``

ASIMPLE ANDEASY APPROACH

TOTHE STUDY OF

MANAGERIAL ECONOMICS

PROFESSOR ( Dr. ) GAURI MODWELL

DEAN ACADEMICS.
NEW DELHI INSTITUTE OF MANAGEMENT
(AICTE Approved )N.D.

Preface 1

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There is no shortage of textbooks on Managerial-economics in the market. Students of
management find most of these books tough and difficult to cope with. Reason is that
these books are meant for pure Economics students. Basic principles have been dealt
within these books. There is need to demarcate a clear line between the needs of
Economics students and students of management. These days graduates in science and
engineering also pursue management courses. They need a book that can present the
subject matter in a simple and easy manner. They do not take interest in books having
difficult explanations with local illustrations.

The present book has been designed in view of the above. The book covers
syllabus prescribed in most of the management institutes. Topics have been
explained in an easy and concise manner. Unnecessary diagram and equations
have been avoided. Only relevant numerical exercises have been provided. These
cases acquaint students with practical problems of real business issues. The
purpose is to enable students to deal with management decision making.

1. We hope that the present book will be very useful to the students of MBA/
PGDM.BBA, BBS,B.A. &B.COM . Students will develop clear understanding of
relevant concepts in an easy manner without much hassles.

Case studies have been discussed to help students analyze the complex issues faced
in real life business situations

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 PLAN OF THE BOOK

Topics have been selected on the basis of their usefulness in real life
business decision making.

The contents will sharpen analytical skills of students of Management

courses. The book starts with a description of some vital concepts of
Management economics such as profit, opportunity cost etc. Explicit costs
and implicit costs explanation of decision making process. To make, this
concepts easy to understand, case studies have been provided. The concept
of production possibility curve has been introduced.

No book on business Economics / Managerial- Economics can avoid

discussion of tools Like Demand. Supply and price-determination.
The discussion starts with the meaning of these terms, and goes on to
develop the topic to a higher level Method for calculation of Demand
function and supply of function have been explained. Students are
made aware of the procedure to find out the price of the product.
Methods to calculate Demand or supply of the product have been
explained in an easy to understand manner.

The tool of elasticity of demand is a practical concept In the world of

actual business. The calculation of elasticity of a product is highly useful.

In making changes in output and fixing the price of the product. This knowledge
is very significant to a firm in surviving in a competitive environment. Number of
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numerical problems have been incorporated. This description will enable students
to manage the issues related to elasticity.

3. Demand estimation and demand forecasting is a very important area of

management studies. This issue has been discussed incorporating various
methods of estimation and forecasting.

4. The managers and business executive are expected to possess good

knowledge of factors determining production behaviour. Different
variables have been explained with the help of easy examples and
diagrams.

The area of cost of production has been dealt in the book along with its
various variants. Cost value profit has been analyzed from a practical angle.
Discussion consists of method of calculate required, amount of profit and break-
even point etc.

Various firms operate under different market-conditions. Some firms

face tuff- competition and some firms work under limited competition. So
the pricing methods differ widely from each other, all of these features
have been incorporated in the book.

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 The working of cartels and quota system finds adequate place in the

discussion. The application of games theory in solving the problem of

choice in decision making has been analyzed.

Thus, it is going to be a great learning experience to the readers of this

book.Students will find this book useful for understanding various concepts

Of Managerial Economics /Business–Economics.This book will equip

students for meeting challengs of real management world.

Comments from students and teachers for further improvement in the

book are highly solicited .

Authors

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About the authors

Dr Hamideen Shah ,is an ex –principal of Z.H. Delhi College Evening,

University Of Delhi .At present ,he is a visiting Professor at N.D.I.M.,

Tughlakabad,New- Delhi .

Dr. Hamideen has also taught at the University of Basrah.Iraq.He has a long

teaching and research experience of more than 40 years.

Dr.Hamideen was on the panel of UNESCO. He presented research – papers

in international –conferences held in Bangkok and Beijing, Peoples Republic

of China .

He has good grasp of difficulties faced by students in understanding difficult

and tricky issues of Managerial –Economics .The book is an attempt to offer

easy solution to these –problems ,

Professor (Dr .) Gauri Modwel is an experienced and a distinguished

faculty.She is working as the Dean Academics at NEW DELHI INSTITUTE

OF MANAGEMENT, Approved by AICTE and Accredited by National

Board of Accreditation . She is heading Department of Economics .

She has a rich academic experience of 25 years in teaching and research in

various management institutions and research organization as Research and

Information System for the Non – aligned and other developing countries,

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New- Delhi .She has given consultancy to various research institutions

.Ministry of consumer ,WHO and Government of Maharashtra .

Acknowledgements

Authors are grateful to Shri V.M. Bansal ,chairman N.D.I.M. We highly

appreciate the inspiration and encouragement given by Shri V.M. Bansal, a

person whose constant and continuing endeavor is to see improvement in the

academic – content and training of students of management –studies .

We wish to thank our colleagues at NDIM for their cooperation and in

maintaining cordial atmosphere conducive for academic development at the

Institute.

Authors

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 List of contents

CHAPTER : 1 Introduction to Managerial –Economics Pages 13 --37

o Basic-concepts
o Process of Management decisions
o Opportunity-costs
o Explicit – cost, Implicit cost, Economic profit, numerical
o Production – possibility – curve
o Discounting and time-value numerical
OCase studies

Demand, Supply and price-mechanism 38 ---56

Demand, factors determining Demand
Demand-schedule numerical exceptions to the law of Demand
Supply, factors determining supply, supply-schedule
Equilibrium-price

3. Elasticity of Demand 57--------87

Price-elasticity of Demand: determinants of Demand, types, measurement,
numerical-problems, significance of the study of price-elasticity of Demand.

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 Income elasticity of Demand: types, measurement cross elasticity of Demand:
types, measurement cross elasticity of demand: implications, measurements
case-study.

4. Demand Estimation and forecasting: 88----96

Estimate and Forecasting
Quantitative-methods
Qualitative methods

5. Market System97------106
o Ideal – market
o Market failure
o 1111107Forms of state-interference
o Regulatory System in India
o Case studies

6. Production-function107----------129
o T.P. A.P. and M. P.
o Law of variable – proportions
o Returns to scale
o The law of Diminishing Marginal
Rate of Substitution
o ISO-quant’s, meaning , properties
o ISO-Cost-line
o Least – cost – combination
o Internal and external economies and diseconomies.
o Economies of scale and economies of scope

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 o Increasing – Returns to scale, constant rate of scale and diminishing
rate of returns.
o Ridge – lines,
0 case study
7. Cost theory130------145
o Fixed- factor and variable factors
o Short-period and long period
o T.F.C., T.V.C. & T .C.
o A.F.C. A.V.C. & ATC
o Shape of A.T.C. in the short-period
o Shape of L.P.A.C. in the long-period

o Relevant concepts like expansion Path, profit elasticity, output-

elasticity, production-tables operating leverage, breakeven point

8. Market-structure145-------157
Concept of equilibrium of firm
o Characteristics of perfect competition
o Short-period equilibrium , necessary and sufficient condition of
equilibrium
o Short period equilibrium
o Long-period equilibrium under perfect competition

9 Monopoly 158------165
o Characteristics of Monopoly
o Short period equilibrium under Monopoly
o Long period equilibrium under Monopoly

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 o Control of Monopoly
o Case study: Competition commission of India

10. Monopolistic – competition166-------173

o Main characteristics of Monopolistic- competition
o Short-period equilibrium under Monopolistic- competition
o Long period equilibrium under monopolistic competition.
o Concept of selling -cost
o Excess capacity under Monopolistic-competition

11 : Chapter173--------189
. Price-discrimination
Implications
Conditions- required
Types of price-discrimination
Dumping

12. Modern Pricing techniques 190-----194

13. Oligopoly – market 195 -----213

o Characteristics of Oligopoly
o Oligopoly-models:
o Cartel, Price Leadership, Market-sharing, Quota system. Kinked
demand curve

14. Game theory 214------223

o Implications
o Zero sum game, Non zero sum game, pays off

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 o Nash – equilibrium, Dominant – strategy, prisoner’s dilemma, maximin
strategy

15. Objectives of a firm 224---------228

o Sales-maximization
o Utility – maximization
o Growth maximization
LIST OF CASE STUDIES;
o Case study no. 1 :case of Xerox corporation
o Case study no. 2 Nokia :The deposed king of mobile phones
o Case study no.3 Business –management
o Case study no.4.producers vs.consumers
o Case no. 5 elasticity in Policy formulation
o Case no. 6 :case of Flipkart
o Case no. 7 case of SEBI
o Case no. 8 economies of scale in medical world
o Case no 9.The route to progress
o Case no. 10.A success-story
o Case no.11. Unique pricing
o Case no. 12 Bundling
o Case no. 13 Marriage between companies
o Case no 14. case of price –leadership
o Case no. 15 Incentive & efficiency

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 CHAPTER – I

Introduction to Managerial Economics

1. Need for Managerial Economics

2. Area of Study

3. Decision making Process

4. Common-usable Terms

5. Case Study

6. Explicit costs, implicit costs numerical

7. Net present Value

8. Production possibility – curve

9. Business – case Study

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Chapter I Introduction to Managerial Economics

1. Managers have to face certain situations in their career that can be better
understood and resolved on the basis of economic-theories and policies.

2. Economics develops thinking to deal with business.

3. Proper business decision-making requires knowledge of tools of Economics.

4. The Economic theories are made application based.

5. The above enables managers to understand and resolve their problems by

using economic tools.

6. The costs and benefits of a particular decision can be analyzed in a more

precise manner to get clear-results.

7. How individual decision makers or individual firms can be made to respond,

under the impact of economic incentives is an important subject matter in
Business. Economics

Area of Study:
Managers main concern is with sales, market share of their product concerned,
total –revenue and gross income etc.

Likewise – individual consumers main goal is, how to get maximum-

satisfaction.Sellers have to think about total volume of sales and cost of production.

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Applied Economics refers to the use of economic laws and theories in the analysis of
business-enterprises, this deals with relationship of enterprises with labour, capital
and product markets.

Features of Decision Making Process:

First of all, the nature of the problem has to be understood i.e. issues linked
with the problem.

Second step- is to be clear about the main objective. What needs to be done in
the larger interest of the enterprise?

Next-step is to study and find out the possible solution of the problem in the
light of the objectives set out by the enterprises.

The fourth-step is to use all the skills and knowledge to find out the best
possible solution of the problem, with which the management has been engrossed
with.

Final-step is to implement the decision/ policy which is considered as the best

in the larger interest of the enterprise.

To understand the above mentioned positions better read the real

example of an enterprise. Such studies are known as case-studies.

Common – practice:

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1. Enterprises appoint – production manager. Their job is related to minimization
of cost of production. Their main concern is to maximize production with the
help of available resources.

2. The issue of maximization of sales-revenue within the framework of a given

advertising budget.

3. Likewise maximization of profit becomes the job of the division’s president.

Common Terms used in this Study:

Students should be very clear about the meaning and implications of these
terms. This will help you to understand the subject in a convenient manner.

1. Scarcity: This is a reference to a quantity which goes on diminishing as its use

increases for – example; income to an individual is scarce. The more you use
it less shall be the quantity left with you.

2. Unlimited: This is opposite of scarcity like air, the quantity of which does not
diminish. Our wants are unlimited.

3. Needs: This is a reference to our basic requirements, such as need for food,
shelter and clothing.

4. Wants: Those items that we want to have, to make our living better, such as
better quality of TV’s, cars and jewelry etc.

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5. Resources: This is a reference to all those items which help us to produce
more goods. These are also known as inputs.

(A) Land: This includes not only the upper-crust of the soil, but what is available
inside earth and above it. These are provided to us by nature such as, water,
natural gas, oil etc.

(B) Labour: This is a reference to the doing-process in production. Labour is

manpower. This may be taken as physical power or skilled power.

(C) Capital: These are man-made items used to make various items of our need.
It is basically a reference to, factories, machines instruments etc.

These days human capital is also regarded as very important. This includes
innovation etc. The term Capital is also used in financial terms.

(D) Entrepreneurship: The act of taking-risk of ones investment in business is

known as entrepreneurship.

Investment is undertaken to earn more money.

The persons who possess this quality and bear the risk of business are known
as entrepreneurs.

E) Difference between goods and services: All those items which possess
physical shape and satisfy our need are known as goods.

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 Services: These also satisfy our needs but do not possess physical-shape such
as work of a doctor, work of a servant etc.
Classification of the products:

(A) Normal goods – these are those goods in which we find inverse relationship
between price of the product and the quantity demanded.

(B) Inferior – goods- In such goods we find direct relationship between price of
the product and the quantity demanded. Such as low quality of cooking-oil, low
quality of rice and cloth etc.
(C) Giffen- goods: These are lowest graded goods in the category of inferior-
goods. These are a part of inferior goods.
(D) Substitute goods: Take the case of coffee and tea.
(E) Complementary goods: Goods that are demanded together i.e. car and petrol.
(F) Autonomous – Demand: When the Demand of a product is not tied with
another product for example, demand for food grains, etc.

(G) Derived Demand: When the demand of a product is tied (linked) to some other
product for example, demand of cement has relation to the construction industry.

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CASE STUDY No. 1

Business Problems and Business Solutions

1. THE PROBLEM :
Xerox Corporation is remembered as a very strong and prosperous company
of America. It was a leading name in the field of copiers. Xerox Corporation was the
first-one to produce a photo-copier. So the company enjoyed all benefits of being
early-bird. This resulted in huge profits.

However, the situation changed, around 1979. Japanese companies developed

better quality copiers. These were economical in use and convenient to handle. The
Xerox corporation had to solve this problem.

2. Alternative Course of Action:

The top management of the Xerox-Corporation discussed various alternative
objectives to overcome the tight market-condition.

(i) One of the options was to leave the copier market.

(ii) To find another source of earning money.
(iii) To struggle in the competitive market.

3. Possible- Solution:
1. One of the possible solution was to improve the quality of the
machines.
2. To reduce – cost of production
3. To import cheaper parts from Japan

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 4. Another drastic solution was to transfer its manufacturing unit to its
subsidiary in Japan, known as Fuji-Xerox.

4. Selecting the best possible solution:

1. Xerox management decided to increase the involvement of Fuji Xerox.
This was expected to provide parts produced in Japan, at reduced rates.

2. Quality of product was expected to improve.

5. Implementation of the Decision:

1. The Japanese – subsidiary was selected to produce components of
better- quality and at competitive rates.
2. The Management starting rolling – downprograms for quality
control. Special attention was given to customer – satisfaction.

The Management also decided to learn and follow the Japanese production
process in order to survive in the market. This act is known as Benchmarking.

Meaning of Explicit Costs:

Monetary payments for resources owned by others outside the firm e.g. paying
wages to workers, paying rent, lease payments and bank interest charges etc.

Implicit Costs:
Opportunity costs of using self-owned resources (non-monetary) e.g. the value
of a business owner’s timeforegone. Rent of office /factory owned by the owner
foregone,used by the firm.

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The Concept of Opportunity Costs

The firm uses several inputs also known as resources for producing goods.

(A) One category is known as Market Supplied resources. These are those
resources for which payment is made to others parties. These inputs are either
purchased, rented or leased from others. Such inputs may be hired from the market.

(B) The other category is known as owner-supplied resources. This is a reference

to those resources which are owned by the producers themselves and are used in the
process of production. Such as self-land or self-capital, market value of owner’s time
used in the production process.

(C) Explicit – cost:

Money-payments made to owners of market – supplied resources such as
wages, salaries, rent and interest etc.

(D) Implicit –Cost: This is not judged in terms of money. This cost is the cost of
using owner – supplied resources (is the same would have been used by other firms)
for example, if the owner would have provided his services to another firm. He
sacrifices this amount by working for his own firm by not accepting payment. This is
also known as opportunity cost. To avail the present opportunity how much do you
give-up, in monetary and non-monetary form.

Another example: by providing his own – capital to the company & his own
land etc.

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Total Economic Cost: This is the sum total of explicit cost plus implicit costs. Or in
other worlds, this is taken as the total of opportunity cost of market – supplied
resources as well as owner supplied resources.

Difference between Economic profit and Accounting profit: Economic profit is

the surplus over economic-costs.

Economic – Profit= Total revenue – total economic cost

Economic profit = Total revenue – explicit cost – implicit cost.

In contrast to the above, the Accounting – profit does not take into account, the
implicit costs.

Accounting profit = Total revenue – explicit – costs.

Note: Numerical problems will make the above concepts more clear.

Problems:
No. (1) A qualified engineer wants to further improve his qualifications. The
projected cost of undertaking the training – course is given below. Find out, the total
economic cost, explicit cost and implicit cost of this venture.

• The fee for the training program is 3000. The food will cost 1500 and the
room rent will be 1000. Miscellaneous expenses will be 500.

• If he decides not to join the above training program, he can deposit the money
with a bank and he can earn 10 percent interest on the above amount.

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 • The said engineer can earn Rs. 20,000 by way of salary if he opts for a job and
not for training.

Answer:
The explicit costs are the following:
(i) 3000 for training fees
(ii) 1500 for food
(iii) 500 miscellaneous
= Total = 6,000 per year.

The implicit cost may be calculated as follows:-

(i) Rs. 20,000that he foregoes by not joining the job
(ii) Interest income that he foregoes by not putting the money with the
bank 500/- so implicit cost = 20,000 + 500 = 20,500
Thus, the total economic cost = 6,000 + 20,500 = 25,500/-
Economic – costs include explicit cost + implicit – cost.

Problem No. 2:
Mr. Avinash is employed in Apollo Hospital at the rate of Rs. 30,000/-. He is
considering a proposal to start his own clinic. The project report gives the following
information . The interest rate is 5 percent.

(i) An Investment of 2,00,000

(ii) Expected income 90,000
(iii) Cost of material 40,000
consumables etc.
(iv) Advertising expenditure 10,000
(v) Office establishment 10,000

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(v) Miscellaneous-expenses 10,000
SolutionNet – accounting profit = 90,000 – 40,000 + 30,0000 = 20,000

Interest foregone is 10,000. This is implicit cost. This is called as opportunity

– cost.

The present salary of the doctor that he will have to forego to establish his
clinic is 30,000/- This is also an implicit cost. The total implicit cost is 10,000 +
30,000 = 40,000.

Important notes:
Economic cost is the monetary value of all inputs used in a particular
economic activity over a given period.

Problem No. 3:
Mr. Sahil went on a trip to Benaras. He bought some silk material from
Benaras at the rate of Rs. 50 per meter.

Mr. Sahil Contacted few traders in Jaipur. He received an offer of Rs. 150 per
meter.

Sahil is an enterprising person. He thought of converting this material into dresses.

Calculations were carried out regarding the alternative. Each dress needed four
meters of material. Furthermore, this work also needed four hours of his time. The
money value of Mr. Sahil’s one hour was estimated to be Rs. 100.

The dress is likely to be sold for Rs. 900 each. Find out whether this venture
would provide positive economic profit to Mr. Sahil?

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Solution:
There are two implicit cost:-
(i) Opportunity cost of Sahil’s own time = Rs. 100
(ii) Opportunity cost, of the income from the
Alternative, that Sahil can receive by
Selling the material. = Rs. 150

Opportunity – cost
Thus, the cost will be
(i) 4 hour of labour = Rs. 400
(ii) 4 meters of material = Rs. 600

Total cost = Rs.1000

Revenue is only = Rs. 900
Economic profit/loss (-) Rs. 100
By calculating only the explicit cost, the profit would be Rs. 700
Problem: Calculate explicit cost and implicit cost from the following:-
Wages to employees 6000
Office Supplies 400
Rent foregone on self-owned building 1000
Interest foregone on self-owned funds 700
Interest paid to a Bank 500
Monthly equipment Leasing charges 800
Answer:
Find out explicit cost and implicit cost
Explicit costs = 6000 + 400 + 500 + 800 = 7700
Implicit costs = 1000 + 700 = 1700

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Problem ;
Mr. Robin works as a Sole proprietor and his business reported a net- income
of Rs. 30,000 for the year. Since a sale proprietor does not receive a salary / wages.
There is no explicit cost in this business.

Mr. Robin, had an offer of Rs. 40,000 for a job in another company. He
foregoes this amount to carry-out his own business. The Rs. 40,000 is the implicit
cost for his company. After considering this implicit cost, Robin is losing Rs.10,000
by working in his firm.

The business owner’s salary is an implicit-cost. In the case of a small

business, the owner foregoes salary in the early days of the company is quite a
common practice. This decreases the cost burden on the company.

Definition of net-present value:

The difference between the present value of cash inflows and present value of
cash-outflows:

NPV is used to analyze the profitability of an investment (referred as project).

Determining the value of a project is a difficult job. Different methods are

used to calculate the value of future cash flows:

Money has time value, because of this, a rupee earned in the future is not
worth as much as one earned today. The discount rate in the NPV formula is away
to account for this.

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 Net present value is a method of determining the current value of all future
cash flows generated by a project.

Example of calculation of Net-Present Value: No.1

Management wants to invest in a new project. They are going to invest
5,00,000 for the development of the new project.

The company estimates that the first-year cash flow will be 2,00,000, the
second year cash flow will be 3,00,000 and the third year cash-flow to be 2,00,000.
The expected return of 10 percent is applicable. (interest rate)
Using the formula
NPV = - 5,00,000 + 2,00,000 + 3,00,000 + 2,00,000
1.10 1.102 1.103

Year Cash flow Present-value

0 5,00,000 5,00,000
1 2,00,000 1,81,818.18
2 3,00,000 2,47,933.89
3 2,00,000 1,50,262.96

Net present value = 80,015.02

This new project would be estimated to be a valuable venture

NPV is used to analyze the profitability of an investment/ project

Q.2 Assume a company is planning to invest $ 9,000 in a project. The project is

expected to have a life of four years.

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 The expected cash flows at the end of each of the next four years are $ 2,000 $
3,000, $ 3,000 and $ 4,000. The rate of interest is 10 percent.
PV = Future value
(1 + r)n
PV = $ 2,000- (1.10)1 = $ 1,818.18
PV = $ 3,000/(1.10)2 = $ 2,479.34
P.V. = $ 3,000/ (1.10)3 = $ 2,732.05
P.V. = $ 4,000/(1.10)4 = $ 2,732.05

PVo = -9,000.0
1,818.18
2,479.34
2,253.94
2,732.05
NPV = $283.51
A positive NPV means the combined PV of all cash inflows exceeds the PV of
cash outflows

In our example the NPV of $ 283.51 suggests that the combined PV of all cash
inflows exceeds the PV of cash outflows by $ 283.51

This is a good investment since it adds $ 283.51 to the value of the company.
- Value would need to be positive in order to be considered a valuable investment.

For making, a decision regarding investment which will yield a return over a
period of time, it is, therefore, advisable to find its net – present worth. Unless future

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returns are discounted to find their present worth, it is not possible to judge whether
or not it is worth undertaking the investment today.

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Production – possibility –curve
The figure shows the combinations of two goods that a company or economy
can produce. Points within the curve, like the point A, are considered inefficient
because the maximum combination of the two-goods is not reached. While points
outside of the curve, like point B, cannot exist because they require a higher level of
efficiencythan what is currently possible.
Production points outside the curve can only be reached by an increase in
resources or by improvements to technology. The curve represents maximum
efficiency.
A well-known example of PPF in practice is the “guns and butter” model. This
shows the combinations of defense spending and civilian spending that a government
can support. More a government spends on defense, the less it can spend on non-
defense-items.
The P.P.C. shows variousproduction possibilities. The production possibility
curve in fact, shows the opportunity cost, when the firm moves from one possibility
point to another point, The rate of transformation increases as we move from point
B to Cand to D.The opportunity cost keeps on increasing.The manager has to
minimize the opportunity cost.

Capital Goods

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Case study No: 2NOKIA
The deposed-king of mobile phones
The case of missed opportunities:-
Everyone knows Nokia the cell phone company, but no one really knows “about”
them.

Nokia started in 1865 as a small timber concern in rural Finland. In the 1970’s
and 80’s company was transformed into a diversified, global corporation that led
many extraordinary advances in portable communications. At one stage, Nokia used
to make about one out of every three cell-phones in the world.

Nokia’s leadership recognized that in this ‘changing new environment, the

ability to segment markets and target niche segments within those markets was
critical to success, in order to compete, Nokia would need to focus globally.

Nokia treated its Human Resource Management as a strategic issue. However,

Nokia spent less than, its rivals on research and development.

There is little doubt Nokia is in a tough place right now. It is losing money
and struggling to make in- roads into the smart phone market. And all this despite
producing a new range of pretty good devices.The trouble is, this Finish handset
maker.Just cannot get back the momentum it lost to apple, Google, and Samsung
over the last few years.

Experts have suggested the following steps to redemption.

(1) To cut- the mess of systems and services Nokia was trying to balance.
(2) Nokia should not make too many products

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Problems of Nokia
Compared to the same quarter last year, Nokia’s overall revenue is down 29
percent to $ 9.7 billion. The company is now losing money. Nokia’s net cash went
down 24 p.c. in one year.

Bad things happen to cash when the market loses confidence in a company’s
future, vendors want to be paid more quickly, customers become more hesitant, all
precipitating a crisis. We all agree that never under-estimate intense competition.
Do not rest on laurels. Be modest, flexible and open to change.

Questions:
(1) What made Nokia to occupy the number one position?
(2) What made Nokia to lose its position of prominence?
(3) What is the future of Nokia?
(4) What steps would you recommend for a better future of Nokia?

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Exercisesfor Students:

Q.No. 1 What do you understand by

a) Explicit – costs (b) Implicit – cost
2) In what aspect Economic profit is different from Business profit
(3) A running garments show-room is being offered for sale. This involves Rs.
80,000 for maintaining supplies, Rs. 10,000 expenses as rent for the show-room, and
miscellaneous expenses Rs. 5000 and for payment to employees Rs. 40,000.

A businessman Harpreet Singh is planning to purchase this show-room. The

show-room is expected to provide an income of Rs. 2,00,000/- per year. Harpreet has
to invest Rs. 20,000 and will need to borrow Rs. 80,000at an interest rate of 10
percent per year. Harpreet has to give up his present job of Rs. 40,000.
(a) Calculate accounting profit
(b) Calculate Economic profit
(c) What should be the choice of Harpreet Singh

Q.No.4What do you understand by net present value?

Q.No.5 What is the significance of the concept of net present value?

Q.No.6 Calculate the present value of Rs. 100 which is due after one-year. The
imaginary rate of interest is 10 percent.

Q.No.7Calculate the discounted value of a prospective yield of a project in the first,

second, third, fourth and fifth year is Rs.1,000, Rs.1000, Rs. 850 and Rs. 700
in the successive years. The applicable rate of interest is 5 percent.

34
Q.8 What is the significance of production possibility- curve

Question No. 9:
A small farmer grows wheat. He manages to grow 20 bushels of wheat, which
he can sell for $ 5 per bushel. This means, of course that his total – revenue is $ 5
time, the 20 bushels, or $ 100. The farmer’s explicit costs of production are $ 40.

Acc. Profit = T.R. explicit cost

= 100-40 = 60

Suppose for every hour he can earn $ 5 per hour in the city .

For every hour he spends farming, he sacrifices $ 5 salary elsewhere. So if for

example farming is a round the clock job. His implicit cost will be $120 Should he
take up thejob in the city?

Case Study no.3 Business Management

How business firms can take advantages of the rules of the land. A careful and well-
thought out plan is made and implemented to the full advantage of the company.

Reliance industries do not produce petrochemical grade naphtha for its Hazira
facility. Therefore, its plant at Hazira imports the same. The terms of trade are very
interesting. Reliance unit at Jam Nagar sells another grade of naphtha in the foreign
market.

Reliance company saves 24 percent sales tax, by not purchasing the product
locally and by importing from abroad.

35
 On the other hand, Reliance will also be entitled for a 10 percent duty
drawback on its crude imports if it exports naphtha from the refinery at Jam Nagar.

As per reports appearing in Economic times, three cargoes of 50,000 tons each
were to be exported every month from Reliance Jam Nagar refinery. As per this
agreement known as swap deal three cargoes of the same amount were to be
imported by Reliance at Hazira Unit. This deal was done with Japanese companies.

Questions:
1. What would be the strategic reason behind the decision to import and export
naphtha?

2. Is the above practice legal?

Case Studies No. 4

Whether to help producers or to protect consumers ?
The large firms own and control new machines, new technical processes and
new products. Such firms get their products patented by the competent authorities. A
check is imposed on the use of those machines etc. There are several forms of patents
such as copyrights etc. This gives exclusive right of use to the firm (that has been
assigned the copyright. This does not permit, spread of information from the copy-
righted works. Under the patent Laws, reproduction and display of copyrighted book
is not allowed (without written permission of the copy right holder).

However, there are few exceptions to this arrangement for example

reprographic copying is permitted in educational establishments subjects to certain
conditions.

36
 The copy-right is justified on the ground that this system would encourage
creation of new works. . It is reported that copying of books, magazine remain a
popular practice. This causes monetary loss to the original writers of text-books etc.

A court case was filed in the Delhi High Courts against a photocopier agency
having its business of photocopying in university area. The students body was not
happy with this development. They wanted this facility to continue. They wanted
books to be photocopied for them. Otherwise they would not afford an expensive
textbooks etc.

The publishers lobby argued against this kind of facility. The strongly opposed
sale and distribution of text books by the unlicensed agency on the university of
Delhi campus.

Another suggestion was also put-up. It was proposed that the academic
institutes may apply for license against yearly payment of 12,000 rupees. But this
suggestion was not accepted

The publisher’s lobby pointed out that other countries also do not allow this
type of practice.

Questions:

1 What is the need for Government interference in the business matters of

the country?

2. What are the various forms of patents?

37
3. What is your opinion about the controversy discussed in the above
written case?

38
 Chapter : 2

Study of Demand, Supply And Price – determination

A. Study of Demand:

(i) Definition, Factors determining Demand

(ii) Demand Schedule and Demand Curve
(iii) Reasons for downward slopingdemand curve
(iv) Factors determining Demand
(v) Derivation of Demand – function
(vi) Exceptions to the Law of Demand.

B. Study of Supply
Definition, Factors determining supply

C. Process of Price-determination

d) Numericals on Demand, Supply and equilibrium price

39
Study of Demand:

Preview: M. Micky is a senior officer of a big conglomerate. He was conducting

a meeting of his subordinates. He wants to know the latest status of his
company’s products in the market. Mr. Hari reported that the sale of
product-A was not picking up. Because the income of the buyers is not
rising. Mr. Bajwa reported that the product B is facing tough
competition in the market. Rivals have reduced price.Mr. Ravi,
reported that the demand of the product C, is adversely affected by the
change in fashion. However, there was a good news as well, product D,
the sale of engine oil etc. was picking up, due to rise in the sales of
auto-cars.

Meaning of Demand:
Demand refers to a quantity of a product that a consumer wants to purchase at
a particular price, at a particular point of time, in the market.

Law of Demand:

Other things remaining same, as price of the product decreases, the quantity –
demanded increases, and vice-versa.

Demand – Schedule:

It is a presentation of the opposite relationship between quantity – demanded

(Demand) and the price of the product in the form of a table

40
 Price (Rs. Per unit) Qty.
Demanded (in
KGs.)
P1 Q5
P2 Q4
P3 Q3
P4 Q2
P5 Q1

Demand Curve:
This is a graphical method of showing the opposite relationship between
quantity demanded and the price of the product. The Demand-curve takes a
downward sloping shape; otherwise, the opposite relationship cannot be shown. Price
of the product is shown on the vertical axis and the quantitydemanded is shown on
X-axis.

Determinants of Demand:
1. Price of the product: At higher price, buyers purchase less amount of the
product and vice-versa, other factors remaining constant.
2. Price of related goods: In case of complements like car and petrol, we find
direct relation between the products.
In case of substitutes goods, if price of X-good increases, then demand of the
substitute – y good will increase.
3. Tastes of Consumers: Consumers like to purchase more of the good for
which they have preference, for example, vegetarians do not spend money on
non-vegetarian products (irrespective of the price of the non-vegetarian
product).

41
 4. Number of consumers in the market: The more the number of consumers,
greater will be the increase in the demand of the product.
5. Income of the Consumers: If the income of the consumers increases, then the
demand of the product will also increase, due to more purchasing power in the
hands of buyers.
6. Expected price of the product: Other things remaining same, if consumers
expect the price of the product to increase in the future, then they purchase
more of the same product, today.

Demand function:
Demand depends on price of the product other variables remaining constant. In other
words, Demand is a function (f)of price. This is written as follows: Qd = f (p). This is
called simple Demand-function.

General Demand Function:

This incorporates other variables also
Qd = f (P,M, PR, T, PE, N)
If we put the slope parameters, as shown below, then we can measure effect
on Qd of a change in one of the variables.

Qd = a + bP + c M + d PR + eT + f PE + gN
Here b, c, d, e, f and g are slope parameters. Each parameter shows the relation of
variable factor to Qd.

(i) Price and Qd have an inverse relationship; this is shown by negative-slope.

(ii) M (Income): It is a two-way relationship

42
 It is a positive relationship for Normal-goods
It is a negative relationship for inferior good

(iii) For T, PE and N, direct relationship, shown by positive slope.

iv) PR = Direct for substitutes, .Price of Tea increases ,shown on Y -axis

,consequently demand of coffee increases .,as shown on X-axis .

Difference between individual

Demand and Market-Demand
Schedule:

• Qty. demanded by an individual

consumer of a particular commodity, is

known as individual demand.

• Qty. demanded by all the consumers of a particular commodity is known as

Market-Demand

• If individual demand of an individual-consumer is shown in a tabular-form,

then it is known as individual demand schedule.

• On the other hand, if total demand for all the consumers in the market is

shown in a tabular form then it is known as Market Demand-Curve.

Difference between changes in Qty. demanded and Shift in Demand.

43
A. If the change in Demand is due to change in price of the product, then it is
known as change in Qty. demanded. The change is shown on a particular
curve. This is also known as contraction and extension in Demand.
B. On the other hand if the change in Demand is due to change in Non-price
factors, then it is known as shift in Demand (upwards or downwards) The shift
in Demand-curve is caused by change in consumer-income, prices of related
goods, tastes, expectation of future price and number of buyers.

44
45
Why does the Demand-curve slope downwards?
Explanation of Law of Demand:

(1) Income effect: As the price of the product increases, the capacity of the
consumer to purchase the product decreases. This is called reduction in Real-
income. So the quantity – demanded will decrease, other things remaining
same.

(2) Substitution effect: The price of x-good falls, it appears cheaper than other
products. So more quantity is demanded of the cheaper product, Consumers
want to take advantage of the product, that has become cheaper than other
similar products for example, cheaper vegetables and cheaper fruits are
purchased more as compared to others.

(3) Change in the number of buyers: After the fall in the price, the product
enters into the budget of low, income families. The Demand increases, due to
emergence of additional buyers.

(4) Impact of diminishing Marginal Utility: The additional units of the product
provide diminishing utility to the consumers. So they stop purchasing the
product. But when the price falls, they start purchasing more.

Exceptions to the Law of Demand:

There are few cases in which the Law of Demand does not apply. We may find direct
relationship; between demand of the product and the price of the product.

46
In case of Giffen goods, it has been observed that these products are demanded more,
when the price of such-goods increases.

O During a period of natural calamity, riots, drought, war etc. we may find more
demand at higher price.
O Veblen effect: The demand of very expensive items like diamonds &jewelry is
found to be high, at a high price such goods have a “Snob-value”.
O Future – expectations: If consumers expect price of the product to increase in
future, they start purchasing more quantity of the product in the current period.

47
Study of Supply

Meaning of Supply:
Supply refers to the quantity of a product which is offered for sale at a
particular price in the market at a particular time. If a producer produced 200 Kg of a
product, but he is willing to sell only 100 kgs of the product, then, the supply of the
product in this case is 100 kgs.

Law of Supply:
Other things remaining same, as the price of the product increases, the
quantity supplied by the producer in the market, also increases. Thus, there is a direct
relation between price and supply of the product.

Supply schedule (individual supply schedule)

The tabular representation of the direct relationship between price and supply
of the product is known as supply – schedule.

Supply – Curve:
The graphical representation of the direct relationship between price and
supply of the product is known as supply – curve. This curve is an upward sloping –
curve from left to right.

48
Market Supply Schedule:

This shows the direct relation between price of the product and the total
supply of the product in the market.

Determinants of supply:
The quantity supplied of a product depends on the following factors-:
(1) Price: This is the most important-factor in determining the quantity of the
product being supplied in the market. Increase in price implies more income to
the producers, therefore, they try to produce more and supply more.

(2) Input prices (PI): Decline in inputs prices used in production of the product,
enables producers to produce more and supply more.

(3) Prices of goods related in production (PR): If producers find a better

opportunity to earn money, as compared to x-good, then they shift to other
product.

(4) Technological – advances (T): New technology and new machines enable
producers to increase production with the use of available resources.

(5) Expected future price of the product (PE): If producers expect the price of the
product to increase in future. They produce less in the current period.

(6) Number of firms producing product (F): An increase in the number of firms
producing the product, x, will result in more production, and more supply of
the product.

49
Direct-supply Function:
The supply-function, shows how quantity – supplied is related to product
price, when all other variables are held constant.
Q s = f (P)

(i) Relation between price and quantity -supplied is positive.

(ii) Technological improvement and quantity supplied have positive
relationship.
(iii) Number of firms are directly related to quantity supplied. This is a
positive relationship.
(iv)
(a) Relationship with substitutes is negative and with complements is
positive.
(b) Input-prices and qty. supplied are inversely related. This relationship is
negative.

General Supply Function:

Qs = F (P, P1, PR, T, P, F)
We put the slope parameters in the General Supply Function F, K, l, m, n, r and s to
obtain the General Supply-function

50
Increase in supply due to increase in prices. This is known as movement along –
supply – curve”. (also known as expansion or contraction in supply)
Diagram No. 2.7 shows:
Increase in supply at the same price. It is due to change in non-price factors.
This is called as shift in supply-curve, rightwards leftwards

51
Determination of price

The process of price – determination is an interesting issue:

How the price of a product is determined? To understand this, we have to
keep in mind that the price is paid by the buyers and the product is sold by the sellers.
So, these two parties become important in determining the price. Buyers want to
pay minimum possible price for the product. On the other hand, the sellers want to
obtain maximum possible price. Both parties try to fulfill their respective interests.
As a result of this fluctuation in price keeps on taking place. Ultimately, a stage
arrives when the buyers accept a particular-price, as the optimum price (minimum-
price) and the said price is accepted by the sellers as the optimum-price (maximum
possible-price). This particular price is set by the intersection between Demand curve
and supply curve. The quantity demanded of the product is just equal to quantity
supplied at this point.

The above process is the result of the working of Demand and supply forces.
Any change in any of these two forces or change in both of them will cause a change
in the market-price.

Increase in Demand above supply, results in higher-price and vice-versa.More

supply as compared to Demand, results in lower price & vice-versa.

52
 But, if both of them change simultaneously, then price may increase or
decrease or remain the same. It would depend on the relative impact of change in
Demand and Supply.

Derivation of Demand – Function:

A general demand function is given below:
Q.N.1 = 4000 – 10 P + 0.5 (60000) – 24 (200)
= 4000 – 10 P + 3000-4800
= 4000 – 10 P – 1800
= 2200 – 10 P
In the above case the demand function = Qd = 1400 – 10 P
Q.2 A general demand function for good x-is given below calculate the qty.
demanded of good x,
Qd = 600 – 4 Pa – 0.03M – 12 PR + 15 T + 6 PE + 1.5 N
In this case, PX = price of good X
M = Income, PR = price of related good B
T = consumer taste PE expected price of the product in future
Pa = 5 PR = 40 T = 6.5 M = 2500
PE = 5.25 and N = 2000
Qd = 600-4 (5) – 0.03 (25000) – 12 (40) + 15 (6.5) + 6 (5.25) + 1.5 (2000)
= 2479.0 Units of good-x per month
Derivation Of Demand Function

Q.3
Derive the equation for the Demand – function
Qd = 8000 – 16 P + 0.75 M + 30 Pr
Where M = $ 30000 and Pr = 50
Qd = 8000 – 18 P + 0.75 (30000) 30 (50),

53
 = 8000 – 18 P + 22500 + 1500
= 3200 – 16 P

Q.No.4
Q.No. Find out the Demand function?
Given P = 3000 – 2Q
2 Q = 3000 – P
Q = 3000 – P
2
Ans. Q = 1500 – 0.5 P

Q.5 Calculate – equilibrium Quantity and Price

(a) The Demand – Curve is
QD = 100 – 0.75 P
(b) The supply – curve is given by
Qs = 80 + 0.25 P
On the basis of above find equilibrium price and quantity
QD = Qs = Q
100 – 0.75 P = 80 + 0.25 P
100 – 80 = 0.25 P + 0.75 P
$ 20 = P
Q = 100 – 0.75 P
Q = 100 – 0.75 (20) = 85
Or
Q = 80 + 0.25 P
Q = 80 + 0.25 (20) = 85
= 80 + 5 = 85
Answer

54
Problem (6) Solve equilibrium price, and quantity Mathematically. Find
equilibrium. Price and quantity
Answer:
Steps:
(1) Solve the demand & supply functions interms of quantity
(2) Set Qs = Qd / qty. equal to each other
(3) Solve for P or equilibrium Price
(4) Take price to Qd & Qs function to find equilibrium quantity demanded and
supplied.
if Qd = 10000 – 80P
80P= 10,000 – Qd
P = 10000– Qd
80 80
Qd = 10,000 – 80P
Qs = 20P
10,000 – 80p = 20P
10000 = 100 P
100 = P
(This is equ. Price = 100)
Now we put this 100 P in the Demand
Equ. Price = 100
Qs = 20 P = 20*100 = 2000 so equilibrium quantity should be 2000
Qd = 10,000 – 80 P
= 10,000 – 8000 = 2000
This is equ. Demand this qty. demanded is equal to qty. supplied
Q.No.7 Calculate equilibrium Quantity and price

55
Given the following inverse demand and supply-curves calculate equ. Price and
quantity.
P = 300 – 2 Q
And
P = 50 + 3 Q
Equate P
300 – 2 Q = 50 + 3Q
300 – 50 = 3Q + 2 Q
250 = 5 Q
50 = Q
P = 300 – 2 Q
P = 300 -2 (50) = $ 200
Or
P = 50 + 3 Q
P = 50 + 3 (50) = 200
Answer
Q.8 Find out the supply – function?
Given P = 50 + 3 Q
Demand – curve is
1) Qd = 100 – 0.75 P
2) Supply – curve is given by
Qs = 80 + 0.25 P
Find the equilibrium price and quantity?
Qd = Qs
100 – 0.75 P = 80 + 0.25 P
100 – 80 = 0.25 P + 0.75 P
20 = P
Q.= 100 – 0.75 P

56
 Q= 100 – 0.75 (20) = 85
Or
Q = 80 + 0.25 P
Q = 80 + 0.25 P
Q = 80 + 0.25 P (20) = 85
Q.No. 9
Given the following inverse demand and supply-schedules . Calculate
equilibrium price and quantity.
P = 300 - 2 Q
And
P = 50 + 3 Q
Equate p
300 -2 Q = 50 + 3 Q
300 – 50 = 3 Q + 2 Q
250 = 5 Q
50 = Q
P = 300 – 2 Q
P = 300 – 2 (50) = $ 200
Or
P = 50 + 3 Q
= 50 + 3 (50) = $200

57
Exercises for Students:

Q.1 Using an example, identify and explain the effect of a change in three non-
price determinants of demand on the quantity for the good.

Q.2 Distinguish between “a movement along the demand” – curve and a shift of
the demand – curve. Give diagram to explain your answer.

Q.3 Describe the determinants of supply.

Q.4 Find the supply-function from the following information

Suppose the general supply function
Q5. 100 + 20P – 10 Pi + 20F
Price of the inputs 100
Number of firms 25

Q.5 Explain the determinants of supply?

Q.6 Why more is purchased at a lower price?

Q.7 What is the relation between inferior-goods and Giffen-goods.

58
 Chapter – 3

STUDY OF ELASTICITY OF DEMAND

[A] Study of Price-elasticity of Demand

(i) Meaning and formula

(ii) Percentage-method & Point-method of calculation of price elasticity of

Demand, types of price elasticity of demand.

(iii) Arc Price elasticity of Demand

(iv) Factors determining price elasticity of Demand.

(v) Significance of the study of price-elasticity of Demand.

[B] Income elasticity of Demand

[C] Cross elasticity of Demand.

[D] Price-elasticity of supply

59
 Price Elasticity of Demand

Meaning:

This refers to price sensitivity. If a small change in price is accompanied by a

large change in quantity demanded, the product is said to be elastic. On the other
hand, a product is inelastic if a large change in price is accompanied by a small
amount of change in quantity demanded.

Price elasticity of demand measures the responsiveness of demand to changes

in price for a particular good. Percentage change in quantity demand divided by the
percentage change in price.

Type of price elasticity of demand or values for price elasticity of demand

1) If demand does not change at all due to price change, then, this is known as
perfectly-Inelastic Demand. The value of price elasticity of Demand – Zero. Example
salt .The demand – curve is vertical. See diagram number 1.

2. Inelastic Demand:
Change in demand, NH1 is less than the change in price PP1. The value of P.ed
is between zero and one (say 0.4, 0.6 etc.) see diagram number 2.

3. Unit elastic-Demand.
In this case, change in demand is exactly the same as the change in price. The
value of P.ed is equal to one. See figure no.3

(4) Elastic – Demand.

60
The change in Demand, KK1, is greater than the change in price PP1. The value of
P.ed is greater than one (say 1.3 or 1.6 etc). See figure number 4.

(5) Perfectly-elastic Demand

Change in supply brings no change in price. The value of P.ed is equal to
infinity. See diagram No. At a particular price, Demand becomes infinite.
No. 1 No. 2

No.2No.4

NO: 3 NO: 4

61
NO:5

Factors affecting the price elasticity of demand.

(1) Availability of substitutes: the more the number of substitutes, the greater is
the elasticity. It is easy to shift from x-product to other products.

(2) Degree of necessity: Necessity products have inelastic demand. Luxury

products tend to have greater elasticity.

(3) Proportion of the buyer’s budget spent on a particular item. Products that
consume a large portion of the buyer’s budget tend to have greater elasticity.

(4) Time period Considered: Elasticity tends to be greater over the long-run
because buyers have more time to adjust to change in pri

Who makes the payment: Where the purchaser does not directly pay for the
good they consume, such as perks enjoyed by employees demand is likely to be
more inelastic.

62
Brand Loyalty: An attachment to a certain brand either can override
sensitivity to price changes, resulting in more inelastic demand.
Number of uses
-------------------
The number of uses to which the commodity can be put in is an important
factor determining elasticity.Ifthe commodity can be put to several uses then
the elasticity will be greater.
.

(5) Price-range: high priced items have elastic demand Price elastic demand is
always negative, due to inverse relationship between price and demand.

Methods to measure price Elasticity of Demand: The following formula is used

Q P here Q change in Demand

------ ------------
z P change in price
P q ----

P initial-price

Q initial demand

Problem
If price falls from Rs. 50 to 48 and consequently demand increases from 100
to 110 calculate P.ed.

. Q P
P.Ed= ------ X ----

63
 P Q

= 10 50
----- ------ = 2.5
2 100

Note:

Above formula can be rewritten

P
EP = a1 ------
Q

Q
----- is given by a1.
P

The estimated co-efficient of P

Problem: Find point price-elasticity of demand if price is Rs.10 and

Qd = 100 – 4 P

P
P.ed = a1 ----
Q

A1 = -4/Rs. 1 Qd = 100 – 4x10 = 60

10
P.Ed = -4 X ------ = - 0.67 Answer
60

Calculation of P.ed on a linear Demand – curve

Q
The formula = Q p
------ X ----
Y P Q

64
 A
6

5 B

4 C

3 F

2 G

1 H

0 J DX

100 200 300 400 500 600 K

65
A Point = (6) =
0

B Point = (5) = 5 P.ed> 1 less than one

1

C Point = (4) = 2 P.ed> 1

2

F Point = (3) = P.ed 1

3

H Point = (1) = 1/5 (inelastic)

5

J Point = (0) = -0 Perfectly inelastic

6

A tangent is drawn at the point on the demand-curve whose elasticity is to be

found.
The elasticity of demand at that point is simply the ratio of the two portions of
the tangent.

Point elasticity = Lower segment of the tangent

Of demand upper segment of the tangent

Arc Elasticity of Demand

The method of Arc elasticity of Demand is used to make the correct

estimates of price elasticity of demand. In this method, price elasticity of
demand between two points on the demand-curve is measured. An average of
66
the two prices and the average of the two quantities is considered in the
calculations.

In other words, arc elasticity of demand is used to measure elasticity

over a range on Demand curve and not On a Point on Demand curve. The
following formula is used:

Q2 – Q1 P2 + P1
= ------------ x -----------
P2 – P1Q2 + Q1

Example:

The price of x-good decreased from Rs. 5 per unit to Rs. 4 per unit. Due
to this, the quantity demanded increased from 3 Units to 4 Units.

Solution:
4–3 4+5 9
------- x -------- = ---- = 1.24

4 -5

NOTE1 : percentage change in quantity demanded can be calculated for a given

percentage in price as:
%change in quantity demanded = % change in price x E

Note 2 ; percentage change in price required for a given change in quantity

demanded can be calculated

% change in price = percentage in quantity demanded + E

67
 Significance of the Study of
ELASTICITY IN ‘BUSINESS DECISIONS’

The concept of elasticity of Demand is a very useful concept in economic

analysis. The following description proves this point.

(1) Useful in the Determinations of Price:

The business – firms can decide ideal price for their products. There are two
ways of earning profit. The firm may charge lower price and sell more. This
policy is suitable for those firms that face relatively – elastic demand.

On the other hand, the firms facing inelastic- demand should use the oppositie
policy i.e. higher price and relatively less output.

(2) Useful in the price-discrimination:

A monopoly firm may charge different prices from consumers for the same
product. A higher price may be charged in the market having inelastic-
Demand. On the other hand a lower price in other market having elastic
Demand.

(3) Useful in the International trade:

Terms of trade refers to the ratio of import price to export price. If the country
A, is facing inelastic Demand in the foreign market.So country A, can charge
higher price in the foreign-market and vice-versa.

68
Demand Useful in estimating future Demand after the rise in price : While price
and cross-elasticities are useful for pricing-policy, income elasticity can be used for
forecasting demand for the product in future.

Thus production planning and management in the long-run depends

significantly upon the knowledge of income elasticity, as the businessman can then
find out the impact of changing income levels on the demand for his commodity. The
prospective marginal-revenue can be calculated, along with total revenue after the
change in the price of the product. Impact of change in price on sales can be
visualized on the basis of elasticity of demand.

What would happen to the total income (Total revenue) and income from the
sale of the next-unit (Marginal-revenue) can be known with the help of price
elasticity of demand.

We know that, total revenue does not show any change if it is a case of unit
elastic demand.

On the other hand, total – revenue declines if demand is inelastic with the
reduction of price, total-revenue increases if demand is elastic.

As long as demand is price-elastic, price reduction increases total revenue and

Marginal revenue is found to be positive.

69
 If demand is unit price elastic, total-revenue of the firm (total-income) is
maximum, and Marginal-revenue is zero.

When demand is price inelastic price reduction reduces, T.R. and M.R.,
income from the sale of the additional unit becomes negative.

The above relationship is given by

MR = P (1 + 1)
P.ed

Relationship between TR, MR and price elasticity with a decline is price:

TR increases if P.Ed > 1

TR remain unchanged if P.ed = 1
TR declines if P.ed = < 1

70
Price-elasticity and its relation with
Average – Revenue and Marginal – Revenue:

71
 INCOME ELASTICITY OF DEMAND

The extent of responsiveness of demand to changes in income is called

income elasticity of demand.

Percentage change in the quantity demanded

Ey = -------------------------------------------------------------
Percentage change in Income

Dq y
Ey = ----- X ------
DY Q

Example: At a level of income of Rs. 5000 per month, a consumer buys 2 Kg. of
butter per month. When income rises to Rs. 6000 per month, the consumer increases
the consumption of butter to 2.50 per month.

Initial income (y) = Rs. 5000, change in income ( = Rs. 1,000). Initial
demand for butter ( q) =2 kg change in demand ( q) = 0.50 kg.

q y 0.50 5000
Ey = ----- X ------ = ------- X ---------
y q 1000 2

5
= ---- = 1.25
4

72
TYPES OF INCOME ELASTICITY OF DEMAND:

(1) High Income Elasticity: This is shown in the diagram No.[ a ]. The change in
Demand is greater than the change in Income therefore Ey> 1. Example,
luxury products.

(2) Unitary Income Elasticity: Figure No.[ b ] shows the case of unitary
income elasticity as the percentage change in quantity demanded in income
(Ey =1) is equal to change in Demand example, comfortable goods.

(3) Low-Income Elasticity: The percentage change in quantity demanded is less

than the percentage change in income. Ey< 1. This is shown in Fig. No. [ c ]
. Example necessary-products

(4) Zero-Income Elasticity: Change in income does not lead to any change in the
quantity Ey = Zero see Fig. [ d ] example product like salt

(5) Negative Income Elasticity: Figure[e] , with a rise in the level of income,
the quantity demanded actually falls example, Giffen-goods

73
74
INCOME ELASTICITY OF DEMAND

Commodities differ widely in terms of their income elasticity. Goods like

jewellery, ornaments, precious, stones, furniture, automobiles etc. have high income
elasticity of demand.

In contrast, goods like, sugar, soap, safety, matches etc. have low income
elasticity of demand.

Goods which are generally regarded as luxuries have high income elasticity,
while those commodities which require a very small proportion of consumer income
to be spent on them, have low income elasticity. Similarly, necessities have a low
income elasticity of Demand.

75
Meaning: Change in the demand of a product due to change in income, other
factors remaining constant is known as Income elasticity of Demand.
Percentage change in the quantity demanded
Yd = -------------------------------------------------------------
Percentage change in Income
Formula
Q y
Yd = ----- X ------
Y Q

The formula can be rewritten

Y
Yd = ai ---
Q
Q.No.1: The co-efficient of income in a regression of the quantity demanded of a
commodity on income is 10

The income is 10,000 and sales are 80,000 units

Solution
1
Yd = ai ---
Q

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10 (10,000/80,000) = 1.25 Answer

Q.No.2: Calculate income elasticity of demand on the basis of the following

information
Y = Rs. 10500 Q = 1,02,500

Given equation is Q= 50,000 + 5 Y

Answer: ai = 5
Y
Income elasticity of demand = ai ---
Q

105000
= 5 X --------- = 0.5123 Answer
102500

Question:3 The co-efficient of income in a regression of the quantity demanded of

a commodity on income is 10. Calculate the income-elasticity of Demandat income
of Rs.10,000 and sales of 80,000 Units. Calculate the income elasticity of demand
Answer
Y
Income e.d. = ai ---
Q

10 (10,000/80,000) = 1.25 answer.

Q.N.4: Calculate the income – elasticity of demand if income increases from

10,000 to 11,000 and sales of 80,000 units 90,000 units.
The co-efficient of income in a regression of the quantity demanded of a
commodity on income is 10.
Answer. Q2 – Q1 Y2 + Y1
Income e.d. = ------------- ---- x ---------
Y2 - Y1 Q2 + Q1

77
 90,000 – 80,000 11000 + 10000
-------------------- X -------- -----------
11,000 – 10000 90,000 – 80,000

= 1.24 answer.

Cross e.d. (XED)

Cross price elasticity measures the responsiveness of demand for good – x following
a change in the price of a related goods.

The following diagrams exhibit the case of substitute goods. The goods that
have a status of substitute goods.

In diagram no.1, a relationship has been shown in which increase in the price
of x-good, leads to a large increase in Demand for Y-good.This happens in the case
of close substitute.

In this case of goods that are not very close to each other, a large increase in price
ofx -good leads to small increase in Demand for B-good.

78
Case of Complementry goods:A a small fall in price of A-good causes a large rise
in Demand for B-good.There are some cases in which a large decline in price of y-
good may lead to a small increase in demand of another good .

79
 Cross Elasticity of Demand
As stated above, the responsiveness in the Demand for Commodity x to a
change in the price of Commodity Y is measured with cross-price of elasticity of
demand (E xy) for commodity X divided by the percentage change in the price of
commodity y, other factors remaining constant –

If the price of tea rises, the demand for coffee increases as consumers
substitute coffee for tea in consumption.

On the other hand, if the price of sugar rises, the demand for coffee declines,
because the price of a cup of coffee with sugar is now higher.

Example: Sale of digital music downloads have been soaring with the growth of
broadband and falling prices for downloads. As a result, sales of music CDs have
fallen sharply
% change in the quantity demanded of good x
-------------------------------------------------------------
% change in price of good B

Note:
• Complements are in Joint demand
• When there is a strong complementary relationships, the cross elasticity will
be highly negative.

Unrelated Products:

Unrelated products have a zero-cross elasticity for example the effect of

changes in taxi-fares on the market demand for cheese.

80
Substitutes:
The cross price elasticity for two substitutes will be positive because the
demand for one good will increase if the price for the other good; increases coca-cola
and Pepsi.
Another example
Py2 + Py1
EXY = --------------------
Qx2 + Qx1
OR
Py2 + Py1
as = --------------------
Qx2 + Qx1

Q.No1: Calculate the Arc-cross price elasticity if Py increases from Rs. 50 to 100
and Qx increases from 125 units to 150 units.

The given demand – function is

100 + 0.5 PY
Answer
Py2 + Py1
as = --------------------
Qx 2 + Q x 1

100 + 50
=0.5x ------------ = 0.27 Answer.
150 + 125

Q Py
Cross elasticity of demand = ------- x ------
Py Qx

here, QX/ PY refers to the change in quantity of X to the change in price of Y-

good value of Qx and+ PY I given by as, the estimated co-efficient of PY.

81
 The above formula of cross-price elasticity can be rewritten as follows:

Py
Exy = as X-----
Qx

Q.No.2.: Calculate point cross price elasticity on the basis of the following
information: Price of Y commodity is Rs. 20

The given Demand function is

Qx = 100 + 0.5 PY

Answer:

20
Exy = 0.5 ----- = 0.09
110

Per one percent increase in price of Y-good caused demand reduction of X-

good by 0.09 per cent.

Question: Solved – exercise

1) Manpreet Kaur is the owner of a Chocolate shop. The price for her chocolates
is 10 per unit. The elasticity of demand for chocolates is 2.5. If she wants to
increase her total revenue what advise will you give and why? Explain your
answer.

Answer:

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 She should lower her price. Her price elasticity of demand for Chocolate is
elastic (greater than one) and therefore, when she lowers her price she will sell a lot
more chocolate.

The greater quantity sold will make up for her lower price, increasing her
total-revenue.

In other words, she is selling at lower price but making up for it in volume of
sales.

Q.2 If the cross-elasticity of demand between peanut butter and milk is – 1.11,
then are peanut butter and milk substitutes or complements? Explain it.

Ans. Complements: Because a negative cross price elasticity of demand means that
as the price of milk goes up the demand for peanut butter goes down.

Q.3 Manisha’s elasticity of demand for mini pizzas is constantly 0.9 and she buys
4 pizzas when the price is 1.50 per pizza, how many she will buy when the
price is 1.00 per unit?

Ans: In this problem, elasticity has been given. The elasticity is to be used to find
quantity. To obtain the answer, same formula is to be used.

Q.4 If supply is unit elastic and demand is inelastic, a shift in which curve would
affect quantity more?/ Price more?

83
Ans: Shifting the demand-curve would affect quality more, and shifting the supply
– curve would affect price-more.

Exercises for students:

Q.1 Kashmera Lal Sells x product at a price of 4 per dozen. At this price, he sells
50 dozens. Later on, he raises the price to 6 a dozen and sell 40 dozen.
(a) What is the elasticity of demand?
(b) What quantity he will self if the price was 10 a box, assuming that the
elasticity of demand is constant.

Q.2 The co-efficient of the price of petrol in the regression of quantity – demanded
of automobiles (in million of units) on the price of petrol (in dollar) is – 14

Calculate the cross-price elasticity of demand between automobiles and petrol at the
petrol price of $ 1 per dollar and sales of automobiles of 8 million units.

Q.3 Income increases from Rs. 45,000 to 50,000 .

This increase causes sales to rise from 800 to 1400 units.Calculate income
elasticity of demand.

Q.4 The price of butter increases from 100 for 10 gm to 10.50. The demand for
margarine goes up from 500 gm. To 600 gms. Calculate cross elasticity of
demand.

84
Methods of Measuring Elasticity of Supply:

The following formula is used:

Relative change in the quantity supplied of the good
Es = ----------------------------------------------------------------------
Relative change in the price of the good

Q P
= --- X ---
P Q

Es = Elasticity of supply of the commodity

Q = Original quantity supplied up the commodity

Q = change in the quantity supply

P = Original price of the commodity

= Change in the price.

Example: Seller of x good supplies 2,000 pens at the price of Rs. 8/- per pen. When
price increase to Rs. 10 percent, the supply of x-good increases to 3000 pens. Find
the elasticity of supply of pens for this firm.

1000 88
ES = ------- X ------ = 2
2 2000

Determinants of Elasticity of Supply

(1) Time period – Time period can be broadly classified into three categories.

(a) Market period: is the one where supply is fixed as no factor of production can
be varied.

ELASTICITY OF SUPPLY

85
 Elasticity of supply of a commodity is defined as the responsiveness of
quantity supplied to a unit change in price of that commodity.

(1) Perfectly inelastic-supply: The quantity supplied does not change at all when
price changes. This is in case of goods with fixed supply and is shown by the
supply curve parallel to the vertical axis.See diagram no. [b ]

(2) Relatively inelastic supply: If the supply curve cuts the horizontal axis, it is
relatively inelastic supply curve.See diagram [ e ]

(3) Unitary elastic supply: When the quantity supplied changes in the same
proportion as the change in price the unit elastic supply curve is shown as a
straight line passing through the origin.See diagram no. [c ]

(4) Relatively elastic supply: In this case supply-curve cuts the vertical axis.This
is shown by diagram [ d ]

(5) Perfectly – elastic supply: In this case elasticity of a straight line supply-
curve parallel to x-axis is said to be infinity.This is shown by diagram No. [a
]

86
87
In the market period, where the supply is fixed the elasticity of supply of the
commodity will be zero.

(b) Short period is defined as the time period where it is possible to adjust supply
only by altering the variable factors like raw-material, labour etc. The supply
will be two relatively inelastic.

c) Long-period: When the supply can be altered at will because all the factors
can be changed.

Elasticity will be higher in the long run than the short run

(ii) The cost of attracting factors of production. If the industry as a whole is

expanding the cost of inputs will increase relatively more so supply will be
sluggish.

If there is entry of new firms, at a particular price and greater will be the
elasticity of supply.

Exercises:
(1) Elasticity of supply shows the behavior of producers? How?
(2) What is the significance of the study of Price-elasticity of supply?

88
Chapter III
Case Study No 5
Elasticity in Policy – formulation
Elasticity’s of important commodities are calculated by conducting primary
surveys by taking samples of consumers in different regions of a market/ country
important conclusions are drawn on the basis of this study. The standard explanation
runs on the following lines: One per-cent increase in price leads to a reduction in the
quantity of the concerned product. However there may be difference in the short-
period elasticity and long-period elasticity, certain products have low-elasticity
certain products have low elasticity and some others have high elasticity (which
means highly sensitive to change in price).

The bumper crop of food articles like wheat, rice, fruits, vegetables, tea and
coffee, results in abundant availability of these products. As a result of this prices
start declining. The growers of these products suffer losses.

In certain cases, we expect Demand of product to increase under the above-

conditions. But Demand from consumers may not increase in all the cases. What
would happen thereafter some Latin. American countries are famous for growing
coffee beams. The production increased to the extend that international markets were
flooded with the supply of coffee in the early part of this century. The prices crashed.
The govt of Brazil tried to help the coffee growers by starting procurement policy.
The government tried to start mop-up operations, by initiating procurement – policy.
A suitable price was announced. But this policy did not succeed in achieving its
objective. The farmers were encouraged not to sell coffee in the market, rather to
hold-back the stock on a long term basis.

89
 This problematic issue brought to fore another fundamental-issue. It was
noticed that growers of coffee were abandoning cultivation of coffee. Farmers started
shifting to sister-crops. The agricultural-sector had fully been exploited by the
farmers.

Questions:

1. Why the prices did not improve even after the launch of the public-
procurement policy?
2. What do you understand by shifting in supply?
3. How elasticity is a factor in this case-study?

90
 Chapter – 4

DEMAND ESTIMATION AND DEMAND FORE CASTING

(A) Difference between Demand Estimation and Demand forecasting

(B) Need for Demand forecasting

(C) Qualitative methods

i) Survey method
ii) Market experimentation
iii) Delphi method
iv) Collective opinion method
v) Virtual shopping and virtual management
vi) Expert opinion method
(D) Quantitative – Techniques:
i) Trend Projection
ii) Time – series
iii) Regression technique
(E) case studies

91
Demand Estimation and Demand – Forecasting:

The purpose of demand fore-casting and estimation is to find a firm’s

potential-demand. So managers can make accurate decisions about pricing, business
– growth and market potential. Managers base pricing on demand trends in the
market.

Difference between Demand – estimation and fore-casting:

Estimation attempts to quantify the links between the level of demand and the
variables which determine it. Estimation helps to understand the underlying factors
and effects on the relevant variables as of today.
Forecasting, on the other hand, attempts to predict the overall level of future-demand
rather than looking at specific linkages.

An estimation technique can be used to forecast demand but a forecasting

technique cannot be used to estimate. Demand for example, a manager who wishes to
know how demand is likely to be in two-year times might use a forecasting
technique. A manager who wishes to know how the firm’s pricing policy could be
used to generate a given increase in demand would use an estimation technique.

Estimation of Demand is an attempt to determine the sales behavior of the

cars. On the other hand, a study of forecast would only b concerned about the
expected future sales of say, cars.

Need for Demand-estimation:

92
 The more accurate, information the firm has, the less likely it is to take a
decision which will have a negative impact on its operations and profitability.

One of the most important aspects for a manager is to know the behavior of
the market related variables, their inter relationships and future movement
Short-term objectives:

The problem of over-production and under production may be avoided.

This exercise helps in purchasing optimum amount of raw material for use by
the firm. This helps in reducing cost of production.

The estimation of demand helps the management to set realistic targets for the
sales department.

Long Term objectives:

This exercise is needed before starting a new unit.If demand is going to be by

the than there is no logic in establishing a new unit.

Likewise, whether to expand production capacity or not? Should production of

a new product is to be undertaken? Thus, demand forecasting is almost essential for
Business – Planning.

For proper-financial planning also; this exercise is important. The firm has to
plan for future capital investment for purchasing machines, raw-material & R&D

93
programme etc. The appropriate amount of capital has to be raised at the proper
time.

Each firm has to employ workers in its unit. So the requirement of optimum
size of labour force to be employed in the firm has to be estimated. Their training
programme has to be organized. This objective of proper man power planning also
requires information about demand for the products of the firm. Forecasting involves
predicting future economic conditions and assessing their effect on the operations of
the firm.

Forecasting-methods:

These methods are put under two categories:

(A) Qualitative - methods

These are the following:

1) Consumer-Survey method: This requires talking to shoppers elicit

information about the product. A questionnaire may also be used. Questions must be
precisely worked to avoid ambiguity. Sample is chosen with great care. Basically, it
is asking information about their consumption behavior i.e. buying habits and
motives etc. They might be asked, how much more petrol they would buy if its price
was reduced by 10 percent or which brands of several possibilities they prefer

The sample survey method, is a simple method and less time consuming. But
the information collected through this method may not be reliable. The investigators
may not respond with full seriousness.

2. Market-experimentation: A particular area is selected in which the new

product is to launched. Market experiment refers to study the impact of changing

94
price, and change in advertisement strategy on demand. Changes taking place in
demand are recorded.

Laboratory Experiments: (Consumer-clinic method)

Consumers are given some money to buy in a stipulated store; goods with
varying prices, packages, displays etc. This experiments reveals the consumers
responsiveness to the change made in prices etc . Firm can assess the effect of
alternative marketing strategies on demand in several towns. It is a very expensive
method.

(3) Delphi Method:

A panel of experts is chosen. The experts give their opinion regarding future
demand for the products of the firm. If they give different opinion, then the
prediction of all experts is circulated among them (keeping the identity in secret)

The experts are again shown each others revised forecast. They are asked to
revise their opinion till a consensus is reached or differences are narrowed down.

The experience and wisdom of experts lies at the core of this method and
wisdom of experts decide the success of the study.

(4) Collective opinion method:

It is believed that salesmen, being the closest to the customers are likely to
have the most intimate knowledge and customer-response to the products of the firm
and their sales-needs.

95
 Salesmen are required to estimate expected sales in their respective areas.
This method is also known as sales-force polling. The contributors to this method are
sales manager, marketing manager and the top executives.

This method is a simple method. The chances of reliability of information is

quite-high. Because, forecasts are based on first hand knowledge of salesman and
others directly connected with sales.

The shortcoming of this method is that it is applicable to short-term

forecasting. However, the sales-officers may not have knowledge of economic
changes likely to have an impact on the future demand. They may have limited vision
for looking into the future.

Virtual shopping and Virtual Management:

Virtual management refers to the ability of a manager to stimulate consumer

behavior using computer-modals.

Virtual shopping can track rather closely the buying behavior of consumers in
a real store. The consumer can view up any product by touching its image on the
screen so as to able to read its label. Consumers can check its content and they can
purchase the product. An account of this information is recorded to estimate Demand.

Expert opinion methods:

96
 Experts includes executives directly involved in the market such as, dealers,
distributors, and suppliers etc. contribution may be made by specialist marketing
consultants, officers of trade associations and industry analysts etc.

Results are obtained in less time. The results are obtained without indulging in
processing of heavy-data

Quantitative Techniques:

Some of these are described below:

(1) Trend-projection:
In this technique, actual sales-data is plotted on a chart the trend line and
judging just by observation. The identified trend line is extended towards a future
period. This way sales forecast can be studied. Simple equation S=a+bT is also used.
This technique is regarded as a very simple and easy method.

(2) Time-series technique:

Past-data can be used to predict future sales

Sales = a + b + c + d
It is assumed that past demand patterns will continue in the future. A graph can be
constructed where an “X” represents the number of product units purchased at a
particular moment and “Y” represents the moment the products were purchased.

a stands for trend, b stands for season and c stands for cycle.

97
 The forecast can be studied by substituting the values of trend, season and
cycle in the equation.

This is a simple method and involves less cost. However, cyclical changes
may upset all calculations.

(3) Moving Average:

Data are averaged for the whole cycle. The technique is known as rolling-
forward. With a three period moving average,the forecast value of the time seriesfor
the next period –is given by theaverage value of the time series in previous three
periods .
.Suppose the values for three periods is 20 ,23,and 23 respectively . The total is 66.
Dividing this value by 3 ,We obtain 21.6 .This is the forecasted value of 4 th
period .It is calculated on the assumption that there is no secular or seasonal –
variation .
(4) Regression-method:
Sales = a + b price
Using the above equation, linear-trend in the dependent variable can be fitted
to the data.

a) In the form of a graph, data of two variables is plotted. This gives a scatter.
The regression is then estimated by sketching it free hand. The line is drawn in the
middle of the scatter.

(b) In the least squares method the following equation is used. First, the values of
two constants a + bP.
S = a +bP

98
These values are obtained by using the following formula

N ∑ SiPi - ∑ s, ∑ Pi ∑Si-b ∑ Pi
B ----------------------- and a= -------------------
n
N ∑ P2i – (∑P)2

Exercises for Students:

Q.No. 1 What is the difference between Demand estimation and Demand forecasting
Q.2 Explain various method of demand forecastiong
Q.3 What is the need for Demand Estimation?
Q.4 What are the stages of demand forecasting.

99
 UNIT – V

Market System

(i). Working of an Ideal-market

(ii) Causes of Market failure

(iii) Forms of State Interference

100
 Working of a Market and
Failure of a market

Outline:

(A) What is meant by market?

(B) What is a successful-market?
(C) What is market failure? What are the reasons of market failure?
(D) Need for state-interference and forms of state-interference
( E ) case studies
Meaning and features of a successful market:

The term “market” refers to a system. This does not refer to any physical
structure. This simply means free working of Demand and Supply. These two
are known as market forces. Demand and supply is a part of natural system. If
these are allowed to work without any interference restriction or manipulation,
then it is known as working of a successful market.

A market-economy is where economic-decisions are made by the free-

market. Only those goods, are produced which are demanded in the market.
Due to competition, each producer tries to sell at the lowest cost.

Market-System

101
 Most goods and services are privately owned. The forces of competitive
pressure keep prices moderate, and ensure that goods and services be produced
most-efficiently. This is known as productive efficiency.

All buyers and sellers have equal access, and the same information upon
which to base their decisions.The role of government is simply to ensure that
the markets are open and working.

An ideal-market is one that fulfils the interest of consumers, producers

as well as workers. Under perfect competition producers supply the right
amount of goods and charge the right price, and the ‘right” consumers get the
desired goods produced. This is known as allocative-efficiency. In other words,
this is a condition of proper allocation of resources. Resources must be
allocated to various industries as per requirement of the economy, otherwise
too much or too little output gets produced.

Market-failure

Market – failure occurs when the goods are not produced and are not sold at
the lowest cost. When the resources are not used for productionof goods as per
the requirement of consumers.

Market-failure
Six reasons of Market-Failures
(1) Market-Power:

102
 In some industries, a particular firm occupies a very dominating-
position. A single-firm gains economic power to control and manipulate the
production and supply of a product in the market. This may happen when the
firm is an early-entrant in the industry.

(2) Natural Monopoly:

The firm may enjoy economies of scale due to huge production. Such
firms may charge exorbitant prices in order to maximize profits. The firm puts
restrain over competition and thus exploits market in various-ways. These
firms may enjoy undue advantage due to holding of patents & copyrights etc.

(3) Externalities: If a factory emits smoke etc. and the people living in the
neighborhood catch diseases. They have to spend money on their treatment. It
is a case of negative impact on the society. Cost of living becomes higher, but
it finds no place in the pricing system (market-system). It is not captured by the
market-mechanism.

On the other hand, there may be positive effects (beneficial-effect).This

will take place, when an action of a particular firm showers benefit on to
others. This is also called positive – externalities. This benefit is also not
captured by the market system.

d(4) Common Property Resources: This is a reference to forest-resources,

sea-fish; ivory; sand etc. such resources belong to all the citizens of the
country. These resources may be overused .

103
(5) Public goods:
Street lights are used by tax-payers as well as non-tax payers. But the
firm managing-street lights do not collect sufficient revenue on this count, to
cover-costs. No one can be excluded from the use of such facilities. This is
known as non-excludable. These facilities do not diminish with the use. So
these are non-depletable (Police and defense services fall in this category.

(6) Incomplete-Information:
Success of market-system requires perfect market knowledge on the part
of buyers and sellers. But in the modern set-up it is very difficult to fulfil this
condition. Ignorance on the part of buyers leads to failure of market-failure.

Market failure exists when the economy is unable to efficiently allocate-

resources. This can result in scarcity, or overproduction market-failure is
frequently associated with the role that competition plays in the production of
goods and services, but can also arise from asymmetric information or from a
misjudgment in the effects of a particular action. The last one is referred as
externalities).

The above factors prove that the market-system needs controls and
regulation by the State.

Need for State-interference & Forms of State-Interference:

104
 Government is a non-market institution. The state is required to interfere
when market fails.

(1) If price rises too much, specially of necessity items than the govt.
introduces price-control. A ceiling price is fixed for this purpose.

To protect the interest of workers, the government does introduce

“minimum – wage legislations”.

(2) Another form of state interference is to fix ‘quota’ of essential items to

be distributed through the public distribution-system.

(3) “Buffer-stocks” are maintained by the govt. This helps in stabilizing

availability of food grains etc. Thus prices are kept under check.

(4) The govt may discourage production and consumption of ‘non-merit

goods’ like cigarettes, by using various laws such as taxes and fines etc.

(5) The use of subsidy is made to increase the availability of essential goods
such food grains and drugs at low prices etc. Subsidy is given to transport,
hospital and education etc. Taxes and subsidies are effective tools in the hands
of the govt. to ensure efficient and just system in the country.

Price-mechanism works on the basis of private profitability which is

helpful in increasing private wealth. The govt. can work for “Social-
desirability”.

105
(7) Government regulates business, protects consumers, workers and the
environment. Main tools used are licensing, patents, copy-rights and custom
duties. Govt. tries to protect public interest.

The govts constitute number of regulatory bodies to control business

firm such as TRAI, IRDA, ECGC, STC competition commission of India etc.

Case Study No:6

Market systee m the case offlip - kart

There have been rising concern that discount sales launched in 2014 by
various e-commerce websites were anti-competitive in nature. The complaints
were filed against Flippkart India Pvt.Ltd. Amazon services Pvt.Ltd. Vector E-
commerce, Jasper Infotech Pvt.Ltd. and Xerion Retail Pvt.Ltd. cases of unfair
business practices against online retailers were filed with Competition-
commission of India.

(Jasper run snap deal, Com, Xerion owns Jabong, Com, while vector is
the company behind Myntra. Com.

It was alleged that e-commerce websites and product sellers entered into
exclusive agreements to sell-products exclusively on select portals. Discount
sales launched by various e-commerce websites were anti-competitive in
nature.

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 The commission rejected the complaints. The commission declared that
an exclusive arrangement between a manufacturerand e-portal will not create
any entry barriers. Their products face competition, otherwise also

Case study no. 7 Regulatory Body of Indian Market:

Securities And Exchange Board of India:

It is an official body. It was formed to monitor and control the business at the
stock-market, Indian Stock markets were not working in a fair-manner.

SEBI was constituted on April 12, 1988, as a non-statutory body. It is an

apex-body to develop and regulate the stock-markets in India. The officials are
appointed by the government of India.

SEBI has been assigned power to make rules for controlling business at
stock exchanges in India SEBI has to take action to stop fraud in capital
market. The job of SEBI is to monitor and control the mergers between
companies. To see that acquisition and take-over of one company by another
company takes place as per the govt. rules

SEBI has to audit the performance of stock-market. SEBI has to make

new rules on capital market transactions (if needed).

Powers of SEBI:
SEBI can conduct enquiries to investigate business to stock-markets and
also members of stock – exchange. SEBI has powers to amend bye-laws of

107
 stock-markets.

Objectives:
The main job of SEBI is to promote healthy and orderly growth of the
capital market. SEBI has to protect the interest of investors. SEBI has to take
steps to promote efficient services by brokers, merchant bankers and others
players of stock-markets.

The functions of SEBI are but under two categories:

(A) Regulatory functions: To check and eliminate malpractices in stock-
markets such as price-rigging, unofficial premium on new issues, delay in
delivery of shares etc.

It has to prohibit insider trading. SEBI promotes fair practices:

(B) Development Functions:
Provision of training of intermediaries of the securities-market has to be
arranged by SEBI. It has to promote activities of stock exchange SEBI
approves by laws of stock-exchange. The officers of SEBI, inspect the books of
accounts and call for periodical return from recognized stock-exchange.

SEBI make the provision of registration of brokers and to take steps for
listing of securities of public- companies.

SEBI has framed-rules and regulations and a code of conduct to regulate

the business of intermediaries such as merchant bankers, brokers and under
written etc.

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Exercises for Students
1. What are the advantages of an Ideal-market?
2). Explain the meaning of externalities?
3) What is the need for government to intervene in the working of market?
4) What is the meaning of the following?
(a) Patents (b) Subsidy (c) Buffer Stocks (d) Common property-rights

109
 Unit – 6
Production – Theory

(A) Production – function: with one variable input Optimal combination of inputs.
(B) Discussion of T.P. AP and M.P.
(C) Explanation of the Law of Diminishing Marginal-rate of substitution.
(D) Comparative- study of Law of variable Proportions and Return–to scale.
(E) Concept of ISO product-curve and ISO-cost line.
(F) Explanation of Returns– to scale
(G) Internal and External- economies and internal and external dis-economies of
scale.
(H) Difference between economies of scale and economies of scope
(J) Ridge-lines
(k) Case-study

110
: LAW OF RETURNS

The Law of Variable Proportions or Returns to a factor

To understand, the above Law, we have to first understand the following:

1. Total Product (T.P): This refers to the total production made by all the
workers. Suppose, 10 workers produce 100 units of the product in this case, the total
product is 100 units.

2. Average Product (A.P.)

The per worker production is known as A.P. The formula is
T.P. Total output 100
A.P.= ----- = ------------------ = ---------- = 10 Units
N Number of 10 workers
workers

3. Marginal Product (M.P)

The contribution made by the additional worker to the total output, is known
as Marginal – Product.

10 workers produce 100 units

11 workers produce 105 units
So, M.P. = 105 Units – 100 units = 5 Units

In the short-period, production is increased by using more quantity of labour

only. Labour is known as a variable factor.

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The law of variable proportions .

When more and more units of a variable factor are combined with fixed quantity of
other factors. The total product increases at an increasing rate, the later on increases
at a diminishing rate and finally starts falling.

In terms of marginal product we can state that the marginal product first
increases then decrease and finally declines. This can be explained with the help of
the following table and diagram.

No. of Workers Total Product Average Product Marginal Product

1 5 5 5
2. 12 6 71st stage
3. 21 7 9
4. 28 7 7 2nd stage
5 30 6 2
6. 30 5 0
7 28 4 -2 3rd stage

On the basis of above diagram and table we can explain the three stages of the law of
variable proportion.

112
1) Stage I : T.P. rises at an increasing rate:
In this stage total product increases at an increasing rate this is shown by the area A
to B. In this stage AP increases. The firm enjoys increasing returns by applying
more and more units of a variable factor to fixed factor.

2) Stage II: T.P. rises at a Diminishing Rate:

In this stage both AP increases. the total product keeps on rising at a slow rate.This
is shown between point B to point C in the above diagram .this stage is shown as
diminishing returns.

3)_ Stage III: T.P. Starts declining:

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The marginal product becomes negative and the A.P. also declines. This stage begins
after point K .

Assumption of the Law

1) It is assumed that there is no change in the technology.
2) It is assumed that there is no change in fixed factors.
3) The production is increased by using more quantity only of labour (variable
factor).
4) All workers are identical in their capacity to work
5) All factors determining production remain constant.
6) The price of inputs remains constant.
7) No attempt is made to improve the fertility of the soil.

The following are the main factors which result in the operation of the law of
variable proportions.

1) Optimum Combination (Ideal Ratio):

The variable factor should be combined with the fixed factor in a certain
optimum ratio. If the Ideal-Ratio will be maintained than the output will be
maximum otherwise the firm will not obtain highest level of output. If less number of
workers are used or excess worker is used the, output will not be maximum. The use
of more workers than required, results in lower output.
The Diminishing Marginal Technical Rate of Substitution
D.M.R.S.

The amount of one factor used to substitute for a unit of another factor while
output remains constant, is called the Marginal Rate of Technical Substitution.

114
This may be regarded as that quantity of capital which has to be reduced for an
increase in the use of labour by one unit to keep the level of production constant.

We know that capital can be used in place of labour or labour can be used in place of
capital, the ratio of change may be different in different cases.

Marginal technical rate of substitution

For given output, say, 400 units.
Factor Capital Labour Marginal Rate of
Combination Substitution
A 12 1 -
B 8 2 4:1
C. 5 3 3 :1
D. 3 4 2 :1

Combination A needs more of capital and less of labour. Combination-D has more of
labour and less of capital. Last column shows diminishing Marginal rate of
substitution. Diagram

Iso quants
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 OR
Iso – Product – Curve

The long run production function is represented graphically by Iso quant’s. An

Iso quant shows the various combinations of two-inputs, labour and capital, to
produce a specific level of output.

Definition of Isoquants & its properties

Iso product-curves are negatively sloped. Because as the firm moves down on
anIso quant, than it has to use more labour and less capital. The Marginal
productivity of labour declines and marginal productivity of capital increases. As
more and more labour will be used, its contribution from successive units will
decrease but from capital it will increase. So the total output on a curve will be the
same.

Production function

116
In the case of perfect – substitutes, Iso quant’s looks like a straight line example oil
and gas for heating finance. It is because of constant rate of Technical Substitution.

If labour and capital are be used in fixed proportion, then ISO-quant will take the
shape of a right angle. The inputs must be perfect complementary to each other

In this case there is zero substitutability between Labour and capital both the input
should be used in fixed proportion example: In case of cake recipe. Butter and flour
are to be used in a fixed proportion.

Ridge Lines:

117
 Firms should not operate at a point outside the ridge, lines, since it can
produce the same output with less of both output i.e. at point A in comparison to
point B.

This ridge lines are like Laxman Rekha for the firms. Firms should not cross
the ridge lines. Otherwise, resources would be wasted.

The lines connecting the points where the ISO quants begin to slope upward are
called ridge lines.

It indicates the highest output that a firm can produce for every specified
combination of inputs while holding technology constant.

Production function gives us the relationship between inputs and output.

Output (Q depends upon the amount of capital (k), Land (L) and Labour (La) used in
the process of production
The concept of ISO – Cost line

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An ISO-cost line shows various combinations of the factor inputs that the firm can
buy with a given outlay and factor prices. Every point on an iso – cost line costs the
same amount to the firm.
This line is based on the availability of resources with the firm and the prices
of capital and labour. The firm can either purchase OA amount of capital or OB
amount of labour or it can have a combination of these two inputs i.e. as shown at
point C
Thus, the Iso cost line depends upon

1. Prices of the factors of production

2) Total amount of Investment available with the firm. The slope of an Iso-cost
line can be found by taking the ratios of prices of the two factors of
production.

An increase in the amount of money will shift the Iso-cost line upwards. However the
slope of ISO-Cost lines remains constant.

A change in factor-prices, will change the slope of ISO-cost line.

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Optimal Input Combination
OR Minimizing cost and maximizing output
The optimal – combination is established at the tangency point of an Iso quant
and Iso-cost line.

The tangency point is a situation in which, production takes place at the

minimum cost and maximum output for a given output

At the point E, Iso-quant is tangent to Iso- cost line AB. Producers equilibrium
will take place at this point.

By joining various points of tangency of ISO quant and ISO line, we get the
expansion path of the firm. The expansion path is a straight line through the origin.

To obtain maximum profit the firm has to produce at the profit maximizing
level of output with the optimal input combination

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 Returns to Scale
All factors are variable in the long period unlike short-period, in which one
factor is variable.

The term “returns to scale” refers to the degree by which output maychange as
a result of a given change in the quantity of all inputs used in production. Returns to
scale may be constant, increasing or decreasing. The types of returns to scale are
explained below:

1) Increasing- Returns to scale:

By doubling inputs the output is more than doubled. The increase in the output
is proportionately greater than the increase in inputs. Suppose the inputs are being
increased by 10 percent, and the resulting out put rises by 15 percent then, this typeof
situation is

known as Increasing returns to scale. This is shown in following diag. In all these
diagrams , Y-axis shows quantity of capital and X-axis shows quantity of labour
inputs .

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 Labour
labour
2) Constant Returns to Scale:
The proportionate increase in the inputs results in an equal increase in the
output. Suppose if the inputs are increased by 10 percent and the resulting output will
increase at the same rate. Thus, the increase in output is equal to the increase in the
inputs. See the following diagram

capital cc
3) Diminishing returns to scale: labour
In this case the increase in the output is lower than the proportionate increase
in the inputs. An increase in inputs by 10 percent leads to increase in output by less
than 10 percent. Labour input is shown on horizontal axis . The capital input is
shown on Y- axis

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 capital

Labour

In the long period the proportion of variable factors to fixed factors remains
constant. Suppose on one machine, two workers were used. Later on, two machines
were used with four workers. Thus, the ratio of variable factors to fixed factor 1:2
remains the same. This is called increase in the “scale of production”. The change in
production due to change in scale of production is known as “Returns to Scale”.

Factors behind varying returns to scale:

The use of modern machines and technology reduces per unit cost of
production. The reduction in per unit cost is known as economies of scale. On the
other hand, too much use of modern technology leads to increase in the per unit cost
of production. This is known as Dis-economies of scale.

1. The same amount of inputs provides relatively higher amount of output. The
firm enjoys increasing return to scale. This happen due to higher economies of scale
as compared to diseconomies of scale, the net result is increasing returns to scale.
This is a feature of initial stage.

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2. As the scale of production increases, the economies of scale start slowing
down, but the diseconomies start increasing. A stage arrives when the cost reducing
forces become equal to cost increasing forces. In other words, economies of scale
become equal to diseconomies of scale. This is the operation of constant returns to
scale.

3. Ultimately, a condition arrives in which the diseconomies of scale (cost

increasing factors) become very strong.The economies of scale become lower than
the diseconomies of scale. This is a situation in which the firm operates under
Diminishing returns to scale.

Indivisibility is another factor which causes varying returns to scale. Big

machines start reducing per unit cost upto a limit. But this phenomenon stops after a
stage.

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Distinction between law of variable proportion and Return-to-Scale (OR)
Distinguish between Return to a factor and Return-to-Scale?

Ans Law of variable proportions. Return-to-Scale

1. The law of variable proportion applies in This law applies to long period
the short period.
2. This law applies when the production is The quantity of all factors is
increased by using more quantity of changed. The production is
variable factor only . increased by using more quantity
of all the factors.
is3. This law applies when the proportion This law applies when output is
between variable factor and fixed factors increased by increasing the scale
is altered i.e. output is increased by of production but by keeping the
changing., the proportion between fixed proportion b/w variable factors
and variable Factors. However, the scale and fixed factors constant.
of Production remains constant.
4. In this law we find three stages. These are In this case also we find three
distinguished on the basis of the behavior stages i.e. increasing
of Total production and marginal product. returns,constant Return,
diminishing returns.
,

125
Economies of Scale and Diseconomies of scale:
(A) The term economies – refer to reduction in cost of production. The opposite of
this is known as, diseconomies of scale.

In the long period production is increased by using more quantity of capital

and labour in the same ratio. The firm uses more quantity of modern machines and
new techniques in the long period. Due to use of modern technology and some other
advantages that a firm enjoys in the long run, the cost of production decreases in the
initial period. The phenomenon of reduction in cost is known as economies of scale.
The economies of scale are put under two categories:
(A) Internal Economies of scale
(B) External Economies of scale
A) Internal Economies of Scale
If the reduction in the cost of production is due to the efforts made by the firm
itself than it is known as internal economies of scale. This enables the labour in
working faster and therefore, increases the labour productivity so more production
take place with less-inputs.

1) Technical Economies:
As the scale of production increases the firm enjoys, the advantages of
mechanization, new machines and new techniques of production. This reduces per
unit cost of production.

2) Managerial Economies: Large scale production makes the division of

managerial functions. This increases their efficiency. Their exists a production

126
manager, a sales manager, a finance manager a personnel manager and so on in a
large firm.

3) Labour Economies: As the size of production increases the firm enjoys the
advantages of division of labour and specialization of labour.

4) Inventory – economies:
With the increase in output, the firm can hold smaller percentage of
inventories. These do not increase proportionately with the increase in output.

5) Transport economies:
With the increase in production, a large firm can maintain its own fleet of
vehicles. This helps in cutting cost on account of transport charges.

6) Marketing economies:
Advertising expenses increase less than proportionately with the increase in
output. Because the advertising costs per unit of output falls as the output increases.

The firm will be able to get raw materials at lower prices due to bulk buying.
The large firm may be given lower advertising rates.

(B) Internal diseconomies of scale:

Each size of the plant has an optimum size. If the plant is pressed in use
beyond this optimum point. Then, there arises diseconomies of scale.

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 As the output grows beyond certain level, the top management becomes over
burdened. The management becomes less efficient as coordinator and ultimate
decision maker. Managerial structure becomes more complicated. This reduces the
overall efficiency of the management. Diseconomies of use of division of labour and
of use of machinery lead to higher cost of production. That means diseconomies of
scale.

1. External Economies:
There are certain benefits that a firm enjoys from its surroundings (from
Industrial) area.The availability of inputs increases in an industrial area. Raw
material and labour becomes available at cheaper rates . Availability of skilled
labour also increases.

The expansion of an industry may expedite the development of transportation

and marketing facilities. This also leads to reduction in cost of transportation.

The industry passes on the latest developments of production, technical issues

in the form of trade and Industry specialised journals.
2. External diseconomies:
The growth of a big firm in a particular area leads to rise in the price of inputs.
Wages may also increase. Transport charges may also increase.So cost of production
increases from various sources. The diseconomies due to external factors become
very strong.

128
Economies of scope: a proportionate saving gained by producing two or more
distinct goods. When the cost of doing so is less than that of producing each
separately.

An economic theory stating that the average total cost of production decreases
as a result of increasing the number of different goods produced.

Company which produces several products can afford to hire expensive

graphic designs and marketing experts who will use their skills across the product
lines. Because the costs are spread out, this lowers the average total cost of
production for each product.

Economies of scope gives a cost advantage to a company when it produces a

complementary variety of products while focusing on its competencies,on the other
hand, economies of scale offer a cost advantage when there is an increased output of
one good, economies of scale arise due to the inverse relationship between the
average cost per unit and volume of output.

For example, suppose a shoe company has fixed costs of $ 10,000 a month
and only offers one design of show. If the shoe manufacturer produce only one shoe,
the average total cost of the product is $ 10,000. However if it increases production
to higher level of 10,000 shoes per month, the average total cost of the product to $
per unit ($ 10,000/10,000). Economies of scale arise for this company as it increases
its production level of shoes.

129
 A firm can produce shoes and leather bags / purses. The cost of Rs. 5,0000 per
1,000 pair of shoes and Rs. 30,000 per 1,000 leather bags. If firm produces both
products. Then, the cost would be Rs. 70,000/-

TC (QA) + Tc (QB) – TC (QA.QB)

S = ----------------------------------------------
TC (QA, QB)

50,000 + 30,000 – 70,000

S = ---------------------------------- = 0.14
70,000

14 percent reduction will take place in total cost if both the products will be produced
together.

Economies of scale

Case Study No.8

In economics, we give important to innovations. Normally, importance is

given to product innovation and machine, innovations. New techniques of production
and new machines are helpful in cutting down cost of production. There is another
way of cutting-down costs. This is known as “process innovation”. Furthermore,
there is something more which is very useful in reducing cost of production. The
complete phenomenon is known as “economies-of-scale”. Internal and external
economies of scale.

The increasing volume resulted in cutting down cost of production. The

expensive machines are used for a longer period to reduce the per operation cost.
The Narayana hospital is Bangalore, saves money on the cost of machines.

Looking at the higher volume of patients the hospital management succeeds in

obtaining basic supplies of sophisticated equipment at relatively lower prices. The

130
reduction in cost is transferred to the patients. Heart-operations are performed at
lower costs as compared to other hospitals. Further, the insurance facility also helps
patients.

Q.1. What do you understanding by economies of scale?

Q.2 How medical cost can be reduced in other hospitals?

Case Study No. 9 THE ROUTE TO PROGRESS

131
 Different companies make constant efforts to enjoy ever rising profits .To
achieve this goal ,inventions and innovations are required .We find high degree of
competition.The case of car market is worth –reading in this context .
Japanese auto –manufacturers have been known for a high degree of
automation teamwork,machine and quality-control.
Toyota company developed and implemented “just in time’ method . There
is emphasis on avoidance of waste at any stage of the production process. This
efficiently technique is useful in recovering costs as quickly and as
possible.Thisinvolves the process of keeping stocks to a minimum and only
supplying parts when required .
In the auto industry,there is the issue of number of models.Each model
havingvariousvariants. This creates need for flexibility–use of some components to
differentModels . Japanese take less number of hours to assemble a car . Japanese
car plantstend to operate at a much higher level of capacity utilization .
,

Exercises for Students

Q.1 Explain the law of variable proportions.

Q.2 What do you understand by Diminishing Marginal Technical rate of

Substitution.

Q.3 What is a production function? Explain its properties?

Q.4 What do you understand by optimal input combination?

Q.5 Explain economies and diseconomies of scale. What is its impact on returns to
scale?

132
Q.6 Describe (a) increasing return to scale (b) Constant returns to scale and (c)
Diminishing return to scale.

Q.7 What is the difference between economies of scale and economies of scope.

133
 CHAPTER NO. 7
STUDY OF COSTS

1. Concepts of total fixed cost, total variable cost.

2. Concepts of average fixed cost, average variable cost, average, total cost.

3. Relation between A.C. and M.C.

4. Shape of short-period average total cost and shape of long period average total
cost.

5.(A) Cost, value, profit analysis

(B) Concept of leverage and related numerical

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 CHAPTER NO. 7

SUNK COSTS

The sunk cost is said to be uncontrollable and unavoidable costs. It is an

expenditure that has been incurred and cannot be recovered. The cost of inventory

and future rental payments for warehouse etc.

Incremental cost:

The incremental costs are avoidable costs. These costs are incurred when the

business activity is changed. These costs may be avoided by not bringing changes in

production line

135
 Relation between AC and MC

When average cost falls with increase in output, MC is lower than AC and it lies
below the AC.

As long as MC falls it lowers the AC of production.

When MC exceeds AC it results in rise in AC because of rise in total cost.

When MC interests AC, it is the minimum point of Average cost.

Study of Costs
Short-run: If production is increased without increasing the quantity of fixed factors, like
capital (machinery) than it is known as short-period. The production is increased by using
more quantity only of labour, that is known as variable factor.

Long period: Thus refers to a situation in which production is increased by using additional
quantity of both i.e. more quantity of fixed factors as well as variable factors.

136
Concepts of Cost:
1. Total fixed cost (T.F.C.): Total money spent on using fixed factors to produce a
given output T.F.C. curve does not start from zero. This curve starts from Y-axis. This is
shown in diagram No. 1

2. Total variable Cost (T.V.C): Money spent by the firm on using variable inputs such
as labour and raw material T.V.C. originates from zero. This means nil T.V.C. at nil output.
This cost varies with the variation in output Figure No. 2

3. Total cost: It includes total fixed cost plus total variable cost T.C.=T.F.C. + T.V.C.

4 Average fixed cost (A.F.C.): This refers to per-unit fixed cost. It is obtained by
dividing T.F.C. by units produced.

T.F.C.
A.F.C. = ----------
Q

As total output increases, the A.F.C. curves keeps on declining. Because the some amount of
total fixed cost is divided by more output. So the per unit fixed cost goes on diminishing.
Diagram No. 3

137
5. Average – variable cost (A.V.C.)
This refers to per unit variable cost. It is obtained by dividing T.V.C. by units
produced. A.V.C. Shows a rising trends along with the increase in output. So the A.V.C.
takes an upward shape. Figure No. 4

6. Average Cost Cost:

This is also known as average cost
A.T.C.=
A.F.C.+A.V.C.
The A.T.C. is obtained by adding up average fixed cost and average variable cost.
The average cost is traditionally considered as ‘U’ – shaped. In the short period the
S.A.C. is derived from the shape of A.F.C. curve and A.V.C. Curve. This we get a ‘U’
shaped A.C.

Shape of A.T.C. In The Short Period

Average variable cost curve is ‘U’- shaped because initially it falls as the
productivity of variable input increases. This is due to the impact of first stage of Law of
variable proportions. The increasing returns results in decreasing per unit cost with the
increase in production.

138
 The A.V.C. curve touches the minimum point, as soon as the second stage of
decreasing returns becomes effective. Optimal combination of factors takes place.

The average variable cost starts rising when productivity of fixed as well as variable
factors starts declining. A stage in which negative returns start taking place, in other words,
negative returns lead to increase in per unit cost of production.

A.C. is determined by AVC and AFC. As level of output increases AC starts falling due to
fall in AFC mainly and to some extend decline in A.V.C.
When AVC curve begins to rise, AFC still continues to fall. This moves, ATC curve
downwards.

(T.V.C.) (T.F.C.) (T.C.) (M.C.)

Units of output Total variable Total fixed cost Total cost = Marginal cost
cost T.V.C. + T.F.C.
0 0 10 10 -

1 10 10 20 10

2 17 10 27 7

3 25 10 35 8

4 40 10 50 15

5. 60 10 70 20

6. 110 10 120 50

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 Schedule showing A.V.C. A.F.C. and ATC

Units of putput Average variable cost = Average fixed cost Average total cost
T.V.C. = T.F.C. = T.C.
N N N
1 10 10 20

2. 8.50 5 13.50

3. 8.33 3.33 11.2

4. 10 2.50 12.50

5. 12 2 14

6 18.33 1.6 20

SHAPE OF LONG PERIOD AVERAGE COST:

In the long run, firm can choose an optimum combination of factors. This refers to
the fixed as well variable factors. In other words firm has a number of alternatives with
regard to the scale of production. This firm puts up effort to build the most appropriate plant
to produce each level of output.

Experience teaches them that for a particular range of output, there is a suitable
plant. If the suitable plant is chosen, then, the firm will succeed in producing output at the
lowest cost.

The firm starts using a particular plant in the short period. The per unit cost starts
decreasing as more and more units of output are produced. Then, the stage of minimum cost
starts approaching that is the wake up call. After, the minimum cost point, the per unit cost
starts rising. It is not beneficial to produce if the cost is in the rising phase. So the firm
decides to move to another plant in search of decreasing cost of production. This process
continues throughout the life of the firm.

140
 In the following diagram, there are two different scale of production, being
represented by S.A.C.1 and S.A.C.2. “The firm has two options to produce output shown by
ON. The firm will incur N.K. Cost on S.A.C.1, but the A.C. is much lower on NC ON
S.A.C2. The management obviously will choose lower cost. The firm will move to S.A.C.”
(another plant).

In other words, from one S.A.C. to S.A.Cn. By joining the effective production points on
each S.A.C. we get a bigger average cost. This is known as Envelope. This shape is also ‘U’
shaped. It is a bigger ‘U’. Long run costs are also called planning cost or planning horizon.
The firm can choose plants that minimize the cost of production at any anticipated level of
output.

Thus firm plans for long run while it operates in the short run.

Case study No. 10 A Success – story

Role of innovation insuccess

141
1. All of us Know that the Apple computer company drastically changed the face and
shape of the computer industry.
2. The revenue of the company jumped from 4 million dollars in 1979 to over 2 billion
in 1987.
3. This generated a lot of interest in the computer industry. Lot of new investment was
made in the industry around 80 companies entered into the computer market.
4. Competition among the computer firms went on increasing. IBM company tried its
best to be number one in the industry.
5. Profit margins starting dropping.
6. A situation of price-war appeared. The PC prices started declining.
7. The PC industry almost became a non profit industry.
8. Apple Co’ suffered losses in 1997.
9. Innovative products made Apple the winner.
Q. What lesson do you get from the above information?
__________________________________________________

Operating Leverage:
The percentage of fixed cost in a company’s cost structure.
A business that has a higher proportion of fixed cost and a lower proportion of
variable costs is said to have more operating leverage. Operating leverage is the ratio of a
company’s fixed costs to its variable costs.

As explained above, a firm is said to be highly leveraged if fixed costs are large
relative to variable costs.

A general feature of a highly leveraged firm is that more variation in profits takes
place for a given percentage change in output than a less leveraged firm.

Profit changes more in proportion to changes in output in case of a firm with less
fixed cost.

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 Leveraged explains both gains and losses.
Degree of operating Leverage:
% change in profit
EЛ ----------------------------
% change in unit sales

Л Q
or E Л = ---- ----
Q Л

Symbol Л profit elasticity

Calculation of profit elasticity:

Q (P – AVC)
E Л = -------------------
Q (P-AVC) – TFC

Higher profit elasticity is indicator of risk. If output has to be decreased due to some
reason, than profit will decline more rapidly in high leverage firm.

Cost Value profit Analysis

or profit contribution analysis:
Difference between price and average variable cost
P – AVC
is defined as profit – contribution.

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 Once, variable costs are recovered, the revenue from the sale of an additional unit of
output represents a contribution towards profit.

To find output necessary to cover all fixed cost and to earn a “required” profit (Л R).

It is assumed that average – variable cost is constant. Price of the product is also
constant.
FC + Л R
Qr = --------------
P – AVC

The above formula gives us the rate of output necessary to generate a specified rate
of profit. See the following example:
The formula for operating leverage is:
= Quantity X (price – variable cost per unit)
Operating Leverage= ---------------------------------------------------------
Quantity x (Price – variable cost – fixed cost)

Company X, sold 1,000,000 units of X-product for Rs. 12 each. The fixed cost is
10,000,000. Cost of each unit is 0-20 per unit.

(1,000,000 X (12 – 0.10)

Operating Leverage = -------------------------------------------
1,000,000 x (12-0.10)-10,000,000

= 11,900,000/ 1,90,000 = 6,26or 626 per unit

This means that a 10 pecent increase in revenues should yield 62.6 per cent increase
in operating income (1- 0 p.c. 6.26).

Companies with high operating leverage ratio can essentially make more money
from incremental revenues than other companies, because they do not have to increase costs

144
proportionately to make these sales. Reverse, companies with high operating leverage, are
more vulnerable to decline in revenue (for whatever reasons).

Problem:
Find out the amount of output required to generate profit of Rs.20,000: if
F.C. = Rs. 10,000
P = Rs. 20
AVC = Rs. 15
required profit target of Rs. 20,000
Solution
10,000 + 20,000
Qr = ----------------------- -= 6,000
20 – 15
The targeted profit of Rs. 20,000 can be achieved at an output of 6000
Break even point

The company’s sells enough units of its product to cover its expenses without
earning profit or suffering a Loss. Thus, a company’s break even point is the point at which
its sales exactly cover its expenses.

In order to calculate firms break-even point, the following formula is used.

Fixed costs
= --------------------
Price-variable costs

The denomination of the above equation is called the contribution margin. This is
the amount that the firm can contribute to pay its fixed costs.

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production
Break even point can be defined as a point where total costs and total sales are equal.

Problem: How to find break even point?

Answer:

By using the following formula

F.C.
Qe = -----------
P.-A.V.C.

Suppose P
Price = Rs. 20 10000
A.V.C. = 15 =Qe = -------- = 2000
20-15
F.C. = 10,000

Question: Find Out the break-even output for the following firms

There are two firms in the same industry.

Price is Rs. 10

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Firm “A” has total fixed cost = 100
and
Average = 6
Variable cost
Firm B has T.F.C. = 300
and A.V.C. = 3.33
Answer:

T.F.C. = 100
For firm A = ----------------------- = 25
P – AVC 10-6

T.F.C. = 300
For firm A = ----------------------- = 45
P – AVC 10-3.33

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Exercises for Students:

Q.No.1 Explain the relation between average cost and Marginal cost.
Q.No.2 Explain the shape of short period average-cost. What is its
relation with long term average cost?
Q.No.3 The shape of long period average cost is influenced by the
economies and diseconomies of scale.
Q.No. 4 Explain the following:
(a) Operating – leverage
(b) Break-even point
(c) Profit – contribution
(d) Profit – elasticity
Q.No. 5 Describe the following:
(a) Total – Fixed Cost
(b) Total – variable cot
Q.No.6 Distinguish between the following:
(a) Sunk-costs
(b) Incremental costs
Q.No.7 If T.F.C. is Rs. 300. The selling price is Rs. 4 and the average
variable cost is Rs. 3.50 calculate break even point.
Q.No. 8 The contribution ratio is 0.25. The total Fixed cost is Rs. 300,
calculate break even point

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 Chapter -8

Market – Structure

General – Laws of Equilibrium

Perfect – Competition

1. Features of perfect completion

2. Essential Conditions of equilibrium under perfect competition

3. Equilibrium in the short-period & equilibrium in the long – period.

under perfect – competition.

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 CHAPTER NO. 8
Market - Structure
.The concept of equilibrium .It is defined as a condition in which the individual firm
enjoys maximum profit. The point of equality between marginal cost and marginal
revenue is regarded as the point of equilibrium of firm.

The study of these laws will help students to understand the specific equilibrium
condition under specific market conditions
.

As stated above equilibrium is a condition in which the firm earns maximum

profit. The firm takes decision not to produce further. . .

The equilibrium of firm is established at the point of equality between marginal –

cost (M.C.) and Marginal Revenue (M.R.). The firm maximizes its money-profit
when the cost of producing a particular unit is equal to the income received from that
particular unit.

Condition Number: One: In this situation, the firm continues to increase the
production. If the M.C. is less than M.R., the firm will earn profit. This will include
the firm to increase the production. The condition is shown in the following diagram
between O Q output. In this area, the Marginal-revenue curve lies above the
Marginal curve. . Therefore production will not stop in this area.

Condition No.: Two: The equilibrium of firm takes place at point E, due to
intersection between MC and MR. At this point, M.C. is equal to M.R. since at

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output Q point the M.C. is QE and MR is also QE. Both are equal to each other.
The firm will not increase production after this point.

Condition No.: Three: The firm does not produce in this area. The firm will suffer
loss by producing in this area i.e. at output K1, the M.C. is on the higher side. So,
such units of output will not be produced.

Condition No.: Four: Once the equilibrium output is determined, then , the fate of
the firm can also be measured.
At the equilibrium output, OQ, if the Average Cost (A.C.) is less than Average
Revenue (A.R.) then the firm will enjoy abnormal profit that is, also known as super-
profit.

Condition No.: Five: If the Average Cost (A.C.) is less than Average Revenue , then
the firm will obtain normal profit.

Condition No: Six: At equilibrium output, if the Average cost is greater than the
Average Revenue, then the firm will suffer loss.

In the diagram , equilibrium of firm is established at point E due to inter-

section between Marginal-cost curve and Marginal revenue curve. At this point M.C.
is QE. and M.R. is also QE .Thus, this is the equilibrium point. At equilibrium
output OQ, the Average Cost is only QL whereas the A.R. is much higher. Thus, the
firm will enjoy abnormal profit, because the A.R. is in excess to A.C. by the area
shown by LN.
The total profit of the firm can be calculated in the following manner:
Deduct A.C. from A.R. = The difference is QN –LN =LN is the rate of profit.
Thus we can find out the total profit earned by the firm.

151
 The profit = Rate of profit x total – output
= OQ = P L

Thus by multiplying PN with LN, we get PNLP area which shows the total
abnormal profit of the firm.The shaded area shows total super profit of the firm.

Perfect Competition

Features of perfect –competition

1] The number of firms, is very large in this market. NO single firm can
influence the market-price. The single firm can influence the market price. The single
firm is said to be a price-taker. The price is fixed by industry Demand and Supply.

2] Firms produce homogeneous, identical products. These products cannot be

substituted easily. New firms can enter the industry and can leave the industry, as per
their choice.

152
3] There is perfect mobility of factors Firms can move from one place to another
i.e. from one use to another use without any permission.

4]s Buyers and sellers have complete information about-market price. The price
fixed by Demand and Supply forces is known as market price. This price is supposed
to be known to all the players of the market.

5] Advertisement is not a feature of this market. This cost is zero. It has been
observed that no transport cost is incurred.

6] Identical Products: In particular, buyers cannot tell which firm produces a

given product. There are no brand names or distinguishing features that differentiate
products.

7] Perfect mobility: Such a firm has not seek permission of the govt. of leave the
industry.

Price-curve is like a horizontal curve, determined by market demand and

supply. Per unit price is same. So, average revenue (per unit revenue) becomes equal
to Marginal revenue (income from the sale of next-unit). This implies that each
additional unit of sales adds to total revenue an amount equal to price.

Firm continues to produce more, as long as the income received from the sale of the
additional unit is more than the cost of producing the same-unit. In other words, as
long as Marginal-Cost is less than Marginal-Revenue, the production continues to

153
increase.

The production is stopped when M.C. is equal to M.R. This situation is like a
cut-off point. The firm has no chance of earning profit, after this point. This point is
shown by equality between MC and MR curves.
Level of output that maximizes total profit occurs at a different level than the
output that maximizes profit-margin. Managers should ignore profit – margin.
There are two condition of equilibrium of firm under Perfect Competition:
1. MC must be equal to M.R.
2. MC must cut M.R. from below
3. Price should not be less than average variable cost. Otherwise firmwill take a
decision not to produce. This is known as shut – down point.

154
Additional condition of equilibrium:

In the above, diagram, Marginal cost (M.C. ) is equal to Marginal revenue

(M>R.) at two different points i.e. F and E.

However, the production must not stop at F, point. The firm will be deprived
of the profit shown by the shaded area.

E is the main point. Here, the firm must stop the production. Otherwise, after
this point, the Marginal-cost curve goes up and becomes higher than M.C. If any
production is undertaken in this area, the firm suffers loss.

SHUT DOWN POINT

Perfectly - competitive firm .
Shut down point is the minimum market price at which a company would
prefer to close-down its operation rather than manufacture anything.

Under the conditions of perfect-competition,if the firm is not in a

position to recover back the average variable cost of production. In such a
situation, the firm may decide to stop production, the total loss will be equal to
total fixed cost. By not producing, the firm saves on total variable cost. The
155
firm stops production at the lowest point of average variable cost curve. If the
firm fails to recover average cost, then, the firm will stop further
production.In the diagram given below point F is the shut down point.This is
the minimum point on the AVC curve.In the diagram given below , the firm will not
produce below point F . Because Rs. 9 is too low a price .This is less than the
average variable cost . The firm will decide to shut –down its plant to save the
average variable cost .This is an attempt for loss minimisation .The fixed cost is
not a consideration at this stage .It has to be incurred

SHORT PERIOD EUILIBRIUM ;:

Three conditions are possible under Perfect competition in the short period
with reference to the relation between AC and AR.

1. The new entrants into the industry suffer loss, because their AC is on the
higher side as compared to other firms. Such firms cannot increase the price of
their product. It is not within their purview. So such firms need to take steps
to reduce Average cost.

156
2. Firms earning only normal profits. These are relatively experienced firms,
producing relatively at competitive cost. In this case P = A.R. = A.C., = M.R.
This is known as the point of short period equilibrium of firm with normal
profit

3. Another category of firms, which are highly experienced and efficient,

produce at the lowest possible cost. They enjoy maximum profit .This is
shown by the following diagram.The AR curve is higher than short period
average cost ( AVC ).So the firm is spending less money while it is
recovering back more money.The shaded area is showing total profit of the
firm .

157
 The firm cannot change price . So the firm
suffers loss if it’s Average –cost is higher than average –income ( A.R.) .The line C
D is
Cost line , this is higher than revenue line shown by P E in above diagram .
Another possibility is that of a firm earning only normal profits .This is the fate of
those firms who experienced and succeed in reducing cost of production.The AC
curve touches AR line ,shown at point E ,in the following diagram

THE LONG PERIOD EQUILIBRIUM;

The firm ends up with only normal profit .The firm recovers back its Average –Cost.

Because, if existing firms earn super profits in the short period more firms get
attracted towards market. Supply gets increased, price of the product goes down and
super normal profit disappears .

158
 Loss making firms leave the industry or succeed in reducing cost of
production.
Thus, firm is in long-run equilibriumearns only normal profit.The firms operate at
the minimum point on the A C .This implies that the firm has to maintain high level
of efficiency A more efficient firm is expected to have a larger equilibrium output
than a less efficient firm .In other words ,different firms under perfect competition
will have different levels of output.This will depend on the firms efficiency level.

159
Q.No. 1 : Under what conditions should a firm continue to produce in the
short run if it incurs losses at the best level of output?
Q.No.2 : What is meant by the following:

It is a necessary condition that Marginal cost must cut MR curve

for equilibrium under Perfect competition. But it is not a sufficient
condition. Explain with the help of diagrams.
Q.No.3 : Can a firm under competition earn super profits in the short period
as well as in the long period?
Q.No.4 : Explain equilibrium of firm in the short period as well as the long
period.
Q.No.5 : Why the Average revenue curve coincides with Marginal- revenue
curve under Perfect competition.

160
 Chapter 9

Monopoly

1. Features of MONOPOLY MARKET

2. Sources of Monopoly
3. Short-period and long period equilibrium under Monopoly
4. Control of Monopoly

161
Monopoly:
It is a market situation in which the supply of a product/ service is in the hands
of a particular firm. In this case the firm is the industry itself. This would happen if
there are barrier to entry into the industry that allows the single company to operate
without competition in such an industry structure.

In a Monopoly market, factors like govt. license, ownership of resources, copy

right and patent and high starting cost make an entity a single seller of a particular
good. All these factors restrict the entry of other firms in the market.

Firm producing over a declining portion of the Long period Average –cost
(L.P.A.C.) curve poses a great challenge to the entry of new firms. Another hurdle in
the way of entry, is the possibility of one firm controlling a crucial input in the
production process. Brand loyalty is another hurdle in the way of entry .:
Economic - power

Monopoly firm enjoys market power. This is measured by the amount by which
price exceeds marginal cost.

The degree of market – power is inversely related to price elasticity of

Demand. The fewer close substitutes for a firms product, the smaller the elasticity of
demand and greater the firms market power.

On the other hand, when demand is perfectly elastic (demand is horizontal),

the firm has no market power.
This creates a situation known as consumer lock in.

A crucial feature of Monopoly:

162
 The monopolist faces a negative Demand Curve. In other words, demand-
curve faced by Monopolist is down ward sloping. The reason is that the monopoly
firm can sell more units by lowering its price. Although the firm is a price maker.

Since, the only firm happens to be the industry also. So when this firm produces
more, the industry supply increases and the market price comes down. So we say that
the monopolist can either choose his output or the price of his product.

Implied-conclusion:
Since Price (A.R.) is decreased to increase the sales, Marginal revenue
becomes smaller than the price of the product. It is seen below the demand curve of
the monopolist firm.

Equilibrium of firm in Short period under Monopoly:

The profit maximization takes place at that level of output where Marginal-
cost of production is equal to the Marginal revenue from the same output.

163
 As long as MC is less than M.R. the monopoly firm continues to produce
more to earn more profit.

In the opposite case, production does not take place.

In the above diagram, equality between MC and MR takes place at point E,

AB the total profit of the firm is shown by the area ABCD. The A.R. (D) being
higher than ATC.

In the long run, the Monopolist builds the optimum scale of plant to produce
the best level of output. Since the firm finds that all factors of production are
variable.

If the cost conditions becomes unfavourable i.e. if the price of inputs etc. goes
up and puts additional burden on the monopolist. The firm can go for an increase in
price of the product. The additional cost will be passed on to the consumers. So, the
firm is likely to earn super profits in the long run also.

164
 However, some experts have observed by studying the behaviour of
Monopoly firms that all of them do not seek money alone. Such firms invest
enormous amounts of money in research and development. Success has been noticed
with regard to innovations, new products and new technology etc. So, the monopoly
firms end up with normal profit i.e A.C. being A.R. (price). This condition keeps
potential rivals away from the market. So it is in the larger interest of the firm not to
go for super profits in the long run for example at OP price, firm is earning only
normal profits. Its explicit as well as implicit cost is recovered.

However, there is an opinion among experts who want strict controls over
Monopoly firms. In their view, monopolists charge prices above what they would be
with competition so that customers pay more. This results in transfer of wealth from
consumers to producers. Economic welfare of the society is reduced.

Regulators can set price controls. Another method may be to put checks on
rate of return. Breaking up the monopoly empire.

Note: The case of Govt. owned monopolies is entirely different from the above
description i.e. Railways in India.

165
Control of Monopoly:
The monopolist is often criticized for charging a price much higher than the
Marginal cost and for restricting the output much below the competitive level. In this
manner, he is able to generate inequalities in the income distribution. Monopoly may
also result in inefficient allocation of resources Undesirable welfare effect of
Monopoly calls for Government regulation through taxation or by price regulation or
by takeovers.

The government may implement various anti-monopolistic legislations and

can form regulatory bodies such as Competition commission of India, and Anti-Trust
bodies in U.S.A.

Steps may be taken to declare the formation of monopoly as illegal indirect

measures can also be used such as credit squeeze, restrictive licensing policy, etc. to
limit or curb the Monopoly power. Regulation of Monopoly will prevent consumer’s
exploitation and improve income distribution. It will be beneficial to the consumers
and to producers as well.

The Sherman Anti-Trust Act 1890, declared that no person or business could
monopolize trade or could combine or conspire with someone else to restrict trade
and behave like a monopolist.

What is the need for control of Monopoly:

When the Monopolist raises prices above the competitive level in order to reap
his Monopoly profits. So customers buy less of the product, less is produced and
society as a whole is worse-off. Thus, monopoly reduces society’s income.

166
 Anti-Trust Laws have prevented many useful-mergers. However, complete
elimination of monopoly is not desirable. Monopolies spend surplus funds in research
and development monopolies are given the credit inventing of several new products,
new machines and new methods of production etc. Monopolies, thus, contribute to
the development of society. A balanced approach is needed in this context.

167
Exercises for Students:
Q.No.1 : Explain with an example and a diagram the shape of Average
revenue and Marginal revenue curve under Monopoly
Q.No.2 : Describe equilibrium of a firm in the short period and long period
under perfect competition Monopoly
Q.No. 3 : Is Monopoly an evil for the society? How Monopoly can be
controlled?
Q.No.4 : Compare equilibrium under Monopoly with equilibrium under
perfect competition.

168
 Chapter - 10
Monopolistic Competition

1. Features

2. Short-period and long period equilibrium under Monopolistic competition

3. Selling cost under Monopolistic Competition

4. Excess capacity under Monopolistic Competition.

169
 CHAPTER - 10
Monopolistic Competition
Garments, food-processing, shoe stores, petrol-stations, beauty salons and
pizza stores toothpaste, cigarette etc. belong to different market structure, known as
Monopolistic competition.

The number of firms in this market is more than monopoly but less than
perfect competition. Perfect competition creates a degree of market power.

Different firms sell identical products but differentiated product. Each firm
produces a product which has qualities different from other products of the industry.
Consumers develop liking for peculiar properties of the product, for example,
cigarette, smokers become habitual of a particular brand of cigarette. So a particular
firm, succeeds in cultivating a particular group of buyers. Who remain loyal to that
particular brand. This enables the firm to take advantage of this behaviour by
charging higher price. To cultivate brandloyalty, the firms spends huge amounts of
money on advertising. This is known as selling cost.

The firm faces a downward – sloping curve. But it is highly elastic due to
availability of many close substitutes. There is a tinge of competition also. If a
particular firm increases the prices to a high level (above the expectation of
consumers) the demand will shift to other substitutes.

There is no ban as such, on the entry of new firms in the industry, but it is also
not easy to enter industry.

Short-period equilibrium

170
Under Monopolistic competition

The profit-maximization situation under this market is identical to Monopoly.

The firm decides not to produce, once, the M.C. Curve cuts MR curve at a particular
level of production. The A.C. is less than A.R. The equilibrium is shown in the
following diagram.

The Demand curve is more elastic as compared to Monopoly in the above

diagram, the shaded area ABCD, shows super-profits to the firm.

Long period Equilibrium Under Monopolistic Competition

In the long run the firm is most likely to earn only normal profits, due to
competition. In the diagram, R points shows situation of normal profit. The per unit
cost gets recovered due to equality between AC and AR.

In long-Run demand curve of monopolistic curve shift leftward as its market

share decrease because of entry of other competitors got attracted due to economic
profit earned in short-run and free exist and entry.

171
Thus is the long Run, Monopolistic firms break even and produces at negatively
sloped portion of their LAC curve rather than lowest point due to product
differentiation.

As per figure Demand curve D” is more price elastic than short-run because of:
• Large no. of players in the market
• Greater range of competition (P).

At any other price below this point Firm would incur loss.

“Monopolistic firm produces to the left of lowest point of LAC in the long Run
equilibrium because:

Average cost of production and price of product under monopolistic competition are
higher than perfect competition because of differentiate product for varied consumer
taste and advertisement expenses than in perfect competition with homogeneous
product.The equilibrium of firm is not established at the minimum point on the long
run average cost curve . This implies wastage of resources .Efficiency in production
Suffers .The firm takes help of publicity campaigns to increas sales of its product .

172
Selling Costs:
Selling cost is a reference to the expenses in the marketing and distribution of
a product. These are those expenses which are spent for popularizing differentiated
product. The purpose of incurring selling costs is to increase the demand for the
products of the firm.

Selling cost is a referance tothe expenses incurred in the marketing and

distribution of a product. These are those expenses which are spent for popularizing
the differentiated product.The purpose of incurring selling cost is to increase the
demand for the products of the firm.

Such selling costs are incurred in several forms such as sales promotion and
advertising etc. The main objective of undertaking costs is to raise the demand for the
products and changing shape of Demand curve.

Selling costs are of two types i.e. informative and persuasive. Informative
selling costs make the consumers aware about the entry of a new firm, new product,
or any change in the product. This is educative role of selling cost. So this may not
be considered as an item of waste.

Selling cost have resulted in the creation of an industry dealing with

advertisement, publicity etc. These activities have created highly lucrative jobs.

However selling costs may result in advertisement . This may prompt rival
firms to undertake counter advertisement campaigns. This may lead to waste of
resources. Moreover, selling cost may mislead the consumers about the nature of
quality of product. This is not desirable from social point of view.

173
 Selling cost is regarded as the most important instrument by which a firm can
convince its buyers about the distinguished properties of its product, as compared to
other products.

Selling costs, particularly advertising expenditures can affect both shape and
location of the Demand Curve for the firm’s product. The firm seeking maximization
of profits will add that amount on advertizing in the price of the product. This is
regarded as optimum advertisement

The P.R. line is taken as average and Marginal revenue curve. The advertising
expenditure enables the firm to sell more quantity without lowering the price.

. Marginal cost is equal to price which is the same as marginal revenue. The
firm decides that with given sales , the firms advertizing volume is optimum
because the amount of profit earned is the maximum.

Excess – Capacity
Excess-capacity refers to the difference between the minimum average cost
point and the actual output made by a firm under Monopolistic competition in the
long period.

174
 In this market, firms try to attract more demand through advertisements and
by using various sales-promotion techniques. Therefore it is alleged that reducing
cost is not the main objective.

Therefore, the level of production of a firm is below optimum level. Thus, a

situation arises, in which resources are not fully utilized. This creates a situation in
which inefficient firms exists even in the long run. In the diagram the actual
production is OM. This is less than the optimum production, OQ and thus the firm’s
excess capacity will be OQ-ON=NQ.

This case of excess capacity is

Shown by the following diagram:

Exercises for Students:

Q.No. 1 : Explain features of Monopolistic Competition.

Q.No.2 : Explain the concept of selling costs. How do these costs influence
the equilibrium of a firm under Monopolistic competition?

175
Q.No.3 : Describe equilibrium of a firm under Monopolistic competition in
the short period and in the Long period.
Q.No.4 : Distinguish between Monopoly and Monopolistic competition.
Q.No.5 : Explain the concept of selling costs. How do these costs influence
the equilibrium of a firm under Monopolistic competition?

176
 Chapter 11

Price-Discrimination

1 Price discrimination
2 When it is possible ?
3 What are the different degrees of Price –discrimination ?
2. Dumping

3. Case study

177
 Price – Discrimination

Price-discrimination is the practice of charging different prices for the same

good or service.

There are conditions necessary for successful- discrimination.

1. The firm must be able to identify different market segments on the basis of
different price-elasticity.

2. The firm must have some degree of monopoly power.

3. Consumers of one segment must not be in a position to contact the other

market. The markets must be kept separate, either by time, physical distance
and nature of use. Educational institutions are given the benefit of lower price
for schools of software for schools. Buyers have to prove their identity.

Price Discrimination
1. Personal discrimination:

Income: Rich and poor patients appearing before doctors are charged different fees.
Age: Adult railway travelers and children being charged less.

2. Place Discrimination: Price has relation with the area/ localty. Indian
Airlines fares are less for Assam etc.

3. Trade discrimination: Prices depend on the use of the product, Electricity

used for domestic purpose and for commercial purpose [ rates are not same].

178
4. Time discrimination: Price depends on different sizes and weights/ quantities
i.e. wholesale price and retail price.

5. Product discrimination: Price depends on different sizes and weights/

quantities i.e. wholesale and retail price.

Types of price-discrimination:
(A) First degree of Price- discrimination:
In this case, the firm sells each unit of the product separately. This policy
requires precise knowledge about every buyer’s demand for the good. Then only
entire consumers surplus can be taken away by the firm. The demand curve (D )tells
us the
Maximum price that can be charged for various quantities of output .This indicates
thewillingness of the consumer to pay the price .
To start with ,the monopolist can charge higher price on the basis of willingness
of
buyers to pay the price. But to sell O X i quantity the monopolist reduces the price
to
Opi level to sell OS Q I . The willingness of buyer is shown by point B on the
demand –curve.
The profit maximizing output is determined at the point of equality of marginal
–cost and the demand-curve. In the given diagram , the limit is shown by O Q I
output
At price OP ii . The monopolist ,takes- away entire Consumers –Surplus shown AGF
Area. ,Monopolist fixes the price on the basis of Demand –curve representing the
willingness of the buyer to pay .In otherwords,the monopolist charges
everybuyerthe maximum amount he is willing to buy and thus he takes away all the
Consumers –Surplus.

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The firm must have full information on every consumer’s individual preferences and
willingness to pay The firm separates the market into each individual consumer and
charges them the price they are willing and able to pay

s
B) Second degree price -discrimination
:
In this case, price discrimination is quantity based. It is a case of declining
block pricing. The firm lowers price for additional blocks to the buyer.

In the above diagram successive

Blocks are sold at lower prices. .
First block ,is sold at higher price shown by Opi ,the same policy continues In the
process the price is brought down to a lower level at OPi.Thus the consumers surplus
is
shared between the seller and the buyers.The gap between average revenue ( demand
curve )and cost curve shows that the seller does not take away entire consumers
surplus.

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 Air- tickets ar issued at low-prices. Low fares are charged if early
booking of tickets takes place. Low room rent applies for group booking in the
hotels, especially if spare-capacity exists
(C) Third degree price-discrimination;
This is a practice in which the firm discriminates purely on the basis of
elasticity of Demand. If in one market, there is inelastic Demand and in another
market, there is elastic demand, the price charged by the monopolist will not be the
same in both the markets.
In case of market with inelastic demand, the monopolist, firm will charge
higher price as compared to the other market with elastic Demand.

The monopoly firm will distribute the total output in the two markets in such a
way that not only the marginal revenues in both of them are equalized but the
marginal cost also equals these marginal revenue.Price during peak and off –peak
duration is not same. The basic idea is summarized below :
.
Total Marginal = M.C. = M.R.of + MR of
Revenue Market Market
A B

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In above diagram , the firm uses O3 E3 as the base marginal –cost for determining
the
Equilibrium output .So O3 O3 is the yardstick for determining equilibrium in first
two
Diagrams, shown by Q2 E2 and Q1 E1. The equilibrium output is distributed in the
two
Markets .But the prices fixed in these two markets is not same .See points Ri and R 2
In the first diagram ,inelastic demand is shown, with higher price .In the second
diagram ,Elastic demand is shown with lower price .

DUMPING ---- POLICY

This refers to the export by a country ofa product at a price that is lower inthe
foreign market than the price charged in the domestic market. Dumping may also be
treated as an act of, off- loading a stock with little regard for its price .
.The impact of dumping may be disastrous on the importing-country (the recipient
country, in which dumping has been done). This may drive domestic producers out
of business, which would result in job losses and a higher rate of unemployment.
Dumping is a special case of price discrimination.

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Types of Dumping:
1. Predatory dumping: In this case, the firm tries to eliminate the industry in
the foreign-country.

2. Sporadic dumping: This is a temporary phenomenon. If the firm faces the

problem of over-production of its output, then the firm may off-load the
surplus output in foreign market at a lower price.

The output and price determination under dumping; In the home-market, the
producer works under conditions of Monopolistic-competition. On the other hand,
the producer works under perfect - competition. The Demand curve is not same in
both the situations. The Demand curve facing the Monopolist in the foreign market is
perfectly elastic and less-elastic in the home-market. In this scenario, the marginal-
revenue must be equal in both the markets.
Output and Price determination in the Home-market:
This is explained with the help of the above diagram . The Demand curve is
less elastic in the home market. This is shown by the downward sloping-curve . The
relevant Marginal revenue is LRB.

Output and Price determination in the Foreign-market:

PDF is the market demand curve in the international market. This is shown by
horizontal line . Because it is perfectly elastic, the firm faces competition in the

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foreign market. So the Average revenue and Marginal revenue-curves take the shape
of horizontal line, as shown by MR 2 and AR 2.

Combined Marginal Revenue Curve:

The lateral summation of the two MR curves, gives, us the combined
Marginal-Revenue-curve. At point, , is the equilibrium point where the MC cuts the
Marginal revenue . The equilibrium output O M will be produced for sale in the two-
markets.

The total output, OM of will be produced for sale in the two markets. The
distribution of the total output in the two markets will be done on the basis of the
respective equality between Marginal cost (M.C.) and Marginal Revenue (M.R.).
Thus, the equilibrium in the Home-market is established at R-point. The point of
equality between MC and MR.

On the other hand, LM amount will be sold in the foreign market at OPi price.
The basic idea is thus proved. The seller charges lower price and tries to sell more in
the foreign market. On the other hand, the seller charges higher price.

Action against Dumping:

An important observation is that, if the price of the exported commodity falls
below a certain point , the Monopolist will not sell in the foreign markets.
Dumping policy is not appreciated on the international-level. The negative
effect of Dumping on Domestic industry is known as “injury to domestic industry”.
There are rules which allow imposition of anti-dumping duty equal to the difference
between the exporters home market price and the importer’s price.

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 G.A.T.T. article VI of 1994, provides principles to govern the investigation,
determination and application of anti-dumping measures. Nowadays World-Trade
Organization (W.T.O.) can impose anti-dumping measures. However, it is quite
difficult to find out and prove that domestic price is less than the price charged in the
foreign markets. For example, in the case where there are no sales in the exporting
country of the product under investigation. Another case, the level of such sales is so
low that its significance is questionable. (W.T.O. lays down that 5 percent or more
of the export sales )

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186
.

Exercises for Students

Q.No.1 : What do you understand by price discrimination? Discuss

various forms of price – discrimination.

Q.No. 2 : Under what conditions price-discrimination? Is possible

Q.No. 3 : What is the significance of elasticity in price-discrimination?

Q.No. 4 : The practice of Dumping is not justifiable? Why! under what

conditions this may be allowed?

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 CASE – STUDY No.11
UNIQUE PRICING – “PRICE DISCRIMINATION”
Managers have to face a tricky problem in their role as godfather of their companies.
They have to fix an optimum price for the products i.e. an ideal price that will attract
maximum number of buyers for the product of their esteemed firm. The product
should not either be over-priced or under-priced. They have to make sure that the
price is right.

To achieve the above objectives, companies undertake market-research,

especially before introducing a new product in the market. There are number of
cases when the product was either over-priced or under-priced. It is reported that
Apple Computer could not fix an ideal price of the Power Macintosh brand of
computers. There were too many buyers than what the company could supply.

Companies try to gauge the tastes of the buyers, the price of the close
substitutes, consumers ability to pay for the product etc. Their may be situation in
which different consumers may not mind paying different prices, for the same
product or a service. To practice, this one requires in depth knowledge of this
phenomenon known as the technique of price-discrimination, otherwise it may back
fire.

In Singapore Property Registration Charges are different for foreigners and for
locals. Foreigners have to pay 15% of the value of the property for getting the
property registered in their names, whereas, the locals pay only 5%.

Most of you must be aware, that the Electricity Supply Company B.S.E.S.
charges different prices per Unit of electricity used by different consumers vis, the
domestic use and commercial use. In case of domestic category, there are few more

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concessions, referred as subsidy. The B.S.E.S. Company applies the policy of price
discrimination.

In India, as well as elsewhere, airlines apply the above mentioned policy.

Airline tickets are priced differently, higher charges from business class travelers and
less charges from leisure trip travelers. The East-West Airlines tried to decouple the
leisure fares from the rest of fare market by offering low fares. This was done to
stimulate family travel.

Charging the same price for every unit creates consumer surplus for every unit
sold except for very last unit sold. The existence of any amount of consumer surplus
is evidence of under-pricing. The managers try to design pricing schemes to take
consumer surplus away from buyers. Since consumer surplus arises when consumer
pay less for a product than the maximum amount they are willing to pay this. The
lower price is known as curse of uniform pricing.

A pricing scheme that makes each customer to pay an amount that customers
are willing to pay. The practice is known as First Degree Price discrimination. It is
believed that business is not lost by charging too high a price to customers who
would be willing to pay as much.

In some cases, there are two levels of prices. For example in some sports
clubs, amusement parks, holiday resorts and transport facilities offering monthly or
annual access passes etc. in such cases, prices where the consumer must pay a flat fee
for access and then a separate fee for usage is a case of second degree price
discrimination. It is primarily based on the volume of consumer purchases.

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 There is another variety of price discrimination also. This is known as Third
Degree Price discrimination Pricing based on what type of consumer is doing the
purchasing rather the volume purchase.

Take the case of students and business community. Students pay for their
travel out of their own pockets while businessman get their travel expenses. So, it is
natural the student is likely to be willing to pay less for a travel ticket, as compared to
businessman. Thus, two groups a being distinguished on the basis of their paying
capacity i.e. Elasticity of Demand.

Certain conditions are necessary for the firm to be able to price discriminate
profitably. Firm more possess some market power. The firm must be able, in a cost
effective manner to identify and separate some markets. Sub-markets must be
separated to prevent resale of the product.

Consumer arbitrage refers to low price buyers reselling goods in the high price
market. Doctors and lawyers are known to use sliding scales to charge higher prices
to higher income clients and lower prices lower income clients. A patient paying a
lower price for an operation cannot resale these kind of services higher price buyers.

But in some other cases, it is quite difficult to prevent customers in the higher
price market from buying in the lower price market. So third Degree Price
Discrimination may not be profitable. The airline provided discount of more than20
percent to groups of two or more people who were to travel together.

It was assumed that business travelers fly alone they will not be entitled to for
a “group tickets concession”. The airline executive predicted that business people
would not abuse these tickets.

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 East-West Airlines tried to implement certain checks to avoid the possibility
of cross buying. For example passengers were required to book their flight together,
check in together and follow identification itineraries in order to qualify for the group
discounts. There were few more other conditions attached to the new conditions.

The above scenario is entirely different from generally accepted necessary

conditions necessary. Third Degree Price discrimination. Such as firms must separate
the sub-market on the basis of Elasticity Demand and firms must be able to separate
market so as to keep the two different groups of consumer separated from each other.

It is due to the above that price discrimination is only possible – under

particular market environment.

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Questions:
1. Give examples of Price Discrimination taking place in Indian Industry?
2. Explain the various types of Price Discrimination?
3. What is the Consumer’s Surplus? Point out its role in Price Discrimination.

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 Chapter 12
Modern Pricing Practices

1. Pricing-practices by modern companies

2. Case study

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 Modern Pricing Practices:

These days, firms use different type of pricing techniques in order to

maximize their profit. Price selection is also a subject of innovation. Some of the
widely used practices are explained below:

1. Tying: The firm puts a condition that in the use of the main product, if another
product is needed, then, these have to be purchased from the same firm.

2. Bundling: This is a Practice in which two or more products are sold as one
transaction. Some banks go for bundling of tax saving term deposit scheme
with insurance schemes.

3. Peak-Load Pricing: The business increases during certain duration in some

services such as telephones and metro-services. So, the charges are increased
during peak load-hours as compared to off-peak times. In U.S.A. the charge
for metro- are more as compared to non-office hours.

4. Two Part Tariff: In certain cases, there is an entry-price and later on the
customer pays the price for using the product/ services. For example, the
railway platform tickets.

5. Prestige-Pricing: This is rare case. It applies only to the highly prestigious

products satisfying snob-value e.g. expensive perfumes, cosmetics branded
jewelry etc. in such cases, similar and cheaper substitutes may be available in
the market but high society consumers go for high priced products.

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6. Price-lining: This is a marketing requirement. The auto manufacturer may be
facing competition in a particular segment say for example, between 6 lakhs a
car to 8 lakhs. Then, the company will try to produce a car within the same
limit.

7. Skimming: Initially Higher price is charged when the product is introduced a

gradually as the sales increase per unit price is reduced.

8. Price-matching: Firm announce a price for company’s product.

Consumers are encouraged to find similar product at a relatively lower price.
In such a case, the company ‘A’ will reduce the price to match the price
charged by another firm.

9. Auction Pricing: This is a reference to internet trade. Buyer post a price and
the site facilitates a match with seller.

10. Cost plus Pricing: The company decides a particular rate of return and then
adds it to the actual cost of production of the product. Cost plus pricing is
useful when the production costs of a product/ service are not clear in
advance.

This method is used to fix price of large projects for example, building an
aircraft.

Case Study No.12

Bundling

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Tying: refers to the requirement that a consumer who buys a product, is made to
purchase another product. The two products may be having some close relation with
each other. There was a time when IBM made it mandatory for its customers to
purchase IBM punch cards. This practice came under the scrutiny of the court.
Likewise, Xerox company the inventor of photocopies required users to purchase
“paper” from Xerox. The above practice known as Tying is not approved by the legal
bodies. However, firms want to ensure that the correct supplies are used for the
equipment to function properly or to ensure a level of quality. But, we all known that
this policy is used to earn additional profits.

Bundling is a common form of tying. This refers to sale of a package rather

than separately. This refers to sale of a package rather than separately. This makes
the firm to maximize its profits. This can be done to give publicity to help build
awareness of the new product. Firm may charge less when the customer purchases a
bundle at one time.

In India, some banks offer free accident insurance for depositors as a part of
their deposit mobilization effort. Indian Income Tax law provides for deposit
mobilization effort. Indian Income Tax provides for the deduction of an amount one
lakh fifty thousand rupees, to individual tax payers, under Section 80C of the Tax
Act, with respect to the sum deposited in specified schemes. The United Bank of
India has offered to bundle insurance with its tax saving term deposit schemes.

Bundling encompasses two or more products together as a package and selling

it for a single price. Selling bundles of goods together as a packages can be a source
of economic efficiency. More examples of bundling. An old camera might be sold in
a box with a free film. A hotel room might come with accompanying breakfast. A

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product can also be bundled together with a loan. A car seller or a flat selling agency
may also offer finance.

Mobile companies provide free-talk-time, of a certain value on the purchase of

a instrument of the same company. BSNL offered such a scheme in which the SIM
could be used only for their handset.

Bundling can be beneficial to the customers. It can make purchasing activity

comfortable and economical. The bundled goods are made available at one place.
This saves transaction costs. Since, a single purchase is cheaper to carry-out than
multiple one. Bundling sometimes benefits consumers and sometimes producers.
There is some loss of consumer choice. Tying agreements serve hardly any purpose
beyond the suppression of competition. The sale of windows and Microsoft Package
of explorer together is a pure bundle. One has to find out a viable market for each
product on its own. If this can be done, then, this will be regarded as a bundle. There
is need for improvement and of innovations in case of integrated products, so liberal
treatment by legal bodies has to be applied in such cases.

Questions:
1 Distinguish between good and bad features bundling.
2. Can you site few more examples of bundling.
3. Would you like to purchase different parts of an auto car to assemble a car
yourself. How and why?
4. Will – above issue arise in the case of an assembled (computer? How and
why?.

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 Chapter – 13

Oligopoly

1. Features

2. Analysis of Kinked Demand Curve

3. Discussion on cartel price leadership

4 Profitability and efficiency of Oligopoly

5. Porters strategic framework

6. Case-Study marriage between companies

7. Case-study: case of price leadership

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 Oligopoly
A situation in which a particular market is controlled by a small group of firm.
The retail gas market is a good example of an oligopoly because a small number of
firms control a large majority of the market.

In oligopoly market, few firms dominate. The market is shared between a few
firms. Many small firms may also operate in the market. British – Airways and Air.
France operate their routes with only a few close competitors, but many small airlines
also operate side-by-side.

Oligopoly market may be identified as an industry, where there is a high

concentration ratio.

Other characteristics of Oligopoly:

1. Interdependence: A firm operating in a market with just a few competitors
must take the potential reaction of its closest rivals into account when making its own
decisions. For example, if Maruti Company wants to increase its market share by
reducing price, it must take into account the possibility that close rivals, such as
Hyundai and others, may also reduce their price in retaliation.

2. Strategy:
Strategic behavior refer to actions taken by firms to plan for and react to
competition from rival firms.

Such firms have to make critical strategic decisions. Such as complete.

i) Whether to compete with rivals, or collude with them.

ii) Whether to raise or lower price, or keep price constant.

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iii) Whether to be the first firm to implement a new- strategy or whether to wait
and see what rivals do?

The advantages of “going first” or “going second” are respectively called 1st
and 2nd mover advantage. Sometimes it pays to go first because a firm can generate
head-start profits, 2nd mover advantage occurs when it pays to wait and see what new
strategies are launched by rivals and then try to improve on them or find ways to
undermine them.

3) Barriers to entry: The existing firms might make to costly or difficult for
potential rivals to enter the market. There may be natural barriers on the entry of new
firms. This may include economies of scale being enjoyed by the existing firm. The
oligopoly firm may be owning scarce resources such as aluminium, minerals and
others. There may arise the issue of high set up cost for the new firms The existing
oligopoly firm may be having large financial reserves. This may enable the company
to invest heavily in research and development example, pharma and the chemical
industry. There may be artificial barriers, such as predatory pricing policy. This
refers to reduction in prices, so that entrant cannot make a profit at that price. Firm
may also take advantage of patents.

Oligopoly firm may create loyalty. The firm ‘locks in’ existing – consumers.
Advertising plays a very important role in this aspect. The firm may produce
homogeneous or differentiated products.

4. The Demand Curve is indeterminate: Under oligopoly if a particular firm

increases the price, other firms may or may not follow. So there is uncertainly. So
forecasting the nature and shape of its Demand-curve becomes difficult. The firm
cannot make an estimate of sales of its product if it were to cut the price by a certain

201
amount. Hence the demand or the average revenue curve of the firm becomes
indeterminate. So it is not possible to come to clear and precise conclusions about
equilibrium prices and output under oligopoly conditions.

Oligopoly-models: The main models have been described in the following

description”
Cartels
Quota – system
Market – sharing
Kinked – demand curve

(A) Cartel agreement:

This is also known as a case of perfect collusion. This is the most extreme
form of co-operative oligopoly. This is an explicit collusive agreement to drive up
prices by restricting total market output.

Price and output decisions for all the member firms are taken by the cartel
board. The Board decides the price of the product. It is not fixed by Demand and
supply.

Under this system, the firms agree among themselves regarding output, price
and also the area where they should sell their product. They also agree to the creation
of a centralized. Agency through which they fix prices and output such an agency is
known as a Cartel.

In order to maximize joint profits, the cartel takes into account the Marginal
cost and Marginal Revenue. The equilibrium output is decided at which the industry
Marginal cost curve equals the industry Marginal Revenue. Each firm would produce

202
that output at which the M.C. equals the industry Marginal revenue. This is shown at
point E in the following diagram. The share of each firm has been fixed.

The centralized agency will have to estimate, first of all, the industry Demand.
Curve, showing the different amounts of the output that could be sold at different
prices. AR is the industry demand curve. From the AR it is possible to draw the MR
curve. MR is the marginal curve of the industry. The MC curve of the industry is
drawn by adding together the MC curves of the individual firms. The sum of the MC
of the two firms No.1 and 2. Output OQ is determined at the point of intersection
between MC and MR Curve. The two intersect at Q..

Output OQis unique in the sense that it maximizes the joint profits of the
industry. OQ is sold at OP price This is allocated between the two firms. The joint
profits of the industry are thus maximized.

Each firm much get a share of combined profits which will be greater than it
could hope to secure in the absence of price determined by cartel.This is profitable to
all the players .

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 Cartels are not allowed under law in a number of countries. Moreover there is
a tendency on the part of firms to cheat each other by selling at lower prices than the
cartel fixed price.

(ii) Market – Sharing:

Firms divide the market among themselves according to an agreed plan and
each firm gets profits simply on its sales.

In case the cost-curves or the market shares of the firms differ, each firm will
charge an independent price in accordance with its own Marginal cost and Marginal
revenue-curves.

The competitors agree to divide or allocate customers, suppliers or territories

among themselves rather than allowing competitive market.

Market-sharing deals with allocating customers by geographic area. This may

take the form of dividing contracts by value within an area. The contracting parties
also agree not to compete with each other for established customers. They also agree
not to produce each other’s products or services.

D) Price-leadership: In oligopoly, firms have an unspoken understanding that

limits their competition. One way in which firms achieve this is price leadership.

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Market sharing restricts competition, takes prices-up and reduces choice of
consumers.

In this case one particular firm determines the price for the industry, other
firms follow the leading firm. This is possible, if the average cost of the so called
leader firm is much below as compared to other firms. There is always a threat that
the dominant firm may reduce the price to low-level at which the rival firms will find
themselves out of market. Smaller firms do not have the same economies of scale as
the price-leader. Price leader sets its price at a level it believes will maximize total
industry profit. Rest of firms co-operate by setting same price. This may not require
any explicit agreement.

Price leadership may help other firms also to earn more profit for this purpose.
The dominant firm may set relatively higher prices.

In the above diagram, the profit maximizing price P is determined by the

demand curve of the price leader. There are two marginal cost curves one is ∑MCi
and the other is MC2 .These curves are showing two important points at K and ki
respectively. This shows the cost difference.

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If there is a change in cost of production etc. one of the firms in the industry may
take the lead in increasing prices. Other firms will follow this firm. The price leader
may be the largest firm in the industry, or it may be a firm that has particularly good
at assessing changes in demand or cost.
The tacit collusion can be difficult to identify. It is difficult to identify such cases.
Cases of price leadership are found in industries like cement, fertilizers, cigarettes,
cars etc. Price leadership takes shape when there is a dominant firm that has more
than 50 percent market share and a bunch of small firms, each being too small to
influence the market price.

Price leadership can be differentiated into three different forms:

(a) Collusive Price-leadership.
(b) Barometric price leadership
(c) Dominant firm price-leadership

In Collusive price leadership, two or three small firms collude to form a single
entity and act as a price leader.

The second model is barometric price leadership. It refers to a situation in

which the price leader merely announces the price that would prevail. It is done by
estimating demand and cost conditions. Other firms adjust to this price. The leader
has the ability to interpret market conditions and propose price changes that other
firms are willing to follow:

The third dominant firm model of price-leadership is based on the assumption

that between two firms, one firm is a low cost firm or a dominant-firm. The low cost
firm acts is a leader firm.
KINKED DEMAND CURVE

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 A demand curve with two distinct segments which have different elasticity
that join to form a kink. The primary use of the kinked demand curve is to explain
price rigidity in oligopoly.

The kinked demand curve model assumes that a business might face a dual
demand curve for its product based on the likely reactions of other firms to a change
in price.
The M.C. curve passes through the vertical line in the graph. The equilibrium output
remains the same. There is no change in quantity produced as prices are lowered.
If a firm raises its price but the others do not match the increase, then revenue will
decline in spite of the price increase. If the firm lowers its price , then the other firms
will match the decrease to avoid losing market share. The firm will not change the
price as long as MC is between MC1 and MC2. Since the number of firms is small
under oligopoly. The firms are inter-dependent. If a particular firm ‘A’ wants to
change the price of its product. It has to consider the reaction of its rival. If one firm
raises its price, the others will not increase price . Such a situation will give them an
opportunity to . take market share from the price changer.This creates an elastic
demand curve. The firm

207
raising the pricewill loose consumers and revenue, .On the other hand .if one firm
lowers price, then the rival firms will not remain indifferent .these firms will also
reduce
price of their product .This part of the demand curve will not be elastic .At this point
a kink appears in the demand curve see at point B on AR. The marginal –revenue
curve also shows a kink.See in the diagram, from A to G and the portion H J .

The drastic change in the elasticity of demand –curve creates a kink in the
Demand curve . The upper portion and the lower portion of Demand curve show
different degrees of elasticity .

The kinked demand curve model makes a prediction that a business might
reach a stable profit maximizing equilibrium at price and output and have little
incentive to alter prices.

There will be periods of relative price stability under an oligopoly with

businesses focusing on non-price competition as a means of reinforcing their market
position and increasing their super-normal profits.

A rise in marginal cost may have no effect on the profit maximizing price and
output. This change in Marginal cost does lead to a change in output. This price is
profit maximizing for any marginal cost curve that cuts the vertical section of the
Marginal revenue curve. Prices are likely to remain unchanged for smaller changes in
cost, as shown in the diagram.

As a result of the kink in the Demand Curve, The MR curve has a

discontinuity in it. It jumps suddenly from one point B to point C.

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The model suggests that prices will be fairly stable and there is little incentive to
change price. Therefore, firms compete using non-price competition methods

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Limitation of the Concept:
This theory has few limitations.The theory explains why rigid price has been
determined under oligopoly. It does not explain how the price has been determined.

During period of recession, big changes take place even under oligopoly. This
cannot be explained with this approach.

This model is applicable in the short-run. When firms have no clear idea as
how competitors will react.

Oligopoly-firms appear in a very sound economic-conditions. Firms under

oligopoly face competition from rivals, there is always possibility of entry of new
firms and possibility of substitutes in the market. Another area of concern is
strengthening power of buyers and suppliers. The competition among competitors
may become more intense.

All these factors will have adverse impact on profitability of existing firm.
The profitability of the firm will go up if the above challenges are not faced by the
firm.

The factors determining the intensity of competition among the rival firms
will depend on the ratio of fixed total costs, the degree of concentration in the
market, growth rate of industry, existing barriers, and non-price competition etc. The
famous cigarette manufacturers may have earned much more profit in the absence of
rivalry among them.

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 Efficiency and Profitability
Under oligopoly
Oligopoly market structure is associated with several debits and credits. On
the one hand, all of us acknowledge that the development of huge capital eating –
industries like steel, automobiles and aluminum, power etc. would not have been
possible, without the growth of oligopoly firms.

The level of investment required is enormous, for research and development.

Innovations have flown mainly from these firms. Oligopoly firms enjoy
technological advantages. This has led to the new jobs and new perspectives. The
credit goes to oligopoly firms. This would not have been possible under Perfect –
competition.

On the other hand, oligopoly firms are accused of wasting resources. Such
firms do not produce at the minimum point of the average cost. This causes under
utilization of the country’s resources. Too much resources are wasted on making
unnecessary changes in the models of cars, AC’s etc

Case No.13 Marriage between companies

The world is changing. The nature of business is changing. But as the size of
business started increasing, more and more capital is needed; for example in the field
of civil aviation, huge investment is needed. Requirement of capital can be judged by
the fact, that, air carriers must have a fleet of at least 20 planes. Indian carriers do not
have the financial strength to leverage their international operations. Indian carriers
have suffered a combined net loss of more than 35 billion rupees on their
international operations.

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 It was in 2012 that the government allowed first investment by foreign airlines
in Indian carrier. Etihad airlines invested 24 percent in the equity of the Jet-Airways.

To overcome its financial problems, Jet-Airways sold 24 percent stake in

India’s second largest airline by market share. Etihad paid more than $ 379 million
dollars. Mr. Naresh Goyal remained as the Chairman of the Jet-Airways with stake of
51 percent.

This agreement was considered as beneficial for both the parties. Jet got cash.
Jet needed money to pay its debt of more than 100 billion rupees.

Jet and Etihad together planned to link 140 cities on the global level. Both the
companies agreed to increase their weekly flying rights four times. These airlines
also agreed to add 36,670 seats in the near future. This deal is regarded as a game
changing opportunity for both the carriers. This would add profits to the new entity.

Critics of the above deal point out that Etihad carrier wants to enjoy the status
of a full-fledged and a strong oligopoly firm. The above deal would limit the
competition in the civil aviation market. The mal practices of oligopoly would take
shape in the future Flyers would be exploited.

It has been pointed out that the deal forebode a gloomy future for Indian-
airlines has faced the problem of higher costs of doing business in the country i.e.
rising fuel expenses etc.

Civil aviation experts have pointed out that our carriers find it difficult to
compete with foreign airlines. So, they choose to join them. Under the existing poor
infrastructure and mis-management and use of old-aircraft etc. Kingfisher Airlines

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has withdrawn from the scene. New agreements on the above model have recently
surfaced in the country.

Q.1 Why Jet-airline became heavily indebted?

2. Why Indian air-carriers could not compete with foreign airlines
3. What is the role of efficiency in this case study?
4 The said agreement mentioned in the case study is a case of cartel-formation
or of mergers

Case Study No.14 The case of price leadership

The situation is very unique in the oligopoly-market. This is the case of price-
leadership. A particular firm plays the role of a price leader. The price fixed by the
leader is followed by all other firms of the industry. But this practice is not regarded
as a fair practice. Because this may lead to the creation of a Monopoly like situation.
The result is exploitation of labour.

There are laws in this context. Regulated bodies keep a watch on such
developments. This issue was raised and studied by the commission in United
Kingdom in early nineties. The commission has to investigate the possibility of
existence of Monopoly in Britain. The case of price leadership was thoroughly
examined.

The three largest supplies of new cars were Ford, Rover and Vauxhall. These
companies used to increase prices in the same month, with Ford often in the lead.
Prices were increased by Ford on most of the occasion. The report found monopoly
situations

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Case Stud No15 : Incentives and efficiency:

There is a strong belief that bonus-schemes and other incentives for workers
especially to the senior executives bring rich dividends for the company in the form
of improved all-round productivity. But, some experts have concluded to the
contrary.

Corporate executives in Western World, were allotted small percentages of

shares in their respective companies. The shareholding represented substantial
individual wealth. The policy allotment of shares of senior executives is regarded as a
motivational factor. It was reported that a substantial number of executive directors
became millionaires through holding of their own companies stock. The managers
have to look after the interest of shareholders.

The studies investigate the relationship between pay and performance have
yielded important conclusions. The basis of the incentives can be manipulated by the
managers, for example bonuses are based on the annual profits of the company. This
may lead a new thinking on the part of managers. They would like to projects with
high expected return which might add to the wealth of shareholders.

Incentives and efficiency

Number of countries have introduced compensation packages for executives.
For example Germany introduced executive performance related pay schemes.
Managerial shareholdings are far less significant in large Japanese firms than in their

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American equivalents. Company’s stock holdings system is not very important in
Japan. It is observed that executive income in Germany and Japan is even less closely
linked to the performance of their companies in the U.K. and the U.S. It is due to the
fact that achievement of certain goals is considered more important than profitability.

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Exercise for students:

Q.1 What do you understand by the following:

(a) Indeterminate Demand- Curve
(b) Price-leadership

Q.2 What is a kinked Demand-curve?

What is the logic behind price-rigidity?

Q.3 Explain the following:

(a) Quotas under oligopoly
(b) Market-sharing in oligopoly

Q.4 Describe Porters strategic framework.

Q.5 Explain the special characteristics of oligopoly. How does inter dependence
lead to indeterminateness under oligopoly.

Q.6 Describe the determination of price and output in an oligopolistic- market in

which the dominant firm is the price-leader.

Q.7 What are cartels? How do they attempt joint profit maximization?

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 Chapter No. 14

1. Introduction to Game – Theory

2. Implications of Strategic relationship

3. Zero-sum game

4. The prisoner’s Dilemma

5. Nash equilibrium

6. Dominant strategy.

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Game – Theory

Game – theory attempts to look at the relationship between participants in a

particular model and predict their optimal decisions.

Game-theory is an attempt to study conduct of firms in oligopolistic markets.

The firm has to choose the best policy in a situation of conflict. “Game” refers to the
policies and decisions taken by the firms. Firms have incomplete information about
others intentions. Game theory provides useful guidelines on behavior for strategic
situations involving inter dependence.

The policies are known as strategies. So we have a term known as games of

strategy. Strategy deals with choice to change price? Whether to keep the price of
the product constant or to increase it or decrease it. While playing a game of football,
when player of one team kicks the ball towards the other side, one has to be ready to
meet the action taken by the player of the opponent. Which side of the field he plays
out the ball? Prompt action is needed. Likewise, if the rival firm develops a new
product, or undertakes more advertisement etc., then, the other firm has to worry
about its future. Proper reaction is needed. Managers make individual decisions
without knowing their rival’s decisions.

Action taken by firm in the above context and the reaction of the other firm,
create a new scenario for the firms. This is known as the result of the ‘game’. If the
gain of one firm is equal to the loss of rival’s firms, than, it is known as zero-sum
game.

If the action of one firm raises costs more than revenues and the profits of
both firms decline, than, it is known as negative-sum game.

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 On the other hand, non-zero-sum game is a reference to the gains of one firm
that do not come at the expense of rival firm’s losses.

Positive sum game would mean gain to both firms. For example, if increased
expenditure on advertising brings higher profits to all the firms.

It should be clear by now that decision makers are known as players. The
outcome of these policies is known as pay. Off

Prisoner’s dilemma:
This is a famous case. Two prisoners are held in two separate cells. They
cannot communicate with each other. Both of them are suspected of a crime. They
can either confess or they can deny the crime. The following table shows matrix
confess|confess! Suspect Deny
Suspect A Suspect (B) (A) Suspect (B)
Confess 5 Years 5 years `1 year 10 years
Suspect ‘A’
Deny Suspect 10 years 1 year 2 years 2 years
‘A’

Looking at the above pay-off’s, what is the best-strategy for each prisoner?
The obvious answer is, each player should take decision which maximises the
outcome for each of them. The dominant strategy for each player is to confess.
Because, each prisoner will be under the belief that the other prisoner will confess,
to get less prison-term. So both of them will confess instead saying no to the crime.
So, no. matter what the other prisoner does; confessing to the crime is better for each
of them.

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 But if they deny the crime, the imprisonment will be only 2 years in prison.
But there is great risk, if one of them denies and the other makes the confession. In
prisoner’s dilemma, all rivals have dominant – strategies. All are worse off than if
they had co-operated in making their decisions

Game-theory is attributed to provide an insight into the interdependent

decision making that lies at the heart of the interaction between businesses in a
competitive market.

NASH - EQUILIBRIUM
Nash equilibrium is an important idea in game-theory. All participants in a
game pursue their best possible strategy given the strategies of all of the other
participants.

In Nash equilibrium, the outcome of a game that occurs in when player A

takes the best possible action And ‘Player B’ takes the best (independently of each
other)

“Strategic interaction” refers to cases where your happiness depends not only
on your choice but also on the choices of others.

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 NASH-EQULIBRIUM

A No price A Price
change increase
No Price Firm A Firm B Firm A Firm B
change 10 10 50 - 30

Firm A Price -20 FIRM, Firm B 30 Firm A Firm B

increases A 60 35

1. If firm A decided not to raise prices, it will have 10m in profits. But this can

only happen, if the firm B, also decides not to change-prices.

2. On the other hand, if firm B decides to go for a price increase, then, FIRM A

will earn 100 million. Firm B will suffer loss of – 30 million.

3. Another possibility, if firm A raises prices, this firm will suffer loss of – 20

million. (firm B keeps same in price.}

4. If both firms decide to increase prices, then ‘A’ will obtain 130 million as

against 35 million of ‘B’.

The objective of each firm is to do its best, irrespective of what the other firm
does. Neither firm can benefit by increasing its price if the other firm does not. This
result is known as Nash-equilibrium.

None of the players in a game can improve their pay-off alone.

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Dominant Strategies:
In some situations, one firms best strategy may not depend on the choice made
by other participants in the game. This is a case of dominant-strategy.
A Firm B A Firm B
New Do not produce new
Product product
New 4 3 5 1
Firm ‘A’ Product
Do not 2 5 3 2
produce
new
product

Profit in the form of pay-off is shown in the above cells for two different firms, A
and B. Produce the new product is the dominant strategy for firm ‘A’. This will give
pay-off of 4 to firm ‘A’.

The dominant strategy is the optimal choice for a player no matter what the
opponent does.

The conclusion is same for ‘firm B’. Whatever A firm does it would be
profitable for firm ‘B’ to produce the new product.

If firm ‘A’ produces new product, B’s profit would be 3 if it also produces
new product.

If firm B does not produce new product, it will get only 1

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 The dominant strategy for firm B also is to go for new product. This provides
best outcome no matter what decisions rivals make.

Dominant strategy equilibrium exists when all decision makes have dominant
strategies.

Maximin strategies:
In this scenario, we are looking for a situation in which, each firm first
determines the minimum profit that could result from each strategy it could choose. It
is not a profit maximizing strategy. It is like choosing the maximum of the
manimums.

Neither firm should introduce a new product because they will be guaranted a
profit of at lest 4 million by adopting this strategy.

Firm Firm 2 Firm Firm 2

1
1 No New Product 1 New
Product
No new product 4 4 3 6
Firm 1 New Product 6 3 2 2

Fundamental Ideas:
1. Firms working under Oligopoly market conditions, stand to improve their
economic position by earning more profits, by co-operating by each other.

2. Firms may adopt dominant strategy.One particular firm may exercise a choice
without caring about choice made by other firm. But, even in such a scenario

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 co-operation between firms would be more profitable. This can be a better
solution of the prisoner’s dilemma.

3. The implications of prisoner’s dilemma influence the decision making process

of firm’s in matters of pricing and advertising etc.

4. It has been observed that, a dominant strategy is always a Nash-equilibrium,

but a Nash-equilibrium is not necessarily a dominant strategy equilibrium.

In a Nash-equilibrium cell, no decision maker can unilaterally change its

decision and improve its individual pay-off. A strategy that leads to the best outcome
for a firm no matter what decision rivals make. In Nash-equilibrium firms are
onlydoing best for themselves given what they expect their rivals will do. It is
frequently the case that if rivals could indeed collude or co-operate they could all do
better individually.
Fundamental ideas
[ 1 ] Firms working under oligopoly –market conditions ,stand to improve their
economic position by earning more profits ,by cooperating by each –other .
[ 2 ] Firms may adopt dominant –strategy .Oneparticular firm may exercise a
choice
Without caring about choice made by other firm .But even in such a scenario
cooperation between firms would be more profitable.This can be a better solution of
the
Prisoners dilemma.
[ 3 ]The implications of Prisoners dilemma influence the decision –making process of
Firms in matters of pricing and advertising etc.
[4 ] It has been observed that ,a dominant strategy is always a Nash – equilibrium
,but a Nash –equilibrium is not necessarily a dominant strategy equilibrium.

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 In a Nash –equilibrium cell,no decision maker can unilaterally change its
decision and improve its individual pay off . A strategy that leads to the best outcome
for a firm
No matter what decision rivals make .
In Na sh –equilibrium , firms are only doing best for themselves given what they
expect their rivals will do .It is frequently the case that if rivals could indeed collude
or co- operate they could all do better individually at decision sets other than the
Nash- point .

Exercises for Students:

Q.N.1 How do you distinguish between zero-sum games and non-zero sum-games?

Q.2 Explain Nash equilibrium with the help of an example.

Q.3 Explain prisoners dilemma

Q.4 What is the use of game theory?

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Q.5 In there any relation between Nash-equilibrium and prisoner’s dilemma?

Q.6 What do you undersand by the following:

(a) Pay-off (b) Strategy

Q.7 What is a dominant strategy? Give example to explain the concept.

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 Chapter : 15

Objectives of a firm

1. Sales-maximisation as the main objective of a firm.

2. Output maximisation as the main objective.

3. Growth – maximization as the main objective

4. Satisfaction maximization

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 Objective of a firm

Profit is regarded as the main objective of a firm. Each firm tries to obtain
maximum profit. Business planning is meant to fulfill this objective.

But nowadays we find that there is a separation between ownership and

management. The large companies are organized as joint stock companies. The
interest of managers is different from the interest of owners. The owners are
interested in higher profits but the managers take interest in earning more salaries and
benefits. So there are alternative approaches on this issue.

Sales Maximisation Model:

Baumol’s sales revenue Maximisation model highlights that the primary
objective of a firm is to maximize its sales rather than maximize its profits.

According to this approach the goal of the firm is maximization of sales-

revenue subject to a maximum profit constraint. The minimum profit constraint is
determined by the expectations of the share-holders.

Managers are more interested in maximizing sales revenue rather than

profits.The basic philosophy is that when sales are maximized automatically profits
of the company would also go up.

Most real world firms operating under relatively competitive markets,

increasing sales is bound to increase profits.

Justification of the model:

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(i) The banks and other financial-institutions keep a close eye on the sales of
firms and are more willing to finance firms with large and growing sales.

ii) There is evidence that salaries and other earnings of top managers are co-
related more closely with sales than with profits.

iii) Personnel problems are handled more satisfactorily when sales are growing.
The employees at all levels can be given higher earnings and better terms of work in
general.

iv) Large sales, growing overtime, give prestige to the managers, while large
profits go into the pockets of shareholders.

v) Large growing sales strengthen the power to adopt competitive tactics, while a
low or declining share of the market weakens the competitive position of the firm and
its bargaining power vis - a - vis its rival . This enhances its influence in market.

There are two models. The first is static second one is the Dynamic model.
The firms aims at maximizing its sales revenue subject to a minimum profit
constraint. Dynamic model explains how change in advertisement. Expenditure,
would influenceS the sales revenue of a firm under severe competitions.

Several other theories have been developed as an alternative to above theory. These
are given below:

2. Utility Maximization:

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 This theory was developed by O.E. Williamson.This theory is related to the
maximization of the managers utility which is a function of the expenditure on staff
and other benefits. The manager has discretion to pursue goals other than profits.

The manager desires to expand his staff because more staff is appreciated by
the business circles. This is a source of prestige and more security. The managers
appoint secretaries and manage cars etc. Managers maintain discretionary funds for
those projects that are close to their heart.

The limitation of the above theory is that there are number of factors which
give utility to the managers. The makes the issue quite complicated.

3. Growth Maximisation:
According to this approach, managers of modern firms are interested in
growth maximization rather than profit maximization. The managers of large firms
aim at promoting the growth and security of his firm. Growth results in more
financially secure position.

According to Marris, the firm may grow in overall size. To achieve this
objective, the firm explores new markets. This involve creation of new products.
This is needed to strengthen the position of the management of the company.

The valuation of firm’s shares in the market is an important factor in

determining the status of the company. There is always a threat of company’s take-
over. The threat of take-over is more if the company’s assets are not being used
efficiently.

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 The management is expected to retain higher proportion of current profit for
spending money on growth projects. They choose a constant rate of growth at which
sales, profits and assets etc. grow.The above theory has certain limitations. This
theory assumes that factor prices, and rate of interest will remain constant over a long
period of time. These days firms are not independent in deciding the prices of their
products. The output and price-policy of a firm is influenced by the behavior of the
rival firms. Firm may not grow at the same rate. This may differ from time to time.

4. Satisfaction Maximization:
According this theory, propounded by Scitovsky, Managers want to maximize
satisfaction and keep his efforts and output below the level of maximum profits. At
higher level of income, all of us prefer leisure to work. So managers feel contended
at a level where the output may not be the maximum possible.

The above theory also suffers from certain defects. It is not correct to believe
that money chase would get slowed-down due to a rising income. It is also not
correct to believe that willingness to work is independent of his income of manager.

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