Managerial economics

 Economics is branch of knowledge that

studies allocation of scarce resources
among competing ends.
 Managerial economics may be viewed
as economics applied to problem solving
at the level of a firm.
Managerial Economics

 Study of economic theories, logics and

tools of economic analysis that are used
in business decision making.
 Economic theories, techniques of
economic analysis are applied to
analyze business problems, evaluate the
options and opportunities with a view to
arriving at an appropriate business
decision.
Managerial economics (contd)
 Business decision making is essentially a
process of selecting the best out of
alternative opportunities open to the firm.
 It involves four main phases:
1. Determining and defining the objectives
to be achieved
2. Collecting and analyzing information
regarding economic , social, political and
technological environment and
foreseeing the necessity and occasion
for decision making
3. inventing, developing and analyzing
possible courses of action
4. Selecting a particular course of action
from available alternatives
Factors influencing Managerial
decisions
 While economic analysis contributes to a
great deal to problem solving in a firm
three other variables also influence
choices and decisions by managers –
 Human behavior
 Technological forces
 Environmental factors
Scope of Managerial Economics

 Economics has two major branches

Micro economics and Macro economics
Both Micro and macro economics are
applied to business analysis and
decision making directly or indirectly –
depending on the purpose of analysis.
Business issues are
 Operational or internal
 Environment or external
Microeconomics applied to
Operational issues
 Operational issues are of internal nature-include
problems which arise within the business
organization and fall within the purview and
control of the management.- Choice of business
and nature of products to produce, how much to
produce (size of the firm), choosing the factors
combination (technology), how to price, how to
decide on new investments, how to manage
profits and capital, how to manage inventory etc
Micro economic theories

 Theory of Demand
 Production theory (Theory of firm)
 Pricing theory
 Profit analysis and Management
 Theory of Capital and investment
decisions
Macro economic applied
Macro economics issues is generally pertain to factors in
the economic environment in which the business
operates-
 Type of economic system,
 General trends in production, employment, income,
-prices, savings and investments
 Structure & trends of working of the financial institutions
 Magnitude of and trends in foreign trade
 Govt’s economic policies
 Social factors
 Political environment-govt attitude towards business
 Degree of openness of the economy
National Income Analysis
National Income concepts

 National Income is the final outcome of all

economic activities of a nation, as a whole, in
terms of money
 National Income is the most important
macroeconomic variable that determines the
level of business and environment of a country.
 Level of NI determines the level of aggregate
demand for goods and services.
 The distribution pattern determines the
pattern of demand for goods and
services i.e., how much of which good is
demanded
 The trend in national income determines
the trend in aggregate demand for goods
and services and therefore the business
prospects.
Definition

 Conceptually National income is the money

value of the end result of all economic activities
of the nation.
 Economic activities – include all human
activities that which create goods and services
that can be valued at market price. Thus
economic activities include production by
farmers (whether for consumption or for
market), production by firms and companies in
the industrial sector,
 Production of goods and services by
Govt. enterprises, services produced by
business intermediaries (wholesalers &
retailers), banks and other financial
organisations, universities, colleges,
hospitals etc.
 Non economic activities are those
activities that produce goods and
services that have no market / economic
value.
 These activities include spiritual , social
and political services.
They also include hobbies, services of
self, services of housewives, services of
members of the family to other members
and exchange of mutual services
between neighbors.
National income from product flows
versus
National income at factor cost.
National income at factor cost

 We have seen that economic activities

generate flow of goods and services
which are valued in terms of money.
 These activities also generate money
flows in the form of payments – wages,
interest, rent, profits etc. (subject to
certain adjustments like for subsidies
and indirect taxes )
DEMAND ANALYSIS
AND
FORECASTING
DEMAND
 Demand is one of the crucial
requirement for the existence of any
business enterprise.
 A firm is interested in its own profit or
sales both of which are partially depend
on demand for its product or service.
 While how much a firm can produce
depends on the capacity, how much a
firm must try to produce depends on the
demand for its products.
 The decisions which management
makes with respect to production,
advertising, cost allocation, pricing,
inventory holding etc call for analysis of
demand.
 Once demand analysis is done the
alternative ways of managing or
manipulating can be determined.
Meaning of Demand

 Demand in economics means desire to buy

backed by purchasing power.
 Mere desire to wish can not buy goods. It also
needs ability and willingness to pay for it.
 Unless a person has adequate purchasing
power or resources and preparedness to
spend his resources, his/ her desire for a
commodity would not be considered as
his/her demand for it.
 Demand for a commodity therefore
implies:
(a) desire to acquire it
(b) willingness to pay for it, and
(c) ability to pay for it
 Any statement regarding demand for a
commodity without reference to its price,
time of purchase and place has no
practical use for any business. e.g.,
demand for CTVs is 50,000 vs demand
for TV sets @ Rs 15,000 each in
Mangalore is 50,000 per annum
Basis of Consumer Demand

 Consumers demand a commodity or

product because they derive or expect to
derive utility from that commodity or
product.
What is utility?
From the product or commodity’s point of
view it is the want or need satisfying
property
Utility (contd)

 From the consumer’s point of view utility

is the psychological feeling of
satisfaction, pleasure, happiness or
wellbeing which a consumer derives
from the consumption, use or
possession of the product or commodity.
 This is a subjective or relative concept –
 A product need not be useful for all e.g.,
cigarettes
 Utility varies from person to person
 A commodity need not have the same
utility for the same consumer at different
points of time, different levels of
consumption and in different moods of a
consumer
Total Utility

 Assuming that utility is measurable and

additive, total utility may be defined as the
sum of utilities derived by a consumer from
the various units of goods and services he
consumes.
 Suppose a consumer consumes four units of
a commodity X, at a time, and derives utility
as u1,u2,u3 and u4,Total utility derived is
TUx = u1 + u2 + u3 + u4
 If a consumer consumes n number of
commodities, his total utility is
TUn = TUx + TUy + TUz
 Marginal Utility may be defined as as the
utility derived from the marginal unit
consumed.
 It may also be thought of as the addition
to the total utility resulting from the
consumption (or accumulation) of one
additional unit.
 MU= dTU / dQ
Law of Diminishing MU

 As the quantity consumed of a commodity

increases, the utility derived from the each
successive unit decreases, consumption of
all other commodities remaining the same.
When a person consumes more and more
units of the a commodity per unit of time (say
ice cream) keeping the consumption all other
commodities constant, the utility which he
drives from the successive units of
consumption goes on diminishing.
Why does MU Decrease

 The utility gained from a unit of

commodity depends on the intensity of
desire for it. When a person consumes
successive units of the commodity his
need is satisfied by degrees in the
process of consumption and the intensity
of his need goes on decreasing so also
the utility. ( Ref table 6.1 and fig 6.1
page 106 Dwivedi)
 Assumptions
1. Unit of good must be standard
2. Consumer taste or preference must
remain same
3. There must be continuity in
consumption
4. Mental condition must remain normal
during the period of consumption
Market Demand
 The quantity demanded of a product by an
individual per unit of time, at a given price is
known as individual demand for the product.
 The aggregate of individual demands for the
product is called the market demand for the
product.
 In other words, the total that all the
consumers /users are willing to buy per unit of
time at a given price, all other things remaining
same, is called the market demand for the
product.
Determinants of Demand

Demand for a commodity or product

depends on several factors the main
among them are:
 Price of the product
 Price of related goods- substitutes,
complements and supplements
 Level of consumer’s income
 Consumers taste and preference
5.Advertisement for the product
6.Consumers’ expectations about the future
price and supply position
7.Demnostration effect or band wagon effect
8. Consumer credit facility
9. Population and its distribution
10.National Income and its distribution
pattern
The Law of Demand

 Other things remaining same, the

quantity of a commodity demanded is
inversely proportion to its price.
 In other words, the higher the price,
lower the demand and vice versa, other
things remaining same.
The main characteristics
 Inverse relationship
The relationship between price and quantity
demanded is inverse. i.e., if the price rises, the
demand falls; the price falls, demand goes up.
 Price is an independent variable, demand a
dependent variable.
Under the law of demand it is the effect of price
on demand that is examined and not the effect
of demand on the price. When demand goes up
price goes up and when demand falls price
would fall. But the law of demand does not
concern with this phenomenon.
 The law of demand assumes that Other things
remain the same
In other words there should be no change in
other factors influencing demand except the
price. Changes in income, substitutes’ prices,
consumer tastes and preferences, advertising
spend etc due to which the demand may rise
even if price increases or demand may fall in
spite of fall in prices
 Factors Behind law of Demand
Substitution effect
Income effect
Utility maximizing behavior
Demand Curve

 Graphical representation of law of

demand
 Demand curve is the locus of points
showing alternative price quantity
combinations
Demand curve shows the quantities of a
commodity which a consumer will buy at
different prices per unit of time, under
the assumptions of the law of demand.
Demand change

 At a particular price say Rs 10 people

were buying100 nos of product X. They
may buy 90 nos for two reasons:
 Price may rise to Rs 12 or one of the
factors assumed to be constant may
change e.g. price of a substitute product
has reduced or income has gone down.
 In the first case there is only change in
the quantity demanded.
 In the second case the demand has
changed – new combination of price and
quantity has resulted.
 This is also called Demand shift
 Reasons for shift in Demand

1. Increase in consumer Income

2. Price of substitute rises/falls –
substitution effect
3. Price of a complement falls
4. Advertisement by the producer
changing the consumer’s tastes and
preferences
Exceptions to Law of Demand
While the Law of demand holds good for most of
the goods, there are exceptions:
 Snob appeal –goods purchased not for direct or
indirect benefit but for the impressions they
create on other people examples – curios and
diamonds
 Speculative markets – shares are bought when
price increases
 Giffen case of potatoes in the 19th century
Ireland
Elasticity of Demand

 The degree of responsiveness of

demand to the changes in its
determinants is called the elasticity of
demand.
 Price elasticity
 Income elasticity
 Cross elasticity
 Advertising or promotion elasticity
Price Elasticity of Demand

 Defined as the responsiveness or

sensitiveness of demand for a
commodity to the changes in its price.
 It is also the percentage change in
demand as a result of one percent
change in the price of the commodity
 Ep= (Q1- Q2)/Q1x100/(P1- P2)/P1 x100
=dQ/dPx P1/Q1
Determinants of Price elasticity

 Availability of substitutes
 Nature of commodity- essentials, luxuries
 Weight age in the total consumption –if
the commodity purchase accounts for a
very small percentage of total income
then less elastic
 Time factor in adjustment of consumption
pattern
 Range of use of commodity
Income elasticity of Demand

 Measures the responsiveness of demand foe a

commodity to changes in consumer income.
Income Elasticity of demand depends on the type
of goods:
Essential consumer goods
Inferior goods
Normal goods
Luxury and prestige goods (page 153 Dwivedi)
Cross elasticity of Demand

 Describes the responsiveness of

demand for good X to changes in the
price of good Y
Demand Distinctions
(Types of Demand)
 Producer goods & Consumer goods
 Durable & non durable
 Derived and autonomous demand
 Industry demand and firm’s demand
 Short run and long run
 Individual and market demand
(Refer chapter 5 pp59 Varshney &
Maheshwari)
Demand Forecasting
 Forecast is a predication or estimation of a
future situation.
 Demand forecasting is the estimation of the
demand for a particular good in a future period
of time.
 Accurate demand forecasting is essential for a
firm to enable it to produce the required
quantities at the right time and to arrange in
advance for the various inputs
 Passive and active forecasts by a firm
Purposes of Forecasting
 Sort term forecasting:
 Appropriate production scheduling – to
avoid over production and shortages
 Help reduce cost of acquiring inputs &
finance
 Determining appropriate price policies
 Setting sales targets, establishing controls
and incentive schemes
 Evolving suitable promotional programmes
 Long term Forecasting:

 Planning of a new unit or expansions

 Planning long term financial
requirements
 Planning man power requirements
Factors involved in Demand
forecasting
1. How far ahead ? Long term 10 to 20 yrs
short term - quarterly, half yearly and
yearly
2.Level of forecasting:
 Macro level
 Industry level
 Firm level
Factors (continued)

3. General or specific
Commodity or product wise, nationwide
or area wise.
4. New products vs established products
5. Type of products – consumer goods,
producer goods, durable goods, non
durable goods etc.
6. Factors specific to particular goods
SUPPLY ANALYSIS
Meaning of Supply

 The Supply of a commodity means the

amount of that commodity which the
producers are able and willing to offer for
sale at a given price.
 Supply is related to scarcity.
 Only scarce goods have a supply price;
goods which are freely available have no
supply price
Supply Schedule

Supply schedule is a tabular

representation of the data on the
quantity supplied and the price of that
commodity or product.
As the price increases, a firm supplies
greater quantity of output and vice versa.
The quantity supplied and the price both
move in the same direction.
Supply curve

 The graphical representation of the Supply

schedule is called the supply curve.
 Each point on the supply curve shows the
price- quantity supplied combination of a firm.
 The supply curve shows the minimum price
which a firm is prepared to receive for
different quantities or it shows the max
quantity the firm is willing to sell at each
possible price.
Law of Supply

Other things remaining the same, as the price

of a commodity rises, its supply increases
and as the price falls its supply declines.
 An increase in the price generally implies higher
profits leading producers to offer increased
quantities. Again,
 In the long run, due to higher profitability new
producers may enter the market leading to an
increased output offered for sale.
Limitations

1. Future price: When price rises seller

expects the price to rise further and in
order to get more profits in future he
may sell less now.
Likewise when the price declines, the
seller may anticipate further decline
and to make the best of the situation
he may offer to sell more, thus
increasing the supply.
2. Agricultural output:
In case of agricultural commodities, as their
production can not increase at once when the
price increases.
3. Subsistence farmers:
In underdeveloped countries where agriculture is
characterized with subsistence farmers, as
food grain price increases marketable surplus
of food grains, farmers can get the required
amount of income by selling less and keep
the remaining for their own consumption.
4. OTHER FACTORS not remaining
same
If prices of other commodities rise the
quantity supplied will fall at a given price.
Change in technology can bring about
change in quantity supplied even if the
price of the commodity does not undergo
change
Elasticity of Supply

 Degree of responsiveness of supply to a

given change in price
 Es = dQ/Q1 /dP/P1
= Percentage Change in Quantity
Supplied
Percentage Change in price
Cross Elasticity of Supply

 Proportionate change in quantity

supplied
Proportionate change in he price of
Other
commodity
Factors influencing supply

1. The supply depends on the goals of

the company.
2. Depends on the price of the commodity
3. Depends on the price of other
commodities
4. Depends on the prices of factors of
production
 5.The State of Technology
6.Time factor can also determine the
elasticity of Supply
7.Supply may be consciously decreased
by agreement among producers.
8.Supply destroyed to raise price
9.Taxation and imports
10.Political disturbances/wars creating
scarcity
COST ANALYSIS
Cost concepts

 Cost concepts used for accounting

purposes
 Analytical Cost Concepts used in
economic analysis for business
activities.
 Opportunity Cost and Actual cost
Opportunity cost also called alternative
cost is the expected return from the next
best use of the resource(s) which are
foregone due to scarcity of resources.
Actual costs are those which are actually
incurred by the firm in payment for inputs
– labor, materials, plant, bldg,
advertising, transport, traveling etc.
 Business costs and Full costs.
 Business cost includes all expenses
incurred to carry out the business –
include all payments and contractual
obligations made together with book cost
of depreciation.
 Full costs include business costs,
opportunity costs and normal profits.
Explicit cost and implicit (imputed) cost
Production Function

Meaning of Production

 A process by which resources (men, matl,

time etc) are transformed into a different
more useful commodity or service.

 Inputs --> Production  Outputs

function
Production Function

 A production function refers to the

relationship between the output of a
commodity and its inputs.
 Traditional Economics considers factors
of production – land, labor, capital,
organization /management (and
technology)
Output X= f( Ld, L,K,M,T)
Y= f ( X1,X2,X3, etc)
 In a specific situation, one or other of the inputs
may not be important – relative importance
varies from product to product.
In the production of agricultural product land is
importance while in steel production, land is not
that important but Capital is.
For easier understanding of production decision
problems, it is convenient to work with two input
factors for an output – labour and Capital
 Production function, x = f ( L,K)
3 variables - output of commodity X (x),
units of labor (L) and units of capital (K)
For any given value of x, there will be
alternative combinations of L and K.
These combinations of L & K, vary with
variations in x. K and L are to a certain
extent are substitutes to each other.
Isoquants

 Isoquant is the locus of all those

combinations of labour and capital that
yield the same output. (sometimes called
iso-product curves)
 Geometric representation of a production
function
 Isoquants shape
(a) they are falling- one input decreases while the
other decreases
(b) the higher the isoquant the higher the output it
represents
(c) they do not intersect each other
(d) they are convex – lesser and lesser unit of the
second input is used while increasing the
quantity of the first input
Least- cost combination of inputs

 The production function indicates

alternative combinations of inputs or
factors of production which can produce
a given output.
 Of these an entrepreneur would like to
choose that combination of inputs which
costs him the least.
 There are two ways to determine the
least cost combination of inputs for given
output.
 Find the cost of each combination and
find out the one that gives the least value
arithmetically.
 Geometric method by drawing isocost
curves and superimposing them on the
isoquant curves.(Ref pp53-55 Mote et al)
Factor Productivities

 Production function is a relationship

between the output and inputs or factors
of production.
 The short term relationship between
inputs and outputs are denoted by
productivity of a factor of production
 There are three productivities – total
product, average and marginal product
The Total Product (TP) of a factor of
production is defined as the total
production we obtain by employing
different amount of that factor, keeping
all other factors constant.
Average Product (AP) of a factor is the
total product divided by the quantity of
that factor, with all other factors held
constant
 The Marginal Product (MP) of a factor of
production is the extra physical product
we obtain by adding an extra unit of that
factor, with all other factors held constant
Law of Diminishing Returns

When more and more units of a variable

input is applied to a given quantity of
fixed inputs, the total output may initially
increase at an increasing rate and then
at a constant rate but eventually
increase at diminishing rate.
Stages of Production

Stage I :TP increases in increasing rate,

MP increases, AP increases
Stage II: TP increases at diminishing rate till
reaches a maximum level, MP diminishes
and becomes zero, AP starts diminishing
Stage III:
TP starts declining, MP becomes negative
Continues to decline
Return to Scale

 Returns to scale explains what happens to the

output rate when each input is increased by the
same proportion.
 If out put increases by larger percentage than
the in each of the inputs we have the case of
increasing returns to scale; increases by
smaller percentage then diminishing return to
scale and if the increase is by the same
proportion we have the case of constant return
to scale.
 If one increases all inputs in equal proportions,
one moves along a ray from the origin in the
graph.
 If a 10% increase in all inputs yields more than
a 10% increase in out put , the production
function has an increasing return to scale. If it
yields less than 10%increase in the output,
there is decreasing return to scale. If it yields
exactly 10% increase in output it has a constant
return to scale
 Return to scale concept is important for
determining how many firms will
populate an industry.
 When increasing returns to scale exist,
one large firm will produce more cheaply
than two smaller firms. Small firms have
a tendency to merge to increase profits
while those which do not merge will
eventually fail.
 If an industry has decreasing returns to
scale, a merger of two units will produce
a larger firm which will reduce output,
raise average cost and lower profits. In
such industry it is better to have many
small firms than a larger ones.
Cost Analysis

 Theory of cost deals with behavior of

cost in relation to a change in output.
 In other words cost theory deals with
cost – output relations
Short run cost analysis

 Total cost (TC) is the actual cost that

must be incurred to produce a given
quantity of output
 Average Cost (AC) is the cost per unit of
output. Obtained by dividing TC by
Quantity produced (Q)
 Marginal Cost (MC) is the extra cost of
producing one additional unit of output.
 In practice however it may not be
possible to determine the extra cost of
producing one extra unit, say one extra
metre of cloth, in large scale production
say in textile manufacturing. In this case
one can determine the incremental cost
of producing additional 100 metres and
then divide the incremental total cost by
the additional units
Fixed and Variable costs

 Fixed costs are those which remain the

same at a given capacity and do not vary
with the output. These costs exist even if
there is no output .
 Variable costs vary directly as output
changes
Short run Cost output Relationship

 This refers to a particular scale of

operation i.e., to a fixed capacity plant.
 It indicates the variations in cost over
output of a given capacity .This
relationship will vary with plants of
different capacity.
 TC = f (x) + A
 Total cost = Total VC + Total Fixed cost
Fixed cost and output
 By definition Fixed cost does not vary with
output. Total fixed cost curve is horizontal line
(.Rs 176 at all output levels).
 The larger the quantity produced the lower will
be the fixed cost per unit. The Average Fixed
Cost =TFC/ quantity of output declines as
output increases.
 AFC=176 at output 1,88 at output 2,12 at out 15
etc. AFC curve is falling continuously (shape is
rectangular hyperbola).
 This relationship is same for types of business.
Variable cost and output

 Total Variable cost increases as output

increases.
 In the beginning, as the output
increases, TVC increases at a
decreasing rate, then at a constant rate
and eventually at an increasing rate.
Increase in TVC goes on diminishing up
to a certain level of output, then constant
over a range ,finally starts rising.
 Reasons ?
 Need for variable factor input for increased
output behaves in a similar fashion and
 the operation of the law of diminishing returns.
 While this behaviour pattern generally holds
good in all situations the exact behavior may
vary from product to product. For capital
intensive products the first phase may be
longer than for labour intensive products.
Total Cost and Output
 Total cost increases as out put increases.
 As one of the components of TC, the TFC
remains constant at all output levels, the
behavior of TC follows the behavior of
TVC. The TC curve is parallel to TVC
curve.
 Average Total Cost ATC or Average Cost
first falls as output increases ,remains
constant and eventually rises – U shaped
Summary of Relationships

1.AVC, ATC and MC first fall, then remain

constant and then rise as output
increases.
2.AC falls for a longer range of output than
AVC.
3. AVC = MC when AVC is the least
4. AC = MC when AC is the least
(page 73 Mote et al)
Long Run Cost Output
Relationship
In the long run there is no fixed factor of
production and therefore no fixed cost.
TC = f (x, k) where k=plant size.
As k changes, TC changes.
Q: What Is TC at a given output? It is small for a
small size plant compared to a large one, when
the output is small. Large size plant capacity
remains unutilized, whereas for large outputs
small size plant may be insufficient/ inadequate.
Managerial use of Production
Function
MARKET STRUCTURE
AND
PRICING DECISIONS
Type of Market Structure

1. Perfect Competition

2. Imperfect Competition
a. Monopoly
b. Oligopoly
c. Monopolistic competition
Perfect Competition

1. There are many small firms, each

producing an identical product and each
is too small to affect the market price.
It is a price taker. No control over price.
2. The firm faces a completely elastic
demand.
3. Extra revenue earned from extra unit
sold by the firm is the market price.
4. Free entry and exit from industry.
Imperfect Competition

 Imperfect competition prevails in an

industry where individual sellers have
some measure of control over the price
of their output.
 Demand has a finite elasticity
Monopoly

Most extreme case of imperfect competition.

Greek : Mono – one ; polist- seller
It is the only firm producing in its industry and
there is no industry producing a close
substitute. (examples: Microsoft windows,
patented drugs, franchise monopolies, public
utilities)
Very good control over the price of its product.
(nowadays regulated by govt)
Monoplolies are rare today.
Monopsony

 There is only one buyer of goods or

services
 Rivalry from buyers who offer substitute
outlet is so remote as to be insignificant.
 Buyers are in a position to determine the
price
Oligopoly

 Oligopoly in Greek means “few sellers”

- 2 to 10 or 15.
Products- no difference in products like
steel chemicals etc
Or some differentiation like cars,word
processing softwares
Each firm can affect market price.
Monopolist Competition

Many producers
Real or perceived difference in products.
products are not identical.
Resembles perfect competition in that
there are large number of producers,
none have large market share.
Barriers to entry
PRICING POLICIES
AND
PRICING METHODS
General considerations in
formulating pricing policy
1. Objectives of the business
2. Competitive situation
3. Product and promotional policies
4. Price Sensitivity
5. Interests of Manufacturers and
middlemen
6. Influence of Non business entities on
price determination
Objectives of Pricing Policy

1. Profit maximization of product line

2. Promoting long term welfare of the firm
– discouraging competitor entry
3. Adaptation of prices to diverse
competitive situations for products
4. Flexibility to changes in economic
conditions
5. Stabilization of prices and margins
 Market penetration
 Market skimming
 Early cash recovery
 Satisfactory ROI

 Professional Managers’ motives also

can determine objectives (p 236 V&M)
PRICING METHODS

Cost Oriented
1. Cost- plus or Full cost pricing
2. Pricing for return or target pricing
3. Marginal cost pricing
Competition Oriented
1. Going rate pricing
2. Customary pricing
3. Sealed bid pricing
Full cost or Cost plus pricing

Most common method used.

Cost set to cover variable and fixed
costs including overheads plus a pre
determined percentage for profit margin.
(Margin varies from industry to industry)
 Fair and plausible prices determined for
all products with ease and speed.
 Full cost prices look factual and precise
and defensible on moral grounds.
 Firms preferring stability use full cost
pricing in a market with insufficient info
and knowledge.
 Fixed costs are covered even in short
run
 Managements know the costs better
than the market forces to set prices.
Full cost pricing is used in:
Public utility pricing
Monopsony buying situations
Tailor made products
Product (cost) tailoring to price when
selling price is predetermined -
(HLL challenge cost concept)
Pricing for a Rate of return

 Price adjusted to changes in costs.

1. Profit as a percentage over costs
2. Profit as a percentage on sales
3. Profit as a percentage on Capital
employed.
(worked out example p 253 V & M)
Marginal Cost Pricing

Fixed costs are ignored and prices are

determined on the basis of marginal cost.
The firm uses only those costs that are
directly attributable to the output of a
specific product.
Each product is considered in isolation
and price fixed at a level to maximize
contribution to the fixed cost and profits.
Assumptions:
1. It is able to segregate its markets to
charge higher price in one and lower in
others.
2. No legal restriction for the above.
 Advantages:
 Prices are never rendered uncompetitive unless
by virtue of higher variable cost which are
controllable.
 Permits manufacturer far more aggressive
pricing policy than full cost pricing
 Helps in pricing over product life cycle where
short run relevant fixed costs and MC are
isolated
Going - Rate pricing

 Emphasis is on the market.

The firm adjusts its pricing policy to the
general pricing structure of the industry.
This
Customary pricing
Sealed Bid Pricing
Profit

 What is Profit ?
Profit is essentially a residual sum.
Net profit is a sum over and above the
ordinary costs including contractual outlays
Land ,labor and capital are frequently used
under contracts whereby they receive pre
determined return.
Nobody contracts to the entrepreneur the
residual sum - profits
Business is faced with a number of uncertainties:
Technical uncertainties
Cost uncertainties
Demand uncertainties
Market uncertainties
Profit is the reward to entrepreneur for combining
factors of production to meet the economic needs
of the world and successfully managing the risks
and uncertainties in the process.
Accounting Profit and
Economic Profit
 In the accounting sense profit is revenue
realised during the period minus the
explicit or actual cost and expenses
incurred in producing the revenue – the
residual concept.
 The economic profit also calls for
deduction of imputed costs –
 Entrepreneur’s wages (which he could
earn by working for others)
 Rental income from self owned land and
buildings (he would got by renting to
others)
 Interest on self owned capital (which he
would earned by investing elsewhere)
 Economic Profit =
Accounting profit – imputed costs
From the managerial point of view
economic profits are more important than
accounting profits as the former reflect the
true profitability of the business. A firm
incurring economic loss but making
accounting profit may have to withdraw
from business in the long run.
Functions of profit

The basic function of profit is to provide

businessmen with an incentive to produce
what the consumers want, when and where
they want at the lowest feasible cost.
Profits also serve these main purposes:
1. Measure of performance
2. Premium to cover cost of staying in business
3. Ensuring supply of future capital
Profit as measure of
performance
 Profits measure the net effectiveness
and soundness of business effort.
A higher profit is an indicator that business
is run successfully and effectively. Profit
is probably the best indicator of the
general efficiency of a firm and only one
which allows a quick and easy
comparison of performance of various
firms
Profit measure has following advantages:
1. It provides a single criterion that can be
used to compare future courses of
action.
2. It permits a quantitative analysis of
proposals where benefits can be
directly compared with costs
3. It provides a single broad measure of
performance
4. It facilitates decentralization
5. It permits comparison of performances
of responsibility centers with dissimilar
functions.
Premium to cover Costs of
staying in business
 Costs of staying in business -
replacement, obsolescence, market and
technical risks & uncertainties.
Management of business has to provide
adequately for these by generating
sufficient profit. (In this sense there is no
such thing called profit but only costs of
staying in business)
Ensuring supply of future
capital
 Profits ensure supply of future additional
capital either directly (self financing
through Retained profits) or indirectly
through inducement of new external
capital to optimize the company’s capital
structure and minimize cost of capital.
 A firm must have growth because it is
the only way it can perpetuate itself and
profits are natural concomitant of growth
Profiteering Vs profit earning

 Profiteering is a case when the amount

of profits made exceeds acceptable limit
by questionable means. Profiteering is
often done by creating artificial
shortages through hoarding and
curtailing production.
Profit policies

 Business firm aims at making profits; .

volume of profit is the primary measure
of its success.
 In economic theory the basic assumption
is that the firm aims at maximizing
profits. However this may not be true
always – we see that there are many
reasons for this.
1. Attainment of Industry leadership
2. Forestalling potential competition
3. Preventing Govt intervention
4. Maintaining consumer goodwill
5. Restraining demand for wage increases
6. Accent on liquidity of the firm
7. Risk avoidance
8. Changed business structure – entrepreneur
to professional managers with different
focuses – other stake holders also considered.