MBA Business Economics

How to Use Self-Learning Material?
The pedagogy used to design this course is to enable the student to assimilate the concepts
with ease. The course is divided into modules. Each module is categorically divided into units or
chapters. Each unit has the following elements:
Table of Contents: Each unit has a well-defined table of contents. For example: “1.1.1.
(a)” should be read as “Module 1. Unit 1. Topic 1. (Sub-topic a)” and 1.2.3. (iii) should
be read as “Module 1. Unit 2. Topic 3. (Sub-topic iii).
Aim: It refers to the overall goal that can be achieved by going through the unit.
Instructional Objectives: These are behavioural objectives that describe intended

learning and define what the unit intends to deliver.
Learning Outcomes: These are demonstrations of the learner’s skills and experience
sequences in learning, and refer to what you will be able to accomplish after going
through the unit.
Self-Assessment Questions: These include a set of multiple-choice questions to be

answered at the end of each topic.
Did You Know?: You will learn some interesting facts about a topic that will help you
improve your knowledge. A unit can also contain Quiz, Case Study, Critical Learning
Exercises, etc., as metacognitive scaffold for learning.
Summary: This includes brief statements or restatements of the main points of unit and
summing up of the knowledge chunks in the unit.
Activity: It actively involves you through various assignments related to direct application
of the knowledge gained from the unit. Activities can be both online and offline.
Bibliography: This is a list of books and articles written by a particular author on a

particular subject referring to the unit’s content.
e-References: This is a list of online resources, including academic e-Books and journal
articles that provide reliable and accurate information on any topic.
Video Links: It has links to online videos that help you understand concepts from a
variety of online resources.
Business Economics
LEADERSHIP KLEF
President Vice Chancellor

Er. Koneru Satyanarayana Dr. G. Pardha Saradhi Varma
Pro-Vice Chancellor Incharge Registrar

Dr. N. Venkatram Dr. K. Subbarao
Business Economics
CREDITS
Authors
Dr. Neti Subrahmanyam

Dr. N. Subramanian
Director CDOE
C. Shanath Kumar
Instructional Designer
Nabina Das
Content Editors
M. Radha Krishnan
M. Mounika
Project Manager
K. D. N. Lakshmi
Graphic Designer
K. Dinesh
Business Economics
First Edition, 2023.
KL Deemed to be University-CDOE has full copyright over this educational material. No

part of this document may be produced, stored in a retrieval system, or transmitted, in
any form or by any means.
Business Economics
Author's Profiles
Dr. Neti Subrahmanyam
Dr. Neti Subrahmanyam is a Professor of Finance and the Area Chair of Finance at K L
University Business School. He is a B.Sc. gold medalist, an MBA gold medalist, and holds a
Ph.D. in Finance with over 25 years of experience in industry and academics. Throughout his
career, he has held several positions of responsibility, including Head of the MBA
Program, Research, Development & Publications. Dr. Subrahmanyam has been a session
chair and panel expert for many conferences and has organised national-level
conferences. He has contributed numerous articles and research papers to referred
national and international journals, including those indexed in ABCD and Scopus.
Dr. Subrahmanyam has been actively involved in academic processes at institutions such as
NMIMS, IMI, and VIT B. School. He has taught and guided Ph.D. scholars, students in
their dissertation projects, and evaluated Ph.D. thesis reports. He has served as a
member of academic advisory boards and boards of studies at various institutions. Dr.
Subrahmanyam has customised the design and delivery of several corporate training
programs, including those for ONGC and the National Institute of Entrepreneurship and
Small Business Development. He has been invited as a Guest Faculty at IIM Kozhikode to
teach in their PGP Programme and was a resource person for financial programmes. Dr.
Subrahmanyam has attended numerous FDPs and QIPs at reputed institutions and has been
actively involved in designing, developing, and delivering executive education programmes for
many organisations.
Dr. N. Subramanian
Dr. N. Subramanian is a renowned expert in the field of Equity Research and Valuation, with
more than two decades of experience teaching postgraduate and executive education
programs. He holds a Ph.D. from Anna University, Chennai, and an MBA in Finance from
Madurai Kamaraj University.
In addition to his academic achievements, Dr. Subramanian has practical industry
experience, having worked for five years in Equity and Fund Management. He has taught
at prestigious institutions in the country, including NMIMS, and has conducted numerous
training programs for corporate executives on Valuation and Modeling. Additionally, he has
reviewed articles for several peer-reviewed journals.
Business Economics
Business Economics
Course Description
For profit organisations always go for producing maximum with least inputs. To make this a
reality, managers must be well equipped with various economic concepts and theories. This
is where business economics comes in. Business economics is nothing but using economic
principles in business decision-making.
The word “business economics” is used based on the context. Similarly, managerial economics,
economics for business, industrial economics are also used. One way to see these differences is
that business economics is broader than industrial economics that deals not only with “industry”
but also with companies in the service sector. Business Economics focuses on the application of
those economic principles to business in the real sense.
This is part of economics and can simply be seen as a combination of economic theory that
relates to business theory. Business economics is a study that focuses on how economic theory
affects the performance of actual business and business activities. It also has some case studies
that link economic theory to corporate development.
Product Lifecycle Theory has categories such as introduction, growth, maturity, and decline. For
example, Samsung is a multinational technology company focused on electronic product design.
However, smartphone products are in the stage of maturity and decline, and the competitive
environment of the smartphone market is becoming fiercer and the profit margin is declining, so
they consider developing new products such as electric vehicles. This example well illustrates a
scenario in which economic theory helps support decision making in a real business organisation.
Although, economic theory may provide theoretical insights to explain the business context,
management has to make accurate business decisions in organisational management. This
suggests the fact that it may still be difficult. While there are some specific assumptions in the
modeling environment, they are very complex and difficult to predict in a real business environment.
Economic theory does not always mean that business decisions are correct. Therefore, in a real-
world business environment, managers should not only consider applying economic theory, but
also consider internal and external factors of the organisation before making decisions.
Business economics is a discipline which studies various economic theories and uses those for
better decision-making in business. It uses various economic concepts such as supply and
demand, resource allocation, competition, and economic trade-offs, so that managers take
good decisions in business. is a discipline that helps us understand the way individuals,
organisations, and countries use the scarce resources to maximise the profit.
Business Economics
1
The Business Economics course contains 4 modules
Module 1: Nature and Scope of Business Economics
Meaning, characteristics, scope and subject matter relationship with other disciplines decision
-making and forward planning. Fundamental principles of Business economics: - Opportunity
cost principle-incremental principal, principle of time perspective, discounting principle and equi-
marginal principle.
Module 2: Demand Analysis
Meaning and definition of demand, determinants of demand, law of demand, exception to the
law of demand, elasticity of demand. Demand Forecasting, Meaning and definitions - methods of
demand forecasting, criteria of good forecasting methods.
Module 3: Production and Cost Analysis
Concept of production function – Short-run production functions and long-run production – Internal
and external economies of scale. Cost – meaning, money, real, opportunity, implicit and explicit,
short–run costs, total cost, fixed cost economics of scale. Revenue – meaning – total revenue,
average revenue and marginal revenue - Break-even analysis - break-even chart.
Module 4: Market Classification
Perfect competition, Monopoly, Monopolistic and Oligopoly.
Business Economics
2
Table of Contents
MODULE 1
Nature and Scope of Business Economics
Unit 1.1 Meaning and Characteristics of business Economics
Unit 1.2 Fundamental Principles of Business Economics
MODULE 2
Demand Analysis
Unit 2.1 Meaning, Definition, and Law of Demand and Exceptions
Unit 2.2 Elasticity of Demand and Demand Forecasting
MODULE 3
Production & Cost Analysis
Unit 3.1 Production Analysis
Unit 3.2 Economies of Scale and Cost Analysis
MODULE 4
Market Classification
Unit 4.1 Perfect and Monopolistic Competitions
Unit 4.2 Monopoly and Oligopoly
Business Economics
3
Business Economics
Module 1
Unit 1
Meaning and
Characteristics of
Business Economics
Business Economics
4
MODULE 1
Nature and Scope of Business Economics

Module Description
This module deals with the definition and scope of Business Economics. Many economists say
this is about applying various techniques, concepts and methods to find solutions for business
problems. Here it can be seen how it is related to various disciplines. Managers typically see
the issues relevant to one entity instead of the whole economy. It is therefore seen sometimes
as an application part of microeconomics. An organisation works in an external world, i.e. it
serves the buyer, which is a crucial part of the economy. Considering this, managers take into
cognisance the varied macroeconomic factors like market dynamics, economic changes,
government policies, etc., and their effect on the corporate. In this sense, this is just in line with
Macroeconomics.
Multidisciplinary: This makes use of tools and principles taken from disciplines
like accounting, finance, statistics, mathematics, production, operational
research, human resources, marketing, etc Hence, this is multi-disciplinary.
Prescriptive/Normative approach: By introducing corrective steps, it achieves the target

and solves specific issues or problems.
The answer to day-to-day business challenges is realistic and rational. Both managers take
a special view of the principle of managerial economics. Some may concentrate more on
customer service, while others may prioritise efficient production.
Business Economics
5
Table of Contents
Unit 1.1 Meaning and Characteristics of Business Economics
Aim ------------------------------------------------------------------------------------------ 07
Instructional Objectives ---------------------------------------------------------------- 07
Learning Outcomes --------------------------------------------------------------------- 07
1.1.1 Meaning and scope ------------------------------------------------------------- 08
Self-Assessment Questions ------------------------------------------------ 10
1.1.2 Subject relationships with other disciplines -------------------------------- 11
Self-Assessment Questions ------------------------------------------------- 14
1.1.3 Decision-making and other forward planning ---------------------------- 15
Summary ---------------------------------------------------------------------------------- 17
Terminal Questions --------------------------------------------------------------------- 17
Answer Keys ----------------------------------------------------------------------------- 18
Activity ------------------------------------------------------------------------------------- 18
Glossary ----------------------------------------------------------------------------------- 18
Bibliography ------------------------------------------------------------------------------ 19
e-references ------------------------------------------------------------------------------ 19
Image Credits ---------------------------------------------------------------------------- 19
Video Links ------------------------------------------------------------------------------- 19
Keywords --------------------------------------------------------------------------------- 19
Business Economics
6
Aim
To familiarise students with the application of economic concepts in decision-making.
Instructional Objectives
This unit intends to:
• Describe business economics
• Relate business economics with other disciplines
• Business decisions and forward planning
Learning Outcomes
At the end of the unit you are expected to:
• Explicate the meaning of business economics
• Recognise its relationship with other disciplines
• Match planning concepts with business decisions
Business Economics
7
1.1.1 Meaning and scope
Economics is the field which studies human behaviour patterns. The important function of
economics is to study how individuals, households, organisations, and countries use
their scarce resources to achieve their greatest interests. Economics can be broadly
divided into microeconomics and macroeconomics. Microeconomics is a part of economics
that studies how individual consumers and firms behave in the market. It focuses on supply and
demand, pricing and performance for individual organisations. Macroeconomics, on the other
hand, studies the economy as a whole, deals with variable like national income, employment
patterns, inflation, recession, and economic growth.
For this reason, managers need to understand various economic concepts, and tools. Business
economics is a discipline that uses various economic theories, logics, and tools for corporate
decision making in areas such as supply and demand outlook, production levels, pricing, market
structure, and levels of competition.
Some popular definitions of business economics:

Mansfield
“Managerial economics is application of economic concepts and economics to the

problems to formulate rational decision making”
Spencer and Seigelman
“Managerial Economics is the integration of economic theory with business practice for
the purpose of facilitating decision making and forward planning by management.”
Scope of business economics

The figure shows the scope of business economics
Demand analysis &

Cost & Benefit analysis Pricing decision, policies,
forecasting
Profit maximisation
Fig. 1: scope of business economics
Business Economics
8
Demand analysis and forecasting
The willingness or capability of individuals to buy a product at a specific price is called demand.
The demand analysis is a process which identifies potential consumers, the quantity and the
right price at which people are ready to buy. Demand forecasting has an important role in
business economics. Hence it helps corporations on areas such as business planning
and strategic area.
Cost and benefit analysis (CBA)

Cost analysis estimates costs required for running the organisation. This will help the firm know
hidden and uncontrollable costs. It also helps firms take steps to control cost in turn improves
the return on investment (ROI). In other words, CBA evaluates the cost and benefits of a
selected activity.
Pricing
Pricing is a system of fixing the price for a service or product that a corporation offers.
The profit of a company relies much on its pricing policies. Business economics is about
pricing methods, pricing of product-line, and price trend in future.
Profit or wealth maximisation

Profit creation and maximisation is the principle intention of each corporation (besides for non-
income enterprises). In order to maximise income, enterprises want to have entire understanding
approximately diverse financial concepts, which include income regulations and break-even
point and analysis.
Capital management
Here choices require sound understanding and know-how on diverse financial components.
Cost of capital and rate of return are factors which help firm make right funding choices.
Some say that Jean Drèze (the man behind MGNAREGA, Right
to Food Movement, Indian Peace Movement, etc.) is the Belgium-
DID born Indian welfare economist. He has worked on several
YOU
KNOW developmental issues that are faced by India, such as social welfare
and gender inequality. Jean Drèze is co-author (with Amartya Sen)
of Hunger and Public Action (Oxford University Press, 1989).
Business Economics
9
Self-Assessment Questions
1. Managerial economics uses______.
a) Micro Economics only

b) Macro Economics only
c) Both Micro & Macro Economics
d) None of the above
2. By analysing some variables like cost of production and capital, organisations could
forecast the future.
a) Yes
b) No
c) Variables cannot be analysed
d) Can analyse but cannot forecast the future
3. Managerial Economics is_____.
a) Concerned with micro aspects

b) Normative
c) Relates to practical aspects
d) All of the above
4. The business conditions prevailing in the economy is about _____ demand forecasting.
a) Macro level
b) Industry level
c) Firm level
d) None of these
Business Economics
10
1.1.2 Subject relationships with other disciplines
The subjects such as economics, Mathematics, Statistics Management theory, and

Accounting concepts contributed much to business economics. Since this synchronises
planning and control of any firm, its importance increases in business decisions.
As a discipline this borders on economic and business management.
Any ideas from other disciplines such as psychology, sociology, etc., are found relevant for
decision-making, this discipline incorporates into itself. In fact, business economics takes the
help of other disciplines as well if they are useful to some explicit and implicit constraints subject
to optimal resource allocation.
Economic theory Decision Sciences

Microeconomics Mathematical Economics
Macroeconomics Econometrics
Managerial Economics Application of

(economic theory + decision science)
Solves managerial
decision problems
Fig. 2: subject relationships with other disciplines
1. Business Economics and Economics

The two subjects, namely microeconomics and macroeconomics will make us understand what
is business economics and economics. Microeconomics studies the economic behaviour of
businesses and other micro level organisations. Business economics is rooted in microeconomic
theory. Business economics uses many microeconomic concepts such as marginal cost and
revenue, elasticity of demand and nature of market competition. But Macro theory studies the
economy as a whole. It covers the analysis of issues related to external environment such as
employment levels, national income, and general price levels.
Business Economics
11
2. Managerial Economics and Decision-making
Decision theory is a new field that is gaining currency from the start of this century. Most
economic theories explain a single consumer goal of maximising a company’s profits.
However, decision theory was developed to explain numerous goals and many uncertainties.
Therefore, this new branch is useful for companies that need to make quick decisions about a
number of goals. In this way, decision theory has better standing than economic theory in
terms of practicality and application.
3. Business Economics and Management theory/Accounting

Developments in management theory and accounting techniques had a great influence on
business economics. Accounting refers to recording a company’s financial transactions in a
particular book. Since maximising profits is the company’s main goal, business economics
entails a good understanding of income and expenditure. The focus of accounting in an
organisation is rapidly shifting from the concept of warehousing to administrative decisions,
resulting in research in a new discipline called management accounting.
4. Managerial Economics and Mathematics

Business economics uses mathematics as well for its goal of maximising profits with the use of
resource options. The company’s main issues are cost minimisation, profit maximisation, or
sales optimisation. Mathematical methods calculate and predict economic factors in turn
help take better decision for the future. Mathematical symbols are useful for processing and
understanding various concepts such as incremental costs and demand elasticity. Calculus,
geometry and algebra are major areas of mathematics useful for business research. Besides
usual tools such as logarithms, and exponentials, more advanced techniques designed recently,
viz., game theory; linear programming and inventory models are used extensively in business
economics.
5. Business Economics and Statistics

Business economics requires statistical tools in several ways. Successful business persons need
to correctly assess the future demand for their products. He should be able to analyse the
effects of flavour changes. The methods in statistics offer a secure foundation for decision
making. Therefore, we use statistical tools to collect and analyse data to support the
decision-making process. Probability theory and some forecasting methods help companies
predict the future course of an event. Economics uses multiple regressions and correlation
of related variables such as price and demand to estimate how one variable depends on the
other. For problems with uncertainty, probability theory is very useful.
6. Business Economics and Operations Research/Computer science

Making effective decisions is a primary concern of management in the areas of economics and
operation research. The growth of concepts such as linear programming, game theory, and
Business Economics
12
inventory modelling was due to the advancement in operation research in the post-war period.
The complex problems due to management of people, machines, materials, and money are
easily addressed by operation research methods. Operations research with its scientific model
of the system helps business economists in new product development, materials management
and inventory control, quality, and marketing and needs analysis.
7. Computer Science
Computers are changing the way we work around the world, and economic and business
activities are no exceptions. To maintain data and accounts, manage inventory and forecast
demand and supply, nowadays the computers are used. What used to be done in days or
months is now done by a computer in minutes or hours. In fact, the computerisation of large-scale
business operations has reduced the burden on managers. In many countries, a basic
knowledge of computers has become an essential for new workforce.
In summary, business economics, a derivative of traditional economics, is empowering as an

independent division of knowledge. The strength lies in the ability to integrate ideas from
different subject areas and provide the right outlook for a good decision-making. Being well
versed in mathematics and economics will make a great business economist. Philosophical
and historical knowledge would lend a helping hand.
Decision science is also used in business administration. Decision science offers the possibility
to analyse the effects of alternative behavioural policies. Use optimisation techniques such as
differential calculations and mathematical programming to determine the optimal course of
action for decision makers. Using econometric methods (i.e., applied statistics), decision-
makers can develop models that estimate the relationships between variables of interest and
predict their values.
Business Economics
13
5. Management decision problems comprised three elements. Pick one which is not an
element.
a) Alternatives
b) Profitability
c) Objectives
d) Constraints
6. Implicit cost is_____.
a) Economic profit minus explicit cost.

b) Business profit plus economic profit.
c) Economic profit minus business profit.
d) Business profit minus economic profit.
7. The total revenue from sales divided by the number of quantity sold is_____.
a) Average revenue
b) Total revenue
c) Marginal revenue
d) Incremental revenue
8. Which one of the following is not a macroeconomic concept _____.
a) Business cycle
b) National income
c) Government policy
d) None of these
Business Economics
14
1.1.3 Decision-making and other forward planning
Business economists with a deep knowledge of theory and analytical tools for business informatics
are in a respected position in the workforce. Business economists are close to policy making.
They have the expertise and the latest technology to analyse internal and external processes of
the company. With the inputs from these, decisions related to finance, price, sales and labour
are evaluated keeping in mind the objective of the organisation.
The role of the Business Economist in internal control includes a wide range of areas such as
production, sales and inventory planning for the company.
The business economist’s most important role is in forecasting demand, as analysis of business
situations is essential to the success of a business. It associates general economic forecasts
with specific market trends to provide short-term forecasts of general business activity. Most
companies need two predictions. One is a short-term (3 months to 12 months) and the other is a
long-term forecast that represents a period snapping more than a year.
One must always be vigilant to assess consumer preferences and changes in preferences. One
needs to evaluate the potential of the market. That is to be familiar with market research. The
market research will provide companies with information about their current market position and
future trends in the industry. A well-informed business economist can help companies
improve the product offerings, new product policies, and promotional strategies.
The fourth task is conduct performance analysis of the branch office. This includes project
evaluation and feasibility studies at the organisation level. In other words, you need to be able
to assess whether it is wise and beneficial to carry out a project based on cost-benefit analysis.
Business economists need to be familiar with investment valuation methods. At the external level,
economic analysis is about analysis of competition, domestic and international sales potential,
general business environment and more.
Another feature is security management. This is very important for defence-oriented industries,
energy projects, and nuclear power plants where safety is of paramount importance. This means
that production and business secrets regarding technology, quality, and other relevant facts. This
security is further needed for important strategic and defence-oriented projects in the country.
Business economists must be able to handle these issues.
Another function is advisory in nature. An advisory's advice is much sought in all production
and trade-related areas. In the management pyramid, business economists line up with
executives and policy-makers.
The managerial economist must have sound theoretical knowledge to face the challenges
in everyday affairs. The economist Baumol refers this as a role of managerial economist: “A
managerial economist could be an important member of the management by doing economic
analysis, he becomes an effective model builder and he develops tools and techniques which
he can use to address the issues of the firm in more demanding, probing and a deeper way”.
Business Economics
15
9. Business economics is very similar to _____ Economics.
a) National
b) Managerial
c) Industrial
d) Micro
10. Baumol’s model is otherwise called _____.
a) Price disease
b) Income model
c) Cost disease
d) Expense model
11. The famous book on economics “An Enquiry into the Nature and Cause of Wealth of
Nation” was written by ____________.
a) Alfred Marshall
b) Adam Smith
c) J M Keynes
d) AC Pigou
12. Baumol considers managers are more interested in maximising ___ rather than
profit.
a) Quantity
b) Sales
c) Price
d) Customers
Business Economics
16
Summary
Terminal Questions:
1. Distinguish between microeconomics and macroeconomics.Explain.

2. Explain the nature of economic laws.
3. Briefly explain economic dynamics
4. “Managerial Economics well integrates economic theory and business practice to
facilitate better decision-making and forward planning”-- Explain.
Business Economics
17
Answer Keys
Question No. Answers
1 C
2 A
3 D
4 A
5 A
6 D
7 A
8 D
9 B
10 C
11 B
12 B
Activity
Activity type: Offline Duration: 40 Minutes
Considering the differences between economics and business economics,

you learnt above, distinguish the role of economists and that of managers in anyone of
new generation banks, preferably HDFC bank.
Glossary
• Inflation: An increase in the general price level of goods and services in an

economy.
• Micro Economics: The study of individuals, households and firms’ behaviour

in decision-making and allocation of resources.
Business Economics
18
Bibliography
e-References:
https://content.kopykitab.com/ebooks/2014/06/3212/sample/sample_3212.pdf
https://www.ddegjust.ac.in/studymaterial/bba/bba-103.pdf
https://siiet.ac.in/wp-content/uploads/2019/05/CSE-III-IIMEFA-NOTES.pdf
Textbooks
Dean, J. (1951). Managerial economics (1st ed.). New York: Prentice-Hall.
Graham, P., & Bodenhorn, D. (1980). Managerial economics (1st ed.). Reading,
Mass.: Addison-Wesley Pub. Co.
Samuelson, W., & Marks, S. (2006). Managerial economics (1st ed.). Hoboken,
NJ: John Wiley and Sons.
Image Credits
Fig. 1: self-generated
Fig. 2: self-generated
Keywords
Recession
Demand Outlook
Pricing
Managerial Economics
Business Economics
19
Business Economics
Module 1
Unit 2
Fundamental Principles of
Business Economics
Business Economics
20
Business Economics
21
Aim
To familiarise students with the usage of various principles in decision-making.
In this unit, you will be able to:
• State various principles involved in business economics
• Describe their contribution towards managerial decision-making
Learning Outcomes
At the end of the unit, you are expected to:
• Identify the principles behind business economics
• Recognise the impact of each principle on business decisions
Business Economics
22
Fundamental Principles of Business Economics
The principles which are core of business economics contribute in a significant manner towards
the larger scope of economics. These have become in a way tools of managerial economics
practised in the modern times. They are:
Principles
I. Opportunity Cost
II. Incremental
III. Time Perspective
IV. Discounting
V. Equi-marginal
I. The Opportunity Cost Concept:

Opportunity cost is the benefit foregone which could have been accrued from the second-best
alternative. As human beings, we always tend to choose the best alternative as per our own
valuation.
Let us consider there are three alternatives:

Alternative 1-benefit - Rs10,000
Alternative 2- benefit - Rs 5,000
Alternative 3-benefit - Rs 2,000
Normally, we tend to choose alternative 1 since it yields maximum benefit. So, opportunity
cost is Rs 5,000, next best benefit one foregoes from the second option. If one had not gone
for the first option, what would one have done? We would have chosen the second alternative
which would bring us Rs 5,000. So, by going for the best option 1, we forego the benefit from
the second-best option. This benefit Rs 5,000 is the opportunity cost of one’s present decision.
The reason why we give importance to opportunity cost is:
• To have some idea about the risk we take or what minimum we must earn in the venture
we get into.
• To produce one, we must forego another one. Because resources are scarce, we
cannot produce all, and so, we are forced to go for a choice.
Managerial economists use opportunity cost to:

• Decide prices of goods.
• Calculate remuneration for the factors.
• Allocate factor resources properly.
Business Economics
23
1. Mr. Kevin charges ₹400 an hour as a lawyer and is to pay ₹1,000 to paint his office.
If he has to do the work himself, he needs five hours. The opportunity cost of doing the
work himself is:
a) 400
b) 1,000
c) 4,000
d) 2,000
2. Mr David wants to hone his skills further for two years. So, he considers quitting his
day job. What would be the opportunity of his idea?
a) Cost of the material for the period

b) Cost of the training for the period
c) The lost income for period
d) Further training
3. The opportunity cost is the benefit from _______ which is sacrificed for the preferred
one
a) All the items
b) The next best alternative
c) The least important alternative
d) Everything except the item that was chosen
4. A firm can use all its resources to produce 40 videos or 200 shoes. The opportunity
cost of producing a video is:
a) 20 cents.
b) Rs 5
c) 5 shoes
d) 1/5 of a shoe.
Business Economics
24
1.2.2 The Incremental Concept:
Incremental concept is almost as similar as marginal cost and marginal revenues of economic
theory.
Incremental cost and incremental revenue are two important things to discuss here. Incremental
cost is new rise in total cost and incremental revenue is new rise in total revenue because of the
new decision, taken in the firm.
A decision will become profitable if:
(i) The incremental revenue is more than incremental cost.
(ii) There is a greater fall in some cost than the total rise in other costs.
(iii) There is a greater rise in some revenue component than the total fall in
other revenue components.
(iv) The cost reduction is more than the revenue.
Example:
Some entrepreneurs are of the view that they should earn profit on every order they undertake
to have a good overall profit. This results in not taking the orders that do not meet all costs plus
some return margin. It prevents short-run profit.
Let us see this with illustration:

If the new order brings in extra revenue of Rs. 18,000, the breakup of cost will be as below:
Raw materials Rs. 6,000

cost of Labour Rs. 5,000
Overhead Rs.5,600
Selling and other

administrative expenses Rs. 3,400
Full Cost Rs.20,000
Business Economics
25
At the first look this may appear to be unprofitable since it brings a loss of 4,000 (20,000-16,000).
But the scenario will be different if the company has idle capacity. Here if the order adds only
2,000 to overheads and 4,000 to labour cost because some workers (who are idle and already on
the payroll) can be made to work without any additional cost and no change in selling and admin
cost,
The actual incremental cost is
Overheads 2,000
Labour cost 4,000
Material (same) 4,000
Total incremental cost 10,000
Now the profit is 6,000 (16,000-10,000). Hence, the order can be accepted.
This incremental concept is mainly used by the progressive firms. But there are some limitations
as given here:
(a) Since observed behaviour of the firm is always varying, this principle cannot be generalised.
(b) The result may vary based on existence of idle capacity.
(c) The concept holds true for a short period.
Business Economics
26
5. The total cost of 100 units is Rs. 6,000 and that of 101 units is Rs. 6,070, then the
rise of Rs. 70 in the total cost is _________.
a) Prime cost
b) All variable overheads
c) Marginal cost
6. While computing the profit in marginal costing _________.
a) Total marginal cost is deducted from total sales revenues

b) Total marginal cost is added to total sales revenues
c) Fixed cost is added to contribution
7. Salary is best categorised as _________.
a) fixed cost
b) variable cost
c) total cost
d) Marginal cost
8. As the production increases, fixed cost per unit _________.
a) will remain constant

b) increases
c) decreases
d) increases then becomes constant
Business Economics
27
1.2.3 Time Perspective Concept:
Alferd Marshal introduced this economic theory. This concept says that consideration
must be given to both short-run and long-run impact of the decision. It is difficult to
maintain the right balance between short-run and long-run effects on revenue and cost.
In the short run, the firm can change its output by changing variable factors not by changing
size (fixed factor). Because, for a short-run period, the firm cannot change its operational
capacity. Over a period, the organisation can change its size (fixed factor), and in turn change
the output.
In the short run, average cost could be high or even less than the AR (average revenue).
Whereas in the long run, average cost is equal to average revenue. Hence in the short run,
profit or loss will be the case but in the long run, either more profitable or less profitable will be
the case. Because increase in the operational capacity will lead to reduction of average.
Illustration
With the help of following example, we will see how failure happens when the firm does
not distinguish short-run and long-run considerations.
A company, suppose, with an idle capacity (temporarily) has got an order for 15,000 units.
Here the client can pay only Rs 5 per unit equal to Rs 75,000 for a lot but no further. Increase
in the cost, in the short run (excluding fixed cost) is Rs 4. So, the contribution (price-v.c) per unit
is Rs 1.
If the firm accepts this order, the following would be the consequences:
In the long run, the company may not attract business with higher contributions, may
be because other clients could also ask for similar or lesser price.
In the industry, the company’s brand image may be affected.
Though there is a gain in the short term, the firm may not fully offset long-run effect of
pricing below the full cost.
Economists Haynes, Mote and Paul cite a company whose quotes will never under the full cost
due to two reasons:
The long-run effects of this kind of pricing cannot be offset by any short-run gains.
Reduced quotes for some selected customers will have the adverse effect on the
company’s image.
For these reasons, the managerial or business economist should consider revenue and cost
weighing relevant time periods.
Business Economics
28
9. Contribution is _________.
a) selling price –fixed cost

b) selling price- variable cost
c) total cost- marginal cost
d) total revenue-Profit
10. Contribution consists of _____.
a) revenue and cost

b) fixed cost and variable cost
c) profit and variable cost
d) profit and fixed cost
11. The difference between variable cost and fixed cost is important only in the _____.
a) long run
b) short run
c) medium term
d) mixed period
12. One of the following is not the purpose of short-term Demand forecasting:
a) Making a suitable production policy

b) To reduce the cost of purchasing raw materials and to control inventory.
c) Deciding suitable price policy
d) Planning of a new unit or expansion of existing unit
Business Economics
29
1.2.4. Discounting Concept:
• Discounting and compounding are two processes used to find present value and
future value respectively. Here, we will discuss about discounting.
• Discounting is the process by which present value of something which you get in
future, say after one year.
DID Have you heard the following phrase?

YOU
KNOW ‘The value of a rupee today is more than that of tomorrow’.
It is simply because money can earn a return in the period.
The mathematical technique to compute present value is called

‘discounting’. That is, the present value of Rs.1,000 will be reduced to
₹909 in a year, if the discount rate is 10%.
To make the point, consider the cases, you are given a choice of ₹1,000 today or ₹1,000 next
year. Obviously, you will select ₹1,000 today. this is the case because the future is uncertain.
Suppose you have the possibility to earn 10% return in a year.
You may be indifferent to ₹1,000 today and ₹1,100 next year which indicates ₹1,100 has the
present worth of ₹1,000.
Therefore, to make a decision regarding any investment, calculating its ‘net present value’ is
required.
Without the ‘discounting’ in turn of the present value of return, we cannot conclude the cost of
investment is worth or not.
In the investment planning or capital budgeting, managerial economics will use this discounting
to take a decision.
Business Economics
30
The formula given below is used to compute present value:
PV = FV/1+i
Where:
PV = Present value
FV = Amount received in future
i = Rate of interest or discount rate
Example
PV = 100/1+0.05 = 100/1.05 =Rs. 95.24
If the period is 2 years:
that is present value of money received 2 years after
PV = FV/ (1+i)2
For n years PV = FV/ (1+i)n
Example
What is the present value of ₹1,000 received in two years if the interest rate is
12% per year discounted semi-annually
1,000 / (1 + 0.12/2) 2*2 = ₹792.09
12% per year discounted quarterly
1,000 / (1 + 0.12/4) 2*4 = ₹789.41
12% per year discounted daily
1,000 / (1 + 0.12/365) 2*365 = ₹786.66
The concept has been used in investment and financial planning. Banks use this for determining
home loan EMIs. Financial planners use this to calculate the returns from insurance policies,
bond yields, and mutual fund plans.
Using the discount rate, we can also measure the effect of inflation relating today’s price and past
price.
Here inflation of the time in the economy is used as discount rate.
The same formula can also be used to find real value.
Real value= today’s value / (1+i)n
For example, a study found that the inflation rate (by WPI) in the country seems to have averaged
6.07% annually for some 21 years.
When we substitute these values in the formula
for i=6.07 (inflation rate cum discount rate), n=21, today’s value or current value=100, we
get the value of 29.
The interpretation is that the value of Rs 100 today is equal to Rs29 some 21 years ago. That is
what we can buy today for Rs 100 what could have been bought by Rs 29 some 21 years before.
Business Economics
31
13. The minimum return that an investor should get while investing in a project is selling
price-fixed cost.
a) Required rate of return

b) Bond rate
c) Inflation/discount rate
d) Compensation
14. One of the following is least likely to be a right interpretation of interest rates:
a) The rate required to calculate PV

b) Opportunity cost.
c) The maximum rate of return an investor must receive to accept an investment
d) Discount rate
15. Present value of ₹100 received two years hence, if the prevailing yield is
10% per year when it is discounted two times in a year (semi-annually):
a) 933
b) 823
c) 983
d) 776
16. Mr A is buying a house. He expects he can pay monthly payment (EMI) of ₹1,500 for
a period of 25 years with an interest rate of 6.8%. If 10% down payment he pays, the
most he can pay is closest to:
a) ₹216,116
b) ₹240,129
c) ₹264,706
d) ₹294,706
Business Economics
32
1.2.5 Equi-Marginal Concept
This is also called principle or concept of maximum satisfaction.
The law
“The available resources (time, money, etc) should be allocated
between the alternative options in such a way that the marginal
productivity gains (MP from all the options are equalised.”
In Marshall’s words, “if a person has a thing which he can put to several
uses, he will distribute it among these uses in such a way that it has the
same marginal utility in all.”
Consider an example where the students having limited number of days, to study the available
subjects during the examinations for getting good grade.
They have 18 days to go for exam and have 6 subjects to complete. Here for each subject,
numerically they need to allot 18/6=3 days. But they will not do that. For, difficult subjects they
will allot more than 3 days and less than 3 for easy subjects.
Here they may not allot 3 days for each subject, they may allot more days for difficult subject
and less days for easy subjects
This concept also explains behaviour of a consumer when he consumes more than one
product.
The law says, “the consumer spends his limited income on different commodities in such a
way that last rupee spent on each commodity yield him equal marginal utility to get maximum
satisfaction’’.
This can be written in an equation as:
MUA / PA = MUB / PB = … = MUN / PN
MU’s - marginal utilities for the commodities
P’s - prices of the commodities.
Business Economics
33
Example
Equi-marginal principle is applied in the allocation of the resource in the way of
production. Example: a farmer who has four different agricultural farms, viz.,
1. Chilli
2. Guava
3. Flower
4. Corns
Farms Employees
Chilli 35
Guava 19
Flower 23
Corns 23
Total 100
The above four agricultural farms are in the total 60 acres. Each farm is in the 15 acres. The farmer
has limited 100 employees to be employed in the four farms. In general, 100/4=25 employees
must be allocated for each farm. But guava needs fewer employees, whereas chilli farm requires
greater number of employees. Flower and corn farms require average number of employees.
This principle is used in investment decisions and research expenditure

allocation.
For a consumer, this principle is useful to allocate her/his money in various goods in
such a way that marginal utility she/he derives from using each good is same.
For a manufacturer, resources are allocated in such a way that marginal product of
each input remains the same.
Business Economics
34
Example
A consumer wants her/his entire income to be spent on two fruits Apple and Orange. The price of
Apple and Orange is Re 1 each. To get maximum satisfaction in what quantity each of the fruits
she/he should buy?
Apple Orange
Solution Total utility Total utility

1 25 30
2 45 41
3 63 49
4 78 54
5 88 58
6 92 61
Apple Orange
Marginal Marginal
Total utility utility MUA/PA Total utility Utility Mu0/Po
1 25 25 25 30 30 30/1=1
2 45 20 20/1=20 41 11 11
3 63 18 18 49 8 8/1=8
4 78 15 15/1=15 54 5 5
5 88 10 10 58 4 4
6 92 4 4 61 3 3
Business Economics
35
See
MUA/PA = MUO/PO = 4, at this point the consumer will get maximum satisfaction, so 6 number
of apples and 5 no of oranges she or he can buy.
From apple, the total utility is 92, from orange, the total utility is 48, so totally she or he will get
92+58=150, in this combination he will get the maximum utility.
In the other combination, e.g., 5 apples and 6 oranges total utility will be 88+61 = 149 only.
Business Economics
36
17. What happens to total utility when the marginal utility becomes zero?
a) Laws of return
b) Maximum
c) Minimum
18. A consumer is said to be in equilibrium when the marginal utilities (MU) are
____.
a) Minimum
b) Increasing
c) Equal
d) Highest
19. When MU is positive, the total utility ____.

a) Decreases
b) Is at max
c) Remains same
d) Increases
20. What does utility generally mean?
a) useful
b) necessity
c) wants
d) satisfaction
Business Economics
37
Risk and Uncertainty:
Decisions by the management are actions taken today which will bring results tomorrow.
The results are, however, hard to predict. The future, as it goes, is uncertain and involves risk.
The uncertainty may be caused because of the changes in business cycle, nature of economy,
and sometimes changes in Government policies.
Firms are operating under various uncertainties of production, market prices, competitors,
etc. Under uncertainty, the consequences of any move of the firms may not be known.
But management must continue to go ahead with the risk of taking decisions in changing
economic conditions. In a way, they practice what is called ‘best way to create the future is to
create it’.
Uncertainty arises because of the dynamic changes in the industry, market, and the
economy. Hence, with no reasonable accuracy on the data of revenue and cost, the firms must
move ahead like groping in the dark.
External environment may be hard to understand. But internally, products or the firms must be
able to predict the cost benefit data and design the policies for the output and price.
Through the subjective probability, managerial economists try to gauge uncertainty.
This method requires formulation of definite subjective expectations about environment, cost,
and revenue. But here, time horizon, rate of change of environment, risk appetite, etc., will
influence the probabilities.
Business Economics
38
Summary
Incremental cost denotes change in total cost, whereas incremental revenue means
change in total revenue resulting from a decision of the firm.
The time perspective concept states that the decision-maker must give due
consideration both to the short-run and long-run effects of his decisions. Having the
right balance between the long-run and short-run is the major issue.
Opportunity cost is the benefits from the next best option we choose to forego by
opting for the best.
Equi-marginal principle says that an input should be allocated in such a way that the
value added by the last unit is the same in all cases.
The value of rupee today is worth more than a rupee tomorrow. That is, the value of
money decreases as time goes by.
Terminal Questions
1. Write and justify the principles in the descending order of importance in
managerial decision-making.
2. Discuss the applications of equi-marginal and opportunity cost principle.
3. Describe your views on quantifying risk and uncertainty.
Business Economics
39
Answer Keys
Question No: Answers
1 d
2 c
3 b
4 c
5 c
6 a
7 a
8 c
9 b
10 d
11 b
12 d
13 a
14 c
15 b
16 b
17 b
18 c
19 d
20 d
Business Economics
40
Activity
Activity Type: Offline Duration: 40 Minutes
Pick up a plastic cup and a carton of chocolate milk (pint or larger). Then pour a half a cup
(you can use other amounts depending on your situation). After drinking the first half cup pour
another half cup. Having finished drinking the second half cup of milk, compare the satisfaction
you have got by consuming the second half cup of milk to the first half cup of chocolate milk
they started with. The comparison has several choices to make the decision and application
and data collection more manageable.
Compared to the previous half cup of chocolate milk you consumed this half cup of
Milk gave you ___________ than the previous half cup of chocolate milk.
More satisfaction [ ] same satisfaction [ ]
A little less satisfaction [ ] A lot less satisfaction [ ]
Glossary
• Opportunity cost: As the worth of a missed alternative opportunity in accounting

also. The concept is somewhat the same in economics as well as accounting.
• Variable cost: A corporate expense that changes in proportion to how much a
company produces or sells.
• Marginal utility: The additional benefit derived from consuming one more unit of
a specific good or service.
Bibliography
Text Books
• Dean, J. (1951). Managerial Economics (1st ed.). New York: Prentice-Hall.
• Graham, P., & Bodenhorn, D. (1980). Managerial Economics (1st ed.). Reading,
• Samuelson, W., & Marks, S. (2006). Managerial Economics (1st ed.). Hoboken, NJ:
John Wiley and Sons.
e-References
• https://www.managementstudyguide.com/principles-managerial-economics. htm
• https://www.yourarticlelibrary.com/managerial-economics/managerial-econom
• ics-6-basic-principles-of-managerial-economics-explained/28361
• https://www.washburn.edu/sobu/dnizovtsev/200P01_OCans.html
Business Economics
41
Video Links
Topic Link
Managerial Economics https://www.youtube.com/watch?v=3B-I--MN66M
Business Decision https://www.youtube.com/watch?v=4RvfYNZRbt8

Making
Keywords
Incremental cost
Equi-marginal principle
Opportunity cost
Discounting concept
Business Economics
42
Business Economics
Module 2
Unit 1
Meaning, Definition, and

Law of Demand and
Exceptions
Business Economics
43
MODULE 2:
Demand Analysis
Module Description
Companies use demand analysis techniques to determine if they can successfully enter a market
and generate expected profits to expand their business operations. Demand analysis is the
process of understanding the customer demand for a product or service in a targeted market. It
also gives a better understanding of the high-demand markets for the company’s offerings,
using which businesses can determine the viability of investing in each of these markets. Here,
you will study about determinants, law of demand and exceptions to the law of demand. This will
help you to understand the product and its place in market including demand schedule and
function.
The elasticity of demand concept helps the management to take a decision that notifies how
much price rise will not lead to reduction in demand or how much price reduction will ensure the
net positive revenue and so on. Another important area where companies’ management finds it
difficult to estimate the optimal quantity of production. This, to some extent, is addressed by the
technique or process called demand forecasting. As the organisation becomes good at demand
forecasting methods, it can manage its resources effectively. The reason is that when you can
rightly forecast the demand, you will tweak your production accordingly. This way, no extra
resources will be kept locked, or lack of resources will not disrupt production. Some methods
such as trend projection, sales force composite, Delphi method, econometric, market
research have been extensively discussed here.
Business Economics
44
Table of Contents
Unit 2.1 Meaning, Definition, and Law of Demand and Exceptions
Aim ----------------------------------------------------------------------------------------- 46
Instructional Objectives --------------------------------------------------------------- 46
Learning Outcomes -------------------------------------------------------------------- 46
2.1.1 Meaning and definition -------------------------------------------------------- 47

Self-Assessment Questions ----------------------------------------------- 48
2.1.2 Determinants of demand ------------------------------------------------------ 49
2.1.3 Law of and exception to the law of demand ----------------------------- 55
Summary --------------------------------------------------------------------------------- 61
Activity ------------------------------------------------------------------------------------- 61
Terminal Questions -------------------------------------------------------------------- 62
Answer Keys ----------------------------------------------------------------------------- 62
Glossary ----------------------------------------------------------------------------------- 63
Bibliography ------------------------------------------------------------------------------- 63
e-References ------------------------------------------------------------------------------ 63
Video Links ------------------------------------------------------------------------------- 63
Keywords ---------------------------------------------------------------------------------- 63
Business Economics
45
Aim
To explain the determinants of demand, exceptions and the law of demand.
After completing this unit, you will be able to:
Explain the determinants of demand
Infer the law of demand
Distinguish the exceptions
Learning Outcomes
Classify the determinants to the law of demand
Differentiate the exceptions from the law of demand
Business Economics
46
2.1.1 Meaning and scope
Demand is defined as a quantity of a product one is willing to buy at a specific point of time.
Demand refers to individuals’ willingness or their effective desire to buy a commodity or service
supported by their purchasing power. Effective desire is the quantity of the commodity or
service that is purchased at a given price from the market at a given time.
The terms demand, want, desire, etc., are used interchangeably almost frequently. Let us
understand the meaning of each word with the help of an example. Suppose an individual
wants to purchase a personal computer for work. She/he has the purchasing power, but she/he
is not willing to spend the money for it. This is called want. If she/he is also ready to spend, then
wants become demand.
Two variables, one is purchasing power, another one is willingness to spend, determine
whether desire becomes want or demand. If the individual has the purchasing power to
purchase the computer but is not unwilling to sacrifice his/her money, the desire becomes a
want. However, if the individual is willing to sacrifice his/her money, the desire becomes a
demand. Hence the demand is the quantity of a commodity or service that the buyers are
willing and able to purchase at a given price at a given point of time. And the quantity
demanded is not always the same as the quantity bought. This may be due to various factors
including that the goods or service demanded may not be available in the required quantity.
Business Economics
47
1. Two factors required for a demand____.
a) Money and desire

b) Willingness and purchasing power
c) Sacrifice and money
d) Unwillingness to sacrifice
2. Demand is a ____.
a) Price
b) Purchasing power
c) Quantity
d) Price and time
3. Desire becomes a want when there is ____.
a) No money
b) Ability to spend
c) No quantity
d) Willingness to spend
4. When consumer has no money but willingness, it is ____.
a) Part-demand
b) No purchasing power
c) Not a demand
d) Demand
5. Want becomes demand when there is a ____ .
a) Part-demand
b) Actual spending
c) Desire
d) Quantity reduction
6. the consumer may have the ability to spend but not ready to____is not a
demand
a) Reduce the quantity

b) Save the money
c) Sacrifice the money
d) Accumulate the good
Business Economics
48
2.1.2 Determinants of demand
• The price of the product or service
• Real Income of consumers
• Price of related (substitute/
complementary) goods individual
• Consumer’s tastes and preferences
• Buyer’s expectation of goods future price
• Distribution of income
• The climate broader determinants
• Govt polices
The individual demand arises from the individual consumers whereas market demand is the total
demand for a product or service. The buying of a product by an individual depends on various
factors such as price of the product, his income, the tastes, price of the substitutes, and so on.
These factors determine the demand of the product. Let us see how each factor affects the
demand of the product.
Individual determinants
A. Price of the product
The price and the quantity demanded are inversely related. This means that when the price of
the goods or service rises, the demand for the product falls and vice versa.
B. Income of the consumer
The demand for the product is directly related to the income of the consumer. As the income
increases, the consumer will try to buy more in numbers, so the demand will also increase.
There are two kinds of incomes: one is real income; another one is nominal income. Nominal
income is the income which is in name only. For example, last year X earned an income of Rs
5,000; this year her/his income is Rs 5,500. It just mentions what is on the name, just the numbers,
quantity. It is not considering about the value of the money.
Value of the money may increase or decrease in course of time due to the factor called inflation.
When inflation is higher the value of the money will be lesser, when the inflation is less in the said
period, the value of the money becomes greater.
We will understand this with the case given here. The income has grown by 10% and becomes
5,500. In the same period if the inflation is more than 10%, say 15%, then value of the real income
is 4782 [3500/ (1+0.15],
using the formula,
Real income = nominal income / (1+inflation rate)
Business Economics
49
So, the real income has fallen to 4,782, not 5,500, from 5,000.
On the contrary, if the inflation is lesser, say 7%, then the real income is 5,093, increased from
5,000.
So, literally, as the real income increases, the demand for the goods will increase. But we mostly
mention nominal income though real income is what is really meant.
As we generalise the relationship, some exceptions, based on the type of goods, also ought to
be shown here.
There are three types of goods namely normal goods, Inferior goods and inexpensive goods.
Each type behaves differently with the rise of income.
Normal Goods: The demand for these goods rises as the income of consumers increases.
Example: clothes, mobile, furniture, etc.
Here too, the concept of marginal utility will apply. Initially, the goods demanded will rise due the
increase in income. Because of the marginal utility, the utility of goods becoming lesser than the
previous one, demand will reduce, then will drop to zero.
Luxury goods: This is a sub class in the normal goods. When the percentage change of income
is higher, then there will be a rise in demand for luxury goods.
Example: Car, mobile, jewellery, etc.
Inferior goods: The demand for these goods falls as the income of the consumer increases.
Example: Cheaper grains-barley, maize. Here as the income increases, people will start
moving up the value chain for high quality grains. These are called Giffen goods in
economics.
Inexpensive goods: These are necessary or necessity goods. These goods and services are
purchased by the consumers irrespective of the change in their income. The concept called
elasticity comes here.
These goods are inelastic, that is the demand for these goods are less sensitive to the income.
In other words when there is a rise or fall in income, the demand for these goods will not change
much. The income elasticity of these goods is between zero and one, mostly near zero.
Example: salt, soap, match box
Business Economics
50
C. Price of related goods:
Complementary goods: a good is a complementary good without which the main good cannot
be used. That is, it is a good that is bought together with the chief good.
When the price goes up on one, the demand goes down for the other good. When the price of
petrol goes up, the demand for car will fall.
Example: car and petrol, tea and sugar, DVD and DVD player, Mobile phone and Sim card
Price of petrol
Qty
(car)
Fig. 1: Price of related goods
Substitute goods:
Substitute goods are those that can be used in place of another. Both serve the same purpose.
Price and quantity will behave opposite to complementary goods. Here when the price of one
goods goes up, the demand for other goods increases.
Price of good(RS)
Qty of substitute
Fig. 2: Substitute goods
D. Tastes and preferences: The tastes and preference of the people for a specific goods are
a function of changes in fashion and advertisements. So, this often changes. That is, people or
consumers’ liking/disliking for the product always changes. When they like the product more, the
demand for the goods will increase.
Similarly, when the liking for the product falls, the quantity demanded will be lesser.
E. Buyers’ expectation of goods’ future price: If the people think that the price of goods will rise
more in the future, they will start buying the goods more now, that will lead to the rise of demand. v
When the perception is that the price of goods will remain same or fall in the future, the demand
will not see any change or fall.
Business Economics
51
Broader Determinants
F. Distribution of income: Distribution of income in an economy is also a factor which determines
the demand for goods. When the distribution is even or equal, the propensity to consume (Keynes’s
idea) will be high which will lead to good demand for the goods. If there is an unequal or uneven
distribution, that is, the wealth of the society is accumulated with the very few, the propensity
to consume will be lesser. Rich people may have more money but their propensity to consume
is less. That is to say, the poor’s propensity to consume may be higher but they may not have
enough money. These will lead to lesser demand for the goods.
When there is a system of levying progressive taxes (more the income, higher the slab), money
collected as tax will be spent on creating employment to the poor people. This will make the
distribution of income equal. This will transfer the purchasing power from the rich to the poor. With
higher purchasing power, the poor will buy more goods. So, the demand will be more for these
goods. At the same time because of this tax system, rich people’s purchasing power will decline.
This will lead to lesser demand for the goods which are generally purchased by the rich.
G. The climate: The climate condition of an economy or region also determines the demand for
the product. The climate condition could be dry, cold, hot and humid. Example: In the monsoon,
demand for umbrella would be higher and in the summer the demand for air conditioners/air
coolers would be higher.
H. Govt policies: Policymaking is the prerogative of the Government and government-controlled

central banks. RBI does that in India. Through policies, the government gives signals to the
economy. Due to these policies, some goods will see a great demand; some see the
indentation in their demand. Some important policies are fiscal policy and monetary policy
which give signals through budget, tax rate/slab, money supply, bank rate and interest rate.
For example, if the govt reduces the tax on any good, the price will fall. As per the law of demand,
demand will increase for those goods and vice versa. In the same way, interest rate-sensitive
sectors like automobile and real estate will do better when repo rate, in turn interest rates, are
lowered by RBI and vice versa.
Business Economics
52
7. To calculate real income from nominal income__________is used.
a) Inflation
b) Deflator
c) Deflation
d) Nothing
8. When there is a higher inflation, the value of the money___________.
a) Increases
b) Remains same
c) Falls
d) Value and quantity same
9. Demand is dependent on_________ income.
a) Nominal
b) Real
c) National
d) Inflation (CPI)
10. The goods which will have an increase in the demand proportional to increase in
income are __________.
a) Luxury goods
b) Normal goods
c) Inferior goods
d) Giffen goods
Business Economics
53
11. When there is more rise in income, the demand for_______will
rise.
a) Luxury goods
b) Normal goods
c) Inferior goods
d) Giffen goods
12. Fiscal policy is the prerogative of ___________.
a) Governor
b) Finance minister
c) Cabinet
d) FICCI
13. Demand is_______when distribution of income is good.
a) Equal
b) Less
c) More
d) Unaffected
Business Economics
54
2.1.3 Law and exception to the law of demand
Law of demand
Law of demand says, “as the price falls, the quantity demanded will be more”. In other words,
price and quantity are inversely related.
Demand ∝ 1/price
In economics, when it comes to supply and demand curves, “shifts” and “movement” are im-
portant concepts.
Demand schedule
It is a table which shows the demand of a particular commodity at different prices.
Market demand for apple
Total
Price DemandBy DemandBy market demand
Per kg “A’ “B’ (A+B)
70 3 5 8
60 4 6 10
55 5 8 13
50 6 9 15
Movement
A movement means a change along a curve. On the demand curve, a movement means a change
in both price and quantity demanded from one point to another point on the curve. Here the
demand and price relationship remain constant. In other words, a movement takes place when
change in price only causes a change in the quantity.
In the diagram given below, any two points on curve D1 or D2 is a movement:
Business Economics
55
P D1 D2 S
P 2 ------------------------
-----------------
P1
---------------------
--------------
Q1 Q2 Q|
Fig. 3: Curve of movement
A shift
A shift in a demand curve happens when the quantity demanded changes even when the price
remains the same. Shifts in the demand curve suggest that the original demand price relationship
has changed, meaning that demand is affected by factors other than price.
A demand curve shifts from D1 to D2. This is what is called shift.
Demand function
Already we established how demand varies with price. We will represent the same
in mathematical form:
Demand ∝ 1/price
D=constant Y * (price P)
Since they share inverse relationship,
D= -y*P
for commodity ‘a’, the demand is
Da = -y Pa
When we include intercept ‘x’, then the equation becomes
Da = x-y Pa
If we know the value of ‘x’ and ‘y’, the demand for a commodity at any given price can be
computed using the equation given above.
Business Economics
56
For example, let us assume x = 20, y = 2 and Pa= 3.5
Substituting these,
Da = 20-2 (3.5) = 13 units
Demand schedule using linear equation Da = 20-2 (Pa)
Commodity ‘a’
Quantity demanded price level
16 2
13 3.5
12 4
8 6
when this demand schedule is drawn on a graph
16 x
x
12 x
8 x
2 4 6
Fig. 4 Demand schedule graph
Exceptions to the law of demand

So far, we studied that there exists an inverse relationship between the price and the demand
of a product.
However, there are some exceptions. With a fall in the price, in some cases, the demand also
falls and with the rise in the price, there is a rise in demand as well. These are paradoxical and
considered as exception to the law of demand. That exception to law of demand means the
cases where law of demand is not applicable.
Business Economics
57
Here demand curve is upward sloping
Demand
Fig. 5: Demand curve
Exceptions to the law of demand:

Giffen Goods
Giffen good is a commodity whose consumption increases when price increases. So, it is an
exception to the law of demand. In these goods, out of two effects, the income effect dominates
over the substitution effect
DID In the Irish Famine (1845), due to plant disease potato crop failed, and
YOU
the price of potatoes shot up heavily. Despite the increase in the price,
KNOW people moved away from luxury products and their consumption of
potatoes increased.
Goods of distinction/Veblen goods

These commodities, named after the economist Thorstein Veblen, are purchased by the upperclass
people that distinguish themselves from others in the society.
Example: antique goods, diamonds, vintage cars and rare paintings.
At the time of Crisis:

During crisis such as war and famine, people tend to purchase in huge quantities thinking that
they may not get the product later, or price will be much higher in future. In some cases, they will
try to buy and stock which will further accentuate the price of commodities in the market. So, they
demand more as the prices rise.
And at the time of depression too, a fall in the price of commodities make people think that the
goods have become cheaper. At these times people may not have money as well to buy goods.
Business Economics
58
And at the time of depression too, a fall in the price of commodities make people think that
the goods have become cheaper. At these times people may not have money as well to buy
goods.
Other cases:
When the future price expectation is high, people buy more even at the current high prices.
Example: speculation
This is subject to the peculiar tendency or ignorance of the people that high-priced goods are
better in quality than low-priced goods.
Some goods have become necessities though they are non-necessities.
Example: television, fridges, cars. The demand for these goods is high even at high prices.
Business Economics
59
14. Change in demand price relationship is shown in _______.
a) Law of demand
b) Exceptions to the law
c) Shift of demand curve
d) Movement
15. In demand schedule the difference in quantity is shown in _______.

prices
a) Increased
b) Decreased
c) Various
d) Samee
16. The negative sign in the demand function denotes _______.
a) More rise in demand with less rise in price

b) Demand and price are inversely related
c) More fall in demand with less fall in price
d) Price is varying hugely
17. The intercept is helpful to find _______.
a) Zero demand at constant prices

b) Decreased demand at zero prices
c) Varying demand at constant prices
d) Total demand at zero prices
18. When the price increases,_____goods are bought more.
a) Agricultural goods
b) Normal goods
c) Veblen goods
d) Giffen goods
19. The income effect dominates in _______.
a) Veblen goods
b) Griffin goods
c) Necessity goods
d) Normal goods
Business Economics
60
Summary
Demand refers to individuals’ willingness or their effective desire to buy a commodity
or service supported by their purchasing power.
Effective desire is the quantity of the commodity or service that is purchased at a

given price from the market at a given time.
The quantity demanded is not always the same as the quantity bought. This may be
due to various factors including that the good or service demanded may not be
available in the required demand.
The individual determinants of demand are: The price of the product or service,
Real Income of consumers, price of related (Substitute/ Complementary) goods,
consumer’s tastes and preferences, buyer’s expectation of good’s future price.
The individual determinants of demand are Distribution of income, the climate,

Govt policies.
Law of demand says, “as the price falls, the quantity demanded will be more”. In
other words, price and quantity are inversely related.
Demand ∝ 1/price
Demand schedule is a table which shows the demand of a commodity at different

prices.
The demand function for a good ‘a’ is Da = x-y Pa
There are some exceptions with a fall in price, the demand also falls, with rise in
price, there is a rise in demand as well. These are paradoxical and considered as
exception to the law of demand.
Activity
Activity Type I : Offline Duration: 30 minutes
• With last five years data, confirm that ‘Audi’ cars can be shown as
Veblen Goods.
Activity
Activity Type II : Offline Duration: 30 minutes
• Collect last five years’ nominal GDP and inflation data. After calculating deflator,
find out the real GDP for each year.
Business Economics
61
Terminal Questions
Nominal income and real income differ because of inflation: substantiate with data.
Differentiate individual determinants from market determinants.
Distribution of income as a factor has more to do with govt polices: Explain.
When there is a zero price, what will happen to demand?
Explain demand schedule and demand function.
In exceptions to the law of demand, Giffen goods are product of circumstances.
Explain.
Answer Keys
1 a
2 c
3 a
4 c
5 b
6 a
7 a
8 c
9 b
10 d
11 b
12 d
13 a
14 c
15 b
16 b
17 d
18 c
19 a
Business Economics
62
Glossary
• Demand schedule: A tabular arrangement of different prices of a product or
service and its quantity at various prices during a specific period.
• Inferior goods: An item that becomes less desirable as the income of
consumers increases.
• Deflation: A decrease in the general price level of goods and services.
Bibliography
Textbooks
• Dean, J. (1951). Managerial economics (1st ed.). New York: Prentice-Hall.
• Graham, P., & Bodenhorn, D. (1980). Managerial economics (1st ed.).
Reading, Mass.: Addison-Wesley Pub. Co.
e-References
• https://www.thebalance.com/five-determinants-of-demand-with-examples-and-
formu-la-3305706
• https://www.yourarticlelibrary.com/economics/law-of-demand/7-factors-which-
deter-mine-the-demand-for-goods/36633
Video Links
Topic Link
The Determinants of
the Demand https://www.youtube.com/watch?v=6yjsiXAtSGE
Law of Demand https://www.youtube.com/watch?v=vRtXhCAxlAg

Exceptions
Image Credits
Figures: Self-generated
Keywords
Veblen goods
Giffen goods
Complementary goods
Inflation
Business Economics
63
Business Economics
Module 2
Unit 2
Elasticity of Demand
and Demand Forecasting
Business Economics
64
Table of Contents
Unit 2.2 Elasticity of Demand and Demand Forecasting

Aim -------------------------------------------------------------------------------- 66
Instructional Objectives ------------------------------------------------------ 66
Learning Outcomes ----------------------------------------------------------- 66
2.2.1 Elasticity of demand --------------------------------------------------- 67

Self-Assessment Questioins ----------------------------------------- 73
2.2.2 Demand forecasting --------------------------------------------------- 74
Self-Assessment Questioins ---------------------------------------- 76
2.2.3 Methods of demand forecasting ------------------------------------ 77
Self-Assessment Questioins ----------------------------------------- 79
Summary ------------------------------------------------------------------------ 81
Terminal Questions ---------------------------------------------------------- 82
Answer Keys ------------------------------------------------------------------- 82
Activity --------------------------------------------------------------------------- 83
Glossary ------------------------------------------------------------------------- 83
Bibliography -------------------------------------------------------------------- 84
e-References ------------------------------------------------------------------ 84
Video Links --------------------------------------------------------------------- 84
Image Credits ------------------------------------------------------------------ 84
Keywords ----------------------------------------------------------------------- 84
Business Economics
65
Aim
To appraise the implications of the elasticity of demand forecasting and its methods.
Explain elasticity of demand with its implications
Compare different methods of demand forecasting
Learning Outcomes
Categorise elasticity of demand
Demonstrate the needs and factors of elasticity of demand
Analyse the methods of forecasting
Business Economics
66
2.2.1 Elasticity of demand
(ODVWLFLW\ RI GHPDQG LV D GHJUHH RI FKDQJH LQ WKH GHPDQG RU TXDQWLW\ RI D SURGXFW LQ
UHVSRQVH WR LWV GHWHUPLQDQWV VD\ SULFH RI WKH SURGXFW LQFRPH RI WKH FRQVXPHUV 5LFKDUG
/LSVH\ GHILQHVHODVWLFLW\DVUDWLRRISHUFHQWDJHFKDQJHLQGHPDQGWRWKHSHUFHQWDJHFKDQJHLQ
WKHSULFH
7KHVDPHLGHDLVSXWIRUWKGLIIHUHQWO\E\3URIHVVRU%RXOGLQJ³LWLVWKHSHUFHQWDJHFKDQJHLQWKH
TXDQWLW\GHPDQGHGZKLFKZRXOGUHVXOWIURPRQHSHUFHQWFKDQJHLQSULFH´6RWKHHODVWLFLW\RI
GHPDQGLVQRWKLQJEXWUHVSRQVLYHQHVVRIWKHGHPDQGWRWKHFKDQJHLQLWVGHWHUPLQDQWVOLNHSULFH
LQFRPHDYDLODELOLW\RIVXEVWLWXWHV7KHGHPDQGLQWHUPVRILWVHODVWLFLW\FDQEHRIWZRNLQGV
(ODVWLF,QHODVWLF
7KHTXDQWLW\GHPDQGHGFKDQJHVZKHQLWVGHWHUPLQDQWJHWVFKDQJHGWKHQWKHSURGXFWLVVDLG
WREHORQJWRHODVWLFGHPDQG
6RWKHWKUHHFDWHJRULHVRIHODVWLFLW\RIGHPDQGDUH
3ULFHHODVWLFLW\RIGHPDQG
,QFRPHHODVWLFLW\RIGHPDQG
&URVVHODVWLFLW\RIGHPDQG
Price Elasticity of Demand (PED)

7KLV 3(' LVWKHSHUFHQWDJHFKDQJHLQWKHTXDQWLW\GHPDQGHGRIDVHUYLFHRUSURGXFWGXHWR
FKDQJHLQWKHSULFHRIWKHSURGXFWLQWKHPDUNHW,QVLPSOHZRUGVLWLVUDWLRRIWKHSHUFHQWDJH
FKDQJHLQTXDQWLW\GHPDQGHGDQGWKHSHUFHQWDJHFKDQJHLQSULFH
,WFDQEHPDWKHPDWLFDOO\H[SUHVVHGDV
Price elasticity of demand = Proportionate Change in the Quantity Demanded or
Proportionate Change in the Price.
ǻGHQRWHFKDQJHLQGHPDQGDQGSULFH
7KXVWKHIRUPXODWRFRPSXWH
ep = (ΔQ/ ΔP) x (P/Q)
HS 3ULFHHODVWLFLW\RIGHPDQG
3 ,QLWLDOSULFH
ǻ3 &KDQJHLQSULFH
4 ,QLWLDOTXDQWLW\GHPDQGHG
ǻ4 &KDQJHLQTXDQWLW\GHPDQGHG
3('FDQEHEHWWHUXQGHUVWRRGZLWKWKHEHORZH[DPSOH
%XVLQHVV(FRQRPLFV
67
Example: A company sells a product for the price of ₹ 300. The company reduces the price to 200
from the present 300. Subsequently, the demand is increasing from 3,000 units to 4,200 units.
Calculate the price elasticity of demand.
Here,
P = 300
ΔP = 100 (a reduction in price; = 100)
Q = 3000 units
ΔQ = 1200
ep = (ΔQ/ ΔP) x (P/Q)
=1200/100) x (300/3000)
=1.2
Elasticity of demand is more than 1.
Based on the elasticity of demand, whether it is more than 1, or equal to 1, or less than 1, we have
various types of price elasticity.
If PED > 1 then Demand is Price Elastic (Demand is sensitive to price changes)
If PED = 1 then Demand is Unit Elastic
If PED < 1 then Demand is Price Inelastic (Demand is not sensitive to price changes)
Price Elastic has again two categories
Perfectly Elastic Demand

Relatively Elastic Demand
Price inelastic has again two categories
Perfectly Inelastic Demand

Relatively Inelastic Demand
Business Economics
68
Perfectly Elastic Demand
When a small change (fall or rise) in price results in large change in the quantity demanded, it
is called perfectly elastic demand. That is, for 1% rise in price, the fall in quantity demanded is
more than 10%
ΔQ= 10 ΔP=1
ΔQ/ ΔP=10
Demand line
Fig. 1: Perfectly Elastic Demand Curve
Relatively Elastic Demand

The demand is called relatively elastic demand when the change in demand (effect) is more
than the change in price (cause). That is, for 1% rise in price, the fall in quantity demanded is
1.2 or 1.5%
ΔQ= 120 ΔP=100
Then elasticity is
= (ΔQ/ ΔP) = 120/100=1.2
Demand curve
Fig. 2: Relatively Elastic Demand Curve
Business Economics
69
Perfectly Inelastic Demand
If the change in the price of a product does not cause any change in the quantity demanded;
the demand is called perfectly inelastic demand.
Graphically, perfectly inelastic demand curve is represented as a vertical straight line (parallel
to Y-axis)
ΔQ=0, ΔP=100
Elasticity=0
Y Demand line
Q X
Fig. 3: Perfectly Inelastic Demand Curve
Relatively Inelastic Demand

The demand is called relatively inelastic when the change in price causes less change in
demand. For 1% rise in price, the fall in quantity demanded is 0.8 or 0.9
Example
ΔQ=80, ΔP=100, then elasticity is
= (ΔQ/ ΔP) =80/100=0.8
Demand curve
Fig. 4: Relatively Inelastic Demand Curve
Business Economics
70
Thus, it is essential for a business to appreciate the idea and significance of price elasticity of
demand in order to understand the relationship between the price of a good and the associated
demand at that price.
Price elasticity of demand can be used to identify pricing strategies for different marketplaces,
goods, and services.
Unitary Elastic Demand

When the percentage change in quantity demanded is equal to percentage change in price, it
is called unitary elastic demand. One is the value for unitary elastic demand.
P A ed = 1
B ed = 1
P1
Q Q1 X
Fig. 5: Unitary Elastic Demand Curve
Cross Elasticity of Demand

The cross elasticity of demand is the percentage change of the quantity demanded for a goods
to the percentage change in the price of another goods. In reality, demand for the goods is
dependent on not only its own price (Price elasticity of demand) but also the price of other
“related” products.
Cross price-elasticity of demand = % change in demand for good X

% change in price of good Y
The concept is used to identify the relationship between two goods, they can be:
Complements
Substitutes
Unrelated
A negative cross elasticity denotes two products, those are complements, while a positive
cross elasticity denotes two products those are substitutes. For example, in response to a 5%
increase in the price of printer’s ink, the demand for printer would decrease by 15%, so the
cross elasticity of demand would be:
-15% / 5% = -3
This means an increase in the price of tyre will decrease the demand for tube, so tube and tyre
are complements.
Business Economics
71
Example
The average annual income rises from Rs 50,000 to Rs 75,000, and the quantity of rice consumed
in a year by the average person falls from 40 kg to 26 kg. What is the income elasticity of bread
consumption? Is bread a normal or an inferior good?
Percentage change in quantity demanded

= [(change in quantity)/ (original quantity)] ×100
= [26−40]/ [(66)/2] ×100
=−14/33×100 = −42.4
Percentage change in income
= [(change in income)/ (original income)] ×100
= [76,000−50,000]/ [(126,000)/2] ×100
=26000/63000×100=41.27
Here, we can say that the rice is an inferior good because as the income increases consumption
decreases.
Solved cases
A. The government decides to put the norm to the car manufacturers to install new anti-erosion
equipment that costs Rs 20,000 per car. Could car makers pass almost all this cost to the
buyers? When can car makers not pass this cost along to car buyers?
Ans: Car makers can pass this cost along to consumers if the demand for these cars is inelastic.
If the demand for these cars is elastic, then the manufacturer must pay for the equipment.
B. A pharmaceutical company has found a new drug. Assume that the company wants to earn as
much revenue as possible from this drug. If the elasticity of demand for the company’s product
at the current price is 1.4, would you advise the company to raise the price, lower the price, or
to keep the price the same? What if the elasticity were 0.6? What if it were 1? Explain your
answer.
Ans: If the elasticity is 1.4 at current prices, you would advise the company to lower its price
on the product, since a decrease in price will be offset by the increase in the amount of the
drug sold. If the elasticity were 0.6, then you would advise the company to increase its price.
Increase in price will offset the decrease in number of units sold but increase your total
revenue. If elasticity is 1, the total revenue is already maximised, and you would advise that the
company maintain its current price level.
Business Economics
72
1. The elasticity of demand________.
a) Responsiveness of price to quality

b) Responsiveness of the price to demand
c) Responsiveness of the demand to its determinant
2. Elasticity is zero for__________.
a) Relatively inelastic goods

b) Perfectly inelastic goods
c) Perfectly elastic goods
3. % change in quantity and price are equal, it is_____.
a) Equal elasticity
b) Price elasticity
c) Demand elasticity
d) Unitary elasticity
4. Relatively elastic curve is__________.
a) Steeper
b) Flatter
c) Horizontal line
d) Vertical line
5. Complements will have___________.
a) Zero cross elasticity

b) Negative cross elasticity
c) Positive cross elasticity
d) Unit cross elasticity
6. Producers can pass the price rise along to the customers when
__________.
a) The demand is elastic

b) The demand is inelastic
c) The demand is relatively elastic
Business Economics
73
7. Substitutes will have________.
a) Zero cross elasticity

b) Negative cross elasticity
c) Positive cross elasticity
d) Unit cross elasticity
Price for experimental COVID-19 treatment raises concerns

DID A five-day course of medication that had shown promise treating
YOU COVID-19 was estimated to cost $17.74 to produce, but pharmaceutical
KNOW firm Merck planned to charge the U.S. government $712, according to
news reports in 2021.
A study found that the drug, molnupiravir, reduced the risk of
hospitalisation among study participants with moderate or mild
illness by half.
The price discrepancy was detailed in an October 1, 2021, report
led by researchers from Harvard T.H. Chan School of Public Health
and King’s College Hospital. Melissa Barber, a doctoral candidate in
Harvard Chan School’s Department of Global Health and Population
who co-authored the report, said the steep price of the drug—while
not as extreme as some other medications—could limit access to it.
2.2.2 Demand Forecasting

Demand forecasting is a process by which demand is predicted for the product or services
rendered by an organisation for the specific time period in future. It helps to manage the
business better. The companies use this to mitigate risks and make effective decisions. This
comes handy to the companies in their expansion decisions.
Need for demand forecasting: To determine the right quantity of production: Based on
the demand, production is scheduled. With the help of demand forecasting, organisations can
decide the requirement of various factors of production (land, labour, capital, and enterprise) in
advance. So that, production continues without any impediments.
Inventory management: From the production schedule and planning, organisations can
manage the inventory better by reducing unnecessary costs locked up in the huge inventory
of raw material, spare parts and so on.
Manpower requirement: Since the production level is well planned, determining right level
of manpower will be easy. This avoids the problem of surplus or lack of manpower.
Ensuring stability: Demand forecasting helps an organisation to meet cyclical and
seasonal fluctuations, in turn stabilises the business.
Business Economics
74
Factors affecting demand forecasting
Prevailing economic conditions: Changing price levels, consumption pattern, per capita
income, saving and investment practices, employment level, etc., of an economy must be duly
considered while estimating the demand forecasting. They can potentially change the course of
demand forecasting even if there is a small variation.
The industry condition: Conditions of the industry also affect demand. For example, huge
number of players operating in the industry creates the competition. This may lower the price or
make industry non profitable. Closure of companies can happen. Such a situation will create the
demand forecasting much fluctuating.
Company condition: Organisational factors such as plant capacity, product quality, product
price, advertising and distribution policies, financial policies, etc., could affect demand
forecasting
Changing market conditions: Market factors such as prices of goods; change in consumers’
expectations, tastes and preferences; change in the prices of related goods; and change in the
consumers’ income level also influence the demand forecasting for the organisation’s products
and services.
Sociological conditions: when the changes in sociological factors such as size and density
of population, age group, size of family, family life cycle, education level, family income, social
awareness, etc., it may largely impact the demand forecasts. For example, electronic gadgets will
be in huge demand in markets having a large population of youth.
Import-export policies: when the Government changes the export import policy, demand
forecasting will tend to change favourable or unfavourable. This may affect the demand forecasting.
Business Economics
75
8. Stability is related to avoid_________.
a) Seasonal fluctuation
b) Cyclical fluctuation
c) Both
d) Demand forecasting
9. More companies entering and exiting the market will keep the demand______.
a) Constant
b) Fluctuating
c) Rise with price
d) Fall with price
10. Example for sociological factors__________.
a) Size of family
b) Tastes and preferences
c) Price of goods
11. Export import policy may turn demand___________.
a) Favourable
b) Adverse
c) Both
d) None
Business Economics
76
2.2.3 Methods of demand forecasting
There are various methods adopted for forecasting the demand.
1. Expert Opinion
In this method, the company employs outside consultant for forecasting the demand. Both
the parties; the company and consultant do the brainstorming session on various assumptions
for the future reference period. Then the company leadership will tweak. If required, here and
there and the final number on the demand will be made.
2. Delphi Method
This method was developed in 1950s by RAND Corporation. It is used in conjunction with
‘expert opinion’ method. A facilitator will call the panel of industry experts. A questionnaire will
be given to them. After collecting the responses, facilitator will summarise. Then the summary
will be given to each one of them.
The panel will be encouraged to revise their earlier opinions in the light of other members’
replies and the summary. This will go on for another two more rounds. It allows each member to
build on each other’s expertise. The purpose of this method is to arrive at an informed
consensus.
3. Collective Opinion-Sales Force Method

Here, sales agents do the forecasting in their respective territories such as area, branch,
region, etc. This method seems to have built on the premise that salespeople know the
ground reality better than any experts. Because they deal with the people directly.
Customer affluence, product price, marketing campaign and competitors will differ based on
the geography. These must be considered while using this method for forecasting.
4. Statistical Method
Statistical methods are reliable and cost-effective. The trend projection and regression
analysis are
Tare rend projection: This method is used to predict the past and future. This method will
remove any anomalies (unlikely to be repeated), if there is anything, and do the trend
projection.
Regression Analysis: This method analyses the relationships between different
variables such as sales, conversions, and email signups. Knowing how each impact the other
will enable the company to identify the causes of high or low demand in the
foreseeable future.
Business Economics
77
5. Econometric Method: The econometric method accounts for relationships between economic
factors. For example, an increase in disposable income is coinciding with an increase in travel, as
more people go on vacations with their extra money.
In controlled experiments, only one variable is changed and the response of the subject to that
change is measured.
Whereas econometrics is using a complex system of related equations, in which all variables may
change at the same time. Though this is complicated, the results are worth the effort. The people
who employ and interpret are called econometricians.
6. Market Research/Surveying: In this method, a customer survey is a tool. Online surveys

easily target the audience. The survey software makes analysis much less time-consuming.
Surveys give better picture about the customer and their needs, inform marketing efforts, and
identify opportunities.
Some of the most popular surveys with sales and marketing teams include:
● Sample surveys: Here, a select sample of potential buyers is interviewed to

determine their buying habits.
● Complete enumeration surveys: The largest possible sample of potential buyers
is interviewed to gather a broader data set.
● End-use surveys: Other companies are surveyed to determine their view on end-
use demand.
SurveyLegend, SoGoSurvey, and Qualtrics platforms are used to conduct online surveys.
7. A/B Experimentation: Here, A/B testing or two different promotions, features, website imagery
or features, email subject lines, and much more is done. If consumers strongly favour one over the
other, companies gain a better understanding of what appeals to them in order to forecast demand.
For example, one experiment found that companies experience more sales when offering prices
ending in odd numbers.
8. Barometric
This forecasting method uses three indicators to predict trends.
● Leading indicators: These are indicators which can be used to foretell what is likely to
happen in the future. For example, an increase in customer complaints could give a clue
to a fall in sales.
● Lagging indicators: These can be used to analyse the impact of past events. These
come after the completion of an event. For example, a spike in sales the month prior could
indicate a growing trend that needs to be watched closely for inventory purposes.
● Coincidental indicators: These indicate what happens. For example, real-time inventory
turnover shows current sales activity.
Business Economics
78
12. ________method is used in conjunction with expert opinion method.
a) Statistics
b) Delphi
c) Barometer
d) All the above
13. Facilitator plays an important role in________.
a) Expert opinion
b) Sales force method
c) Trend projection
d) Delphi
14. Sales-force method has________.
a) Anomalies
b) Ground reality
c) Tools
15. Anomalies will be done away with in________.
a) Regression
b) Expert opinion
c) Trend projection
d) Econometric
16. In Econometrics model________.
a) All variables may change one by one

b) All variables may change at the same time
c) One variable may change at a time
d) Two variables may change at a time
Business Economics
79
17. Indicators which precedes the event is________.
a) Coincidental indicators
b) Preceding indicators
c) Succeeding indicators
d) Leading indicators
18. Sample size is smaller in________.
a) Sample survey
b) Enumeration surveys
c) Customers survey
d) All the above
19. ________is a method to compare two versions of something.
a) A/B testing
b) Barometric
c) Regression
d) Econometric model
Business Economics
80
Summary
Price elasticity of Demand is the percentage change in the quantity demanded of a
service or product due to change in the price of the product in the market.
ep = (ΔQ/ ΔP) x (P/Q).
Based on elasticity of demand, whether it is more than 1, or equal to 1, or less than 1,
we have various types of price elasticity.
If PED > 1 then Demand is Price Elastic (Demand is sensitive to price changes).
If PED = 1 then Demand is Unit Elastic.
If PED < 1 then Demand is Price Inelastic (Demand is not sensitive to price changes).
When the % change in quantity demanded is equal to % change in price, it is called
unitary elastic demand. One is the value for unitary elastic demand.
The cross elasticity of demand is the percentage change of the quantity demanded for
a good to the percentage change in the price of another good.
A negative cross elasticity denotes two products that are complements, while a positive
cross elasticity denotes two products are substitutes.
Need for demand forecasting: to determine right quantity, manpower, inventory,
manpower, ensuring stability and so on.
Factors affecting demand forecasting: Economic conditions, Industry conditions,
company, market conditions, sociological condition, export-import policies.
Methods used for demand forecasting: expert opinion, Delphi method, sales force
method, statistical method, econometric method, Market research method, A/B
experimentation, Barometric.
Business Economics
81
Terminal Questions
1. Compare cross elasticity with other elasticities.
2. Discuss the need for demand forecasting.
3. Explain why Delphi method is used in conjunction with expert opinion method.
4. Compare econometric model and statistic model of demand forecasting.
5. Discuss the disadvantages of sales force, A/B version and barometric indicators
approach.
Answer Keys
1 c
2 b
3 d
4 b
5 b
6 b
7 c
8 c
9 b
10 a
11 c
12 b
13 d
14 b
15 c
16 b
17 d
18 a
19 a
Business Economics
82
Activity
Activity Type: Offline Duration: 30 Minutes
Forecast the yearly new home sales and sales of major appliances for 2010, using
the information in the table below. Explain the reasons for your forecast.
Cost Sales 2007 Sales 2008 Sales 2009 Sales 2010
New Homes $300,000 $300,000 3,50,000 3,30,000 ?

(average) (average)
Major Appliances $600.00 $600.00 24,00,000 22,00,000 ?
Mortgage Rates % % 4.75% 4.00% 3.50%

(average)
Unemployment % % 6.60% 8.80% 8.90%

rate
Glossary
• Price elasticity: Price elasticity of demand is a measurement of the change in
the con-sumption of a product in relation to a change in its price.
• Elastic Demand: An economic concept which states that the demand for a good
or service changes with the fluctuations in its price.
Business Economics
83
Bibloography
Textbooks
Samuelson, W., & Marks, S. (2006). Managerial economics (1st ed.). Hoboken, NJ:
John Wiley and Sons
e-References
https://www.toppr.com/guides/business-economics/theory-of-demand/elastici
ty-of-demand
https://redstagfulfillment.com/what-is-demand-forecasting/
https://www.thefulfillmentlab.com/blog/demand-forecasting
Video Links
Topic Link
Elasticity of Demand
https://www.youtube.com/watch?v=J82_xd5XxXg
Demand Forecast- https://www.youtube.com/watch?v=KgmNg2d8XDk

ing
Image Credits
Image credits: Self generated
Keywords
Price elasticity
Elastic demand
Demand forecasting
Business Economics
84
Business Economics
Module 3
Unit 1
Production Analysis
Business Economics
85
Module 3
Production and Cost Analysis

Module Description
In this module, we will discuss a concept called production function. In the ordinary sense,
production means the manufacturing of goods. Here comes a function called production function.
This production function assumes constant returns to scale. It implies that production increases
at the same rate as the increase in the total inputs of labour and capital put together. Classical
economists considered how output can be increased by keeping one or some factors constant,
while increasing the other.
The classical economists considered it as the law of diminishing returns. There is one more type
of increase in which one factor is varied, while keeping the other constant. This is called the law or
“returns to scale” refer to the long-run. While the law of diminishing returns or the law of variable
proportions relates to the short-run, the law, of “returns to scale” relate to the long run. Economies
of scale are cost advantages reaped by companies when production becomes efficient. They are
able to make economies of scale by increasing production and lowering costs.
This happens because costs, both fixed and variable, are distributed over a greater number of
products. In economies of scale, there is an increase in production. 1. Increasing returns to scale
2. Constant returns to scale 3. Diminishing returns to scale. The increasing, constant, decreasing
returns to scale, since the production varies, will lead to an increase/decrease in the revenue.

Business Economics
86
Table of Contents
Aim ---------------------------------------------------------------------------------- 88
Instructional Objectives -------------------------------------------------------- 88
Learning Outcomes ------------------------------------------------------------- 88
3.1.1 Production ----------------------------------------------------------------- 89

3.1.2 Production function ------------------------------------------------------ 91
3.1.3 Short-run production function ------------------------------------------ 94
3.1.4 Long-run production function ------------------------------------------- 100
Self-Assessment Questions ---------------------------------------------- 103
Summary ---------------------------------------------------------------------------- 105
Terminal Questions --------------------------------------------------------------- 106
Answer Keys ----------------------------------------------------------------------- 107
Activity ------------------------------------------------------------------------------- 108
Glossary ----------------------------------------------------------------------------- 108
Bibliography ------------------------------------------------------------------------ 109
Video Links ------------------------------------------------------------------------- 109
Keywords --------------------------------------------------------------------------- 109
Business Economics
87
Aim
To classify the different costs of production and how they affect short and long-run
decisions.
After completing this, you should be able to:
Describe how long-run and short-run cost work out
Examine the ways by which Cobb-Douglas Law works
Discover the implications of the functions of the law of variable proportion
Learning Outcomes
At the end of the unit, you will be able to:
State the reasons behind the varying nature of cost of short-run and
long-run operations
Differentiate The impacts of Cobb-Douglas and the law of variable proportions
Business Economics
88
3.1.1. Production
In the earlier units, you learnt the meaning of demand, elasticity of demand, etc. You must have
noticed that the consumers demand goods and services, use them and obtain satisfaction. But
these goods and services have to be produced before they are consumed. Without production
and how factors of production help in production. You will also study the meaning of production
function and the law of variable proportions which relates to the production.
In the ordinary sense, production means the manufacture of goods. But in Economics, the word,
“Production” is used in a much wider sense. It is not simply the manufacture of goods alone.
Here, production means, “creation of utility” having exchange value. It is the addition of utility
which has value-in-exchange. For example, a producer converts raw materials into finished
products which command a price in the market. These commodities which have utility and value
are considered to have been produced. However, production does not mean the manufacturing
of goods alone. The addition of various types of utility is considered production in Economics.
We will now consider various utilities that are created by producers, and which come under the
definition of production:
I. Form utility: As mentioned already, most of the producers take up the work of conversion of
various raw materials into finished products that are demanded in the market. Such conversion
of raw materials into finished products is called the creation of form utility. By changing the form
of raw materials into finished products, producers have added utility to the raw materials. This is
one type of production (e.g., wood is converted into tables, chairs, etc. Utility is added to the
wood in this process). This creation of form utility is one type of production.
II.Place utility: By changing the place of a commodity if utility is added to that it is called the
creation of place utility. This is another type of production. (For example, the transport of raw
materials to the places of manufacture). The transport of finished products to market centers is
also production. Transportation creates place utility. So it also considered Production.
III. Time utility: Business secures various goods from different manufacturers and keeps
them ready for sale. Buyers can purchase from them whenever they require those goods.
Sellers secure goods in advance and offer them for sale whenever required by the buyers.
In this process sellers create time utility. This is also one type of production.
IV. Service utility: Some people produce only services. But not goods. They produce
services which have utility and also exchange value. This is the creation of service utility. This is
also one kind of production. For example, Teachers, Doctors and Lawyers produce services
which have utility and exchange value. They are also producers. They are the producers of
service utility. Thus, production does not mean only the manufacture of goods. Transportation
Business activity and the rendering of services having exchange value, all these come under the
meaning of “production”.
Business Economics
89
1. Place utility is created by _______ .
a) Raw material
b) Transportation
c) finished goods
d) Production process
2. Life-blood of the Industry by _______ .
a) Service
b) Time
c) Capital
d) Labour
3. When the goods are kept ready for sale, it is called_______ Utility.
a) Place
b) Land
c) Organisation
d) Time
4. Production is _______.
a) Creation of utility
b) Manufacturing
c) Conversion of raw material
d) Effort
5. This factor of production which is mother of all production is _______.
a) Capital
b) Service
c) Land
d) Labour
Business Economics
90
3.1.2 Production Function
Production function refers to the functional relationship between inputs and output, under given
technology, per unit of time. It is a physical and technological relationship. It denotes the maximum
output that can be produced by a given combination of inputs, per unit of time, under given
technology.
Production function may be defined as the technical relationship between the physical input
and physical output at a given level of technology during a period. Here, inputs refer to the
raw materials, fuel, labour, transportation, etc., The inputs imply the factors of production whose
services are made use of in the process of production.
The production function in the short run differs from that in the long run. In the short-run production
can be increased or decreased by varying only the variable factors of production. The size of the
plant remains constant. But in the long run even the fixed factors or production also undergo
a change. In the long run all factors become variable. So there is much greater flexibility in
production. The scale of production changes in the longrun.
The production function may be denoted as follows:

P = f (a, b, c, d….T)
Here P = Production (Output)
a, b, c, d… = Various inputs or factors of production
T = Technology
Normally technology is assumed to be constant
f = function of it means depends upon.
Sometimes, economists propose a simplified production function assuming a two factor model.
P = f(K, L)
Here P = Production (Output)
K = Capital
L = Labour
In this model also, Technology is assumed constant.
Cobb-Douglas Production Function

Cobb and Douglas, two economists, made empirical studies of some manufacturing industries in
America and other countries. They evolved a production function, popularly known as Cobb-Doug-
las production function. They considered two variable inputs (Labour and capital) and evolved the
following production function.
Q = aL aLb K(1-b)
Here Q = Output (Production)
L = Labour
K = Capital
a and b = Positive constants
Above production function assumes constant returns to scale. It is a linear and homogeneous
production function. It implies that production increases at the same rate as the increase in the
total inputs of labour and capital put together.
Business Economics
91
Laws Of Production
The process of production implies that the inputs are transformed into output. Different combinations
of inputs lead to different quantities of output even when technology remains constant. The
same set of inputs will lead to different quantities of output, if technology changes. That is why,
technology is assumed constant, while changing the combinations of inputs.
The classical economists considered how output can be increased keeping one or some factors
constant, while increasing the other. This was originally explained by Malthus, Ricardo and Mill.
Marshall refined it and gave out a detailed explanation. The classical economists considered it as
the law of diminishing returns:
(a) Prof. Benham considered another type of increase in which one factor is varied,
while keeping the other constant. This is the modern version of the law of diminish
ing returns (the law of variable proportions).
(b) There is still one more type in which all the inputs are varied at the same time in the
same ratio. This is called the law or “returns to scale” refer to the long run.
(c) While the law of diminishing returns or the law of variable proportions relates to the
short-run, the law, of “returns to scale” relate to the long run.
(d) While in the law of variable proportions one or some factors are varied, in “returns to
scale” all the factors are varied.
(e) While the fixed factor or factors are kept constant in case of the law of variable
proportions, all factors are variable in case of “returns to scale”.
Business Economics
92
6. Cobb-Douglas function is a linear and homogeneous function because_____.
a) i/p changes at the o/p rate

b) o/p changes at the i/p rate
c) i/p changes at the labour rate
d) o/p changes at capital rate
7. In the short run _____.
a) only variable factors change

b) only labour changes
c) only capital changes
d) both the factors change
8. In the long run _____.
a) fixed factors change

b) variable factors change
c) both the factors change
d) factors linearly change
9. In the law of production, technology is assumed to be ________.
a) varying
b) varying on return to scale
c) constant
d) the same ratio
10. Law of variable proportion is said to _____.
a) for short run

b) for long run
c) first for short run then for long run
d) for production run
Business Economics
93
3.1.3 Short-run production function
The short-run production function means the time period over which quantities of all inputs cannot
be changed by the firm. On the other hand, long-run production function means the time period,
over which quantities of all inputs can be changed by the firm.
In the short run when output of a commodity is sought to be increased, the law of variable
proportions comes into operation. Therefore, when the number of one factor is increased or
decreased, while other factors remain constant, the proportion between the factors is altered.
Law of variable proportions (Law of diminishing returns)
The classical economists introduced the law diminishing returns. Malthus, Ricardo and
Mill enunciated this law. Marshall refined it and gave out a detailed explanation. That is why
it is associated with the name of Marshall.
Subsequent economists like Stigler, etc., modified it further. To rectify the defects in the
Marshallian analysis, the theory was modified. It was named as the law of variable proportions.
So, the law of variable proportions is only a refined form of the law of diminishing returns. The
law of diminishing returns is also called the law of diminishing marginal returns.
According to Marshall, “An increase in the capital and labor applied in the cultivation of
land causes in general a less than proportionate increase in the amount of production
raised unless it happens to coincide with an improvement in the arts of agriculture.”
This is the law of diminishing returns. The statement of Marshall implies that land is kept constant,
while increasing the capital and labour. This generally results in less than proportionate returns. It
means that production increases at a lower rate than the increase in capital and labour. However,
in his statement, Marshall says “in general “. It means that production generally increases at a
lower rate than capital and labour. The statement also implies that production may not always
increase at lower rates. In fact, in the early-stage production is most likely to increase at a more
than proportionate rate. This is because the fixed factor (land) is not fully and effectively used in
the early stage.
Additional doses of capital and labour, in the early stage, result in increasing returns. It means that
the Marginal product or Marginal returns increase more than proportionately in this stage. But,
afterwards diminishing returns arise, just before diminishing returns set in, constant returns may
also arise. Marshall confined his law of diminishing returns to agriculture. In fact, the law applies
to all fields or production, including industries. So the law has been stated in a refined form by
modern economists like Benham and Stigler. This is called the law of variable proportions.
According to Benham, “As the proportions of one factor, in a combination of factors, is
increased, after a point, first the marginal and then the average product of the factor will
diminish.Similar statements were made by economists like Stigler and Samuelson. As per the
modern economists, the law applies to all fields of production such as agriculture, industry, mining,
fishing, etc.
a. Assumptions
(a) All the units of the variable input are homogeneous.
(b) Techniques of production remain constant.
(c) It is possible to vary one input, keeping the others constant.
(d) The analysis relates to the short run.
(e) Diminishing returns arise after a stage.
Business Economics
94
b. Explanations of the Law
Now let us try to explain the law of variable proportions with the help of a table (Table 1) and a
diagram (Fig. 1). Here, we assume labour as the variable input and the other inputs are kept
constant.
No.of Units of Total product Marginal Prod- Average Prod- Stages

Labor (TP) uct (MP) uct (AP)
1 7 5 5
I
2 12 7 6
3 18 6 6
4 20 2 5 II
5 20 0 4
6 18 -2 3
III
7 14 -4 2
Table 1: law of variable proportions
From the above table you can notice that marginal product first increased, then decreased. When
we employed fifth labour the M.P. is zero. It became negative three after. We may sum up the
table:
(a) In stage 1M.P. increased, T.P. increased at an increasing rate. M.P. is more than A.P. in
this stage.
(b) In stage 2 M.P. started decreasing but T.P. continued to increase of course at a decreas
ing rate. In this stage the A.P. is more than M.P. In fact, stage 2 began when M.P. did cut
A.P. to the maximum point. Stage 2 ended when M.P. is zero and T.P. was at its maximum
point.
(c) In stage 3 M.P. became negative. A.P. continued to the positive. T.P started decreasing.
The above table can be represented by means of a diagram as given below.
Fig. 1: Explanations of the Law Curve
Business Economics
95
In the above example, the total production is increasing at an increasing rate in the first stage.
This is the stage of increasing returns. The Marginal product and the Average product are
increasing. The producer will not stop in the first stage.
In the second stage the total product is increasing at a decreasing rate. This is the stage of
diminishing returns. Towards the end of this stage, total product becomes maximum and constant.
Then Marginal Product becomes zero. A rational producer will not go beyond this stage.
If the producer proceeds further and applies additional doses of labour, the total product
decreases and the Marginal product becomes negative, no producer takes up production in this
stage because the marginal product has become negative and the total product is decreasing.
This is the stage of negative marginal returns.
So a rational producer carries on production only in the second stage of diminishing returns. This
is the most important stage in the law of variable proportions. That is why the law of variable
proportional is also called the law of diminishing returns.
However, we should note that diminishing marginal returns (or marginal product) but not average
or total returns.
c. Relationship between Total Product and Marginal Product
(a) When total product increases at an increasing rate, marginal product increases (increasing
returns).
(b) When total product increases at a decreasing rate, marginal product decreases (Diminishing
returns).
(c) When total product becomes maximum and constant, marginal product becomes zero (End
of second stage).
(d) When total product decreases, marginal product becomes negative (third stage and the
stage of negative returns).
ci. Relationship between Average Product and Marginal Product
(a) When average product increases, marginal product will be above it.
(b) When average product is constant, marginal product will be equal to it.
(c) When average product decreases, marginal product will be below it.
The marginal product curve moves upward and lies above the average product curve in the initial
stage. Afterwards, it starts diminishing and cuts the average product curve at its maximum point
(i.e., When average product is maximum and constant). After that, marginal product decreases at
a faster rate than average product. So, the marginal product curve lies below the average product
curve. The marginal product curve cuts the X-axis when the total product is maximum. Then
marginal product becomes zero. After that the marginal product curve goes below the X-axis.
Then total product decreases and marginal product becomes negative.
Here, we have to remember that only marginal product can become zero and negative. Modern
techniques of product will decrease in this stage. But they will not become zero or negative.
Here, we have to remember that only marginal product can become zero and negative. Modern
techniques of product will decrease in this stage. But they will not become zero or negative.
Business Economics
96
e. Limitations
(a) The law operates only when the techniques of production are kept constant. Modern techniques
of production may result in increasing returns.
However, we have to remember one thing. Even modern techniques will not result in increasing
returns for ever. After a stage, diminishing returns are a must.
(b) The law of diminishing returns operates only at a stage if it does not from the beginning.
(c) This law is only a short-run phenomenon. In the long run fixed factors also undergo a change.
So the law cannot be applied to the long run.
(d) The concept of negative marginal returns is more theoretical. No rational producer ventures
to go into that stage.
(e) All the units of the variable inputs are rarely homogenous.
(f) The law cannot be applied if factors of production to be combined in fixed proportions. In spite
of the limitations, the law is of great practical significance.
f. Practical Importance
(a) The law is the basis for the Malthusians of population. Population has to be held in check since
the returns on land diminish.
(b) The Ricardian theory of rent is also based on the law of diminishing returns. Marginal returns
diminish when additional land of inferior quantity is brought under cultivation.
(c) The marginal productivity by theory of distribution is also based on this law. Employment of a
factor is carried on until the diminishing marginal productivity becomes equal to its remuneration.
Production means the creation of variable kinds of utility – form utility, place utility, time utility,
and service utility. There are four factors of production land, labour, capital and organisation
which are responsible for production. In fact, production is the result of the co-operation of
these factors of production.
Production function is the technical relationship between physical inputs and output at a given
level of technology during a period of time. Cobb-Douglas production function is a production
function that examines how production increased in American industry with an increase in labour
and capital.
The law of variable proportions indicates how production increases when a variable factor is
increased in the short run, under given technology, keeping the rest of the inputs constant.
Business Economics
97
11. As per the production function, production is a function of_________.
a) Total Expenditure
b) Price
c) Factors of Production
d) None of these
12. Short-run production function is explained by ________.
a) Elasticity of Demand
b) Returns to Scale
c) Law of Variable Proportion
d) Law of Demand
13. Expression of production function is _________.
a) Qx = f (A, B, C, D)
b) Qx = Px
c) Qx = Dx
d) None of these
14. Which of the following is included in money cost ?
a) Normal Profit
b) Explicit Cost
c) Implicit Cost
d) All of these
15. Changes in production quantity cause affect in ________.
a) Both Fixed and Variable Cost

b) Only Variable Cost
c) Only Fixed Cost
Business Economics
98
16. Another name of opportunity cost is:
a) Marginal Cost
b) Equilibrium Price
c) Economic Cost
d) Average Cost
17. The two primary inputs to the Cobb-Douglas production function are:
a) Labour and total factor productivity

b) Labour and entrepreneurship
c) Physical capital and labour
d) Land and labour
Business Economics
99
3.1.4 Long-run production function
Unlike short-run function, here all the factors are treated as varying and in the same proportion.
The law that is used to explain long-run production function is the law of returns to scale. The
law helps us to measure how much change occurs in output when we effect proportionate
change in inputs.
Law of Returns to Scale
This law is about by how much proportion the output changes when inputs are changed pro
portionately.
When the scale of production is increased, the resultant returns are called the returns to
scale.
In the law of variable proportions, we studied how production varies when there is an increase
in one or some factors of production (or inputs). We assumed that the other factors of
production are kept constant. Also, we assumed that the technology remained constant. We
considered production in the short run, where fixed factors remain constant. Increase in
production takes place with an increase in the variable factors only.
But in case of returns to scale all the factors of production are varied. Their impact on
production is studied. All factors become variable only in the long-run. So returns to scale relate
to the long-run. The variation in factors of production is in the same proportion and at the same
time. There is no concept of increasing one or two factors, keeping the other constant.
So, the law of variable proportion relates to the short-run, whereas “Returns to scale” relates to
the long-run, only one or some factors are varied in the former and all factors are varied in the
latter.
Three Phases Of Returns To Scale
As a firm increases all the inputs in the long run, other things remain the same, output increases
more than proportionately in the initial stage, proportionately in the second stage and less than
proportionately in the third stage.
These three stages or phases respectively are called:
1. Increasing returns to scale
2. Constant returns to scale
3. Diminishing returns to scale.
If we increase all the inputs by 10 percent, production increases by more than 10 percent in
the first stage. This is known as the stage of increasing returns. If the inputs are continued
to be increased further by 10 percent, the output increases by 10 percent. This is known as the
stage of constant returns. If this process is continued and inputs are increased still further by 10
percent, the output increases by less than 10 percent in the third and final stage. This is
known as the stage of diminishing returns.
Thus, the three stages occur in the order mentioned above. It means that in the first stage
increasing returns arise, in the second stage constant returns arise, and in the third and final
stage diminishing returns arise.
This can be represented in the form of a diagram as follows:
• I = Stage of Increasing Returns to scale
• II = Stage of constant Returns to scale
• II I= Stage of diminishing Returns to scale
Business Economics
100
Fig. 2: Returns To scale curve
Increasing Returns To Scale

As already mentioned, increasing returns to scale arise in the first stage. In this stage when all
inputs are increased in a given proportion, production increases by a greater proportion. Let us
examine the causes of increasing returns to scale.
1. Dimensional economies: These arise when a capital asset is enlarged in order to increase
production. This enlarged capital asset results in output more than theproportionate cost. For
example, if the diameter of a water pipe is doubled, the water flow increase by more than
double. When compared to the increased investment on the water pipe, the output increase is
much greater.
So, we can observe that, when the size of a capital good is increased, its total capacity of
output increases at a greater rate than the expenditure (cost) incurred in increasing its size.
These dimensional economies increase the output and reduce the average cost.
2. Economies of indivisibility: Another cause of increasing returns is the indivisibility of some

of the capital goods (e.g.: machinery) indivisibility implies that these capital goods are available
only in specific range of sizes. Suppose a machine has the capacity to produce 10,000 soaps.
If it is used to produce only 5,000 soaps, then the fixed cost of the machine is spread over
5,000 soaps. In the other hand, if 10,000 soaps are produced, now the fixed cost of that
machine is spread over 10,000 soaps, it means that the arranged fixed cost is, reduced by 50
percent.
So, when the output is increased, the machinery and other fixed assets are fully and effectively
used. The average cost of production decreases. These are considered technical economies.
Indivisibilities are also associated with labour, management, advertisement, etc. In case of
a taxi, the salary of the driver is spread over a few passengers. In case of a bus, the salary of
the driver is spread over many passengers. Similarly, the salary of a manager is spread over
units and its production of the firm. Also the advertisement cost is spread over more units,
if the output of the firm is increased.In all these cases, with the increase in production, the
average cost decreases.
Business Economics
101
3. Economies of specialisation: Increasing returns are also due to the economies of special
isation. In a small sized firm, the workers have to look after a wide variety of jobs. There is no
occupational specialisation.
But when the firm expands its output, more workers can be employed. Each can specialise in
one job. Then the average productivity of the worker increases. The total production also in
creases more than proportionately. All this is due to the specialisation of workers in particular
jobs. These are referred to as the economies of specialisation. They result in increasing returns
and lower costs of production.
Thus, economies of scale arise resulting in increasing returns in the initial stage.
These economies of scale can be classified as internal and external economies. They are
discussed later in this unit.
Constant Returns To Scale

As the firm goes on expanding its output, the economies of scale are gradually exhausted.
Beyond a point, expansion of output fails to generate increasing returns. At that stage, constant
returns arise. It means, at that stage, production increases in the same proportion as the
increase in inputs. For example, if inputs are increased by 10 percent, production also
increases by 10 percent.
At this stage, the internal and external economies balance with the diseconomies.
Diminshing Returns To Scale
The stage of constant returns to scale does not last long.
As the scale of production is increased further and further, the internal and external economies
are outweighed by their diseconomies. Then production increases at a less than
proportionate rate. At this stage, if the inputs are increased by 10 percent, production increases
by less than 10 percent.
So diminishing returns arise because the diseconomies of scale (Internal and external)
exceed the economies of scale (Internal and external).
As the scale of production is allowed to increase, beyond a limit, the business becomes unwieldy,
all kinds of problem arise. There is too much pressure on supervision and control. A host
of supervisors are appointed for effective supervision. As a result, decision-making becomes
difficult followed by delay. The firm’s efficiency will be at stake and slowly inefficiency creeps
into the management.
Diseconomies multiply resulting in higher cost of production per unit of output. The output
increases at a less than proportionate rate. With the expansion of output, there is increased
demand for raw materials, power, transport, labour etc., so their prices increase resulting in
higher cost of production. Thus, as the scale of production increases, the returns to scale arise
in the following order:
(a) Increasing return in the first stage.
(b) Constant returns in the second stage.
(c) Diminishing returns in the third stage.
Business Economics
102
18. The diminishing return, second stage completes when_________.
a) MP is negative
b) MP is 0
c) AP is negative
d) AP is 0
19. In third stage, MP is __________.
a) 0
b) Constant
c) Positive
d) Negative
20. When all input variables are changing, _________ occurs.
a) Scale of production
b) Input of production
c) Factor of production
d) Proportionate production
21. In the constant return to scale, why further expansion does not help?
a) Economies of scale increases

b) Economies of scale exhausted
c) Economies of scale in the negative
d) Economies of scale at the peak
22. One of the factors at work in the increasing return to scale is _________.
a) Economies of indivisibility
b) More demand for raw materials
c) Economies of scale in the negative
d) Economies of scale at the peak
Business Economics
103
23. Economies of specialisation works in __________.
a) Constant returns to scale

b) Diminishing return to scale
c) Increasing return to scale
d) Economies of variable proportion
24. In diminishing return to scale:
a) Economies of the scale and diseconomy of the scale are same (EOS=DOS)
b) EOS outweigh DOS
c) Both are decreasing
d) DOS outweigh the EOS
Business Economics
104
Summary
Classical economists considered how output can be increased by keeping one or
some factors constant, while increasing the other.
Another type of increase in which one factor is varied, while keeping the other
constant. This is the modern version of the law of diminishing returns (the law of
variable proportions).
There is still one more type in which all the inputs are varied at the same time in the
same ratio. This is called the law or “returns to scale” refer to the long run.
While the fixed factors are kept constant in case of the law of variable proportions, all
factors are variable in case of “returns to scale”.
In the explanation of law of variable proportion (short run), there are three stages.
The total production is increasing at an increasing rate in the first stage. This is
the stage of increasing returns. The Marginal product and the Average product are
increasing. The producer will not stop in the first stage.
In the second stage the total product is increasing at a decreasing rate. This is the
stage of diminishing returns.
Towards the end of this stage, total product becomes maximum and constant. Then
Marginal Product becomes zero. A rational producer will not go beyond this stage.
Companies are able to do economies of scale by increasing production and lowering
costs.
For the long run, in the economies of scale, there is increase in production. As the
firm increases all the inputs in the long run, other things remaining the same, the
output increases in three stages
In increasing returns to scale, dimensional economies, economies of indivisibility,
economies of specialisation work.
In constant return to scale, the economies of scale are gradually exhausted
In diminishing return to scale, as the scale of production is increased further and
further, the internal and external economies are outweighed by their diseconomies.
Business Economics
105
Terminal Questions
1. What is production function? Explain the Law of Variable Proportions.
2. Cobb-Douglas production function: Distinguish it from law of variable proportions.
3. Explain the law of diminishing returns with its assumptions.
4. With the help of diagram show how marginal product, average product change in three
stages.
5. Compare the Increasing return to scale and constant returns to scale with diagrams.
Business Economics
106
Answer Keys
1 b
2 c
3 d
4 a
5 c
6 b
7 a
8 c
9 c
10 a
11 c
12 c
13 a
14 d
15 a
16 c
17 c
18 b
19 d
20 a
21 b
22 a
23 c
24 d
Business Economics
107
Activity
Activity Type : Offline Duration: 40 minutes
Estimate the labour cost per unit of marginal product for each of the rounds completed and
record the results in Column D of the overhead. For example, say each worker gets paid ₹7
during the period of production. Since the first worker added 5 units of output, those units
cost the company an additional (in addition to the cost of the scissors and the paper) ₹1.40
per unit of output (₹7 divided by 5). The second worker added 7 units of output, or added
output at ₹1 per unit of output (₹7 divided by 7). The third worker added output at ₹1.40 per
unit of output and the fourth worker added output at a cost of ₹2.33 per unit of output added.
Answer the following questions based on the results recorded on the overhead:
1) What factors of production were used to produce the cups? (Capital scissors and paper;
labor)
2) With the addition of what worker(s) did diminishing returns occur? (At any point where
marginal product was lower than the previous round)
3) What happens to the cost per unit as diminishing returns set in? (It rises)
Glossary
• Short-run function: The cost price which has short-term inferences in the
manufacturing procedures.
• Proportionate production: Function implies that fixed factors of production such as
land, labor, raw materials are used to produce a fixed quantity of an output and these
production factors cannot be substituted for the other factors.
• Equilibrium Price: The consumer cost assigned to some product or service
such that supply and demand are equal, or close to equal.
Business Economics
108
Bibloography
Textbooks
• Graham, P., & Bodenhorn, D. (1980). Managerial economics (1st
ed.). Reading, Mass.: Addison-Wesley Pub. Co.
• Samuelson, W., & Marks, S. (2006). Managerial economics (1st
ed.). Hoboken, NJ: John Wiley and Sons.
Video Links
Topic Link
Deriving short run https://www.youtube.com/watch?v=dManN3nBQ9U

costs
Cost Theory Basis https://www.youtube.com/watch?v=LvDQatlWXeQ
Image Credtis
Fig.1 : https://www.researchgate.net/figure/Graph-of-Classical-production-function_
fig4_332211665
Fig.2 : https://www.thekeepitsimple.com/law-of-returns-to-scale/
Keywords
Marginal products
Diminishing returns
Cobb-Douglas function
Business Economics
109
Business Economics
Module 3
Unit 2
Economies of Scale
and Cost Analysis
Business Economics
110
Table of Contents
Aim ------------------------------------------------------------------------------------ 112

Instructional Objectives ----------------------------------------------------------- 112
Learning Outcomes ---------------------------------------------------------------- 112
3.2.1 Economies of scale --------------------------------------------------------- 113

3.2.2 Cost_Long run and short run -------------------------------------------- 118
3.2.3 Break-even analysis and chart ------------------------------------------- 124
Self-Assessment Questions ---------------------------------------------- 125
Terminal Questions ------------------------------------------------------------------ 126
Answer Keys --------------------------------------------------------------------------- 126
Activity ----------------------------------------------------------------------------------- 127
Glossary --------------------------------------------------------------------------------- 127
Bibliography ----------------------------------------------------------------------------- 127
Video Links ------------------------------------------------------------------------------ 127
Image Credits --------------------------------------------------------------------------- 127
Keywords -------------------------------------------------------------------------------- 127
Business Economics
111
Aim
To familiarise the students with the impact of cost and break-even analysis in busi-ness
decisions.
Describe the long and short-run cost
Apply break-even concept and business decisions
Learning Outcomes
Recognise implications of cost in the long run and short run
Analyse the importance of break-even analysis in business decisions
Business Economics
112
3.2.1 Economies of scale
When the scale of production increases, economies of scale arise. These economies are
called the economies of large-scale production. The reductions in production costs as a
result of an increase in the scale of production are considered economies of scale.
These economies of scale are broadly classified in two categories. They are:
1. Internal economies
2. External economies.
Let us study them in detail.
Internal Economies
Internal economies may be defined as those reductions in production costs that accrue to a firm
are a result of its own expansion of output. Internal economies are the advantages that a firm
receives in the process of its expansion or development. The important internal economies are
technical economies, managerial economies, marketing economies, financial economies, risk-
bearing economies, and labour economies. These are limited to the firm or company which is
under the process of expansion. They are not applicable to other firms in the same industry.
When a firm expands i ts output, it secures certain r eduction i n production costs. These are
considered internal economies. They accrue only to firm.
The internal economies can be further sub-divided into the following.
(i) Technical economies
(ii) Managerial economies
(iii) Marketing economies
(iv) Financial economies
(v) Risk-bearing economies
(vi) Labour economies
(i) Technical Economies

Certain types of capital assets (e.g., Machinery) are normally big in size. They are
indivisible. They can be used only by big firms. A small firm may not have sufficient work to
make use of such machinery which is indivisible. Machines of different capacities may be
available. There are certain ranges of capacity (e.g., Machinery having the capacity of different
ranges like 1,000 units of production capacity. 5,000 units, 10,000 units, and so on). If the fixed
cost is distributed over its production, the average fixed cost becomes higher per unit of output.
Due to increased orders suppose the firm produces 5,000 units per day. Then the
machinery can be put to full use. The average fixed cost decreases.
Prof. Carincross classifies these technical economies as follows:

(a) Economies of superior techniques
(b) Economies of increased dimension
(c) Economies of linked processes
(d) Economies in power
(e) Economies of by-products
(f) Economies of continuation
Business Economics
113
By adopting superior techniques, a firm can turn out more output in less time. The average cost
of production decreases (e.g., Automation). Similarly, if bigger sized machines are used, the
turnout of output will be much greater than the increased cost of the bigger machines. Here also
the cost of production decreases. Suppose various production processes are linked and carried
out without loss of time. Then the output can be increased at less average cost. Power
consumption can be economised; raw materials and by-products can be used without any
wastage. Continuation in the production process reduces average cost, for example, instead of
printing 1,000 pamphlets, suppose 2,000 are printed. The composing cost remains the
same. So, the average cost of printing decreases.
(ii) Managerial Economies
When the output is increased managerial economies arise. Managerial economies are
the reductions in managerial costs as a result of the expansion of output. Management is an
indivisible factor. When production is expanded, the management cost per unit of output
decreases. A good manager can organise greater output with the same efficiency. But his
salary remains the same. So, the average cost of management decreases.
Suppose the salary of the Manger is Rs.30, 000/-per month. Instead of 15,000 units per month
suppose 20,000 units are produced. Earlier the cost of management was Rs.2 per unit of output
and now it is Rs.1.50 per unit of output. Moreover, a large firm can appoint a first-rate
Manager who can be paid a good salary. She or he can administer better, can save time and
money, and also can supervise the work better. Productivity of the workers can be increased. So,
the average cost of production decreases.
The work can be divided into different sections. Each section can have a supervisor. Workers
work better when there is close supervision. So, productivity increases and average cost
decreases.
(iii) Marketing Economies
The economies of buying and selling are known as marketing economies. When a firm
increases its scale of production, it purchases raw materials on a large scale. So, it can
obtain them at concessional rates. It can employ marketing experts who can purchase quality
raw material at reduced wholesale prices. These are known as economies of buying.
Similarly, a big firm can obtain economies in selling. It can appoint sales managers to look at the
orders that are placed by various Stockiest and distributors and arrange. Bulk quantities can be
sent to them. They will distribute them to retailers. By transporting finished products in bulk to
stockiest and distributors, the average cost of transport can be reduced.
A big firm can take up publicity and advertising on a large scale. The average cost of publicity
becomes less. A big firm can have its own vehicles for transport. It can economies transport
costs. Thus, big firms can obtain marketing economies.
(iv) Financial Economies
A large firm has a greater advantage in financial matters. It has a greater reputation and
influence. Big firms attract large capital at low rates of interest. People have greater faith in
them. Their shares and debentures can be sold easily. Thus, they can secure large capital.
Small firms cannot raise much capital in the money market. It is not easy to sell their shares
and debentures. They need to depend on personal resources, bank finance and private
money lenders. The cost of borrowing is high. They are prone to borrow at high rates of
interest.
Thus, when a firm increases its scale of production, it gains all the advantages and financial
economies of a big firm.
Business Economics
114
(v) Risk-bearing Economies
A large firm can produce a wide variety of goods and spread risks among various products.
It can eliminate or minimise risks. It can spread risks in the following ways.
a) By diversification of output: As already mentioned, a big firm can produce a wide variety of
goods. The loss secured in the production or sale of one good can be compensated by the gain
in others. For example, the Godrej Company produces Almirahs, store wells, locks, refrigerators
etc. If there is some loss in any one of these products, it can be compensated by the gain incurred
by the others, it can spread risks over the products.
b) By diversification of market: A big firm not only produces a wide variety of products. It sells
them in different markets, all over the country. The loss in one market can be covered by the gain
of the others.
c) By diversification of sources of supply as well as process of manufacturing: A large
firm can secure raw materials, fuel, etc. For different sources. It maintains sufficient stocks. It
tries to prevent disruption in production due to shortage of raw materials, fuel, etc. Breakdown in
production is prevented as far as possible. The process of manufacturing is streamlined to that
extent.
(1) Labour Economies
Labour economies can be obtained through division of labour. The entire work can be
subdivided into units and entrusted to trained and skilled labour. Productivity increases due to
specialisation of labour. All the advantages and economies of division of labour can be obtained.
Since productivity increases, the average cost of production decreases.
The above are considered the internal economies. When a firm expands its output, it derives
from the above economies. So far, the internal economies are discussed. In fact, firms receive
external economies also.
External economies
External economies may be defined as those reductions in production costs that accrue to a
firm as a result of the expansion of industry. External economies are the advantages that the
firms in an industry receive as a result of the expansion or development of the industry as a
whole or the state policy. These advantages come from outside the industry and hence they
are called external economies. The important among them are economies of localisation,
economies of information, economies of disintegration and economies of by-products.
The various ways by which external economies work are:
Business Economics
115
1. Economies of information
The perfect information on prices of inputs can be accessed easily when some firms are
located close to each other. Since the prices of the inputs are known to all the firms its supplier
cannot charge different prices to different buyers. Avoiding impartial selling input prices to
different firms reduces the overall cost for all such firms.
2. Economies of innovation
Efficient production methods that involve research and development practices could be the
center point for establishing the premises for many firms. Eventually, that practice helps the
firms to undergo all the technological innovations and advanced developments to optimise cost
effectiveness, that reduces the production cost.
3. Economies of concentration
Collaboration of firms of the same industry enhances advantages of utilising the existing
infrastructure and supply networks. Such practice will also help the skilled workers to shift
from one firm to another for work. This will also help the firms to get the labour easily.
4. Tax breaks
If the government of a country provides tax modifications on the production of some products
or offers subsidy on the purchase of raw materials, that would reduce the cost of production of
all such firms in that respective industry. It could also be another determent source of external
economies of scale.
Business Economics
116
1. The gain the companies can make on their own ____.

a) External economy
b) Labour economy
c) Internal economy
d) Innovation
2. Through regulation of power consumption, if the cost is reduced, it is_____.

a) Price economies
b) Cost economies
c) Economy of power
d) Technical economies
3. Specialisation of labor leads to _____.

a) External economy
b) Labour economy
c) Labour
d) Division of labour
4. Diversification of companies’ products is one of the forms of _____.

a) financial economy
b) product economy
c) technical economy
d) internal economy
5. When the cost is reduced through cluster, it is ______.

a) external economy
b) product economy
c) technical economy
d) internal economy
6. External economy can also be achieved through _______.

a) R&D center
b) Product economy
c) Technical economy
d) Internal economy
7. Govt can also contribute by:

a) innovation
b) subsidy
c) diversification
d) internal economy
Business Economics
117
3.2.2 Short-Run and Long-Run Costs
Unlike short-run costs, long-run costs do not have fixed factors of production. In the short run, there
are both fixed and variable costs. Coherent long-run costs are encouraged when the
combination of outputs that a firm produces results in the desired quantity of the goods at the
lowest possible cost. Variable costs change with the output. Examples of variable costs include
employee wages and costs of raw materials.
The short-run costs rise, or decline based on variable cost as well as the rate of production. If a
firm manages its short-run costs well over time, it will be more likely to succeed in reaching the
desired long-run costs and the targets.
Variable cost: A cost which gets modified with the change in volume of activity of an
organisation.
Fixed cost: The costs that remain constant or fixed irrespective of the production activity of the
business.
Long-Run Costs
Long-run costs are accumulated when firms change production levels over time in response to
expected economic profits or losses. In the long-run there are no fixed factors of production.
The land, labour, capital goods, and entrepreneurship all vary to reach the long-run cost of
producing a good or service. The long run is a planning and implementation stage for producers.
Efficient long-run costs are sustained when the combination of outputs that a firm produces
results in the desired quantity of the goods at the lowest possible cost.
Examples: change in the quantity of production, decrease or expand the operations of a company
and entering or leaving a market.
Short-Run Costs
Short-run costs are accumulated in real time throughout the production process. Fixed costs have
no impact of short-run costs, only variable costs and revenues affect the short-run production.
Variable costs change with the output. Examples of variable costs include employee wages and
costs of raw materials. The short-run costs increase or decrease based on variable cost as well
as the rate of production. If a firm manages its short-run costs well over time, it will be more
likely to succeed in reaching the desired long-run costs and goals.
Differences
The main difference between long-run and short-run costs is that there are no fixed factors in
the long run; there are both fixed and variable factors in the short-run. In the long run the
general price level, contractual wages, and expectations adjust fully to the state of the
economy. In the short-run these variables do not always adjust due to the condensed time
period. In order to be successful a firm must set realistic long-run cost expectations.
How the short-run costs are handled determines whether the firm will meet its future production
and financial goals.
C = f(X)
where C is the cost of production and X represents the level of output.
Since the firm is constrained in the short run, and not so in the long run, the long-run cost TC(y)
of producing any given output y is no greater than the short-run cost STC(y) of producing that
output:
TC(y) < STC(y) for all y. Now consider the case in which in the short run exactly one of the firm's
inputs is fixed.
Business Economics
118
Fig. 1: short-run and long-rum costs
Total Fixed Cost

Fixed cost does not change with the level of output (thus, fixed). This includes building,
machinery etc. Hence the cost of such inputs such as rent, or cost of machinery constitutes
fixed costs. Also referred as overhead costs, supplementary costs or indirect costs, these costs
remain the same irrespective of the level of output.
Hence, if we plot the Total Fixed Cost (TFC) curve against the level of output on the
horizontal axis, we get a straight line parallel to the horizontal axis. This indicates that these
costs remain the same and that they must be incurred even if the level of output is zero.
Total Variable Cost
These costs vary with the level of output or production. When production level is zero, TVC
will also be zero. Thus, the TVC curve begins from the origin. The TVC shape is peculiar. It is
said to have an inverted-S shape. This is because, in the initial stages of production, there is
scope for efficient utilisation of fixed factor by using more of the variable factors. Hence, as the
variable input employed increases, the productive efficiency of variable inputs ensures that the
TVC increases but at a diminishing rate. This makes the first part of the TVC curve that is
concave.
As the production continues to increase, more and more variable factor is employed for a
given amount of fixed input. The productive efficiency of each variable factor falls, and it adds
more to the cost of production. So, the TVC increases but now at an increasing rate. This is
where the TVC curve is convex in shape. And so, the TVC curve gets an inverted-S shape.
Total Cost
Total cost is the sum of fixed and variable costs incurred in the short-run. Thus, the short-run
cost can be expressed as
TC = TFC + TVC
Note that in the long run, since TFC = 0, TC =TVC. Thus, we can get the shape of the TC curve
by summing over TFC and TVC curves.
The TC curve looks like inverted-S shaped. It is mainly due to the TVC curve. Since the TFC
curve is horizontal, the difference between the TC and TVC curve is the same at each level of
output and equals TFC. This is explained as follows: TC – TVC = TFC
The TFC curve is parallel to the horizontal axis while the TVC curve is inverted-S shaped.
Thus, the TC curve, with the shape of TVC, begins from the point of TFC not from the origin. The
law of variable proportions explains this.
Business Economics
119
Fig. 2: Total cost curve
To change the output there are two ways. In the short run we change one input while keeping the
rest constant-which is known as the law of variable proportions. The other one is to change all the
inputs to bring a change in the output. To change all the inputs, the firm needs some time which
is known as long run, and this is known as the law of returns to scale. Under this law of returns to
scale we get first increasing returns then constant and finally diminishing returns to scale.
Opportunity cost
Opportunity cost is the benefit foregone which could have accrued from the second-best
alternative had it been chosen instead of the best alternative which we have chosen and enjoying
it. Example, suppose there are three opportunities, and the yield or benefit of each opportunity
are given below
Benefit
Opportunity 1 Rs 10,000
Opportunity 2 Rs 8,000
Opportunity 3
Any rational decision maker will always go for opportunity1, because it has more benefits to offer.
Now by going for opportunity 1, the benefit from opportunity 2, he foregoes. So here opportunity
cost is Rs 8000 when he selects undertakes opportunity1.
Explicit cost
The costs which are spent for regular operations and are easily quantifiable and can be shown
on the accounting records are called explicit cost.
Example: advertisement cost, inventory cost.
Implicit cost
It is an opportunity cost that arises when a company uses internal resources toward a project
without any explicit compensation for the utilisation of resources. For example, the company
uses one room for storing the goods produced. If the room is not used for this purpose, it could
have been given to some other individual or company for rent. Since the company uses that
room as warehouse, it is foregoing the rental income. This rental income which the company
would otherwise have received is the implicit cost for the company which is not recorded in the
statements of accounts.
Business Economics
120
Revenue
Revenue is the top line figure on the income statement. Revenue or income is nothing but
money. It is generally generated from normal business operations of any commercial
organisations. This is calculated as the average sales price times the number of units sold.
From the revenue, costs are subtracted to determine net income. Royalties, fees, or interests
may also be a source of revenue.
By setting a cost price less than or equivalent to the market cost price, an enterprise believes
it can sell as many quantities of its products as it needs. The rationale for lowering the cost price
of a product is lost in such a scenario. As a result, the enterprise should set a cost price that
matches the market price of the commodity to the greatest possible extent.
Total Marginal Revenue
Total revenue: The total revenue is the total amount a vendor can collect by the sale of commodities
or services from the customer. The price of the commodities can be expressed as P × Q,
which means the cost price of the commodities multiplied by the amount sold. Therefore, total
revenue (TR) is defined as the market cost price of the commodity (p) multiplied by the
enterprise's output (q).
Thus,
TR = p × q
Where,
TR-Total Revenue,
P-Price,
Q-Quantity.
Average revenue: The average revenue represents the revenue initiated per unit of output sold.
The average revenue contributes greatly to the profit of any enterprise. In calculating profit per
unit, the average (total) cost is subtracted from the average revenue. It is usually more profitable
for an enterprise to manufacture the greatest amount of output.
AR = TR/q = p × q/q = p
Where,
AR-Average Revenue,
TR-Total Revenue,
P-Price
Q-Quantity.
Marginal revenue: It is defined as the revenue earned from the sale of a new product or unit. In
other words, it is the revenue that a company generates when it sells an extra unit. Management
uses it to analyse customer demands, plan the production schedules, and set the prices of
products.
In accordance with the law of diminishing returns, the margin of revenue remains constant to a
certain output level and slows down as output increases.
MR = Change in total revenue/Change in quantity
Where,
MR-Marginal Revenue,
TR-Total Revenue,
Q-Quantity.
Business Economics
121
8. The factors which are fixed in nature are not in _____.
a) short-run production
b) long-run production
c) variable cost production
d) marginal production
9. Inverted S-curve is the shape of ______.
a) TVC and AVC

b) TC and AVC
c) AVC and AFC
d) TVC and TC
10. Implicit cost is _________.
a) marginal cost
b) an opportunity cost
c) variable cost
d) fixed cost
11. Change in total revenue and output gives:
a) average revenue
b) fixed revenue
c) marginal revenue
d) revenue from price
12. _______could be an example for explicit cost.
a) depreciation
b) wages
c) lease payment
d) all given
Business Economics
122
13. If all the factors of production are increased in the same proportion and consequently
output increases by a greater proportion then it is called ____.
a) Constant returns to scale

b) Decreasing returns to scale
c) Increasing return to scale
(d) None of these
14. If there is an increase in production the difference between TC and TFC:
a) Remains Constant
b) Increases
c) Decreases
d) Both Increases and Decreases
15. Which of the following is true?
a) AC=TFC – TVC
b) AC = AFC + AVC
c) AC=TFC + AVC
d) AC = AFC + TVC
16. When the production is shut down _________.
a) Fixed Cost Increases

b) Variable Costs Decline
c) Variable Costs become zero
d) Fixed Costs become zero
17. Which of the following is true?
a) AC=TFC – TVC
b) AC=TFC + AVC
c) AC = AFC + AVC
d) AC = AFC + TVC
18. The AFC at 5 units of output is Rs. 30. AVC at 5 units of output is Rs. 80. The average
cost of producing 10 units is:
a) Rs. 200
b) Rs. 220
c) Rs. 56
d) Rs. 80
Business Economics
123
3.2.3 Break-even Analysis
A break-even analysis is an analysis which compares the costs of the business with the
revenue it generates and determines the period or output quantity at which revenue is equal
to the cost incurred. In other words, the analysis estimates the point at which there will be no
profit and no loss.
The formula
Break-even level of production =Total fixed costs/ Contribution per unit
{Contribution = Selling price/unit – Variable cost per unit}
(This is the value added/contributed to the product when sold)
Break-even output is the output at which total revenue equals total costs (neither a profit
nor loss is made, all costs are covered).
Break-even chart
A break-even chart, given below, shows the costs and revenues of a business across
different levels of output and the output needed to break even.
Fig. 3: Break-even chart
In the break-even analysis, the margin of safety is how much output or sales level can fall
before a business reaches its break-even point. If the company’s BEO (break even output)
is 3,000 units and the company produces 5,000 units then MOS (Margin of safety) is 2,000
units.
Example
The fixed cost is 5,000 across all output (since it is fixed!).
The variable cost is ₹3 per unit so will be ₹0 at output is 0 and ₹6,000 at output 2,000. so, you
just draw a straight line from ₹0 to ₹6,000.
The total costs will then start from the point where the fixed cost starts and be parallel to the
variable costs (since T.C.= F.C.+V.C).
You can calculate the total cost at output
2,000: (₹6,000+₹5,000=₹11,000).
The price per unit is ₹8 so the total revenue is ₹16,000 at output 2,000.
Now the break-even point can be calculated at the point where total revenue and total
cost equals– at an output of 1,000.
At 1,000 units, cost is =₹5,000+1,000*₹3=₹8,000
(In order to find the sales revenue at output 1000, do ₹8*1,000= ₹8,000.
Business Economics
124
19. Contribution contributes to _________.
a) total variable cost

b) fixed cost
c) marginal cost
d) selling price
20. Beyond the break-even point ____ occurs.
a) output
b) sales
c) loss
d) profit
21. Contribution is a function of:
a) variable and fixed cost

b) variable cost
c) selling price and fixed cost
d) selling price and variable cost
22. Break-even point is where,
a) TR=TC
b) TR=TVC
c) TR=TC
d) TVC=TFC
23. Margin of safety occurs when:
a) the output is equal to BEO

b) BEO is more than actual production
c) actual production is more than BEO
d) the production cost is less
Business Economics
125
Terminal Questions
1. What are returns to scale? How do they arise?
2. What are the economies of large-scale production?
3. Inverted s-shape curve: Explain.
4. Differentiate average revenue and marginal revenue when production increases.
5. Analyse break-even chart.
6. Write your views when the margin of safety is negative.
Answer Keys
1 c
2 d
3 b
4 d
5 a
6 a
7 b
8 b
9 d
10 b
11 c
12 d
13 d
14 b
15 b
16 c
17 c
18 b
19 b
20 d
21 d
22 a
23 d
Business Economics
126
Activity
Relate the cost of Indian telecom sector with the long-run cost curve
Glossary
• Managerial Economies: A branch of economics involving the application of
economic methods in the organisational decision-making process.
• Risk-bearing Economies: Are often derived by large firms who can bear business
risks more effectively than smaller firms.
Bibliography
Textbooks
• Graham, P., & Bodenhorn, D. (1980). Managerial economics (1st ed.).
Reading,
Video Links
Topic Link
Cost Functions https://www.youtube.com/watch?v=niW8GS2_k_o
Understanding Firm https://www.youtube.com/watch?v=OSaLDDQk0OE

Short-run curves
Image Credits
Figures taken from source: https://economics.utoronto.ca/
Keywords
Diversification of Market
Diversification of
Sources Economies of
information Economies
of innovation
Business Economics
127
Business Economics
Module 4
Unit 1
Perfect and Monopolistic

Competitions
Business Economics
128
Table of Contents
Unit 4.1 Perfect and Monopolistic Competitions
Aim ------------------------------------------------------------------------------ 130

Instructional Objectives ---------------------------------------------------- 130
Learning Outcomes --------------------------------------------------------- 130
4.1.1 Perfect competition-Demand and supply ---------------------- 131

Self-Assessment Questions ------------------------------------ 135
4.1.2 Perfect competition-Equilibrium ---------------------------------- 136
Self-Assessment Questions ------------------------------------ 142
4.1.3 Monopoly --------------------------------------------------------------- 143
Self-Assessment Questions ------------------------------------- 151
Summary ----------------------------------------------------------------------- 153
Terminal Questions --------------------------------------------------------- 155
Answer Keys ------------------------------------------------------------------ 156
Activity -------------------------------------------------------------------------- 156
Glossary ------------------------------------------------------------------------ 157
Bibliography ------------------------------------------------------------------- 157
Video Links --------------------------------------------------------------------- 157
Image Credits ----------------------------------------------------------------- 157
Keywords ---------------------------------------------------------------------- 157
Business Economics
129
Aim
To explain the determinants of demand, the exceptions, and the law of demand.
Describe demand and revenue of the firm
Explain the market demand curve and firm’s demand curve
Compare market supply curve and firm’s supply curve
Distinguish between short run and long-run equilibrium
Learning Outcomes
At the end of the Unit you will be able to:
Assess performance of markets and firms
Differentiate between short-run and long-run equilibrium
Compare perfect and monopoly competitions
Business Economics
130
4.1.1 Perfect Competition-Demand and Supply
Introduction
For the purpose of analysis and understanding economic dimensions of decision-making
like production and pricing, markets may be characterised based on the parameters discussed
in this section.
This refers to the number, size and distribution of sellers in any market. There can be a market
in which a very large number of sellers exist, and size of an individual seller is very small.
Whereas there can be another market with only one very large player, without any competitor.
These are two extremes, while there can be various combinations between these two levels.
Nature of Product
This refers to whether the product is homogeneous or differentiated (even if slightly). The
market we face may have sellers producing (and selling) the same products which are almost
identical. Typical examples may be vegetables, minerals, precious metals and jewels. Then
there can be a market with large number of sellers selling similar yet somewhat different
products like cosmetic, medicines and banking. As is obvious, decisions related to price,
output, etc., in each such market would be different for these situations.
Number and Size of Buyers

We know that any market has two players. One is buyer and the other is seller. As we
can categories markets on the basis of number and size of sellers, so also can be done on the
basis of number and size of buyers. If number of buyers is very large but the size of individual
buyer is small, the market will be evenly balanced between buyers and sellers. However, when
number of buyers is small and their size is large, the market is driven by buyers’ preferences.
Freedom to Enter into or Exit from the Market

Some markets may be very difficult to enter; there may be financial restrictions, legal
compulsions and technological constraints on entry. The other extreme, entering a market
may be very easy, without any such restriction. In agricultural and allied industries, a person
or a group of persons may enter with a motive of making profits through farming, without any
legal, financial or technological constraints. In such a situation, a perfect competition or a
monopolistic competition form of market arises.
Business Economics
131
Types of Markets
Type of Number Nature Number Freedom of Examples

Market of Firms of product of buyers entry and exit
Perfect Very Homogeneous Very (undifferentiated) Agricultural

competition Large (undifferentiated) Large commodities
shares un-
skilled labour
Monopolistic Many Differentiated Many Undifferentiated Retail stores,
competition detergents
Cars,
Oligopoly Few Undifferentiated Few Restricted computers,
or differentiated universities
Monopoly Single Unique Many Restricted Indian
Railways,
Microsoft
Monopsony Many Undifferentiated Single Not applicable Indian
or differentiated defense
Industry
Features of Perfect Competition

Presence of Large Number of Buyers and Sellers
There are many sellers (or suppliers) in the market, each being too small in size, relative to the
overall market, to affect the market price through a change in its own supply, the number of firms
also is so large that any particular firm, being so negligible with respect to the market, can, in no
way, affect the market price by selling a little more or a little less of the product. Market is also
classified by many buyers. Besides, buyers are so small in comparison to the entire market, that
they cannot exert any influence on the market price.
Homogeneous Product
The products sold by perfectly competitive firms are so identical that buyers are not able to
distinguish the product of one firm from that of another firm. In other words, perfectly competitive
firms sell a homogeneous product. Let us explain with an example. Consider unbranded spices,
it would be very difficult for any consumer to differentiate between spices sold across the
market. This, we refer to as product homogeneity; this makes the buyers totally indifferent
towards various sellers with respect to purchase of the product. Because products of all the
firms are perfect substitutes for each other.
Business Economics
132
Freedom of Entry and Exit
In a perfectly competitive market, there is no barrier to the entry of new firms into the industry in
the long run; a new firm can enter the industry with even a very small investment. This implies
that the market is open to competition from new suppliers. This, as we shall see subsequently,
would affect the long run profit made by existing firms in the industry. Similarly, any firm in the
industry has the freedom to move out in the long run. In fact, firms incurring losses do leave the
industry in the long run.
Perfect Knowledge
Producers and buyers have perfect knowledge about the market. All firms, whether existing or
new entrants, know about the production functions, technology(s), input prices and the
prevailing market price. Also, all buyers know the quality of the product and the price charged by
the firms, and they have no preference for any firm, as the products sold by all the firms are
homogeneous. Thus, there is complete information or perfect knowledge in the market.
Perfectly Elastic Demand Curve

The demand curve of a perfectly competitive firm is perfectly elastic. If a particular firm decides
to charge a price higher than the existing market price, its demand will be reduced to zero. This
is because buyers have perfect knowledge about the product and the prevailing market price and
they are indifferent about a particular firm; if one firm increases the price, buyers would promptly
move away from this firm and shift over to its competitors.
On the other hand, if a firm tries to gain advantage of increased demand by lowering the price,
its demand would increase to infinity. Either of these would lead to a perfectly elastic demand
curve. Refer to Figure 1 for the demand curve of a perfectly competitive firm.
INDUSTRY
Market FIRM
D Demand S Market
Price
Price
Supply
E
P* -----------------------------------------------------------
P = AR = MR
-------------------
S D
O Q* Quantity O Quantity
Fig. 1: Demand Curves of Industry and Firm
Business Economics
133
Market Supply Curve And Firm’s Supply Curve
You have seen that the demand curve of the firm is its average revenue curve. Let us also see
how to derive the short run supply curve for a firm. As we have seen in the previous section, the
perfectly competitive firm produces above the minimum point of its AVC and
discontinues production if price falls short of minimum AVC. This can be summed up with
the following conditions:
Condition I: If Price < minimum AVC, then shut down.

Condition II: If Price > minimum AVC, then choose any output that would maximise
profit.
We can derive the short run supply curve for an individual firm from these two conditions. It is
obvious that if the price is any less than minimum AVC, the firm would not produce (or supply),
i.e., output would be equal to zero. In other words, for such price, the supply curve would coincide
with the vertical axis. For any price above minimum AVC, the firm would choose an output level
that would satisfy the conditions of profit maximisation. Thus, supply curve of the firm would be
identical to the short run marginal cost curve above the minimum point of the AVC curve.
Consider the following market demand and supply curves in a perfectly competitive industry
as
D: q=25-0.5P and S:q=10+1.0P. Now, Consider a firm in this industry whose cost function is
C= 25-2Q+4Q2. Should this firm produce in the short run? if it produces, then in how much
quantity should it produce?
Solution:
The Market equilibrium price is 25 - 0.5 P = 10+1.0 P ( D=S )
=> P = 10 and Q = 20
The cost function of the firm is C = 25 -2q+ 4q2
For profit maximisation MR = MC =P
=> MC=-2+8q=P
q=1/8 (P+2)
The firm Will produce as long as the AR> AVC

TVC= -2q+4q2
=> AVC= -2+4q
AVC is a linear function and has no minimum. The firm would produce that quantity which
is: q=1/8 (P+2) = 1/8 (10+2) = 1.5 units
Business Economics
134
1. A perfectly competitive firm has all the following features EXCEPT:
a) Price taker
b) Quantity adjuster
c) Perfectly informed
d) Price discriminator
2. Perfect competition is a market condition with ______.
a) Many sellers
b) Single buyer
c) Very large number of sellers
d) Restricted entry and exit of players
3. In perfect competition the buyers are indifferent to the sellers because

of ______.
a) difference in price
b) many sellers
c) place
d) homogeneous product
4. The demand curve of perfectly competitive market is ______.
a) perfectly inelastic
b) perfectly elastic
c) unitary elastic
d) relatively elastic
5. When the price is high, the demand becomes zero because buyers are ______.
a) indifferent to the firm

b) indifferent to the brand
c) indifferent to the product
d) reluctant
6. Shut down decision can be taken when ______.
a) P=VC
b) P<min AVC
c) P>AVC
d) P=TC
Business Economics
135
4.1.2 Short-Run and Long-Run Equilibrium
I. Short-Run Equilibrium
In the short run, an individual firm under perfect competition may either earn supernormal profit,
or normal profit, or can incur losses. This depends on the positions of the short-run cost curves.
These three possibilities are shown by the three short-run equilibrium positions of competitive firm.
Let us begin this section with the assumption that in each case, the point of market equilibrium
is attained by the intersection of market demand curve and market supply curve, at point E.
An individual firm takes the equilibrium price P* as given, and faces an infinitely elastic demand
curve given by P=AR=MR, as shown in Figure 2.
Case of Supernormal Profit
In the short run a perfectly competitive firm can earn supernormal profits (when revenue
exceeds cost). The Average Cost (AC) and Marginal Cost (MC) curves are the usual short-
run cost curves. As the firm maximises profits at the point where MR is equal to MC and where
MC cuts MR from below, the point of equilibrium of the firm in Figure 2 is at point E; output at
this price is OQ*. So, by selling OQ* equilibrium output at equilibrium price P*, the total
revenue earned by the firm is given by the rectangular area OP*EQ* (area below the AR curve,
since TR = AR. Q). To produce this output, the rectangular area OABQ* (area below the AC
curve, since
TC=AC.Q). Therefore, profit earned by the firm is given by the rectangular region AP*EB. This
is the supernormal profit made by the firm in the short run, because the ruling market price P* is
greater than average cost.
In the short run, a perfectly competitive firm may earn supernormal profit, or normal prof-
it, or can incur losses, depending on the position of the short-run cost curves.
INDUSTRY
Market
D Demand
Price
MC AC
E
P* _____________________ AR = MR
A
------------------
B
-------------------
S D
O Q* Quantity
Fig. 2: Demand Curves of Industry and Firm
Business Economics
136
Let us explain maximisation by a perfectly competitive firm with a numerical example.
Total cost function of a competitive firm selling its product at ₹640 per unit is
Tc = 240Q - Q2+ Q2.
Find the profit maximising output and the value of maximum profit.
Solution:
TC = 420Q - 20Q2 + Q3
MC = 240 - 40Q + 3Q2
For profit maximisation MR = MC, when MC is rising.
Since this firm is in perfect competition P = MR = AR = 640

240 - 40Q + 3Q2 = 640
Solving for Q, we get: Q = - 20/3 ( rejected ) and 20 ( accepted )

Second order condition: d2 π/ dQ2 = - 80 < 0
The equation for total profit is: π = R (Q) - C (Q) = 640Q - 240Q - 20Q2 +Q3
Substituting Q = 20 in this equation, we get: π = 8,000
Case of Normal Profit

Not all firms earn supernormal profits in the short run; some of them may also earn
normal profits (when revenue is equal to cost). As in the previous case, equilibrium of the
firm shown at E in Figure 3, the output that maximises profit is OQ*. Total revenue earned
by the selling OQ* is the rectangular area OP*EQ*. Similarly, the total cost of producing OQ*
is also given by the area OP*EQ*. Profit is thereby nil, in other words, the firm makes
normal profit, and ends up producing at the break-even level of output.
This situation occurs because the average cost curve is tangent to:
MC AC MC AC
Price
Price
B
E A
P* _____________________ AR = MR _____________________ AR =
P*
_____________
D D
O Q* Quantity O Q* Quantity
Fig. 4: Loss in the Short Run

Fig. 3: Normal Profit in the Short Run
Business Economics
137
Case of Loss (or Subnormal Profit)
In Figure 4, point E determines the equilibrium level of output OQ* to be produced by the firm.
Total revenue is given by the rectangular area OP*EQ* (as in the earlier cases) and the cost of
producing OQ* level of output is given the rectangular area OABQ*. Thus, the total cost
producing OQ* is more than the revenue earned by selling OQ*. The amount of loss incurred by
the firm is given by the area P*ABE. The firm incurs loss or subnormal profit in the short run.
Because the average cost of producing this output is more than the ruling market price.
Example
The Total Cost (TC) of a pertectly competitve firm is given as: TC = 1000 + 200Q - 20Q2 +
2Q3. Below what price of the product may the firm decide to shut down its
operations?
Solution:
TC = 1,000+200Q - 20Q2+2Q3
MC = 200 - 40Q + 6 Q2, AVC = 200 - 20Q + 2Q2
The shut down point is where P = minimum AVC. But profit maximisation requires that
P = MC. Thus, by setting MC = AVC, we get:
200 - 40Q+6Q2 = 200 - 20Q+2Q2
4Q2 - 20Q = 0, soloving this equation we get Q = 0,5.
Substituting Q = 5 in the MC equation, we get P = MC 150. Substituting Q = 0 in the MC
equation, we get P = MC = 200. thus, we can conclude that if price falls below 150 per unit,
the firm should shut down its operation. This is because if price is less than AVC, the firm is
not even able to cover the variable costs of production.
II Long-Run Equilibrium
In the long run, perfectly competitive firms earn only normal profits. This is due to the
unrestricted entry into and exit of firms from the industry in the long run. Let us explain this with
two extreme possibilities: first, when existing firms enjoy supernormal profits in the short run;
and next, when the existing firms incur losses in the short run. If some of the existing firms,
earn supernormal profit, this attracts new firms to the industry to gain profits. With the entry of
new firms, the supply of the commodity in the market increases. Assuming no change in the
demand side, this lowers the price level. This process of adjustment continues till the price
becomes equal to the long-run average cost (AR = AC = MR = MC). As such, supernormal
profits of the existing firms are squeezed until all the firms in the industry earn normal profit.
In the long run, perfectly competitive Alternatively, suppose firms are making losses in
firms earn only normal profits. the the short run.
This would force some of them to leave the industry in the long run, as they may not be able to
sustain losses for long. Their exit from the industry causes a reduction in the supply of the product
and as a result the equilibrium price in the industry rises. This process of adjustment continues
up to the point where the marginal firms no longer earn losses (i.e., till the price line becomes
tangential to the AC curve). Equilibrium occurs at a point where price is tangent to the long-run
average cost and all the firms make normal profit in the long run.
Thus, perfectly competitive firms earn only normal profits in the long run. From the above
discussion; we may conclusively say that the condition of profit maximising behaviour of firms in
the long run is:
Business Economics
138
Price
SMC SAC
LAC
EL
____________________________________ AR = MR
P LAC = SAC = SMC = MR = AR
O Output
Fig. 5: Long-Run Equilibrium
Caselet
Does Perfect Competition Exist?
The street food and fruits and vegetable market somewhat reflect the same conditions
prevalent in any other sector, viz., sellers may be selling homogenous products with little or no
variations in the product’s nature, consumers/sellers possessing perfect information of the
product in question and relatively few barriers to entry or exit. However, the scenario of
perfect competition in the street food/fruits and vegetable market is slightly more as
compared to being present in other sectors due to advertising and branding efforts being
used in other sectors to differentiate the product. Street vendors do not have any transaction
costs as they do not advertise or brand their products. Moreover, consumers are not dedicated
to any vendor in specific and can negotiate the price to a great extent.
Questions
1.Do you agree with the analysis in the case that street food/fruits and vegetable market is
more similar to perfect competition like condition?

2.What other characteristics of prefect competition can be seen in the street vendors of such
items?
Business Economics
139
Case
Indian Stock Market: Does it Explain Perfect Competition?
The stock market is one of the most important sources for corporate to raise capital. A
stock exchange provides a marketplace, whether real or virtual, to facilitate the exchange of
securities between buyers and sellers. It provides real time trading information on the listed
securities, facilitating price discovery.
Participants in the stock market range from small individual investors to large traders, who can
be based anywhere in the world. Their orders usually end up with a professional at a stock
exchange, who executes the order. Some exchanges are physical locations where transactions
are carried out on a trading floor. The other type of exchange is of a virtual kind, composed of a
network of computers and trades are made electronically via traders.
By design, a stock exchange resembles perfect competition. Large number of rational profit
maximisers actively competing, trying to predict the future market value of individual security
comprises is the main feature of any stock market. Important current information is almost freely
available to all participants. Price of individual security is determined by market forces and reflects
the effect of events that have already happened and expected to happen. In the short run it is
not easy for a market player to either exit or enter; one cannot exit or enter for few days in those
stocks which are under no delivery.
For example, Tata Steel was in no delivery from 29 October, 2007 to 2 November, 2007.
Similarly, one cannot enter or exit in those stocks which are in upper or lower circuit for few
regular trading sessions. Therefore, a player must depend wholly on market price for its
maximising output (in this case stock of securities). In the long run, players may exit the market
if they are not able to earn profit. But at the same time new investors are attracted by the rise in
the market price.
As on 1 November, 2007, total market capital at Bombay Stock Exchange (BSE) is $ 1,589.43
billion* out of this, individual investors account for only $ 100bn. Although individual investors
exist in a very large number, their total capital base is less than 7% of total market capital; rest
of capital is owned by foreign institutional investor and domestic institutional investors (FIIs and
DIIs), which are very small in number.
Average capital owned by a single large player is huge in comparison to a small investor.
This situation seems to have prompted Dr. Dash of BSE to comment ‘The stock market
activity is increasingly becoming more centralised, concentrated and non-competitive, serving
interest of big players only.” The table below shows the impact of change in FII on National
Stock Exchange movement during three different time periods.
Business Economics
140
Table. 1: Impact of FIIs’ Investments on NSE
Wave Date Nifty Close Change in FIIs Net Change in Market

Nifty index Investment Capitalisation (Rs.
(Rs. Cr.) Cr.)
Wave 1
From 17/05/04 1388.75
To 26/10/05 2408.50 1019.75 59520 540391
Wave 2
From 27/10/05 2352.90
To 11/05/06 3701.05 1348.15 38258 620248
Wave 3
From 12/05/06 3650.05
To 13/06/06 2663.30 -986.75 -9709 -460149
Source: Indian Journal of Capital Market, April-June 2007

By design, an Indian Stock Market resembles perfect competition, not as a complete description
(for no markets may satisfy all requirements of the model) but as an approximation.
Sources:
Business Standard (29/10/07 to 02/11/07).
Business Standard (01/11/2007).
Business Today dated 4 November 2007, p.98.
Hagstrom, Robert G. (2001), The Essential Buffett: Timeless Principles for the New
Economy, John Wiley and Sons, New York.
Indian Journal of Capital Market, April-June 2007, pages 15, 28 and 29.
The Economic Times (29/10/07 to 02/11/07).
Business Economics
141
7. In the short run, perfectly competitive firms earn ______.
a) normal or supernormal profit

b) loss or super normal profit
c) anyone of two
d) any one of three
8. In the short run, perfect firms profit variability is due to ______.
a) cost
b) price
c) competition
d) production
9. In some cases, in the short run there could be loss as well because ______.
a) Ac=AR
b) Ac >AR
c) Ac< AR
d) Ac is tangential
10. In the long run, perfect firms earn ______.
a) low profit
b) super normal profit
c) no profit no loss
d) normal profit
11. The formula behind long-run normal profit is ______.
a) P=AR=LAC
b) P = MC = MR = LAC
c) P=LAC
d) P=MC=MR
Business Economics
142
4.1.3 Monopoly
Economists often distinguish between pure monopoly and monopoly. Pure monopoly is
that market situation in which there is absolutely no substitute for the product, and the entire
market is under control of a single firm. As we can see, this is a hypothetical situation, because
there will be some substitute to every good or service. But such substitutes would vary in terms
of their ability to satisfy a particular human want. Other alternative may not satisfy the same
want with the same efficiency and at the same (or similar) price as the good in question.
Take the example of common salt; you may say that it has no substitute as such. We
would, however, like to remind you of rock salt that can be used as an alternative to
common salt. So, there is an alternative to common salt, but in terms of availability and price,
there is a wide difference between the two. Hence, common salt appears to be monopolised
product and if there was only a single seller of salt, it would become a case of monopoly.
Therefore, we agree to say that a monopoly exists when there is no close substitute to the
product and when there is a single producer and seller of the product, like Indian Railways, as
mentioned above.
Before venturing into the cause of formation of monopoly, it is useful to understand the
main characteristics of this type of market. In the previous unit, you have seen that market
characteristics are identified broadly based on the number of sellers, type of product sold, and
number of buyers. Therefore, it is worthwhile to study the main feature of monopoly under
these dimensions.
Features Of Monopoly
The following are the important features or characteristics of monopoly.
1. Single seller and large number of buyers: Monopoly is said to exist when there is only
one seller of a product. The existence of single seller of one product eliminates the difference
between the firm and the industry. In other words, under monopoly firm and industry are one
and the same. It means that there is no distinction between the two. In monopoly the number of
buyers is large. No single buyer can influence the price with his individual action.
2. No close substitutes: There will be any close substitutes for the monopoly product. In the
absence of a close substitute, the cross elasticity of demand is less or zero.
3. Restriction on the entry of new firms: In a monopoly type of market, there is a strict barrier
on the entry of new firms. Monopolist faces no competition. These restrictions may take the form
of the following.
Legal
Artificial
Natural and
Exclusive control over the raw materials, etc.
Business Economics
143
4. Price market: Since a monopolist has a complete control over market supply in the absence
of a close substitutes for his product. He can fix price as well as quantity of output to be sold
in the market. But he can determine only one of them and leave the other to the market. If the
monopolist determines the supply, then what price is to be paid depends on the market demand.
On the other hand, if he determines the price, what quantity is to be produced, and sold should be
left to the market. Therefore, a monopoly firm can either determine price or supply, but it cannot
determine both.
5. Nature of demand curve: A monopolist increases his sales only by reducing his price. So,
his Average Revenue (AR) or demand curve will slope downwards from left to right. It shows that
large quantities can be sold at lower price. In other words, to sell additional units, a monopolist will
have to reduce the price. Therefore, his Marginal Revenue (MR) curve also slopes downwards
from left to right. MR curve lies below the AR curve. This can be seen from the following diagram
(Fig. 6).
Y
Revenue
AR ( Demand curve)
MR
Output X
Fig. 6: Nature of demand curve
In the above diagram the downward sloping demand curve tells us that average revenue or
price goes on falling as sales are increased. When the Average Revenue (AR) slopes down-
wards, Marginal Revenue (MR) always lies below the AR. This implies that Marginal Revenue
(MR) of monopoly output is less than its price.
6. Informative selling costs: In the monopoly, selling costs are incurred only to educate the
consumers or to inform about a product. These are done to give information to the buyers about
the product. For example, Indian railways, now and then releases advertisements about the
services that they provide, the dos and don’ts to the passengers.
Business Economics
144
Types Of Monopoly
Monopoly is of different types. Important types of monopoly are mentioned below.
(a)Legal monopoly: If monopoly arises on account of legal support or as matter of legal privilege
it is called legal monopoly. They enjoy copyright, paten right trademark etc. no other institution
is allowed to produce commodities of the monopolist. If, under any conditions, a person or
institution produces commodities again the rules they are liable for legal action.
(b)Natural Monopoly: If a commodity is available in a particular region or country that region or
country enjoys natural monopoly over that commodity.
Diamonds in South Africa and petroleum oil in the Gulf countries are examples of natural monopoly.
(c)Social Monopoly: Social monopolies refer to those firms or industries which produce
commodities or services useful to the society. They aim at the promotion of the interest of society.
They provide the basic needs to the people like electricity, water supply, transport, communications,
etc.
(d)Artificial Monopoly: Artificial monopolies are those which arise due to the combination
of different firms in an industry. Different firms in an industry form a new agency for avoiding
competition and secures maximum profits. They enter a contract regarding the price output and
cost of production.
(e)Discriminating Monopoly: Discriminating monopoly is common in the present-day commercial
world. We find different manufacturers selling the same product by different brand names,
labels,etc. Indian Railways, A.P. Transco are good examples of discriminating monopoly.
Price And Output Determination Under Monopoly

A monopolist is a price maker and not a price taker. A monopolist has control over the
market supply. Hence, he is a price maker. Under the given cost and demand situation of his
product in any period, he must determine the price and output simultaneously. The aim of the
monopolist like every other producer is to maximise his total profits.
In other words, he will be in equilibrium at that price output at which his profits are the
maximum. He will be in equilibrium position at that level of output at which marginal revenue
equals marginal cost. He will continue producing so long as marginal revenue exceeds
marginal cost. At the point where MC = MR, the profits will be maximum and here he stops
further production. If the production is carried beyond this point, profits will start decreasing.
The price and output determination of the monoploy firm can be easily grasped from the
following diagram (Fig.7)
On the X-axis we are measuring output, and, on the Y-axis, we are measuring revenue and the
cost output. AR is the average revenue curve sloping downwards from left to right indicates as
if price decreases, the quantity demanded increases. MR is the marginal revenue curve, which
lies below the average revenue curve AR. The monopolist will be equilibrium at the output OM
where MC = MR. Here the equilibrium output is attained.
The price at which output OM is sold in the market can be known from looking at the
average revenue curve AR. It can be seen from the diagram that corresponding to equilibrium
output OM, the price or the average revenue is MQ or OP which can be seen in the diagram
(AR curve). Thus, the given cost, revenue situation as presented in the above diagram, the
monoploy firm will be in equilibrium at the output OM and will be charging price equal to MQ =
OP.
Business Economics
145
Y
Revenue cost
AR = AC
MC
Q
P
E AC
MR AR
X
O M Output
Fig. 7: Normal profit under monopoly
Equilibrium Under Monopoly

Under monopoly, the equilibrium output and price determination can be explained with the above
diagram itself (Fig.7). Unlike the perfect competition, under monopoly, price determination and
equilibrium output go together. However, for clarity's sake let us try to analyse the equilibrium
separately.
Equilibrium under monopoly may be studied under two heads. They are:
Short-run equilibrium
Long-run equilibrium
Now let us try to examine these two in detail.
Short-Run Equilibrium
In a monopolistic market a single firm constitutes the whole industry and there is no distinction
between the firm and the industry. Hence, a separate analysis of the equilibrium of the firm and
industry is not necessary under this market. Whereas, in case of the perfect competition, the firm
and industry are two separate entities. The conditions of firm’s equilibrium remain unchanged
irrespective of the nature of the competition. The conditions of equilibrium are as follows.
MC must be equal to MR
MC should cut MR from below.
Of course, the second condition is not an essential condition to attain equilibrium under monopoly.
A firm under monopoly attains equilibrium when MC = MR. There MC may not cut MR from
below.
In the short period, production can be changed only by changing the variable factors of
production. In the short period a monopoly firm can earn super normal profits, normal profits, or
losses. A monopoly on the short run may even suffer losses. Any unfavourable conditions on the
market may bring losses in the short run. In case of losses, price must cover at least the average
variable costs.
A situation of excess or abnormal or super normal profits is shown in the following
diagram:
Business Economics
146
Y
Revenue/cost MC
AR > AC AC
Q
P
Profits
R
S
E
AR
MR
X
O M Output
Fig. 8: Abnormal Profits
Short run may even suffer losses. Any unfavourable conditions on the market may bring losses in
the short run. In case of losses, price must cover at least the average variable costs.
A situation of excess or abnormal or super normal profits is shown in Fig. 8.
The AR and MR curve under monopoly slopes downwards from left to right. A firm finds its
equilibrium at the point where MC equal MR and MC cuts the MR from below as shown in the
above diagram. In this ‘E’ is the firm’s equilibrium where MC = MR and OM are the equilibrium
output. Here price is OP.
At OM level of output.
Average revenue = MQ
Average cost = MR
Here, average revenue is greater than average cost to average profit.
MQ – MR = QR
Total profits = Average profit x Output
QR x OM (Instead of OM we can write SR)
QR x SR = PQRS
The firm in the short run is getting supernormal profits equal to the area of the
rectangle.
PQR
In the short run a monopoly firm may get normal profits also. This is shown in the following
diagram (Fig. 9)
Business Economics
147
Y
Revenue/cost
AR = AC
MC
P Q
E AC
MR AR
X
O M Output
Fig. 9: Normal Profits
In the above diagram ‘E’ is the point of equilibrium where MC = MR. OM is the equilibrium output.
Price is OP or MQ price which is equal to AC. The firm is earning normal profits at OM level of
output.
Average Revenue = MQ
Average cost = MR
Here, both average revenue (Price) and average cost are equal. So, the firm is earning
normal profits. Since normal profits, which are included in the average cost.
Now, let us see a monopoly firm which is incurring loss. In short run period a monopoly firm
may incur loss also. This has been shown in the following diagram (Fig.10)
Y
Revenue/cost
MC
AR < AC
AC
R AVC
P
Loss
Q
S
MR AR
X
O M Output
Fig. 10: Loss
Business Economics
148
In the above diagram, firm is suffering from losses. Minimisation of losses is achieved by the
equality between MC = MR at point E. OM is equilibrium level of output. OP is price.
At the OM level of output

Average Revenue = MQ
Average cost = MR
Here, average cost is greater than average revenue, the firm is incurring losses.
Average loss = QR
Total loss = Average loss x Output
QE x OM (OM = PQ)
= QR x PQ = PQRS
In the above diagram, monopoly firm is incurring loss shown by the shaded area PQRS. SAC
exceeds the price (AR). At the price OP, the firm will continue production since price is higher
than the Average variable cost.
APSRTC and AP Transco are the examples for loss under monopoly in the short run.
Long-Run Equilibrium
A monopoly firm will earn super normal profits even in the long run. Because there are strong
barriers to enter industry. In other words, as the monopolist is the single producer and as new
firms cannot enter the industry, the monopolist will continue to earn super normal profits in the
long run.
Long period is a time period which is enough to fully adjust the supply to the demand of
product. It can increase the size of the plant, hire more labour, purchase more quantities of raw
materials and other factor inputs. The long-run equilibrium price and output position of a
monopoly firm will be like that of its short-run position. The long-run equilibrium of the monopolist
will be at the output where the long-run marginal cost curve (LMC) intersects the marginal
revenue curve (MR). This can be explained through the following diagram (Fig. 11)
Y
Revenue/cost
LMC
P Q
LAC
S R
--------------------
R1
E AR
MR
X
O M M1 Output
Fig. 11: Long-run equilibrium curve
Business Economics
149
From the diagram we can say that price MQ (QP) is fixed by the equality between LMC and MR
at point E. OM is the output determined in the equilibrium state. In the long-run equilibrium, the
monopolist produces more and sells at a lower price thus making large monopoly profit.
The firm is earning super normal profits equal to the area PQRS since its average cost exceeds
average revenue by QR. It is earning profit even in the long run. This is due to the monopoly
power of the firm. That is why the long period super normal profits are sometimes called
monopoly profits.
Limitations Of Monopoly
Though monopolist has some power to fix the price according to his own choice he is also
subject to some limitations. He cannot go on exploiting the consumer by charging the price as
well as output according to his own choice.
There are some limitations against the arbitrary powers of the monopolist. They are the
government may enact ant-monopoly laws for curbing the activities of the monopolists. The
government may fix the price and quantity of output of the monopolist’s firm. Consumers will
form association and resist the exploitative policy of the monopolists.
Business Economics
150
12. A monopoly is:
a) One of the few producers of a homogenous product

b) A single producer of a single product
c) One of the many producers of a homogenous product
d) One of many producers of a differentiated product
13. A profit maximising monopolist produces a quantity corresponding to:
a) MR = MC
b) P = MC
c) P = MR
d) P = AR = MR = MC
14. The sufficient condition for price discrimination is:
a) Different in need
b) Separation of market
c) Difference in price elasticities
d) Direct contact with consumer
15. A natural monopoly is characterised by:
a) Government restriction
b) Economic efficiency
c) Small size of market
d) Control of key raw materials
16. Slope of AR is:
a) Equal to slope of MR
b) Twice the slope of MR
c) Thrice the slope of MR
d) Half the slope of MR
17. In the long run, a monopolist would always:
a) Incur losses
b) Earn supernormal profit
c) Lower its price
d) Earn at least normal profit
Business Economics
151
18. Formation of monopoly due to economies of scale is known as:
a) A natural barrier
b) A legal barrier
c) A structural barrier
d) An efficiency barrier
Business Economics
152
Summary
Perfect competition is defined as a market structure, in which many sellers selling
homogeneous products at the market price.
Each firm sells a very small portion of the total industry output; hence, it cannot
affect the price in the market and must accept the price given to it by the market. As
such, it is regarded as a “price taker”.
A firm faces a perfectly elastic demand curve; hence, average revenue is constant
and is equal to marginal revenue.
The equilibrium price is determined by demand and supply in the market and an
individual firm has no influence on market forces.
Profit maximising output is that where marginal cost is equal to marginal revenue
while marginal cost is increasing.
In the short run, firms can earn supernormal profits, or normal profits, or even losses
This depends on the position of the short-run cost curves.
The supply curve of the firm would be identical to the short-run marginal cost curve
above the minimum point of the AVC curve.
The industry supply curve is obtained by the horizontal summation of the supply
curves of all firms in the industry.
In the long run, perfectly competitive firms earn only normal profits. If firms are
making supernormal profits in the short run, this would attract new firms and if firms
are incurring losses, some firms would exit the market, leaving existing firms with
normal profits in either case.
A monopoly has a single seller, who sells a single product (pure monopoly) and
decides on its own price and output, based on individual demand and cost
conditions. Hence, it is regarded as a price maker. In monopoly, the firm and the
industry are one and the same.
Barriers to entry are the major sources (or reasons) of monopoly power and
may include restriction by law, control over key raw materials, specialised
know-how restricted through patents or licenses, small market and
economies of scale.
A monopoly firm has a normal demand curve with negative slope. The
demand curve is highly price inelastic because there is no close substitute.
Business Economics
153
A monopolist firm may earn supernormal profits, or normal profit, or may even incur
loss in the short run, but would not incur loss in the long run.
The monopolist being a price maker does not have any supply curve.
A multi plant monopolist decides on how much to produce and what price to sell to
maximise its profit based on the principle of marginalism.
When a seller discriminates among buyers on basis of the price charged for the
same good (or service), such a practice is called price discrimination.
Price discrimination can be done on personal basis (demographical, paying capacity
or need), on geographical basis and on the basis of time or purpose of the use.
Business Economics
154
Terminal Questions
1. Assume that the domestic PC market in India is perfectly competitive. “Magnetics” is a
company that makes PCs and has its Total Variable Cost (TVC) function as TVC =
300Q - 40Q^2 + 2Q^3. The company is having difficulties in importing the semiconductor
chips used in its PCs, because of which its costs of production are rising; coupled with
this, prices of PCs are falling sharply. In fact, it is finding it difficult to sustain losses and
the managers of the firm are discussing about a likely shut down. Below what price
should the firm closure?
2. The Long-Run Average Cost (LAC) function of a firm in perfect competition is given as
LAC= 1200-4Q + 2Q^2.
i. Find its profit maximising output in the long run.
ii.Also verify whether LAC and LMC (Long-Run Marginal Cost) are equal at this level of
output.
3. The total cost function (monthly) of a perfectly competitive firm is given as: TC=7500 +
150Q + 3Q^2. Determine the price of the product, if the industry is in long run equilibrium.
4. Only Greens company sells green vegetable and has a total cost function as
TC=200+8Q+2Q^2. Assume the industry to be perfect competition.
a. If vegetables are charged at Rs. 20 per kg, determine the optimal output level.
b. Find the profit at this output.
c. Being an expert, comment on whether the firm should continue operations, or shut
down.
5. A firm in the assembled PCs market has the following Total Cost and Total Revenue
functions; TC=100+50Q+ 5/2 Q^2 + 1/3 Q^3 and TR= 100Q. Where Q is the level of
output. Find:
a. The profit maximising level of output.
b. Levels of cost, revenue and profit at this level of output.
6. The aggregate demand and supply equations of perfectly competitive industry are given
as: q=1000-p and S=2p + 500. If a tax or Rs. t per unit of output sold is levied on all the
firms in the market, find the value of t that would maximise tax yield. Assume the
following:
a. With imposition of tax each firm would get a price less than original by the
amount of tax per unit.
b. Tax yield would be maximised with respect to a unit. Explain the features of
monopoly and price determination under monopoly
7. What is monopoly? How is the price determined under monopoly?
8. Explain the features of monopoly and price determination under monopoly
Business Economics
155
Answer Keys
1 d
2 c
3 d
4 b
5 a
6 b
7 d
8 a
9 b
10 d
11 b
12 b
13 a
14 c
15 d
16 b
17 b
18 d
Activity
Justify: Indian agriculture sector earned normal profits in the long run.
Business Economics
156
Glossary
• Average Revenue: The revenue that is earned per unit of output. In other words, it
is the revenue that is obtained by the seller on selling each unit of the commodity.
• Abnormal Profits: A profits that exceed the amount a firm must receive to become
capable of continuing the production.
• Legal Monopoly: A state-sponsored monopoly where the company restricts the
entry of firms and provides and regulates all the business of a market through a
single firm.
Biblography
Textbooks
Graham, P., & Bodenhorn, D. (1980). Managerial economics (1st ed.).
Reading, Mass.: Addison-Wesley Pub. Co.
Video Links
Topic Link
Perfect Competition https://www.youtube.com/watch?v=B_49lQxwMaM
Monopolies vs Perfect https://www.youtube.com/watch?v=PgDrR2wj_Jc

Competition
Image Credits
Images taken from - shorturl.at/ejHI5
Keywords
Monopoly
AVC curve
Perfect competition
Supernormal profits
Business Economics
157
Business Economics
Module 4
Unit 2
Monopoly and
Oligopoly
Business Economics
158
Table of Contents
Unit 4.2 Monopoly and Oligopoly
Aim ----------------------------------------------------------------------------------------- 160
Instructional Objectives --------------------------------------------------------------- 160
Learning Outcomes -------------------------------------------------------------------- 160
4.2.1 Monopolistic competition ------------------------------------------------------ 161

Self-Assessment Questions --------------------------------------------------- 162
4.2.2 Oligopoly --------------------------------------------------------------------------- 163
Self-Assessment Questions -------------------------------------------------- 171
Summary --------------------------------------------------------------------------------- 173
Terminal Questions -------------------------------------------------------------------- 174
Answer keys ----------------------------------------------------------------------------- 175
Activity -------------------------------------------------------------------------------------- 175
Glossary ----------------------------------------------------------------------------------- 176
Bibliography ----------------------------------------------------------------------------- 176
Video links ------------------------------------------------------------------------------- 176
Image Credits ----------------------------------------------------------------------------- 176
Keywords ---------------------------------------------------------------------------------- 176
Business Economics
159
Aim
To comprehend the nature of monopolistic and oligopolistic competition.
Explain monopolistic competition
Describe kinked demand and cartelisation in oligopoly
Learning Outcomes
At the end of the unit, you will be able to:
Comprehend various markets and strategies
Compare monopolistic and oligopolistic competitions
Business Economics
160
4.2.1 Monopolistic competition
Monopolistic competition is a type of imperfect competition, where many sellers are engaged
in offering heterogeneous products for sale to buyers. The conditions of monopolistic
competition resemble with that of a perfect competition. However, the main difference between
the two is that the products sold in monopolistic competitive markets are not perfect substitute of
each other and differ from one another in some sense or the other.
Important features of Monopolistic competition

Large number of sellers and buyers: Many sellers offer different kinds of products in the
market. This is the uniqueness of this competition.
Differentiation in the Product: Products in the market vary in style, quality standards,
trademarks and brands. With this, buyers differentiate among the available products. However,
here products are close substitutes for each other.
Easy entry and exit: Since the restrictions by the government are minimal, here too like perfect
competition, organisations found it easy to enter or exit the market.
Mobility: The factors of production are not mobile in monopolistic competition as in the case of
perfect competition. Here, firms get ready to pay high transportation costs to pass the factors of
production.
Price policy: Since the products are closely substitutable, the buyers would switch to other
sellers if the prices of the products are higher. Hence, the firms’ price policy is swayed by the
price move of the competitors.
Monopolistic competition
Type of Number of Nature of Number of Freedom of Examples
Market Firms product buyers entry and exit
Perfect Very Large Homogeneous Very Large Undifferentiated Agricultural
competition (undifferentiated) commodities
shares
Monopolistic Many Differentiated Many Undifferentiated unskilled
competition labour
Retail stores,
detergents
Business Economics
161
1. Major difference between perfect and monopolistic competition is in _____.
a) product differentiation
b) buyers
c) price differentiation
d) place
2. Perfect substitute goods can be in _____.
a) monopoly
b) perfect competition
c) Monopolistic competition
d) monopoly and monopolistic
3. In monopoly, the competitors’ price policy has an influence on price because of ____.
a) resemblances
b) perfect substitution
c) close substitution
d) far substitution
4. As far as number of sellers are concerned, perfect competition and monopolistic

have ___and____respectively.
a) many and a few

b) the few and very large numbers
c) very large and many
d) a few and many
Business Economics
162
4.2.2 Oligopoly
Oligopoly is a market where a few dominant sellers sell differentiated or homogenous products
under continuous consciousness of rival’s actions. There is one aspect which differentiates
other market forms and that is various firms: no player can take a decision considering the
action (or reaction) of rivals. This continuous consciousness of rivals’ actions competition, in
which rival firms heavily on advertisements and product promotions. This results in price rigidity,
i.e., a single price prevails in the market just like perfect competition, but the difference is that
the price is not governed by market forces but by a dominant firm.
In fact, in real life, there may be cases where there is a very large number of small
players (thus, making the market monopolistic) but only few large players dominate and
govern the market forces (thus, creating an oligopoly like situation). For example, in
India, newspaper industry is a market in which there are more than 8,000 newspapers in
circulation, but the market is typically ruled by few very large players, who have indulged
in price wars more than once to get hold of the market and keep small players to operate
at local or regional level.
In a nutshell, it can be said that oligopoly is kind of market where a few dominant
sellers (oligopolists) sell differentiated or homogenous products under continuous
consciousness of rivals’ action. When there is product differentiation among the sellers, the
market is called differentiated oligopoly or oligopoly with product differentiation, and in case of
identical product, the market is called pure oligopoly or oligopoly without product differentiation.
Let us now look at the main characteristics of this market.
Features of Oligopoly
Few Sellers: The word ‘oligopoly’ itself implies a market dominated by a few sellers, although
the term ‘few’ is ambiguous, and does not specify any number of players. However, any
market in which a small number of large firms compete may be termed as ‘oligopoly’.
Automobile industry is a very good example of oligopoly, where one can count the number
of players. In Indian automobile industry, major players like Maruthi Suzuki, Honda, Toyota
and Ford are examples of oligopoly, because one can count the number of players in this
market. Indian Oil, IPCL and Hindustan Petroleum are another set of examples.
In the case of cars, each seller tries to differentiate its product by name, shape and other
features, whereas in the second case, the product (petrol or diesel) is identical, and the buyer is
indifferent among all the players. Hence, the case of car manufacturers represents
differentiated oligopoly and that of petroleum refers to pure oligopoly. In FMCG sector, Coke
and Pepsi represent an extreme case of oligopoly where there are only two players, this
situation is known as duopoly
Business Economics
163
Product
The product under oligopoly may be differentiated (like cars, motorbikes, televisions,
washing machines, and soft drinks) or homogenous (like petrol, cement, steel and
aluminium). Thus, it is not a simple case like perfect competition, in which all the firms sell
identical products, or monopolistic competition, in which all the firms sell differentiated
products. In oligopoly, some industries may consist of firms selling identical products, while in
some other industries firms may sell differentiated products.
Entry Barriers
There are no legal barriers as such to enter the market under oligopoly. However, at the
same time there are various economic barriers which restrict the number of firms in the
market. These are huge Investment Requirements; you would understand that it is not easy to
collect such huge amount of funds as required for starting a cement manufacturing plant or
petroleum product or cars. Hence, this creates a kind of natural barrier to enter and thus,
restricts the number of players.
Strong Consumer Loyalty for Existing Brands Unlike other market forms, customers in an
oligopoly market have strong loyalty for specific brands. When Maruti introduced its small
car to Indian customers, many took long time to accept the concept and continued to be
loyal to the studier Premier or Ambassador cars. The extent of such loyalty can be
translated to the fact that many of such products have become generic brands by virtue of
being pioneers in their respective categories. Examples include Xerox for photocopying,
Godrej for steel almirah, and Jeep for SUV.
Economies of Scale: The existence of an oligopoly market is substantially dependent upon

the fact that the existing firms earn large scale economies and are thereby able to earn
margins despite adopting a low-price strategy. This creates a strong deterrent to new entrants
as they may not be able to sustain at such a low price. HP printers can be cited as an example,
as they are sold at such a low price that other players have become almost extinct. Domination
of few newspapers as national dailies has also been possible due to this reason. You will learn
more about this aspect in the unit on pricing.
Interdependent Decision-Making
As it has been pointed out earlier, the single most distinctive feature of oligopoly is that one
firm cannot take any decision independently of other firms. There are few firms in the industry,
and each is selling a product which is either a perfect substitute (homogenous) or a very close
substitute (differentiated). Is it possible that Hyundai changes the price of Verna without fear
of retaliation by Honda City? Can Coke introduce a different design or size of bottle without
anticipating a counter move by Pepsi? No. This interdependence of decision-making is the
consequence of continuous consciousness of rivals’ moves and countermoves and it is
quintessential to oligopoly.
Even a new advertisement would attract counter strike by rivals. The advertisement war
between cola majors is well known. If one company engages film celebrities to endorse its
product, others also follow suit. If Virat Kohli and Ranbir Kapoor promote Pepsi, Ranveer
Singh is roped in to promote Thums Up and Diljit Dosanjh to sell Coca Cola. Lux, since time
immemorial, has been using film personalities, so Nirma also adopted the same strategy for
its ‘beauty soap’ segment. The use of celebrities has been extended to such heights that
now people are talking of brand confusion. Same is the story with punch lines, if Honda
Motorcycle & Scooter India says, ‘Live your Style’, Hero MotoCorp tagline says,
‘Hum Mein Hai Hero’.
Business Economics
164
Price And Output Decisions
There is no single model to explain the determination of equilibrium price and output of an oligopoly
firm. Difficulty in determining the demand curve and hence, the revenue curve of the firm,
tendency of the firm to influence market conditions by various activities like advertisement, and
fear of price war resulting in price rigidity are some of the reasons which pose a major constraint
in developing a model to explain oligopoly. Consequently, economists have tried to build various
models from time to time to explain the equilibrium of a firm under conditions of oligopoly.
Such attempt was first made in 1938 by French economist Cournot, thereafter followed by
various other models. Although these models refer to oligopoly situation but for sake of
simplicity, they have been developed around the assumption of two firms. However, they may
be extrapolated to n number of firms. Interestingly, no model gives any clear explanation of the
question of how much to produce and at what price to sell. They only depict the impact of
interdependence among firms, and how does this influence their decisions of output and pricing.
In the following sections, we shall discuss some important models including those by Cournot,
Stackleberg and Sweezy; we shall also talk about cartels, price leadership and barometric firms.
Cournot’s Model
Augustin Cournot has illustrated the market situation under oligopoly with an example of two
firms engaged in the production and sale of mineral water. Each firm owns a spring of mineral
water, which is freely available from nature. The crux of this model is a situation in which the
firms ignore interdependence and take decision as if they are operating independently in the
market. One firm enters the market first and the other firm follows. Cournot has made a few
assumptions to build this model which, in modern context, may appear very simplistic, but it
sets a precursor to more advanced models on oligopoly.
Assumptions of Cournot’s Model
(i) Each firm aims at maximising profit, i.e., equilibrium will be at MC = MR.
(ii) Cost of production is nil because the springs are available free from nature, i.e., MC = 0.
(iii) Market demand is linear; hence the demand curve is a downward sloping straight line.
(iv) Each firm decides on its price assuming that the other firm’s output is given (i.e., the other
firm will continue to produce and sell the same amount of output in next period).
(v) Firms sell their entire profit maximising output at the price determined by their demand curves.
Cournot’s model can be understood from (Fig. 1). Firm A is the first entrant to the market of
mineral water. Being rational, this firm would try to maximise its output and would produce till MR
= MC. Its demand curve is given as DD* and MRA is its marginal revenue curve. To maximise
profit, firm A will produce where MC = MR; since MC = 0, therefore, at equilibrium MR = MC = 0.
Hence, it will produce OQA output and charge OPA price which is governed by the demand (AR)
curve. You will note that the firm A is able to sell half of the total market demand (equal to OD*).
Note further that point A is the midpoint of DD* curve.
Business Economics
165
D
PA
Price Revenue, Cost
------------------------- A
----------------------------
B
PB -----------------------------------------
---------------
D
O QA QB Quanti
MRA MRB
Fig. 1: Cournot's Model
Firm A will react to firm B’s entry by assuming that B will continue to serve one fourth of the market
and hence, treats the remaining three- fourth as its own market. So, in the next period, firm A will
supply to one half of three-fourth
of the total market. In this period, B will assume that A will continue to three-eighth of
total market, hence will take the remaining market, i.e., As its domain. B will not produce
of the total market demand.
The most interesting part of this action-reaction phenomenon is that the share of firm A will
continue to decline and that of firm B will increase until each of the firm supplies to an equal market
size, i.e., one-third demand unsatisfied. The above discussion can be summarised in the form of
equations for a better understanding of the behaviour of firms A and B, as follows:
Business Economics
166
Thus, A’s output is declining progressively (with ratio = 1/4), whereas B’s output is
increasing at a declining rate.
Business Economics
167
Business Economics
168
Stackelberg’s Model
German economist H.V. Stackelberg developed a model where, the sophisticated firm
determines the reaction curve of the rival and incorporates it in its own profit function. It is
popularly known as the Leader Follower Model, as an extension of the model of Cournot.
Stackelberg assumes that one of the players is sufficiently sophisticated to recognise the rival
firm that acts to Cournot’s assumption.
Thus, this sophisticated firm can determine the reaction curve of the rival and is also able to
incorporate it in its own profit function. Thus, it acts as monopolist. As is obvious, the naïve firm
will act as follower, like the one in Cournot’s model. the figure below illustrates the
reaction functions of oligopoly firms in Stackelberg’s model.
Fig. 2: Stackelberg’s Model
Point E shows Cournot’s equilibrium, where both firms are producing equal output and selling at
the same price. As per Stackelberg’s model, if firm A is the sophisticated one, it will operate within
the area RA ERA and will try to produce that output at which it can maximise its profit, it is shown
at point a in the figure, Here, A will produce OXB and B will be contended with OXB. In this case,
firm B will act as a follower and accept the leadership of A and act accordingly. On the other hand,
if firm B is the sophisticated firm, it will produce within RB ERB and will be at equilibrium at point
b, producing OXA. What if both firms are sophisticated? In that case, there will be a price war like
situation and will either result in a cartel or in the final emergence of one firm as the leader.
In the figure, RARA curve is the reaction function of firm A and RB RB is the reaction function of firm
B. E being the point of equilibrium at which firm A is producing XA amount of output and firm B is
producing XB amount of output. Note that at this point, both the firms are in equilibrium because
they are maximising their profits and have no tendency to change the output. However, this point
is reached when each firm can assess the other’s output correctly, and this is achieved after a
series of changes in output by each firm in anticipation of the other’s output remaining unchanged,
Business Economics
169
Case – 1
Jio: The New Samurai in Telecom Battle
RIL chairman Mukesh Ambani's new venture Reliance Jio launched is tariff plans
on 1 September, 2016. It offered free voice and data services for its users till 3 December,
2016, in order to capture the market. Immediately Bharti Airtel Rs. 12,000 crores in
market capitalisation eroded and Idea Cellular Ltd., lost its market value by Rs.2,800 crore.
Reliance Jio new venture of conglomerate Reliance Industries Ltd. has recently appealed TRAI
on 10 April, 2017, for strongest possible action and highest penalty against Bharti Airtel, Aditya
Birla gourp’s Idea Cellular and UK-based Vodafone’s Indian subsidiary – for using unfair means
to retain customers using number portability to exit their networks and join services of Jio.
Many analysts now believe that Reliance Jio’s entry with such kind of offers of free voice
calls, roaming and probably world’s cheapest data plans will kickstart the telephone industry
consolidation and will push smaller mobile service providers such as Airtel, Telenor India, Tata
teleservices and Reliance Communication towards exiting the industry. Bharti Airtel, the country’s
largest mobile operator, along with Vodafone and Idea reacted in September itself, by launching
unlimited voice plans bundled with data.
For example, Airtel announced a 90-day free 4G data pre-paid pack, though initially restricting it
only to Rs.1,495 plan. This effectively brings down 4G data rates to Rs. 50 per GB, which Jio
has also promised on its launch. Airtel has also introduced free-voice plans on some of its
existing premium plans by then. Even state-owned BSNL announced a counterattack by
offering free voice calling beginning in 2017. The strategy of BSNL’s offer would be available
across 2G and 3G customers, while Jio’s plans are only available to 4G users.
Jio continued to surprise the market beyond its ‘Welcome Offer’. The next one was Happy New
Year. From 1 January to 31 March, 2017, extended the services of free domestic voice
calls and data. Days after Jio’s extension, Airtel came out with two prepaid offerings, including
a Rs. 145 pack with free unlimited free local/STD calls to any network in India and 1GB of
4G data. Both packs were launched with validity of 28 days. On 31 March, 2017, Jio introduced
‘Summer Surprise’, which offered complimentary data and voice from April for three months,
against a month’s recharge of minimum Rs. 303. Airtel subsequently came up with two plans
of Rs. 293 and Rs. 449 that offered 1GB data per day for a total validity of 70days.
The battle has further intensified with operators approaching authorities with allegations and
counter allegations. Bharati Airtel moved fair trade regulator CCI (Competition Commission of
India) with the allegation that Jio is indulging in ‘predatory pricing’ by way of providing free services.
Strategy of Jio has been alleged to bind a customer to free voice calls and minimise competition
from smaller players in the telecom market, to gain a higher market share. Airtel also alleged
the Reliance Jio is abusing its dominant position. Jio has, in turn, accused, Airtel for misleading
consumers through advertisements claiming, “Airtel is officially the fastest network in the
country”. The Advertising Council of India has ruled against Airtel and asked it to modify or
withdraw the commercial by 11 April, 2017. The modified advertisement is pitching Airtel as
“India’s fastest network”, dropping the word “officially”. At the same time, Telecom Regulatory
Authority of India (TRAI) has advised Jio to withdraw its summer surprise offer and the
company has agreed to comply, while assuring that all customers who have already
subscribed to the offer prior to its discontinuation shall “remain eligible for the offer”.
Another change shaping up is the proposed merger of Vodafone India and the Kumar Mangalam
Birla-owned Idea-Cellular. This merger would only create the country’s biggest phone company
in terms of number of subscribers, dislodging the 15-year long leadership stint of Bharati Airtel,
but will also be the second worldwide, after China Mobile.
Business Economics
170
5. Sweezy’s model fails to explain:
a) The effect of the discovery that the firm’s belief about the demand curve is not
correct.
b) Indeterminate demand curve and price rigidity.
c) Non-price competition.
d) Interdependent decision-making.
6. Find out the only incorrect statement about cartels from the following:
a) The lower the number of firms in the industry, the easier is to monitor their
behaviour.
b) Cartels are generally formed in markets with differentiated goods.
c) Similar cost structures make it easier to coordinate.
d) Short-term gains encourage members to indulge into cheating.
7. In the Kinked Demand Curve theory, it is assumed that:
a) An increase in price by the firm is not followed by others.

b) An increase in price by the firm is followed by others.
c) A decrease in price by the firm is followed by others.
d) Firms collude to fix the price.
8. When an oligopolist individually chooses its level of production to maximise its profits,
it produces an output that is:
a) more than the level produced by a monopoly and less than the level produced
by a competitive market.
b) less than the level produced by a monopoly, and more than the level produced
by a competitive market.
c) less than the level produced by either monopoly or a competitive market.
d) more than the level produced by either monopoly or a competitive market.
9. A firm emerges as a leader in an oligopoly market due to all the following reasons
except:
a) Market share.
b) Presence in all segments.
c) Indeterminate demand curve.
d) Pioneer in the particular product category.
Business Economics
171
10. The extreme case of non-price competition in an oligopoly is:
a) Formation of duopoly
b) Formation of cartels
c) Interdependent decision-making
d) attaining of economies of scale
11. In cartels:
a) Each individual firm profit maximises

b) There may be an incentive to cheat
c) The industry as a whole is loss making
d) There is no need to police agreements
Business Economics
172
Summary
• Oligopoly is a market with a few sellers, it consists the characteristics of various
other markets. Its features included few sellers, differentiated or homogenous
product, and interdependent decision-making by firms, non-price competition
and indeterminate demand curve. Continuous consciousness of rivals’
actions (or reactions) is the kingpin of this market.
• When there is product differentiation among the sellers, the market is a
differentiated oligopoly or oligopoly with product differentiation and in case of
identical products, the market is called a pure oligopoly or oligopoly without
product differentiation.
• Duopoly is special case of oligopoly, in which only two players operate (or
dominate) in the market. All the characteristics of duopoly are same as those of
oligopoly.
• Difficulty in determining the demand curve, tendency to influence market
conditions and fear of price war resulting in price rigidity are some of the
reasons which pose a major constraint in developing a model to explain
oligopoly.
• In Cournot’s model, firms ignore interdependence and take decision as if they
are operating independently in the market. At equilibrium in a two-firm industry,
each firm will be maximising profit by selling equal amounts of output (1/3)
and at the same price.
• In Stackelberg’s model, the sophisticated firm is able to determine the reaction
curve of the rival and is also able to incorporate it in its own profit function.
Thus, it acts as a monopolist. As is obvious, the naïve firm will act as follower.
• In Sweezy’s kinked demand curve model firms avoid a situation like price
war, therefore, they stick to the current price. Thus, the oligopoly price remains
rigid.
• The kink in demand curve signifies that the demand curve has two different
degrees of price elasticity.
• Under collusion, rival firms enter into an agreement in mutual interest on
various accounts such price, market share, etc., collusion may be open or
tacit. The most found form of explicit collusion is known as a cartel.
• A centralised cartel is arrangement by all the members, with the
objective of determining a price which maximises joint profits. In market
sharing, cartel members decide to divide the market share among them and fix
the price independently.
Business Economics
173
Terminal Questions
1. Assume that the domestic cola market in India is dominated by two firms and has a
linear demand curve P = 1550 – Q, where P is the price and Q is the total output in the
market. Also assume that the firms have a constant cost function with MCA = MCB = 50.
Find the reaction curves of the two firms and their profit maximising levels of output.
2. Suppose the only two firms selling motherboards for handheld devices in India form a
cartel. The demand function for the product is 2P = 670 – 3Q, where P is the price in
hundreds of Rupees and Q is the output in thousand. The total cost functions of the
members are TC1 = 10Q1 + 2Q12 and TC2 = 25Q2 + 2Q22. Derive the equilibrium output
and price of the cartel. Also find the output of each firm.
3. Assume that the domestic market for CDMA mobiles in India is dominated by a two-firm
market and has a linear demand curve P = 65 – Q, where P is the price in Rupees
hundred and Q is the total output in thousands in the market. Also assume that the firms
have a constant cost function with MCA = MCB = 5. Find reaction curves of the
two firms and their profit maximising levels of output.
4. The market for steel in India is considered to be oligopolistic. Hard Core Pvt. Ltd.,a
major producer of steel faces a kinked demand curve. The demand functions for
increase and decrease of price for P1OBJ 2Q1OBJ P2OBJ Q2OBJ Q² OBJ - 2Q +
550.
i) Derive the MR1 MR2 and MC functions facing the firm.

ii)Determine the price and output at the kink.
iii) What are the upper and lower limits of the MR curve?
iv) Prove that MC falls in the MR gap.
Business Economics
174
Answer Keys
1 a
2 c
3 c
4 c
5 b
6 b
7 a
8 a
9 c
10 b
11 b
Activity
Activity Type: Offline Duration: 40 minutes
Indian cement industry frequently goes through cartelisation. Collect data

and show kinked demand for the industry.
Business Economics
175
Glossary
• Price policy: A company's approach to determining the price at which it offers a
good or service to the market.
• Perfect substitution: Those goods that can satisfy the same necessity in exactly
the same way.
• Kinked demand: Hypothesis states that the firm faces a demand curve with a kink
at the prevailing price level.
Biblography
Textbooks
Video Links
Topic Link
Monopolistic Competition https://www.youtube.com/watch?v=d57jftLwi4s
Collision of Oligopoly,
Duopoly, and Cartels https://www.youtube.com/watch?v=N0L00FZnhtg
Image Credits
Fig. 1 Cournot's Model: shorturl.at/wCGIY
Fig. 2 Stackelberg’s Model: shorturl.at/wFISV
Keywords
Monopoly
Oligopoly
Perfect competition
Perfectly elastic competition
Perfectly inelastic competition
Business Economics
176
177

MBA Business Economics

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

MBA Business Economics

Uploaded by

Copyright:

Available Formats

How to Use Self-Learning Material?

Instructional Objectives: These are behavioural objectives that describe intended

Self-Assessment Questions: These include a set of multiple-choice questions to be

Bibliography: This is a list of books and articles written by a particular author on a

President Vice Chancellor

Pro-Vice Chancellor Incharge Registrar

Dr. Neti Subrahmanyam

KL Deemed to be University-CDOE has full copyright over this educational material. No

Dr. Neti Subrahmanyam

Module 1: Nature and Scope of Business Economics

Module 2: Demand Analysis

Module 3: Production and Cost Analysis

Module 4: Market Classification

Perfect competition, Monopoly, Monopolistic and Oligopoly.

Nature and Scope of Business Economics

Prescriptive/Normative approach: By introducing corrective steps, it achieves the target

1.1.1 Meaning and scope ------------------------------------------------------------- 08

Self-Assessment Questions ------------------------------------------------ 10

1.1.2 Subject relationships with other disciplines -------------------------------- 11

Self-Assessment Questions ------------------------------------------------- 14

1.1.3 Decision-making and other forward planning ---------------------------- 15

Self-Assessment Questions ------------------------------------------------- 16

Some popular definitions of business economics:

“Managerial economics is application of economic concepts and economics to the

Spencer and Seigelman

Scope of business economics

Demand analysis &

Fig. 1: scope of business economics

Cost and benefit analysis (CBA)

Profit or wealth maximisation

1. Managerial economics uses______.

a) Micro Economics only

3. Managerial Economics is_____.

a) Concerned with micro aspects

The subjects such as economics, Mathematics, Statistics Management theory, and

Economic theory Decision Sciences

Managerial Economics Application of

Fig. 2: subject relationships with other disciplines

1. Business Economics and Economics

3. Business Economics and Management theory/Accounting

4. Managerial Economics and Mathematics

5. Business Economics and Statistics

6. Business Economics and Operations Research/Computer science

In summary, business economics, a derivative of traditional economics, is empowering as an

6. Implicit cost is_____.

a) Economic profit minus explicit cost.

8. Which one of the following is not a macroeconomic concept _____.

9. Business economics is very similar to _____ Economics.

10. Baumol’s model is otherwise called _____.

1. Distinguish between microeconomics and macroeconomics.Explain.

Question No. Answers

Activity type: Offline Duration: 40 Minutes

Considering the differences between economics and business economics,

• Inflation: An increase in the general price level of goods and services in an

• Micro Economics: The study of individuals, households and firms’ behaviour

I. The Opportunity Cost Concept:

Let us consider there are three alternatives:

The reason why we give importance to opportunity cost is:

Managerial economists use opportunity cost to:

a) Cost of the material for the period

A decision will become profitable if:

(i) The incremental revenue is more than incremental cost.

other revenue components.

(iv) The cost reduction is more than the revenue.