what they do pay- which is their
total expenditure on that product- is called consumer’s surplus. In fact, the
demand curve exhibits the price a consumer is willing to pay for an additional
unit of the commodity. As the number of units increases, the consumer’s
willingness to pay decreases because every additional unit of the commodity
gives lesser satisfaction (utility) to the consumer. Thus, the total consumer
surplus is the area under the demand curve and above the market price line
(P0). Consumer surplus is equal to the net benefit that consumers receive from
the consumption of a good. It occurs because the marginal benefit from each
unit of the good exceeds the marginal cost (price) up to the point until the last
unit (Q0) is consumed. (Fig. 2.5) 51
Fig. 2.5: Consumer’s and Producer’s Surplus
Hicks however has tried to salvage the doctrine with the help of the indifference
curve analysis, which may be summarized as follows: (Fig. 2.6)
Fig 2.6: Hicks Analysis
If the consumer’s income is OM, and the price of X is indicated by the slope
[
of ML, which touches the indifference curve at P, ON will be the quantity of

X purchased and PF the price paid for it (since the combination yielded by
drawing perpendiculars from P is ON (commodity) plus PN (income), PF of
income is obviously sacrificed for the purchase of ON (commodity). From the
other (lower) indifference curve MR we find that ON+NR is another possible
combination that has got the individual the same utility as OM. That is to say, the
individual is prepared to pay RF in order to secure ON of X. Actually, however,
he pays PF. Thus PR is the amount of consumer’s surplus that the individual
can enjoy because his conjuncture enables him to pass on from a lower to a
higher indifference curve. And Hicks claims that PR is a perfectly general
representation of consumers’ surplus, independent of any assumption about the
marginal utility of money. But the consumer’s surplus is not necessarily the
same thing as in Marshall’s diagram: the two measurements of surplus would
be identical only if the marginal utility of money is assumed to remain constant.
According to Hicks, the best way of looking at a consumer’s surplus is to regard

it as a means of expressing, in terms of money income, the gain which accrues
to the consumer as a result of a fall in price. Or rather, a consumer’s surplus is
the compensating variation in income whose loss would just offset the fall in
52
the price, and leave the consumer no better off than before. This point may be Microeconomic Theory
illustrated as follows: and Initial Applications
Suppose a person buys 6 oranges when the price of oranges is Rs.2 each. Suppose
the price of oranges comes down to Rs.1 each and the person’s income also
declines by Rs. 6. In that case, the person may go on buying as many oranges as
before, even though his income has declined, and will not be any worse off on
that account. Another alternative definition is to define a consumer’s surplus as
equivalent variation: the amount of added income that would compensate the
consumer for the loss of the opportunity to purchase any of the commodities.
Theoretical and Practical utility of the Doctrine:
The concept of consumer surplus was first introduced by Marshall. The

doctrine points out the important fact that the price of a commodity does not
always indicate the exact amount of satisfaction derived from it. It provides a
satisfactory explanation of the fact that for many commodities of ordinary use,
like salt, etc., the value-in-use and the value-in-exchange differ, and it provides
a tool for a somewhat rough measurement of this difference. It enables us
to compare the amount of real income. It may be of some importance to the
monopolist. Gains from international trade may be measured in terms of an
increase in consumer surplus obtained by inhabitants of countries trading with
each other. Thus interlaced with many intricate problems of economic theory,
the doctrine of consumer surplus remains a very serviceable engine for the
discovery of concrete truth.
2.9.2 Producer’s Surplus

A producer surplus is analogous to a consumer surplus. Producer surplus
is defined as the net benefit received by producers from the sale of a good.
It occurs because all units of each firm’s output are sold at the same market
price (P0), while given a rising supply curve, each unit except the last (Q0)
is produced at a marginal cost that is less than the market price. A producer
surplus is an amount that producers are paid for a product less the total
variable cost of producing the product. The total variable cost of producing
any output is shown by the area under the supply curve up to that output.
Thus, the producer’s surplus is the area above the supply curve and below the
market price line.
In the diagram above, the yellow shaded region equals the amount of the
consumer’s surplus, while the blue shaded region represents the producer’s
surplus. The net benefit to society, also known as the “economic surplus” or
"gains from trade," equals the sum of these two areas. The sum of producer’s
and consumer’s surplus is maximized only at the perfectly competitive output.
If production is pushed beyond the competitive equilibrium (Q0), the sum of
two surpluses would fall. Firms would lose producers’ surplus on those extra
units because their marginal costs of producing the extra output would be
above the price that they received for it. Consumers would lose consumer
surplus because the valuation that they placed on these extra units (demand
curve) would be less than the price that they would have to pay.
53
Managerial Economics Check Your Progress 2.4
1. Define consumer surplus.
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2. How are the consumer’s surplus and market price related?
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3. Why does the producer’s surplus get affected if the production level
increases beyond the equilibrium level of output?
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4. How the consumer gets to benefit from a higher consumer surplus?
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2.10 FORECASTING OF DEMAND FOR

SEASONAL AGRI-PRODUCTS
The modus operandi of managing risk and uncertainty draws a comprehensible
demarcating line between Managerial economics and Pure economics.
Traditional economic theory presupposes a risk-free world of certainty, but in
the real world business is full of all sorts of risk and uncertainty and the degree
54 of risk and uncertainty is amplified many-fold in the case of Agribusiness.
An agribusiness manager cannot, therefore, afford to ignore the risk and Microeconomic Theory
uncertainty attached to the business. Since the element of risk is associated and Initial Applications
with the future which is indefinite and uncertain. Business forecasting in terms
of all associated variables is an essential ingredient of corporate planning. Such
forecasting enables the decision-makers to minimize the element of risk and
uncertainty.
The seasonal instability invariably affects CPI (Consumer Price Index)

values thereby directly influencing varied social predicaments. Therefore,
it is essential to forecast probable supplies and demand patterns of farm and
non-farm commodities which are by and large dependent on the very nature
of seasonality. As a result, the agribusiness professionals make research on
the factors affecting agricultural and livestock product prices, establish a
forecasting model of agricultural and livestock products prices, and develop
an early warning system that is suitable for the regional/geographical climate.
During 2008, the reduction of rice production in the world’s major grain-
producing countries led to a sharp drop in their exports of agricultural products,
which resulted in skyrocketing food prices and socio-economic disability
in some areas of food-importing countries. The rising price of agricultural
products promotes the CPI to a large degree. At present, the forecast method
for the price of agricultural and livestock products is mainly based on the past
products' prices and work experience, which can not forecast product prices
accurately and timely in some situations. Therefore, it is necessary to propose
the agricultural and livestock products price prediction model in case of
emergent agriculture, animal, and husbandry disaster, so that decision-makers
can foretell and adopt appropriate corrective measures.
2.10.1 Concepts of Forecasting

An adequate and stable supply chain of agricultural commodities is the
keystone of a successful agribusiness enterprise. An agribusiness manager can
conceptualize the future if he is well versed with the future event- its order,
intensity, duration, and variables- like demand, price, or profit, he can project
the future. Thus prediction and projection both have reference to the future;
in fact, one supplements the other. Suppose, it is predicted that there will be
inflation (event). To establish the nature of this event, one needs to consider the
projected course of the general price index (variable). Exactly, in the same way,
the predicted event of business recession has to be established with reference to
the projected course of variables like sales, inventory, etc.
Projection is of two types – forward and backward. It is a forward projection

of data variables, which is named forecasting. By contrast, the backward
projection of data may be named ‘back casting’, a tool used by the new
economic historians. For practical managers concerned with futurology, what
is relevant is forecasting, the forward projection of data, which supports the
production of an event. Thus, if a marketing manager fears demand recession,
he must establish its basis in terms of trends in sales data; he can estimate such
trends through extrapolation of his available sales data. This trend estimation is
an exercise in forecasting.
55
Managerial Economics 2.10.2 Need for Demand Forecasting
In a complex, global market, price and supply fluctuations for rural produce
affect resource and infrastructure planning and access to credit, at both farm
and national levels. Production surpluses may not translate into higher incomes.
The efficiency of enterprises is affected by the choice of commodity, product
end-use, or market, as well as sourcing of inputs such as fertilizers, seed,
pesticides, and technology. Rural communities’ governments and agribusiness
professionals must become more ‘market smart’. They need to forecast,
interpret and respond to supply signals from domestic and global markets and
capitalize on consumer preferences for perceived nutritional benefits, novelty,
and convenience. They must balance sustainable resource use and demands
for quality with the challenges of higher food safety standards and long and
complex supply chains.
The significance of demand or sales forecasting in the context of business policy

decisions can hardly be overemphasized. Sales constitute the primary source of
revenue for the corporate unit and a reduction in sales gives rise to most of the
costs incurred by the firm. Demand forecasting is essential for a firm because it
must plan its output to meet the forecasted demand according to the quantities
demanded and the time at which these are demanded. The forecasting demand
helps a firm to arrange for the supplies of the necessary inputs without any
wastage of materials and time and also helps a firm to diversify its output to
stabilize its income over time.
You need to apply forecasting techniques for the following management

functions:
• Long-Range Strategic Planning,
• Corporate Objectives: Profit, market share, ROCE, strategic
acquisitions, international expansion, etc.
• Annual Budgeting,
• Operating Plans: Annual sales, revenues, profits,
• Annual Sales Plans,
• Regional and product-specific targets,
• Resource Needs Planning, and
• HRM, Production, Financing, Marketing, etc.
2.10.3 Purpose of Short Term Forecasting

It is difficult to define the short run for a firm because its duration may differ
according to the nature of the commodity. For a highly sophisticated automatic
plant 3 months the time may be considered as short-run, while for another plant
duration may extend to 6 months or one year. Time duration may be set for
demand forecasting depending upon how frequent the fluctuations in demand
are, short- term forecasting can be undertaken for the following purpose:
56 • Appropriate scheduling of production to avoid problems of over-
production and under-production, Microeconomic Theory
• Proper management of inventories,
• Evolving a suitable price strategy to maintain consistent sales,
• Formulating a suitable sales strategy in accordance with the changing
pattern of demand and extent of competition among the firms, and
• Forecasting financial requirements for the short period.
2.10.4 Purpose of Long-Term Forecasting

The concept of demand forecasting is more relevant to the long-run than the
short-run. It is comparatively easy to forecast the immediate future than to
forecast the distant future. Fluctuations of a larger magnitude may take place in
the distant future. In a fast developing economy, the duration may go up to 5 or
10 years, while in a stagnant economy it may go up to 20 years. Moreover, the
time duration also depends upon the nature of the product for which demand
forecasting is to be made. The purposes are:
• Planning for a new project, expansion, and modernization of an
existing unit, diversification, and technological upgradation.
• Assessing long-term financial needs. It takes time to raise financial
resources.
• Arranging suitable manpower. It can help a firm to arrange for a
specialized labour force and personnel.
• Evolving a suitable strategy for changing the pattern of consumption.
2.11 METHOD OF FORECASTING

Broadly speaking, there are two approaches to demand forecasting- one is to
obtain information about the likely purchase behavior of the buyer through
collecting expert opinions or by conducting interviews with consumers, and the
other is to use past experience as a guide through a set of statistical techniques.
Both these methods rely on varying degrees of judgment. The first method
is usually found suitable for short-term forecasting, the latter for long-term
forecasting.
2.11.1 Simple Survey Method

For forecasting the demand for an existing product, such survey methods
are often employed. In this set of methods, we may undertake the following
exercise.
1) Experts Opinion Poll: In this method, the experts on the particular
product whose demand is under study are requested to give their ‘opinion’
or ‘feel’ about the product. These experts, dealing in the same or similar
product, are able to predict the likely sales of a given product in future
periods under different conditions based on their experience. If the number
of such experts is large and their experience-based reactions are different,
then an average-simple or weighted –is found to lead to unique forecasts.
57
Managerial Economics Sometimes this method is also called the ‘hunch method’ but it replaces
analysis with opinions and it can thus turn out to be highly subjective in
nature.
2) Reasoned Opinion-Delphi Technique: This is a variant of the opinion
poll method. Here is an attempt to arrive at a consensus in an uncertain area
by questioning a group of experts repeatedly until the responses appear to
converge along a single line. The participants are supplied with responses
to previous questions (including seasonings from others in the group by a
coordinator or a leader or operator of some sort). Such feedback may result
in an expert revising his earlier opinion. This may lead to a narrowing
down of the divergent views (of the experts) expressed earlier. The Delphi
Techniques, followed by the Greeks earlier, thus generate “reasoned
opinion” in place of “unstructured opinion”; but this is still a poor proxy
for market behaviour of economic variables.
3) Consumers Survey- Complete Enumeration Method: Under this, the
forecaster undertakes a complete survey of all consumers whose demand he
intends to forecast. Once this information is collected, the sales forecasts
are obtained by simply adding the probable demands of all consumers.
The principal merit of this method is that the forecaster does not introduce
any bias or value judgment of his own. He simply records the data and
aggregates it. But it is a very tedious and cumbersome process; it is not
feasible where a large number of consumers are involved. Moreover, if the
data are wrongly recorded, this method will be totally useless.
4) Consumer Survey-Sample Survey Method: Under this method, the
forecaster selects a few consuming units out of the relevant population
and then collects data on their probable demands for the product during
the forecast period. The total demand of sample units is finally blown up
to generate the total demand forecast. Compared to the former survey, this
method is less tedious and less costly, and subject to fewer data errors; but
the choice of sample is very critical. If the sample is properly chosen, then
it will yield dependable results; otherwise, there may be sampling error.
The sampling error can decrease with every increase in sample size.
5) End-user Method of Consumers Survey: Under this method, the sales
of a product are projected through a survey of its end-users. A product is
used for final consumption or as an intermediate product in the production
of other goods in the domestic market, or it may be exported as well as
imported. The demands for final consumption and exports net of imports
are estimated through some other forecasting method, and its demand for
intermediate use is estimated through a survey of its user industries.
2.11.2 Complex Statistical Methods

We shall now move from a simple to complex set of methods of demand
forecasting. Such methods are taken usually from statistics. As such, you
may be quite familiar with some statistical tools and techniques, as a part of
quantitative methods for business decisions.
(1) Time series analysis or trend method: Under this method, the time
58 series data on the under forecast are used to fit a trend line or curve either
graphically or through the statistical method of Least Squares. The trend Microeconomic Theory
line is worked out by fitting a trend equation to time series data with the and Initial Applications
aid of an estimation method. The trend equation could take either a linear
or any kind of non-linear form. The trend method often yields a dependable
forecast. The advantage of this method is that it does not require the formal
knowledge of economic theory and the market; it only needs the time series
data. The only limitation of this method is that it assumes that the past
is repeated in the future. Also, it is an appropriate method for long-run
forecasts, but inappropriate for short-run forecasts. Sometimes the time
series analysis may not reveal a significant trend of any kind. In that case,
the moving average method or exponentially weighted moving average
method is used to smoothen the series.
(2) Barometric Techniques or Lead-Lag indicators method: This consists
in discovering a set of series of variables (indicators) that exhibit a close
association in their movement over a period of time. The indicators used in
this method are classified as:
1. Leading indicators: These consists of indicators that move up and
down ahead of some other series e.g. new order of durable goods, new
building permits, etc.
2. Coincidental indicators: The ones that move up and down
simultaneously with the level of economic activity. e..g. number of
employees in the non-agricultural sector, rate of unemployment, sales
recorded by the manufacturing, trading, and retail sectors, etc.
3. Lagging indicators: Consists of those indicators, which follow a
change after some time lag. e.g. lending rate for short-term loans etc.
We may have the following two examples to understand this method;
Development and allotment of land by the Delhi Development Authority
to Group Housing Societies (a lead indicator) indicates higher demand
prospects for cement, steel, and other construction material (coincidental
indicators) and an increase in housing loan distribution (lagging indicators).
Similarly, the movement of agricultural income (AY series) and the sale
of tractors (ST series) The movement of AY is similar to that of ST, but
the movement in ST takes place after a year’s time lag compared to the
movement in AY. Thus if one knows the direction of the movement in
agriculture income (AY), one can predict the direction of movement of
tractors’ sales (ST) for the next year. Thus agricultural income (AY) may
be used as a barometer (a leading indicator) to help the short-term forecast
for the sale of tractors.
Generally, this barometric method has been used in some developed
countries for predicting business cycles situation. For this purpose, some
countries construct what are known as ‘diffusion indices’ by combining the
movement of a number of leading series in the economy so that turning
points in business activity could be discovered well in advance.
Some of the limitations of this method may be noted. The leading indicator
method does not tell you anything about the magnitude of the change that
can be expected in the lagging series, but only the direction of change. 59
Managerial Economics Also, the lead period itself may change over time. Through our estimation,
we may find out the best-fitted lag period on the past data, but the same
may not be true for the future. Finally, it may not be always possible to find
out the leading, lagging, or coincident indicators of the variable for which
a demand forecast is being attempted.
(3) Correlation and Regression: These involve the use of econometric
methods to determine the nature and degree of association between/among
a set of variables. Econometrics, you may recall, is the use of economic
theory, statistical analysis, and mathematical functions to determine the
relationship between a dependent variable (say, sales) and one or more
independent variables (like price, income, advertisement, etc.). The
relationship may be expressed in the form of a demand function, as we
have seen earlier. Such relationships, based on past data can be used
for forecasting. The analysis can be carried out with varying degrees
of complexity. Here, we shall not get into the methods of finding out
‘correlation coefficient’ or ‘regression equation’; you must have covered
those statistical techniques as a part of quantitative methods. Similarly,
we shall not go into the question of economic theory. We shall concentrate
simply on the use of these econometric techniques in forecasting.
We are in the realm of multiple regressions and multiple correlations. The
form of the equation may be:
DX = a + b1 A + b2PX + b3Py
You know that the regression coefficients b1, b2, b3, and b4 are the components
of relevant elasticity of demand. For example, b1 is a component of the price
elasticity of demand. They reflect the direction as well as the proportion of
change in demand for x as a result of a change in any of its explanatory
variables. For example, b2< 0 suggests that DX and PX are inversely related;
b4 > 0 suggest that x and y are substitutes; b3 > 0 suggests that x is a normal
commodity with a positive income effect.
Given the estimated value of and bi, you may forecast the expected sales
(DX), if you know the future values of explanatory variables like own price
(PX), related price (Py), income (B), and advertisement (A). Lastly, you
may also recall that the statistics R2 (Coefficient of determination) gives
the measure of goodness of fit. The closer it is to unity, the better the fit, and
that way you get a more reliable forecast.
The principal advantage of this method is that it is prescriptive as well
as descriptive. That is, besides generating a demand forecast, it explains
why the demand is what it is. In other words, this technique has got
both explanatory and predictive value. The regression method is neither
mechanistic like the trend method nor subjective like the opinion poll
method. In this method of forecasting, you may use not only time-series
data but also cross-section data. The only precaution you need to take is
that data analysis should be based on the logic of the economic theory.
(4) Simultaneous Equations Method: It is also known as the ‘complete
system approach’ or ‘econometric model building’. This method is
normally used in macro-level forecasting for the economy as a whole; in
60 this course, our focus is limited to microelements only. Of course, you, as
corporate managers, should know the basic elements of such an approach. Microeconomic Theory
The method is indeed complicated. However, in the days of the computer, and Initial Applications
when package programmes are available, this method can be used easily to
derive meaningful forecasts. The principal advantage of this method is that
the forecaster needs to estimate the future values of only the exogenous
variables, unlike the regression method where he has to predict the future
values of all, endogenous and exogenous variables affecting the variable
under forecast. The values of exogenous variables are easier to predict than
those of endogenous variables. However, such econometric models have
limitations, similar to that of the regression method. In this section, we will
discuss two models, which are being used by business forecasters.
A. Box Jenkins Method
Box Jenkins Models, also known as ARIMA (‘Auto-Regressive Integrated
Moving Average’) models. This is an empirically driven method of
systematically identifying, estimating, analyzing, and forecasting time
series. BJM is used only for short-term predictions and is suitable only
for demand with stationary time-series sales data,i.e the one that does not
reveal the long-term trend.
In this method, the models are designated by the level of autoregression,
integration, and moving averages (P, d, q) where P is the order of regression,
d is the order of integration and q is the order of moving average, therefore,
in this method, there are three components of the ARIMA process:
• AR (Autoregressive) Process.
• MA (Moving Average) Process.
• Integration Process.
AR process: of order ‘p’, generates current observations as a weighted
average of the past observations over p periods, together with a random
disturbance in the current period.
Yt=μ+a1Yt-1+a2Yt-2+….+apYt-p+et
MA process: Order q, each observation of Yt is generated by the weighted
average of random disturbances over the past q periods.
Yt= μ +et-c1et-1-c2et-2+….-cqet-q
Integrated Process: Ensures that the time series used in the analysis is
stationary. The previous 2 equations are combined to form:
Yt=a1Yt-1+a2Yt-2+...+apYt-p+μ+et-c1et-1-c2et-2+…-cqet-q
B. Input-output model
An input-output model uses a matrix representation of a nation's (or a
region's) economy to predict the effect of changes in one industry on others
and by consumers, government, and foreign suppliers on the economy.
One who wishes to do work with input-output systems must deal skillfully
with industry classification, data estimation, and inverting very large, ill-
conditioned matrices. Wassily Leontief won the Nobel Memorial Prize in
Economic Sciences for his development of this model in 1973. Let us 61
Managerial Economics consider the output functions of the following four industries in a closed
economy;
Industry 1: X1=X11+X12+X13+X14+C1
Where, Xij= Output of the industry i which is purchased by industry j for

the production of its output. Ci = Demand of the customers for products for
final use. Let Xij=aijXj for i=1 to 4 and j=1 to 4 or Xij/Xj=aij
Where aij is the output of ith industry required to produce a unit output of
jth industry, thus we have,
X1=a11X1+a12X2+a13X3+a14X4+C1
X2=a21X1+a22X2+a23X3+a24X4+C2
X3=a31X1+a32X2+a33X3+a34X4+C3
X4=a41X1+a42X2+a43X3+a44X4+C4
This equals to:
X=AX+C
[I-A]X=C
X=[I-A]-1C
1 0 0 0 a11 a12 a13 a14 X1 C1

0 X C
1 0 0 a21 a22 a23 a24
2 2
I= A= a31 a32 a33 a X= X 3 C= C3
0 0 1 0 34

0 0 0 1 a41 a42 a43 a44 X4 C4
Where,
I=Unit Matrix; A=Technology Coefficient Matrix; X=Output Vector; C=Final

Demand Vector
If we know/get a forecast for X, total output, we can easily find labor, capital
& other requirements. This makes the Input-Output method a powerful tool for
planning. In order to find the component D (represented as C before), Demand,
one may use the previously discussed methods or a simple projection method.
Dit = Di0 (1+ ρi) t
Dit-Level of Final Demand; ρi= Growth rate of final Demand
Pt=P0(1+s)t
Pt-Population at time t ; s = Rate of growth of Population
62 dit=di0(1+x)t
dit = Per-capita consumption in time t ; x = rate of growth of per-capita Microeconomic Theory
consumption in time t. and Initial Applications
eyi=(∆dit/dit)/(∆ y/y)∆
eyi=Income elasticity of Demand ; r=∆ y/y= Rate of growth of per capita income.
thus, we have, eyi=x/r;

x= eyi *r
dit=di0(1+eyi*r)t
dit=Dit/Pt, di0=Di0/P0
We get,
Dit/Pt=Di0/P0*(1+eyi*r)t
Dit=Di0/P0*(1+eyi*r)t * P0*(1+s)t
i.e Dit=Di0*(1+eyi*r)t*(1+s)t
Comparing with the original eqn. for Demand,
ρi=[(1+eyi*r)(1+s)]-1
This equation gives the growth rate of final demand for the ith commodity in
terms of its income elasticity of demand, the target rate of growth of per capita
income, and population growth. If these parameters are known exogenously
then ρi can be computed and final demand Dit can be predicted.
Advantages:
It gives sector-wise breakdown of demand forecasts for commodities and

helps the firm to formulate its marketing policies in a better way by taking into
account various market segment strengths for its products.
Disadvantages:
Input-output tables are not available every year. Sometimes there may be a large
gap between the years for which input-output coefficients are available and the
years for which the forecasts are needed. The larger the time gap, the less stable
will be the coefficients, thus reducing the forecasting accuracy. Also, a change
in the production technology, tastes, preferences, etc. during the period makes
the forecast less valid.
Controlling the Forecast
Control of forecasting is the process of comparison, evaluation, interpretation,

and auditing of the performances of the firm against the objectives and standards
forecasted. We measure the inaccuracy in forecasting in terms of Percentage
Forecasting Inaccuracy (PFI).
●● PFI1=(|Yt-Yt’|*100)/Yt
●● PFI2=( *100)/ 63
Managerial Economics PFI1 stands for one period forecast and PFI2 stands for multi-period forecasts,
t for time, and k for the length of time. Based on these ratios we fix some
acceptable limits for them which depend on the commodity type, market nature,
and forecasting method.
2.12 LET US SUM UP

In microeconomic analysis, we usually study how the individual market
operates. An individual consumer’s demand curve shows the relation between
the price of a product and the quantity of that product the consumer wishes to
purchase. Its negative slope indicates that the lower the price of the product,
the more the consumer wishes to purchase. It is drawn on the assumption that
all other prices, income, and tastes remain constant. A market is said to be in
equilibrium when no buyer or seller has any incentive to change the quantity of
the good, service, or resource that he or she buys or sells at the given price. The
equilibrium price and quantity of a commodity are defined at the intersection
of the market demand and supply curves of the commodity. Different kinds of
elasticities of demand exhibit the responsiveness of the own price or income
of the consumer or price of other commodities on the quantity demanded of
any commodity. A consumer’s surplus is the difference between the value
a consumer places on his total consumption of some product and the actual
amount paid while the producer’s surplus equals the excess of the commodity
price over the producer’s marginal cost of production.
2.13 KEYWORDS
Ceteris paribus : Other things being equal, as when all but
one independent variable are held constant
so as to study the influence of the remaining
independent variable on the dependent
variables.
Change in demand : A shift in the whole demand curve brought
out due to changes in factors other than the
price of that commodity.
Demand :
The entire relationship between the quantity
of a commodity that buyers wish to purchase
per period of time and the price of that
commodity, other things being equal.
Derived demand : The demand for a factor of production that
results from the demand for the products it
is used to make.
Diminishing Marginal Utility : The decline in the extra utility received
from consuming one additional unit of a
commodity.
Indifference curve : A curve showing all combinations of
commodities that yield equal satisfaction to
the household.
64
Marginal utility : The change in satisfaction resulting Microeconomic Theory
from consuming one additional unit of a and Initial Applications
commodity.

REFERENCES
1. Ahuja, H.L. 2000. Advanced Economic Theory: Microeconomic Analysis.
S. Chand & Company Ltd, New Delhi.
2. Henderson, J.M. and R.E. Quandt 1980 (3rd edn). Microeconomic Theory:
A Mathematical Approach. McGraw Hill Book Company.
3. Koutsoyiannis, A. 1994 (2nd edn). Modern Microeconomics. The Macmillan
Press Ltd.
4. Lipsey, R.G. and K.A. Chrystal 1995 (8th edn). An Introduction to Positive
Economics. Oxford University Press.
5. Salvatore, D. 2003 (4th edn). Microeconomics: Theory and Applications.
Oxford University Press.
Website:
• http://www.vikalpa.com/pdf/articles/1988/1988_jan_mar_53_62.pdf
• http://notesandassignments.blogspot.in/2012/10/methods-of-demand-
forecasting.html
• http://www.slideshare.net/shivrajsinghnegi/demand-estimation-and-
forecasting
• Economics. StudyMode.com. Retrieved 02, 2013, from http://www.
studymode.com/essays/Economics-1409192.html

ANSWERS
1. Desire is how much consumers wish to purchase, not necessarily how
much they actually succeed in purchasing. Demand means the quantity of
any commodity that ‘buyers are willing and have the ability to buy.
2. Price of the product, price of other (substitute & complementary) products,
the income of the consumer, taste & preferences of the consumer, and
various sociological factors.
3. Ceteris paribus means ‘other things remaining same. It is difficult
to determine the effect of each factor simultaneously on the quantity
demanded. To avoid this difficulty, we consider the influence of only one
variable at a time. For example, we study the effect of changes in the price
of that commodity on the commodity demanded assuming that all other
factors remain unchanged.
4. The price of the product (and the change in it) plays an important part in
determining its demand. A change in the quantity demanded is indicated
65
Managerial Economics with movement along the demand curve (up or down accordingly). This
change is subject to the ceteris paribus condition. On the other hand, other
factors like the price of other products, the income of the consumer, etc.
are also likely to alter the quantity demanded. This causes a shift in the
demand curve, which may be upward or downward.
5. Demand for any input is derived from the demand for the goods and
services that it helps to produce; for this reason, the demand for a factor of
production is called derived demand.

1. There are three kinds of elasticity: price, income, and cross.
2. According to income: normal goods, inferior goods, necessary goods,
and luxury goods. According to cross-elasticity: substitute goods and
complementary goods.
3. The elasticity of a downward-sloping straight-line demand curve varies
from infinity (∞) at the price axis to zero at the quantity axis. It is because
a straight line has a constant slope, i.e. ∆q/∆p is constant, but the ratio of
price and quantity (p/q) changes along the demand curve.
4. If the goods are perfectly inelastic, the quantity demanded does not
change as the price changes. If the goods are unit elastic, quantity
demanded changes by exactly the same percentage the does price and
if goods are elastic, quantity demanded changes by a larger percentage
than does the price.

1. Price of the good, price of factors of production, goals of the firm, state
of technology.
2. The elasticity of supply measures the response of quantity supplied to
changes in any of the factors that influence it.
3. Equilibrium is attained at the point of intersection between demand and
supply curves.

1. Consumers' surplus is the monetary gain obtained by consumers because
they are able to purchase a product for a price that is less than the highest
price that they would be willing to pay.
2. On a standard supply and demand diagram, consumer surplus is the
area (triangular if the supply and demand curves are linear) above the
equilibrium price of the good and below the demand curve. This reflects
the fact that consumers would have been willing to buy a single unit of
the good at a price higher than the equilibrium price, a second unit at a
price below that but still above the equilibrium price, etc., yet they in
fact pay just the equilibrium price for each unit they buy.
3. In the supply-demand diagram, producer surplus is the area below the
equilibrium price but above the supply curve. This reflects the fact that
66 producers would have been willing to supply the first unit at a price
lower than the equilibrium price, the second unit at a price above that Microeconomic Theory
but still below the equilibrium price, etc., yet they in fact receive the
equilibrium price for all the units they sell.
4. Consumers always like to feel like they are getting a good deal on
the goods and services they buy and consumer surplus is simply an
economic measure of this satisfaction. For example, assume a consumer
goes out shopping for a CD player and he or she is willing to spend Rs.
250. When this individual finds that the player is on sale for Rs. 150,
economists would say that this person has a consumer surplus of Rs.
100.

1) What is demand? What are the two factors which underlay the negative
relationship between price and quantity along a demand curve?
2) What is the price elasticity of demand? Define elastic and inelastic demand.
3) Which would likely be more elastic: the demand for all cars as a group or
the demand for Maruti? Explain.
4) Which would likely be more elastic the demand by students for paper clips
or the demand for student housing on campus? Explain.
5) (a) Does frequency of consumption affect elasticity? Support your answer
with an illustration.
(b) Differentiate between Elasticity of demand and elasticity of supply.
67
UNIT 3 MARKET EQUILIBRIUM
Structure
3.0 Objectives
3.1 Introduction
3.2 Market Equilibrium
3.3 Law of Demand
3.4 Law of Supply
3.5 Changes and Shift in Demand
3.6 Income vs. Substitution Effect
3.7 Relationships among Elasticities
3.8 Tools of Economics and Complicated Agricultural Problems
3.9 Let Us Sum Up
3.10 Keywords
3.0 OBJECTIVES
After going through this unit, you will be in a position to:
●● describe the concept of demand and supply theory;
●● explain the law of demand and supply and the market equilibrium;
●● examine the concept of changes and shifts in demand; and
●● explain the income and substitution effects.
3.1 INTRODUCTION
This unit illustrates the key tools of the market demand curve and market
supply curve and the concept of an equilibrium price and quantity. Demand is a
multivariate relationship, that is, it is determined by many factors simultaneously.
Some of the most important determinants of the market demand for a particular
product are its own price, consumers’ income, prices of other goods, consumers’
tastes, income distribution, population, consumers’ wealth, credit availability,
government policy, etc.
There are two basic approaches for the comparison of utilities, the cardinal
approach, and the ordinal approach. The cardinal approach postulates that
utility can be measured. The ordinal approach postulates that utility is not
measurable but is an ordinal magnitude. The elasticity of demand is a concise
68 way to describe the substitutability of goods. The concept of demand and supply
curves and elasticity are important in many business decisions. Market Equilibrium
There are two types of changes in demand;

i) Change in demand for a product due to a change in price,
ii) Change in the quantity of a product demanded regardless of price.
When there is a change in the amount purchased due to lower prices and surplus
money spending it is called the income effect. Income effects basically happen
when real incomes are on the rise. The substitution effect of demand is when
the prices drop and consumers buy more than usual at the expense of a different
product.
The law of demand states that the quantity demanded is inversely proportional
to price, while the law of supply states that the quantity supplied is directly
proportional to price. Market or equilibrium price is the point where what sellers
are willing to sell for and what buyers are willing to buy for. This is the price
the product will sell for. Price is negotiated between the buyers and the sellers.
3.2 MARKET EQUILIBRIUM

Equilibrium refers to the market condition that once achieved, tends to persist.
This occurs when the quantity of a commodity demanded in the market per
unit of time equals the quantity of the commodity supplied to the market over
the same time period. Geometrically, equilibrium occurs at the intersection of
the commodities market demand curve and market supply curve. The price and
quantity at which equilibrium exists are known, respectively, as the equilibrium
price and the equilibrium quantity or equilibrium amount.
The General Theory of Supply and Demand
Value and Price: The theory of pricing or the theory of value occupies a central
place in economic doctrine. The purpose of the value theory is to explain the
determination of exchange value. Price is nothing but value expressed in terms
of a particular commodity, namely, money. The theory of pricing thus takes the
place of the theory of value in a monetary economy. The Theory of value tells
us that individual prices are governed by the condition of supply and demand.
Market Value or price is obviously determined in a market. The market in

economics is simply the network of dealings in any product or factor between
buyers and sellers.
The more nearly perfect a market is, the stronger the tendency for the same
price to be paid for the same thing at the same time in all parts of the market.
But if the market area is large, allowance must be made for the expanse of
delivering the goods of different purchasers, each of whom must be supposed
to pay in addition to the market price a special charge on account of delivery.
If different prices rule for the same commodity in different parts of the market
at a given time, such a difference must be regarded as a measure of market
imperfection unless, and except to the extent that, they are accounted for by the
differences in delivery charges. Market imperfection is then fundamentally due
to ignorance or prejudice on the part of buyers and sellers. 69
Managerial Economics The area of a market depends largely upon the nature of a particular commodity.
There are many special causes that may widen or narrow the market of any
particular commodity. Markets may be classified from the standpoints of both
space and time.
From the point of view of space, the market may be classified as purely
local, regional, national, and international markets. The larger the area, the
lesser the risk of fluctuation in price due to the sudden contraction in supply
or demand in particular areas.
From the standpoint of time, we can distinguish three fundamental time

periods in pricing:
(1) Market Price: the price of a commodity during a period in which its
supply is fixed.;
(2) Short-Run Normal Price: The price of a commodity during a longer
period in which the rate of production is variable, but in which there
exist fixed plants, and
(3) Long-Run Normal Price: The price of a commodity during the period
in which the rate of production is completely variable, and a fixed plant
no longer exists. Markets vary with regard to the period of time which
is allowed for the forces of demand and supply to bring themselves into
equilibrium with one another.
Theory of Supply and Demand
Ricardo, while not denying the influence of utility on value thought that
value is determined by the cost of production, and by “cost of production;
Ricardo mainly implied the quantity of labour used directly in the production
of anything. Jevons went to the opposite extreme and asserted that value
depends entirely on utility. According to Jevons, the cost of production
determines supply. Supply determines the final degree of utility and the final
degree of utility determines value.
Thus it may be argued as follows: utility determines the amount that has
to be supplied; the amount that has to be supplied determines the cost of
production; cost of production determines value. The truth is that neither
Ricardo nor Jevons correctly stated the theory of value. Value is determined
by the interaction of the forces of supply and demand and we might as
reasonably dispute whether it is the upper or the under the blade of a pair of
scissors that cut a piece of paper as whether the value is determined by utility
or cost of production. Most economic goods have their costs of production
because if there were no such costs such goods would become free goods. It
is therefore possible to construct the list of prices at which different amounts
of a commodity can be supplied. Such a list may be described as a supply
schedule. Similarly, in a market, there is a demand price for each amount of
the commodity, i.e., a different set of prices at which different amounts of a
commodity can be sold. In this way, we can construct a demand schedule.
When the amount produced is such that the demand price is greater than the
supply price, then sellers receive more than is sufficient to make it worth
70 their while to bring goods to market to that amount, and there is at work
an active force tending to increase the amount brought forward for sale. Market Equilibrium
Conversely, when the amount produced is such that the demand price is
lower than the supply price, then sellers receive less than is sufficient to
make it worth their while to bring goods to the market on that scale. An
active force will be at work tending to diminish the amount brought forward
for sale. When the demand price is equal to the supply price, the amount
produced has no tendency either to be increased or to be diminished; it is
in equilibrium. When demand and supply are in equilibrium, the amount of
the commodity which is being produced in a unit of time may be called the
equilibrium amount and the price at which it is being sold may be called the
equilibrium price.
The above proposition can be proved with the help of the following example:
Table 3.1: Schedule of quantity demanded and quantity supplied
Price Quantity Quantity Supplied

(Rs.) Demanded
1 70 10
2 60 20
3 50 30
4 40 40
5 30 50
6 20 60
7 10 70
Fig. 3.1: Quantity demanded and quantity supplied
Here, Rs. 4 is obviously the equilibrium – price, and 40 is the equilibrium

amount. If the price is lower than Rs. 4 the amount demanded will exceed the
amount that will be supplied at the lower price. If the price is higher than Rs.4
the supply will exceed the demand. Supply will be adjusted to demand only
when the price settles at Rs 4.
71
1. What is the three fundamental pricing based on the time period?
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2. Differentiate between the value and price of a commodity.
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3. List four important determinants of market demand.
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3.3 LAW OF DEMAND

The law of demand expresses the functional relationship between price and
quantity demanded. According to the law of demand, other things remain
constant, if the price of a commodity falls, the quantity demanded of it
will rise and if the price of the commodity rises, its quantity demanded
will decline. Thus, according to the law of demand, there is an inverse
relationship between price and quantity demanded, other things remaining
the same. These other things which are assumed to be constant are the tastes
and preferences of the consumer, the income of the consumer, and the prices
of the other goods. If these other factors which determine demand also
undergo a change, then the inverse price-demand relationship may not hold
good. Thus, the constancy of these other things is an important assumption
of the law of demand.
In the demand schedule of Table 3.2, we see that the lower the price of
the commodity, the greater the quantity demanded by the individual. This
inverse relationship between price and quantity is reflected in the negative
72
slope of the demand curve in Fig. 3.2 Market Equilibrium
Table 3.2: Demand Schedule
Price (Rs.) Quantity Demanded

7 10
6 20
5 30
4 40
3 50
2 60
1 70
Fig. 3.2: Demand Curve
3.4 LAW OF SUPPLY

The Law of Supply states the relationship between the price of a commodity
and its supply. According to the law of supply, other things remain constant,
the supply of a commodity extends with a rise in its price and contracts with a
fall in its price. The minimum price for a given amount of a commodity that is
necessary to induce a seller to offer that amount for sale is known as the supply
price. The other factor which affects supply price is the cost of production. In
order to get a producer’s supply schedule and supply curve of a commodity,
certain factors which influence costs of production must be held constant.
These are technology, the prices of the inputs, and for agricultural commodities,
climate, and weather conditions.
In the supply schedule of Table 3.3, we see that the lower the price of the
commodity, the smaller the quantity offered by the supplier. The reverse is, of
course, also true. The supply curve in Fig. 3.3:
Table 3.3: Supply Schedule
Price(Rs.) Quantity Supplied

1 10
2 20
3 30
4 40
5 50
6 60 73
7 70
Fig. 3.3: Supply Curve
3.5 CHANGES AND SHIFT IN DEMAND

The change in demand or variation in demand may be caused by the change
in factors other than price like income, tastes and preferences change in prices
of related commodities, etc. A movement along a given demand curve for a
commodity as a result of a change in price is called a change in the quantity
demanded, whereas, a shift in the entire demand curve of a commodity resulting
from a change in the individual’s income, tastes, and preference, or prices of
other commodities is called the shift in demand.
The difference between the two concepts can be shown with the help of
diagrams. In the following diagram, Fig 3.4 the demand curve D shows the
amount demanded X1 for price P1. When the price decreases to P2 the quantity
demanded increases to X2. This movement along the demand curve is called the
change in quantity demanded due to a change in price.
Fig. 3.4: Change in demand Fig. 3.5: Shift in demand curve
A shift in the entire demand curve is shown in the diagram, Fig 3.5. Price
remaining fixed at P, the entire demand curve shifts to the right from its old
position D to the new position D’. In this diagram, the increase in demand is
measured as X1 and X2.
74
Check Your Progress 3.2 Market Equilibrium
Note a) Use the spaces given below for your answers.

1. How does price affect the demand pattern of a commodity?
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2. What are the factors that affect the supply of a commodity?
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3. What are the conditions of the market equilibrium of a commodity?
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3.6 INCOME VS. SUBSTITUTION EFFECT

Change in the price of a commodity affects directly the consumer’s demand
for the commodity. The increase in demand in response to a fall in price is
called the Price Effect. The Price Effect may be split into two separate effects,
a substitution effect and an income effect. The substitution effect is the increase
in the quantity bought as the price of the commodity falls, after adjusting
income to keep the purchasing power of the consumer the same as before.
This adjustment in income is called compensating variation and is shown
graphically by a parallel shift of the new budget line until it becomes tangent
to the initial indifference curve (Fig.3.6). The purpose of the compensating
variation is to allow the consumer to remain on the same level of satisfaction
as before the price change. The compensated-budget line A`B` is tangent to
the original indifference curve (I) at a point (e1) to the right of the original
tangency (e). The movement from e to e1 shows the substitution effect of the
price change: the consumer buys more of x now that it is cheaper, substituting
y for x. However, the compensating variation is a device that enables the 75
Managerial Economics isolation of the substitution effect but does not show the new equilibrium of the
consumer. This is defined by point e2 on the higher indifference curve II. The
consumer has a higher purchasing power, and he spent some of his increased
real income on x, thus moving from x1 to x2. This is the income effect of the
price change.
Fig. 3.6: Income and substitution effect
Hicks vs. Slutsky Analysis
The price effect is the combined result of the income effect and the substitution
effect. To find out the substitution effect we need to keep the real income of the
consumer constant. Now, there are two concepts of real income available to
us. The first is that of Hicks and the second is developed by Slutsky.
According to Hicks if an imaginary budget line is drawn which is tangential to

the indifference curve I on which the consumer was in equilibrium before the
price fall of the commodity taking care that it is also parallel to the redrawn
budget line (AC) after the price fall, then the imaginary budget line A`B`
represents the same level of real income as the old budget line (AB). Therefore,
Hicks’ Substitution Effect is the movement of the consumer along the same
indifference curve (I) from one combination (e) to another combination (e1).
In Fig. 3.7, therefore, as the consumer moves from equilibrium point e to e2,
he purchases xx2 more of the commodity. Out of this, xx1 is the substitution
effect, and x1x2 is the income effect.
In Slutsky’s view, if we draw an imaginary budget line (A``B``) that is parallel

to the redrawn budget line (AC) after the fall of the price of commodity X,
and which also passes through the old equilibrium point e on the old budget
line (AB), it represents the same old level of real income. This is because the
A``B`` budget line gives the consumer a choice to buy the old equilibrium
combination e if he likes. But moving down the same budget line A``B`` he
can choose a combination e1` which lies on a higher indifference curve I1.
The substitution effect in Slutsky’s view is equivalent to rotating the budget
line about a point which leads to the movement of the consumer into a higher
indifference curve than before (Fig.3.7). Slutsky’s substitution effect is shown
76
in the diagram as xx1`. Market Equilibrium
Fig. 3.7: Hicks and Slutsky’s substitution effect
Thus, in the above two analyses, Slutsky’s approach gives us a greater substitution
effect than Hicks's. The budget line A``B`` lies vertically higher than the budget
line A`B`. The point of equilibrium e1` of Slutsky’s is on a higher indifference
curve I1 while the point of equilibrium e1 of Hicks is on the old indifference
curve I. Correspondingly the substitution effect xx1` of Slutsky is greater than
xx1 of Hicks. Slutsky’s method of eliminating the income effect is preferable
to the Hicksian method because it is more objective in its approach. Though
Slutsky shows constant real income by a different indifference curve than the
original, the Slutskian measure is conceptually less satisfying.
3.7 RELATIONSHIPS AMONG ELASTICITIES

When the price of a commodity falls (rises), its demand goes up (down) on
account of two factors which we call the income effect and substitution effect.
The two effects when added is called price effect. Therefore, when the price
of a commodity falls, it means an increase in the real income of the consumer.
He will like to purchase more of the commodity that has become cheaper on
account of the income and the substitution effects. The increase in the amount
demanded of the commodity as a result of a fall in its price will depend upon:
(a) the proportion of increased (real) income that will be spent on an increased
purchase of this commodity. This will depend on the nature of the commodity
and the income effect it is able to induce on the consumer. If we call the
proportion of increased income spent on this commodity as k and the income
elasticity of demand Ei, the influence on demand as a result of a fall in price
will be k x Ei ; (b) the proportion of increased (real) income that will be spent to
increased purchase of other commodities. It will depend on the strength of the
substitutability between this commodity and other commodities. The balance of
increased income that will remain with the consumer is 1-k. If Es is the elasticity
of substitution, then the second influence on the demand for the commodity
whose price has fallen is (1-k) Es.
The first influence is the income effect and the second is the substitution effect.
Since the price effect is the net result of those two effects, we can set up the
relation.
Price elasticity of demand, Ed = income effect + substitution effect 77

Managerial Economics i.e. Ed = kx x Ei + (1-kx) x Es
Where,
Ei is the income elasticity of demand, and
Es is the substitution elasticity of demand
kx is the proportion of income spent on the commodity x, and 1-kx) is

the proportion of income spent on other goods.
The practical importance of the interrelationship formula is that if we know the

two elasticities of demand we can find out the third.

1. Explain the price effect of the commodity.
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2. What is the fundamental difference between Slutsky’s approach and Hicks’
approach to real income?
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3. Write the relationship between the proportions of income spent for a
commodity and the proportion of income spent on the other commodity in
terms of Elasticities of demand.
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78
Market Equilibrium
3.8 TOOLS OF ECONOMICS AND
COMPLICATED AGRICULTURAL
PROBLEMS
This section will examine the predicament of farmers, and the usefulness
of government policy in alleviating it. The farm problem and agricultural
economics present some very complicated problems, but our basic tools can
provide many insights into what the situation is and how the problem came
about. We can use elasticities to illustrate one of the most famous paradoxes of
all economics: the paradox of the bumper harvest. Imagine that in a particular
year nature smiles on farming. The good weather and bumper crop have
lowered their and other farmers’ incomes. How can this be? The answer lies in
the elasticity of foodstuffs. The demands for basic food products such as wheat
and rice tend to be inelastic; for these necessities, consumption changes very
little in response to price. But this means farmers as a whole receive less total
revenue when the harvest is good than when it is bad. The increase in supply
arising from an abundant harvest tends to lower the price. But the lower price
doesn’t increase the quantity demanded very much. The implication is that low
price elasticity of food means that large harvests (high Q) tend to be associated
with low revenue (low P X Q).
Short-Run Problems of Farming: Several characteristics inherent in farming

can create short-run problems for farmers. First, the short-run demand for most
farm products tends to be highly inelastic. That is, consumers are relatively
unresponsive to price changes. They are unwilling or unable to use substitutes
when prices go up, and there is a limit to how much food one can eat when prices
go down. As a consequence, prices can fall substantially with even a small
increase in supply, depressing the farmer’s revenues. Second, modern farming
requires substantial investment in land and equipment. Thus farmers must incur
significant fixed expenses. By harvest time, most of these expenses are sunk
costs and cannot be considered in the decision to harvest. They, therefore, have
little or no influence in determining the short-run supply of any crop on the
market. Only the costs of harvesting and transporting the crop to market enter
into the farmer’s decision on how much to harvest. Even at very low prices, the
revenues acquired from a harvest will usually cover those costs. But they may
well not cover the farmer’s entire costs, including the sunk costs of planting,
land, and equipment. Farmers can store some of the harvests in the hope that
prices will rise, but storage can be expensive. And there is no guarantee that
prices will rise; they may fall further. Meanwhile, by delaying, the sale of a
crop, a farmer postpones repayment of his debts, adding to the interest he owes.
For these reasons, the short-run supply of most farm commodities tends to be
highly inelastic. The quantities available change very little with changes in
market price. Given the inelastic supply and demand for farm products, factors
like climate, over which farmers have no control, can cause substantial changes
in the prices and income framers receive. If good weather produces a bumper
crop, farmers may be worse off than if bad weather lowers production. Thus
highly inelastic demand and supply curves are the characteristics of the short-
run markets for most farm products. Over the years the prices of many farm
commodities have risen. But their relative prices – that is, the ratios of farm
79
Managerial Economics prices to non-farm prices – have tended to fall. The prices of non-farm goods
have simply risen faster than those of farm goods.
Third, most farm commodities, are sold in highly competitive markets.

Thousands of buyers and farmers come together to determine prices for almost
all lines of produce. Consumer benefits from the competitiveness of agriculture,
for they receive more of the foods they want at lower prices. But farmers must
cope with some problems that characterize competitive markets. In the short
run, the prices of agricultural goods respond rapidly to the forces of supply
and demand. Prices can change substantially over a growing season – that is,
between the time a crop is planted and the time it is harvested and marketed.
Only rarely have farmers been able to collude to control competitive force.
That is, any efforts to join together to restrict output; divide the market, raise
prices, and increase their incomes have not succeeded for very long. There are
just too many farmers to form a workable cartel. Thus it is understandable that
farmers have turned to the government for assistance.
The Indian government has a policy of helping farmers to get “remunerative”

prices through the minimum support price (MSP) system. That is, the government
announces prices for wheat and rice at which it is ready to buy (through the Food
Corporation of India (FCI) any amount offered to it by the producers. If the
MSP for (say) wheat is higher than the market clearing price, then one would
expect that there would to excess supply of wheat that would be sold to the FCI.
The amounts purchased by the government are used to build up “buffer stocks”
of food grains. Some of these buffer stocks would be sold through the ration
shops at below-market prices to help the poorer sections. The amount released
through the rationing system is more or less uniform throughout the year. The
rest would be kept as a buffer against possible harvest failures or shortfalls in
a season. The price charged in the ration shops is called the issue price. The
issue price is lower than the MSP.
The farm problems cannot be settled with the tools of economics, but these tools
can point out some fundamental truths. The Agricultural policy illustrates the
difficulties government can encounter in the scheme of helping farmers. There
are political implications, especially in states with large farm constituencies,
that are obvious.
3.9 LET US SUM UP

In the theory of demand, we have seen that two basic questions arise, (i) why a
consumer demand goods and services, and (ii) how should a consumer spend
his limited income on different goods so that the consumer may get maximum
satisfaction. To answer these questions, economists put forward different
theories like cardinal utility theory, ordinal utility theory, etc. The law of demand
says that the quantity demanded is inversely proportional to the price. The law
of supply says that the quantity demanded is directly proportional to the price.
The equilibrium occurs when the quantity of a commodity demanded equals
the quantity supplied to the market. There are two types of changes in demand;
first, the change in the quantity demanded due to a change in price, and second,
the change in the amount of a product demanded regardless of price also called
80 the shift in demand. When there is a change in the amount purchased due to
lower prices and surplus spending money it is called the income effect. When Market Equilibrium
prices drop consumers buy more than the usual at the expense of a different
product, which is called the substitution effect.
3.10 KEYWORDS
Hicksian Substitution Effect : The change in the quantity demanded of
commodity results from a change in its
price while holding real income constant
by keeping the consumer on the same
indifference curve before and after the price
change.
Income Effect : The increase in the quantity purchased of
a commodity with a given money income
when the commodity’s price falls.
Indifference Curve : Shows the various combinations of two
commodities that yield equal utility or
satisfaction to the consumer.
Marginal Utility : The change in the total utility per unit
changes in the quantity of a commodity
consumed per unit of time.
Slutsky Substitution Effect : The change in the quantity demanded of a
commodity resulting from a change in its
price while keeping real income constant
in the sense that the consumer could if he
or she wanted, purchase the same bundle of
goods after the price change as the consumer
did before the price change.
Substitution Effect : When prices drop consumers buy more
than the usual at the expense of a different
product.
Total Utility : The overall satisfaction that an individual
receives from consuming a specified quantity
of a commodity per unit of time.
Utility : The property of a commodity that satisfies a
want or need of a consumer.

REFERENCES
1. Chopra, P. N. (1996), Advanced Economic Theory, Kalyani Publishers.
Ludhiana.
2. Gould, J. P and E. P. Lazear (1998), Microeconomic Theory, Richard D.
Irwin, Inc., Illinois.
3. Koutsoyiannis, A. (1979), Modern Microeconomics, ELBS/, Macmillan
Publishers Ltd., Hong Kong.
81
Managerial Economics 4. Salvatore, Dominick (1983), Microeconomic Theory, McGraw-Hill,
Singapore.

ANSWERS
1. Market price, short-run normal price, and long-term normal price.
2. Value is the exchange value of the commodity. Price is the value of a
particular commodity expressed in terms of money.
3. Commodity its own price, consumers’ income, prices of other goods,
consumers’ tastes, income distribution, population, consumers’ wealth,
credit availability, government policy, etc.

1 According to the law of demand, other things remain constant, if the price
of a commodity falls, the quantity demanded of it will rise and if the price
of the commodity rises, its quantity demanded will decline.
2. Price of commodity, cost of production, technology, the prices of the inputs,
and for agricultural commodities, climate and weather conditions, etc.
3. The demand price is equal to the supply price and the amount produced has
no tendency either to be increased or to be diminished; it is in equilibrium.

1. Change in the price of a commodity affects directly the consumer’s demand
for the commodity. The increase in demand in response to a fall in price
is called the Price Effect. The Price Effect may be split into two separate
effects, a substitution effect and an income effect.
2. Hicks’ Substitution Effect is the movement of the consumer along the same
indifference curve from one combination to another combination. The
substitution effect in Slutsky’s view is equivalent to rotating the budget line
about a point which leads to the movement of the consumer into a higher
indifference curve than before.
3. Ed = kx x Ei + (1-kx) x Es

1. Please explain with the help of the diagram Law of demand and supply.
How we can estimate the market price of a product?
2. Please explain, how the price effect on demand of a commodity split into a
substitution effect and an income effect?
3. Differentiate Hicksian and Slutskian Substitution Effects with the help of a
diagram.
4. Define equilibrium price. If the actual price is above the equilibrium, what
82 will force it down? If the actual price is below the equilibrium, what will
force it up? Why is it said the market equilibrium is a highly unstable one? Market Equilibrium
5. What can be the possible effect on the supply curve of a commodity if the
price of the commodity is expected to rise in the future?
6. What is the economic meaning of an upward-sloping supply curve? Why
do producers or suppliers behave in this fashion?
7. Distinguish between income and substitution effect and explain Hicks vs.
Slutsky analysis.
83
UNIT 4 PRINCIPLES OF FARM
MANAGEMENT AND PRICING
PRACTICES
Structure
4.0 Objectives
4.1 Introduction
4.2 Basic Principles of Farm Management
4.3 Factor Product Relationship
4.3.1 Factor-Factor Relationship
4.3.2 Product-Product Relationship
4.4 Overview of Production and Cost Theory

4.5 Production and Cost Functions
4.6 Applications of Production and Cost Functions
4.7 Cost-Output Relationship
4.7.1 Short Run Cost Curves
4.7.2 Long Run Cost Curves
4.8 Concept of Selling Costs

4.9 Pricing Practices
4.9.1 Cost Plus Pricing
4.9.2 Marginal Cost Pricing
4.9.3 Average Cost Pricing
4.9.4 Bain’s Theory of Limit Pricing
4.9.5 Incremental Reasoning in Pricing
4.9.6 Product Line Pricing
4.10 Determination of Price under Pure and Imperfect Competition

4.11 Let Us Sum Up
4.12 Keywords
4.13 Suggested Further Readings / References
84
Principles of Farm
4.0 OBJECTIVES Management and
Pricing Practices
After reading this unit, you should be able to:
●● explain the principles of farm management;
●● describe the relationship between production and cost functions;
●● analyze the relationship between the various cost curves;
●● identify the applications of production and cost functions;
●● classify the various types of pricing practices; and
●● determine the price under pure and imperfect competition.
4.1 INTRODUCTION
Production is an important economic activity, which directly or indirectly
satisfies the wants and needs of the people. It is concerned with the supply side of
the market. The standards of living of the people depend on the volume and the
variety of goods produced. Without production, there can not be consumption.
The richness or poverty of the nation and the performance of the economy is
judged by its level of production. Those nations which produce commodities
and services in large quantities are considered rich and others that produce less
are considered poor.
Production is the transformation of inputs into the output of a commodity or

several commodities (in the case of joint production) in a specific period of
time at the given state of technology. In the production process, even both input
and output may be intangible. Thus, the word production in Economics is not
simply confined to effecting physical transformation in the matter, it also covers
the rendering of services such as teaching, consultancy, transporting, financing,
retailing, packaging, etc. In a broad sense, production implies the creation or
addition of form, place, and time utilities by the production and storage, and
distribution of different usable commodities and services.
Production enhances the utility of the product by changing it to the form in

which the consumers need it. Distribution through transportation increases the
usefulness of the product by bringing it to the location where the consumer
needs it. In the absence of transportation, the product may be just as useless
to the consumer as it would be if it were still a collection of raw materials.
Likewise, storage gets the product to the consumer when he needs it.
During the process of production, a number of factors (both fixed and variable)
join hands. These factors are available only at a price. Expenses incurred on the
factors of production are known as the cost of production, or in short, the cost.
On the other hand, the producer receives payment from the sale of the goods
produced. Such sale proceeds are referred to as revenue in Economics.
The producer aims to maximize its profit. Since profit is the difference between
revenue and cost, profit maximization amounts to the maximization of the
difference between revenue and cost, by increasing the former and lowering the
latter. While the level of revenue is primarily determined by the market factors, 85
Managerial Economics the cost can be brought down either by producing the optimum level of output
using the least-cost combination of inputs, increasing factor productivities or by
improving organizational efficiency. A profit-maximizing firm needs to monitor
revenue and cost continuously. Thus, the concepts of cost and revenue are very
important in the price theory. They exhibit not only the profits or losses earned
by the firm but also help in price and output determination. A rational producer
chooses the production decision through the cost and revenue analysis.
Cost of production provides the floor to pricing. It helps the manager to take
correct decisions, like which price to quote, whether to place a particular order
for inputs or not, whether to abandon or add a product to the existing product
line, whether to expand or contract production, and whether or not to use
idle capacity, whether to buy or manufacture a product and so on. Decisions
about payment of tax, bonus, dividend, choice of technology, sales promotion
channels, etc., also involve computations of costs.
Production function as such does not reveal anything about the economic aspect
of costs and prices. Once prices of factor inputs are known, the technological
relationship (in physical units) implied by the production function can be used
to derive the cost functions. Hence, the theory of costs is a restatement of the
theory of production in monetary terms.
4.2 BASIC PRINCIPLES OF FARM

MANAGEMENT
Marshall provided the foundation for the basic principles of farm management
through his law of diminishing returns. In his words, “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 art of agriculture.” This law of production
shows the maximum output obtainable from different amounts of the variable
input, given a specified amount of the fixed input and the required amounts of
the ingredient inputs. This law assumes constant technology.
4.3 FACTOR PRODUCT RELATIONSHIP

The firms organize factors to achieve the possible production goals. The factors
are combined or used up at one end to produce the product at the other end.
Thus factors of production help in the process of production as inputs.
The product of one industry may be used in another industry. For example,
what is a product (output) for a farmer, when it is used to produce bread; it
becomes a factor of production. A firm purchases / hires factors (inputs) for use
in its production, whereas it produces or processes the product (output) for sale.
The relationship between the two is determined by the technology, embedded
in the production function. A firm can produce more by using more inputs or
with advanced technology. Thus, a change in technology alters the input-output
relationship depicted by the production function.
4.3.1 Factor-Factor Relationship

86
During the process of production four factors, namely, land, labour, capital, and Principles of Farm
entrepreneur participate in the production activity. A piece of land is required Management and
Pricing Practices
on which crops are grown. This also requires the services of labour. Capital is
required to meet expenditure on seeds, fertilizers, pesticides, irrigation facilities,
etc. Finally, the services of entrepreneurs are required to organize, supervise
and coordinate the whole process of production. In the production process, it
is not the factor but his services are bought.
Unlike other factors of production, the land is immobile. It cannot be taken to

other places, resulting in variations in land rents at different places. However,
different crops can be grown on the same plot of land.
Labour is distinct from other factors of production in the sense that it cannot
be labour separated from its supplier. Further, labour is perishable as against
other factors. It cannot be stored. If a labourer does not find work on a particular
day, his labour is wasted for that day, his labour cannot be postponed. That is
why; the bargaining power of workers is poor. Furthermore, the supply curve
of labour is backward bending. If wages rise beyond the accustomed standard
of living of workers, they are tempted to enjoy more leisure rather than work.
Capital is produced, man (laborer) working on nature (land). These two

factors are used to produce capital, which is highly mobile. It gets interest as
a reward.
Entrepreneur brings together all factors of production. He makes payments to

the factors for their contribution to the production process. An entrepreneur is
different from other factors of production in the sense that he is not employed
by anyone. His profit reward is residual, while he has to make fixed contractual
payments to other factors of production. He may even suffer a loss in case
their contractual payments exceed the revenue from the sale of goods and
services.
According to Karl Marx, labour is the most important factor of production.

In his view, land cannot produce anything by itself, unless it is used by man.
Further, capital is man-made and is the embodiment of labour. Finally, the
entrepreneur is not a separate factor of production; rather it is a form of
labour. Therefore, all factors of production are reducible to labour. However,
most economists consider two factors of production, viz., labour and capital
for simple analytical understanding.
4.3.2 Product-Product Relationship

Product(s) produced by a firm faces competition from the product(s) produced
by the competitors launching, influenced by those of rival firms. Even a slight
change in price and promotional strategies by a firm may change the demand
pattern, affecting the profits of the firm.
On account of competitive threats, modern firms have become multi-product

producers. Multiple product firms may produce by-products along with the
main product, which is very common in the field of agriculture, poultry
farming, dairying, etc. The firm can also produce related products in different
87
Managerial Economics varieties, sizes, shades, etc. The firm can also engage itself in unrelated
products. In all such cases, the multi-mission firm can expand the demand
base, achieve cost efficiency, and utilize capacity more optimally through
diversification, joint costs, and disaggregated capacity, respectively.
4.4 OVERVIEW OF PRODUCTION AND COST

THEORY
The theory of production plays a vital role in the price theory. It provides
a base for the firm’s demand for factors of production. It together with the
corresponding supply determines the prices of the factors. Cost of production
provides the floor to pricing. It helps managers to take correct decisions, like
which price to quote, whether to place a particular order for inputs or not,
whether to abandon or add a product to the existing product line, whether to
expand or contract production, and whether or not to use idle capacity, whether
to buy or manufacture a product and so on.
The physical relationship between inputs and outputs as well as prices of factors
of production (inputs) influence the costs of production, and hence, the supply
of the product. This supply together with demand plays an important role in
determining the price of the product.
The theory of production explains the forces which determine the marginal
productivities of the factors. Accordingly, the relative prices of the factors,
i.e., wages (of labour), rent (for land), interest (on capital), and profits (to
entrepreneurs) are determined through their corresponding demand, which
in turn, depend on the marginal productivities of the factors. The theory of
production can also be used to determine the aggregative distribution (the
theory of relative prices).
The theory of production helps us to determine the profit-maximizing output,

which depends on marginal and average costs of production besides demand
conditions. The change in marginal and average costs of production as a result
of an increase in output is determined by the physical relationship between
inputs and outputs, besides the prices of the factors of production. Thus, the
theory of production has great relevance to the theory of the firm. The theory of
production also explains the optimum combinations of factors so as to minimize
the cost of products by a firm.
4.5 PRODUCTION AND COST FUNCTIONS

Production is the transformation of inputs into outputs at the given state of
technology. The technical relation between physical inputs like labour and
capital (factors of production) and the physical outputs are depicted by the
production function. It shows an efficient utilization of inputs and output. In
other words, it explains the maximum amount of goods that can be obtained
from different combinations of productive factors per unit of time or minimum
quantities of various inputs required to yield a given quantity of output, for a
given technological knowledge and managerial ability. A production function
is a catalogue of output possibilities. Prices of factors or the product do not
88
enter into the production function. Mathematically, the production function Principles of Farm
can be expressed as Management and
Pricing Practices
Q = f (K,L, l, O)
Here, ‘Q’ stands for the quantity of output ‘co’ ‘K’, ‘L’, ‘l’ and ‘O’ represent
the quantities of four factors of production, namely, capital, labor, land, and
organization.
A rational producer always chooses the technically most efficient method of

production. Such a method uses less of at least one-factor input and no more
of the other factor input to produce one unit of the commodity. Suppose, the
two methods P1 and P2 require two and two units of labour each, while three
and four units of capital respectively. Here, the producer will choose method
P1 to produce the commodity, since it saves one unit of capital without using
more amount of labour. Hence, this method is economical and more efficient.
The theory of production considers only efficient methods.
However, it is not possible to directly compare the production processes,

when the production of a commodity requires more of some factor and less
of some other factor(s) as compared with any other production process.
Suppose, the production process P3 requires three units of labour and four
units of capital, while process P4 requires four units of labour and three units
of capital. Here, neither of the two processes is more efficient than the other.
These two processes are technically efficient and included in the production
function. The choice of a particular production process is an economic one
and depends on the prices of factors. Thus, a technically efficient method may
not be an economically efficient one.
Production function differs from firm to firm and industry to industry, depending
upon the state of technology and managerial ability. It can be represented by
schedules, input-output tables, graphs, mathematical equations, total, average
and marginal curves, isoquants (equal product curves), and so on.
Various types of production functions can be formulated on the basis of

statistical analysis of an input-output relationship. In the short run, the
production function is of variable proportions form. Here, a given amount
of a product can be produced by several alternative combinations of factors.
Most of the commodities in the real world are produced under conditions of
variable proportions production function. On the other hand, in the long run,
factors are used in a fixed proportion in order to produce a given level of
output.
Production functions may be linear and non-linear or homogeneous and

non-homogeneous. They may take the form of power, quadratic, or cubic.
Cobb-Douglas production function and constant elasticity of substitutions
production function are some special types of the production function.
Production function as such does not reveal anything about the economic
aspect of costs and prices. Once prices of factor inputs are known, the
technological relationships (in physical units) implied by the production
function can be used to derive the cost function. It studies the functional 89
Managerial Economics relationship between the level of output and total cost, assuming that other
factors are held constant. These determinants include size and utilization of
plant, input prices, technology, efficiency (labour or management), etc.
1. Linear Cost Function: Suppose, the fixed costs are represented by ‘a’.
In order to produce ‘X’ units of the good, it must buy a proportional
amount of raw material, labour, and other necessary inputs, the cost of
which is the variable amount bX. If the total cost of the fixed and variable
quantities is denoted by ‘C’, the type of equation representing the total
cost of production for the firm is the linear function
C a bX
The shape of the curve is illustrated in Fig.4.1
Fig.4.1: Linear TFC and TC Curves
Certain important economic and mathematical properties of this function are

given below:
(i) At zero output, total fixed cost, such as rent, property taxes, insurances, and
depreciation due to time and obsolescence, equals total cost. Increases in
total cost due to increases in output are represented by total variable costs.
(ii) The average or unit cost function can be obtained by dividing the total cost
function by output, ‘X’.
C a
Average Total Cost = b
X X
The shape of this curve is illustrated in Fig.4.2
Note that it continues to decline as ‘X’ increases and remains practically

constant after it nearly ‘flattens out’.
Subtracting the average fixed cost from the equation leaves the average variable
cost ‘b’, which is also equal to the marginal cost.
90
Principles of Farm
Management and
Pricing Practices
Fig.4.2: Average Total Cost curve

2. Quadratic Cost Functions: This type of function which has been widely
used in empirical studies is represented by the equation:
C=a+bX+cX2
The shape of the curve will be as in Fig.4.3
Fig.4.3: Quadratic Cost Curve

The implications of this equation may be noted:
(i) When X=0, C=a. In other words, total cost equals fixed cost when
output is zero.
(ii) The equation is quadratic. Therefore, it has only one bend as against
the linear total cost function C=a+bX which has no bends. The number
of bends is always one less than the highest exponent of ‘X’.
(iii) The average cost equation can be derived by dividing the total cost
function by output ‘X’.
C a
Average Total Cost = b cX
X X
a
(iv) Since the average fixed cost in the above equation equals ,
X
subtracting this from the average total cost gives the average variable
cost, b+cX.
91
Managerial Economics (v) The equation for marginal cost can be obtained by differentiating the
total cost function. Thus,
MC b 2cX
(vi) It may be noted that the quadratic total cost function may also take the
form:
C a bX cX 2
The shape of the curve is given in Fig.4.4.
This function and curve represent increasing productivity or returns or
decreasing costs. This is because the total cost curve is rising at a decreasing
rate.
Fig. 4.4: Total Quadratic Cost Curve

3. Cubic Cost Functions: The typical total cost function of economics
textbooks is not usually of a linear or quadratic form, but rather of the cubic
type: C a bX cX 2 dX 3
The curve shall have two bends-one less than the highest exponent of ‘X’.
Fig.4.5 illustrates this function.
This function combines the phase of both increasing and decreasing
productivity and returns. In Fig.4.5, we see that increasing returns occur
at all levels to the left of the vertical dashed line as the total cost rises at a
decreasing rate. Thereafter, on the right-hand side of the dashed line, the
total cost is rising at an increasing rate denoting diminishing returns.
92
Fig.4.5: Cubic cost curve
Cubic cost functions have not often been fitted in actual studies on account of Principles of Farm
inherent complications. Management and
Pricing Practices
4.6 APPLICATIONS OF PRODUCTION AND

COST FUNCTIONS
Production function can be used to derive an economically efficient production
method, given the prices of the inputs. A profit-maximizing producer, thus,
minimizes his cost for producing a given output or maximizes the output, given
the total cost by applying the optimum decision rule. This happens where the
isoquant (equal product curve) is tangent to the isocost line and the marginal
rate of technical substitution (MRTS) is diminishing.
When a producer becomes financially well off, he has to change the factor
combinations with the expansion of his output, given the factor prices. The
line or curve joining the least cost combination is called the expansion path.
For the linear homogeneous production function, the expansion path will be
a straight line through the origin. This second application of the production
function shows the cheapest way of producing each output, given the relative
prices of the factors.
Linear homogeneous production functions can be handled easily and used for
empirical analysis. Economists call such functions well-behaved production
functions. Due to the important property of constant returns to scale, the linear
homogeneous production function finds applications in linear programming,
and input-output analysis. It has also applications in production, distribution,
and economic growth in model analysis.
Production function can be used to compare inter-firm, inter-industry, and

international variation to scale and efficiency of the firm through efficiency
parameter. This is particularly true with the Cobb-Douglas production function.
The production function also helps in deriving the cost function, which together
with the revenue function enables the firm in computing profits. Cost function
helps in attaining optimum output level and optimal length of queues. It is also
useful in break-even analysis and sound inventory management by obtaining
economic order quantity. Identification of the shutdown point of a firm and
deriving the supply curve is yet another application of cost function. Thus,
both operational (short-run) and strategic (long-term) decisions require the
knowledge of cost function.
4.7 COST-OUTPUT RELATIONSHIP

In economic theory, the cost-output relationship may be studied in the short-
run as well as in the long- run.
4.7.1 Short Run Cost Curves

Some short-run cost curves, namely, total fixed cost (TFC), total variable cost
(TVC), and total cost (TC) have already been discussed under the heading
‘Production and Cost Functions’. Let us explain other short-run cost curves. 93
Managerial Economics 1. Average Fixed Cost (AFC): The greater the output, the lower the fixed
cost per unit, i.e, the average fixed cost. The reason is that the total fixed
cost remains the same and does not change with a change in output. The
relationship between output and fixed cost is a universal one for all types
of business. Suppose the fixed costs amount to Rs.176, whatever the
output. When the output is 4 units, the average fixed cost is Rs.44; when
output is 8 units, the average fixed cost falls to Rs.22. Thus, the average
fixed cost falls continuously as output rises. The reason is that certain
factors are indivisible. Indivisibility means that if a smaller output is to
be produced, the factor cannot be used in a smaller quantity. It is to be
used as a whole.
2. Average Variable Cost (AVC): The average variable costs will first fall
and then rise as more and more units are produced in a given plant. This
is so because as we add more units of variable factors in a fixed plant;
the efficiency for the inputs first increases and then decreases. In fact, the
variable factors tend to produce somewhat more efficiently near a firm’s
optimum output than at very low levels of output. Once the optimum
capacity is reached, any further increase in output will undoubtedly
increase the average variable cost quite sharply. Greater output can be
obtained but at a much greater average variable cost. For example, if more
and more workers are appointed, it may ultimately lead to overcrowding
and bad organization. Moreover, workers may have to be paid higher
wages for overtime work.
3. Average Total Cost (ATC): Average cost consists of average fixed cost
plus average variable cost. Average fixed cost continues to fall with an
increase in output, while average variable cost first declines and then
rises. So long as the average variable cost declines, the average total
cost will also decline. But, after a point, the average variable cost will
rise. Here, if the rise in variable cost is less than the fall in fixed cost, the
average total cost will still continue to decline. It is only when the rise
in average variable cost is more than the drop in average fixed cost that
the average total cost will show a rise. There will be a stage where the
average variable cost may have started rising yet the average total cost
is still declining because the rise in average variable cost is less than the
drop in average fixed cost, the net effect being a decline in average cost.
It is clear that the turning point in the case of an average cost is at a point
later than that in the case of average variable cost.
The least cost-output level is the level where the average total cost is the
minimum. In fact, at the least cost-output level, the average variable cost
will be more than its minimum. The least cost-output level is also the
optimum output level. It may not be the maximum output level. A firm
may decide to produce more than the least cost-output level.
4. Relationship between Different Cost Curves: The cost-output
relationship can also be shown through the use of graphs. It will be
seen that the average fixed cost (AFC) curve falls as output rises from
lower levels to higher levels. The shape of the average fixed cost curve,
94
therefore, is a rectangular hyperbola. The average variable cost (AVC) Principles of Farm
curve first falls and then rises. So also the average total cost (ATC) curve. Management and
Pricing Practices
However, the AVC curve starts rising earlier than the ATC curve. Further,
the least cost level of output corresponds to the point Lr on the ATC curve
and not to the point Lv which lies on the AVC curve.
Another important point to be noted is that in Fig.4.6, the marginal cost
(MC) curve intersects both the AVC curve and the ATC curve at their
minimum points. This is very simple to explain. If the marginal cost
(MC) is less than the average cost (AC), it will pull AC up. If the MC is
equal to AC, it will neither pull AC up nor down. Hence, the MC curve
tends to intersect the AC curve at its lowest point. Similar is the position
of the average variable cost curve.
The rate of change in MC is greater than that in AVC and hence the
minimum MC is at an output lower than the output at which the AVC
or ATC is minimum. Further, ATC falls for a larger range of output than
AVC and hence the minimum ATC is at a large output than the minimum
AVC.
Fig. 4.6: Relationship among Cost Curves in Short Run
The interrelationships among AVC, ATC, and AFC can be summed up as

follows:
If both AFC and AVC fall, ATC will fall.
If AFC falls but AVC rises:
(a) ATC will fall where the drop in AFC is more than the rise in AVC.
(b) ATC will be minimum where the drop in AFC is equal to the rise in AVC.
(c) ATC will rise where the drop in AFC is less than the rise in AVC.
95
Activity 4.1:
Draw total fixed cost, total variable cost and total cost curves in a single
diagram to show relationship among them.
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4.7.2 Long Run Cost Curves

In order to study the cost-output relationship, in the long run, it would be
necessary to explain the derivation of the long-run average cost curve and its
relationship with the long-run marginal cost curve.
The long run is a period long enough to make all costs variable including such
costs as are fixed in the short run. Here, the entrepreneur has before him a
number of alternatives which include the construction of various kinds and sizes
of plants. Thus, there are no fixed costs since the firm has sufficient time to fully
adapt its plant and all costs become variable. In view of this, the long-run costs
would refer to the costs of producing different levels of output by changes in the
size of the plant or scale of production. The long-run cost-output relationship
is shown graphically by the long-run average cost curve- a curve showing how
costs would change when the scale of production is changed (Fig.4.7).
Fig.4.7: Derivation of LAC Curve
The concept of long-run costs can be further explained with the help of an
illustration. Suppose that at a particular time, a firm operates under the short-
run average cost curve SAC2 and produces OM level of output (Fig.4.7). Now,
96
it is desired to produce ON. If the firm continues under the old scale, its average Principles of Farm
cost will be NT. If the scale of the firm is altered, the new cost curve would be Management and
Pricing Practices
SAC3. The average cost of producing ON would then be NA. NA is less than
NT. So, the new scale is preferable to the old one and should be adopted. In the
long run, the average cost of producing ON output is NA. This may be called
the long-run cost of producing ON output. It may be noted here that we shall
call NA as the long-run cost only so long as the SAC3 scale is in the planning
stage and has not actually been adopted. The moment the scale is installed, the
NA cost would be the short-run cost of producing ON output.
Fig.4.8: LAC Curve

To draw a long-run curve, we have to start with a number of short-run average
cost (SAC) curves, each such curve representing a particular scale or size of the
plant, including the optimum scale. One can now draw the long-run cost curve
(Fig.4.8) which would be tangential to the entire family of SAC curves, that is,
it would touch each SAC curve at one point. In this connection the following
points are to be noted:
(i) The LAC curve is tangential to the various SAC curves. It is said to envelop
them and is often called as the ‘envelop curve’ since no point on a SAC
curve can ever be below the LAC curve.
(ii) The LAC curve is U-shaped or like a ‘dish’. The U-shape of the LAC curve
implies lower and lower average cost in the beginning until the optimum
scale of the enterprise is reached, and successively higher average cost
thereafter, i.e., with plans larger than that of the optimum scale.
The tendency for the long-run average cost to fall as the firm expands its
scale of operations is a reflection of cost economies available with the
increase in size, while the ultimate rise in the long-run cost curve is largely
due to the eventual setting in of diseconomies of scale.
The SAC curve also has a U-shape but the difference is that the LAC curve
is flatter, that is, the U-shape of the LAC curve will be less pronounced.
This is because, in the long run, such economies are possible and cannot be
had in the short run. Likewise, some of the diseconomies, which are faced
in the short run, may not be faced in the long run.
(iii) The long-run average cost curve can never cut a short-run average cost
curve (though they are tangential to each other). This implies that for any
given output, the average cost cannot be higher in the long run than in 97
Managerial Economics the short run. This is because any adjustment which will reduce costs and
which it is possible to make in the short run can also be made in long run.
On the other hand, it is not always possible in the short run to produce a
given output in the cheapest possible way.
(iv) LAC curve will touch the ‘optimum scale’ curve at the latter’s least-cost
point, i.e., N1.
(v) LAC curve will touch SAC curves lying to the left of the optimum scale
curve at the left of their least cost points.
(vi) LAC curve will touch SAC curves lying to the right of the optimum scale
curve at the right of their least cost points.
Thus, it will be seen that the LAC curve is tangential to the minimum cost point
in the case of optimum scale SAC and not in the case of other SAC curves.
Further, its relationship with LMC is similar to what we observed in the short
period. Thus, the LMC curve intersects LAC from below at its minimum point.
1. Usefulness of LAC Curve: A firm is not interested in achieving the
minimum cost output for a given plant. On the other hand, it is interested
in producing a given output at the minimum costs. The LAC curve helps
a firm to decide the size of the plant to be adopted for producing the given
output. For outputs less than the low-cost combination at the optimum scale
(when the firm is operating under increasing returns to scale), it is more
economical to underuse a slightly larger plant operating at less than its
minimum cost output level than to overuse a smaller plant. Conversely, at
outputs beyond the optimum level (when the firm experiences decreasing
returns to scale), it is more economical to overuse a slightly smaller plant
than to underuse a slightly larger one.
An example might make it easier to understand why a firm may choose to
operate plants at other than their minimum cost-output (optimum capacity)
levels. Suppose a firm has a choice to use any of the four plants, A’, B’, C’,
and D’ arranged in order of increasing size. The average cost curves for the
plants are AA’, BB’, CC’, and DD’ respectively (Fig.4.9). The firm’s long-
run average cost curve will be the scalloped curve AQRSTD’. This curve
consists of the lowest segments of all the short-run average cost curves.
98
Fig.4.9: Long run average cost curve
As will be clear from Fig.4.9 that output OP can be obtained from plant ‘C’ Principles of Farm
at the lowest cost. However, if the firm desires an output OP1, i.e., output Management and
Pricing Practices
less than the minimum unit cost output OP, it could have either plant. ‘A’
or plant ‘B’, but it would find it cheaper to have plant ‘B’ and underuse it
rather than have plant ‘A’. If the firm desires an output OP2, i.e., output
more than the minimum unit cost output OP, it could have either plant ‘C’
or plant ‘D’, but it would find it more economical to have plant ‘C’ and
overuse it rather than having plant ‘D’.
Thus, in managerial decision-making, the usefulness of the long-run cost
curve lies in its ability to assist the management in the determination of the
best size of the plant to construct when a new one is being built or an old one
is being expanded. As the long-run cost curve can help the entrepreneur in
planning the best scale of plant, or the best size of the firm for his purposes,
it is also known as the planning curve. At the planning stage, management
is faced with the problem of selecting one of the several possible sizes of
plant.
2. L-Shaped LAC Curves: A number of studies have concluded that long-
run average cost curves are typically L-shaped (Fig.4.10). This implies
that, while economies of scale may be present, diseconomies have not been
encountered within the range of plant or firm sizes observed in practice. It
also suggests that there may be no unique optimum scale of the plant as is
inherent in the U-shaped curve. Thus, the existence of an L-shaped curve
does support the hypothesis that economies of scale cause a decline in the
long-run average costs as the rate of output increases. It also indicates that
after a certain period, the effects of cost on economies or diseconomies of
scale are equal, resulting in constant costs, which coincides with LMC.
Fig.4.10: L-Shaped LAC Curve

3. Inverted J-shaped LAC Curve, (i.e., Declining LAC Curve): There is
still one more possibility regarding the shape of the LAC curve as given in
Fig.4.11. In this case, LAC falls monotonically as output expands. Here,
the economies of scale outweigh the diseconomies of scale at all levels
of output. However, the hypothesis does recognize that the rate of the fall
in LAC declines as output expands and thus the LAC curve is downward
sloping but is convex from below. In such a situation, there is nothing 99
Managerial Economics like an optimum level or MES (minimum efficient scale), but one could
approximate this by estimating the output level beyond which fall in LAC
is insignificant - 1 or 2 percent. At all levels of output, the LMC curve lies
below the LAC curve.
Fig. 4.11: Inverted J-Shaped LAC Curve

4. Do Firms Operate at Optimal Scale? If we were to look at all the firms in
any particular industry, we would probably find a wide divergence in size.
Why are not all the firms of the optimal size? There are many reasons:
(i) The optimal scale is only the lowest cost scale of the enterprise. It is
not necessarily the most profitable scale.
(ii) In many cases, the market is not big enough to permit all firms to
operate at an optimal scale. In such a case, a firm may, in fact, operate
at lower costs per unit with a small plant than it would with a larger
plant that could be used at only partial capacity.
(iii) Firms may become ‘over-expanded’ as part of a drive to attain
dominance in their industry. Some firms just want to be big. Apart from
profits or even at the expense of profits, with dreams of the industrial
empire, they may expand beyond the optimal scale.
(iv) Sometimes, fear of government action holds back firms from profitable
expansion. This is true when a firm fears that further growth may
bring government action to break it up. This is especially true of firms
governed by the Monopolies and Restrictive Trade Practices Act and
Industries (Development and Regulation) Act.
(v) Probably most important of all, errors in judgment and the inevitable
slowness in adjusting to changed conditions mean that at any time
most firms will not be at the optimal scale.

1. Which of the costs necessarily decline continuously?
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100 ......................................................................................................................
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Management and
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2. Why do short-run average costs eventually rise?
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3. What is the relationship between marginal cost and average cost, when
average cost is falling?
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4.8 CONCEPT OF SELLING COSTS

Selling costs broaden the market and create demand. Salesmen's salaries,
other expenses of the sales department, window displays, and different types
of advertisement are some examples of sales expenses. Such expenses exploit
irrational consumer preferences through subtle advertisement and salesmanship.
Advertising assumes greater importance when there is product differentiation.

In such a situation, advertisement renders the function of convincing ignorant
buyers of the superiority of the product. Selling expenses have an important
role under imperfect competition (particularly monopolistic competition) on
account of imperfect knowledge on the part of buyers. The selling cost is zero
under perfect competition.
4.9 PRICING PRACTICES

Pricing decision is involved in every economic activity. We pay rent for a house,
fees to doctor or dentist. Commission to the salesman, premium for insurance,
wages to workers. Likewise, business firms also face the problem of deciding
the price of the product. The problem is not easy, particularly, when it is to be
decided for the first time, i.e. for a new product and that too for a new market.
The reason is that consumer behavior regarding the new product cannot be
accurately known. A slight change in price may change the demand pattern,
affecting the profits of the firm. It is easier to predict the demand change as a
result of such quantitative and unambiguous changes in price than for ambiguous
changes in product quality, product image, customer service, promotion, and
similar factors. Entry of the new firms can also influence the situation. Pricing 101
Managerial Economics decisions must be reviewed and reformulated from time to time.
Pricing is one of the most important functions of business firms. As these firms
incur expenses in producing goods and services, they must set prices for these
goods and services to get revenue. Price exerts a direct influence on the demand
as well as supply of the product and hence turnover (sales) as well as profit. If
a firm sets an appropriate product price, it would succeed and flourish in the
market. When the price is set too high, competitors are attracted to the market
and the firm will not find enough customers to buy the expensive product. While,
if the price is set too low, the firm will not be able to recover even the cost of
production, though, it will deter competitors. Besides, the consumers may tend
to think that a product of inferior quality is being offered. Thus, manufacturers
should not drastically cut the price, even if there is a reduction in the cost due
to improvements in production. In these situations, the products may be offered
to the consumers at lowered prices by selling them under another brand name.
In small firms, prices are decided by the top management. While, in large firms,
it is handled by division or product-line managers. However, even here, the top
management sets the objectives, lays down policies for operations, and keeps a
close watch on the working of the firm, keeping in view the profitability of the
corporation.
Various pricing practices are explained in this unit.
4.9.1 Cost Plus Pricing

It is the most popular method used for pricing purposes. Here, the price is fixed
so as to cover costs (materials, labor, and overhead) along with some predefined
percentage of profit. This percentage may differ among industries, member
firms, and even among products of the same firm. It actually shows some vague
notion of a just profit.
These mark-ups may be determined by trade associations either through

advisory price lists or by the actual lists distributed to the members. Sometimes,
profits are sanctioned under price control as the maximum profit margins
remain unchanged even after the price control is discontinued. Such margins
are except in certain situations, the margins charged are very sensitive to the
market conditions considered ethical as well as reasonable. Profit margins under
price controls are generally set in a manner to make it possible for even the least
efficient firms to survive. That is why the margin of profits tends to be higher
than what would be the case under competitive conditions.
Advantages: Following are the advantages of full-cost pricing:

(i) Full cost pricing enables finding fair and plausible prices irrespective of the
number of products the firm handles.
(ii) Prices based on cost-plus pricing are more factual and defensible on moral
grounds than prices established through other means.
(iii) Companies having a desire for stability use it as a guide, particularly for
pricing in an uncertain market where knowledge is incomplete. Full cost
102 pricing is often used for decision making where trial and error process and
information gathering is costly. Principles of Farm
Management and
(iv) When products and production processes are similar, cost-plus pricing Pricing Practices
generally offers competitive stability by fixing a price that is expected to
yield acceptable profit.
(v) This type of pricing is especially useful in the case of product tailoring, i.e.
for determining the product design when the selling price is predefined. By
working back from this price, the product design, as well as the permissible
cost, is determined. This approach takes into account the market realities
by viewing from the point of the buyers.
In India, a cost-plus method is widely used on account of the following two

reasons:
(i) The prevalence of the sellers’ market made it possible for the manufacturers
to pass on the increases in costs to the buyers.
(ii) Costs plus a reasonable margin of profit are taken into account for price
fixation in the price-controlled industries. In other words, this method has
the tacit approval of the Government of India.
4.9.2 Marginal Cost Pricing

Under marginal cost pricing, prices are determined on the basis of marginal
cost, the cost which is directly attributable to the output of a specific product.
Here, the firm fixes its prices so as to maximize its total contribution to fixed
costs and profit.
Advantages: Following are the advantages of marginal cost pricing:

(i) Marginal cost pricing more accurately reflects the future as different from
present cost levels and cost relationships. While making a pricing decision
one is more interested in the changes in cost that results from these
decisions. Marginal cost represents these changes, while total cost includes
fixed cost also, which is not incurred as a result of the pricing decision.
(ii) This type of pricing permits a manufacturer to develop a far more aggressive
pricing policy than does full-cost pricing.
(iii) It is more useful for pricing over the life cycle of a product, which requires
a short-run marginal cost and separable fixed cost data relevant for each
particular stage of the cycle, not long-run full-cost data.
Limitations: Following are the limitations of marginal cost pricing.

(i) The accountants may not be fully conversant with the marginal cost
techniques.
(ii) During a business recession, firms using marginal cost pricing may lower
prices to maintain business. This may cause other firms to reduce their
price leading to cut-throat competition. With the prevailing idle capacity
and the pressure of fixed costs, firms may ultimately cut down prices to
a level at which no one is earning sufficient total contribution to cover its
fixed costs and earn a fair return on capital employed.
103
Managerial Economics In spite of its advantages, due to its inherent weakness of not ensuring the
coverage of fixed costs, marginal cost pricing has usually been confined to
pricing decisions relating to special orders. In practice, full-cost pricing still
forms the basis of most pricing decisions. Of course, marginal cost data have
been used to supplement the total costs in pricing decisions.
4.9.3 Average Cost Pricing

This type of pricing practice is generally used in non-profit enterprises. Here,
the price is fixed at a level equal to the average cost, which includes a fair
return on capital. This policy may not ensure economic efficiency in resource
allocation. The output under average cost pricing is lower and price higher than
under marginal cost principle. That is why, average cost pricing is considered
a second-best policy since, unlike marginal cost pricing, it does not require the
grant of subsidy on the part of the government.
However, sometimes average cost pricing is criticized. Here, enterprises often

inflate their costs by paying huge salaries and perks to their employees. Further,
average cost pricing becomes a tool in the hands of enterprises that seek to
cover up their operational inefficiency. Its burden is borne by the consumers.
4.9.4 Bain’s Theory of Limit Pricing

J.S. Bain did pioneering work in developing the theory of limit pricing. His
basic concern was to answer why duopoly firms charge a price below the short-
run profit maximizing equilibrium price. Bain considers four barriers to entry,
namely, product differentiation, absolute cost advantage, economies of scale,
and large initial capital requirement.
A firm (or firms) may try to establish a price that reduces or eliminates the threat
of entry of new firms into the industry. This is called ‘limit pricing’. For limit
price to be effective some sort of collusion is necessary among existing firms.
Note that even if the entry appears profitable 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 firms’ output are going to be affected. The
price must consequently fall and the new entrant may ultimately find that price
has fallen and he has, therefore, made a wrong decision.
4.9.5 Incremental Reasoning in Pricing

Here, instead of the average total cost, the average variable cost is used as a
basis for price fixation. The average variable cost to be covered includes direct
material cost, direct labour cost, other direct expenses, variable production
overheads, variable selling and distribution expenses, etc. This is a general
consideration in shutting down point decision, P ≥ AVC. Anything above this
cost is a contribution (price minus average variable cost) over the fixed cost
on the loss thereupon. The contribution margin over the variable cost would
obviously be greater than the profit margin over the full cost, as it has to cover
both fixed cost and the desired profit margin. Under this pricing, there is
arbitrariness in the allocation of fixed costs on a unit basis. This method widens
104
the range of prices, which would be acceptable as profitable. Principles of Farm
Management and
Pricing Practices
4.9.6 Product Line Pricing
A product line is a group of products performing mostly similar functions with
similar physical features, classified according to size, quantity, customer’s age,
sex, etc.
Companies usually develop product lines aiming at different segments of the

market in the multi-product firm. The prices of individual products should be
set in such a way that they reinforce each other’s sales and bring optimum
surplus to the firm, over time, a change in the product mix can contribute to the
profit improvement.
4.10 DETERMINATION OF PRICE UNDER

PURE AND IMPERFECT COMPETITION
The equilibrium of a firm is at the point where the marginal cost (MC) curve
cuts marginal revenue (MR) from below resulting in maximum profits or
minimum losses. For a pure competitive firm, this is corresponding to the price
determined by the competitive industry. Here, the firm is a price taker, which
may earn profits, suffer losses or get only normal profits. In the long run, the
firm gets only normal profits on account of homogenous products and free
entry and exit. At equilibrium P = AR = MR = MC. On the other hand, under
imperfect competition, price (AR) exceeds MR. thus, in equilibrium P < MR =
MC or P < MC. These equilibrium situations have been discussed in detail in
the next unit on ‘Equilibrium Condition’.

1. When should the price be fixed below marginal cost?
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2. Which price does practice restrict or eliminates the entry of new firms into
the industry?
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105
3. Under which market firm, the firm is a price taker?
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4.11 LET US SUM UP

The production function shows the functional relationship between inputs and
output. Marshall laid the foundation of farm management through the law of
diminishing returns expressing the input-output relationship. Relationships
also exist within inputs and outputs or products.
During the process of production, a number of factors (both fixed and

variable) join hand. These factors are available only at a price. Expenses
incurred on the factors of production are known as the cost of production.
The cost of production of a firm is determined by the physical conditions
of production, prices of factors of production, and the efficiency in the use
of inputs. When a cost-output relationship is studied in the short run, fixed
cost (expenses incurred on the fixed factors) and variable cost (expenses
incurred on the variable factors) are considered. Under the long-run cost-
output relationship, there is no distinction between fixed and variable costs.
The cost function is derived from the production function. When such a
relationship between cost and output is shown graphically, it becomes
a cost curve. Internal economies and diseconomies explain falling and
rising portions of the long-run unit cost curves. On the other hand, external
economies of scale result in a downward shift in curves, while external
diseconomies cause an upward shift in such curves.
Arriving at the correct price involves examining a number of financial and

non-financial variables, placing these variables in the context of the overall
business environment. Pricing involves analysis of market conditions,
identification of constraints, the establishment of objectives, analysis of
profit potential, determination of initial price level, and adjustment of prices.
Price is a reflection of the quality, image, and value of a product or service in

terms of money. Management should make pricing decisions in the context
of overall business objectives and strategies. Pricing decisions are mainly
affected by cost and demand. While cost normally determines the lowest
level of price, demand can determine the upper limit for price. That is, the
price would not exceed what the market will bear. The gap between the upper
limit of demand and the lower limit of cost can be widened by reducing costs
or improving manufacturing techniques and by increasing the perceived
106
value of the benefits of the product to the buyer. Other factors affecting Principles of Farm
pricing decisions include frequency of purchase, stage of the product life Management and
Pricing Practices
cycle, method of distribution, number of substitutes, range of products, level
of competition, product positioning, corporate objectives, the target rate of
profit, Government policy, etc.
4.12 KEYWORDS
Cost of Production : Expenses incurred on the factors of
production are known as costs of
production.
Cost Plus Pricing : Under this method, the price is set to
cover costs and a certain predetermined
percentage of profit.
External Economies : Such economies arise from the expansion
in the size of an industry, involving an
increase in the number and size of the firms
engaged in it.
Internal Economies : Such economies arise from the expansion
of the size of a particular firm, which is
available to only that firm.
Limit Pricing : A price that reduces or eliminates the entry
of new firms.
Marginal Cost : It is the addition to the cost due to the
production of one more unit of output.
Marginal Cost Pricing : Here, prices are determined on the basis of
marginal costs, ignoring fixed costs.
4.13 SUGGESTED FURTHER READINGS /

REFERENCES
1. Chaturvedi, D.D. & Gupta, S.L. (2013), Business Economics: Theory
and Applications, International Book House.
2. Chaturvedi, D.D. & Gupta, S.L. (2013), Managerial Economics: Text
and Cases, International Book House.
3. Chaturvedi, D.D. (2014), Micro Economics I, Kitab Mahal.
4. Dean, Joel (1976), Managerial Economics, Prentice Hall of India.
5. Gupta, G.S. (1974) Forecasting Techniques, Management Annual, Vol.
IV, November, pp 8-21.
Website:
• http://www.archive.org/stream/managerialeconom031613mbp/
managerialeconom031613mbp_djvu.txt
• http://www.management4all.org/2014/01/pricing-methods.html
107
ANSWERS
1. The average fixed cost falls continuously as it is the fixed cost spread over
more and more number of units.
2. Short-run average costs eventually rise because of falling marginal and
average productivity.
3. When average cost falls, the marginal cost lies below the average cost since
marginal cost falls (as well as rises) at faster rate than average cost.

1. During the business recession, firms using marginal cost pricing may lower
prices to maintain business. This may cause other firms to reduce their
price leading to cut-throat competition. With the prevailing idle capacity
and the pressure of fixed costs, firms may ultimately cut down prices to
a level at which no one is earning sufficient total contribution to cover its
fixed costs and earn a fair return on capital employed.
2. Bain’s limit pricing practice restricts or eliminates the entry of new firms
into the industry.
3. The firm is a price taker under pure (or perfect) competition with large
numbers of buyers and sellers producing the homogenous product.

Short Answer Questions:
1) Why is the average cost curve of a firm ‘U-shaped’ in the short run?
2) What is the relationship between average cost and marginal cost? Can
average cost fall, when marginal cost is rising?
3) Derive traditional LAC curve from short-run average cost curves and
explain their interrelationship.
4) Explain why the planning curve is ‘U-shaped’?
5) Explain briefly:
a) Overview of Production and Cost Theory
b) Principles of Farm Management
c) Factor Product Relationship
d) Factor-Factor-Relationship
e) Product-Product Relationship
f) L-shaped LAC Curve.
g) Inverted ‘J-shaped’ LAC curve.
108
h) Quadratic and Cubic Cost Functions.
i) Selling Cost
Long answer Questions:
6) “Managerial economics consists of the use of economic models of thought
to analyze the business situation.” Elaborate.
7) “Managerial economics bridges the gap between abstract theory and
business practice. It uses tools of economic analysis in classifying problems,
in organizing and evaluating information, and in comparing alternative
courses of action.” Outline the nature and scope of managerial economics
in the light of this statement.
8) Explain the various decision areas of managerial economics. How does its
study help a manager in decision-making?
9) Discuss the various steps in decision-making.
10) Critically evaluate various types of pricing practices.
109
110
UNIT 5 EQUILIBRIUM CONDITION
Structure
5.0 Objectives
5.1 Introduction
5.2 Perfectly Competitive Market

5.2.1 Equilibrium of Firm in Short Run
5.2.2 Supply Curve of Firm and Industry
5.2.3 Equilibrium of Firm in Long Run
5.2.4 Effects of Changes in Costs on Equilibrium
5.2.5 Effects of Imposition of Tax on Equilibrium
5.2.6 Effects of Providing Subsidy on Equilibrium
5.3 Monopoly Market

5.3.1 Equilibrium of Monopolist in Short Run
5.3.2 Supply of Monopolist
5.3.3 Equilibrium of Monopolist in Long Run
5.3.4 Price Discriminating Monopolist
5.3.5 Regulation of Monopoly Price by Government
5.4 Monopolistic Competition

5.5 Oligopoly and Duopoly Markets

5.5.1 Cournot’s Solution
5.5.2 Collusion Solution
5.5.3 Market Sharing Solution
5.5.4 Stackelberg’s Solution
5.5.5 Kinked Demand Curve Solution
5.6 Let Us Sum Up
5.7 Keywords
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5.0 OBJECTIVES
After going through this unit, you should be able to:
●● describe important characteristics of different markets structure;
●● explain the equilibrium condition of the firm under different markets;
●● analyse determination of equilibrium quantity and price of the product
under various market conditions;
●● derive supply curve of firm and industry in case of important markets;
●● examine the effects of changes in costs on the equilibrium of a firm under
perfect competition and monopoly markets;
●● predict the impact of the imposition of tax / providing subsidy by the
government on the equilibrium of firm in case of important markets;
●● discuss the price discriminating policy of the monopolist;
●● narrate the regulation of monopoly prices by the government for social
welfare; and
●● suggest market solutions in the case of oligopoly and duopoly
markets.
5.1 INTRODUCTION
There are two main branches of Economics: (i) Microeconomics and (ii)
Macroeconomics. In microeconomics, we study the economic behavior of
an individual say a consumer or producing firm whereas macroeconomics
is a study of aggregates such as total national income or employment of the
country. First, it is necessary to state the different markets existing in the
economy. The important markets are:
(i) Perfect Competition,
(ii) Monopoly,
(iii) Monopolistic Competition, and
(iv) Oligopoly and Duopoly.
In this Unit, we shall discuss the theory of firms operating under different
market structures as mentioned above. This is the part of microeconomics.
Here, we shall concentrate on the equilibrium condition of the firm attaining
the maximum profit in the short run and long run situations under different
markets. The entrepreneur of a firm wants to know the equilibrium quantity
and price of products in various markets. The economic principles/laws for
attaining the maximum profit by the firm in various market conditions are
discussed here. The impact of the imposition of tax or subsidy given by the
government and changes in the costs on the equilibrium condition of the firm
in case of perfect and monopoly markets is described in different sections
of this unit. Output supply of firm and industry is to be derived in case of
important markets. The monopolist, who has the market power, has overall
112 control over the supply of products and price. He is in a position to adopt
the price discriminating policy and is able to sell his product at different Equilibrium Condition
prices in the various markets or groups of society. How does the government
regulate the monopolist price for the welfare of society? How the price and
quantity produced are determined in the case of a few firms existing in the
market? These aspects will be discussed in different sections of this Unit.
5.2 PERFECTLY COMPETITIVE MARKET

The important characteristics of the perfectly competitive market are:
(i) There are a large number of sellers (firms) and buyers (consumers)
in the market.
(ii) Firms are producing homogenous products.
(iii) The firms are free to enter or exit the industry.
(iv) The factors of production are completely free to move from one
firm to another firm.
(v) All sellers and buyers have complete knowledge of the conditions
of the market.
These are some important attributes of perfect competition. The price of the
product remains the same throughout the market. The firm is a price taker
and its demand curve is infinitely elastic. That is, the demand curve is a
horizontal line. The demand curve of the individual firm is also its average
revenue as well as marginal revenue curve. The cost structure such as average
cost (AC) and marginal cost (MC) are as usual.
Under the above assumptions/conditions, the equilibrium situation of the firm

and industry operating under perfect competition in the short run and long
run will be discussed here. The objective of the firm is profit maximization.
The effects of changes in costs, imposition of a tax, or providing subsidy
by the government on the equilibrium condition will be given in different
subsections. Derivation of the supply curve of the firm and industry will also
be discussed in a subsection.

Firms are the producing units of various products. The objective of all the
firms is profit maximization. A firm remains in equilibrium where it attains
the maximum profit and produces the optimum level of output. Under a
perfectly, competitive market, the condition for the equilibrium of a firm is
that “the marginal cost (MC) should be equal to the marginal revenue (MR)”
i.e;
MC = MR
MC = Py (MR = Py in the perfect competition)
At this point, profit is the maximum and optimum level of output produced.
If MC < MR,
113
Managerial Economics Total profit has not been maximized and the profit is increased by expanding
output.
If MC > MR,
Total profit/loss is being reduced by reducing production.
This may be illustrated with the help of Figure 5.1. We draw the SATC and SMC
of the firm. In perfect competition, the demand curve of the individual firm is
the horizontal line. The demand curve which is also the MR and price line in
this market is drawn. In the figure, the firm is in equilibrium at the point ‘E’
where the SMC curve cuts the MR or price line from below. At the equilibrium
condition, the firm is producing an optimum level of output Q at price ‘P’ and
is having the maximum profit. The second-order condition for equilibrium
requires that the SMC curve has a rising trend at the point of intersection with
the MR curve. It means that the SMC curve must cut the MR curve from below.
In the figure, you will find that the total revenue of the firm is equal to the area
POQE and the total cost is equal to the area COQS. Thus total profit will be
equal to the area PCSE.
Fig. 5.1: Equilibrium of Firm in Short Run
The firm mostly earns excess profit in the short run. But it is not necessary
that the firm always earn excess profit. It depends on the level of the SATC
and the price of the output. In the short run, the firm will continue to produce
only if it covers its variable costs, otherwise, it will close down. The point at
which the firm just covers its variable cost is called the closing down point
Pw (Fig. 5.2(a)). At this point, the SAVC is just equal to the price of output.
If the price falls below Pw, the firm will not produce at all.
Mathematically, we can also work out the optimum level of output, if we

know the cost function and the price of output. Find out the MC from the
given cost function and equate MC to the price of output. We solve this
equation for output ‘Q’ which is the optimum level of output to be produced
at the equilibrium condition of the firm.
114
5.2.2 Supply Curve of Firm and Industry Equilibrium Condition
The short-run supply curve of a firm under perfect competition is derived

by different points of intersection of SMC curve and price line (Fig. 5.2 a).
As the price of output changes, the quantity supplied by the firm changes.
As the price rises, the output supplied by the firm increases. The price line
intersects the SMC curve above the minimum average variable cost. If the
price falls, the quantity supplied decreases. The firm will supply up to the
minimum SAVC or up to Pw point but the firm will not supply if the price
falls below Pw. Because at a lower price the firm does not cover its short-run
average variable cost.
If we plot different points of intersection of the MC curve and price line

on a separate graph (Fig. 5.2 (b)) we get the short-run supply curve of the
individual firm. This supply curve of the firm is identical to its MC curve to
the right above the minimum SAVC or closing down point, Pw. Below Pw
the quantity supplied by the firm is zero. The supply curve of the firm as
shown in Fig. 5.2(b) is a straight line with a positive slope.
The industry-supply curve is the horizontal summation of the supply of the

individual firms in the industry. That is, under the conditions if all factors
like technology and price of inputs remain constant, the total supply of
a commodity of the industry at each price is the sum of the quantity of
commodity supplied by all the firms in the industry at that price.
Fig. 5.2 (a): Different Equilibrium Points of Firm
115
Fig. 5.2 (b): Supply Curve of Firm

In the long run, all the inputs are variable. An entrepreneur has the option of
the adjustment of the plant size as well as output level to achieve maximum
profit. The condition for the long-run equilibrium of the firm is that the long-run
marginal cost should be equal to the long-run average cost and also equal to the
output price i.e;
LMC = LAC = P
In the long run, the firm does not earn excess profit. It earns just normal profit.
The firm adjusts its plant size and produces the output level at which LAC is
the minimum possible. Hence at equilibrium, the LMC is equal to the SMC
and LAC is equal to the short-run average cost (SAC). Thus the equilibrium
condition is:
LMC = LAC = SMC = SAC = P = MR.
This condition is presented in Figure 5.3. In the figure, you can see that the firm
produces the quantity Q at price P and gets the normal profit.
116
Fig. 5.3: Equilibrium of Firm in Long Run
5.2.4 Effects of Changes in Costs on Equilibrium

As a result of an increase in the fixed costs, AFC and ATC curves will shift
upwards. However, the AVC and MC curves will not be affected. Thus the
equilibrium position of the firm is not affected in the short run. Hence, the
output level and the price will not change in the short run due to a change in the
fixed costs.
If the variable costs increase, the AVC, AC, and MC curves of the firm shift
upwards to the left (Fig. 5.4(a)). The equilibrium of the firm changes due to
changes in the marginal costs. As a result of the increase in the average variable
costs, the quantity supplied by the firm at the going market price will decrease.
Thus, even in the short run, the market supply will shift upwards to the left.
Hence, at market demand, the price will rise due to declining market supply
(Fig. 5.4(b)).
Fig. 5.4(a): Effects of Changes in Variable Costs

117
Fig. 5.4(b): Changes in Supply
5.2.5 Effects of Imposition of Tax on Equilibrium

As a result of the imposition of a lump sum tax or profit tax by the government,
in the short run, the equilibrium of the firm will not change. Hence, the
output level and the price will not change but the total profits of the firm will
reduce.
Sometimes Government imposes a specific sales tax, that is, tax per unit of
output produced. Such rising tax causes a shift of the AC and MC curves
upwards to the left. Due to the shift of the MC curve to the upward, the
supply of firms will reduce (Fig. 5.4 (a)). The price will increase because of
decreasing market supply (Fig. 5.4(b)). How much price will increase? Will
the price rise be equal, smaller, or greater than the specific tax? It depends on
the price elasticity of supply at the given market demand. More is the price
elasticity of supply; a greater tax burden is to be borne by the consumer.
Hence, the price will raise more.
5.2.6 Effects of Providing Subsidy on Equilibrium

In order to encourage production, the government provides a subsidy to
the producers. Assuming government gives some subsidy on the per unit of
output, it will affect the cost. The cost per unit of output will decrease. Hence
the AC and MC shift downwards (Fig. 5.5(a)). Due to the shift in the MC
curve to the lower side, the supply of the firm will increase and the price will
decrease. The price will decrease due to market supply increases (Fig. 5.5b).
How much price will reduce? It depends on the price elasticity of supply at
the market demand.
118
Fig. 5.5(a): Effects of Subsidy on Equilibrium
Fig. 5.5(b): Changes in Supply

1. Give the condition for the equilibrium of firm in the short run under perfect
competition.
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2. What is the slope of the MC curve at the profit-maximizing condition?
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3. If MC > MR, what decision will be taken by the entrepreneur to minimize
the loss?
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4. Does the firm always earn excess profit in the short run? Explain.
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5. “Supply curve of the firm is the MC to the right above the minimum AVC”.
Do you agree? Explain, why?
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6. Which cost is to be covered by the firm in the short run?
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7. What is the closing down point? Equilibrium Condition
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8. Does the firm earn excess profit in the long run? Yes or No. Explain, why?
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9. What is the effect of change in variable cost on quantity and price of
equilibrium of firm in the short run?
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10. What is the effect of an increase in sales tax on the equilibrium of a firm in
the short run?
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5.3 MONOPOLY MARKET

A monopoly is a market structure in which there is only one seller (producer) of
a commodity. There are no rivals in the market. There is no close substitute for
the commodity produced. There are barriers to entry for the firms.
Some important points of the monopoly are as follows:
In a monopoly, the demand curve is negatively sloped which is identical to the

market demand curve. The marginal revenue curve is also having a negative
slope. Furthermore, marginal revenue is less than the price at all the points. The
relationship between MR and P is given as
121
Managerial Economics MR = P(1 – 1/ e); where e = price elasticity of demand.
The monopolist can change both the price and output level. He has the market
power to change the price or output level of the commodity produced in the
market. In order to increase the sale of a product, he can reduce the price of the
product. The goal of the monopolist is profit maximization. He is able to change
the price or output level for attaining maximum profit. The cost structure of
the monopolist is identical to the perfectly competitive firm. The equilibrium
condition under monopoly in the short run and long run and its applications are
discussed in the following sub-sections. The price discriminating policy of the
monopolist is also explained in a subsection. Regulation of the monopoly price
by the government is discussed in a sub-section 5.3.5.
5.3.1 Equilibrium of Monopolist in Short Run

The short-run equilibrium of the firm under monopoly is at the point where the
monopolist attains the maximum profit. The condition for profit maximization
of the firm under monopoly is that the marginal cost (MC) should be equal to
the marginal revenue (MR) ie;
MC = MR
The equilibrium condition of the firm in the short run is given in Fig. 5.6. You
will find in the figure that the MC curve intersects the MR curve at point ‘E’.
The second-order condition for the equilibrium of the firm requires that the MC
curve intersects the MR curve from below. This you can see in the figure. At
this point, the monopolist produces the optimum quantity of output ‘Q’ at the
price ‘P’. The cost of production is ‘C’. It is to be noted that the price is higher
than the marginal revenue. The monopolist earns the excess profit which is
equal to the area APCB. The profit and loss of the monopolist depend upon the
price and average total costs.
Fig. 5.6: Equilibrium of Monopolist in Short Run

122
The monopolist can either set his price and sells the quantity of product in the Equilibrium Condition
market or produces an output level and sells at a price. Thus, the monopolist
cannot decide independently both the price and the quantity of output to produce.
Mathematically, we can also find out the optimum quantity of output if the
cost function and demand function are given. From the cost function, you can
find out the MC function. The total revenue function which is equal to ‘PQ’ is
worked out from the demand function. From the total revenue function, you
can work out the MR function. Apply the condition of MC equals MR for
equilibrium. Solve this relation for a quantity of output ‘Q’. Find out the price
from the demand function by putting the value of quantity ‘Q’.
It is important to mention here that the change in variable costs, imposition

of sales tax, providing subsidies, and shift in the market demand will affect
the equilibrium of a firm in monopoly. If variable cost increases, the supply
will decrease and the price will increase because of an upward shift in the
MC curve as you have seen in the case of the perfectly competitive market.
A similar effect of the imposition of sales tax on the quantity supplied and the
price will be observed. As a result of providing subsidies, the supply of output
will increase and the price will reduce. If market demand shifts, either way, the
equilibrium of the firm changes. Consequently, the quantity supplied and the
price will change.
5.3.2 Supply of Monopolist

There is no unique relationship between price and quantity supplied in the case
of a monopoly market. The same quantity may be supplied at different prices
depending on market demand. Graphically, this is shown in Fig. 5.7 (a). The
quantity ‘Q’ will be supplied at price P1 if demand is D1, while the same quantity
‘Q’ will be supplied at price P2 if demand is D2.
Similarly, for a given MC of the monopolist, different quantities may be supplied
at one price, depending upon the market demand and the corresponding MR
curve. This situation is depicted in Fig. 5.7(b). Given the MC of the monopolist,
he would supply Q1 at price P if the market demand is D1 while at the same price
P, he would supply only Q2 if the market demand is D2.
Fig. 5.7 (a): Supply of Monopolist 123

Fig. 5.7 (b): Supply of Monopolist
5.3.3 Equilibrium of Monopolist in Long Run

In the long run, the monopolist has the time to expand his plant. With entry
blocked, it is not necessary for the monopolist to reach up to the optimum plant.
He may also build sub-optimal plant and earns supernormal profits even in the
long run.
Let us consider a case where the monopolist is using sub-optimal plant size
(Fig. 5.8). The condition for equilibrium, in the long run, is that the long-run
marginal cost (LMC) should be equal to the marginal revenue i.e;
LMC = MR
The equilibrium is at point ‘E’ where the price is P and the quantity is Q. The
long-run profit is given by the area PCBA.
Fig. 5.8: Equilibrium of Monopolist in Long Run

124
Consider the firm is adopting a sub-optimal plant size, the SAC is tangent to Equilibrium Condition
the LAC at its falling part (less than minimum LAC) and also SMC is equal to
the LMC i.e;
SMC = LMC = MR
Since the monopolist is not using the optimum plant size where LAC is not the
minimum one, there exists excess capacity.
5.3.4 Price Discriminating Monopolist

Price discrimination exists when a producer sells the same product at different
prices in different markets. Price discrimination is easily implemented by a
monopolist because he has control over the whole supply of a commodity. A
monopolist can sell the same product to the poor and rich people at different
prices and considers the welfare of the society. In this way, he is able to increase
the total profit.
There are some necessary conditions for the implementation of price

discrimination: (a) Different price elasticities of demand in the various markets,
(b) Spatially separated markets - no reselling takes place.
The objective of the monopolist is profit maximization. He would like to know

how much to sell in each market at what price so that the total profit is the
maximum. The MR in each market is different due to the different demand
curves of the market. The profit in each market is maximized by equating the
MR of each market to the MC as a whole product i.e;
MR1 = MC ----------------- First market
MR2 = MC ---------------- Second Market
That is,
MC = MR1 = MR2
This is the condition for profit maximization of the price discriminating

monopolist.
If, MR1 > MR2
The monopolist will sell more quantity in the first market and less quantity in
the secondary market until the condition of MR1 = MR2 is fulfilled.
Graphically, the discrimination of the prices and quantities in the two markets is
shown in Fig. 5.9. The total quantity is produced where the aggregate MC and
the MR intersect with each other at point ‘E’. Thus, the total quantity produced
is OX at a uniform price P. Now we draw a line ‘ER’ parallel to the quantity
axis. This line cuts the MR1 at point E1 and the MR2 at point E2. At these points
we have the required condition i.e;
MC = MR1 = MR2
125
Managerial Economics From E1 and E2 we drop vertical lines to the quantity axis and we extend them
upwards up to the demand curves D1 and D2 in two markets. These vertical
lines define the quantity and price in each market. Thus in the first market, the
monopolist will sell OX1 at the price P1 and in the second market, the monopolist
will sell OX2 at the price P2. So the total output OX = OX1 + OX2.
Fig. 5.9: Price Discriminating Monopolist
The profits from price discrimination are more than selling the whole output at
a uniform price P. This is known as third-degree price discrimination.
If the MRs are equal in two markets, it does not necessarily imply the equality
of price in two markets. It depends on the price elasticity of demand in the
markets. With the relationship between MR and price as given earlier, you can
find out the price in each market if the demand elasticity of each market is
known.
It is to be noted that the price is lower in the market where the price elasticity of
demand is greater and vice-versa. For the same product, the monopolist charges
the lower price from the poor society where the price elasticity of demand
is greater and charges the higher price from the rich society where the price
elasticity of demand is lower. In this way, monopolist takes into consideration
social welfare. One of the effects of price discrimination is that the monopolist
manages to reap part of the consumer’s surplus and thus increases his total
revenue.
5.3.5 Regulation of Monopoly Price by Government

In the case of a simple monopoly, the equilibrium price is P and the quantity is
Q which is attained by the equilibrium condition as:
MC = MR
Under this situation, the monopolist earns the excess profit by charging higher
126 prices P.
But sometimes government makes interventions and regulates the monopoly Equilibrium Condition
prices which are allowed to charge by the private monopolist. The government
has to set the prices or different levels of price by adopting a price discriminating
policy.
Firstly, the government may set a price at the level of MC. That is, the MC
equals to price i.e; MC = P1. This you can see in Fig. 5.10. The price is P1 which
is lower than the equilibrium price P and output level Q1 is higher than the
equilibrium quantity Q of the product. There is still profit to the monopolist.
Fig. 5.10: Regulation of Monopoly Price
Secondly, the government may set a price equal to AC, i.e; AC = P2. In Fig.
5.10, the price is P2 which is lower than the equilibrium price P and it leads to
higher output Q2 in comparison to equilibrium output Q. Although the price is
lower than the equilibrium price P, the monopolist still gets normal profits.
Sometimes the government may apply a price discrimination scheme for social
welfare, particularly in public utilities like electricity, gas, telephone, railways,
etc. Government charges the different prices from different sections of the
society or on the basis of the levels of consumption of the utility goods/services.

1. Give one important characteristic of a monopoly market.
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Managerial Economics 2. What is the condition to attain the equilibrium of a firm in monopoly in the
short-run?
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3. Do you agree that MR is equal to price in monopoly? Yes or No. Why?
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4. Explain the relationship between the supply of output and price in a

monopoly. Is it a unique relationship between them? Explain.
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5. Why does excess capacity exist in the long-run equilibrium of a firm?
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6. What is the effect of changes in variable costs on the equilibrium of a firm?
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7. What do you understand about the price discrimination of monopolists? Equilibrium Condition
What are the conditions for that?
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8. If MR1 = MR2 in two markets for price discrimination, do you agree the
price will also be equal in two markets? Yes or No. Why?
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9. In case of price discrimination, price is lower in the market where demand
elasticity is higher. Is it true or false? Explain why.
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10. Sometimes government controls the monopoly price. Explain how?
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5.4 MONOPOLISTIC COMPETITION

So far as we have discussed two important markets namely perfect competition
and monopoly. These markets are at two extremes from the point of view of a
number of producers. In a perfectly competitive market, there is a large number
of producers producing homogenous products, whereas in a monopoly market
there is only one producer. In the case of the monopolistic competitive market,
there is a large number of firms that are producing heterogeneous products. The
products are slightly differentiated yet they are close substitutes for one another.
Product differentiation is an important feature of this market. Monopolistic
129
Managerial Economics competition contains some elements of both perfect competition and monopoly.
Perfect competition is in the sense that there is a sufficiently large number of
producers so that the actions of a producer have no perceptible influence upon
his competitors. The market is like a monopoly in the sense that when products
are differentiated in nature, then each product is unique and its producer has
some degree of monopoly power.
Chamberlin has developed a model of monopolistic competition. In place of
industry, he has given the concept of ‘large group’ which is the collection of a
large number of firms producing very closely related products. For example,
there is a large number of firms producing soap of different brands which are
the substitute for one another.
Chamberlin has given the following assumptions/characteristics of monopolistic
competition for the large group model:
(1) There is a large number of sellers (producers) and buyers in the group.
(2) The products of the sellers are differentiated, yet they are close
substitutes for one another.
(3) There is free entry and exit of firms in the group.
(4) The prices of factors of production and technology are given.
(5) Finally, Chamberlin makes the ‘heroic’ assumption that both demand
and cost curves for all products are uniform/identical throughout the
group. Although this assumption is unrealistic. But for simple analysis,
it has been assumed.
The goal of the firms in the product group is profit maximization both in the
short run and long run. Chamberlin adopted that the shape of cost curves is
similar to the traditional theory of the firm. The AVC, ATC, and MC are similar
to that of perfect competition and are worked out assuming only a single level
of output.
Because of the product differentiation, the producer has some discretion in the
determination of price. He is a price taker but has some degree of monopoly
power that he can exploit. Thus the individual firm possesses a negatively
sloped demand curve dd/ for its distinct product. In monopolistic competition,
there is one more demand curve DD/ which is known as the actual sales curve
or the share of the market curve or the effective demand curve. DD/ demand
curve shows the actual sales of the firm at each price after accounting for the
adjustments of the prices of the other firms in the ‘product group’. The DD/
demand curve is less elastic than that of the dd/ demand curve. That is DD/
demand curve is steeper than the dd/ demand curve because the actual sales from
a reduction in price are smaller than expected on the basis of the dd/ demand
curve as all firms reduce their price and expand their own sales simultaneously.
The equilibrium condition of the firm in the short run and long run under
monopolistic competition is discussed in the following subsections.

Chamberlin said that the short-run equilibrium of a firm in monopolistic
130
competition acts as a monopoly. According to Chamberlin the cost and demand Equilibrium Condition
curves are identical for all the firms in the product group under monopolistic
competition. In the short run firm maximizes its profit by producing the output
at which marginal cost is equal to the marginal revenue, i.e,
MC=MR
The price in the market will be the same. No firm has an incentive to change its
own price. The second condition for profit maximization requires that the MC
cuts the MR from below.
The equilibrium of a firm in the short run is illustrated in Figure 5.11. In the
figure, MC and SAC curves are drawn. The individual firm’s demand curve is
presented by dd/ and the share of the market demand curve is shown by DD/.
For the firm’s demand curve dd/, the MR curve is also drawn. The firm is in
equilibrium at the point ‘e’ when the MC curve intersects the MR curve. We
extend the vertical line passing through the equilibrium point ‘e’ and it meets
the demand curve dd/ at ‘F’ where the demand curve dd/ intersects the share of
the market demand curve DD/. The firm produces the quantity Qe at the price
Pe. In the short run, the firm earns an abnormal profit which is equal to the area
PFCR.
Fig. 5.11: Short-Run Equilibrium in Monopolistic Competition

As you have seen in the case of short-run equilibrium, the firm realizes the
abnormal profits. In the short run, the existing firms do not have any incentive
to adjust the price but in the long run, the existing firms are in a position of price
adjustment. Secondly, in the long run, new firms also enter the product group
because of the attraction of excess profits. Hence Chamberlin gave two models
for the long run equilibrium of a firm:
(I) Long-run Equilibrium of Firm with Price Competition.
(II) Long-run Equilibrium of Firm with Price Competition and Free Entry
of Firms. 131
Managerial Economics We shall discuss each model with a diagram separately.
(I) Long-run Equilibrium of Firm with Price Competition.
In this model, it is assumed that there are optimum numbers of firms in the
product group. Neither entry nor exit will be taken place by the firms in the
product group. The ruling price in the short run is assumed to be higher than
the equilibrium price. In this model, Chamberlin assumed also that the long-run
cost structure and demand curve are identical for all the firms in the product
group. The price adjustments are shown along the dd/ demand curve. The actual
sales of the firm at each price after accounting for the adjustments of the prices
are shown by actual sales or share of the market demand curve DD/.
We assume that the firm is at the non-equilibrium at point e0 where the price is
P0 and the quantity supplied is Q0 (Figure 5.12). The firm can increase its output
by lowering its price P1. It is expected to sell quantity Q1/ on the basis of its
individual demand curve dd/. The level of sales is not actually realized because
all other firms have the incentive to act in the same way simultaneously. Each
firm attempts to maximize its own profit, ignoring the reactions of competitors,
on the assumption that the effect on the demand curve of other firms in the
group is negligible. Thus all firms act independently and reduce their price
simultaneously to P1. As a result, the dd/ demand curve shifts downward (d1d1/)
having equilibrium at e1 and firm ‘A’ instead of selling the expected quantity
Q1/ sells actually a smaller quantity Q1 on the shifted demand curve d1d1/
along with share of demand curve DD/. The firm again reduces its price on the
assumption that its new demand curve (d1d1/) will not shift further because its
own decision on other sellers’ demand would be negligible. The firms reduce
their price further though independently. The demand curve d1d1/ continues to
slide downwards along DD/ (in terms of Chamberlin). This process stops when
the d2d2 / demand curve is tangent to the LAC curve. Equilibrium is determined
by the tangency of d2d2 / and the LAC curve at point ‘e2’. The equilibrium
quantity and price are Qe and Pe. The profits are only normal at the equilibrium.
The firm will not reduce its price further otherwise the average cost would not
be covered. At this point, the LMC is equal to the MR for the demand curve
d2d2/ which is tangent to the LAC curve.
132
Fig. 5.12: Long Run Equilibrium with Price Competition
(II) Long-run Equilibrium of Firm with Price Competition and Free Entry Equilibrium Condition
of Firms.
Chamberlin suggests that equilibrium is actually achieved both by price by

adjustment of existing firms and by the new entry of firms. Price adjustments
are shown along the dd demand curve while the entry and exit of firms cause
shifts in the DD curve.
It is assumed that profits are abnormal at point e1 as given in Figure 5.13.

Because of the attraction of abnormal profits, the new firms enter the new
product group. As a result of this DD shifts to D/ D/. One may think that e2 is
a long-run equilibrium with price p and quantity q since only normal profits
are earned by the firm. Now each entrepreneur’s dd is the demand curve and
he feels that if he reduces his price his sale would expand along dd and profit
would increase. Each firm is acting in the same way and they also reduce their
prices. As price is reduced by all firms, dd slides downward along D/ D/ and
each firm realizes a loss instead of profit.
Fig. 5.13: Long Run Equilibrium with Price

Competition and Free Entry of Firms in Industry
For example, at a position d/ d/ the firm has reduced its price to p1 and all the
firms act similarly and q1 is produced with a total loss equal to the area ABP1C.
The reason for the loss is that the average cost is higher than the price. The loss
increases still further as dd slides further down along D/ D/. The financially
weakest firm will eventually leave the product group first and the remaining
firms will have a larger share. Hence D/ D/ moves to the right as D// D// together
with dd. The exit will continue until dd becomes tangent to the LAC curve.
Hence the changed D// D// cuts the downward d// d// at the point of tangency e3 to
the LAC curve. Equilibrium is then stable at point e3 with normal profits earned
by all firms producing quantity qe at price pe. The firm will not enter or exit the
product group. At this point, the LMC is equal to the MR.
133
1. What is the difference between monopoly and monopolistic competition?
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2. Give an example of a monopolistic competitive market for a product.
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3. Give two most important characteristics of monopolistic competition.
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4. What are Chamberlin’s heroic assumptions? Comment on that.
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5. Give the condition for the short-run equilibrium of a firm in monopolistic
competition.
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134
6. If price competition occurs which demand curve is influenced? Equilibrium Condition
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7. What happens to the DD demand curve if firms exist or enter the product
group?
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8. In the case of the long-run equilibrium of a firm, the demand curve dd is
tangent to the LAC curve. Do you agree or not. Give reason.
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9. In the long-run equilibrium, the firm earns the normal or abnormal profit.
Why?
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5.5 OLIGOPOLY AND DUOPOLY MARKETS

An oligopoly market is said to exist when there is a small number of sellers
in the market. If two sellers are in the market, the duopoly market exists. The
price, quantity, and profit of an oligopolist and duopolist depend upon the action
of all producers who are producing identical products. Interdependence of the
different actions of the sellers is the main feature of these markets. The profit of
each producer is the result of the interaction of the decisions of his rivals.
There are no generally accepted behavior assumptions for oligopoly and

duopoly markets as in the case of perfectly competitive and monopoly markets. 135
Managerial Economics Each market solution for a producer is based upon a different set of behavior
assumptions. Some of the important solutions are discussed in the following
sub-sections. For simplicity, most of the solutions are developed for the duopoly
market but some of the solutions may be used for the oligopoly market.
5.5.1 Cournot’s Solution

French economist A. Cournot has developed a classical solution for the duopoly
market. The firms are assumed to produce a homogenous product. Secondly,
the basic behavior assumption of this solution is that each firm or duopolist
maximizes his profit on the assumption that the quantity produced by his rival
does not change with respect to his own quantity-producing decision. That is,
a competitor or rival will not change his output, and he decides his own output
so as to maximize profit.
In this case, the inverse demand function is considered. That is, price is a
function of the aggregate quantity produced
p= f (q1+q2)
Where q1 and q2 are quantity levels of the duopolists.
The revenue of each duopolist depends upon his own output level and that of
price as aggregate quantity i.e.
R1=R1 (q1,q2)
R2=R2 (q1,q2)
The costs are different for different duopolists i.e.
C1= C1 (q1)
C2=C2 (q2)
The first-order condition for profit maximization for both the duopolist is:
MR1 = MC1 -------(i)
MR2 = MC2 -------(ii)
That is the first-order condition for attaining maximum profit requires that
each duopolist equates his marginal revenue to its marginal cost. The second-
order condition requires that the MR curves cut the MC curves from below.
Solving the first equation for q1 as a function of q2 gives the reaction function
for the first duopolist. Similarly, the second equation for q2 in terms of q1
gives the reaction function for the second duopolist. These equations or
reaction functions may be depicted with the graph (Figure 5.14). The point of
intersection of the two reaction curves will give the equilibrium quantity q1
and q2 produced by the first duopolist and second duopolist respectively.
136
Fig. 5.14: Cournot’s Solution
Mathematically, by solving the first and second equation simultaneously we

can get the equilibrium quantity q1 and q2 for the first and second duopolist
respectively. This is known as the Cournot solution or equilibrium.
Equilibrium is reached through a sequence of adjustments of the outputs of

duopolists. Cournot’s solution is easily extended to the markets having more
than two sellers say oligopoly market.
5.5.2 Collusion Solution

Duopolists and oligopolists have mutual interdependence. They produce
a homogenous product for selling in the market. Direct agreement among
duopolists or oligopolists is an example of collusion. There are several types of
collusion namely cartels, market sharing, price leadership, etc. Here we shall
discuss the cartels aiming at joint profit maximization of the industry. Here the
duopolists or oligopolists are agreed upon the maximization of the total profit
of the industry. Both variables i.e. quantity produced and price of product are
then under a single control and the industry. It is, in fact, like a monopoly. This
situation is identical to that of the multiplant monopolist who produces in two
or three plants and maximizes the total profit whereas the costs are different for
the product in different plants.
For simplicity, we assume that there are two firms (duopoly) in the cartel. Their
cost structures are different and are given in Figure 5.15(a) for A firm and
in Figure 5.15(b) for firm B. Their marginal costs are MC1 and MC2 and the
aggregate marginal cost MC is the horizontal summation of the individual MCs
which is presented in Figure 5.15(c). The market demand curve is DD and the
marginal revenue of the output of the cartel as a whole is MR.
The condition for maximization of the total profit of the industry is that the
aggregate MC should be equal to the MR of the output as a whole. You will find
in Figure 5.15(c) that the equilibrium point is at ‘e’ where aggregate MC cuts
137
Managerial Economics to MR from below. The equilibrium price is P and the total quantity produced
is (q1+q2).
Fig. 5.15(a): Firm A Fig. 5.15(b): Firm B Fig. 5.15(c): Industry

Fig. 5.15: Collusion Solution
For individual firms, the first-order condition for profit maximization requires
that the marginal cost of each firm must be equal to the marginal revenue of the
output as a whole i.e.
MC1=MC2=MR
At this condition, firm A has the equilibrium at ‘e1’ and is producing the quantity
q1 and firm B has the equilibrium at ‘e2’ and is producing the quantity q2 at price P.
Although this solution is very easy to drive but in practice, these cartels rarely
have achieved the maximum joint profits due to several reasons such as wrong
estimation of the demand curve and marginal cost curve, slow negotiations
of cartels, existing high-cost firms, fear of entry of new firms, government
interference, etc.
5.5.3 Market Sharing Solution

In this case, the firms of the industry agree on the share of the total sales
of products by an individual firm. That is the share of each firm in the total
product has some proportion say equal proportion or one third and two-third.
For example, there are two firms (duopoly) in the market and have an equal
share in the total product selling in the market. That is the market sale is being
shared equally between two firms. The firms have identical costs. Each firm
will act like a monopolist. The equilibrium of each firm is at the point where
the MC of each firm is equal to the MR, and each firm is producing half of the
total product at price p is determined by the equality of the aggregate MC and
MR. The quantity q1 and q2 of the product are produced by the Ist and IInd
firms respectively. Hence q (total product) = q1+q2. If the costs of the firms are
different the shares of the market will differ.
138
5.5.4 Stackelberg’s Solution Equilibrium Condition
This solution was developed by the German economist H.V. Stackelberg and
it is an extension of Cournot’s model. The firms in the industry are producing
homogenous products. In this model one of the firms is a leader and the
other firms are the followers. There are two possibilities in which the stable
equilibrium emerges:
(i) Firm A is the leader and firm B is the follower.
(ii) Firm B is the leader and firm A is the follower.
We shall discuss the case (i) in which firm A is the leader and firm B is the
follower as a rival. Firm A determines the reaction function of the follower
firm B and substitutes this reaction function with his own profit function.
Firm A maximizes its profit like a monopolist and produces a q1 level of
output. Firm B considers the q1 level of output of firm A and substitutes in
its reaction function producing q2 level of output. For example, the aggregate
demand function is:
p= f (q1, q2)
and marginal costs of firm A and firm B are MC1 and MC2.
For-profit maximization:
MR=MC1 ----------(i)
MR=MC2 ----------(ii)
These conditions are derived from the profit maximization condition of both
firms. By solving equations first and second we shall get the reaction equation
of firm A in terms of q2 and the reaction equation of firm B in terms of q1.
Now if firm A is the leader, firm A will substitute the reaction equation of firm
B in its profit function and it maximizes the profit like a monopolist with the
condition of equality between MR and MC1. Firm A produces the q1 quantity
of output. After that, the follower firm B considers the quantity q1 of output
produced by firm A and substitutes in its reaction equation and produces the
q2 quantity of output. These reaction curves are presented in Figure 5.16. The
quantity produced by firm A and firm B is q1 and q2 respectively.
Similarly, we can discuss the case (ii) in which firm B is the leader and firm
A is the follower. This situation is presented in Figure 5.16. The quantity
produced by firm B and firm A is obtained as q2/ and q1/ respectively.
139
Fig. 5.16: Stackelberg’s Solution
Managerial Economics 5.5.5 The Kinked Demand Curve Solution
This solution was given by Paul Sweezy for a stable oligopoly price. In duopoly
and oligopoly markets, the prices are frequently changing. Firms in such
markets do not change equilibrium prices and quantity due to changes in their
costs. The main reason is that if one of the duopolists decreases his price for
increasing his sale he expects that his rival will follow suit, matching the price
decrease. On the other hand, if one of the duopolists raises his prices, his rival
is assumed to change but he does not change his price. Thus the price decrease
will be followed by his rival but the price increase will not be followed. This
behavioral pattern has a ‘Kink’ in the demand curve dd/ at point E (Figure
5.17) where the price is P. the price reduction below ‘P’ is the relevant demand
curve Ed/ for decision making and for price increase above P is the relevant
demand curve dE. The upper section of the kinked demand curve has higher
price elasticity than the lower part.
Fig. 5.17: Kinked Demand Curve Solution
Due to the Kink in the demand curve of the duopolist, his MR curve is
discontinuous at the level of output corresponding to the kink. The MR has
two segments: segment dA corresponds to the upper part of the kinked demand
curve while the segment BC corresponds to the lower part of the demand curve.
At point E, however, there is finite discontinuity represented by the AB segment
of MR.
The equilibrium of the firm is defined by the point of the kink because at any
point to the left of the kink at E, MC is below the MR while to the right of the
kink the MC is more than the MR. Thus the total profit is maximized at point
‘E’ of the kink. The equilibrium price is ‘P’ and the quantity is ‘Q’. However,
this equilibrium is not necessarily defined by the intersection of the MC and
the MR curve. The MC curve passes through anywhere of the discontinuous
segment AB of the MR, and the equilibrium price and quantity remain the
same. This discontinuity (between A & B) of the MR curve implies that there
is a range within which costs may change without affecting the equilibrium P
and Q of the firm.
140
According to Sweezy, oligopoly price tends to be very sticky. Hall and Hitch Equilibrium Condition
use the kinked demand curve in order to explain the ‘stickiness’ of prices in an
oligopolistic market but do not use it as a tool for the determination of the price
itself.
1. Define oligopoly market.
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2. How equilibrium is attained in the case of Cournot’s solution?
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3. What is the Cartel? How equilibrium is attained by the two firms under
Cartel?
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4. Why does kink occur in the demand curve under oligopoly?
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5. ‘Oligopoly price tends to be very sticky.’ Why?
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6. How the equilibrium is determined in the case of a kinked demand curve
solution?
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5.6 LET US SUM UP

The theory of firms operating under different market situations is the subject
matter of microeconomics. The important markets are (i) Perfect Competition,
(ii) Monopoly, (iii) Monopolistic Competition, (iv) Oligopoly and Duopoly.
The objective of the firm is profit maximization. The firm is in equilibrium

when it attains the maximum profit. The equilibrium conditions of the firm and
its applications under different markets in the short run and long-run conditions
are given in brief:
(i) Perfect Competition: The important characteristics of a perfectly
competitive market are (a) Large number of sellers and buyers exist
in the market (b) Firms are free to enter or exit from the industry (c)
Factors of production are completely free to move (d) Sellers and
buyers have complete knowledge of the market.
The short-run equilibrium of a firm under perfect competition occurs
when the marginal cost equals the price of output. Under this condition,
firms achieve the maximum profit and produce the optimum level of
output.
The supply curve in the short run of a firm is derived by the different
points of intersection of the price line and the given marginal cost
curve. The supply curve of the firm is identical to its marginal cost
curve to the right above the minimum average variable cost.
The supply curve of the industry is the horizontal summation of the
quantity supplied by all the firms in the industry at different prices.
The long-run equilibrium of a firm in perfect competition is at the
point where long-run average cost, as well as marginal cost, equals
the price of output. At this point, the firm earns only the normal profit.
The firm selects the optimum plant size and at this point, the minimum
short-run average cost equals the minimum long-run average cost.
As a result of an increase in the average variable cost, the equilibrium
of a firm in the short-run changes, consequently quantity supplied will
142 decrease and at the market demand, the price will rise.
If sales tax i.e. tax per unit of output rises the quantity produced will Equilibrium Condition
be reduced and the price will increase.
If the government gives a subsidy per unit of output to the entrepreneur,
the supply will increase and the price will decline.
(ii) Monolpoly: There is only one seller (producer) in the market. There
are no rivals. Monopolist has market power either to change the price
or output level of the product. The demand curve of the monopolist is
identical to the market demand.
The short-run equilibrium of a firm under monopoly attains the point
where the marginal cost is equal to the marginal revenue. In this case,
the price is not equal to the marginal revenue but more than that.
Under this condition, the firm gets the maximum profit and produces
an optimum level of output. The monopolist earns the excess profit.
The supply of monopolists is determined by the profit maximization
condition. In this case, there is no unique relationship between price
and quantity supplied. It depends on the shape of the demand curve.
The long-run equilibrium of a firm in monopoly is at the point where
the long-run marginal cost is equal to the marginal revenue. The firm
earns the abnormal profit even in the long run by adopting the sub-
optimal plant size. Since the firm is mostly using the sub-optimal plant
size, the short-run average cost is tangent to the long-run average cost
curve at its falling apart. Hence the short-run average cost is more than
the minimum long-run average cost.
As a result of an increase in the average variable cost or rise in the sales
tax, the equilibrium of the firm changes, consequently, the quantity
produced will reduce and the price will increase. If the government
gives a subsidy per unit of output to the producer, the supply will
increase and the price will decline.
In order to increase the total profit monopolist practices, a price
discriminating policy provided the price elasticities of demand are
different in the different markets which are located separately. The
total output is determined by equating aggregate marginal cost and
marginal revenue. The profit in each market is maximized by equating
the marginal revenue of each market to the marginal cost as a whole
product and hence sells the product at different prices in the different
markets.
Sometimes government regulates the monopoly prices and sets the
price equal to marginal cost or average cost. In some of the cases
government apply a price discrimination scheme for social welfare.
(iii) Monopolistic Competition: In this market, there is a large number of
firms producing heterogeneous products which are differentiated but
products are close substitutes for one another.
Short-run equilibrium of a firm is attained by equating the marginal
cost to the marginal revenue where profit is the maximum. In the case
of the short run, the firm earns abnormal profits and there is not much
143
competition among the producers.
Long-run equilibrium model was developed by Chamberlin. In the
first case, it is assumed that there is an optimum number of firms in
the product group and price competition occurs. As a result of price
competition, the dd/ demand curve of the individual firm continues to
slide downwards along DD/ market share demand curve and becomes
tangent to the long-run average cost curve attaining the equilibrium.
The profits, in the long run, are normal.
In the second case, it is assumed that firms are free to enter or exit
the product group and price competition occurs. Price competition
is shown along the dd/ demand curve and entry (exit) causes shifts
in the DD/ demand curve. Now new firms enter due to the attraction
of the abnormal profits, the DD/ demand curve shifts to the left and
is reaching equilibrium. But the price competition starts, hence the
dd/ demand curve moves downwards along the DD/ demand curve.
Some firms have losses and the financially weaker firms will leave
the product group. The DD/ demand curve shifts to the right. Now
the dd/ demand curve moves the downwards along DD/ demand curve
and it becomes tangent to the long-run average cost curve. A stable
equilibrium is attained and all the firms earn the normal profits.
(iv) Oligopoly and Duopoly: There are few sellers in the oligopoly
market. Duopoly is a special case in which two sellers exist in the
market. In these markets the firms are interdependent and the policy
of one directly affects the others. The products may be differentiated.
There is no general accepted behavior for producing the product in
these markets as in the case of other markets. Some solutions namely,
Cournet’s, Stackelberg’s, kinked demand curve, Collusion, and Market
Sharing solutions are given for these markets.
5.7 KEYWORDS
Abnormal Profits : The profits which are over and above the
average total cost are known as abnormal
profits.
Bilateral Monopoly : It is a market consisting of a single seller
(monopolist) and also a single buyer
(monopsonist).
Cost Elasticity : It refers to the percentage change in the cost
as a result of a percentage change in output
i.e.
c / c c q MC
Ec
q / c q c AC
Economies and Diseconomies : As the plant size increases the LAC
of Scale decreases due to economies of scale. After
that plant size becomes optimal where the
LAC reaches the minimum. If the plant size
144
further increases, the LAC increases because Equilibrium Condition
of diseconomies of scale. Due to economies
and diseconomies of scale, the LAC is of ‘U’
shape.
Excess Capacity : It refers to the difference between the
ideal output level corresponding to the
minimum long-run average cost and the
actually attained output level in the long-run
equilibrium.
Firm : It is a production unit under one management.
Firm’s Equilibrium : The firm is in equilibrium where it attains
the maximum profit for producing a product.
First Degree Price : In this case, the monopolist negotiates with
Discrimination each buyer and charges him the maximum
price which he is willing to pay under the
threat of denying the selling of any quantity
to him.
Industry : It is a collection of firms producing a
homogenous product.
Industry’s Equilibrium The aggregate supply of a commodity for
the industry which is obtained by horizontal
summation of the supply of individual
firms, is equal to the market demand for the
commodity.
Market Equilibrium : Market equilibrium of a commodity is
achieved when the aggregate demand
is equal to the aggregated supply of the
commodity in the market.
Normal Profits : The profits which just cover all costs are
called normal profits.
Perfect Competition : In addition to the above characteristics, a
perfectly competitive market has two more
assumptions – perfect mobility of factors
of production and perfect knowledge of the
market to the buyers and sellers.
Product Group : It is used to denote a collection of firms
producing closely related products which
are good substitutes.
Pure Competition : The pure competitive market has the
characteristics of a large number of sellers
and buyers, product homogeneity, and free
entry and exit of firms.
145
5.8 SUGGESTED FURTHER READINGS /
REFERENCES
1. Ahuja, H.L. (1997), Advanced Economic Theory-Micro-economics
Analysis, S.Chand & Company Ltd, Ram Nagar, New Delhi-5.
2. Gould, J.P. and C.E.Ferguson (1998), Micro-economic Theory, Virendra
Kumar Arya, Delhi.
3. Henderson (J.M.) and Richard E.Quandt (1983), Microeconomic Theory-A
Mathematical Approach, Mc Graw-Hill, New Delhi.
4. Koutsoyiannis, A. (1994), Modern Microeconomics, Macmillan Press Ltd,
Hong Kong.

ANSWERS
1. The marginal cost (MC) should be equal to the marginal revenue (MR).
2. SMC curve has a rising trend at the point of intersection with the MR curve.
It means that the SMC curve must cut the MR curve from below.
3. Reduce the production.
4. No. It is not necessary that the firm always earn excess profit. It depends on
the level of the Short-run average total cost and the price of the output.
5. If the price falls, the quantity supplied decreases. The firm will supply up
to the minimum SAVC or up to Pw point but the firm will not supply if the
price falls below Pw. Because at a lower price the firm does not cover its
short-run average variable cost.
6. Short-run average variable cost.
7. If we plot different points of intersection of the MC curve and price line on
a separate graph we get the short-run supply curve of the individual firm.
This supply curve of the firm is identical to its MC curve to the right above
the minimum SAVC which is called as closing down point (Pw). Below Pw
the quantity supplied by the firm is zero.
8. In the long run, the firm does not earn excess profit. It earns just normal
profit. The firm adjusts its plant size and produces the output level at which
LAC is the minimum possible.
9. As a result of an increase in the average variable costs, the quantity supplied
by the firm at the going market price will decrease. Thus, even in the short
run, the market supply will shift upwards to the left. Hence, at market
demand, the price will rise due to declining market supply.
10. Such tax causes a shift of the AC and MC curves upwards to the left. Due
to the shift of the MC curve the upward, the supply of firms will reduce.
The price will increase because of decreasing market supply.
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Check Your Progress 5.2 Equilibrium Condition
1. A monopoly is a market structure in which there is only one seller (producer)

of a commodity.
2. Marginal cost (MC) should be equal to the marginal revenue (MR).
3. No. Marginal revenue is less than the price at all the points. The relationship
between MR and P is given as
MR = P( 1 – 1/ e ); where e = price elasticity of demand.
4. There is no unique relationship between price and quantity supplied in the
case of a monopoly market. The same quantity may be supplied at different
prices depending on market demand.
5. The monopolist is not using the optimum plant size where LAC is not the
minimum one, there exists excess capacity.
6. If variable cost increases, the supply will decrease and the price will
increase because of an upward shift in the MC curve.
7. Price discrimination exists when a producer sells the same product at
different prices in different markets. There are some necessary conditions
for this: (a) Different price elasticities of demand in the various markets,
(b) Spatially separated markets - no reselling takes place.
8. If the MRs are equal in two markets, it does not necessarily imply the
equality of price in two markets. It depends on the price elasticity of
demand in the markets.
9. It is true. The price is lower in the market where the price elasticity of
demand is greater and vice-versa. One of the effects of price discrimination
is that the monopolist manages to reap part of the consumer’s surplus and
thus increases his total revenue.
10. Sometimes the government may apply a price discrimination scheme for
social welfare, particularly in public utilities like electricity, gas, telephone,
railways, etc. Government charges the different prices from different
sections of the society or based on the levels of consumption of the utility
goods/services.
1. In a monopoly market, there is only one producer. In the case of the
monopolistic competitive market, there is a large number of firms that are
producing heterogeneous products.
2. Soap of different brands which are the substitute for one another.
3. A large number of sellers (producers) and buyers and the products of the
sellers are differentiated, yet they are close substitutes for one another.
4. Chamberlin makes the ‘heroic’ assumption that both demand and cost curves
for all products are uniform/identical throughout the group. Although this
assumption is unrealistic, for simple analysis it has been assumed. 147
Managerial Economics 5. In the short run, firm maximizes its profit by producing the output at which
marginal cost is equal to the marginal revenue.
6. The individual demand curve shifts downward.
7. If a new entrepreneur feels that if he reduces his price his sale would
expand along the individual demand curve (dd) and profit would increase.
Each firm is acting in the same way and they also reduce their prices. As
price is reduced by all firms, dd slides downward and each firm realizes a
loss instead of a profit.
8. When all firm has reduced prices, they incur a loss the reason that the
average cost is higher than the price. The financially weakest firm will
eventually leave the product group first and the remaining firms will have a
larger share. Hence D/ D/ moves to the right as D// D// together with dd. The
exit will continue until dd becomes tangent to the LAC curve. Hence the
changed D// D// cuts the downward d// d// at the point of tangency e3 to the
LAC curve.
9. In the long run, firms earn normal profits earned. The firm will not enter or
exit the product group. At this point, the LMC is equal to the MR.

1. An oligopoly market is said to exist when there is a small number of sellers
in the market. If two sellers are in the market, the duopoly market exists.
The price, quantity, and profit of an oligopolist and duopolist depend upon
the action of all producers who are producing identical products.
2. Each duopolist equates his marginal revenue to its marginal cost and the
MR curves cut the MC curves from below.
3. The duopolists or oligopolists are agreed upon the maximization of the
total profit of the industry. Both variables i.e. quantity produced and price
of product are then under a single control and the industry. It is, in fact,
like a monopoly. The condition for maximization of the total profit of the
industry is that the aggregate MC should be equal to the MR of the output
as a whole.
4. If one of the duopolists decreases his price for increasing his sale he
expects that his rival will follow suit, matching the price decrease. On the
other hand, if one of the duopolists raises his prices, his rival is assumed
to change but he does not change his price. Thus the price decrease will
be followed by his rival but the price increase will not be followed. This
behaviour pattern causes a ‘kink’ in the demand curve.
5. Discontinuity of the MR curve implies that there is a range within which
costs may change without affecting the equilibrium P and Q of the firm.
6. The equilibrium of the firm is defined by the point of the kink because at
any point to the left of the kink at E, MC is below the MR while to the right
of the kink the MC is more than the MR. Thus the total profit is maximized
148 at point ‘E’ of the kink.
1) How does an imperfectly competitive firm differ from one that is perfectly
competitive? If an imperfectly competitive firm wishes to increase the
quantity sold, what must it do to the price? What if it wishes to increase the
price?
2) What is a monopoly? Why monopoly is considered socially undesirable?
3) What are the two characteristics that cause monopolistic competition?
Give some examples of monopolistically competitive firms.
4) Why do firms advertise? Would society be better off if advertising was
banned? Explain.
5) To what extent does the kinked demand curve help in explaining price
rigidity under oligopoly?
149
150

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MAM-053

BLOCK 1: MANAGERIAL ECONOMICS

Unit 1 : Introduction to Managerial Economics

Unit 2 : Microeconomic Theory and Initial Applications

Unit 3 : Market Equilibrium

Unit 4 : Principles of Farm Management and Pricing Practices

Unit 5 : Equilibrium Condition

BLOCK 2 : FUNDAMENTALS OF ACCOUNTING

Unit 6 : Introduction to Accounting

Unit 7 : Accounting Records and Systems

Unit 8 : Preparation of Accounts

Unit 9 : Understanding Financial Statements

Unit 10 : Fund Flow Statement

Unit 11 : Analysis of Financial Statements

BLOCK 3 : AGRICULTURAL FINANCE AND RISK MANAGEMENT

Unit 12 : Source of Agricultural Finance

Unit 13 : Agricultural Risk and Insurance

The course on Managerial Economics and Finance in Agribusiness has

The course assessment as per IGNOU norms will be through assignments

Prof. R. P. Das, PVC, Dr. Leena Singh, Assistant Professor,

Dr. V.C. Mathur, Former Professor and Dr. Mita Sinhamahapatra

Prof. M. K. Salooja, School of Agriculture, Dr. P. K. Jain, Associate Professor and

Dr. Anjali Ramtake, Associate Professor,

Programme Coordinator: Dr. Praveen Kumar Jain

Unit Writers Editors

Course Coordinator: Dr. Praveen Kumar Jain

1.5 Definition, Concepts and Basic Principles of Economics

1.6 Economic Goals and Choices

1.2 MEANING AND NATURE OF MANAGERIAL

Business managers apply economic theories, concepts, and analytical tools

Identify the differences between managerial economics and pure economic

1.3 SCOPE OF MANAGERIAL ECONOMICS

Other factors like your preference for travelling by air, etc.

A production function is a relation that gives us the technically efficient

1.4 MANAGERIAL ECONOMICS IN DECISION

Managerial economics is concerned with the decision process, decision model,

1.4.1 Decision Areas

Decision-making and processing information are the two important tasks of

Fig. 1.1: Steps in Decision Making

Check Your Progress 1.2

1.5 DEFINITION, CONCEPTS AND BASIC

1.5.1 Microeconomic Concepts

4. Concept of equilibrium: The concept of equilibrium is an important tool

1.5.2 Macroeconomic Concepts

Analysis of macroeconomic environment requires the understanding of the

The national capital, human capital, national wealth, total employment,

1.6 ECONOMIC GOALS AND CHOICES

Fulfillment of economic goals helps in the optimal allocation of resources through

1.7 LET US SUM UP

General equilibrium : Equilibrium takes into account the effects of

1.9 SUGGESTED FURTHER READINGS/

Check Your Progress 1.2

Check Your Progress 1.3

Check Your Progress 1.4

1.11 UNIT END QUESTIONS

Essay Types Questions:

2.4 Elasticity of Demand

2.5 Elasticity of Substitution

2.10 Forecasting of Demand for Seasonal Agri-products

2.11 Methods of Forecasting

2.12 Let Us Sum Up

The scarcity of resources and commodities is the fundamental economic fact

Similarly, with the technological improvement in the production process, it is

This is all, we will discuss in the forthcoming sections in detail.