MBAD 2111 Managerial - Micro - Economics

DIRECTORATE OF DISTANCE EDUCATION
M.B.A
MASTER OF BUSINESS
ADMINISTRATION
MBAD 2111
MBAD 1911
MANAGERIAL (MICRO) ECONOMICS
First Semester
Semester – I
SRM INSTITUTE OF SCIENCE AND TECHNOLOGY,

Potheri, Chengalpattu District 603203,
Tamil Nadu,INDIA
Phone: 044 – 27417040 / 41
Website: www.srmist.edu.in / Email:office.dde@srmist.edu.in
EXPERT COMMITTEE
S.N NAME DESIGNATION ORGANISATION

o.
1 Dr.R.Rajagopal Director DDE - SRMIST
2 Dr.V.M.Ponniah Dean - Management FOM - SRMIST
FOM – SRMIST, KTR
3 Dr.G.Venugopalan Academic Coordinator
FOM – SRMIST, KTR
4 Dr.T.Ramachandran Head of II year MBA
FOM – SRMIST, KTR
5 Dr.V,M.Shenbagaraman Head of I year MBA
Course Writer(s) Dr.P.S.Rajeswari
Information contained in this book has been obtained by its Author(s) from sources believed to be
reliable and are correct to the best of their knowledge. However Publishers and the Author(s) shall in
no event be liable for any errors, omissions or damages arising out of this information and specifically
disclaim any implied warranties or merchantability or fitness for any particular.

SRM Institute of Science and Technology,
Potheri, Chengalpattu District 603203, Tamil Nadu, INDIA
Phone: 044 – 27417040 / 41
Website: www.srmist.edu.in / Email:office.dde@srmist.edu.in
CONTENTS
MODULE I
1.0 Introduction
1.1 Meaning of Managerial Economics
1.2 Nature of Managerial Economics
1.2.1 School of economics
1.3 scopes of economics
1.3.1 Economic Decision Making
1.3.2 Scarcity
1.3.3 Branches of economics
1.3.4 Micro economics
1.4 Importance of managerial economics
1.4.1 Determinants of value in trade
1.5 Major functions
1.6 Summaries
1.7 check your answers
MODULE II
2.0 Introduction
2.1 Meaning of Demand
2.2 Type–I Demand Short term demand
2.3 Type–II Demand Long term demand
2.4 Demand Forecasting
2.5 Meaning of Supply
2.6 Type–I short term supply
2.7 Type–II Long term supply
2.8 Conclusion
2.8.1 Check your Answers
MODULE III
3.0 Introduction
3.1 Production and Cost Analysis
3.2 Meaning of Production and Production Function
3.3 Type–1 production–short run production
3.4 Type II production–long run production
3.5 Cost of Production
3.6 Various types of cost of production
3.7 `Type I Cost of production: Short run cost of production analysis
3.8 `Type II cost of production: Long run cost of production analysis. Cost–output
3.9 Relationship–production capacity determination
3.9.1 Conclusion
3.9.2 Check your answers
MODULE IV
4.0 Introduction
4.1 Objectives of Firm and Price Determination
4.2 Types of market structure
4.3 Price Determination under Perfect Competition
4.4 Imperfect Competition
4.5 Price and output determination
4.6 Pricing and Non Pricing strategies
4.7 Conclusion
4.7.1 Check your Answers
MODULE V
5.0 Components of a Game
5.1 Types of Games
5.2 Prisoner’s Dilemma
5.3 Market Structure
5.4 Asymmetric Information (AI)
5.5 Conclusion
MODULE - 1 NOTES
______________________________________________________________
MANAGERIAL (MICRO) ECONOMICS
STRUCTURE
1.0 Introduction
1.1 Meaning of Managerial Economics
1.2 Nature of Managerial Economics
1.2.1 School of economics
1.3 scopes of economics
1.3.1 Economic Decision Making
1.3.2 Scarcity
1.3.3 Branches of economics
1.3.4 Micro economics
1.4 Importance of managerial economics
1.4.1 Determinants of value in trade
1.5 Major functions
1.6 Summaries
1.7 check your answers
SRMIST DDE MBA Self Instructional Material Page 1

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MEANING AND IMPORTANCE OF MANAGERIAL ECONOMICS
1.0 INTRODUCTION
In this lesson we shall understand the basic concepts and functional

role of Economics in Managerial Decision Making Process. After
studying this, you will be able to:
1. Discuss the Meaning, Evolution, scope, purpose and functions of
Managerial Economics.
2. Analyse the significance of Managerial Economics in Decision
Making Process.
Definition:
Economics is the social science that analyzes the production,
distribution, and consumption of goods and services. The term
economics comes from the Ancient Greek οἰκονομία (oikonomia,
"management of a household, administration") from οἶκος (oikos,
"house") + νόμος (nomos, "custom" or "law"), hence "rules of the house

(hold)". Current economic models emerged from the broader field of
NOTES
political economy in the late 19th century. A primary stimulus for the
development of modern economics was the desire to use an empirical
approach more akin to the physical sciences.Introduction- Meaning
and Nature of Managerial Economics
Economics is the study of choice. Its application in management,
enables the choice of feasible course of action, the pragmatic decision
– making.
Economics is descriptive, whereas managerial economics is
prescriptive explaining what should be done to solve any problem.
Economics is positive, neutral between ends (choice) – accepting both
rational and irrational choices. Managerial economics is normative,
making value judgements about choices. It deals with ethical dilemma
in managerial decision making.
NATURE OF ECONOMICS
Under this, we generally discuss whether Economics is science
or art or both and if it is a science whether it is a positive science or a
normative science or both.
Economics - As a science and as an art:
Often a question arises - whether Economics is a science or an art or
both.
(a) Economics is a science: A subject is considered science if
It is a systematised body of knowledge which studies the relationship
between cause and effect.
It is capable of measurement.
It has its own methodological apparatus. It should have the ability to
forecast.
If we analyse Economics, we find that it has all the features of
science. Like science it studies cause and effect relationship between
economic phenomena. To understand, let us take the law of demand.
It explains the cause and effect relationship between price and
demand for a commodity. It says, given other things constant, as price
rises, the demand for a commodity falls and vice versa. Here the
cause is price and the effect is fall in quantity demanded. Similarly,
like science it is capable of being measured, the measurement is in

terms of money. It has its own methodology of study (induction and
deduction) and it forecasts the future market condition with the help
of various statistical and non-statistical tools.
But it is to be noted that Economics is not a perfect science. This is
because Economists do not have uniform opinion about a particular
event.
The subject matter of Economics is the economic behaviour of man
which is highly unpredictable.
Money which is used to measure outcomes in Economics is itself a
dependent variable.
It is not possible to make correct predictions about the behaviour of
economic variables.
(b) Economics is an art: Art is nothing but practice of knowledge.
Whereas science teaches us to know art teaches us to do. Unlike
science which is theoretical, art is practical. If we analyse Economics,
we find that it has the features of an art also. Its various branches,
consumption, production, public finance, etc. provide practical
solutions to various economic problems. It helps in solving various
economic problems which we face in our day-to-day life.
Thus, Economics is both a science and an art. It is science in its
methodology and art in its application. Study of unemployment
problem is science but framing suitable policies for reducing the
extent of unemployment is an art.
Economics as Positive Science and Economics as Normative Science
(i) Positive Science: As stated above, Economics is a science. But
the question arises whether it is a positive science or a normative
science. A positive or pure science analyses cause and effect
relationship between variables but it does not pass value judgment. In
other words, it states what is and not what ought to be. Professor
Robbins emphasised the positive aspects of science but Marshall and
Pigou have considered the ethical aspects of science which obviously
are normative.
According to Robbins, Economics is concerned only with the study of
the economic decisions of individuals and the society as positive facts
but not with the ethics of these decisions. Economics should be
neutral between ends. It is not for economists to pass value

judgments and make pronouncements on the goodness or otherwise
NOTES
of human decisions. An individual with a limited amount of money
may use it for buying liquor and not milk, but that is entirely his
business. A community may use its limited resources for making guns
rather than butter, but it is no concern of the economists to condemn
or appreciate this policy. Economics only studies facts and makes
generalizations from them. It is a pure and positive science, which
excludes from its scope the normative aspect of human behaviour.
Complete neutrality between ends is, however, neither feasible

nor desirable. It is because in many matters the economist has to
suggest measures for achieving certain socially desirable ends. For
example, when he suggests the adoption of certain policies for
increasing employment and raising the rates of wages, he is making
value judgments; or that the exploitation of labour and the state of
unemployment are bad and steps should be taken to remove them.
Similarly, when he states that the limited resources of the economy
should not be used in the way they are being used and should be
used in a different way; that the choice between ends is wrong and
should be altered, etc. he is making value judgments.
(ii) Normative Science: As normative science, Economics involves
value judgments. It is prescriptive in nature and described 'what
should be the things'. For example, the questions like what should be
the level of national income, what should be the wage rate, how the
fruits of national product be distributed among people - all fall within
the scope of normative science. Thus, normative economics is
concerned with welfare propositions. Some economists are of the view
that value judgments by different individuals will be different and
thus for deriving laws or theories, it should not be used.
Managerial economics is in intelligent application of

quantitative techniques (Mathematics, statistics, accountancy,
operation research, econometrics, business analytics, block chain)
towards business problem – solving.
Economics is concerned about awareness of resources.
Managerial economics deals with acquisition and utilisation of

resources. Finance function is about acquiring funds and efficient use
of funds in various avenues of investment.
1.1 MEANING OF MANAGERIAL ECONOMICS
Managerial economics is the science of directing scarce

resources to manage cost effectively. Wherever
resources are scarce, manager can make more effective
decisions by applying the discipline of managerial economics. These
may be decisions with regard to customers, suppliers, competitors, or
the internal workings of the organization. It does not matter whether
the setting is a business, nonprofit organization, or home. In all of
these settings, managers must make the best of scarce resources.
Economics aims to explain how economies work and how
economic agents interact. Economic analysis is applied throughout
society, in business, finance and government, but also in crime,
education, the family, health, law, politics, religion, social institutions,
war, and science. The expanding domain of economics in the social
sciences has been described as economic imperialism.
Common distinctions are drawn between various dimensions of
economics. The primary textbook distinction is between
microeconomics, which examines the behavior of basic elements in
the economy, including individual markets and agents (such as
consumers and firms, buyers and sellers), and macroeconomics,
which addresses issues affecting an entire economy, including
unemployment, inflation, economic growth, and monetary and fiscal
policy. Other distinctions include: between positive economics
(describing "what is") and normative economics (advocating "what
ought to be"); between economic theory and applied economics;
between mainstream economics (more "orthodox" dealing with the
"rationality-individualism-equilibrium nexus") and heterodox
economics (more "radical" dealing with the "institutions-history-social
structure nexus"); and between rational and behavioral economics.

Managerial economics
NOTES
Managerial economics is a branch of
economics that applies microeconomic
analysis to decision methods of businesses or
other management units. As such, it bridges
economic theory and economics in practice. It
draws heavily from quantitative techniques such as regression
analysis and correlation, Lagrangian calculus (linear). If there is a
unifying theme that runs through most of managerial economics it is
the attempt to optimize business decisions given the firm's objectives
and given constraints imposed by scarcity, for example through the
use of operations research and programming.
1.2.NATURE OF MANAGERIAL ECONOMICS
Economics is the study of choice. Its application in

management, enables the choice of feasible course of action, the
pragmatic decision – making.
Economics is descriptive, whereas managerial economics is
prescriptive explaining what should be done to solve any problem.
Economics is positive, neutral between ends (choice) – accepting both
rational and irrational choices. Managerial economics is normative,
making value judgements about choices. It deals
with ethical dilemma in managerial decision
making.
Managerial economics is in intelligent
application of quantitative techniques (Mathematics, statistics,
accountancy, operation research, econometrics, business analytics,
block chain) towards business problem – solving.
Economics is concerned about awareness of resources. Managerial
economics deals with acquisition and utilisation of resources. Finance
function is about acquiring funds and efficient use of funds in various
avenues of investment.

1.2.1. SCHOOL OF ECONOMICS
Classical economics
Publication of Adam Smith's The

Wealth of Nations in 1776, has been
described as "the effective birth of
economics as a separate discipline."The
book identified land, labor, and capital
as the three factors of production and the major contributors to a
nation's wealth.
Adam Smith wrote The Wealth of Nations Smith discusses the
benefits of the specialization by division of labour. His "theorem" that
"the division of labor is limited by the extent of the market" has been
described as the "core of a theory of the functions of firm and
industry" and a "fundamental principle of economic organization." To
Smith has also been ascribed "the most important substantive
proposition in all of economics" and foundation of resource-allocation
theory — that, under competition, owners of resources (labor, land,
and capital) will use them most profitably, resulting in an equal rate
of return in equilibrium for all uses (adjusted for apparent differences
arising from such factors as training and unemployment).
In Smith's view, the ideal economy is a self-regulating market

system that automatically satisfies the economic needs of the
populace. He described the market mechanism as an "invisible hand"
that leads all individuals, in pursuit of their own self-interests, to
produce the greatest benefit for society as a whole. Smith
incorporated some of the Physiocrats' ideas, including laissez-faire,
into his own economic theories, but rejected the idea that only
agriculture was productive.
In his famous invisible-hand analogy, Smith argued for the seemingly
paradoxical notion that competitive markets tended to advance
broader social interests, although driven by narrower self-interest.

The general approach that Smith helped initiate was called political
NOTES
economy and later classical economics. It included such notables as
Thomas Malthus, David Ricardo, and John Stuart Mill writing from
about 1770 to 1870.The period from 1815 to 1845 was one of the
richest in the history of economic thought.
While Adam Smith emphasized the production of income,

David Ricardo focused on the distribution of income among
landowners, workers, and capitalists. Ricardo saw an inherent conflict
between landowners on the one hand and labor and capital on the
other. He posited that the growth of population and capital, pressing
against a fixed supply of land, pushes up rents and holds down wages
and profits.
Malthus cautioned law makers on the effects of poverty

reduction policies Thomas Robert Malthus used the idea of
diminishing returns to explain low living standards. Human
population, he argued, tended to increase geometrically, outstripping
the production of food, which increased arithmetically. The force of a
rapidly growing population against a limited amount of land meant
diminishing returns to labor. The result, he claimed, was chronically
low wages, which prevented the standard of living for most of the
population from rising above the subsistence level.
Malthus also questioned the automatic tendency of a market

economy to produce full employment. He blamed unemployment upon
the economy's tendency to limit its spending by saving too much, a
theme that lay forgotten until John Maynard Keynes revived it in the
1930s.
Coming at the end of the Classical tradition, John Stuart Mill

parted company with the earlier classical economists on the
inevitability of the distribution of income produced by the market
system. Mill pointed to a distinct difference between the market's two
roles: allocation of resources and distribution of income. The market

might be efficient in allocating resources but not in distributing
income, he wrote, making it necessary for society to intervene.
Value theory was important in classical theory. Smith wrote

that the "real price of everything is the toil and trouble of acquiring it"
as influenced by its scarcity. Smith maintained that, with rent and
profit, other costs besides wages also enter the price of a commodity.
Other classical economists presented variations on Smith, termed the
'labour theory of value'. Classical economics focused on the tendency
of markets to move to long-run equilibrium.
Marxian economics
The Marxist school of economic thought

comes from the work of German economist
Karl Marx.Marxist (later, Marxian) economics
descends from classical economics. It derives
from the work of Karl Marx. The first volume of
Marx's major work, Das Kapital, was published in German in 1867. In
it, Marx focused on the labour theory of value and what he considered
to be the exploitation of labour by capital. The labour theory of value
held that the value of an exchanged commodity was determined by
the labor that went into its production.
Neoclassical economics
A body of theory later termed 'neoclassical

economics' or 'marginalism' formed from
about 1870 to 1910. The term 'economics'
was popularized by such neoclassical
economists as Alfred Marshall as a concise synonym for 'economic
science' and a substitute for the earlier, broader term 'political
economy'. This corresponded to the influence on the subject of
mathematical methods used in the natural sciences.
Neoclassical economics systematized supply and demand as
joint determinants of price and quantity in market equilibrium,

affecting both the allocation of output and the distribution of income.
NOTES
It dispensed with the labour theory of value inherited from classical
economics in favor of a marginal utility theory of value on the demand
side and a more general theory of costs on the supply side. In the
20th century, neoclassical theorists moved away from an earlier
notion suggesting that total utility for a society could be measured in
favor of ordinal utility, which hypothesizes merely behavior-based
relations across persons.
n microeconomics, neoclassical economics represents
incentives and costs as playing a pervasive role in shaping decision
making. An immediate example of this is the consumer theory of
individual demand, which isolates how prices (as costs) and income
affect quantity demanded. In macroeconomics it is reflected in an
early and lasting neoclassical synthesis with Keynesian
macroeconomic.
Neoclassical economics is occasionally referred as orthodox

economics whether by its critics or sympathizers. Modern mainstream
economics builds on neoclassical economics but with many
refinements that either supplement or generalize earlier analysis,
such as econometrics, game theory, analysis of market failure and
imperfect competition, and the neoclassical model of economic growth
for analyzing long-run variables affecting national income.
Keynesian economics
John Maynard Keynes (right), was a key theorist in economics.
Keynesian economics derives from John Maynard Keynes, in
particular his book The General Theory of Employment, Interest and
Money (1936), which ushered in contemporary macroeconomics as a
distinct field. The book focused on determinants of national income in
the short run when prices are relatively inflexible. Keynes attempted
to explain in broad theoretical detail why high labour-market
unemployment might not be self-correcting due to low "effective
demand" and why even price flexibility and monetary policy might be
unavailing. Such terms as "revolutionary" have been applied to the
book in its impact on economic analysis.

Keynesian economics has two successors. Post-Keynesian
economics also concentrates on macroeconomic rigidities and
adjustment processes. Research on micro foundations for their
models is represented as based on real-life practices rather than
simple optimizing models. It is generally associated with the
University of Cambridge and the work of Joan Robinson.
New-Keynesian economics is also associated with developments in the
Keynesian fashion. Within this group researchers tend to share with
other economists the emphasis on models employing micro
foundations and optimizing behavior but with a narrower focus on
standard Keynesian themes such as price and wage rigidity. These are
usually made to be endogenous features of the models, rather than
simply assumed as in older Keynesian-style ones.
Chicago School of economics
The Chicago School of economics is best known for its free

market advocacy and monetarist ideas. According to Milton Friedman
and monetarists, market economies are inherently stable if left to
themselves and depressions result only from government intervention.
Friedman, for example, argued that the Great Depression was result
of a contraction of the money supply, controlled by the Federal
Reserve, and not by the lack of investment as Keynes had argued. Ben
Bernanke, current Chairman of the Federal Reserve, is among the
economists today generally accepting Friedman's analysis of the
causes of the Great Depression.
Milton Friedman effectively took many of the basic principles

set forth by Adam Smith and the classical economists and modernized
them. One example of this is his article in the September 1970 issue
of The New York Times Magazine, where he claims that the social
responsibility of business should be “to use its resources and engage
in activities designed to increase its profits...(through) open and free
competition without deception or fraud.”

Other schools and approaches
NOTES
Other well-known schools or trends of thought referring to a

particular style of economics practiced at and disseminated from well-
defined groups of academicians that have become known worldwide,
include the Austrian School, the Freiburg School, the School of
Lausanne, post-Keynesian economics and the Stockholm school.
Contemporary mainstream economics is sometimes separated into the
Saltwater approach of those universities along the Eastern and
Western coasts of the US, and the Freshwater, or Chicago-school
approach.
Within macroeconomics there is, in general order of their
appearance in the literature; classical economics, Keynesian
economics, the neoclassical synthesis, post-Keynesian economics,
monetarism, new classical economics, and supply-side economics.
Alternative developments include ecological economics, institutional
economics, evolutionary economics, dependency theory, structuralist
economics, world systems theory, econophysics, and biophysical
economics.
1.3 SCOPE OF ECONOMICS
The integration of conceptual Economics with business practices is

termed as managerial economics. Managerial economics facilitates
1. Decision – Making
2. Forward planning by management.

1. Decision – making:
Decision requirement is felt
Defining the problem from all perspectives
Diagnosis of causes
Developing possible alternatives
Deliberating alternatives on the basis of pros-
cons
Delving in plausible alternatives
Desired feasible, viable course of action
Determination in execution
Deleting in case of unfavourable consequences.
Decision is a commitment to action plan. Decision involves
hindsight, insight and foresight. Decision making process reduces
the uncertainty surrounding each alternative by getting into more
information.
Forward Planning:
The actual future outcomes will differ from those expected ahead
of time. Firms have to be future –ready through predicting.
Firms can impute the present value of future revenue earnings,
through the analysis of internal rate of return. Risk and return go
together. The risks may be changes in taste of consumers,
technology and tactics of competitors.
The changes in cost cutting technology, competition and customers
put pressures on the profit margins of business firms. Profit
planning is based on profit-forecasting, the projection of the entire
profit and loss statement for a specified future period.
Profit budgeting is not mere allocation of fund, but assigning
delegating activities (performance budgeting) and averting
the unnecessary duplication of work process (reengineering)
Profit targeting is the act of steering, manipulating cost with
reference to a pre-determined profit to be secured.

1.3.1 ECONOMIC DECISION MAKING NOTES
Managerial Economics has winged its

techniques for various Business applications,
Almost any business decision can be analysed
with managerial economics techniques, but it
is most commonly applied to:
1. Risk analysis - various models are used to quantify risk and
asymmetric information and to employ them in decision rules to
manage risk.
2. Production analysis - microeconomic techniques are used to
analyse production efficiency, optimum factor allocation, costs, and
economies of scale and to estimate the firm's cost function.
3. Pricing analysis - microeconomic techniques are used to analyze
various pricing decisions including transfer pricing, joint product
pricing, price discrimination, price elasticity estimations, and
choosing the optimum pricing method.
4. Capital budgeting - Investment theory is used to examine a firm's
capital purchasing decisions.
At the core of economics is the notion that there are valuable

gains from trades between individuals and between firms, and
between firms and individuals. Value is created when the exchange of
goods and services brings more in total to each party than each would
obtain if the exchange did not take place. However, to facilitate trade,
an appropriate price must be negotiated so that each party benefits
from trade relative to their alternative opportunities.
To work out whether value can be created between a buyer and

a seller, the buyer’s willingness-to-pay for a product is compared with
the seller’s willingness-to-sell. These calculations rely on an
appropriate economic formulation of the choices facing each party,
which depends upon each party’s other trading opportunities. This
establishes a clear relationship between potential competition and
what each party actually receives from trade.

Having established that there is a value-creating trading
opportunity, the next key issue is the terms of that trade. In
particular, what price should the buyer and seller agree on? This
price depends both on the value created and on what would occur if
trade did not take place.
At the core of economics is the notion that there are valuable

gains from trades between individuals and between firms, and
between firms and individuals. Value is created when the exchange of
goods and services brings more in total to each party than each would
obtain if the exchange did not take place. However, to facilitate trade,
an appropriate price must be negotiated so that each party benefits
from trade relative to their alternative opportunities.
To work out whether value can be created between a buyer and

a seller, the buyer’s willingness-to-pay for a product is compared with
the seller’s willingness-to-sell. These calculations rely on an
appropriate economic formulation of the choices facing each party,
which depends upon each party’s other trading opportunities. This
establishes a clear relationship between potential competition and
what each party actually receives from trade.
Having established that there is a value-creating trading

opportunity, the next key issue is the terms of that trade. In
particular, what price should the buyer and seller agree on? This
price depends both on the value created and on what would occur if
trade did not take place.
Businesses, such as General Motors, IBM or Time-Warner, are

able to earn money for their shareholders by receiving payments from
their customers that exceed payments made to their suppliers. Their
ability to do this depends critically on the presence of “money on the
table”. That is, customers will not pay more for a product than the
benefits they derive from it, and suppliers will not accept payments
that do not cover their own costs. So ultimately, for there to be

something left for the business, a customer’s actual benefits must
NOTES
exceed the suppliers’ actual costs.
By bringing customers and suppliers together, businesses can

create value, and can ensure that they appropriate some of this value
for themselves as profit. For this reason, the first important set of
tools of economic analysis is concerned with identifying value and its
sources so as to understand the role of a business in value creation.
Value is not often a readily quantifiable concept. It cannot

simply be reduced to monetary terms. A natural question to ask is
how profit, which is a distinctly monetary measure, can arise from
value, with elements that are often not monetary? The answer lies in
the way in which money, something people and businesses prefer to
have more than less of, can assist in guiding the decisions of rational
agents.
The benefits a person derives from consuming an ice cream

cannot be readily quantified; however, that same person can be asked
to name the highest price that they would be willing to pay for an ice
cream. This would give a monetary equivalent for the benefit that that
person places on ice cream. Moreover, it can be related back to the
payment that an ice-cream supplier would need to receive in order to
cover supply costs.
By stepping into the shoes of key decision-makers, one can

potentially determine the monetary equivalents of different actions.
This exercise allows one to analyse whether there is an opportunity to
create value. In this topic, one will learn how to put one self in the
place of decision-makers to establish the existence of value-creating
opportunities for business.
We begin our study of decision-making with the simple case of

non-strategic decisions. A decision is strategic if it requires one to take
into account how others will react to one’s decision. For instance, if a
firm raises the price of its product, it has to consider how one’s

competitors may react. Strategic decisions are the focus of segment 5.
In a non-strategic environment, on the other hand, either there are no
other competitors or their response can be predicted. Tools such as
decision analysis are aimed at decision-making in the non-strategic
environment. Some of the concepts presented in this chapter will
therefore be familiar to those who have a background in decision
analysis. The advantage of economics, and more specifically of Game
Theory, is the ability to expand decision-making into strategic
environments.
1.3.2 SCARCITY
Scarcity also plays vital role in dis

shortage of resources in relation to unlimited
wants. Resources are like a line that becomes
smaller relative to a tall line drawn nearby –
Birbal’s puzzle. Economics is concerned about
management of resource. It is obvious. Relative scarcity is non –
obvious.
Apart from shortage, scarcity actually means a ‘’ price tag’’ for
everything. There is ‘’NO FREE LUNCH’’ in the world. The payment of
price means that something is sacrificed for gaining something else,
called trade – off. The extent of sacrifice for gaining something is
called opportunity Cost.
Opportunity cost is the sacrifice of the next best alternative. Rational

choice is the selection of the most desirable alternative from among all
possible alternatives. Decision making is the rational choice of a
feasible course of action. Etymologically the Latin origin word for
decision is decider meaning cutting off, separating, and segregating
the desirable from the undesirable alternative.
The basic economic problems in resource management are

what to produce how to produce and for whom to produce. They are
about taste, technology and targeting respectively.

Regarding
g what to
o produce the grea
ater the investmentt in
NOTES
capitall good the lower will be the inv
vestment for mer good. The
f consum
ction of capital good and consume
produc er good are
a mutu
ually
consisttent or inc
consistent.. The capittal produc
ction is don
ne at the c
cost
of cons
sumer goo
ods produc
ction. How
w to produ
uce questio
on is a ch
hoice
betwee
en capitall – inten
nsive tech
hnique an
nd labourr – inten
nsive
techniq
que. For whom
w to produce is the questiion as to sacrificing
s the
presen mption of natural re
nt consum esources for
f the sa
ake of futture
consum
mption by posterity.
Decisio
on Trees
A common
n way of representin
r ng decisions is to use
u a tree--like
structu
ure called a decision
n tree. Dec
cision trees
s are made up of no
odes
and brranches, which
w are used
u to rep
present the
e sequence
e of moves and
the acttions, resp
pectively. Here
H is a decision
d tre
ee for a la
andlord wh
ho is
choosin
ng betwee
en leasing a propertty or using
g it as a base
b for their
own bu
usiness.
Decisio
on nodes
In this su
ubject, decisions arre represented by square
s nod
des.
Node L is the decision
d n
node wherre the lan
ndlord cho
ooses betw
ween
leasing
g or using the properrty themse
elves. Node
e L is the first
f node and
is know
wn as the initial nod
de. The tria
angle-shap
ped ending
g nodes on
n the
right are
a the te
erminal nodes,
n whiich also have
h the payoffs tto L
associa
ated with each
e outco
ome listed beside the
em.
SRMIST
T DDE MBA Self
S Instructioonal Material Pag
ge 19
Nottice that the land
dlord earn
ns more by leasin
ng the property
p
($120,000) th
han by using
u it for
f their own
o busin
ness ($10
00,000).
Con
nsequently
y, the landlord shoulld choose to
t lease the
e property
y.
ance node
Cha es
In add
dition to decision nodes,
n a decision ttree can include
cha
ance nodes
s. These arre represen
nted in this
s subject b
by circles.
To see this, suppose that each
h of the choices
c th
he landlord
d faces
invo
olves som
me risk. Th ome bankrrupt and will be
he tenant may beco
una
able to pay
y the rent. The land
dlord’s own
n business
s might no
ot be as
ofitable as was foreca
pro asted. Dec
cision trees
s can inco
orporate th
his type
of uncertainty
u y over payo
offs.
This de
ecision tre
ee incorporrates unce
ertainty ov
ver the retu
urns to
sing or us
leas sing the prroperty forr the landllord’s own
n business
s. If the
landlord leas
ses, there is a 20 percent probability
p that the tenant
mig
ght go ban
nkrupt and
d not pay rent.
r This is depicte
ed by the 0.8
0 and
0.2 numbers
s on each of the brranches em
manating from the chance
nod
de. If the la
andlord us
ses the pro
operty for their
t own b
business, there
t is
an equal cha
ance it willl earn pro 00,000 or $80,000. This is
ofits of $10
reflected by th
he 0.5 num
mbers on each
e branc
ch.
In orde
er to evalu
uate the le
ease decis andlord needs to
sion, the la
look
k forward and work
k backward
ds. This in
nvolves firs
st calculatting the
exp
pected pay
yoff from each deciision. For the lease
e, this is (0.8 x
SRM
MIST DDE MBA
M Self Instrructional Matterial Page 20
120,00
00) + (0.2 x 0) = 96
6,000. For the own business, this is (0.5 x
NOTES
00) + (0.5 x 80,000) = 90,000. Taking th
100,00 his into acc
count redu
uces
cision tree back to a tree when
the dec n there is no
n uncertaiinty.
Thus, takiing into ac

ccount the
e uncertain
nty over pa
ayoffs, we can
e the land
reduce dlord’s prroblem to a choice
e between leasing and
xpected profit of $96,000 and
obtainiing an ex d using itt for her o
own
busine
ess and ob
btaining an
a expecte
ed profit of
o $90,000
0. Faced w
with
these choices,
c th
he landlord
d should sttill choose to lease.
When deciding whetther to undertake an

n advanced
d degree s
such
as an MBA, stu
udents nee
ed to mak
ke similarr judgements regard
ding
options
s available
e and the liikely outco
omes to th e and career if
heir income
they ob
btain an MBA
M or no a examplle of how one
ot. Before one see an
prospe
ective stude
ent made her
h career decision.
Comm
mon Decisiion-Makin
ng Pitfalls
Decision trees
t are useful
u in that
t they can
c assist in identify
ying
some common
c piitfalls in business de
ecision-ma e we illustrate
aking. Here
four off these.
1. Sun
nk costs
Costs thatt have alre
eady been incurred and
a cannott be recove
ered
unk costs. When ma
are known as su aking decis
sions, man
nagers sho
ould
SRMIST
T DDE MBA Self
ge 21
igno
ore these costs; oth
herwise, th
hey risk making
m poo
or decision
ns. The
follo
owing exam
mple demo
onstrates this
t point:
A Texa
an oil comp
pany is co
onsidering investing US$40 miillion in
new
w leases off land in the
t Gulf off Mexico fo
or oil drilliing. Its geo
ologists
favo
our the plan, saying
g that the company has alread
dy spent US$200
U
million on oill exploratio
on in that area and that the c
company needs
n to
see the projec
ct through or the mo
oney will ha
ave been w
wasted.
The
e company
y's chief financial
f officer
o tells
s the geollogists tha
at their
logiic is flawe
ed. He poiints out th
hat because the com
mpany spe
ent the
mon
ney to ac
cquire the exploratio
on inform
mation, the
ere is no way to
over it. He demonstrates this
reco y constructing the relevant
s logic by r
dec
cision tree.
If the company
c ( spends
(C) s $40 milliion on new
w leases and
a has
an expected return
r from
m this of R,
R its totall payoff fro
om this activity is
R – 40 million
n – 200 miillion. If it does not invest,
i it still faces a loss of
$20
00 million. Comparin
ng these tw
wo activitie
es, the com
mpany cho
ooses to
inve
est in the lease if R – 40 millio
on – 200 million
m > -2
200 million
n or R>
40 million. Thus,
T the decision is indepen
ndent of tthe total amount
a
spe
ent on explloration to date.
The money
m spe
ent on pre
evious exp
ploration is a sunk
k cost.
Wh
hether the oil
o compan ues to drill in the area
ny continu a or uses the
t $40
million for another
a p
project, th
he $200 million
m they have already
inve
ested can
nnot be recovered.
r his sunk cost to justify
Using th
con
ntinued inv
vestment could
c lead to greaterr losses. In
nvestment should
SRM
MIST DDE MBA
only co
ontinue iff the expe
ected returrn exceeds
s the inve
estment co
osts
NOTES
from th
his time on
nwards ($4
40 million).
This su
uggests a useful
u prin
nciple.
When making decisions
s, manage
ers need to be forw
ward-look
king
and th
hus should
d ignore sunk
s costs
s.
2. Irrelevant opttions
Firms usu
ually are making
m seve
eral decisions at the
e same tim
me. It
is critic
cal, thereffore, that a decision whose outtcome is in
ndependen
nt of
anothe
er decision
n is recog
gnised as such and
d not driv
ven by th
hose
decisio
ons.
To see th
his, let’s re
eturn to our
o oil-drillling exam
mple. Supp
pose
he refining
that th g operation
n of the oiil company
y leaps in
nto the deb
bate
and arrgues thatt new leas
ses should
d not be purchased
p d because the
company needs to
t make an
n investme
ent of US$
$50 million
n in upgrad
ding
the effiiciency of its
i existing
g refining operations
o .
In this in
nstance, the
t chief financial officer sides with the
engineers in the debate. He
e points ou e decision tree looks like
ut that the
the folllowing (wh
here we ign
nore past exploration
e n costs bec
cause they
y are
sunk):
SRMIST
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Here S is the level of cost savings that is expected to be
achieved by the plant upgrade. In choosing whether to upgrade or not,
if a new lease has been purchased, the company compares payoffs of
R - 40m + S - 50m to R - 40m and will upgrade if S> 50m. On the
other hand, if the new lease is not purchased, the company compares
S - 50m to 0 and upgrades if S> 50m. Regardless of the decision on
new leases, the decision to upgrade or not rests on the same factors.
That is, the company should upgrade if S> 50m regardless of whether
it purchases new leases or not. The upgrade decision is, therefore,
irrelevant to the decision as to whether to purchase the new leases or
not and should not be factored into the debate.
This suggests a useful principle:
When making decisions, ignore other decisions: the outcome of
which does not impact upon the decision at hand.
Care must be taken, however, in applying this principle. One
need to work out if a decision is truly independent. For example, if the
refining plant was considering an expansion in capacity, it may be
relevant whether new oil reserves were available or not. In this case,
the decisions to upgrade and continue exploration would be
interdependent.
3. Margins versus averages

When considering increasing or decreasing their production levels,
firms should base their decisions on marginal cost (MC) rather than
average cost. MC accurately reflects the cost of producing an
additional unit of output or the savings from producing one unit less.
To see how mistakes can be made by not considering marginal costs,
consider the following:
A railway owner notices that their engines have the capacity to

haul more cars and is considering putting on an additional car. At
present, they receive $1,000 per carload and operate 10 of these and
this would not change if an 11th car was added. A look at the
accounts of the company confirms that the cost per carload consists
of $600 for the rental value of the car, $300 for the allocated cost of
the rail (that is, $3,300 divided by 11) and $200 for physical loading

and un
nloading. Therefore,
T the avera
age cost off each carrload is 60
00 +
NOTES
300 + 200
2 = $1,1
100 per loa
ad.
If one werre to comp

pare this to
o the price
e per carload, one m
might
mpted to co
be tem onsider an
n expansio
on unprofittable. How
wever, fram
ming
the dec
cision in a tree revea
als a differe
ent picture
e.
Notice tha
at the com kes a loss regardless
mpany mak s of whethe
er it
uses 10 or 11 cars.
c Howe
ever, comp
paring thos
se losses indicates
i tthat
mpany ma
the com akes $100 more
m if it adds
a a car than if it does
d not. T
This
happen
ns even though on av
verage carrloads are unprofitab
u ble.
xamination
A closer ex n reveals what
w is going on herre. Notice tthat
g another car
adding c only adds
a car re
ental and loading co
osts, ie, MC
C is
$800, but does not e the rail cost. The rail costs are fixed c
n change cost
that would
w be unchanged if more ca
ars were hauled.
h ence, they are
He
not parrt of the re
elevant dec
cision here
e to add an
nother car or not.
Average co
ost plays a role in some analy
yses, but in most ca
ases,
seful to folllow this ru
it is us ule:
st to consider when
The prroper cos n trying to
t maximise profitts is
the firrm's MC.
SRMIST
T DDE MBA Self
ge 25
4. Economic versus accounting costs
When economists talk about a good's cost, they refer to its
opportunity cost, a measure not only of explicit costs like labour and
materials used in production, ie, the items that are included in a
firm's income statement, but also of implicit costs, such as revenues
that the inputs could have generated through some other use.
Consider the following example:
For the past year, a couple has owned a speciality bookstore in

a major metropolitan area. The bookstore is operated in a space of a
building the couple owns. In that year, the store had revenues of
$559,135. One of them has calculated that total cost, including
labour, the wholesale costs of books, equipment costs and marketing
costs, are $431,296. He reports to his partner that the bookstore is
very successful, with profits of $127,839 for the year.
His partner is unconvinced. She notes that they did not take
into account the rent that the two could have earned on the space
they used, as much as $8,000 per month. They also did not consider
the wages of $54,000 per year he gave up by choosing to manage the
bookstore. The sum of these two implicit costs, $150,000, needs to be
added to the original estimate of the bookstore's costs to get the total
economic cost.
Because the implicit costs together are greater than the original
estimate of the bookstore's profits, in an economic sense, the
bookstore is losing money.
The bookstore example suggests an important principle:

When making decisions, economic agents should take into
account the opportunity costs of actions, not merely their
explicit costs.
The key point here is that when contemplating a decision, it is
important to use only relevant costs in weighing up alternative
options. If additional costs are brought in, then profitable decisions

may be
b mistak
kenly held
d to be unprofitab
ble and value-crea
v ating
NOTES
opportu
unities wo
ould be lostt.
Anothe
er cost rela
ated to acc
counting co
osts is histtorical costts.
Willing
gness-to-P
Pay
Two critica
al decision omics are a customer’s decision to
ns in econo
purcha
ase a good
d or service
e and a su
upplier’s decision
d to produce tthat
good or service. Before
B con
nsidering th
he value customers
c and supplliers
might generate
g frrom trade,, it is usefu
ul to consiider these two decisiions
in more detail.
A monetarry measure esire customers have

e of the de e for a prod
duct
is theiir willingn y. A custtomer’s wiillingness-tto-pay is the
ness-to-pay
maxim
mum price he or she
e would pa
ay and stilll choose to
t purchas
se a
produc
ct.
This can be easily depicted in a deciision tree.. Suppose

e an
e dealer sees
antique s a Miing vase for
f sale in
n China. There
T willl be
$8,000
0 of costs associated
a with bring
ging the va
ase to his home coun
ntry
and se
elling it. Th
he trader has
h a certa
ain buyer he knows will purch
hase
the vas
se for $200,000. The
e price the hina is p. The
e vase sells for in Ch
dealer’s decision tree is as follows:
Notice that the dealer

d (D) will
w choose
e to buy th
he vase if $192,000
$ – p>
$0 or p<
p $192,00
00. Thus, so long as
s the price of the vas
se is less tthan
SRMIST
T DDE MBA Self
ge 27
$192,000, the dealer will purchase it. In this example, $192,000
represents the dealer’s willingness-to-pay for the vase.
In general, a customer’s willingness-to-pay for a product is

determined by many factors. These include the subjective benefit or
utility a customer may derive from a product’s consumption, eg, a
vacation package, or the increased profits that result from utilisation
of a product, eg, a more modern production technology. Consumers
may be willing to pay more for a product when their incomes rise,
when a complementary product becomes cheaper, such as CDs and
lower priced CD players, or when they are located closer to a
particular firm or that firm provides a more favourable brand image.
All of these factors -- often the domain of marketing subjects -- are
involved in forming a customer’s willingness-to-pay.
Willingness-to-pay, however, is not an absolute notion. It often

depends on the alternative outcome customers face if they choose not
to purchase a particular product. Thus, one need to examine the
overall decision customers are facing as they evaluate purchasing and
not purchasing the product.
For instance, suppose that the dealer can only carry one item
back from China and has identified another piece that could be
shipped. The dealer expects that he will earn $12,000 for that piece.
Now the dealer’s decision tree is:

NOTES
So in this situatiion the dea

aler will bu
uy the vase
e if
000 - $8,00
$200,0 00 – p> $12,000
p< $20
00,000 - $8
8,000 - $12
2,000
p< $18
80,000
The de
ealer’s williingness-to
o-pay has fallen
f to $180,000
$ b
because off the
alterna
ative profittable oppo
ortunity th
hat would have to be
b sacrifice
ed if
the vas
se were pu
urchased.
In summa
ary, willing
gness-to-pa ncept that relates to the
ay is a con
situatio
on a custtomer is facing.
f It not only depends on the diirect
benefitts from a product, such as consumpttion utility
y, but it also
depend
ds on the alternative
a es that face
e the custo se include the
omer. Thes
prices of relate
ed produc
cts and the custo cific costs in
omer-spec
consum e products. As we will see in
ming those n later segments, s
such
interac
ctions betw
ween diffe
erent business products in a custom
mer’s
decisio
on problem
m play a critical
c role
e in deterrmining th
he intensity
y of
compettition among those businesses
b s.
SRMIST
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ge 29
Willlingness-tto-Sell
Similarr to willin
ngness-to--pay, determining w
willingness
s-to-sell
olves cons
invo sidering th
he decisio b an agent; in this case,
on faced by
sup
ppliers. Wh
hen suppliiers choos
se to supplly resources or inpu
uts to a
bus
siness, they are un
nable to supply th
hose resou
urces else
ewhere.
The
erefore, su
uppliers es
ssentially give
g up th
he returns they migh
ht have
earned had they not su
upplied the business
s. This los
st opportun
nity for
alte arnings is the opporrtunity cos
ernative ea st incurred
d by supp
pliers. A
sup
pplier’s willlingness-to-sell is th
he minimu
um price th
hey would
d accept
and
d still choo
ose to supp
ply the resource. It is
s equal to their oppo
ortunity
cost of supply
ying the re
esource.
To see how willin

ngness-to--sell is dettermined, s
suppose one own
and
d operate an
a ice-crea
am stand on
o weeken
nds. One n
need to dettermine
on a month-b
by-month basis whe
ether or not hould continue to
n one sh
kee
ep the stan
nd open. In
n a typical month, on
ne can selll 1,000 ice
e-cream
nes on weekends. The cost of ic
con ce-cream materials
m is $0.20 pe
er cone,
and
d imagines
s the stand
d involves no cost to
o one. Thus, if the prrice per
con
ne is p, one expect to
o earn (p - 0.20) x 1,000
1 per m
month. Do
oes this
mea
an one sho
ould stay open so lo
ong as p ex 20? If one do, one
xceeds 0.2
willl earn som
me money.
The
e following decision tree
t repres
sents oner decision:
SRM
MIST DDE MBA
Notice that the decision tree highlights a missing variable: what
NOTES
does the vendor do if the stand shuts down. The vendor could work
for someone else; perhaps another stand. Suppose that this
employment would give $500 in wages. In this case, the vendor would
be better off keeping the stand open only if (p - 0.20) x 1,000 > 500 or
p> 0.70. Thus, the vendor’s willingness-to-sell is $0.70 per ice cream.
It is driven by the vendor’s explicit costs of materials as well as their
implicit cost of labour
1.3.3 BRANCHES OF ECONOMICS
The two main branches of economics are

microeconomics and macroeconomics.
Macroeconomics is about the economy in general and the study of
aggregate economic variables. For example, if a country's wealth goes
up or if millions of people become unemployed, those are things that
macroeconomists study. Microeconomics is about smaller and more
specific things and about individual economic behavior where
resources are costly. Such as how families and households spend
their money.
Microeconomics is the study of individual economic behavior
where resources are costly. It addresses issues such as how
consumers respond to changes in prices and income and how
businesses decide on employment and sales. Microeconomics also
extends to such issues as how voters choose between political parties
and how governments should set taxes. Managerial economics has a
more limited scope – it is the application of microeconomics to
managerial issues. By contrast with microeconomics, the field of
macroeconomics focuses on aggregate economic variables.
Macroeconomics addresses such issues as how a cut in interest rates
will affect the inflation rate and how a depreciation of the U.S. dollar
will affect unemployment, exports, and imports. While it is certainly
true that the whole economy is made up of individual consumers and

businesses, the study of macroeconomics often considers economic
aggregates directly rather than as the aggregation of individual
consumers and businesses. This is the key distinction between the
Fields of macroeconomics and microeconomics.
Some issues span both macroeconomics and microeconomics.

For instance, energy is such an important part of the economy that
changes in the price of energy have both macroeconomic and
microeconomic effects. If the price of oil were to rise by 10%, it would
trigger increases in other prices and hence generate price inflation,
which is a macroeconomic effect. The increase in the price of oil would
also have microeconomic effects; for instance, power stations might
switch to other fuels, drivers might cut back on using their cars, and
oil producers might open up new fields.
1.3.4 MICRO ECONOMICS
Microeconomics, like macroeconomics, is a fundamental method for

analysing the economy as a system. It treats households and firms
interacting through individual markets as irreducible elements of the
economy, given scarcity and government regulation. A market might
be for a product, say fresh corn, or the services of a factor of
production, say bricklaying. The theory considers aggregates of
quantity demanded by buyers and quantity supplied by sellers at
each possible price per unit. It weaves these together to describe how
the market may reach equilibrium as to price and quantity or respond
to market changes over time.
Such analysis includes the theory of supply and demand. It

also examines market structures, such as perfect competition and
monopoly for implications as to behavior and economic efficiency.
Analysis of change in a single market often precedes from the
simplifying assumption that relations in other markets remain
unchanged, that is, partial-equilibrium analysis. General-equilibrium

theory allows for changes in different markets and aggregates across
NOTES
all markets, including their movements and interactions toward
equilibrium.
1.4 IMPORTANCE OF MANAGERIAL ECONOMICS
1. Trade – Off
Dilemma is a conflict between two alternatives. Trilemma is conflict

among three options.
Make or Buy choice:
A multi – tasking juggler woman entrepreneur balances among work –
life and quiet leisure.
At the cost of ignoring secure job, one man gained in risky
entrepreneurship. Trade – off suggests a contract with consideration -
benefit to one and detriment to another. One man’s expenditure,
spending is another man’s income. The gain in production of wooden
furniture is at the loss of forest resources. Plastic carry bag enables
shopping, but kills a cow, when it is eaten and got stuck in intestine
of cow. Cloth bag when decomposed, decayed in soil becomes food for
bacteria.
The longer the time (in 25 hours’ day due
to moon changing path and earth slowing its
rotation) devoted to scientific experiments, the
shorter the quality time with family for scientist.
The greater the spending for away from home
restaurant eating, the less importance to slow
food and the quicker the entry into health problems like obesity. The
80 percent known work is combined with 20 per cent delegated out
sourcing or getting the help of an expert.
2 Lateral Thinking:
A small line will become smaller, when a tall line is drawn
nearby – it is Birbal’s out of the box thinking. The small line is
resource and the tall line is the unlimited wants, aspirations,

objectives, aims, purposes in ordinary business of life. It explains the
relative scarcity of resource.
Opportunity cost is the sacrifice of the next best alternative

use. The first best use of water is in agriculture. The subsequent next
use of water for industrial purpose say Pepsi needs to be given up to
save crop cultivation.
Exclusive use:
It is difficult to “have the cake and eat it too” The greater the
use of rice for direct consumption, the lower its use in energy
generation.
Externality:
It is the positive or negative influence of one’s action on a third
party or stakeholder. The waste effluent from a factory cause
waterborne disease, a spill over cost or negative externality. The
minimal use of fish by present population is a spill over benefit or
positive external effect on future population.
Intangibility:
A woman entrepreneur gives up quality time with family for
profit making in business. Forgoing quality time is the implicit or
hidden cost.
Imputation:
Opportunity cost is the expenditure not actually incurred, but
would have been incurred in case of self-owned factors. When land is
not leased out and the owner undertakes cultivation in own land,
shadow rent is imputed. When one is not lending but investing money
in own business, a surrogate interest needs to be imputed.
Economic Way of Thinking (Dynamic)

Choice Among Alternatives:
All possible alternative combinations of two products based on
a resource are represented in production frontier / production
possibility curve/ transformation curve.

Time Perspective:
NOTES
A right balance between short run and long run business
perspective is necessary for effective decision making. Long – range
view is preferable to short – sighted view.
Marginalism:
The extent of change in revenue/ cost due to one unit change
in output is marginal revenue/ marginal cost.
The extent of change in revenue / cost due to chunk change in
output in new technology is incremental revenue and incremental
cost.
Economic thinking expects that “further benefits” (marginal
revenue) should outweigh “further costs” (marginal or incremental
cost) in the long run, over a period of time
1.4.1 DETERMINANTS OF VALUE IN TRADE
The value that is created by activities in a business is

potentially complex and diverse. It results from relationships with
other players in the economy including its customers, suppliers and
other businesses that deal with those same players, ie, competitors
and complementors. Given this, it is useful to consider a stylised
representation of the process of value creation in order to state a
definition of value that is readily applicable to realistic situations.
A very simple way of defining value is to track a particular

activity of a business. Recall that a business utilises inputs from
suppliers and turns them into products that it’s the customers desire.
The flow of product from suppliers, through the business, to the
customers is referred to as the value chain of production, which is
depicted in the figure below. It shows the vertical flow of goods and
services and also money between customers, oner business and
suppliers.

These flows willl only occu
ur if the relevant
r d
decision-makers -
stomers an
cus nd supplie
ers are willing
w to engage
e in their res
spective
tran
nsactions. Custome
ers must be willing ange money (the
g to excha
pro
oduct price
e) for the business’
b product
p and supplierrs must be
e willing
to accept
a mon
ney (inputt payments
s) for the provision
p of inputs. Finally
the business will only be willing
g to partic
cipate in th
he value chain
c if
sitive gap between
there is a pos b product
p priice and inp
put payme
ents, ie,
me “money
som y on the ta
able”. It is only when there is such a ga
ap that
valu
ue is creatted.
Cre
eating Vallue Throu
ugh Excha
ange
There will only be value created

c if the highe
est possiblle price
ceeds the lowest po
exc ossible inp
put payme
ents. The highest possible
p
pric
ce is, by definition, the
t custom
mer’s willin
ngness-to-p
pay for a product
p
whiile the lowest possiblle price is defined by
y the supp
plier’s willin
ngness-
to-s
sell. Therefore, add
ditional surplus
s w
will only b
be created if a
SRM
MIST DDE MBA
customer’s willingness-to-pay exceeds suppliers’ willingness-to-sell.
NOTES
Thus, the total surplus is the difference between the customers’
willingness-to-pay for a product and the suppliers’ willingness-to-sell
that product (this is the additional value created through exchange).
As an example, suppose that a customer’s willingness-to-pay

for an ice cream at a sports stadium was $3. An ice-cream vendor at
that stadium has a willingness-to-sell of $1 he sells an ice cream to
that customer. Therefore, if an exchange or transaction were to occur,
the total surplus would be $2; equal to the difference between the
customer’s willingness-to-pay of $3 and the vendor’s willingness-to-
sell of $1. So long as one can determine the willingness-to-pay and
willingness-to-sell associated with a particular transaction, one can
easily quantify that transaction’s total surplus.
Businesses can appropriate some of the value created by

bringing customers and suppliers together in completing the value
chain. However, it will not usually appropriate all additional value
because price will often be less than a customer’s willingness-to-pay,
and input prices may exceed suppliers’ willingness-to-sell. So it is the
difference between price and input price that will determine a
business’ profitability. The first step for business is, therefore, to
ensure that it assists in creating value.
Value Creation with Many Agents
The above discussion considered trade between a customer and

a supplier. However, many trading situations involve more than two
agents. Here we briefly review two of the most important of these (i)
when there are many customers and sellers and (ii) when there are
several providers of complementary goods.

Many customers and sellers
In addition to building the building blocks of value, willingness-

to-pay and opportunity cost are directly related to the economic
concepts of demand and supply, respectively. Indeed, by definition
For each unit price of a product, the quantity demanded for a

product is the quantity of output for which a customer’s willingness-
to-pay for a unit of output exceeds price.
For each unit price of a product, the quantity supplied of a product is

the quantity of output for which suppliers’ willingness-to-sell for a
unit of output exceeds price.
Notice that, given this definition, as the price falls, quantity

demanded for a product will rise, as more customers are willing to pay
for more units of output. On the other hand, as price falls, quantity
supplied is likely to fall if suppliers face diminishing returns
Not only are the concepts of demand and supply related to the
underlying sources of value, they are also useful concepts in
determining what level of output would maximise the total value
created. To see this, suppose that a market for a product consists of
four customers, with willingness’s-to-pay of $1,000, $800, $600 and
$400 for a single unit of the product, and four suppliers who are able
to produce one unit of output each at willingness’s-to-sell of $900,
$700, $500 and $300. Recall that there is value created when the
willingness-to-pay of a customer exceeds the willingness-to-sell of a
supplier. So it would be tempting to think that supplier 1 could
supply customer 1, supplier 2 could supply customer 2, etc. In this
case, the total value created in the market would be $400 as each
customer’s willingness-to-pay exceeds their supplier’s willingness-to-
sell by $100.
This matching of customers and suppliers would not maximise

the total value created. Consider an alternative matching whereby

customer 1 is matched with supplier 4, customer 2 is matched with
NOTES
supplier 3 and the remaining two customers and suppliers do not
trade at all. In this case, the total value created is $1,000 (= 1,000 -
300 + 800 - 500), which is higher than the situation where all four
customers are supplied. Moreover, notice that, given this, if either of
the other customers were supplied, value created would be lower as
those customers’ willingness’s-to-pay would be below the suppliers’
willingness’s-to-sell. So to maximise the value created, customers 1
and 2 must be supplied with suppliers 1 and 2 and no other trades
should take place.
This example illustrates a more general principle: in order to

maximise the total value created, the customer with the highest
willingness-to-pay should be matched with the supplier with the
lowest opportunity cost, the customer with the next highest
willingness-to-pay should be matched with the supplier with the next
lowest opportunity cost and so on. Moreover, trades should not take
place beyond the point where the willingness-to-pay of the next
customer is less than the willingness-to-sell of the next supplier.
It is important that the matching exercise is used to order

customers and suppliers to form demand and supply curves and find
their intersection. In our example, so long as two units are sold from
suppliers 3 and 4 to customers 1 and 2, the total value created is
maximised. Thus, customer 1 could purchase from supplier 3 and
customer 2 from supplier 4; generating the same level of value.
This situation can be depicted graphically where we rank

customers from highest to lowest willingness-to-pay and suppliers
from lowest to highest willingness-to-sell. This is done in the following
figure. The line of customers’ willingness’s-to-pay is what is called the
market demand curve for the product while the line of suppliers’
willingness’s-to-sell is the market supply curve. Notice that the value
created is maximised where the two curves intersect: that is, where
demand effectively equals supply.

By con
nsidering willingnes
ss-to-pay and willin
ngness-to--sell in
ms of dem
term mand and supply,
s it becomes easier
e to s
see what quantity
q
willl the greattest value.. As we will
w see in segment 4
4, market forces,
whe
ereby prices change
e in respon
nse to sho
ortages an
nd surpluses, can
ens
sure that demand
d eq
quals supp
ply and hen otal value created
nce, the to
is maximised
m .
To see a com
mmentary of how demand
d an
nd supply
y might as
ssist in
derstandin
und ng whetherr or not to invest in new
n products to save
e time.
Co--Operating
g with Com
mplementtors
A more
e subtle fo ue creation comes ffrom dealin
orm of valu ng with
mplemento
com ors.
An age
ent is ow
wner comp mers value owner
plementor if custom
oduct more
pro e when th
hey have th
he other agent’s
a pro
oduct than
n when
they
y have own
ner produc
ct alone.
Interde
ependent industries
i o achieve greater
often co--operate to
ofitability. Such
pro S co-op
peration is oopetition”.
s called “co
This is
s perhaps easiest to
o see with
h complem
mentary products.
The
e existenc
ce of and
d demand for com
mplementarry produc
cts can
imp
prove indu
ustry proffitability. After all, complem
mentary prroducts
stim
mulate de
emand forr an ind
dustry's products. For exam
mple, a
SRM
MIST DDE MBA
customer is willing to pay more for shaving cream and razors when
NOTES
they are both available than razors and shaving cream separately.
Competition occurs in the computer software and

microprocessor industries. The demand for the processing power
supplied by microprocessors results in part from the development of
complex computer software. In addition, the introduction of complex
computer software necessitates microprocessor advancements that
can execute software commands. As a result of their interdependence,
these industries co-operate with open exchanges of information,
which benefits both industries.
Another way of viewing complementarity is on the supply-side.

A player is one complementor if it is more attractive for a supplier to
provide resources to one when it is also supplying the other player,
than when it is supplying one alone.
If a particular supplier has a greater willingness-to-sell to one

and another customer together than to each separately, then one and
the other customer are complementors in supply. For instance, some
customers might use a broadband Internet connection during the day
while others might use it at night. If both types of customers are
available, an Internet provider can provide the service to each at a
lower price than it could if only one type were available.
Scarcity is shortage of resources in relation to unlimited wants.
Resources are like a line that becomes smaller relative to a tall line
drawn nearby –Birbal’s puzzle. Economics is concerned about
management of resource. It is obvious. Relative scarcity is non –
obvious.
Apart from shortage, scarcity actually means a ‘’ price tag’’ for
everything. There is ‘’NO FREE LUNCH’’ in the world. The payment of
price means that something is sacrificed for gaining something else,
called trade – off. The extent of sacrifice for gaining something is
called opportunity Cost.
Opportunity cost is the sacrifice of the next best alternative. Rational
choice is the selection of the most desirable alternative from among all

possible alternatives. Decision making is the rational choice of a
feasible course of action. Etymologically the Latin origin word for
decision is decided meaning cutting off, separating, and segregating
the desirable from the undesirable alternative.
The basic economic problems in resource management are

what to produce how to produce and for whom to produce. They are
about taste, technology and targeting respectively.
Regarding what to produce the greater the investment in capital good
the lower will be the investment for consumer good. The production of
capital good and consumer good are mutually consistent or
inconsistent. The capital production is done at the cost of consumer
goods production. How to produce question is a choice between
capital – intensive technique and labour – intensive technique.
For whom to produce is the question as to sacrificing the present
consumption of natural resources for the sake of future consumption
by posterity.
1.5 MAJOR FUNCTIONS
Strategic decisions commit substantial resources and demand

commitment of all individuals in the firm.
Marketing Decision:
The push strategy believes in sales promotion. The pull
strategy aims at customer loyalty.
Financial Decision:
Debt financing is meant for unrelated product diversification.
Equity financing is necessary for related product diversification.
Research and Development Decision:
A new approach to R & D is “Open innovation” in which a firm
uses alliances and connections with corporate, government, academic
immersion lab to develop new products, and processes.

HR Decision:
NOTES
There is choice between hiring low-skilled cheap labour and
hiring high – skilled self – directed work team.
IT Decision:
Information Technology follows the practice of “follow-the-sun-
management” in which project team members in one country can
pass their work to team in another country.
Operations Decision:
There is a choice between backward integration and forward
integration. Yarn industry induces cotton production, in back ward
integration. Yarn is used as input in cloth and clothes readymade
garment industry in forward integration.
At this juncture it is apt to specially mention the relationship of

managerial economics with the important fields of study such as
statistics, mathematics, operations research, and accounting.
MANAGERIAL ECONOMICS AND STATISTICS

Statistics provides several tools to Managerial Economics;
Statistical techniques are used in collecting, marshalling and
analysing business data that makes possible an empirical testing of
the economic generalisations before they are applied for decision-
making. Economic generalisations cannot be fully accepted until they
are verified and found Valid against the real data. The theory of
probability and forecasting techniques help the manager in decision-
making process. When the manager is to meet with the reality of
uncertainty in decision making the theory of probability provides the
logic for dealing with such uncertainty.
MANAGERIAL ECONOMICS AND MATHEMATICS

Mathematics is especially of to the manager when several
economic relationships are to logic in the analysis of economic events
provides clarity of the concepts and also helps to establish a
quantitative relationship. Managers deal primarily with concepts that
are quantitative in nature eg., demand, price, cost, capital, wages,
inventories etc. Mathematics is the manager's most useful logical tool.

MANAGERIAL ECONOMICS AND OPERATIONS RESEARCH
Operation research and managerial economics are related to a
certain extent. Operation research is the application of mathematical
and statistical techniques in solving business problems. It deals with
construction of mathematical models that helps the decision making
process. Operation research is helpful in business firms in studying
the inter-relationship and relative efficiencies of various business
aspects like sales, production etc. Linear programming, techniques of
inventory control, game theory etc. are used in managerial economics.
These are used to find out the optimum combination of various
factors to achieve the objects of maximisation of profit, minimizations
of cost and time etc.
MANAGERIAL ECONOMICS AND ACCOUNTING

Accounting is closely related with managerial economics.
Accounting is the main source of data regarding the operation and
functioning of the firm. Accounting data and statements represent the
language of the business. A business manager needs market
information, production information and accounting information for
decision- making. The profit and loss statement reflects the
operational efficiency of the firm.
The balance sheet tells the financial position of the firm. The
accounting information provides a basis for the manager in decision
making and forward planning. In short, accounting provides right
information to take right decisions.
1.6 SUMMARY
This lesson explains the fundamentals on Economics, scope

and their branches. Thus Economics is the social science that
analyzes the production, distribution, and consumption of goods and
services. It has two main branches and they are, Macroeconomics is
about the economy in general. Microeconomics is about smaller and

more specific things such as how families and households spend their
NOTES
money.
Managerial economics is the science of directing scarce
resources to manage cost effectively. Wherever resources are scarce,
manager can make more effective decisions by applying the discipline
of managerial economics. These may
be decisions with regard to
customers, suppliers, competitors, or
the internal workings of the
organization. It does not matter
whether the setting is a business,
nonprofit organization, or home. In all
of these settings, managers must make the best of scarce resources.
Something people and businesses prefer to have more than less of can
assist in guiding the decisions of rational agents.identify value-
creating trading opportunities in a vertical chain by comparing a
customer’s willingness-to-pay to a seller’s willingness-to-sell relate
willingness-to-pay, willingness-to-sell and value created to the
demand and supply in a market.
Identify the potential for value creating co-operation between
complementors. Hence Managerial Decision making is highly
essential.When making decisions, economic agents should consider
the opportunity costs of actions, not merely their explicit costs and
ignore sunk Cost.
Points to be remembered:
Economy: A system of providing

living to people.
Microeconomics: Study of the

behaviour of individual, small,
isolated and disaggregated units.
Macroeconomics: Study of groups and broad aggregates of the

economy.

Firm: An individual producing unit.
Industry: A group of firms producing identical or closely related

goods.
The term microeconomics and macroeconomics were first given

by Ragner Frisch in 1933.
Adam Smith wrote the book- “An Enquire into the Nature and Causes
of Wealth of Nations” or in short “Wealth of Nations” in 1776.
Adam Smith is known as father of modern economics.
Positive economics deals with describing relationships of cause

and effect. It deals with explanation and prediction.
Normative economics deals with what ought to be or what

should be. It is related to value judgments.
Partial equilibrium analysis is the study of the behavior of

individual decision- making units and working of individual
markets in isolation.
General equilibrium analysis is the study of the behavior of all

individual decision-making units and all individual markets
simultaneously.
Partial equilibrium analysis is developed by Marshall whereas

general equilibrium analysis is developed by Walras.
The basic definition of economics:

“Economics enquire into the nature and causes of wealth of
nations” (Adam Smith)

“Economics is a study of mankind in the ordinary business of life and
NOTES
examines that part of individual and social action which is connected
with material requisites of well-being.” (Marshall)
“Economics is a science which studies human behavior as a
relationship between ends and scares resources which have
alternative uses.” (L. Robbins)
An economy exists because of two basic facts:
1. Human wants for goods and services are unlimited; and
2. Productive resources with which to produce goods and services

are limited.
3. Thus a society is faced with the problem of choice – choice

among unlimited wants/desires that are to be satisfied with limited
resources.
The basic problems/questions in an economy:

1. What goods are produced and in what quantities by the productive
resources;
2. How to produced, that is what production methods are employed

for production of various goods and services;
3. How to distribute, that is how is the total production of goods and

services is distributed among its people;
4. Are the uses of production resources economically efficient?
5. Whether all available productive resources with a society are being

fully utilized?
6. Is the economy’s productive capacity increasing, declining or

remaining constant over time?

Economics has been divided into two parts by Ragnar Frisch (First
Nobel Prize winner in Economics):
Microeconomics; and Macroeconomics
Micro means small and macro means large.
Microeconomics deals with the analysis of small individual

units of the economy such as individual consumers, individual firms
and small aggregates or groups of individual units such as various
industries and markets.
Macroeconomics deals with the analysis of the economy as a

whole and its large aggregates such as total national output and
income, total employment, total consumption, aggregate investment,
etc.
Differences between Microeconomics and Macroeconomics:
Differences based on Microeconomics and Macroeconomics

1. Subject- matter: Small segments such as Large aggregates
such as aggregateindividual household, individual demand,
aggregate supply, nationalfirm, individual price, etc. income, general
price level, etc.
2. Use of Partial equilibrium analysis General equilibrium
analysis techniques:
3. Assumptions: Full employment in the economy
Underemployment of resources.
4. Core Price is the main determinant of Income is the main
determinant of differences: microeconomics and macroeconomics.
Scope of Microeconomics and Macroeconomics:

Microeconomics

Product pricing
NOTES
• Theory of demand
• Theory of production & costs
Factor pricing
• Wages
• Rent
• Interest
• Profits
Theory of economic welfare Macroeconomics
Theory of income & employment
• Theory of consumption function
• Theory of fluctuations or business cycles
• Theory of investment
REVIEW QUESTIONS
Objective Type Questions:
1. Who is known as father of modern economics?

a. Ragnar Frisch b. Adam Smith c. Marshall d.
None of these.
2. Who was the first person who got Nobel Prize in economics?
None of these.

3. Who wrote the book Wealth of Nations
Robbins.
4. Wealth of Nations was published in---

a. 1976 b. 1876 c. 1776 d. 1676.
5. Microeconomics and Macroeconomics was first coined by ----
Robbins.
6. The study of the behavior of individual decision- making units

and working of individual markets in isolation is known as-----
a. General equilibrium analysis b. Partial equilibrium analysis.
Answer:
1 2 3 4 5 6
b a b c a b
True and false statements:
1. Microeconomics is the study of the behavior of individual,

small, isolated and disaggregated units.
2. Partial equilibrium analysis is developed by Walras.
3. The term microeconomics and macroeconomics were first given

by Adam Smith in 1933.
4. Product pricing, factor pricing and theory of economic welfare

are the scope of microeconomics.
5. General equilibrium analysis is used in microeconomics.

Ques. 1 2 3 4 5
NOTES
Ans. T F F T F
QUESTIONS WITH ANSWER
Ques: Why does economy exist in the world?
Ans: An economy exists because of two basic facts:
1. Human wants for goods and services are unlimited; and
2. Productive resources with which to produce goods and services

are limited.
Ques: What are the main definitions of economics?
Ans: The main definitions of economics are given by Adam Smith,

Marshall and Robbins.
According to Adam Smith, “Economics enquire into the nature and

causes of wealth of nations.”
Marshall defines “Economics is a study of mankind in the ordinary

business of life and examines that part of individual and social action
which is connected with material requisites of wellbeing.”
Robbins defines, “Economics is a science which studies human

behavior as a relationship between ends and scares resources which
have alternative uses.”
Ques: Who has written the book- “An Enquire into the Nature and
Causes of Wealth of Nations?”
Ans: Adam Smith has written this book in 1776.

Ques: Who is known as known as father of modern economics?
Ans: Adam Smith
Ques: What are the basic problems/questions in economy?
Ans: The basic problems/questions in an economy are:
1. What to produce;
2. How to produce; and
3. For whom to produce?
Ques: Who divided economics into two parts as microeconomics and

macroeconomics?
Ans: Ragnar Frisch (First Nobel Prize winner in Economics).
Ques: What is microeconomics?
Ans: Microeconomics deals with the analysis of small individual units

of the economy such as individual consumers, individual firms and
small aggregates or groups of individual units such as various
industries and markets.
Ques: What is macroeconomics?
Ans: Macroeconomics deals with the analysis of the economy as a

whole and its large aggregates such as total national output and
income, total employment, total consumption, aggregate investment,
etc.

Ques: What is positive economics?
NOTES
Ans: Positive economics deals with describing relationships of cause

and effect. It deals with explanation and prediction.
Ques: What is normative economics?
Ans: Normative economics deals with what ought to be or what

should be. It is related to value judgments.
Ques: What do you understand by partial equilibrium?
Ans: Partial equilibrium analysis is the study of the behavior of

individual decision- making units and working of individual markets
in isolation.
Ques: What is general equilibrium analysis?
Ans: General equilibrium analysis is the study of the behavior of all

individual decision- making units and all individual markets
simultaneously.
Ques: Who developed partial and general equilibrium analysis?
Ans: Marshall developed partial equilibrium analysis and Walras

developed general equilibrium analysis.
1.7 CHECK YOUR ANSWERS
1. Define the term, “Economics” and mention its importance.

2. Explain the branches of Economics with relevant Examples.
3. Illustrate the role of Managerial Economics in Decision Making
Process.
4. Discuss the determinants of Value in Trade.

Case Study
Equal prize money in tennis A British cabinet

minister has now stepped into the debate regarding
equal prize money at Wimbledon, the British Open
tennis championships. Patricia Hewitt (no relation to
the men’s winner), the Trade and Industry Secretary, announced that
it is ‘simply wrong’ that the winner of the men’s singles should collect
£525,000, while the women’s winner should receive only £486,000,
when they had both worked equally hard. The debate regarding prize
money is not new, and has aroused some strong feelings in the last
ten years. The 1996 men’s champion, Richard Krajicek, commented in
1992 that most women players were ‘fat, lazy pigs’ who deserved to
win less. This attracted a storm of protest from many supporters of
women’s tennis, and these supporters and lobbyists have been
successful in gradually reducing the differentials in prize money.
Tim Henman, the British number one player, attracted

criticism in 1999 for accusing female players of being ‘greedy’ in
demanding more prize money in ‘Grand Slam’ tournaments. The
situation in 2002 was that in the four ‘Grand Slam’ tournaments the
prize money was equal for men and women at both the US and
Australian Opens, but interestingly the women’s prize money was only
half that of the men’s at the French Open. Let us consider some of the
main arguments that have been put forward both for and against
equal prize money: FOR 1 Women have to train just as long and hard
as men. 2 The ball is in play longer in women’s matches, because the
game involves more rallies and less ‘serve and volley’ tactics,
according to research by the Women’s Tennis Association. 3 Female
stars are just as popular with the crowds as male players. 4 Unequal
pay is an example of unfair discrimination, which in many countries
is illegal.
AGAINST
1 Men have to play the best of five sets, while women only play the
best of three. Therefore men play longer. Research from Stirling
University shows that, on this basis, men earn less. The 1998 men’s

singles champion, Pete Sampras, earned £26,270 per hour, compared
NOTES
with £42,011 per hour received by the women’s champion, Jana
Novotna.
2 Competition at the top of women’s tennis is less stiff, allowing
female stars to compete in the doubles more easily, and win two
prizes. The combination of singles and doubles prizes for women
would exceed the singles prize for men.
3 Male players attract bigger crowds.
4 Women are not as good as men. The last point has also raised
argument, since it is difficult to make any objective evaluation. On a
purely objective measure, the top female stars serve nearly as fast as
the top male players, but obviously there are many other factors
which make a top tennis player apart from a fast serve. In a recent
television interview John McEnroe, never one to shy away from
controversy, opined that the top female seed at Wimbledon in 2002,
Venus Williams, would only rank about number 400 in the world
among male players.
1. Adding another dimension to the debate is sponsorship income.
2 The term business must be considered in very broad terms, to
include any transaction between two or more parties. Only then can
we fully appreciate the breadth of application of the discipline.
3 Decision-making involves a number of steps: problem perception,
definition of objectives, examination of constraints, identification of
strategies, evaluation of strategies and determination of criteria for
choosing among strategies.
4 Managerial economics is linked to the disciplines of economic
theory, decision sciences and business functions.
5 The core elements of the economic theory involved are the theory of
the firm, consumer and demand theory, production and cost theory,
price theory and competition theory.
6 A neoclassical approach involves treating the individual elements in
the economy as rational agents with quantitative objectives to be
optimized.
7 Positive statements are statements of fact that can be tested
empirically or by logic; normative statements express value
judgements.

8 The application of economic principles is useful in making both of
the above types of statement.
9 A theory is a statement that describes or explains relationships
between phenomena that we observe, and which makes testable
predictions. won a major tournament; she is currently ranked number
55 in the world. Her career total prize winnings amounted to just
under £3 million at the end of 2001. However, it is estimated that she
has accumulated around £50 million in sponsorship income, mainly
from Adidas, the sportswear supplier. Although sponsorship income
tends to be directly related to the talent of the player, as reflected in
computer rankings, there are obviously other factors that are
relevant.
However, one factor that is important here is that sponsorship

income is determined much more by the market forces of demand and
supply than is the amount of prize money in a tournament. The
amount of tournament prize money at Wimbledon is determined by
the management committee of the All England Club. What do the
public make of all this? In a recent television poll by the BBC the
viewers calling in were nearly equally divided: 51 per cent thought the
men should receive more, 49 per cent thought prize money should be
equal.
Questions
1 Do the observations by Patricia Hewitt make any sense in economic
terms?
2 How relevant is hard training to determining prize money?
3 How relevant is length of playing time to determining prize money?
4 Why is sponsorship relevant to the prize money debate? Is it a good
idea to relate prize money to sponsorship?
5 Can you suggest any way of using economic forces to determine
prize money?

NOTES
MODULE –2
______________________________________________________________
Demand Supply
2.0 Introduction
2.2 Type–I Demand Short term demand
2.3 Type–II Demand Long term demand
2.4 Demand Forecasting
2.5 Meaning of Supply
2.8 Conclusion

2.0 Introduction
Demand is defined as the quantity of goods and services

desired by an individual backed by the ability and willingness to pay.
Demand = Desire + Ability to Pay
+ Willingness to Pay
Ordinarily by demand we mean

desire. But demand is different from
desire. The willingness to have
something can be called as desire.
Those desires become demand
which are backed by purchasing
power, e:g., ability to pay and
willingness to pay for it. It means the following three conditions are
necessary for demand:
1. Desire
2. Purchasing Power or ability to pay
3. Willingness to pay
Above conditions must be there to create demand.
Individual and Market Demand
Individual demand is a demand by an individual. Individual

demand indicates amount of goods purchased by an individual at
different prices during a given period of time. Market demand is
aggregate of all quantities purchased by all buyers of a commodity at

different prices during a given period of time. Since there are
NOTES
numerous consumers of a commodity, market demand is the total of
all individual demand.
Factors effecting Demand
-Price
- Income
- Price of related goods
-Taste and Preferences
-Availability of substitutes
2.2 TYPE–I DEMAND SHORT TERM DEMAND
Short-run demand refers to existing demand, with its

immediate reaction to price changes, income fluctuation etc. Short
run is the period during which only some factors or variables can be
changed because there is not enough time to change the others. In
short run, some inputs are variable and some are fixed.

Dem
mand
Fig
gure 1-Dem
mand curv
ve
Figu
ure 1, Dem
mand curve
e represents for every
ry increase
e in price Quantity
Q
dem
manded go
ot decreas
sed hence for increa
ase in pricce from £0.20
£ to
£0.50 demand got decre
eased from
m 400 units
s to 100 un
nits respecttively.
w of dema
Law and: At hiigher prices
s, a lower quantity w
will be dem
manded
tha
an at lowerr prices, other
o things
s being eq
qual. Altern
natively, at
a lower
pricces, a high
her quantity
y will be de
emanded, other thing
gs being eq
qual.
Rea
asons why
y observe law of de
emand:
Sub
bstitution
n effect: tendency of people
e to substtitute in favor
f of
che
eaper comm
modities
al-income effect: ch
Rea hange in pu
urchasing power
p that occurs when
w the
pricce of a good
d changes
Detterminantts of Dema
and
The ma
ajor nonprrice determ
minants of demand a
are:
(1) inco
ome
SRM
MIST DDE MBA
(2) tastes and preferences
NOTES
(3) the price of related goods,
(4) changes in expectations of future relative prices, and (5)
population (i.e., market size).
The major nonprice determinants of supply are:
(1) input costs,
(2) technology,
(3) taxes and subsidies,
(4) expectations of future relative prices, and (
5) the number of firms in the industry.
Substitutes: A change in the price of one causes a shift in demand

for the other in the same direction (e.g. butter and margarine)
Complements: a change in the price of one good causes a shift in
demand for the other in the opposite direction (e.g., stereo amplifiers
and speakers, nuts and bolts)
Change in Demand—results from change in a non-price determinant
of demand (curve moves)
Change in Quantity demanded—results from change in price (move
along curve)
Theory of demand, Law of Demand
Law of demand is one of the

important basic laws of
consumption. Dr. Alfred
Marshall, in his book
"Principles of Economics",
has explained the law of
demand as follows. "Other things being constant the higher the price
of the commodity, smaller is the quantity demanded arid lower the
Mice of the commodity larger is the quantity demanded."
The law of demand explains change in the behaviour of consumer

demand due to various changes in price. Marshall's Law of demand
describes functional relation between demand and price. It can be

expressed as D = f (P) that is demand is function of price. The relation
between price and demand is inverse, because larger quantity is
demanded when price falls and smaller quantity will be demanded
when price rises. The law of demand is explained with the help of the
following schedule.
As shown in the schedule when price of mangoes is Rs. 50/-

per kg. demand is, 1 kg. When price falls to the level of Rs. 40/- per
kg. and demand rises to 2 kg. Similarly, at the price Rs. 10/- per kg.
demand of mangoes is 5 kg., whereas 4 kg. of mangoes are demanded
at price Rs. 20/- per kg. This shows inverse relation between price
and demand.
Table: Demand Schedule

Price of Mangoes Demand for Mangoes
Per Kg. (Rs.) (Kg.)
50 1
40 2
30 3
20 4
10 5
Reasons behind downward slope of demand curveOr, why demand

curve slopes downwards to the right?
Law of diminishing marginal utility;

Substitution effect
Income effect
New consumers
Exceptions to the law of demand:
Giffen goods;
Veblen good;
Exception of a price rise in future;
Bandwagon effect;
Emergency;
Good with uncertain product quality;

Snob appeal;
NOTES
Brand loyalty.
Individual Demand and Market Demand:

An individual demand curve is the demand for a good on the part of
an individual consumer.
Quantity
Price Demanded Quantity
(SR/Kg) by Demanded Quantity Demanded by
Individual by Individual
“A” “B” “A+B” (Market Demand)
1 5 4 5+4=9
2 4 3 4+3=7
3 3 2 3+2=5
4 2 1 2+1=3
5 1 0 1+0=1
Complementary goods:
Two goods are said to be complements if an increase in the price of

one good leads to a fall in the quantity demanded of other.

Substitute goods:
Two goods are said to be substitute if an increase in the price of one

leads to an increase in the quantity demanded of the other.
Example: Tea and Coffee
Demand and Consumer Tastes:
Dx = f (T), ceteris paribus

Change in Quantity Demanded (Movement) Vs Change in Demand
(Shift) of Demand Curve:
Change in Quantity Demanded (Movement: Expansion or

Contraction):
A movement along the demand curve is caused by a change in the

price of the good only, other things remaining the same.
It is also called change in quantity demanded of the commodity.
Movement is always along the same demand curve, i.e., no new
demand curve is drawn.
Movement along a demand curve can be of two types:
Expansion or extension of demand curve; and
Contraction of demand curve
Expansion or extension of demand refers to rise in demand due to fall

in the price of the good.

NOTES
Contraction of demand refers to fall in demand due to rise in the price

of the good.
Change in Demand (Shift: Increase or Decrease in Demand Curve):
A shift of the demand curve is caused by changes in factors other

than price of the good.
These other factors are:

Consumer’s income;
Price of other goods;
Consumers’ tastes and preferences, etc
A change in any of these factors causes shift of the demand curve. It

is also called change in demand curve.
Shift in demand curve means a new demand curve is drawn.
A shift of the demand curve (or change in demand curve) can be of

two types:
Increase in demand; and Decrease in demand.
Increase in demand refers to more demand at a given price or same

demand at a higher price. This is due to-
Increase in the income of the consumers;
Increase in the price of substitute goods;
Fall in the price of complementary goods;
Consumers taste becoming stronger in favour of the
good.

Decrease in demand refers to less demand at the given price or same
demand at a lesser price.
This is due to-
Fall in the income of the consumers;

Fall in the price of substitute goods;
Rise in the price of complementary goods;
2.2.1 ELASTICITY OF DEMAND
Elasticity: a measure of the responsiveness of quantity demanded or

quantity supplied to one of its determinants. In other words, elasticity
is the measure of responsiveness of dependent variables to a given
change in independent variable.
Y= f (X)
Elasticity of Y=Percentage change in Y
Percentage change in X
Measurement of Elasticity: Elasticity can be measured in two ways;

point elasticity and arc elasticity. Point elasticity is used when the
change in the independent variable is very small. If there is a large
change in the independent variable, arc elasticity is used.
Types of Elasticity of Demand:

1. Price Elasticity of Demand:
Price elasticity of demand measures how much the quantity
demanded responds to a change in price.
computed as the percentage change in quantity demanded divided by
the percentage change in price
Types of Price Elasticity of Demand
1. Perfectly Inelastic Demand
2. Inelastic Demand
3. Unitary elastic Demand

4. Elastic Demand
NOTES
5. Perfectly Elastic Demand
2.2.2 Types of Elasticity of Demand
1.Income elasticity:
Income Elasticity of demand
measures how much the
quantity demanded of a good
respond to a change in
consumers’ income.
It is computed as the percentage change in the quantity demanded
divided by the percentage change in income.
ey= Percentage change in demand of X

Percentage change in Income
2. Cross Elasticity of Demand:
The cross-price elasticity of demand measures the response of
demand for one good to changes in the price of another good.
ec= Percentage change in demand of X

Percentage change in price of Y
3. Promotional Elasticity of Demand (Advertisement Elasticity)

The advertisement elasticity of demand measures the responsiveness
of the quantity demanded through the changes in the advertisement
expenditure (assuming other factors unchanged).
ed= Percentage change in demand

Percentage change in expenditure on
advertisements and other promotional efforts

2.2
2.3 SHIFT
TING AND EXPANSIO
E ON OF DE
EMAND
A demand
d cu
urve shows
s how cons
sumers ch
hange theirr purchase
es given
a ch
hange in the
t price of
o the good
d. The grap
ph below s
shows thatt, if the
pric
ce of widg
gets increa
ased from $10 to $1
12 per wid
dget, the quantity
q
dem
manded in
n the mark
ket would decrease from
f 10,000 to 9,00
00. The
pric
ce change is said to
o cause a "change in
i the qua
antity dem
manded"
(mo
ovement allong a dem
mand curve
e).
Oth
her factors
s besides price, how n influence the amo
wever, can ount of
wid
dgets dema he markett. These other factors
anded in th s are repre
esented
graphically as
s a shift in
n the dema
and curve and are sa
aid to reprresent a
"change in demand".
d F
Four of th
he most im
mportant factors th
hat can
ult in a ch
resu hange in de
emand are:
1. Change in
n Consume
er Income
2. Change in
n Consume
er Preferen
nces
3. Change in
n the Price of Related
d Goods
4. Change in
n Expectatiions
If an increase in consu
umer inco
ome stimu
ulates add
ditional
purrchases off widgets, the dema
and curve shifts upward and to the
righ
ht (an inc
crease in demand shown
s on the graph below). If this
occ
curs, widge
ets are callled "norma
al goods."
SRM
MIST DDE MBA
An increa
ase in co
onsumer income,
i however,
h m
may cause a
NOTES
decrease in dema
and for some goods (representted as a do
ownward s
shift
in the demand
d cu
urve). Thes
se types off goods are
e called "in
nferior good
ds."
A chan
nge in cons
sumers’ ta
astes and preference
p es for widg
gets will ca
ause
a chan
nge in th
he deman
nd for wid
dgets. A decrease in consu
umer
prefere
ences for widgets will
w shift the dema
and curve gets
e for widg
downw
ward and to
o the left.
Suppose consumers tend to hen they buy

o buy sprockets wh
widgets
s (sprocke
ets and wiidgets are related goods).
g A change
c in the
price of
o sprocketts will shifft the dema
and curve for widgetts. If the p
price
of spro
ockets dec
creased an
nd consum
mers boug
ght more sprockets
s and
widgets
s, widgets and spro
ockets are called com s. Due to the
mplements
price decrease
d i sprocke
in ets, the widget
w dem
mand curv
ve now sh
hifts
SRMIST
T DDE MBA Self
ge 69
upw
ward and to the rig
ght (shown
n on graph
h below). If sprocke
ets and
wid
dgets were substitute
es, a decrease in th
he price off sprockets
s would
dec
crease the demand fo
or widgets.
A chan
nge in con
nsumer exp
pectations can also shift the demand
d
currve for wid
dgets. Supp
pose a pottential labo
or strike a
against the
e major
wid
dget manu
ufacturers raises con
ncerns am
mong consu
umers abo
out the
futu
ure price and
a availab
bility of wiidgets. Con
nsumers m
might rush
h out to
buy
y more wid
dgets while n, increasing the currrent demand for
e they can
wid
dgets (represented by
y a shift in
i the dem ve upward and to
mand curv
the right). No
othing else
e has chan
nged excep
pt consum
mer’s expec
ctations
of the future.
SRM
MIST DDE MBA
Expansion and Contraction of demand
NOTES
1. Expansion of demand
2. Contraction of demand
1. Expansion of demand: With a fall in price when more of a
commodity is bought there is 'Expansion' (or Extension) of demand,
other things remaining constant.
2. Contraction of demand: With a rise in price when less of a
commodity is bought there is contraction. of demand, other things
remaining constant.
Expansion and contraction of demand is shown by the movement
along the same demand curve.
Exceptions to Law of Demand
1. Giffen goods: Certain

inferior goods are-ca1led
Giffen goods, when the
price falls, quite often less
quantity will be purchased
than before because of the
negative income effect and people's increasing preference for a
superior commodity with the rise in their real income. Sir Robert
Giffen observed the situation related to demand for bread & meat in
England. When price of bread was decreasing, less bread was
purchased. Here surplus money was transferred to purchase meat, as
a result demand for meat increased.
This behaviour is known as Giffen's paradox. Thus Giffen goods
are inferior goods which have a direct relationship between price and
quantity demanded. In this case the demand curve slopes upwards
from left to right.
2. Prestige goods: Diamonds, high priced motor cars, luxurious

bungalows are prestige goods. Such goods have a "snob appeal". Rich
people consume such goods as status symbol. Therefore, when the
price of such goods rises their demand also rises.

3. Price illusions or Consumers Psychological bias: Consumers
have illusion that high priced goods are of a better quality. Therefore,
the demand for such goods tends to increase with a rise in their price.
e.g. Branded products which are expensive are demanded at a high
price.
4. Demonstration effect: The, tendency of low income group to
imitate the consumption pattern of high income groups is known as
Demonstration effect. For example demand for consumer durables
such as washing machine, latest mobile etc.
5. Ignorance: Sometimes people do not have proper market
knowledge. They may not be aware of the fall in price of a commodity
and thus they tend to purchase more at a higher price.
6. Speculation: When people speculate a change in price of a
commodity in the future, they may not act according to the Law of
demand. People may tend to buy, more at rising price, when they
anticipate further price rise.
For example, in the stock market people tend to buy more shares at
rising prices. Even if prices of some goods like sugar, oil etc. are rising
before Diwali, people go on purchasing more of these things at rising
prices, because they think that prices of these goods may increase
further during Diwali.
7. Habitual Goods: Due to habit of consumption certain goods like
tobacco, cigarettes etc are purchased even if prices are rising. Thus, it
is an exception.
2.3 TYPE–II DEMAND LONG TERM DEMAND
Long-run demand is that which will ultimately exist as a result

of changes in pricing, promotion or product improvement, after
enough time has elapsed to let the market adjust itself to the new
situation.

Demand Forecasting, Level of Demand Forecasting,
NOTES
9 •Demand forecasting is essentially a judgement of future

probabilities of the future demand.
9 •Demand forecasting is an attempt to predict the future
demand based on past data under conditions of uncertainty.
9 •Prediction or estimation of a future situation, under given
conditions.
9 •Important aid in effective and efficient planning
9 •It is backbone of any business
Steps in Demand Forecasting:

9 identification of the objective
9 Nature of the product
9 Determination of demand
9 Choice of appropriate method
9 Analysis
2.4 DEMAND FORECASTING
1. Survey Methods
Opinion Survey Method
• identification of the objective
• Nature of the product
• Determination of demand
• Choice of appropriate method
• Analysis
Consumer’s Opinion Survey

• The consumer opinion survey can be either census or sample
survey. Where the numbers of buyers are limited, census survey
methods hold. In this case, the opinion of the entire universe is
obtained.

• On the other hand, where the number of buyers is large,
universal survey is not feasible; hence, sample survey methods are
used.
• The sample survey can be either purposive sampling or random
sampling based on the nature of the product or the objectives of the
survey.
Limitations
• consumer opinion surveys are not perfectly reliable
• expensive and time-taking.
2.Expert opinion method or Delphi method

• Expert opinion method is a variant of the consumer’s opinion
survey method. It was also popular as Delphi method and first used
by Rand Corporation in USA for predicting the demand under
conditions of intractable technological changes. It is used under
conditions of nonexistence of data or when a new product is being
launched.
• The fairest step in
this method is the
identification of experts
and eliciting their
opinions about the likely
demand for the product.
The experts may differ in
their views in which case
the firm has to pass on the opinions of one expert to the other, of
course under strict anonymity and seek their reactions. This exercise
should go on until a common line of thinking emerges.
This method will be useful tool of demand forecasting provided the
experts did not have biased opinions.
3.Collective opinion survey or sales force opinion survey method

• In this method, the firm will extract the opinions of the sales
team, which is on the payrolls of the company about the future
demand for the product. The sales personnel are very close to the

consum
mers and dealers.
d Th
hey expres
ss their op
pinions abo
out the futture
NOTES
deman
nd for the product.
p
• The opiniions so gathered
g a
are tabula
ated and the dem
mand
sts will be arrived at..
forecas
• However, care be ta
aken beforre forming
g an opiniion about the
future demand. The
T opinio
ons of the sales
s team
m should no
ot be taken
n on
the fac
ce value as
s an ambitiious sales man gives
s an over estimate
e off the
deman
nd for the product while
w a sceptic fearin
ng the fixa
ation of hig
gher
sales ta
argets always quotes
s a lesser figure.
f
• hod is an inexpensive but more
This meth m reliab
ble method
d of
deman
nd forecasting.
1.Statiistical Me
ethods
• Trend Projjection
• Simple Mo
oving Avera
age
• Weighted moving Av
verage
• Regression
n Method
2. Baro
ometric Method
M
Statisttical Meth
hods–Crite
eria for Go
ood Deman
nd Foreca
asting, –
1. Data availlability
2. Time horizzon for the
e forecast
3. Required accuracy
a
4. Required Resources
R
5 Meaning of Supply
2.5 y
Supply
y: -
SRMIST
T DDE MBA Self
ge 75
Figure 2 -Supply Curve
Figure2, Supply curve denotes, when price stands at £0.20 only 100
units supplied and when price increases to £0.50 then 400 units
supplied.
Law of Supply: At higher prices, a larger quantity will generally be

supplied than at lower prices, all other things being equal.
Reasons why observe supply law:
1. higher prices increase incentives for increasing production

2. the law of increasing costs
Non-Price Determinants of Supply
1. The prices of inputs used to produce the product (lower prices,

curve shifts right)
2. Technology (improvements shift curve right)
3. Taxes and subsidies (taxes behave as a cost, shift left,
subsidies reduce costs, shift right)
4. Price Expectations (e.g., farmers withhold crops in expectation
of higher prices)
5. Number of Firms (more firms shift to the right)
Change in Supply—results from change in a non-price determinant

of supply (curve moves)
Change in Quantity Supplied—results from change in price (move

along curve)
Supply and Demand Together
Equilibrium – a situation in which the plans of the buyers and sellers

coincide so that there is neither excess quantity supplied or
demanded (also called market clearing price)

Figure
e 3-Equilib
brium
NOTES
Here Curve
C show
ws equilibriium state where
w dem
mand is equ
ual to the
supply
y.
Stable equilibriu
um – a situ
uation in which
w a sh
hock disturrbs the
prevailling equilib
brium betw
ween supplly and dem
mand, therre will
normallly be self-corrective forces tha
at automattically caus
se the
disequilibrium to
o return ev
ventually to
o equilibriu
um.
SRMIST
T DDE MBA Self
ge 77
Figure 4 -Shortage and Surplus
Shortage—excess quantity demanded or insufficient quantity

supplied. Difference between the quantity demanded and supplied at
a specific price below the market clearing price.
Surplus—excess quantity supplied or insufficient quantity

demanded. Difference between the quantity supplied and demanded
at a price above the market clearing price.
• Supply comes from the behaviour of sellers.

• The quantity supplied of any good is the amount that sellers
are willing and able to sell.
Law of supply: the claim that the quantity supplied of a good rise
when the price of the good rises, other things equal.
Elasticity of Supply.
The law of supply indicates the direction of change—if price goes up,
supply will increase. But how much supply will rise in response to an
increase in price cannot be known from the law of supply. To quantify
such change, we require the concept of elasticity of supply that
measures the extent of quantities supplied in response to a change in
price. It can be calculated as follows.
ES = ∆Q/Q ÷ ∆P/P = ∆Q/∆P × P/Q
The long-run is supposed to be a period sufficiently long to

allow changes to be made both in the size of the plant and in the
number of firms in the industry. Whereas in the short period, an
increase in demand is met by over-using the existing plant, in the
long-run, it will be met not only by the expansion of the plants of the
existing firms but also by the entry into the industry of new firms.

Theory of long run supply
NOTES
Long run market supply curve. The short run market supply
curve is just the horizontal summation of all the individual firm's
supply curves. The long run market supply curve is found by
examining the responsiveness of short run market supply to a
change in market demand.
Exceptions to the Law of Supply, Changes or Shifts in Supply.
The law of supply states that other things being equal, the
supply of a commodity extends with a rise in price and contracts with
a fall in price. There are however a few exceptions to the law of
supply.
1. Exceptions of a fall in price
If the firms anticipate that the price of the product will fall
further in future, in order to clear their stocks they may dispose it off
at a price that is even lower than the current market price.
2. Sellers who need cash
If the seller needs hard cash, he may sell his product at a price
which may even be below the market price.
3. When leaving the industry
If the firms want to shut down or close down their business, they may
sell their products at a price below their average cost of production.
4. Agricultural output
In agricultural production, natural and seasonal factors play a

dominant role. Due to the influence of these constraints supply may
not be responsive to price changes.

5. Backward sloping supply curve of labor
The rise in the price of a good or service sometimes leads to a

fall in its supply. The best example is the supply of labor. A higher
wage rate enables the worker to maintain his existing material
standard of living with less work, and he may prefer extra leisure to
more wages. The supply curve in such a situation will be ‘backward
sloping’.
Extension and Contraction of Supply
‘Extension’ and ‘contraction’ of supply refer to movements on

the same supply curve. If with a rise in price, the supply rises, it is
called an extension of supply; if, with a fall in price, the supply
declines it is called a contraction of supply.
2.7.1 TYPE–II LONG TERM SUPPLY
Shifts in the Supply Curve: -
A supply curve shows how

total industry output changes due
to a change in the price of output.
The graph below shows that if the
price of widgets increased from
$10 to $12 per widget, the
quantity supplied in the market
would increase from 10,000 to
11,000. The price change is said to cause a "change in the quantity
supplied" (movement along a supply curve).

NOTES
Other facttors beside

es price, ho
owever, ca
an influenc
ce the amo
ount
of widg
gets suppliied in the market.
m Th
hese otherr factors arre represen
nted
graphic
cally as a shift in th
he supply curve
c and are said to
t represen
nt a
"chang
ge in supp
ply". Three
e of the most
m impo
ortant facttors that can
result in
i a chang
ge in supplly are:
An imp
provementt in techno
ology (shiffting the production
p n function up)
reduce
es per unitt costs. Th
he supply curve
c ard and to the
shiftts downwa
right.
SRMIST
T DDE MBA Self
ge 81
An inc
crease in the price
e of inputts (e.g. lab
bor, energ
gy, etc)
incrreases perr unit costs
s. An incre put prices shifts the supply
ease in inp
currve upward
d and to th
he left.
Suppose firms can produ and gadgets.

uce both widgets a A
ange in the price of gadgetts will sh
cha supply curve for
hift the s
wid
dgets. For example, if the price
e of gadgetts decrease
ed, firms will
w now
pro
oduce fewe
er gadgets and move
e more resources intto the prod
duction
of widgets
w (w d gadgets are substtitutes in p
widgets and production
n). The
wid
dget supply
y curve now
w shifts do
ownward and
a to the right.
SRM
MIST DDE MBA
2.7
7.2 ELAST
TICITY OF
F SUPPLY NOTES
The supplly curve shows thatt the quan

ntity of ou
utput supp
plied
will inc
crease as price
p of th
he output increases.
i Elasticity
y quantifies
s by
how much
m the qu
uantity of output su
upplied willl change given
g a cha
ange
in pric
ce. Elasticiity of supp
ply is defin
ned as the ratio of th
he percenttage
change
e in quantiity supplie
ed over the
e percentag
ge change in price.
For exam
mple, elastticity tells w corn prroduction will
s us how
respon
nd to a 20 percent in
ncrease in e of corn. If the pric
n the price ce of
corn in
ncreases in
n May afte
er planting
g has begu
un, farmers
s have lim
mited
options
s to increa
ase produc
ction. The Farmers’ only optio
on to incre
ease
ction this year may be to incrrease fertiilizer use. In this case,
produc
the outtput respo
onse will be
e fairly ins
sensitive to
o a price ch
hange and
d the
quantitty of corn supplied in
i the marrket may increase
i on
nly 2 perc
cent.
In this
s case elas
sticity is equal to 0.1 (+2% diivided by +20%).
+ W
When
the rellative chan
nge in qu
uantity is less than the relatiive change
e in
price, elasticity
e is
s less than
n 1 and is called inellastic.
If the pric
ce of corn remains high
h throug
ghout the year and into
next year,
y expe e more prroduction given the
ect to see e same p
price
increas
se. Farmerrs will inc
crease corrn producttion by us
sing fertiliizer,
more capital
c and
d more lan
nd. Thus, over a lon d of time, the
nger period
ability of farmers
s to respo
ond to a prrice chang
ge increase
es. Over tiime,
the ou
utput resp
ponse to a price in
ncrease be
ecomes mo
ore elastic
c. If
quantitty supplied increase
ed 30 perc
cent next year
y (and price
p incre
ease
holds), elasticity would be 1.5 (+30 % divided by +20%) and is ca
alled
elastic.. The elastticity of sup
pply range
e is shown in the tab
ble 1, below
w.
SRMIST
T DDE MBA Self
ge 83
Es Value Identificattion
0 Perfectly
y Inelastic
Gre
eater than 0 but less
s than 1 Inelastic
c
1 Unitary Elastic
Gre
eater than 1 Elastic
Arc
c Elasticity
y is one wa
ay to calcu
ulate elastiicity of sup
pply. The formula
f
is:
2.8 CO
ONCLUSION
N
Thus Demand
D is
s the willin
ngness of the
t consum
mer or it explains
e
the utility fac
ctor and su
upply repre
esents the quantity o
of goods de
elivered
as per the requiremen
r nt. Law of
o Demand focuses
s on incre
ease in
dem se in price factor by assuming
mand due to decreas a certain fac
ctors as
nstant. Elasticity represents the chan
con nge cause
ed by prrice on
mand and supply.
Dem
REV
VIEW QUE
ESTIONS ON
O DEMAND
I. Objective
O T
Type/Mul
ltiple Choiice Questiions:
1. Which is/are the

e determinants of dem
mand-
a. Priceb. Inc
come c. Taste
T and preference
p e d. All of th
hese.
2. Price of
o the good is fixed in
n a market by-
a. Demand, b. Sup
pply, c. Both,
B d. None off these.
SRM
MIST DDE MBA
3. The reasons for the downward slope of demand curve are-
NOTES
a. The law of diminishing marginal utility
b. Substitution effect;
c. Income effect;
d. All of the above.
4. In case of change in demand-
a. No new demand curve is drawn;
b. New demand curve is drawn;
c. Both can be possible;
d. None of these possible.
5. If an increase in the price of one leads to an increase in the

quantity demanded of the
other than these goods are-
a. Substitute goods; b. Complementary goods;
b. c. Normal goods; d. None.
6. Demand curve slopes upward in case of-

a. Veblen goods; b. Giffen goods
c. Snob appeal; d. all of the above.
7. Which one is not the reason for change in demand -

a. Price of the good;
b. Price of other goods;
c. Income of the consumer;
d. Consumers’ taste and preferences
8. Which one is not correctly matched-

a. Giffen goods……………………a superior or high quality goods.
b. Substitute goods………………..tea and coffee.
c. Complementary goods………….car and petrol.
d. Veblen goods………….a prestigious goods with status symbol.
Ques: 1 2 3 4 5 6 7 8
Ans: d c d b a d a a

II. Write T for True and F False against the following
questions:
1. In case of Giffen goods and Veblen goods, law of demand does

not work.
2. In case of change in quantity demanded, new demand curve is
drawn.
3. If an increase in the price of one good leads to a fall in the
quantity demanded of other then these goods are complementary
goods.
4. In case of normal goods, as income increases, demand for these
goods also increases.
5. Law of demand states that higher the price, lower the demand
and lower the price higher the demand, other things remaining the
same.
Ques: 1 2 3 4 5
Ans: T F T T T
III Questions with Answer

Ques: What is demand?
Ans: Demand is defined as the entire relationship between price and
quantity. Quantity demanded of a commodity is defined as the
quantity of that commodity demanded at a certain price during any
particular period of time.
Ques: What are the factors affecting individual demand?
Main factors: Other factors:
Own price; Income distribution;
Prices of other
goods; Past levels of demand and income;
Consumers’ income; Population growth;
Weather conditions Government policy;
Consumers’ tastes and Wealth of the consumers.

preferences
NOTES
Ques: What is law of demand? Explain it with suitable example.
Ans: The relationship between quantity of a good that consumers

are willing to buy and the price of the good that shows opposite
relationship between price and quantity demanded is known as law of
demand. In other words, higher the price, lower the demand and
lower the price, higher the demand. That is, the quantity demanded is
negatively related to the price of the good.
Dx = f (Px) = a - bPx
here, Dx = Demand of commodity, x Px = Price of commodity, x
a = Intercept of Demand curve b = Slope of demand curve f =

functional relationship
Ques: What are substitute goods?
Ans: Two goods are said to be substitute if an increase in the price
of one leads to an increase in the quantity demanded of the other.
Example: Tea and Coffee
Ques: What are complementary goods?

Ans: Two goods are said to be complements if an increase in the
price of one good leads to a fall in the quantity demanded of other.
Example: Car and Petrol
Ques: What are normal and inferior goods?

Ans: Normal Good: That good when income increases, quantity
demanded also increases is called normal good.
Inferior Good: That good when income increases, quantity demanded
decreases is called inferior good.

Ques: What are the reasons behind the downward slope of demand
curve?
Ans: The reasons for downward sloping demand curve are:
1. Law of diminishing marginal utility;
2. Substitution effect
3. Income effect
4. New consumers
Ques: What are the exceptions to the law of demand curve?

ans: The exceptions to the law of demand curve are:
• Giffen goods;
• Veblen good;
• Exception of a price rise in future;
• Bandwagon effect;
• Emergency;
• Good with uncertain product quality;
• Snob appeal;
• Brand loyalty.
Ques: What are Giffen goods?
Ans: Giffen goods are those inferior goods which do not follow law of
demand. In other words, as price of that commodity decreases,
quantity demanded of that commodity also decreases and vice versa.
In case of Giffen goods, law of demand fails.
Ques: What is Snob and Bandwagon effect?

Ans: Bandwagon Effect: It refers to desire or demand for a good by a
NOTES
person who wants to be in style because possession of a good is in
fashion and therefore many others have it. Itis an example of positive
network externality. Bandwagon effect makes the demand curve
elastic.
Snob Effect: It refers to the desire to possess a unique commodity

having a prestige value. It works quite contrary to the bandwagon
effect. It is an example of negative network externality. Snob effect
makes the demand curve less elastic (inelastic).
Review Questions on supply
I. Multiple Choice Questions:
1. The relationship between quantity supplied and its price is-

a. directly related b. inversely related
c. no relation d. none is correct.
2. The supply curve slopes-
a. downward to the right b. upward to the right
c. horizontal straight line d. vertical straight line
3. What is/are the following reason/ reasons for upward sloping
supply curve?
a.Lawofdiminishingmarginal b. Goals of profit
maximization
productivity
c. (a+b) both is the reason. d. none is the reason.
4. Factors that determine supply of a commodity-
a. Price of the commodity; b. New technology;
c. Price of substitutes; d. Discoveries;
e. Changes in input supply f. All
5. Change in quantity supplied takes place-
a. same supply curve; b. new supply curve;
c. both may be possible; d. none is possible.
6. Change in supply takes place-

a. on the same supply curve; c. both may be possible;
b. on new supply curve;
d. none is possible.
Ques: 1 2 3 4 5 6
Ans: a b c f a b
II. True/ False Statement:
1. In case of change in quantity supplied, new supply curve is

drawn.
2. Law of supply states that higher the price lower the quantity
supplied and lower the price higher the quantity supplied, other
things remaining the same.
Ques: 1 2
Ans: F F
Ques: What are the reasons behind Upward Sloping Supply Curve?
Ans: There are two following reasons:
Law of diminishing marginal productivity;
Goals of profit maximization.
Ques: What are the factors that determine supply of a commodity?
Ans: The factors that determine supply of a commodity: -
Price of the commodity;

Discoveries;
NOTES
New technology;
Weather conditions;
Price of substitutes;
Changes in input supply, etc.
Ques: What do you understand by the term extension of supply and

contraction of supply?
Ans: Expansion or extension of supply refers to rise in supply due to
rise in price of the good.
Contraction of supply refers to fall in supply due to fall in the price of
good.
Ques: What do you mean by increase in supply and decrease in

supply?
Ans: Increase in supply: when supply of a commodity rises due to
favourable changes in factors other than price of the commodity, it is
called increase in supply.
Decrease in supply: when supply of a commodity falls due to
unfavourable changes in factors other than its price, it is called
decrease in supply.
Ques: What are the main differences between expansion in supply

and increase in supply curve?
Ans:
Expansion in supply Increase in supply
1. Expansion or extension of 1. Increase in supply refers to
supply refers more supply
to rise in supply due to rise in the at a given price or same supply at
price of a higher
the good. price.
2. This occurs on the same supply 2. It occurs on the new supply
curve. curve.
3. The reason of extension or 3. The reasons for increase in
expansion in supply are
supply is decrease in price of theother than the price of good.

good only.
2.8.1 QUESTIONS FOR DISCUSSION
1. Explain the concept of Demand and Supply.

2. Define Law of Demand and explain the demand curve.
3. What is market Equilibrium?
4. Describe Elasticity of Supply and Demand.
5. Elaborate price Elasticity.
6. Mention the impact of Shift in Demand Curves.
Case Study
Does M&S have a future?13 The country’s most famous retailer

Marks & Spencer’s big store in London’s Kensington High Street has
just had a re-fit. Instead of the usual drab M&S interior, it is now
Californian shopping mall meets modernist chrome and creamy
marble floors. Roomy walkways and designer displays have replaced
dreary row after row of clothes racks. By the end of the year M&S will
have 26 such stores around Britain – the first visible sign that the
company is making a serious effort to pull out of the nose-dive it has
been in for the past two years.
Things have become so bad that M&S, until recently a national
icon, is in danger of becoming a national joke. It does not help that its
advertisements featuring plump naked women on mountains – the
first-ever TV ads the company has produced – have met with an
embarrassed titter; nor that, last week, the BBC’s Watchdog
programme savaged M&S for overcharging and poor quality in its
range of garments for the fuller figure. As the attacks grow in
intensity, so do the doubts about M&S’s ability to protect its core
value: a reputation for better quality that justified a slight price
premium – at least in basic items, such as underwear. It is a long
time since any self-respecting teenager went willingly into an M&S
store to buy clothes. Now even parents have learned to say no.
Shoppers in their thirties and forties used to dress like their parents.

Now many of them want to dress like their kids. M&S’s makeover
NOTES
comes not a moment too soon. Compared with the jazzy store layouts
of rivals such as Gap or Hennes & Mauritz, M&S shops look like a
hangover from a bygone era. The makeover aims to bring it into the
present.
People tended to join M&S straight from college and work their
way slowly up the ranks. Few senior appointments were made from
outside the company. This meant that the company rested on its
laurels, harking back to ‘innovations’ such as machine-washable
pullovers and chilled food. Elasticity in general terms is concerned
with the responsiveness or sensitivity of one variable to changes in
another. Demand elasticity is concerned with how the quantity
demanded is responsive to changes in any of the factors described in
section 3.4. Essentially elasticities are an alternative way of
measuring responsiveness to the marginal effects discussed in the
first section of this Worse, M&S missed out on the retailing revolution
that began in the mid-1980s, when the likes of Gap and Next shook
up the industry with attractive displays and marketing gimmicks.
Their supply chains were overhauled to provide what customers were
actually buying – a surprisingly radical idea at the time. M&S, by
contrast, continued with an outdated business model. It clung to its
‘Buy British’ policy and it based its buying decisions too rigidly on its
own buyers’ guesses about what ranges of clothes would sell, rather
than reacting quickly to results from the tills.
Meanwhile, its competitors were putting together global
purchasing networks that were not only more responsive, but were
not locked into high costs linked to the strength of sterling. In
clothing, moreover, M&S faces problems that cannot be solved simply
by improving its fashion judgments. Research indicates that overall
demand for clothing has at best stabilised and may be set to decline.
This is because changing demographics mean that an ever-higher
share of consumer spending is being done by the affluent over-45s.
They are less inclined than youngsters to spend a high proportion of
their disposable income on clothes.
The results of M&S’s rigid management approach were not
confined to clothes. The company got an enormous boost 30 years ago

when it spotted a gap in the food market, and started selling fancy
convenience foods. Its success in this area capitalised on the fact
that, compared with clothes, food generates high revenues per square
metre of floor space. While food takes up 15% of the floor space in
M&S’s stores, it accounts for around 40% of sales. But the company
gradually lost its advantage as mainstream food chains copied its
formula. M&S’s share of the British grocery market is under 3% and
falling, compared with around 18% for its biggest supermarket rival,
Tesco.
M&S has been unable to respond to this competitive challenge.
In fact, rather than leading the way, it has been copying rivals’
features by introducing in-house bakeries, delicatessens and meat
counters. Food sales have been sluggish, and operating margins have
fallen as a result of the extra space and staff needed for these
services. Operating profits from food fell from £247m in 1997 to
£137m in 1999, while sales stayed flat. Perhaps the most egregious
example of the company’s insularity was the way it held out for more
than 20 years against the use of credit cards, launching its own store
card instead. This was the cornerstone of a new financial-services
division, also selling personal loans, insurance and unit-trust
investments. When, in April this year, M&S eventually bowed to the
inevitable and began accepting credit cards, it stumbled yet again. It
had to give away around 3% of its revenues from card transactions to
the card companies, but failed to generate a big enough increase in
sales to offset this. Worse, it had to slash the interest rate on its own
card, undermining the core of its own finance business. And this at a
time when the credit-card business was already becoming more
competitive, with new entrants offering rates as low as 5%. If shrunk
to its profitable core, M&S may become an attractive target for
another big retailer. At the moment, however, while its food division
may be attractive to the likes of Tesco, the clothing side represents a
daunting challenge. Why take the risk now, when the brand may be
damaged beyond repair?
Questions
1 Identify the main factors affecting the demand for M&S products.

2 Analyse the weaknesses and threats on the demand side of M&S,
NOTES
relating these to controllable and uncontrollable factors.
MODULE - 3
______________________________________________________________
MBAD 1911 MANAGERIAL (MICRO) ECONOMICS
3.0 Introduction
3.1 Production and Cost Analysis
3.2 Meaning of Production and Production Function
3.3 Type–1 production–short run production
3.4 Type II production–long run production
3.5 Cost of Production
3.6Various types of cost of production
3.7 Type I Cost of production: Short run cost of
production analysis
3.8 Type II cost of production: Long run cost of
production analysis. Cost–output
3.9 Relationship–production capacity determination
3.9.1 Conclusion
3.0 Introduction
In common parlance
the term ‘production’ is
used for an activity of
making something
material. The growing of
wheat, rice or any other
agricultural crop by farmers and manufacturing of cloth, radio-
sets, wool, machinery or any other industrial product is often

referred to as production. But, in Economics the word
‘production’ is used in a wider sense. In Economics, by
production, we mean the process by which man utilises or
converts the resources of nature, working upon them so as to
make them satisfy human wants. In other words, production is
any economic activity which is directed towards the satisfaction
of the wants of people by converting physical inputs into
physical outputs. Whether it is the making of material goods or
providing any service, it is included in production provided it
satisfies the wants of some people. So, in Economics, if making
of cloth by an industrial worker is production, the services of
the retailer who delivers it to consumers is also production.
Similarly, the work of doctors, lawyers, teachers, actors,
dancers, etc. is production since the services are provided by
them to satisfy the wants of those who pay for them. The want
satisfying power of goods and services is called utility.
Production can also be defined as creation or addition of utility.
3.1 PRODUCTION AND COST ANALYSIS
According to James Bates and J.R. Parkinson “Production is

the organized activity of transforming resources into finished
products in the form of goods and services; and the objective of
production is to satisfy the demand of such transformed
resources”.
Production consists of various processes to add utility to
natural resources for gaining greater satisfaction from them by:
(i) Changing the form of natural resources.
(ii) Changing the place of the resources, from the place where
they are of little or no use to another place where they are of
greater use

(iii) Making available materials at times when they are not
NOTES
normally available.
(iv) Making use of personal skills in the form of services, e.g.,
those of organisers, merchants, transport workers etc.
The following concepts provide information on how costs change

to produce different levels of output.
Definitions:
a. Opportunity cost is equal to the value of other
opportunities given up in order to produce any
good.
b. Total Variable Cost (TVC) – total cost to employ
variable inputs to produce a given level of output.
Variable costs change as output levels change.
c. Total Fixed Cost (TFC)– total cost to employ fixed
inputs. Fixed costs do not change as output levels
change.
d. Total Cost (TC) – total cost of producing a given
level of output including both variable and fixed
costs. TC is calculated as:
TC = TFC +TVC
e. Average Variable Cost (AVC) – the variable costs
per unit of output when producing a certain
amount of output. AVC is calculated as:
Total Variable Cost / Output = TVC / Y
f. Average Fixed Cost (AFC) – total fixed costs per
unit of output when producing a certain amount of
output. AFC is calculated as:
Total Fixed Cost / Output = TFC / Y
g. Average Total Cost (ATC) – total costs per unit of
output when producing a certain amount of output.
ATC is calculated as:

Total Cost / Output = TC / Y = AVC + AFC
h. Marginal Cost (MC) – change in the cost to produce
an additional unit of output. MC is calculated as:
Change in TC / Change in Output or Y
Or
Change in TVC / Change in Output or Y
3.2 MEANING OF PRODUCTION

AND
PRODUCTION FUNCTION
Production function states the functional relationship

between inputs and output i.e., the maximum amount of output
that can be produced with given quantities of inputs under a
given state of technical knowledge. The output takes the form of
volume of goods or services and the
inputs are the different factors of
production i.e., land, labour, capital
and enterprise.
According to Richard H. Leftwich,

“The term production function is
applied to the physical relationship
between a firm’s input of resources and its output of goods or
services per unit of time leaving prices aside”.
In short, the production function is a catalogue of output
possibilities. The production function can be algebraically
expressed in an equation in which the output is the dependent
variable and inputs are the independent variables. The equation
can be expressed as:

q = f (a, b, c, d …….n) where ‘q’ stands for the rate of output of
NOTES
given commodity and a,b,c,d…….n, are the different factors
(inputs) and services used per unit of time.
Assumptions of Production Function:
1. It is related to a particular unit of time.
2. The technical knowledge during that period of time remains
constant.
3. The producer is using the best technique available.
Cobb-Douglas Production Function
Q = KLa C (1-a)
where ‘Q’ is output, ‘L’ the quantity of labour and ‘C’ the
quantity of capital. ‘K’ and ‘a’ are positive constants. The
conclusion drawn from this famous statistical study is that
labour contributed about 3/4th and capital about 1/4th of the
increase in the manufacturing production.
3.3 TYPE–1 PRODUCTION–SHORT RUN PRODUCTION
Before discussing the short

run production, it would be
appropriate to understand the
meaning of total product, average
product and marginal product.
Total Product (TP):Total product is
the total output resulting from the
efforts of all the factors of production
combined together at any time. If the inputs of all but one factor are
held constant, the total product will vary with the quantity used of the
variable factor.
Average Product (AP):Average product is the total product per unit of
the variable factor.
Marginal Product (MP):Marginal product is the change in total
product per unit change in the quantity of variable factor. In other

words, it is the addition made to the total production by an additional
unit of input.
Relationship between Average Product and Marginal Product:

(i) when average product rises as a result of an increase in the
quantity of variable input, marginal product is more than the average
product.
(ii) when average product is maximum, marginal product is equal
to average product. In other words, the marginal product curve cuts
the average product curve at its maximum.
(iii) when average product falls, marginal product is less than the
average product.
Production in the short run functions under the law of variable
proportions or the law of diminishing returns which examines the
production function with one factor variable, keeping quantities of
other factors fixed. In other words, it refers to input-output
relationship, when the output is increased by varying the quantity of
one input. This law operates in the short run ‘when all the factors of
production cannot be increased or decreased simultaneously (for
example, we cannot build a plant or dismantle a plant in the short
run).
The law states that as we increase the quantity of one input
which is combined with other fixed inputs, the marginal physical
productivity of the variable input must eventually decline. In other
words, an increase in some inputs relative to other fixed inputs will,
in a given state of technology, cause output to increase; but after a
point, the extra output resulting from the same addition of extra
inputs will become less and less.
3.4 TYPE II PRODUCTION–LONG RUN PRODUCTION
Production in the long run studies changes in output when all

factors of production in a particular production function are increased
together. In other words,
we shall study the

behaviour of output in response to a change in the scale. A change in
NOTES
scale means that all factors of production are increased or decreased
in the same proportion. Changes in scale is different from changes in
factor proportions. Changes in output as a result of the variation in
factor proportions, as seen before, form the subject matter of the law
of variable proportions. On the other hand, the study of changes in
output as a consequence of changes in scale forms the subject matter
of returns to scale which is discussed here.
Returns to scale may be constant, increasing or decreasing. If

we increase all factors i.e., scale in a given proportion and output
increases in the same proportion, returns to scale are said to be
constant. Thus, if a doubling or trebling of all factors causes a
doubling or trebling of output, returns to scale are constant. But, if
the increase in all factors leads to more than proportionate increase in
output, returns to scale are said to be increasing.
Thus, if all factors are doubled and output increases more than
a double, then the returns to scale are said to be increasing. On the
other hand, if the increase in all factors leads to less than
proportionate increase in output, returns to scale are decreasing. It is
needless to say that this law operates in the long run when all the
factors can be changed in the same proportion simultaneously.
Constant returns to scale: As stated above, constant returns to scale

means that with the increase in the scale in some proportion, output
increases in the same proportion. It has been found that production
function for the economy as a whole corresponds to production
function exhibiting constant returns to scale. Also, it has been found
that an individual firm passes through a long phase of constant
returns to scale in its lifetime. Constant return to scale is otherwise
called as “Linear Homogeneous Production Function”.
Increasing returns to scale: As stated earlier, increasing returns to

scale means that output increases in a greater proportion than the
increase in inputs. When a firm expands, increasing returns to scale
are obtained in the beginning. For example, a wooden box of 3 ft. cube

contains 9 times greater wood than the wooden box of 1 foot-cube.
But the capacity of the 3 foot- cube box is 27 times greater than that
of the one-foot cube. Many such examples are found in the real world.
Another reason for increasing returns to scale is the indivisibility of
factors. Some factors are available in large and lumpy units and can,
therefore, be utilised with utmost efficiency at a large output. If all the
factors are perfectly divisible, increasing returns may not occur.
Returns to scale may also increase because of greater possibilities of
specialisation of land and machinery.
Decreasing returns to scale: When output increases in a smaller

proportion with an increase in all inputs, decreasing returns to scale
are said to prevail. When a firm goes on expanding by increasing all
inputs, diminishing returns to scale set in. Decreasing returns to
scale eventually occur because of increasing difficulties of
management, coordination and control. When the firm has expanded
to a very large size, it is difficult to manage it with the same efficiency
as before.
3.5 COST OF PRODUCTION
The relationship between ATC, AVC, and MC is shown on the graph

below (note that output is now on the horizontal axis) Note the general
relationships between the cost curves

NOTES
Figure 5 -Genera
al Relations
ship betwe
een cost cu
urves
The rellationships
s of the cost curves to
t the phys
sical produ
uct curves
s are
important. A few
w general ob
bservation
ns are:
The MC curve
c is a mirror re
eflection off the MPP curve. W
When
MPP is inc
creasing, MC
M is decrreasing. When
W MPP is decreas
sing,
MC is incrreasing
The AVC curve is a mirror re

eflection of
o the APP
P curve. W
When
creasing, AVC
APP is inc A is dec
creasing. When
W APP is decreas
sing,
AVC is inc
creasing.
Given the relationsh

hips above
e, since MP
PP intersects APP w
when
APP is at a maximu
um, MC in
ntersects AVC
A when
n AVC is a
at a
minimum.
ge II of production be
Since stag egins when
n APP is att a maximu
um,
stage II can be identified on a cost cu
urve when
n AVC is a
at a
minimum.
AVC and MC
M are botth increasiing in Stag
ge II.
The re
elationship
p between the cost curves to
o the phy
ysical prod
duct
curves are shown
n below:
SRMIST
T DDE MBA Self
S Instructioonal Material Pagee 103
Figu
ure 6-Phys
sical Produ
uct1
Figu
ure 7-Phys
sical Produ
uct
3.6VA
ARIOUS TYPES
T OF
F COST OF
O PROD
DUCTION
Accou
unting co
osts: Wh
hen an
enttrepreneurr underta
akes an act of
pro
oduction he
h has to p
pay prices for the
fac
ctors wh
hich he employ
ys for
oduction. He thus pays, wa
pro ages to
workers emp
ployed, prrices for the raw
ma
aterials, fuel and pow
wer used, rent
r for
SRM
MIST DDE MBA
the building he hires, and interest on the money borrowed for doing
NOTES
business. All these are included in his cost of production and are
termed as accounting costs. Thus, accounting costs take care of all
the payments and charges made by the entrepreneur to the suppliers
of various productive factors.
Economic costs: It generally happens that an entrepreneur invests a

certain amount of capital in his business. If the capital invested by
the entrepreneur in his business had been invested elsewhere, it
would have earned certain amount of interest or dividend. Moreover,
an entrepreneur devotes time to his own work of production and
contributes his entrepreneurial and managerial ability to do business.
Had he not set up his own business, he would have sold his services
to others for some positive amount of money. Accounting costs do not
include these costs. These costs form part of economic cost. Thus,
economic costs include: (1) the normal return on money capital
invested by the entrepreneur himself in his own business; (2) the
wages or salary not paid to the entrepreneur, but could have been
earned if the services had been sold somewhere else. Likewise, the
monetary reward for all factors owned by the entrepreneur himself
and employed by him in his own business are also considered a part
of economic costs.
Explicit costs: Accounting costs are also called explicit costs whereas
the cost of factors owned by the entrepreneur himself and employed
in his own business are called implicit costs. Thus, economic costs
include both accounting costs and implicit costs.
Implicit costs:the cost of factors owned by the entrepreneur himself

and employed in his own business are called implicit costs.
Outlay costs: Outlay costs involve actual expenditure of funds on,

say, wages, materials, rent, interest, etc. Outlay costs involve financial
expenditure at some time and hence are recorded in the books of
account.

Opportunity costs:Opportunity cost, on the other hand, is concerned
with the cost of foregone opportunity; it involves a comparison
between the policy that was chosen and the policy that was rejected.
For example, the opportunity cost of using capital is the interest that
it can earn in the next best use with equal risk. Opportunity costs
relate to sacrificed alternatives; they are, in general not recorded in
the books of account.
Direct or traceable costs: Direct costs are costs that are readily
identified and are traceable to a particular product, operation or
plant. Even overhead costs can be direct as to a department;
manufacturing costs can be direct to a product line, sales territory,
customer class etc.
Indirect or non-traceable costs: Indirect costs are not readily

identified nor visibly traceable to specific goods, services, operations,
etc. but are nevertheless charged to the jobs or products in standard
accounting practice. The economic importance of these costs is that
these, even though not directly traceable to a product, may bear some
functional relationship to production and may vary with output in
some definite way. Examples of such costs are electric power and
common costs incurred for general operation of business benefiting all
products jointly.
Fixed costs: Fixed or constant costs are not a function of output;

they do not vary with output upto a certain level of activity. These
costs require a fixed expenditure of funds irrespective of the level of
output, e.g., rent, property taxes, interest on loans and depreciation
when taken as a function of time and not of output. However, these
costs vary with the size of the plant and are a function of capacity.
Therefore, fixed costs do not vary with the volume of output within a
capacity level. Fixed costs cannot be avoided. These costs are fixed so
long as operations are going on. They can be avoided only when
operations are completely closed down.
Variable costs: Variable costs are costs that are a function of output
in the production period. For example, wages and cost of raw

materials are variable costs. Variable costs vary directly and
NOTES
sometimes proportionately with output. Over certain ranges of
production, they may vary less or more than proportionately
depending on the utilization of fixed facilities and resources during
the production process.
3.7 TYPE I COST OF PRODUCTION: SHORT RUN COST

OF PRODUCTION ANALYSIS
Short run is a period of

time in which output can be
increased or decreased by
changing only the amount of
variable factors, such as labour,
raw material, etc. In the short
run, quantities of fixed factors
cannot be varied in accordance
with changes in output. If the firm wants to increase output in the
short run, it can do so only with the help of variable factors, i.e., by
using more labour and/or by buying more raw material. Thus, short
run is a period of time in which only variable factors can be varied,
while the quantities of fixed factors remain unaltered.
Short run Fixed costs: there are some factors such as building,
capital equipment, or top management team which cannot be so
easily varied. It requires comparatively longer time to make changes
in them. It takes time to install a new machinery. Similarly, it takes
time to build a new factory. Such factors which cannot be readily
varied and require a longer period to adjust are called fixed factors.
Short run Variable costs: There are some factors which can be easily
adjusted with changes in the level of output. A firm can readily
employ more workers if it has to increase output. Similarly, it can
purchase more raw materials if it has to expand production. Such

factors which can be easily varied with a change in the level of output
are called variable factors.
Short run Total costs: Total cost of a business is thus the sum of
total variable cost and total fixed cost or symbolically TC = TFC +
TVC.
Short run Average fixed cost (AFC): AFC is obtained by dividing the
total fixed cost by the number of units of output produced. i.e. TFC =
AFC/Q where Q is the number of units produced. Thus, average fixed
cost is the fixed cost per unit of output.
Short run Average variable cost (AVC): Average variable cost is

found out by dividing the total variable cost by the number of units of
output produced, i.e. AVC =TVC/Q where Q is the number of units
produced. Thus average variable cost is variable cost per unit of
output. Average variable cost normally falls as output increases from
zero to normal capacity output due to occurrence of increasing
returns. But beyond the normal capacity output, average variable cost
will rise steeply because of the operation of diminishing returns.
Short run Average total cost (ATC): Average total cost is the sum of
average variable cost and average fixed cost. i.e., ATC = AFC + AVC. It
is the total cost divided by the number of units produced. The
behaviour of average total cost curve depends upon the behaviour of
the average variable cost curve and the average fixed cost curve.
Marginal Cost: Marginal cost is the addition made to the total cost by
the production of an additional unit of output. In other words, it is the
total cost of producing t units instead of t-1 units, where t is any
given number. It is to be noted that marginal cost is independent of
fixed cost. This is because fixed costs do not change with output. It is
only the variable costs which change with a change in the level of
output in the short run. Therefore, marginal cost is in fact due to the
changes in variable costs.

The av
verage tota
al cost cu
urve is con
nstructed to capture
e the rela
ation
NOTES
betwee
en average
e total cos
st and the
e level of output. A productiively
efficien
nt firm orga
anizes its factors
f of production
p n in such a way thatt the
average
e cost of production is at lowes
st point.
Figure 6--Average to
otal cost Curve
C
A marrginal costt Curve:

A marrginal costt Curve grraphically representts the rela
ation betw
ween
nal costs incurred by a firm
margin m and th
he quantiity of outtput
produc
ced. This curve
c is co
onstructed
d to captu
ure the rela
ation betw
ween
margin
nal cost an
nd the leve
el of outpu
ut, the ma
arginal cos
st curve is
s U-
shaped
d. Margina
al cost is relatively high
h at sma
all quantitties of outp
put,
then as
a producttion increa
ases, decliines, reaches a min
nimum va
alue,
then riises.
Figure 7-Margina
al cost currve
Duality
y:
Given a cost fun
nction we can
c "solve for" a tech
hnology th
hat could h
have
genera
ated that cost func
ction. This
s means that the cost unc
ction
contain
ns essenttially the same in
nformation
n that th
he produc
ction
functio
on contain
ns. Any con
ncept defined in terrms of the
e propertie
es of
SRMIST
T DDE MBA Self
the production function has a "dual" definition in terms of the
properties of the cost function and vice versa. This general
observation is known as the principle of duality.
Fixed costs: -
Fixed costs are business expenses that do not vary directly
with the level of output i.e. they are treated as independent of the
level of production.
Examples of fixed costs include the rental costs of buildings;
the costs of leasing or purchasing capital equipment such as plant
and machinery; the annual business rate charged by local authorities;
the costs of full-time contracted salaried staff; the costs of meeting
interest payments on loans; the depreciation of fixed capital (due
solely to age) and also the costs of business insurance.
Figure 8-Fixed cost

Fixed costs are the overhead costs of a business. They are
important in markets where the fixed costs are high but the variable
costs associated with making a small increase in output are relatively
low. We will come back to this when we consider economies of scale.
• Total fixed costs(TFC) remain constant as output increases
• Average fixed cost(AFC) =total fixed costs divided by output

Average fixed costs must fall continuously as output increases
NOTES
because total fixed costs are being spread over a higher level of
production. In industries where the ratio of fixed to variable costs is
extremely high, there is great scope for a business to exploit lower
fixed costs per unit if it can produce at a big enough size. Consider
the new Sony portable play station. The fixed costs of developing the
product are enormous, but these costs can be divided by millions of
individual units sold across the world.
A change in fixed costs has no effect on marginal costs.

Marginal costs relate only to variable costs.
Variable Costs
Variable costs are costs that vary directly with output.
Examples of variable costs include the costs of intermediate raw
materials and other components, the wages of part-time staff or
employees paid by the hour, the costs of electricity and gas and the
depreciation of capital inputs due to wear and tear. Average variable
cost (AVC) = total variable costs (TVC) /output (Q)
Average Total Cost (ATC or AC)

Average total cost is simply the cost per unit produced
Average total cost (ATC) = total cost (TC) / output (Q)
Marginal Cost
Marginal cost is the change in total costs from increasing output by
one extra unit.
The marginal cost of supplying an extra unit of output is linked
with the marginal productivity of labour. The law of diminishing
returns implies that the marginal cost of production will rise as
output increases. Eventually, rising marginal cost will lead to a rise in
average total cost. This happens when the rise in AVC is greater than
the fall in AFC as output (Q) increases.
Worked example of short run production costs
A simple numerical example of short run costs is shown in the table
below. Fixed costs are assumed to be constant at £200. Variable costs
increase as more output is produced.

Total Total Total Cost Average Marginal Cost
Output Fixed Variable Cost Per (the change in
(Q) Costs Costs (TVC) Unit total cost from a
(TFC) (TC= TFC + (AC = one unit change
TVC) TC/Q) in output)
0 200 0 200
50 200 100 300 6 2
100 200 180 400 4 2
150 200 230 450 3 1
200 200 260 460 2.3 0.2
250 200 280 465 1.86 0.1
300 200 290 480 1.6 0.3
350 200 325 525 1.5 0.9
400 200 400 600 1.5 1.5
450 200 610 810 1.8 4.2
500 200 750 1050 2.1 4.8
In our example, average cost per unit is minimised at a range

of output between 350 and 400 units. Thereafter, because the
marginal cost of production exceeds the previous average, so the
average cost rises (for example the marginal cost of each extra unit
between 450 and 500 is 4.8 and this increase in output has the effect
of raising the cost per unit from 1.8 to 2.1).
Short Run Cost Curves
Short-run average variable cost curve (SRAVC)

Average variable cost (which is a short-run concept) is the variable
cost (typically labor cost) per unit of output: SRAVC = wL / Q where w
is the wage rate, L is the quantity of labor used, and Q is the quantity
of output produced. The SRAVC curve plots the short-run average
variable cost against the level of output, and is typically U-shaped.
Short-run average total cost curve (SRATC or SRAC)

NOTES
Figure 9-Short Run Average cost curve

Typical short run average cost curve
The average total cost curve is constructed to capture the relation
between cost per unit of output and the level of output. A perfectly
competitive and productively efficient firm organizes its factors of
production in such a way that the average cost of production is at the
lowest point. In the short run, when at least one factor of production
is fixed, this occurs at the output level where it has enjoyed all
possible average cost gains from increasing production. This is at the
minimum point in the diagram on the right.
Short-run total cost is given by
STC = PKK+PLL,
where PK is the unit price of using physical capital per unit time, PL
is the unit price of labor per unit time (the wage rate), K is the
quantity of physical capital used, and L is the quantity of labor used.
From this we obtain short-run average cost, denoted either SATC or
SAC, as STC / Q:
SRATC or SRAC = PKK/Q + PLL/Q = PK / APK + PL / APL,
where APK = Q/K is the average product of capital and APL = Q/L is
the average product of labour.
Short run average cost equals average fixed costs plus average
variable costs. Average fixed cost continuously falls as production
increases in the short run, because K is fixed in the short run. The
shape of the average variable cost curve is directly determined by
increasing and then diminishing marginal returns to the variable
input (conventionally labour).

When diminishing returns set in (beyond output Q1) the
marginal cost curve starts to rise. Average total cost continues to fall
until output Q2 where the rise in average variable cost equates with
the fall in average fixed cost. Output Q2 is the lowest point of the ATC
curve for this business in the short run. This is known as the output
of productive efficiency.
Figure 10-Cost curves

A change in variable costs
A rise in the variable costs of production leads to an upward shift
both in marginal and average total cost. The firm is not able to supply
as much output at the same price. The effect is that of an inward shift
in the supply curve of a business in a competitive market.

NOTES
Figure 11-Change in Variable Cost

An increase in fixed costs has no effect at all on variable costs of
production. This means that only the average total cost curve shifts.
There is no change at all on the marginal cost curve leading to no
change in the profit maximising price and output of a business. The
effects of an increase in the fixed or overhead costs of a business are
shown in the diagram below.

Figure 12-Increase in Fixed cost
The short run total cost can be explained as follows :
Fixed cost: The fixed cost is also called overhead cost, supplementary
cost. The cost incurred in fixed factors is called fixed cost. The fixed
cost cannot be changed in the short run. The fixed cost will have to be
incurred even if the production is stopped for some time. The
expenditure made on machinery, land,building and so on is the
example of fixed cost. The curve representing these costs is called
fixed curve cost curve. The sum of implicit fixed costs is called total
fixed cost. The curve representing this is called total fixed cost curve.
Variable cost: The variable cost is also the prime cost, special cost
and direct cost. The expenditures made on variable factors is called
variable cost. The variable cost varies with output. The expenditure
made on raw materials,wages,fuel are the examples of variable cost.

The sum of the expenditures made on variable factors is the
NOTES
total variable cost.The curve representing this is called total variable
cost curve.
Total cost: The sum of total fixed cost and total variable cost is total
cost.Hence,TC=TFC+TVC. The total cost directly varies with
output.Hence,the total cost is expressed as,TC=f(q), where q=quantity
of output. The curve representing total cost is called total cost curve.
Fixed cost
The costs that do not with output are defined as fixed costs.
These costs will exist even if no output is produced. For example,
interest on borrowed capital, rental expenses on leased plant or
building, depreciation charges associated with the passage of time,
salaries of employees who cannot be laid off during periods of reduced
output are fixed costs. On the other hand, costs that very with
changes in output are known as variable costs. They are function of
the of output level. For example, expense on raw materials, wages,
depreciation associated with the use of equipment, sales
commissions, and the costs of all inputs that very with output are
variable costs. Since all the factors are variable in the long run, so are
all costs.
Such a sharp distinction between fixed and variable costs is
not always realistic. For example, a salesman's salary might be fixed
within a certain range of output, but below a lower limit he might be
laid off,while above the upper limit additional salesman would be
hired. This problem led to the development of semi-variable cost
concept. The semi-variable costs are fixed if incremental output does
not exceed certain limits, but are variable outside these bounds.
The distinction between these cost concepts is useful in decision
making. For example, in the short run a profit maximizing firm will
continue its operation so long as its total variable cost is covered but
in the long run all costs must be covered.
Actual and opportunity cost

The costs that are generally recorded in the books of account is
called the actual costs. They consist of actual expenses of hiring
land,labour,capital and management.
The opportunity costs is the alternative that has been foregone. The
opportunity cost of any good is the next best alternative good that is
sacrificed. For example, the factors which are used for the
manufacture of car may also be used for the production of military
equipment.Therefore,the opportunity cost of the production of car is
the output of the military equipment foregone.
The returns which the entrepreneur could have earned in an
alternative use of his services and capital is called opportunity or
alternative cost. Since the opportunity cost is a national cost, they are
not recorded in a book of account. But they are useful for the purpose
of decision making. The opportunity cost concept applies to all
situation where a thing can have alternative uses. If there are no
alternative, the opportunity cost will be zero. If alternative uses are
many, the earning in the next best use will be the opportunity cost.
According to Pappas and Brigham-"The alternative cost concept, then,
reflects the fact that all decisions are based on choices between
alternative actions. The cost of resource is determined by its value in
its best alternative use."
Concept of cost
It is proper examine the different cost concepts which are useful in
managerial decision making:
Accounting costs economics costs: The entrepreneur pays for
the factors employed in production in the form of wages,interest,rent,
and prices for raw materials, fuel and power. All these are included in
cost of production. An accounting will take into account only the
payments and charges made by the entrepreneur to the suppliers of
various productive services.
The economist's view of cost in different. The entrepreneur
invests his own capital, time,managerial talent in business. In the
absence of his own business, he would have employed his resources
in others business and benefited. The economists,therefore,includes
in his cost of production the normal return on money capital invested
by the entrepreneur himself and the wages or salary he clouds have

earned inworked for others.Likewise,money rewards for the factors
NOTES
owned and employed in his own business are also included by the
economists in the cost of population.
Thus, accounting cost is the costs that cash payments.
Economic costs consist of not only all accounting costs but also
money on capital, service and mother factors the entrepreneur could
have earned if he had invested in next best alternative uses.
The accounting costs which is on contractual cash payment

made by the firm to factor owners is an also called the explicit cost.
On the other hand, the payments made for own service and factors is
called implicit or imputed costs. The managerial decision making
should be based on economic costs since the economic costs show the
real cost of production of a project.
3.8 TYPE II COST OF PRODUCTION: LONG RUN COST

OF PRODUCTION ANALYSIS. COST–OUTPUT
The long run is a period of time when firms have sufficient time
to change size of the plant and scale of operation.Since there are no
fixed factors and fixed in the long run,there no fixed cost curves.All
the factors are variable in the long run.Hence,we need to examine
only long run average and marginal cost curves.The calculation of
both these costs same as in the short run.It should be noted that the
concept of long run cost is only hypothetical.Because,there can be no
change in plant every now and them.
Derivation of long run average cost curve:In the short run,firm is tied
to given plan.So there is only one average cost curve.But in the long
run,the firm can change plant size.The large plant is used to produce
more and the small plant is used to produce less.Hence,in the long
run there may be many average cost curves.The firms produces at

low
west avera
age cost in lon
ng run than in the sh
hortrun.
e long run average co
The ost curve is derived from
f shortt run avera
age cost
hown in the diagrram.Suppo
currves as sh are three plants
ose,there a
ava
ailable-sma
all,medium ented by SAC1,SAC
m and large represe C2 and
SAC
C3.
If a firm beg
gins form small pla
ant SAC1 and the demand for the
pro
oduct incre n produce output up
ease.It can p to ox1 at lower cost.After
this
s the costt increase
e.If deman s ox2,the firm can
nd reaches n either
con
ntinue prod mall plant or install medium p
duction sm plant repre
esented
by SAC2.
S
If demand
d ex
xceeds ox2
2,the firm
m installs medium
m p
plant.Because,the
outtput more than
t ox2 can
c be pro
oduced at lower
l cost by medium
m plant
tha
an by smalll plant.
Sim
milarly,the demand
d exceeds ox3;th
he firms installs large
plan
nt.Because,the outp
put greaterr than ox3
3 can be p
produced at
a lower
cost by large
e plant.the
e thick porrtion of ea
ach SAC c
curve thus
s shows
the lowest lon
ng run ave
erage cost curve of producing
p particular level of
p
outtput.Hence
e,the scallo
op shaped
d thick parrt of the s
short run average
a
cost curves is
s long run average co
ost curve of
o the firm..
Figu
ure 8-Long
g Run Cost Curves
SRM
MIST DDE MBA
The long run cost curves are u shaped for different reasons. It
NOTES
is due to economies and diseconomies of scale. If a firm has high fixed
costs, increasing output will lead to lower average costs.However,
after a certain output a firm may experience diseconomies of scale.
Where increased output lead to higher average costs. For example, in
a big firm it is more difficult to communicate and coordinate workers
Typical long run average cost curve
The long-run average cost curve depicts the cost per unit of
output in the long run—that is, when all productive inputs' usage
levels can be varied. All points on the line represent least-cost factor
combinations; points above the line are attainable but unwise, points
below unattainable given present factors of production. The
behavioral assumption underlying the curve is that the producer will
select the combination of inputs that will produce a given output at
the lowest possible cost.
Given that LRAC is an average quantity, one must not confuse

it with the long-run marginal cost curve, which is the cost of one more
unit. The LRAC curve is created as an envelope of an infinite number
of short-run average total cost curves, each based on a particular
fixed level of capital usage. The typical LRAC curve is U-shaped,
reflecting increasing returns of scale where negatively-sloped,
constant returns to scale where horizontal and decreasing returns
(due to increases in factor prices) where positively sloped.
In a long-run perfectly competitive environment, the

equilibrium level of output corresponds to the minimum efficient
scale,. This is due to the zero-profit requirement of a perfectly
competitive equilibrium. This result, which implies production is at a
level corresponding to the lowest possible average cost, does not imply
that production levels other than that at the minimum point are not
efficient. All points along the LRAC are productively efficient, by
definition, but not all are equilibrium points in a long-run perfectly
competitive environment.

In some industries, the bottom of the LRAC curve is large in
comparison to market size (that is to say, for all intents and purposes,
it is always declining and economies of scale exist indefinitely). This
means that the largest firm tends to have a cost advantage, and the
industry tends naturally to become a monopoly, and hence is called a
natural monopoly. Natural monopolies tend to exist in industries with
high capital costs in relation to variable costs, such as water supply
and electricity supply.
3.9 RELATIONSHIP–PRODUCTION CAPACITY

DETERMINATION
Cost-output relationship in the short run
In the short-run there will not be any change in Total Fixed

C0st. Hence change in total cost implies
change in Total Variable Cost only.
The short-run cost-output relationship can
be shown graphically as follows.
In the above graph the “AFC’ curve continues to fall as output rises an
account of its spread over more and more units Output. But AVC
curve (i.e. variable cost per unit) first falls and then rises due to the

operation of the law of variable proportions. The behavior of “ATC’
NOTES
curve depends upon the behavior of ‘AVC’ curve and ‘AFC’ curve. In
the initial stage of production both ‘AVC’ and ‘AFC’ decline and hence
‘ATC’ also decline. But after a certain point ‘AVC’ starts rising. If the
rise in variable cost is less than the decline in fixed cost, ATC will still
continue to decline otherwise AC begins to rise. Thus, the lower end of
‘ATC’ curve thus turns up and gives it a U-shape. That is why ‘ATC’
curve are U-shaped. The lowest point in ‘ATC’ curve indicates the
least-cost combination of inputs. Where the total average cost is the
minimum and where the “MC’ curve intersects ‘AC’ curve, It is not be
the maximum output level rather it is the point where per unit cost of
production will be at its lowest.
The relationship between ‘AVC’, ‘AFC’ and ‘ATC’ can be summarized

up as follows:
If both AFC and ‘AVC’ fall, ‘ATC’ will also fall.
When ‘AFC’ falls and ‘AVC’ rises
‘ATC’ will fall where the drop in ‘AFC’ is more than the raise in ‘AVC’.
‘ATC’ remains constant is the drop in ‘AFC’ = rise in ‘AVC’
‘ATC’ will rise where the drop in ‘AFC’ is less than the rise in ‘AVC’
Cost-output relationship in the long run
Long run is a period, during which all inputs are variable

including the one, which are fixes in the short-run. In the long run a
firm can change its output according to its demand. Thus in the long
run all factors become variable. The long-run cost-output relations
therefore imply the relationship between the total cost and the total
output. In the long-run cost-output relationship is influenced by the
law of returns to scale.
In the long run a firm has a number of alternatives in regards

to the scale of operations. For each scale of production or plant size,

the firm has an appropriate short-run average cost curves. The short-
run average cost (SAC) curve applies to only one plant whereas the
long-run average cost (LAC) curve takes in to consideration many
plants.
The long-run cost-output relationship is shown graphically

with the help of “LCA’ curve.
To draw on ‘LAC’ curve we have to start with a number of ‘SAC’

curves. In the above figure it is assumed that technologically there are
only three sizes of plants – small, medium and large, ‘SAC’, for the
small size, ‘SAC2’ for the medium size plant and ‘SAC3’ for the large
size plant. If the firm wants to produce ‘OP’ units of output, it will
choose the smallest plant. For an output beyond ‘OQ’ the firm wills
optimum for medium size plant. It does not mean that the OQ
production is not possible with small plant. Rather it implies that cost
of production will be more with small plant compared to the medium
plant.
For an output ‘OR’ the firm will choose the largest plant as the
cost of production will be more with medium plant. Thus the firm has
a series of ‘SAC’ curves. The ‘LCA’ curve drawn will be tangential to
the entire family of ‘SAC’ curves i.e. the ‘LAC’ curve touches each
‘SAC’ curve at one point, and thus it is known as envelope curve. It is
also known as planning curve as it serves as guide to the
entrepreneur in his planning to expand the production in future. With
the help of ‘LAC’ the firm determines the size of plant which yields the

lowest average cost of producing a given volume of output it
NOTES
anticipates.
Production capacity determination (excess capacity and reserve

capacity of production determination)
The U-shaped cost curves of the traditional theory have been

questioned both on theoretical as well as empirical grounds. George
Stigles suggests that the short-run average variable cost has a flat
stretch over a range of output, which reflects the fact that firms build
plants with some flexibility in their productive capacity. The reasons
for this reserve have been discussed in detail by various economists.
The U-shape of LAC has been questioned and is often pointed out that
it is L-shaped. In the following sections, we would look at the short-
run and the long-run costs under modern cost theory.
Short-Run
Short-run total cost (SRTC) consists of short-run total variable

cost (SRTVC) and the short-run total fixed cost (SRTFC) i.e., SRTC =
SRTVC + SRTFC. The corresponding average costs are obtained by
dividing each of the above by total output ‘Q’.
STC = STVC + STFC
or, STC/Q = STVC/Q + STFC/Q
or, ATC = AVC + AFC
Average Fixed Cost
This cost consists of the physical and personal organisation of

the firm. These include expenses of maintenance of buildings, land
machinery, salaries of the administrative staff etc.
The ‘planning’ of the firm consists in deciding the ‘size’ of these

fixed factors, which sets a limit to the firm’s production (In contrast,
variable factors, like labour hours, do not limit the firm’s production
because these can be hired very easily from the market).

The entrepreneur will plan to produce that level of output,
which she anticipates to sell and accordingly she would choose that
size of plant, which will allow her to produce that level of output
efficiently and with maximum flexibility. The chosen plant would,
therefore, have a capacity larger than the ‘expected average’ level of
sales, because the entrepreneur would want to have some reserve
capacity for various reasons.
The reserve capacity helps to meet the seasonal and cyclical

fluctuations in demand. It gives the entrepreneur greater flexibility in
repairing broken-down of the production process. Besides, some
machinery may be so specialised that they are available only to order,
which takes time. In such a cases, the machinery will be bought in
excess of the minimum requirement, as a reserve. Generally, some
reserve capacities are always allowed in the land and building since
expansion of operations may be seriously limited if these have to be
acquired. Therefore, an entrepreneur will not necessarily choose the
plant, which will give her today the lowest cost, but rather that
equipment which will allow the greatest flexibility.
Under these conditions the AFC curve would look like as shown
in Figure 9.1. The firm has some ‘larges-capacity’ units of machinery,
which set an absolute limit to the short-run expansion of output
(boundary II). The firm also has small unit machinery, which can set a
limit to expansion (boundary I). Boundary I is not an absolute
boundary, because the firm can increase its output in the short-run,
until it is encountered. This can be done in two ways: either by raising
the variable factors employed in production or, by buying some
additional small-unit types of machinery. If the first method is
chosen, then we have the AFC getting extended beyond I, (this then
looks like the AFC in traditional theory of cost), if the second is
chosen there occurs a break in AFC, whereby we have the portion ‘ab’.

NOTES
Figure 9.1: Average Fixed cost in the Modern Theory
Average Variable Cost
As in the traditional theory, the average variable cost of modern

theory consists of the cost of variable inputs like labour and raw
materials. The SAVC, in modern cost theory is U-shaped but it also
has a flat stretch over a range of output, as shown in Figure 9.2. Over
this stretch the SAVC = MC, i.e., both being constant per unit of
output. As usual, to the left of the flat stretch, MC lies below SAVC
and to the right, it lies above SAVC.
Fig. 9.2: Short-run

Average Variable
Cost in Modern
Theory
The flat stretch in

the SAVC is due to
the presence of
“reserve capacity”. It may be important to take note of features that
the reserve capacity is planned in order to give the maximum
flexibility in the operation of the firm. It is different from “excess
capacity”, which arises with the U-shaped costs of the traditional

theory of the firm. By definition, excess capacity is given by the
difference in output corresponding to the minimum level of average
cost curve and any other point on the average cost curve to the left of
the minimum point. This is shown in panel A of following figure.
Fig. 9.3: SAVC under Traditional & Modern Theory (Panel A)
Fig. 9.3: Panel B
The traditional theory assumes that each plant is designed

without any flexibility i.e., it is designed to produce optimally only a
single level of output (XM, as shown in panel (A) of Figure 5.19). If the

firm produces an output X < XM there is excess (unplanned) capacity,
NOTES
equal to the difference XM – X. This excess capacity is undesirable
because it leads to higher unit costs.
In the modern theory of costs, the range of output X1X2 in

panel (B), reflects the planned reserve capacity, which does not lead to
increases in costs. The firm sometimes chooses to operate the plant
closer to X1 and at others closer to X2. Generally, the entrepreneur
expects to operate her plant within the X1X2 range.
3.9.1 CONCLUSION
The cost function measures the minimum cost of producing a

given level of output for some fixed factor prices. As such it
summarizes information about the
technological choices available to the firms.
It turns out that the behavior of the cost
function can tell us a lot about the nature
of the firm's technology. The fixed cost is a
constant quantity.
The firm will have incurred fixed

cost even if the output is zero. Hence, the
average fixed cost continuously fall as the output rises. On account of
this, the average cost falls when output rises. The average variable
cost varies with quantity output. In the beginning the average variable
cost declines when the output increases. But beyond normal capacity,
the average variable cost increase sharply. More output can be
produced with more variable cost.

Questions for Review
I. Write T for True and F for False against each statement:
1. Production is a process by which goods and services are made

available to the consumer.
2. The production function is a purely technical relationship

between inputs and output (products).
3. Short- run is a period in which firms can adjust production by

changing all factors of production.
4. TPL curve starts from the origin, increases at an increasing

rate, then increases at decreasing rate, reaches a maximum and then
starts falling.
5. Marginal product is defined as the change in TP resulting from

the employment of an additional unit of a variable factor.
6. APL is U- shaped.
7. Short- run production function is also known as law of returns

to scale.
8. Long- run production function is also known as law of variable

proportion.
9. A rational producer will always operate in diminishing returns

(Stage II).
10. Iso- quants are convex to the origin because of diminishing

marginal rate of technical substitution (MRTS).
Ques 1 2 3 4 5 6 7 8 9 10
Ans T T F T T F F F T T
II. Multiple Choice Questions:
1. Production function provides measurements of-
a. The marginal productivity of the factors of production;
b. The marginal rate of substitution and the elasticity of

substitution;

c. The return to scale;
NOTES
d. Factor intensity;
e. All of the above.
2. Which is/ are true about isoquants-
a. It is convex to the origin;
b. The slope of an isoquant is called marginal rate of technical

substitution of labour for capital (MRTSLK);
c. Iso- quants never cross each other;
d. All are true.
3. The conditions of producer’s equilibrium are-
a. Slope of isoquant = slope of isocost line;
b. Iso- quants must be convex to the origin;
c. a+ b
d. None of these.
4. In Cobb- Douglas production function, elasticity of substitution

(es or σ) is equal to-
a. unity b. zero
c. infinity d. None of these.
5. In Cobb- Douglas production function, the sum of its
exponents measures-
a. Returns to Scale; b. Factors intensity;
c. Marginal productivity of factors; d. Elasticity
of substitution
6. Slope of an isoquant is-
a. MRTS; b. Marginal productivity of factors;
c. Elasticity of substitution; d. Factors intensity.
Ans e d c a a a

III. Very Short Questions:
Ques: What is production?

Ans: Production is a process by which goods and services are made
available to the consumer.
Ques: What is production function?

Ans: The production function is a purely technical relationship
between inputs and output (products). It represents the technology of
a firm of an industry.
Ques: What is isoquant?

Ans: An isoquant shows the different combinations of labour and
capital with which a firm can produce a specific quantity of output. It
is defined as the locus of all the technically efficient combinations of
inputs which yield a given amount of output.
Ques: What do you understand by isocost line?

Ans: An isocost line shows the different combinations of labour and
capital that a firm can buy, given total outlay (TO) and the prices of
the factors.
Ques: What are the main features of isoquants?

Ans: The main features of isoquants are:
a. In the relevant range, isoquants are downward sloping;
b. Isoquants are convex to the origin: Diminishing MRTS;
c. Isoquants Never Cross Each Other.
Ques: How many types of production functions are there in theory of

production?
Ans: There are two types of production functions:
a. Short- run production function; and
b. Long- run production function.

NOTES
Ques: What is short- run production function?
Ans: Short- run production function is that production function in
which firms can adjust production by changing variable factors such
as materials and labour but cannot change quantities of one or more
fixed factors such as capital, land etc. it is also known as law of
variable proportion.
Ques: What is long- run production function?

Ans: The long- run production function is that production function in
which all the factors of production can be changed. It is also known
as laws of returns to scale.
Ques: Define total product, average product and marginal product.

Ans: Total Product (TP): It is defined as the total quantity of goods
produced by a firm during a specific period of time. TP can be
increased by employing more and more of the variable factor labour.
Average Product (AP): AP is defined as the amount of output per unit
of the variable factor employed, i.e.,
APL = Total Output = TP
Labour Input L
Marginal Product (MP): MP is defined as the change in TP resulting

from the employment of an additional unit of a variable factor
(labour). MPL can be written as-
MPL = Change in Total Output = ∆TP
Change in Labour Input ∆L
MPL can be calculated as-
MPL for nth unit = TPn – TPn-1
Ques: What are laws of variable proportions?

Ans: Short- run production function is known as law of variable
proportions in which firms can adjust production by changing

variable factors such as materials and labour but cannot change
quantities of one or more fixed factors such as capital, land etc.
Ques: What are the three stages of production? Or,

Ques: How many types of laws of variable proportions are there in the
short run production function?
Ans: There are three stages of production or the law of variable
proportion can be divided into three phases/stages-
a. Stage I: Stage of increasing Returns;
b. Stage II: Stage of Diminishing Returns; and
c. Stage III: Stage of Negative Returns
Ques: What do you understand by first stage of product or law of

increasing returns?
Ans: In the first stage, TPL is initially increasing at an increasing rate
and then starts increasing at decreasing rate from the point of
inflexion onwards. APL rises throughout in this stage. MPL rises
initially and then starts falling. Increasing returns are due to
indivisibility of factors andspecialization of labour. A rational producer
will not operate in this stage because the producer always has an
incentive to expand through Stage I of labour because rising APL
means the average cost decreases as output is increased.
Ques: What do you understand by second stage of product or law of

diminishing returns?
Ans: The second stage of production ranges from the point where APL
is maximum to the point where MPL is zero. In this stage both APL
and MPL are positive but declining. A rational producer will always
operate in this Stage because he wants to maximize efficiency of
scarce factor, labour. The law of diminishing returns operates in this
Stage II. It is the most fundamental law of production.

Ques: What do you understand by third stage of product or law of
NOTES
negative returns?
Ans: Stage III covers the entire range over which MPL is negative. A
rational producer will not operate in this stage.
Ques: What do you understand by the term returns to scale?
Ans: In the long run output (production) may be increased by

changing all factors by the same proportion, or by different
proportions. The term ‘returns to scale’ refers to the changes in
output as all factors change by the same proportion.
Ques: How many types of returns to scale are there?

Ans: There are three types of returns to scale-
1. Increasing Returns to Scale;
2. Constant Returns to Scale; and
3. Decreasing Returns to Scale.
Ques: What is increasing returns to scale?

Ans: When the increase in output is more than proportional to the
increase in inputs, it is called increasing returns to scale.
Ques: What is constant returns to scale?

Ans: When the increase in output is proportional to the increase in
inputs, it is called constant returns to scale.
Ques: What is diminishing returns to scale?

Ans: When the increase in output is less than proportional to the
increase in inputs, it is called diminishing returns to scale.
Ques: What are the relationships between TPL and APL Curves?
Ans: The relationships between TPL and APL Curves are as follows:

• APL at any point on the TPL curve is the slope of the straight
line from the origin to that point on the TPL curve. The value of slope
rises and declines thereafter.
• APL initially rises, reaches a maximum and then falls.
• As long as TPL is positive, APL is positive.
• APL is inverted- U shaped.
Ques: What are the relationships between TPL and MPL Curves?
Ans: The relationships between TPL and MPL Curves are as follows:
• MPL at any point on the TPL curve is the slope of the TPL curve
at that point. The slope rises then falls till TPL is maximum. At that
point slope is zero and beyond that it is negative.
• MPL rises initially, reaches at maximum when the slope of the

tangent is steepest and then declines.
• When TPL is maximum, MPL is zero.
• When TPL falls, MPL is negative.
• TPL is the area under the MPL curve.
• The falling portion of the MPL curve shows the law of variable
proportions.
• MPL is positive as long as TPL is increasing, but becomes

negative when output (TPL) is decreasing.
Ques: What are the relationships between APL and MPL Curves?
Ans: The relationships between APL and MPL Curves are as follows:
• Initially when both APL and MPL curves are rising, MPL curve
rises at a faster rate than the APL curve. Both APL and MPL curves
rise till the fixed factor (L) is under-utilized.

NOTES
• When both APL and MPL curves are falling, MPL curve falls at a
faster rate than the APL curve. Both APL and MPL curves start falling
once the fixed factor (L) is fully utilized.
• When APL curve neither rising nor falling, MPL = APL.
• There is a range where even through the MPL curve is falling

APL curve continues to rise.
Ques: What are the conditions of producers’ equilibrium?
Ans: There are two conditions for producer’s equilibrium-
a. Slope of isoquant = slope of isocost line,
i.e., MRTSLK = PL/PK
MPL/MPK = PL/PK
MPL/PL = MPK/PK
b. Isoquants must be convex to the origin.
Ques: What is Cobb- Douglas production function? Write down its

main features.
Ans: Cobb- Douglas production function is a linearly homogeneous
production function of the form-
Q = ALαKβ
Where
Q = Output
L = Labour input
K = Capital input
A = Efficiency parameter, technology
α = Output elasticity of labour
β = Output elasticity of capital

Cobb- Douglas production function shows constant return to scale. In
Cobb- Douglas production function, elasticity of substitution (es or σ)
is equal to unity and the sum of its exponents measures returns to
scale-
If α + β = 1=> Constant Return to Scale;
If α + β > 1=> Increasing Return to Scale;
If α + β < 1=> Diminishing Return to Scale;
Case Study
Britain takes to the air
Low-cost carriers are transforming not just the
travel business in Britain, but also the way
people live The air of gloom surrounding much
of European business made Ryanair’s results,
announced on June 25th, particularly
impressive. The low-cost airline reported a 37% year-on-year increase
in pre-tax profits,anditschiefexecutive,MichaelO’Leary,saidhe expects
business to grow by 25% over the next year.
Thanks to Ryanairan ditssort, Britonsarebeginningto hop on
and off planes the way Americans do. Air traveling
andaroundBritainhasgrownbynearly 40% in the past five years, but
the really spectacular growth has come from the low-fare airlines,
which havecarriedaround20mpassengersinthepastyear. By spotting
and satisfying the untapped demand for travel from and between the
regions, they have fuelled the growth of Britain’s smaller airports and
undermined Heathrow’s dominance.
Pricing strategy
EasyJet, the first of the low-cost carriers, was set up in 1995 at
Luton. Eastwards around the M25 at Stansted are Ryanair, Go, the
low-cost offshoot of British Airways (BA) sold to a management buy-
out earlier this year, and Buzz, the British arm of KLM, which uses
the airline partly to feed its international hub at Amsterdam. While

Heathrow has seen the number of passengers rise by about 19% over
NOTES
that period, traffic at Luton and Stansted has more than trebled.
Trafficat Liverpool’s airport nearly quadrupled. Demand for air travel
is highly elastic. Bring down the price and sales rise sharply. The low-
fare carriers are often cheaper not just than the mainstream operators
but also than the railways. While low-fare airlines keep their fixed
costs to a minimum, the railways are burdened by the need to
maintain and improve their crumbling network.
Last year was a disaster for them. A crash blamed on a cracked railed
to mass disruption as managers tried to locate and mend other dodgy
rails. Delays drove passengers onto the airlines. Low-cost airlines fill
their planes differently from mainstream carriers. BA, British
Midland, Air France and Lufthansa aim to make their money out of
business travellers who pay over the odds to enjoy meals and loads of
drinks in the air and on the ground in exclusive lounges. The
economy seats are sold off, discounted as need be, some in advance
and some at the last minute. Cheap seats are made available through
downmarket travel agencies which publicise their deals through
newspapers’ classified columns. The low-cost carriers see their
aircraft as a series of buckets. The first set of buckets are the lowest-
priced seats, with the eye-catching prices. Once these are all sold,
demand flows into the next, slightly more expensive, bucket of seats.
As the flight’s departure approaches, seats get progressively more
expensive. On a typical low-cost flight there could be up to ten
different price buckets, with one-way fares ranging
from£30($42)to£210.Buteventhemostexpensive tickets tend to be
cheaper than for the mainstream airlines. Early assumptions that the
low-cost carriers would struggle to make headway in the business
market, because businessmen do not care how much their companies
pay for their tickets, have turn debut to be wrong. Stelios Haji-
Ioannou, Easy Jet’s founder, says that one of the things he first
noticed when the airline launched was how many business
passengers he seemed to be carrying. Not that business travellers are
set apart, since everybody piles into the same no frills cabin, with
free-for-all seating and pay-for-all drinks and sandwiches; but

business travellers tend to book late (and so more expensively) and
travel mid-week. It turns out that businessmen are more price-
sensitive than had been assumed. Some, presumably, are running
their own businesses, so have an interest in keeping costs down;
others are responding to cost-cutting memos from above.
Wired for take-off
The Internet has also helped the low-cost airlines. Airline
tickets rival pornography as the hottest-selling commodity on the
Internet, with sales estimated at more than $5 billion worldwide. Main
stream airlines sell around 5% of tickets over the web. Easy Jet
decided to focus on Internet sales, so it offers discounts for online
booking and has built a site that is easy to use. These days, some
90% of Easy Jet bookings are made online. Ray Webster, Easy Jet’s
chief executive, reckons that older or techno-illiterate people get a
younger or more wired friend to do it for them. Some 65% of Ryanair’s
bookings are made online. Even this figure is twice as high as the
highest e-booking airline in America, Southwest, the original low-fare,
no-frills carrier which was the model for the British low-cost
operators. The low-cost airlines have not just brought down the price
of flying. They have changed the way British people travel, and also
where they live, holiday and work. Air travel no longer involves the
crowded hell of scheduled flights at Heathrow or charter flight delays
at Gatwick. Cheap fares and European second homes have almost
replaced house prices and school fees as a topic for dinner party chat.
At four o’clock on a summer afternoon at Luton airport, a queue is
forming for the 5.40 to Edinburgh. A holidaying couple are returning
to Edinburgh from Spain. The Easy Jet flight was so cheap that it was
worth their while taking an Air tours package from Luton, rather than
flying from Scotland. Behind them is a management consultant who
uses Easy Jet from Luton because he lives just three exits up the M1
and it is quicker than hacking round the M25 to Heathrow. A
technology transfer specialist at the Medical Research Council in
Edinburgh says Easy Jet is a way of coming down to London once a
month for a fraction of the fare on

Context
NOTES
In all the analysis of pricing so far it has been assumed that the firm
is producing a single product. However, it was explained in Chapter 3
that his common assumption is not at all realistic; indeed, it is
difficult to think of many firms that do only produce a single product,
while it is easy to think of firms that produce or sell thousands of
different products. It is true thattherearesomefirmsthatproduceor sell
a wide diversity of products that are not related to each other in any
way, either in terms of demand or production; in this situation the
firm’s pricing and output decisions can be examined using the same
analytical frame work as the single-product firm. However, this is a
relatively rare situation. More often than not, firms producing
multiple products face both demand and production
interrelationships. It is now necessary to consider these relationships
in more detail.
Midland. ‘It seems silly paying extra when you are dealing with
public funds,’ she explains. Businessmen from small and big
companies alike are hopping onto cheap flights. Robert Jones,
shipping and travel manager for Smit Land and Marine, a Liverpool-
based Anglo-Dutch pipeline company, reckons he is saving £50,000 a
year by using budget airlines. Half of his company’s regular 30trips a
month from Liver pool to Amsterdam are by Easy Jet, at £120 each,
instead of the £350 he would spend on a scheduled airline. Travelling
to Spain, he saves around £500 a trip. And, he says, the low-cost
airlines make it easier to change passenger names if one employee
has to substitute for another at a meeting. According to airport
managers at Liverpool, since Ryanair and Easy Jet have built up their
flights from the city, the number of executive-type cars parked at the
airport has shot up. Leisure travel is changing too. Until recently,
most people flew once or twice a year, to Florida or the south of Spain.
These days, people increasingly hop on planes several times a year.
It’s no big deal any more. A salesman in a London electronics shop
says his parents have a holiday house in the south of France, which
he had stopped visiting after they stopped paying for his holidays.
Recently, however, he has discovered that if he books ahead on the

Internet, he can fly Easy Jet to Nice and back for under £50, making
a monthly visit an affordable treat. Perhaps the most astounding
change is the number of long-distance commuters using the new
airlines. Hang around long enough at Luton and you will meet a
businessman or woman, usually middle aged owners of companies in
the south-east, who spend half their week as lotus eaters in Provence,
nipping back for the other half to oversee their business being
handled day-to-day by their staff. Most incredible of all, there is a
resident of the Luton area who commutes to bustling Glasgow every
morning, only to return to lovely Luton in the evening. That could be
called some sort of progress.
Questions
1 What conditions make price discrimination possible in the airline
industry, and what types of price discrimination are possible? Explain
how different demand elasticises are relevant.
2 Explain the differences in pricing strategy between the mainstream
airlines and the low-cost airlines, in terms of the different types of
price discrimination used.
3 Explain the role of the Internet in the pricing strategies above.
3.9.2 CHECK YOUR ANSWERS
1.Draw various cost curves and explain the respective details.

2.Explain the method of determining maximum output levels.
3.Discuss the general relationship between the cost curves.

MODULE -4 NOTES
______________________________________________________________
4.0 Introduction
4.1 Objectives of Firm and Price Determination
4.3 Price Determination under Perfect Competition
4.4 Imperfect Competition
4.5 Price and output determination
4.6 Pricing and Non Pricing strategies
4.7 Conclusion
INTRODUCTION
In economics, market structure,Monopolistic competition, also

called competitive market, where there are a large number of firms,
each having a small proportion of the
market share and slightly
differentiated products. Oligopoly, in
which a market is dominated by a
small number of firms that together
control the majority of the market
share. Duopoly, a special case of an
oligopoly with two firms. Oligopsony, a market, where many sellers
can be present but meet only a few buyers. Monopoly, where there is
only one provider of a product or service. Natural monopoly, a
monopoly in which economies of scale cause efficiency to increase
continuously with the size of the firm. A firm is a natural monopoly if
it is able to serve the entire market demand at a lower cost than any
combination of two or more smaller, more specialized firms.
Monopsony, when there is only one buyer in a market.
Perfect competition is a theoretical market structure that

features unlimited contestability (or no barriers to entry), an

unlimited number of producers and consumers, and a perfectly
elastic demand curve.
The imperfectly competitive structure is quite identical to the

realistic market conditions where some monopolistic competitors,
monopolists, oligopolists, and duopolists exist and dominate the
market conditions. The elements of Market Structure include the
number and size distribution of firms, entry conditions, and the
extent of differentiation.
These somewhat abstract concerns tend to determine some but not all
details of a specific concrete market system where buyers and sellers
actually meet and commit to trade.
4.1 OBJECTIVES OF FIRM AND PRICE DETERMINATION
Business of business is business. In other words, the concern

of business is profit-making. Profit maximisation is the mercenary
motive. Non-profit objectives of firm are missionary motives. Profit
motive is the obvious objective. Non-profit motives are non- obvious
Missionary and mercenary are Yin-Yang of business. Yin is non-
obvious whereas Yang is obvious. The non-obvious missionary
objectives are reputation, legacy, image, good will and sustainable
growth.
Firms maximise supernormal profit or normal profit, the wages

for management given to entrepreneur, or secure profit, in the case of
severe, strong competition.
Supernormal profits are either Gross profit, Net profit, or Operating
profit or Accounting profit.
Filtering process
1. Gross profit = Total revenue – Direct cost (raw material, labour)
2. Net profit = Gross Profit-Indirect cost (machine, factory
shed) or EBIT

3. Operating profit = Net profit-interest- taxes
NOTES
4. Accounting profit = operating profit-opportunity cost
5. Economic profit = Accounting profit—cost of equity capital
EBIT is Earnings before Interest and Taxes Firms intend to maximise
not a single objective of profit, but profit interests of shareholders,
managers, workers, consumers, government and all stakeholders. A
multi-product firm has the multiple objectives of maximising
production, inventory, sales, market-share and profit. Sales
maximisation is revenue maximisation subject to minimum profit.
Wealth maximisation is expansion of assets by increasing net present
value of future earnings. Entrepreneurial utility maximisation is a
balancing between profit and leisure, the quiet life. Managerial utility
maximisation is the discretionary investment spending power of
managers. Customer satisfaction customer delight, wow ability are
objectives of firms. Social responsibility or philanthropy is
eleemosynary objective.
Sales Maximization
A nonprofit objective of business is to rave up sales revenue,
with minimum profit constraint - Baumol
The success and strength of firm is evaluated in terms of total
revenue growth.
The sales volumes determine market leadership in competition.
Market share is the proportion of a firm’s sales in the total market
sales.
Increasing sales revenue gives prestige to the top management.
The minimum profit satisfies shareholders.
The managers prefer steady performance to spectacular profit
maximisation. It is difficult for managers to show spectacular profit
year after year. Managers’ performance is measured in terms of
achieving sales targets.
In large organisation, management is separate from owners.
There is a dichotomy of managers’ goal and owners’ goal. Managers’
salary and other benefits are largely linked with sales volume.
The conflict of interests between the owners and managers is called

Principal Agent Problem, in organisational set up the owners
(principal) hire managers (agents) who have better knowledge of the
market.
Perfect competition is the bench mark, standard, reference and

desirable imaginary construct of market. Perfect knowledge with
buyers and sellers and perfect easy mobility of factors of production
are desirable market features. The reality is imperfect competition
with asymmetric information between sellers and buyers and limited
mobility of resources.
Monopoly the single seller is complete
absence of competition. Perfect competition
and monopoly are extreme forms of market.
The real world market has some degree of
competition in between monopoly and
perfect competition. They are monopolistic
competition and oligopoly as imperfect
competition.
Pure competition involves large number of
sellers, free entry, the easy start-up of business, free exit, the easy
closing down or winding up of business and identical, homogeneous,
close substitute products. Pure competition plus perfect knowledge
and perfect mobility is the perfect competition.
Monopoly involves
single firm, barriers or
limits or restrictions to
entry of firm and no
substitute product.
Monopolist can control
either price or supply.
Monopolist cannot do
both fixing high price

and reducing supply.
NOTES
A monopolistic competitive firm enjoys monopoly power of product

differentiation, and also confronts competition due to product
substitutability. Indian industries such as clothing fabrics, footwear,
paper, sugar, vegetable oil, coffee, spices, soap, computers, car,
mobile phones are examples of monopolistic competition. Selling cost,
the expenses on advertisement and sales promotion adapts demand
to production. But production
cost adapts production to
demand.
Oligopoly is the severe
competition among few firms.
The cut-throat competition or
head to head competition
between two firms is duopoly. Oligopoly is found among producers of
industrial products aluminium, cement, copper, steel, zinc, tyre,
automobiles, cigarettes, refrigerators, etc.
Competition is useful because it reveals actual customer

demand and induces the seller (operator) to provide service quality
levels and price levels that buyers (customers) want, typically subject
to the seller’s financial need to cover its costs. In other words,
competition can align the seller’s interests with the buyer’s interests
and can cause the seller to reveal his true costs and other private
information. In the absence of perfect competition, three basic
approaches can be adopted to deal with problems related to the
control of market power and an asymmetry between the government
and the operator with respect to objectives and information:
(a) Subjecting the operator to competitive pressures,
(b) Gathering information on the operator and the market, and
(c) Applying incentive regulation.

The correct sequence of the market structure from most to
least competitive is perfect competition, imperfect competition,
oligopoly, and pure monopoly. The correct sequence of the market
structure from most to least competitive is perfect competition,
imperfect competition, oligopoly, and pure monopoly.
Basic Market structure
Market Seller Seller Buyer Buyer

Structure Entry Number Entry Number
Barriers Barriers
Perfect
No Many No Many
Competition
Monopolistic
No Many No Many
competition
Oligopoly Yes Few No Many
Oligopsony No Many Yes Few
Monopoly Yes One No Many
Monopsony No Many Yes One
The main criteria by which one can distinguish between

different market structures are: the number and size of producers and
consumers in the market, the type of goods and services being traded,
and the degree to which information can flow freely. Industrial
organization studies the strategic behavior of firms, the structure of
markets and their interactions. The common market structures
studied include perfect competition, monopolistic competition, various
forms of oligopoly, and monopoly. Natural monopoly, or the
overlapping concepts of "practical" and "technical" monopoly, is an
extreme case of failure of competition as a restraint on producers. The
problem is described as one where the more of a product is made, the

greater the unit costs are. This means it only makes economic sense
NOTES
to have one producer.
Information asymmetries arise where one party has more or

better information than the other. The existence of information
asymmetry gives rise to problems such as moral hazard, and adverse
selection, studied in contract theory. The economics of information
has relevance in many fields, including finance, insurance, contract
law, and decision-making under risk and uncertainty.
Incomplete markets is a term used for a situation where

buyers and sellers do not know enough about each other's positions
to price goods and services properly. Based on George Akerlof's
Market for Lemons article, the paradigm example is of a dodgy second
hand car market. Customers without the possibility to know for
certain whether they are buying a "lemon" will push the average price
down below what a good quality second hand car would be. In this
way, prices may not reflect true values.
Public goods are goods which are undersupplied in a typical

market. The defining features are that people can consume public
goods without having to pay for them and that more than one person
can consume the good at the same time.
Externalities occur where there are significant social costs

or benefits from production or consumption that are not reflected in
market prices. For example, air pollution may generate a negative
externality, and education may generate a positive externality (less
crime, etc.). Governments often tax and otherwise restrict the sale of
goods that have negative externalities and subsidize or otherwise
promote the purchase of goods that have positive externalities in an
effort to correct the price distortions caused by these externalities.
Elementary demand-and-supply theory predicts equilibrium but not
the speed of adjustment for changes of equilibrium due to a shift in
demand or supply.
In many areas, some form of price stickiness is postulated to

account for quantities, rather than prices, adjusting in the short run

to changes on the demand side or the supply side. This includes
standard analysis of the business cycle in macroeconomics. Analysis
often revolves around causes of such price stickiness and their
implications for reaching a hypothesized long-run equilibrium.
Examples of such price stickiness in particular markets include wage
rates in labour markets and posted prices in markets deviating from
perfect competition.
Macroeconomic instability, addressed below, is a prime source of

market failure, whereby a general loss of business confidence or
external shock can grind production and distribution to a halt,
undermining ordinary markets that are otherwise sound.
Environmental scientist sampling water Some specialised fields

of economics deal in market failure more than others. The economics
of the public sector is one example, since where markets fail, some
kind of regulatory or government programme is the remedy. Much
environmental economics concerns externalities or "public bads".
Policy options include regulations that reflect cost-benefit

analysis or market solutions that change incentives, such as emission
fees or redefinition of property rights. Much of economics is positive,
seeking to describe and predict economic phenomena. Normative
economics seeks to identify what economies ought to be like.
Welfare economics is a normative branch of economics that uses

microeconomic techniques to simultaneously determine the allocative
efficiency within an economy and the income distribution associated
with it. It attempts to measure social welfare by examining the
economic activities of the individuals that comprise society.
4.2.1 MARKET CHANGES
If only price and quantity are allowed to change, the interaction

of buyers and sellers in markets results in an equilibrium price and
quantity. The relationship between price and quantity for both buyers

and se
ellers of widgets
w is represented by th
he supply and dem
mand
NOTES
A other influence
curves below. All es on ma
arket participants h
held
constant, an equ
uilibrium price
p and quantity
q will
w emerge
e. Equilibrrium
price and
a quantiity in the widget
w ma
arket are shown
s as P1
P and Q1
1 on
the gra
aph below.
Figu
ure 9-Mark
ket change
es
However, there
t are factors
f oth
her than prrice that in
nfluence
buying
g and sellin
ng behavio
our. As a re
eview, seve
eral of the factors tha
at
influen
nce both bu
uyers (dem
mand) and sellers (prroducers orr suppliers
s)
are sho
own on the
e graph be
elow.
Figure 10-Supply
y And Demand shifterrs
SRMIST
T DDE MBA Self
SUP
PPLY SHIF
FTERS Tec
chnology Prrice of Inpu
uts Price of Related Goods
DEM
MAND SHIFTERS Co
onsumer In
ncome Pre
eferences P
Price of Re
elated
Goo
ods Expecttations
If any
y of these
e factors, previouslly held c
constant, change
(rep
presented as a sh
hift in the demand
d or sup
pply curve
e) then
equ
uilibrium price
p and quantity
q ch
hange. Forr example, suppose a sharp
incrrease in la
abor costs hit the wid
dget marke
et. A chang
ge in inputt prices
dire
ectly impa
acts the su
upply side
e of the market,
m hifting the supply
sh
currve upward
d (reflectin
ng higher costs
c to pro
oduce each
h unit of output).
o
See
e graph bellow.
What happens to
t price and
a quanttity? Due to higherr costs,
pro
oducers are
e no longerr willing to
o offer Q1 and price P1. As pro
oducers
incrrease the price of widgets, consumers purcha
ase less widgets
w
(mo
ovement along
a a demand curve sin
nce consu
umers arre only
resp
ponding to
o price cha
ange). A ne
ew equilibrium will b
be reached
d at Q2
and
d P2. We can
c conclu
ude the prrice of wid
dgets will increase and
a the
qua
antity boug
ght and so
old in the market
m willl decrease..
Sup
pply and D
Demand Sh
hifters
SUPPLY S
SHIFTERS
S
Technology
Price of R
Related Goo
ods
Increase in Price off

Inputs
DEMAND
D SHIFTER
RS
Consume
er Income
Preferenc
ces
Price of R
Related Goo
ods
Expectatiions
SRM
MIST DDE MBA
NOTES
4.2.2 PE
ERFECT COMPETI
C ITION
Because of
o the cha
aracteristic
cs of a com
mpetitive market
m (m
many
firms producing
g similar products),, an indiv
vidual firm
m must ttake
markett prices as
s given. Firrms in a competitive
c e market have
h very llittle
controll over wha
at price they receive for their output.
o Since the firrm’s
outputt is small relative to the tota
al sold in the mark
ket, the firrm’s
outputt decision will
w not sig
gnificantly
y influence market prrices. If a ffirm
tried to gher than the mark
o charge a price hig ket price, no
n one wo
ould
purcha
ase its output (why uyers pay a higher price for the
y would bu
same good?).
g
Examine the
t graph below. No
otice that the
t price in
n the marrket,
P, is what
w the firrm can rec
ceive for its
s output. The
T graph also indica
ates
that P is also equal
e to the
t firm’s demand curve
c D. Recall tha
at a
deman
nd curve indicates
i how much
h buyers are willin
ng to pay for
differen
nt quantitties of ou nce the firrm can sell any giiven
utput. Sin
quantitty of outpu
ut for this price, pric
ce is also equal to D and
a MR.
Given costts and market prices

s, this firm
m will produce q* leve
el of
outputt (MR=MC). Since P is
i greater than
t ATC at
a the proffit maximizzing
outputt level, this
s firm is making an economic
e rent
r (profitt).
Long-ru
un Dynam
mics of Com
mpetitive Markets:
M -
SRMIST
T DDE MBA Self
The graph above indicated that the individual competitive firm
is making a profit (returns above costs). Economic rent will not last
in a competitive market. Why? One explanation is that potential firms
will realize a profit opportunity exists and will enter the market (one of
the characteristics of a perfectly competitive market is relatively easy
entry and exit from the market). This potential response is shown on
the graph below. As more firms enter this market, the market supply
curve increases (shifts to the right). Note that as market prices fall,
economic rents dissipate and approach zero.
4.3 PRICE DETERMINATION UNDER PERFECT

COMPETITION
Demand and supply interactively determine market price.

Demand – side average revenue, marginal revenue (MR) and supply –
side average cost, marginal cost (MC) determine price in the business
firm.
The profit – maximising conditions determine price and output
in all market forms: perfect competition, monopolistic competition,
oligopoly and monopoly.
First order condition MC = MR
First order condition is necessary but not sufficient.
Second order condition
Slope of MC > Slope of MR
Marginal cost curve should cut marginal revenue curve from
below.
Perfect competition – short run equilibrium:

The firm makes supernormal profit as average revenue is a
above average cost, along with fulfilling profit – maximising conditions
Perfect competition – long run equilibrium:

Attracted by supernormal profit, new firms enter. The firm
earns only normal profit as AC = AR

NOTES
Monopolistic competition – short run equilibrium:
As AR >AC, firm makes supernormal profit, under the above
two conditions.
Monopolistic competition – long run equilibrium:

AR curve is tangent to AC curve, touching at an interval
depicting excess capacity, underutilized plant capacity.
Monopoly equilibrium:
Monopolist practises price discrimination, charging low price in
more elastic demand market and high price in less elastic or inelastic
demand market.
Oligopoly equilibrium – kinked demand:

Kinked demand is combination of more elastic upper portion
and less elastic lower portion.
More elastic demand:

When a firm raises the price, the other firms do not follow, to
earn profit with old cheaper price. The firm that raised the price
would experience a sharp fall in demand.
Less elastic demand:

When a firm reduces the price, other firms follow; the firm
cannot expand sales.
Price war finally settles at rigid price at kink.
Price determination under perfect competition is analysed under

three different time periods:
(a) Market Period
(b) Short Run
(c) Long Run

(a) Market Period:
In a market period, the time span is so short that no firm can
increase its output. The total stock of the commodity in the market is
limited. The market period may be an hour, a day or a few days or
even a few weeks depending upon the nature of the product.
For example, in the case of perishable commodities like vegetables,
fish, eggs, the period may be a day. Since the supply of perishable
commodities is limited by the quantity available or stock in day that
neither can be increased nor can be withdrawn for the next period,
the whole of it must be sold away on the same day, whatever may be
the price.
Fig 4.1 shows that the supply curve of perishable commodities like
fish is perfectly inelastic and assumes the form of a vertical straight
line SS. Let us suppose that the demand curve for fish is given by dd.
Demand curve and supply curve intersect each other at point R,
determining the price OP. If the demand for fish increases suddenly,
shifting the demand curve upwards to d’d’.
The equilibrium point shift from R to R” and the price rises to

OP’. In this situation, price is determined solely by the demand
condition that is an active agent.

NOTES
Similarly, if the demand for a product is given, as shown in

demand curve SS in figure 4.2. If the supply of the product decreases
suddenly from SS to S’S’, the price increases from P to P’. In this case
price is determined by supply, the supply being an active agent.
In this case supply curve shifts leftward causing increase in price of
the reduced supply goods. Given the demand curve dd and supply
curve SS, the price is determined at OP. Demand curve remaining the
same, the decrease in supply shifts the supply curve to its left to S’S’.
Consequently, the price rises from OP to OP’.
The supply curve of non-perishable but reproducible goods will

not be a vertical straight line throughout its length. This is for certain
goods can be withdrawn from the market if the price is too low as the
seller would not sell any amount of the commodity in the present
market period and would like to hold back the whole stock.
The price below which the seller declines to offer for any amount of
his product is known as ‘reserve price’. Thus, the seller faces two
extreme price-levels; at one he is ready to sell the whole stock and the
other he refuses to sell any. The amount he offers for sale will vary
with price.
The seller will be ready to supply more at a higher price rather

than at a lower one will depend upon his anticipations of future price
and intensity of his need for cash. The supply curve of a seller will,
therefore, slope upwards to the right up to the price at which he is

ready to sell the whole stock. Beyond this point, the supply curve will
become a vertical straight line whatever the price.
(b) Pricing in the Short Run- Equilibrium of the Firm:

Short period is the span of time so short that existing plants
cannot be extended and new plants cannot be erected to meet
increased demand. However, the time is adequate enough for
producers to adjust to some extent their output to the increase in
demand by overworking their fixed capacity plants. In the short run,
therefore, supply curve is elastic.
Figure 4.3 shows the average and marginal cost curves of the
firm together with its demand curve. Demand curve, in a perfectly
competitive market, is also the average revenue curve and the
marginal revenue curve of the firm. The marginal cost intersects the
average cost at its minimum point. The U-shape of both the cost
curves reflects the law of variable proportions operative in the short
run during which the size of the plant remains fixed.
The firm is in equilibrium at the point B where the marginal cost
curve intersects the marginal revenue curve from below:
The firm supplies OQ output. The QC is the average cost and the firm
earns total profit equal to the area shown by ABCD. The firm
maximizes its profit. Earlier to the point of equilibrium, the firm does
not attain the maximum profit as each additional unit of output
brings more revenue that its cost. Any level of output greater than OQ
brings less marginal revenue than marginal cost.

For the equilibrium of a firm the two conditions must be fulfilled:
NOTES
(a) The marginal cost must be equal to the marginal revenue.

However, this condition is not sufficient, since it may be fulfilled and
yet the firm may not be in equilibrium. Figure 4.4 shows that
marginal cost is equal to marginal revenue at point e’, yet the firm is
not in equilibrium as Oq output is greater than Oq’.
(b) The second and necessary condition for equilibrium requires that
the marginal cost curve cuts the marginal revenue curve from below
i.e. the marginal cost curve be rising at the point of intersection with
the marginal revenue curve.
Thus, a perfectly competitive firm will adjust its output at the

point where its marginal cost is equal to marginal revenue or price,
and marginal cost curve cuts the marginal revenue curve from below.
The fact that a firm is in equilibrium does not imply that it necessarily
earns supernormal profits. In the short-run equilibrium firms may
earn supernormal profits, normal profits or may incur losses.

Whether the firm makes supernormal profits, normal profits or incurs
losses depends on the level of the average cost at the short run
equilibrium. If the average cost is below the average revenue, the firm
earns supernormal profits. Figure 4.5 illustrates that the average cost
QC is less than average revenue QB, and the firm earns profits equal
to the area ABCD.
If the average cost is above the average revenue the firm makes
a loss. Figure 4.6 shows that the Average cost QF is higher than QG
average revenue and the firm is incurring loss equal to the shaded
area EFGH. In this case the firm will continue to produce only if it is
able to cover its variable costs.
Otherwise it will close down, since by discontinuing its

operations the firm is better off; it minimizes its losses. The point at
which the firm covers its variable costs is called ‘the closing-down
point’. If the price falls below or average costs rise, the firm does not
cover its variable costs and is better off if it closes down. Figure 4.7
explains shut- down point.

NOTES
Equilibrium of the Industry:

An industry is in equilibrium at that price at which the quantity
demand is equal to the quantity supplied.
Figure 4.8 explains that DD is the industry demand and SS the

industry supply. The point E at which industry demand and industry
supply equalizes, the price OP is determined. OQ is the quantity
demanded and quantity supplied. This, however, is a short run
equilibrium where at the market-determined price some firms may be
making supernormal profits, normal profits or making losses. In the
long run the firms may not continue incurring losses. Loss making
firms that cannot adjust their plant will close down.
Firms that are making supernormal profits will expand their

capacity. Simultaneously new firms will be attracted into the industry.
Free movement of firms in and outside the industry and readjustment

of the existing firms in the industry will establish a long run
equilibrium in which firms will just be earning normal profits and
there will be no tendency of entry or exit from the industry.
(c) Pricing in the Long Run:
The long run is a period of time long enough to permit changes

in the variable as well as in the fixed factors. In the long run,
accordingly, all factors are variable and non- fixed. Thus, in the long
run, firms can change their output by increasing their fixed
equipment. They can enlarge the old plants or replace them by new
plants or add new plants.
Moreover, in the long run, new firms can also enter the
industry. On the contrary, if the situation so demands, in the long
run, firms can diminish their fixed equipment’s by allowing them to
wear out without replacement and the existing firm can leave the
industry.
Thus, the long run equilibrium will refer to a situation where

free and full scope for adjustment has been allowed to economic
forces. In the long run, it is the long run average and marginal cost
curves, which are relevant for making output decisions. Further, in
the long run, average variable cost is of no particular relevance. The
average total cost is of determining importance, since in the long run
all costs are variable and none fixed.
In the short run a firm under perfect competition is in

equilibrium at that output at which marginal cost equals price or
Marginal Revenue. This is equally valid in the long run. But, in the
long run for a perfectly competition firm to be in equilibrium, besides
marginal cost being equal to price, price must also be equal to average
cost. If the price is greater than the average cost, the firms will be
making supernormal profits.

Lured by these supernormal profits, new firms will enter the
NOTES
industry and these extra profits will be competed away. When the new
firms enter the industry, the supply or output of the industry will
increase and hence the price of the output will be forced down. The
new firms will keep coming into the industry until the price is
depressed down to average cost, and all firms are earning only normal
profits.
On the other hand, if the price happens to be below the average

cost, the firms will be incurring losses. Some of the existing firms will
quit the industry. As a result, the output of the industry will decrease
and the price will rise to equal the average cost so that the firms
remaining in the industry are making normal profits. Hence, in the
long run, firms need not be forced to produce at a loss since they can
leave the industry, if they are having losses. Thus, for a perfectly
competitive firm to be in equilibrium in the long run, price must equal
marginal and average cost.
Now when average cost curve is falling, marginal cost curve is

below it, and when average cost curve is rising, marginal cost curve
must be above it. Hence, marginal cost can be equal to the average
cost only at the point where average cost curve is neither falling nor
rising, i.e. at the minimum point of average cost curve. Therefore, it is
at the point of minimum average cost curve, and the two are equal
there.
Thus, the conditions for long run equilibrium of perfectly competitive
firm can be written as:
Price = Marginal Cost = Minimum Average Cost.

The conditions for the long run equilibrium of the firm under
perfect competition can be easily understood from the Fig. 4.9, where
LAC is the long run average cost curve and LMC in the long run
marginal cost curve. The firm under perfect competition cannot be in
long run equilibrium at price OP’, because though the price OP’
equals MC at G (i.e., at output OQ) but it is greater than the average
cost at this output and, therefore, the firm will be earning
supernormal profits.
Since all the firms are assumed to be identical, all would be

earning supernormal profits. Hence, there will be attraction for the
new firms to enter the industry. As a result, the price will be forced
down to the level Op at which price, the firm is in equilibrium at F
and is producing OQ” output
.
At point F or equilibrium output OQ”, the price is equal to
average cost, and hence the firm will be earning only normal profits.
Therefore, at price OP, there will be no tendency for the outside firms
to enter the industry. Hence, the firm will be in equilibrium at OP
price and OQ output.
On the contrary, a firm under perfect competition cannot be in

the long run equilibrium at price OP”. Though price OP” is equal to
marginal cost at point E, or at output OQ” but price OP” is lower than
the average cost at this point and thus the firm will be incurring
losses.
Since all the firms in the industry are identical in respect of
cost curves, all would be incurring losses. To avoid these losses, some
of the firm will leave the industry. As a result, the price will rise to OP,
where again all firms are making normal profits. When the price OP is
reached, the firms would have no further tendency to quit.
Thus, to conclude that at price OP, the firm under perfect competition
is in equilibrium in the long run when:

Price = MC = Miinimum AC
C
NOTES
Now, at price
p OP, besides all
a firms being
b in equilibrium
e m at
outputt OQ, the industry will
w also be in equilibrrium, since there willl be
no tendency for new firms ms to leave the
s to enter or the exiisting firm
industrry, becaus
se all will be
b earning normal prrofits. Thus
s, at OP prrice,
full equ
uilibrium, i.e. equilib
brium of all
a the individual firm
ms and als
so of
the ind
dustry, as a whole, is achieve
ed in the long run under perrfect
compettition.
4.4 IMPER
RFECT CO
OMPETIT
TION
polist exerc
monop cises some
e control over
o the prrice it can charge forr its
outputt. In fact, the monop emand currve for its output is the
polist’s de
markett demand curve.
c
The follow
wing dem
mand curv
ve shows that if the
t monop
poly
charges $100 forr its outpu
ut, consum
mers woulld purchas
se 10 unitts of
outputt. If the monopolist
m t wanted to sell 11 units of output, the
monop
polist would
d have to lower
l price
e.
Sup
ppose this monopolist lowered
d price from
m $100 to
o $99 in orrder
to sell an additional unit of output (10 to 11
1). The mo
onopolist o
only
es an extra $89 in revenue rather
receive r tha
an $99. Th
he monopo
olist
receive
es $99 extrra dollars from the 11th
1 unit sold.
s ever, since the
Howe
polist now charges $99 for eve
monop ery unit of output, th
he monopo
olist
had to sacrifice $1 in reve
enue on th
he 10 unitts that con
nsumers w
were
SRMIST
T DDE MBA Self
willling to pa
ay $100. Thus,
T the additiona
al revenue
e the mon
nopolist
rece
eives is $8
89 (+$99 - $10).
$
As a double
d chec hen price = $100 is $1,000
ck, total revenue wh
(10 x $100). To
otal revenu
ue when price
p is lo
owered to $99 is
$1,089
9 (11 x $99). The difference in
n total rev
venue is marginal
m
revenu
ue and is eq
qual to $89.
From the above

e, we can
n see thatt the mon
nopolist marginal
m
reve
enue is le
ess than price.
p For a perfectly
y competittive firm, price
p is
equ
ual to marg
ginal reven
nue (see grraph below
w).
Figu
ure 11-Mo
onopolist Revenue
R
Pro
ofit Maxim
mizing Outtput Levell for Mono
opolist
mizing rulle for the monopolis

The prrofit maxim st is no different
d
tha
an from an
ny other firm.
fi The monopolis
m t will continue to produce
p
outtput as lon
ng as the additionall revenue received is
s greater than
t or
equ
ual to the additional
a cost to pro
oduce thatt unit. On the graph
h below,
pro
ofits are ma
aximized at
a q* outpu
ut level.
The
e monopoliist will use
e the dema
and curve to establis
sh the pric
ce it will
cha
arge for output, show
wn as p* on
n graph be
elow.
SRM
MIST DDE MBA
NOTES
4.5 PRICE
E AND OU
UTPUT DE
ETERMIN
NATION
When there
e is prod
duct
diffferentiatio
on, i.e.,
diffferentiated oligop
poly,
tw
wo or few
w sellers m
may
recognise that their
prrices are closely inte
erre-
latted. Since each firm is a
price-s
searcher, each
e will gu
uess and learn
l from ce that as and
m experienc
when it
i cuts its price, its rivals
r tend
d to match
h or even exceed
e suc
ch a
price cut.
c The co
onsequenc
ce: a contin
nuous pric
ce war, wh
hich will co
ome
to a ha
alt as soon as few selllers feel th
hat they arre on the same
s boat.
st oligopolists used to form ca

In the pas artels or trrusts. Of llate,
this strrategy has
s become in
neffective due
d to the enactmen
nt of anti-trrust
laws ev
verywhere. In reality
y the oligop
polists hes
sitate to ch
harge too h
high
a price
e because that
t may tempt
t new
w rivals to enter
e the industry. T
They
e, charge a price higher than the purelly competiitive
would, of course
ut with nec
one bu cessary mo
oderation lest
l new firrms should
d be attrac
cted
into th
he industry
y.
SRMIST
T DDE MBA Self
The most typical form of collusion where firms join hands to
gain the advantages of monopoly is a cartel. A cartel is a formal
agreement among firms regarding pricing and/or market sharing.
Firms often get together and set prices so as to maximize total

industry profits. This collusive oligopoly resembles monopoly and
extracts the maximum amount of profits from customers.
If a cartel has absolute control over its members as is true of

the OPEC, it can operate as a monopoly. To illustrate, consider Fig. 7
below.
The marginal cost curves of each firm are summed horizontally

to derive an industry marginal cost curve. The profit-maximizing
output and equilibrium price (P0) are determined simultaneously by
equating the cartel’s total marginal cost with the industry marginal
revenue curve. Now each individual firm can easily find its output by
equating its marginal cost to the pre-determined industry profit-
maximizing marginal cost level.

NOTES
4.6 PRICING AND NON PRICING STRATEGIES
Non- Pricing Strategies
NON – PRICE COMPETITION (Selling cost)

Apart from production cost, business firms incur selling cost.
Production cost adjusts production to demand. Selling cost adapts
demand to production.
Selling cost includes advertisement expenses and sales

promotion. Advertisement may be informative advertisement or
manipulative advertisement. The successful launching of new product
depends on effective ad.
o Sales promotion is a marketing strategy, encompassing

sales force management
salesmanship, selling staff
expense on sales personnel
allowance to dealers, agents
discounts to customers
retail showroom beautification
window display
convenient location of shop & footfalls
shopping pleasure assured to customers
free sample product to consumers/ coupon
Buy one Get one free gift.(BOGO)
attractive packaging of goods.
celebrity endorsement.
sponsoring cricket match.
brand building
after- sales service
Non – price competition = f (product innovation, selling cost)
= f (Differentiation, cost – efficiency)

Non- Price Competition
Producer’s stand point
1. Physical difference: Strength of product durability of product

size, shape, smell, wrapper, packaging, workmanship
2. Patented feature: registered formula business secrecy
3. Product quality: use of quality raw material fitness for use
specification to standard benignancy, value for money
4. Policy of agility: dramatic change in product feature (white
tooth paste to close up red paste) quick improvement. just – in- time
fulfilment of customer need.
5. Persuasive difference: sales promotion (window display, free
gift)
Advertisement:
¾ informative ad.
¾ manipulative ad. (attracting customers through tall
claim)
Demanding buyer’s stand point
1. Psychological difference: imaginary distinction illusory, fancied

difference in terms of trademark, brand name
2. Peculiar feature: USP – unique selling proposition (zing thing)
singularity image, reputation, good will
3. Product innovation:
New to the region
New to the culture
New to the “market segment” (women / middle class / ultra rich)
4. Plight of sale:
Shopping experience
Buying pleasure
Convenient location
Economies (advantages) of scale, scope.
5. Purchase benefit:
Acceptance of returned good, after – sales – service free door
delivery,

NOTES
Non- Pricing Strategies
Cartel is formal agreement among competitive firms,
resembling the formation of monopoly.
M&A Merger and Acquisition is another kind of integration of firms.
Merger means the purchase of assets of an established company’s
human resource, finance, operation, logistics, R&D, systems or
information technology or ERP are bought by another company.
Acquisition is the purchase of shares of another company and
becoming “holding company”.
Takeover tycoon Agni Rajaratnam in Coimbatore could

diagnose the reasons for sickness of business units and bought as
many as fifty sick enterprises.
Joint – venture is the method of pooling the complementary

resource of two firms to enjoy advantages or economies of large scale
operation.
Strategic alliance is a tie-up, entering into long term co-

operative relationship with trading partners, contracting and
partnership.
Public Private Partnership is a way of taking advantage of

government support and private innovative ventures.
Price Discrimination
A doctor accepts different fees from the different income –group
of patients. A restaurant in Thudiyaloor accepts only the willingness
price from the consumers. Different tariff or unit price is practised in
the use of telecommunication. Some multinationals charge higher
prices in domestic and lower price in foreign market called dumping.
First degree of perfect price discrimination charges different prices
from different consumers on the basis of each one’s maximum
willingness to pay. Hence no consumer will enjoy the consumer’s
surplus.

Second degree or block pricing method intends to siphon off only a
part of consumer’s surplus, rather than the whole of it as in first
degree. Hence, the marginal buyer will not get any consumer’s
surplus, as the price is equal to his willingness price. But the intra –
marginal buyers enjoy consumer’s surplus.
For third degree price discrimination, two markets should be
separate with no seepage or leakage or transfer of goods. Higher price
is charged in less elastic demand market and lower price in more
elastic demand market.
Pricing Strategies
Effective price
The effective price is the price the company receives after
accounting for discounts, promotions, and other incentives.
Line Pricing
Line Pricing is the use of a limited number of prices for all
product offerings of a vendor. This is a tradition started in the old five
and dime stores in which everything cost either 5 or 10 cents. Its
underlying rationale is that these amounts are seen as suitable price
points for a whole range of products by prospective customers. It has
the advantage of ease of administering, but the disadvantage of
inflexibility, particularly in times of inflation or unstable prices.
Loss leader
A loss leader is a product that has a price set below the
operating margin. These results in a loss to the enterprise on that
particular item in the hope that it will draw customers into the store
and that some of those customers will buy other, higher margin items.
Promotional pricing
Promotional pricing refers to an instance where pricing is the
key element of the marketing mix.
Price/quality relationship

The price/quality relationship refers to the perception by most
NOTES
consumers that a relatively high price is a sign of good quality. The
belief in this relationship is most important with complex products
that are hard to test, and experiential products that cannot be tested
until used (such as most services). The greater the uncertainty
surrounding a product, the more consumers depend on the
price/quality hypothesis and the greater premium they are prepared
to pay. The classic example is the pricing of Twinkies, a snack cake
which was viewed as low quality after the price was lowered.
Excessive reliance on the price/quantity relationship by consumers
may lead to an increase in prices on all products and services, even
those of low quality, which causes the price/quality relationship to no
longer apply.
Premium pricing
Premium pricing (also called prestige pricing) is the strategy of

consistently pricing at, or near, the high end of the possible price
range to help attract status-conscious consumers. Examples of
companies which partake in premium pricing in the marketplace
include Rolex and Bentley. People will buy a premium priced product
because:
¾ They believe the high price is an indication of good quality;
¾ They believe it to be a sign of self-worth - "They are worth it;" it
authenticates the buyer's success and status; it is a signal to
others that the owner is a member of an exclusive group;
¾ They require flawless performance in this application - The cost
of product malfunction is too high to buy anything but the best
- example: heart pacemaker.
¾
Demand-based pricing
Demand-based pricing is any pricing method that uses
consumer demand - based on perceived value - as the central
element. These include: price skimming, price discrimination and
yield management, price points, psychological pricing, bundle pricing,
penetration pricing, price lining, value-based pricing, geo and

premium pricing. Pricing factors are manufacturing cost, market
place, competition, market condition, quality of product.
Multidimensional pricing
Multidimensional pricing is the pricing of a product or service
using multiple numbers. In this practice, price no longer consists of a
single monetary amount (e.g., sticker price of a car), but rather
consists of various dimensions (e.g., monthly payments, number of
payments, and a down payment). Research has shown that this
practice can significantly influence consumers' ability to understand
and process price information.
Price-Quality Effect Buyers are less sensitive to price the more

that higher prices signal higher quality. Products for which this effect
is particularly relevant include: image products, exclusive products,
and products with minimal cues for quality. Expenditure Effect
Buyers are more price sensitive when the expense accounts for a large
percentage of buyers’ available income or budget.
End-Benefit Effect:
The effect refers to the relationship a given purchase has to a
larger overall benefit, and is divided into two parts: Derived demand:
The more sensitive buyers are to the price of the end benefit, the more
sensitive they will be to the prices of those products that contribute to
that benefit. Price proportion cost: The price proportion cost refers to
the percent of the total cost of the end benefit accounted for by a
given component that helps to produce the end benefit (e.g., think
CPU and PCs). The smaller the given components share of the total
cost of the end benefit; the less sensitive buyers will be to the
component's price.
Shared-cost Effect:
The smaller the portion of the purchase price buyers must pay
for themselves, the less price sensitive they will be. Fairness Effect
Buyers are more sensitive to the price of a product when the price is
outside the range they perceive as “fair” or “reasonable” given the

purchase context. The Framing Effect Buyers are more price sensitive
NOTES
when they perceive the price as a loss rather than a forgone gain, and
they have greater price sensitivity when the price is paid separately
rather than as part of a bundle.
Cost, customer and competition are the bases for pricing a product. In
other words, supply, demand and the nature of market together
determine price.
Marginal Cost Pricing:
Marginal cost is additional expenditure on raw material, the
direct cost of production, consequent to adding up of one more unit of
output in the firm. Direct cost is traceable and attributable to the
output. When marginal cost determines the price, the indirect or fixed
cost on machines, land and factory-shed is ignored.
Full-Cost Pricing:
Marginal cost pricing is partial-cost pricing, as it does not
include fixed cost but considers only variable cost. Full cost is average
variable cost (prime cost) plus average fixed cost (overhead cost),
equals to average cost. Price is equal to the average cost.
Customer influence in pricing:

The consumer and business buyers join group to buy at a
lower price called group pricing or pool pricing. Bulk purchase
commands, a lower price. Discriminatory pricing is low price for more
elastic demand and high price for inelastic demand. Ethical pricing is
charging fair and moderate, reasonable price to consumer.
Competition based pricing:

When competition is strong, penetration pricing strategy is followed. it
is the low price to gain a foot hold or niche in the market. When
competition is weak, high price, the skim-the-cream pricing method in
adopted.
Going rate pricing :
It is the adjusting of firm’s price policy to the pricing structure
in the market. Customary pricing is going along with the old price or

customised one. For example, new model of electric fan is priced at
the same level as the discontinued model.
Experienced, low- cost producer dominates in the market as price
leader, under oligopoly a competition among few firms. Other
producers imitate price leader and adopt followership pricing strategy.
Pricing as the most effective profit lever. Pricing can be

approached at three levels.
1. The industry
2. Market
3. Transaction level.
• Pricing at the industry level focuses on the overall economics of
the industry, including supplier price changes and customer demand
changes.
• Pricing at the market level focuses on the competitive position
of the price in comparison to the value differential of the product to
that of comparative competing products.
• Pricing at the transaction level focuses on managing the
implementation of discounts away from the reference, or list price,
which occur both on and off the invoice or receipt.
4.6.1VALUE BASED PRICING
The goal of value-based pricing is to align price with value

delivered. Price for any individual customer can be customized to
reflect the specific value delivered. Examples could include metrics
such as number of users and the value per users, number of annual
transactions and the value per transaction, size of revenues and the
impact on revenues, cost savings, or other measurements.
Value based pricing is intended to make companies become
more competitive and more profitable than using simpler pricing
methods. It can also be used in product development and product

management to configure products to maximize value for specific
NOTES
customers.
Value-based pricing is dependent upon an understanding of
how customers measure value, through careful evaluation of
customer operations. Survey methods are sometimes used to
determine the value, and therefore the willingness to pay, a customer
attributes to a product or a service. Frameworks for value-based
pricing include Economic Value Estimation are Relative Attribute
Positioning, Van Westendorp Price Sensitively Meter, Conjoint
Analysis and Navetti Ratio To Complete. Another value pricing method
uses Customer Value Research, which is Bernstein & Macias' method
for gaining the customer's perception of value through the use of both
qualitative and quantitative research methods.
Time-based pricing is a special case of price discrimination in

which producers charge different rates for a given good or service
depending on the time, day, month, and so on. For instance, it is
common practice in the tourism industry to charge higher prices
during the peak season, or during special-event periods and only
charge the operating costs of the establishment during the offpeak
season. Investments for business expansion in this case is funded out
of profit earned during the peak season. Another common example of
this pricing strategy is found in transportation sectors, which may
charge higher prices during rush-hours.
Psychological pricing or price ending is a marketing practice

based on the theory that certain prices have a psychological impact.
The retail prices are often expressed as "odd prices": a little less than
a round number, e.g. $19.99 or $2.98. The theory is this drives
demand greater than would be expected if consumers were perfectly
rational. Psychological pricing is one cause of price points.

4.7CONCLUSION
Thus Monopolistic competition, also called competitive market,

where there are a large number of firms, each having a small
proportion of the market share and slightly differentiated products.
Oligopoly, in which a market is dominated by a small number of firms
that together control the majority of the market share. Duopoly, a
special case of an oligopoly with two firms. Oligopsony, a market,
where many sellers can be present but meet only a few buyers.
Monopoly, where there is only one provider of a product or service.
Natural monopoly, a monopoly in which economies of scale cause
efficiency to increase continuously with the size of the firm. A firm is a
natural monopoly if it is able to serve the entire market demand at a
lower cost than any combination of two or more smaller, more
specialized firms.Monopsony, when there is only one buyer in a
market.
Thus Pricing is the manual or automatic process of applying

prices to purchase and sales orders, based on factors such as: a fixed
amount, quantity break, promotion or sales campaign, specific vendor
quote, price prevailing on entry, shipment or invoice date,
combination of multiple orders or lines, and many others. Automated
systems require more setup and maintenance but may prevent pricing
errors. The needs of the consumer can be converted into demand only
if the consumer has the willingness and capacity to buy the product.
There are various kinds of Pricing in practice.
Review Questions
I.Write T for True and F for False against each statement:

1. The cost of a commodity is determined by production function
NOTES
and the price of inputs.
2. Cost function shows relationship between total cost and its

determinants.
3. The actual expenditure incurred by a firm to purchase or hire

the inputs it needs in the production process is called implicit cost.
4. Sunk cost is the expenditure that has been incurred and

cannot be recovered.
5. TFC curve is a straight line parallel to x- axis.
6. Total variable cost (TVC) curve is inverse- S shaped starting

from the origin.
7. AFC is a rectangular hyperbola showing decreasing fixed cost

per unit as output increases.
8. The minimum point of AC occurs to the left of the minimum

point of the AVC.
9. MC curve cuts AC curve at its minimum point.
10. LAC and LTC are planning curves.
Ques 1 2 3 4 5 6 7 8 9 10
Ans T T F T T T T F T T
II. Multiple Choice Questions:
1. Cost functions are derived from-

a. Production function;
b. Demand function;
c. Supply function;
d. None of these.
2. Total cost (TC) is equal to-

a. TFC + TVC b. MC + AC
c. TFC + MC d. TFC + AC
3. Which of the following is rectangular hyperbola-
a. TFC b. TVC
c. AFC d. AVC
4. An addition made to the TC or TVC as output is increased by

one more units is called:
a. AC b. MC
c. AVC d. AFC
5. When MC is falling, MC is-
a. Below AC b. Above AC
c. Equal to AC d. All may be possible.
6. MC curve cuts AC curve at its-
a. minimum point; b. Maximum point.
c. Any point; d. Never cuts.
7. Shift in cost curves is/are due to–
a. Change in input supply; b. Change in technology;
c. a+b d. None of these.
Ques 1 2 3 4 5 6 7
Ans a a c b a a c

NOTES
III.Questions with Answer:

Ques: What is cost?
Ans: Cost is defined as the payment made to the factors of production
used in the production of the commodity.
Ques: What do you mean by opportunity cost?

Ans: The cost of alternative opportunity sacrificed or given up is
known as opportunity cost. For example, a piece of land may be used
either for building a residential flat or for constructing a hospital. If
the land is used for constructing a hospital then its opportunity cost
is the cost of residential flat foregone. It is also known as transfer
earnings.
Ques: What are fixed cost and variable cost?

Ans: Fixed Cost- Fixed cost, overhead cost or supplementary cost is
the cost that does not change with change in output.
Variable Cost- Variable cost is that costs which vary/change with the
quantity of output produced. It is also called prime cost.
4.7.CHECK YOUR ANSWERS
1. Explain the basic market structure with relevant examples.

2. Describe the concept of Monopolist’s Marginal Revenue.
3. Draw the graph and explain the perfect Competition.
4. Explain the various types of pricing.
5. Describe the Pricing approaches and tactics involved in pricing
methods.

Case Study
One Palm flapping
Carl Yankowski is having a hard time turning Palm’s promise into
profits By rights, it should not have been this hard. Carl Yankowski,
chief executive of Palm, the leading maker of handheld computers, is
a former president of Sony’s American operations. He is a big,
dressedin-black ‘gadget guy’ with just the right combination of
consumer-marketing experience and technology savvy to straddle the
gap between computing and consumer electronics. From its start in
1996, Palm single-handedly generated the personal digital assistant
(PDA) craze, succeeding where many had failed before, and it is now
leading a drive into the new wireless world. Computing meets
telecoms meets consumer electronics – the palmtop becomes
thenewdesktop.Andhere,orsoitmightseem,inthe right place at the right
time, is Mr Yankowski. Yet he is struggling. For all Palm’s success in
defining and leading a booming new industry – its
operatingsystemrunsmorethanthree-quartersofthe world’s PDAs,
giving it an almost Microsoft-like monopoly – the company itself is in a
very unMicrosoft-like financial mess. Recently, it issued a warningthat
itslossesinthe currentquarterwouldbe twice what had been expected –
as much as $190m. Its sinking fortunes also scuttled a planned
merger
Strategy analysis
With Extended Systems, a deal that was meant totake it to new

heights in the corporate market. Palm’s shares have fallen by 90%
over the past six months. The company’s difficulties do not all lie at
the feet of Mr Yankowski – he took over only a year and a half ago, as
Palm was freeing itself from 3Com, its former corporate parent and
the source of its risk-averse corporate culture. But, like it or not, they
are now his to solve. The biggest problem is that Palm is having a
hard time finding the right strategy. At the moment, it
followsacombinationofMicrosoft’swithApple’sthat ends up weaker than
either. Like Apple, it makes its own hardware and software: a line of

PDAs and the famed Palm operating system (OS) that is the secret of
NOTES
its success. Like Microsoft, it also licenses its OS to other companies,
ranging from Handspring, which was started by Palm’s original
founders, to Sony and several mobile-phone makers. The downside to
this is that Palm’s licensees have proved all too good at making
hardware. Today, a mere two years after it released its first PDA,
Handspring is beating Palm in sales. And both Sony and Handspring
have pushed their hardware further than Palm, introducing
innovations such as expansion slots and add-on devices from phones
to music players. The result is that the PDA business is quickly taking
on the savage character of the PC industry, with commodity products,
falling margins and cut-throat competition. Mr Yankowski inherited
most of this, and it had too much momentum for him to change it
quickly or easily. If Palm stops licensing its operating system, it risks
losing out to OS competitors such as Microsoft and Psion. If it stops
making hardware entirely, it would take the best-known brand of PDA
out of circulation. The enthusiasm over Mr Yankowski’s arrival in late
1999 was based largely on his background, which suggested that
there might be a third way for the company. Aside from his Sony
experience, which placed him at the heart of the best consumer
electronics firm just as it was embracing digital technology, his career
has been a virtual tour of great marketing firms: Reebok, General
Electric, Pepsi, Memorex and Procter & Gamble. Starting it all was an
engineering degree from MIT. The hope was that Mr Yankowski could
combine Sony’s design and marketing skills with Palm’s technology.
His type of consumer-marketing
experience can make the difference between a niche gadget and a
Walkman-like hit. Which is why it is so puzzling that Palm has
changed so little since his arrival.
Corporate priority
Many expected him to push the company faster into the consumer
market, with brightly-coloured PDAs and extra consumer features
such as MP3 and video. Instead, he has made his main priority the
staid corporate market. At present, most Palms make it into the office

thanks to somebody’s personal expense account. Mr Yankowski’s aim
is to encourage IT managers to purchase them directly for employees,
much as they buy PCs. This is not a bad strategy–the corporate PDA
market is about the same size as the consumer market, and both
have lots of potential–but it may be a waste of Mr Yankowski’s special
talents. While he tries to sell his firm’s strait-laced productivity tools,
in black and grey, to corporate purchasing managers, his old
company, Sony, is generating enviable buzz with a cool purple PDA
that plays videos and has a headphone jack. Worse, the corporate
market is the one in which Palm faces its toughest competition, in the
form of Research in Motion’s Blackberry interactive pagers, which
have generated Sony-like excitement among the suits. Palm’s recent
results have at last provoked Mr Yankowski into thinking more
broadly. He is now in management retreat with his staff and is
expected to announce a new strategy soon. But his options get more
limited by the day. Palm’s finances are too rocky to get into a
consumer-marketing race with Sony. Nor does it have the products to
justify that. The first Palms designed on Mr Yankowski’s watch are
now out. They do little more than add an expansion slot like the one
Handspring has had for two years. Meanwhile, the collapse of the
planned merger with Extended Systems, which has had success
selling to IT managers, limits the push into the corporate sector. And
abandoning hardware entirely would reduce Palm to a software and
services firm–hardly the place for a consumer-marketing guru. Mr
Yankowski does not have much more time to find the right answer.
Questions
1.Describe Palm’s positioning in the market, in terms of
resources, capabilities, cost and benefit advantage.
2 What criteria can Palm use to segment its market? 3 Evaluate
Palm’s targeting strategy.

NOTES
MODULE - 5
____________________________________________________________________
STRUCTURE
5.0 Components of a Game
5.1 Types of Games
5.2 Prisoner’s Dilemma
5.3 Market Structure
5.4 Asymmetric Information (AI)
5.5 Conclusion
5.0 INTRODUCTION-COMPONENTS OF A GAME
Game is a conflicting, competitive and counterintuitive

situation, between two parties. The two players are B2C, businessman
facing consumers, B2G, businessman confronting Government, B2B,
the two rival firms, industrial relation between employer and
employees, and the interface between polluter and pollute.
Game is interactive decision. One player’s move will be followed by
counter-move by the other player. The action of one player will be
reacted or responded by the other player. Game aims at the choice of
the best alternative from the conflicting options. The alternative
actions are strategies and the best chosen alternative is equilibrium
or saddle point in game. The pay -off corresponding to saddle point is
agreeable to both the players. To arrive at equilibrium, the players
undertake bargaining and negotiating process.
A player while choosing his strategy assume that rival player will react
or adopt a strategy that will be worst for him. The players follow the
policy of “playing it safe” as the conflicting situation is an “adversary
game”.

Pay- off matrix showing maximin strategy
strategies of A player
1
strategies of B player 61 4 3
1
7 8 6
1 1 1
Among the row minimum 1, 6, 1 the maximum is 6. It’s the

maximin value. Among the column, maximum 7, 8, 6 the minimum is
6. It’s the minimax value.
Maximin = minimax = 6 is the saddle point.
Game theory is a framework for hypothetical social situations
among competing players. In some respects, game theory is the
science of strategy, or at least the optimal decision-making of
independent and competing actors in a strategic setting. The key
pioneers of game theory were mathematicians John von Neumann
and John Nash, as well as economist Oskar Morgenstern.
'Game Theory'
The focus of game theory is the game, which serves as a model
of an interactive situation among rational players. The key to game
theory is that one player's payoff is contingent on the strategy
implemented by the other player. The game identifies the players'
identities, preferences, and available strategies and how these
strategies affect the outcome. Depending on the model, various other
requirements or assumptions may be necessary.
Game theory has a wide range of applications, including psychology,
evolutionary biology, war, politics, economics, and business. Despite
its many advances, game theory is still a young and developing
science.
Impact on Economics and Business
Game theory brought about a revolution in economics by
addressing crucial problems in prior mathematical economic models.
For instance, neoclassical economics struggled to understand

entrepreneurial anticipation and could not handle imperfect
NOTES
competition. Game theory turned attention away from steady-state
equilibrium toward the market process.
In business, game theory is beneficial for modeling competing
behaviors between economic agents. Businesses often have several
strategic choices that affect their ability to realize economic gain. For
example, businesses may face dilemmas such as whether to retire
existing products or develop new ones, lower prices relative to the
competition, or employ new marketing strategies. Economists often
use game theory to understand oligopoly firm behaviour.It helps to
predict likely outcomes when firms engage in certain behaviours,
such as price-fixing and collusion.
5.1 TYPES OF GAMES
Pure strategy game:

When a strategy
specifies one and the
same particular
action at each point
in a game, it is a pure
strategy.
Mixed strategy
game: A mixed
strategy would
always keep the rival player alert and wondering about the next move
of a player.
Dominant and Dominated strategy:

If the outcome derived from strategy A is better than that of
strategy B, then A is the dominant strategy and B is the dominated
strategy.

Common Knowledge and mutual knowledge games:
When a particular market information is obvious and known to
all competitors, it is the common knowledge game, when others are
ignorant about a specific precious information, it is non – obvious to
them, but obvious to two players only. The two players take advantage
of precious knowledge. It is their mutual knowledge, not shared with
others.
Cooperative and non-cooperative games:

Inter firm assistance or tie up between two firms, is cooperative
game. Tit – for – tat, head to head, cut – throat competition between
two players is non cooperative game.
Extensive form game:

It is a game decision tree, in which the complete plan of action
of the players over a period of time is displayed.
Simultaneous move and sequential move: In a simultaneous game,
both players act at the same time. In a sequential game, one player
acts, followed by the other.
Constant sum and zero – sum:

When the total benefits of the players in a given strategy is
constant, it is constant – sum game.
Player A’s profit is the loss to player B. Hence, the sum is zero, called
zero – sum – game.
Although there are many types (e.g. symmetric/asymmetric,

simultaneous/sequential, et al.) of game theories, cooperative and
non-cooperative game theories are the most common. Cooperative
game theory deals with how coalitions, or cooperative groups, interact
when only the payoffs are known. It is a game between coalitions of
players rather than between individuals, and it questions how groups
form and how they allocate the payoff among players. Noncooperative
game theory deals with how rational economic agents deal with each
other to achieve their own goals. The most common noncooperative

game is the strategic game, in which only the available strategies and
NOTES
the outcomes that result from a combination of choices are listed.A
simplistic example of a real-world noncooperative game is Rock-
Paper-Scissors.
For the sake of comparison, we first start with an example in

which there is no strategic interaction, and hence one does not
need game theory to analyse.
Example 5.1 (A Single Person Decision Problem). Suppose Ali is an

investor who can invest his
$100 either in a safe asset, say government bonds, which brings 10%
return in one year, or he can invest it in a risky asset, say a stock
issued by a corporation, which either brings 20% return (if the
company performance is good) or zero return (if the company
performance is bad).
State
Good Bad
Bonds 10% 10%
Stock 20% 0%
Clearly, which investment is best for Ali depends on his

preferences and the relative likelihoods
of the two states of the world. Let’s denote the probability of the good
state occurring p and that of the bad state 1 − p, and assume that Ali
wants to maximize the amount of money he has at the end
of the year. If he invests his $100 on bonds, he will have $110 at the
end of the year irrespective of the state of the world (i.e., with
certainty). If he invests on stocks, however, with probabilityp he will
have $120 and with probability 1 − p he will have $100.

We can therefore calculate his average (or expected) money holdings
at the end of the year as
p × 120 + (1 − p) × 100 = 100 + 20 × p
If, for example, p = 1/2, then he expects to have $110 at the end of
the year. In general, if p > 1/2, then he would prefer to invest in
stocks, and if p < 1/2 he would prefer bonds.
This is just one example of a single person decision making

problem, in which the decision problem of an individual can be
analysed in isolation of the other individuals’ behaviour. Any
uncertainty involved in such problems are exogenous in the sense
that it is not determined or influenced in any way by the behaviour of
the individual in question. In the above example, the only uncertainty
comes from the performance of the stock, which we may safely
assume to be independent of Ali’s choice of investment. Contrast this
with the situation illustrated in the following example.
Non-Cooperative Game Model

The Scott text uses the example of an investor and a manager
to demonstrate the non-cooperative game theory of the conflict
situation. A similar example of this model would be in the used car
industry. The buyer desires all the relevant and reliable information
about the car to aid her in assessing the car’s expected value and the
risk of the purchase. The seller may not wish to reveal all of the
negative information about his car. The car may become harder to
sell, he may have to spend money repairing the car, or the buyer may
purchase elsewhere. Both parties are aware of the other’s strategies
and possible reactions. This is a non-cooperative game since there is
not a binding agreement between the seller and the buyer.
The seller has two strategies. He can either lie about the quality
of his used car, making it sound better than it really is. Or, he can be
honest about the quality of the vehicle and risk losing the sale. The
buyer can choose to either buy or refuse to buy the car.

NOTES
The expected utility payoffs are:
SELLER
HONEST LIE
BUY 70,40 30,70
REFUSE 35,10 35,30
The strategy pair chosen will not be Refuse/Honest or Buy/Lie.

This is due to the fact that each party has complete information about
the other and knows their strategies and payoffs. For example, if the
seller chooses to Lie, the buyer would not choose to Buy because she
would receive a higher utility with Refuse. Lie/Refuse is the strategy
pair chosen because given the other player’s strategy, each player is
content with his or her decision even though Buy/Honest would give
each player higher utilities. This is referred to as Nash Equilibrium.
The Game Theory helps us to understand the process of

choosing an accounting policy. It aids us in understanding why in
certain situations a company would choose to distort the financial
statements if it serves them to do so. The theory also aids in showing
how difficult it would be to try and implement new policies and
procedures that have low payoffs to management. The Game Theory
can also be used to show accounting standard boards the danger of
not considering the interests of all parties affected by policy choices
that are found to be difficult to implement.
Models of Cooperative Game Theory

Contracts are agreements that are perceived to be binding by
players in a game situation. There are two types of contracts of
particular importance in financial accounting theory: employment
contracts – between the firm and manager - and lending contracts –
between the manager and the bondholder, the principle and agent,
respectively. The roles of these players are studied with respect to
agency theory, a branch of game theory that studies the design of
contracts to motivate a rational agent to act on behalf of a principal

when the agent’s interests would otherwise conflict with those of the
principal.
Employment Contract
States of nature are assigned to expected payoffs, which in turn

are a function of the action the manager chooses. The action that the
manager chooses affects the distribution of the payoffs. For example,
the greater effort exerted by the manager, the greater the probability
of a high payoff, and vice versa.
Game theory, like decision theory, advocates a maximization of

utility with one exception. In the case of the manager, there is a
reservation utility, which is the minimum utility the manager will
except before going elsewhere. They cannot seek to maximize their
utility above the reservation utility since there is an excess supply of
replacement workers that could take their job. In many cases, the
highest utility for one player is attached to the undesirable action of
the other. In particular, shirking their duties, therefore inducing the
low payoff, maximizes the manager’s utility, especially is they are
remunerated on a fixed basis. This is an example of a moral hazard.
Managers must, therefore, design contracts to control moral hazard.
Contracts to control moral hazard

(1) Hire the manager and put up with the shirking. This option is
not usually put into practice since owners can maximize their
utility using other techniques.
(2) Direct Monitoring.
This type of contract is called first-best because the owner

gains the maximum utility and the manager gains the reservation
utility. More practically, if the manager works hard (= high payoff)
he will be paid his normal wage. If the manager shirks (= low
payoff) he will be paid a reduced wage. This situation is effectively
impossible since it is hard to measure whether or not the manager

is working hard due to the information asymmetry involved; the
NOTES
manager knows his effort level while the owner does not.
(3) Indirect Monitoring.
Like direct monitoring, the wages earned by the manager are

dependent upon the payoff. However, indirect monitoring involves
the issue of moving support versus fixed support. Moving support
is where the set of possible payoffs is different depending on the
action taken. Fixed support means the payoffs stay the same
regardless of action taken. Two problems with this approach are
that penalizing the manager may be against the law and that most
contracts are based on fixed support where indirect monitoring
does not work.
(4) Owner rents firm to the manager.
In this situation, the manager pays the owner a fixed rental

payment so that the owner no longer cares which actions the
manager takes, since he receives a percentage of the potential
payoffs regardless. This is called internalizing the manager’s
decision problem. This is an inefficient option due to the high
agency costs involved. Agency costs are the lost utility to the owner
of due to information asymmetry regarding efforts to monitor,
transfer risk, or adjust for the shirking.
(5) Give the manager a share of the payoff.
This is the most efficient alternative to a first-best contract,

called the second-best contract. The manager is given a percentage
of the payoff, thus he wants to work hard, which is also in the
interest of the owner. This is called incentive-compatibility.
Agency costs are reduced compared to the rental contract and risk
is borne by both the manager and the owner. The measure of
performance can be based either on net income or share price
depending on the nature of the firm’s structure. This implies a

heavy responsibility on the firm’s accounting systems and financial
statements to report complete and accurate information.
A Bondholder-Manager Lending Contract
This contract creates another moral hazard problem, where the

actions of the agent “manager” may not be consistent with the
interests of the principle “bondholder.” A rational lender will raise
interest rates charged to the borrower. Instead, the rational
borrower, not wanting to pay excessive interest rates will agree to
covenants in the lending agreement – like not exceeding
debt/equity ratios or not paying dividends if the interest coverage
ratio is below a specified level. Therefore, lenders are satisfied with
their level of risk and managers are able to borrow at lower rates.
Implications of Agency Theory for Accounting
An important aspect of agency theory is to develop a fair

contract between the agent and principal when the agent’s efforts are
unobservable by the principal, but the payoff is jointly observable by
both parties. There are a number of potential measures that can be
used to determine an agents pay, and one such measure Holmstrom
examines is net income.
Both parties use net income to measure performance because

it is observable; however, there are concerns that creative managers
looking to maximize their pay often manipulate the reported figure.
Therefore, owners should use controls such as GAAP, audits, and
historical cost based accounting to limit adverse managerial
behaviour.
GAAP sets guidelines as to how net income is calculated, and it

deters a manager’s incentive to switch accounting policies to effect net
income. Audits set up a control system which limits the likelihood of
fraud or error, and it ensures net income is calculated according to
the agreed upon terms set out in the GAAP. Auditors also reassure

the owner that the audit is independent and free from influence.
NOTES
Finally, if net income is used as a contract performance measure,
historical-cost-based net income should probably be used instead of
current-value-based net income because it is less susceptible to
management manipulation, and therefore a harder measure of net
income.
Holmstrom also points out that a contract can be made even

more efficient if a second variable such as share price is used in
addition to net income. According to Holmstrom, as long as the
second variable provides some additional information on effort, the
overall efficiency of the contract will increase.
Another important point to be made regarding agency theory is

that contracts tend to be quite rigid once signed. They are usually
long term, and they cannot anticipate all possible state realizations,
which is termed incomplete. This means they are not easily amended,
and unforeseen state realizations impose costs on the firm and/or its
manager.
Managers are not concerned over accounting policy because it

affects the company’s cash flow, but rather it can affect their own
compensation. The aforementioned rigidities in a manager’s contract
mean the changes in accounting policy affect net income and other
financial statement numbers on which their salary is based.
Therefore, managers closely examine any change in accounting policy
because it affects their bottom line.
This raises the question; if managers are concerned over

accounting policy should investors be concerned, and if they are
concerned does the theory of market efficiency still hold? The answer
to this isn’t clear (much like everything else in this class); however, it
is an important topic to think about.

5.2 PRISONER’S DILEMMA
Prisoner’s Dilemma:
Two individuals have been arrested for a crime, but the

evidence against them is weak. The sheriff keeps the prisoners
separated and offers each of them a special deal:1. If the prisoner
confesses, that prisoner can go free, as long as only he confesses, and
the other prisoner will get ten years in prison.2. If both prisoners
confess, each will receive a reduced sentence of two years in jail. 3.
The prisoners know that if neither confesses, they will be cleared of all
but a minor charge and will serve only two days in jail. Both the
prisoners will go free.
Prisoner B’s options
confess Not confess
Prisoner A’s
2 1 Options
1 3
The dominant strategy for both prisoners is to confess and receive

two years of jail as in 2
Nash Equilibrium
The most famous example of Nash equilibrium is the dominant
strategy related prisoners’ dilemma. The modified prisoners’ dilemma
is fisher’s dilemma in harvesting or exploiting a common stock of fish
Country B
Deplete Conserve
Country A
Deplete 3,2 40,-5
Conserve -5, 40 30,20

NOTES
The Co-operative solution (Conserve, Conserve) maximises the
joint pay-off of A and B equal to 50. Neither of the country is satisfied
with the co-operative strategy.
The non –cooperative strategy (deplete, deplete) is a free-riding
over use of fish. This the game theoretic interpretation of tragedy of
commons.
The refinement of Nash equilibrium is non – cooperative game,
in which each player understands other player’s optimal strategies
(equilibrium strategies) and takes into consideration when optimising
his own strategy. No player has anything to gain by changing only
their own strategy. (Compare with kinked demand approach)
Each player wins because everyone gets the outcome they
desire. The optimal outcome of a game is when there is no incentive to
deviate from their initial strategy, after considering an opponent’s
choice.
5.3 MARKET STRUCTURE
Low – cost price leader:

A large scale firm enjoys the economies of scale / advantage of
large scale operation. Internal economies like state-of–the-art
technology, co-operative workers, managerial delegation of work and
external economies such as infrastructural facilities, information
related business intelligence, are cost– advantages. The firms can
produce the product at lower cost than competitors. Other firms
follow the price set by low-cost firm.
Dominant firm as price leader: Market share isthe proportion of

total sales in the entire market. An experienced firm may enjoy the
maximum market share and can dictate price.
Barometric Price Leader: A firm has better knowledge of the prevailing
market conditions and changes in business environment It can
foresee, forecast and predict the future market. As an expert, the firm
fixes a price according to changes in demand and supply conditions.

Collusion: Price leadership is informal price acceptance by all firms,
under tacit collusion also, the firms agree to follow a price without
communicating to each other. Under open collusion, the firms as a
group explicitly communicate and agree for a price.
Cartel: Cartel is a formal collusive oligopoly. Group of firms get
together to make output and price decision. Overt collusion in termed
an cartel. Example OPEC as the international cartel.
Collusion may be either silent (not communicating) or denial

( not accepting others) or active participation as in cartel.
MARKET FAILURE
The automatic self- adjustment between demand and supply
forces will culminate in efficient outcome. In other words, self-interest
will lead to common- interest through market mechanism. The belief
in the free enterprise market economy is that invisible hand facilitates
the free play of demand and supply. The invisible handshake
supported by social cohesion will enable free play of market forces,
The invisible foot supported by judiciary and administration will
favour the smooth functioning of market economy.
But market failure happens under the following cases:
Excess Capacity: Market could not correct the underutilisation of
capacity by monopolists.
Even distribution: Inequality in income and wealth is inevitable.
Environmental protection: Market cannot deal with pollution
abatement and control of resource depletion
Non- Market Failure:
Government interferes with market. Government at times support the
functioning of market economy. Government failures are:
Over – regulation
Over – staffing / over payment
Over – building – undertaking new projects every time and not
spending for the maintenance of already existing old projects.
Bio – diversity failure:
The endangerment or extinction of any one species in flora and fauna,
implies impoverishment to the whole humanity.

Intensified and enhanced food production through irrigation, use of
NOTES
chemical fertiliser, plant – protection oriented insecticide and
pesticide have affected the crop varieties and cropping pattern and bio
diversity.
Human disturbances reduce the abundance of organisms.

Patterns of infectious diseases are sensitive to the disturbances.
Deforestation, land – use change, water management, dam
construction, urban sprawl affects infectious disease reservoirs.
Uncertainty in Decision Making

A better informed decision making will reduce the uncertainty
in business. The reason for the emergence of risk is lack of adequate
information. In principal agent set up, the principal cannot directly
observe the activities of the agent, all because of asymmetry in
information.
Some random / stochastic events can be expressed in terms of

mathematical likelihood called probability. Such risks are insurable,
as probability can be assigned to its occurrence. But some other
random / irregular occurrence cannot be related to probability. They
are uninsurable risk defined as uncertainty.
Game they fall in the category of analysing risk. Decision tree

analysis involves the guesses about probability of loss or profit for a
particular investment.
Along with probability assignment, the “expected utility” is

included in decision making under uncertainly. Expected utility,
though immeasurable, may be assessed or imputed indirectly through
willingness to pay principle or willingness to accept principle, among
polluter and pollute.

5.4ASYMMETRIC INFORMATION (AI)
Contrary to perfect knowledge in perfect competition market, the

reality is imperfect sharing of information. AI isUnequal knowledge of
relevant information, information advantage to one party only,
information disadvantage to the buyer, incomplete communication
and information gap, fake information unethically given by seller
Two outcomes of AI are
1. Adverse Selection
2. Moral Hazard
Adverse Selection:
It is hidden information problem. One of the parties in
transaction cannot observe the quality, cannot distinguish between
good and bag. Adverse Selection is choosing the wrong one.
Bad used car is regarded as LEMON, the improved new car is
cherries. Wronghealthcare insurance, choice of low skilled Labour to
employer, wrongly buying low return share.
Solutions
1. Screening: rejecting the bad, delaying the purchase
2.Signalling: Expensive action revealing / showcasing information. A
candidate for interview reached on time, nearly dressed, comes with
recommendation letter. Hyundai inverted for 10-year warranty as
signalling.
Moral Hazard: It is hidden action problem. It is also the PRINCIPAL-
AGENT Problem. when the principal (Shareholder- employer) is not
monitoring the behaviour of the agent (manager – worker) May turn
out to be shirking work, preferring leisure to work. To seek lower
premium insurance, a patient underreports his medical situation,
though he has family history of diseases.
Solutions: To mitigate moral hazards,
- Make information less asymmetric
- Rash driving driver of an insured car should be educated to
maintain the reputation of call drivers.

- A patient can go for second opinion.
NOTES
- Consumer report about quality
- Accompanying expert mechanic to buy good car.
5.5 CONCLUSION
Thus the subject matter of game theory is exactly those

interactions within a group of individuals (or governments, firms, etc.)
where the actions of each individual have an effect on the outcome
that is of interest to all. Yet, this is not enough for a situation to be a
proper subject of game theory: the interactions way that
individuals act has to be strategic, i.e., they should be aware of the
fact that their actions affect others.
The fact that my actions have an effect on the outcome does

not necessitate strategic behaviour, if I am not aware of that fact.
Therefore, we say that game theory studies strategic interaction
within a group of individuals. By strategic interaction we mean that
individuals know that their actions will have an effect on the outcome
and act accordingly.
5.5.1QUESTIONS FOR DISCUSSION
1 Explain the differences between the Cournot and Bertrand models

of competition; why are these models not true models of
interdependent behaviour?
2 Explain the following terms:
a. Dominant strategy b. Nash equilibrium c. Most favoured customer
clause d. Mixed strategies.

3 Explain the relationship between strategic moves, commitment and
credibility.
4 Explain how you would formulate a strategy for playing the paper–
rock– scissors game on a repeated basis.
5 Explain why it makes a difference in a repeated game if the end of
the game can be foreseen.
6 Explain why in ultimatum bargaining games the result is often a
fifty–fifty split between the players. Does this contradict the
predictions of game theory?
Case Study
The games people play11 Let’s have fun with game theory,
which can shed some light on the outcome of the monetary policy
dispute between Prime Minister Thaksin Shinawatra and former Bank
of Thailand governor MR Chatu Mongol Sonakul. Many might be
perplexed by Chatu Mongol’s abrupt dismissal after he refused to cave
in to the government’s demand to raise interest rates. But by applying
game theory to analyse the jostling between the two, one may find a
surprising answer and become more aware of the usefulness of the
tool. We know that Thaksin and Chatu Mongol took polar positions on
the issue and are by nature rather proud and stubborn. So let us
begin by constructing what the payoff matrix for the interest rate
policy would have been before Chatu Mongol was sacrificed. Faced
with Thaksin’s command to ‘review’ the central bank’s longstanding
low interest rate policy, Chatu Mongol could do one of two things –
concede toThaksin, or not give way. Similarly, Thaksin had two
options in dealing with the obstinate governor – either fire him or keep
him.In order to keep the game simple, we rank the preferences for the
possible outcomes from worst to best, and assign the
respectivepayoffsthenumbers1 through to 4. Chatu Mongol had made
it perfectly clear that he had no intention of changing the low interest
rate policy. Therefore, the worst outcome for Chatu Mongol was to
concede but then get fired, so that outcome would have a payoff of 1
for him.

The second worst outcome was to concede and not be fired, but that
NOTES
would leave Chatu Mongol with his integrity bruised and the central
bank with its independence impaired. The third worst outcome was
not to concede, and get fired. Though he might lose his job, he could
still maintain his integrity and time could prove his stance correct.
Chatu Mongol’s strongest preference was not to concede, but still
keep his job. This outcome would have a payoff of 4 for him. This
would mean he had beaten Thaksin in their two-way gamesmanship.
Meanwhile, the worst outcome for Thaksin would be for Chatu Mongol
to defy his demand, but to keep the maverick as central bank
governor. The second worst option was for Chatu Mongol to make a
concession, but for the PM to have to fire the governor anyway to
avoid future trouble. The next worst scenario was for Thaksin to fire
Chatu Mongol for his defiance. Thaksin’s highest preference was for
Chatu Mongol to fully agree with his demand so that he would not
have to get rid of him as governor.
Questions
1 Describe the type of game that is involved in the above situation.
2 Draw a game tree of the situation, with the appropriate payoffs.
3 Usingthebackwardinductionmethod, analysethe game tree and
explain the result observed.
Courtesy
1.Melbourne Business School-Managerial Economics
2.College of business administration King Saud university- al
Muzahimiyah branch Course Specification: Macroeconomics
3.Institute of Chartered Accountants of India-General Economics
4.BlackWell Publishing
5.School of Business Bangladesh Open University
6.Economic concepts, principles and market dynamics, Department of
Basic Education Republic Africa
7.Cliff Notes-Study Guide
8.Tushar Seth-Economics Discussion
9.Principle. of. Economics.By.Mankiw

10.Principles of Economics and Management-University of
Mumbai

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DIRECTORATE OF DISTANCE EDUCATION

SRM INSTITUTE OF SCIENCE AND TECHNOLOGY,

S.N NAME DESIGNATION ORGANISATION

Course Writer(s) Dr.P.S.Rajeswari

DIRECTORATE OF DISTANCE EDUCATION

3.9.2 Check your answers

MANAGERIAL (MICRO) ECONOMICS

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In this lesson we shall understand the basic concepts and functional

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Complete neutrality between ends is, however, neither feasible

Managerial economics is in intelligent application of

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1.1 MEANING OF MANAGERIAL ECONOMICS

Managerial economics is the science of directing scarce

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1.2.NATURE OF MANAGERIAL ECONOMICS

Economics is the study of choice. Its application in

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Publication of Adam Smith's The

In Smith's view, the ideal economy is a self-regulating market

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While Adam Smith emphasized the production of income,

Malthus cautioned law makers on the effects of poverty

Malthus also questioned the automatic tendency of a market

Coming at the end of the Classical tradition, John Stuart Mill

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Value theory was important in classical theory. Smith wrote

The Marxist school of economic thought

A body of theory later termed 'neoclassical

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Neoclassical economics is occasionally referred as orthodox

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Chicago School of economics

The Chicago School of economics is best known for its free

Milton Friedman effectively took many of the basic principles

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Other well-known schools or trends of thought referring to a

1.3 SCOPE OF ECONOMICS

The integration of conceptual Economics with business practices is

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Managerial Economics has winged its

At the core of economics is the notion that there are valuable

To work out whether value can be created between a buyer and

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At the core of economics is the notion that there are valuable

To work out whether value can be created between a buyer and

Having established that there is a value-creating trading

Businesses, such as General Motors, IBM or Time-Warner, are

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By bringing customers and suppliers together, businesses can

Value is not often a readily quantifiable concept. It cannot

The benefits a person derives from consuming an ice cream

By stepping into the shoes of key decision-makers, one can

We begin our study of decision-making with the simple case of

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Scarcity also plays vital role in dis

Opportunity cost is the sacrifice of the next best alternative. Rational

The basic economic problems in resource management are

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