MANAGERIAL ECONOMICS

Emergence of Managerial Economics

Emergence of ME as a separate course of Management Studies can be attributed to at least three

factors:
a) Growing complexity of business decision making process due to changing market
conditions and business environment
b) The increasing use of economic logic, concepts, theories and tools of economic analysis
in the process of business decision making
c) Increase in demand for professionally trained managerial manpower

What is Economics? – Study of choice making behavior

 A social science
 Basic function is to study how people – individuals, households, firms, and nations –
maximize their gains from their limited (Scarce) resources and opportunities – In
Economic terms this is called maximizing behavior or optimizing behavior.
 Economics studies human behavior in relation to optimizing allocation of available
resources to achieve the given ends.
e.g. Housed holds, Producer or Firms at micro level
 At macro level it studies how nations allocate their resources between competing needs
of the society for welfare maximization of society.
 How govt formulates diff policies like taxation, expenditure, price, fiscal, monetary,
employment, foreign trade, tariff etc.

Introduction & meaning

Meaning of Managerial Economics:

• Managerial Economics is a discipline that combines economic theory with managerial

practice.
• It offers powerful tools and techniques for optimal decision making
• It improves the analytical skills of managers.
• It provides adequate solution to the economic problems.

Definitions of managerial economics:

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 • According to Spencer and Seigelman, “ Managerial Economics is the integration of
economic theory with business practice for the purpose of facilitating decision making
and forward planning by the management.

• According to Douglas, “ Managerial Economics is concerned with the application of

economic principles and methodologies to the decision process within the organization. It
seeks to establish rules and principles to facilitate the attainment of the desired economic
goals of management.

Introduction & meaning

Key Points of Definition

 Decision Making: It is the process of selecting best out of alternative opportunities open
to the firm.
 Economic Methodology: It is a relation between ideas, thoughts, intuitions & experience
with economic tools & techniques.
 Economic goals of firm: In the nutshell, organization is making maximum gains out of
available resources.

Supply, Demand & Scarcity

Resources

Land
Labour Needs and wants of the Capital
population
Entrepreneurship and
management skills

SUPPLY DEMAND

Demand & Supply

 Most fundamental concept and backbone of market economy.

 The theory of Demand and Supply shows how consumer preferences determine consumer
demand for commodities, while business costs are the foundation of the supply of
commodities.
 Demand refers to how much (quantity) of a product or service is desired by buyers. The
quantity demanded is the amount of a product people are willing to buy at a certain price.
 Supply represents how much the market can offer. The quantity supplied refers to the
amount of a certain good producers are willing to supply when receiving a certain price.

Importance of ME

 Gives guidance for identification of key variables in decision making process.

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  Helps the business executives to understand the various intricacies of business and
managerial problems and to take right decision at the right time.
 Helps in understanding the various external factors and forces which affect the decision-
making of a firm.
 Helps in forecasting economic variables like demand, supply, cost, revenue, prices, sales
and profit etc and formulate sound business policies.
 Helps in achieving objectives like attaining industry leadership, market share expansion
and social responsibilities etc.

Scope of Managerial Economics

 Objectives of a firm:
There are multiple objectives and they are multi dimensional in nature.

 Demand Analysis and Forecasting:

Deals with consumers’ behavior. It answers such questions as: How do the consumers decide
whether or not to buy a commodity, quantity of a commodity, price of the product etc.

 Production and Cost Analysis:

Production theory explains relationship between inputs and output.Under what conditions
cost increases or decreases, how total output behaves when units of one factor have been
changed keeping other factor inputs constant.

 Pricing Decisions, Policies and Practices:

Explains how price is determined under different kinds of market conditions.. When price
discrimination is desirable or profitable, to what extent advertising can be helpful in
expanding sales etc

 Market Structure and Conditions:

Knowledge of market structure and conditions existing in various kinds of markets are of
great importance in any business. The number of sellers and buyers, the nature, extent and
degree of competition etc. determines the nature of policies to be adopted in the market.

 Profit Management:
Profit theory guides firms in the measurement and management of profit, in making
allowances for the risk premium in calculating the pure return on capital and pure profit and
also for future profit planning.

 Capital Management:
Capital is foundation of business. Major related issues are choice of investment project,
assessing the efficiency of capital, most efficient allocation of capital etc. Capital theory can
contribute towards investment decision making, capital budgeting etc.
 Strategic Planning:
It provides a framework on which long term decisions can be made which have impact on the
behavior of the firm. The major macro economic issues that figure in business decision
making and particularly with regard to forward planning and formulation of the future
strategy are:
a) Issues related to Macroeconomic trends in the Economy
b) Issues related to Foreign Trade

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 c) Issues related to Government Policies

Market System and Market Equilibrium (Demand and Supply)

Market System

 Market for a product works on certain principles i.e. the laws that govern the working of
the market system.
 Fundamental laws of market called the laws of demand and supply.
 Market system works on two kinds of market forces – demand and supply

Market Concept

 Word market generally means a place or an area where goods and services are bought
and sold
 In economics, the market means a system by which sellers and buyers of a commodity
interact to settle its price and the quantity to be bought and sold.
 According to Samuelson and Nordhaus, “A market is a mechanism by which buyers and
sellers interact to determine the price and quantity of a good or service.”
 Important points about Market concept
No need to be situated in a particular area or locality
Buyers and sellers no need to come into personal contact
Word market may refer to a commodity or service or to a geographical area
Distinguish also on the basis of a) nature of goods or services b) number of firms and
degree of competition

Demand Side of the Market

 Governed by the law of demand.

 Refers to all its consumers and the price that they are willing to pay for buying a certain
quantity of the product during a period of time.
 It determines the market size of the firm.

The law of Demand

 It states the nature of relationship between the quantity demanded of a product and the
price of the product.
 It can be stated as “All other things remaining constant, the quantity demanded of a
commodity increases when its price decreases and decreases when its price increases.”
 This law operates under ceteris paribus assumption.

Demand Schedule and Demand Curve

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A Demand Schedule is a tabular presentation
of different prices of a commodity and its corresponding quantity demanded of a commodity.

A Demand curve is a graphical presentation of the demand schedule. A demand curve is obtained
by plotting a demand schedule.

Pc ( Price inQc (Delhi in

Rs. )` ‘000)
800 8
600 15
400 30
300 40
200 55
100 80

Supply Side of the Market

 In market economy while buyers of a product constitute the demand side of the market,
Sellers of that product make the supply side of the market.
 Supply means quantity of a commodity that its producers or sellers offer for sale at a
given price per unit of time.
 Market supply is sum of supplies of a commodity made by all individual firms and
supply agencies.

The Law of Supply

 The supply of a commodity depends on its price and cost of its production.
 The law of supply is expressed in terms of price-quantity relationship.
 It can be stated as “The supply of a product increases with the increase in its price and
decreases with the decrease in its price, other things remaining constant .”

Supply Schedule & Supply Curve

A supply schedule is a tabular presentation of the law of supply. It is a table showing different
prices of a commodity and the corresponding quantity that suppliers are willing to offer for sale.
A supply curve is a graphical presentation of the supply schedule.

Pc (Price inSupply(Shirts
Rs. )` in ‘000)

5
100 10
200 35
300 50
400 60
600 75
800 80

Shift in Supply Curve

Although price of a commodity is the most important determinant of its supply, it is not the only
determinant.
Many other factors influence the supply of a commodity.
When there is change in its other determinants, the supply curve shifts rightward or leftward
depending on the effect of such changes.

Determinants of Supply Curve

 Change in Input Prices

 Technological Progress
 Price of Product Substitutes
 Nature and Size of the Industry
 Government Policy
 Non-economic Factors

Market Equilibrium ( Equilibrium of Demand and Supply)

 Determination of Price in a Free Market:

A free market is one in which market forces of demand and supply are free to take their own
course and there is no outside control on price, demand and supply.

 The Concept of Market Equilibrium:

Equilibrium means the ‘state of rest’ – Balance in forces working in opposite directions.
Equilibrium refers to a state of market in which quantity demanded of a commodity
equals the quantity supplied of the commodity.
Equilibrium price is the price at which quantity demanded of a commodity equals its
quantity supplied. It is also called Market Clearing price.

 Determination of Market Price:

Equilibrium price of a commodity in a free market is determined by the market forces of
demand and supply. In free market disequilibrium itself creates the condition for equilibrium.

Weekly Demand and Supply Schedules for Shirts

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Price PerDemand Supply Market Effect on Price
Shirt (Rs.) (‘000 shirts) (‘000 Position
shirts)
100 80 10 Shortage 䦋㌌ ㏒ 䦋좈 ໱ 琰 茞
ᓀÜ
200 55 28 Shortage 䦋㌌㏒䦋좈໱琰茞
ᓀÜ
300 40 40 Equilibrium 䦋 ㌌ ㏒ 䦋 좈 ໱ 琰 茞
ᓀÜ
400 28 50 Surplus 䦋㌌㏒䦋좈໱琰茞
ᓀÜ
500 20 55 Surplus 䦋㌌㏒䦋좈໱琰茞
ᓀÜ
600 15 60 Surplus 䦋㌌㏒䦋좈໱琰茞
ᓀÜ
Analysis of Consumer Demand

The law of Diminishing Marginal Utility

Cardinal Approach : The law of Equi Marginal Utility
Ordinal Approach : The concept of Indifference Curve

Introduction
 Consumer Demand is the basis of all productive activities.
 Increasing demand for a product offers high business prospects for it in future and
decreasing demand for a product diminishes its business prospect.
 Essential to understand diff aspects of demand
What is the basis of demand for a commodity?
What are the determinants of demand?
How do the buyers decide the quantity of a product to be purchased?
How do the buyers respond to change in product prices, their incomes and prices of the
related goods?
How can the total market demand for a product be assessed and forecasted?

Meaning of Utility

 Consumers demand a commodity because they derive or expect to derive utility from the
consumption of that commodity.
 The expected utility from a commodity is the basis of demand for it.
 The concept of utility can be looked upon from two angles: a) From the product angle –
Utility is the want satisfying property of a commodity
b) From consumers’ angle – Utility is the psychological feeling of satisfaction, pleasure,
happiness or well-being, which a consumer derives from the consumption, possession or the use
of a commodity.
 Difference between the two concepts : Want satisfying property of a commodity is
absolute in sense that this property is ingrained in the commodity irrespective of whether
one needs it or not. Another important attribute of the ‘absolute’ concept is that it is
‘ethically neutral’.
 From a consumers’ point of view Utility is a post consumption phenomenon as one
derives satisfaction only after consuming or using it.

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  Utility in the sense of satisfaction is subjective or relative concept. Because a) a
commodity need not be useful for all b) Utility of a commodity varies from person to
person and from time to time. c) a commodity need not have the same utility for the same
consumer at different points of times at different levels of consumption and for different
moods of consumer.
 In consumer analysis, only the subjective concept of utility is used.

Concept of Total Utility

 Assuming that utility is measurable and additive, total utility may be defined as the sum
of the utility derived by a consumer from the various units of a good or service he
consumers at a point or over a period of time.
 Suppose a consumer consumes four units of a commodity, X, at a time and derives utility
from the successive units of consumption as u1, u2, u3 and u4.
 Total utility (Ux) from commodity X can be then measured as follows.
Ux = u1 + u2 + u3 +u4
 If a consumer consumes n number of commodities, his total utility TUn, is the sum of the
utility derived from each commodity. For instance, if the consumption of goods are X, Y,
and Z and their respective utilities are Ux, Uy, and Uz, then
TUn = Ux + Uy + Uz

Concept of Marginal Utility

 The concept of Marginal Utility may be defined in number of ways.

 It is defined as the utility derived from the marginal or one additional unit consumed.
 It may also be defined as the addition to the total utility resulting from the consumption
of one additional unit.
 MU thus refers to the change in the Total Utility (i.e. ∆ TU) obtained from the
consumption of an additional unit of a commodity, say X. It may be expressed as
MUx = ∆ TUx / ∆ Qx
 Another way of expressing marginal utility (MU), when the number of units consumed is
n, can be as follows
MU of nth unit = TUn – TUn-1

Law of Diminishing Marginal Utility

 One of the fundamental laws of economics.

 This law states that “ as the quantity consumed of a commodity goes on increasing, the
utility derived from each successive unit goes on diminishing, consumption of all other
commodities remaining the same.
 In simple words, when a person consumes more and more units of a commodity per unit
of time, e.g. ice – cream, keeping the consumption of all other commodities constant, the
utility which he derives from each successive cup of ice cream goes on diminishing.

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 Law of Diminishing Marginal Utility

Total and Marginal Utility Schedules for Commodity X

Units ofTotal UtilityMarginal 70

Commodity (TUx) Utility (MUx) 60

X 50

40

Utility TU / MU for X
30
Law of Diminishing
70 Marginal Utility
1 30 30 20 Total Utility
(TUx)
60
2 50 20 Why Does 10
MU Decrease? Marginal
Utility (MUx)

3 60 10 The utility gained

0 50
from a
1 2 3 4 5 6

4 65 5 commodity -10 depends

40 on the intensity

Utility TU / MU for X
of the desire
-20 for it. When a person
5 60 -5 30
consumes successive units Quantity
of a Total Utility (TUx)

6 45 -15 commodity, his 20

need is satisfied
Marginal Utility (MUx)

by degrees in the process of 10

consumption of the commodity 0

and the intensity of his need 1 2 3 4 5 6

goes on decreasing. Therefore, -10

utility derived from each successive -20

unit goes on decreasing. Quantity

Assumptions of Law of Diminishing Marginal Utility

The law of diminishing marginal utility holds only under certain conditions called
“assumptions of the law”.
 The unit of the consumer good must be a standard one. If the units are excessively small
or large, the law may not hold.
 The consumer’s taste or preference must remain the same during the period of
consumption.
 There must be continuity in consumption.
 The mental condition of the consumer must remain normal during the period of
consumption.

Importance of Law of Diminishing Marginal Utility

1. Basis of the law of demand : The law of demand states that more amounts of a
commodity will be purchased at a relatively lower price. The reason for this is that as
more and more units of a commodity are purchased and consumed, its marginal utility to
the consumers becomes less and less.
2. Basis of the progressive tax-policy : Adam Smith emphasized that canon of “ability to
pay tax” which was later presented in terms of MU of money by Pigou. They argued that
the MU of money or wealth is more for the poor than the rich. This is reason why the rich
have to pay tax at a progressive rate and the poor at a lower rate.

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 3. Basis of the policy of redistribution of wealth : Govt’s policy of public expenditure is
also based on the law of diminishing MU. It helps in transferring the purchasing power
from richer to poor classes.
4. Determination of optimum level of consumption

Cardinal and Ordinal Concepts of Utility

 Measurability of utility has been a contentious issue. Classical economists, viz., Jeremy
Benthan, Leon Walrus, Carl etc. and neo-classical economists like Alfred Marshall,
believed that utility is cardinally or quantitatively measurable like height, weight, length,
temperature and air pressure. This resulted in Cardinal Utility concept.
 However, modern economists, most notably J.R.Hicks and R.G.D., Allen hold the view
that utility is not quantitatively measurable – it is not measurable in absolute terms.
Utility can be expressed only ordinally or in terms of ‘less than’ or ‘more than’. It is
therefore, possible to list the goods and services in order of their preferability or
desirability. This is known as the Ordinal Concept of utility.

Cardinal Utility
 Some early psychological experiments on an individual’s responses to various stimuli led
neo-classical economists to believe that utility is measurable and cardinally quantifiable.
 This belief gave rise to the concept of cardinal utility. It implies that utility can be
assigned a cardinal number like 1, 2, 3, etc.
 Neo-classical economists built up the theory of consumption on the assumption that
utility is cardinally measurable. They coined and used a term ‘util’ meaning ‘units of
utility’.
 In their measure of utility, they assumed (i) that one ‘util’ equals one unit of money (ii)
that utility of money remains constant
 It has, however, been realized over time that absolute or cardinal measurement of utility
is not possible.
 An appropriate measure of unit can not be devised.
 Numerous factors affect the state of consumer’s mood, which are impossible to determine
and quantify.

Ordinal Utility
 The modern economists have discarded the concept of cardinal utility and have instead
employed the concept of ordinal utility for analyzing consumer behavior.
 The concept of ordinal utility is based on the fact that it may not be possible for
consumers to express the utility of a commodity in absolute or quantitative terms, but it is
always possible for a consumer to tell whether a commodity is more or less or equally
useful when compared to another.

Two approaches to the Consumer Demand Analysis

 i) Cardinal Utility Approach : Attributed to Alfred Marshall and his followers, is also
called the Neo-classical Approach
 ii) Ordinal Utility Approach : Pioneered by J.R.Hicks, and R.G.D. Allen, is also called
the Indifference Curve Analysis.
 Both the approaches are not in conflict with one another. They represent two levels of
sophistication in the analysis of consumer behaviour.

Consumer Behaviour Analysis : Cardinal Utility Approach

10
  The fundamental postulate of the consumption theory is that all the consumers aim at
utility maximization and all their decisions and actions as consumers are directed towards
utility maximization.
 The consumer theory seeks to answer questions :
a)how does a consumer decide the optimum quantity of a commodity that he or she
chooses to consume, i.e. how does a consumer attain his/her equilibrium in respect to each
commodity?
b) how does he or she allocate his/her disposable income between various commodities
of consumption so that his/her total utility is maximized?

Consumer Behaviour Analysis : Cardinal Utility Approach

Assumptions
The theory of consumer behaviour based on the cardinal utility approach seeks to answer the
above questions on the basis of the following assumptions:
i. Rationality : Customer is rational in a sense that he or she satisfies his wants in the order
of their preference.
ii. Limited money income
iii. Maximization of satisfaction : Every rational consumer intends to maximize satisfaction
from given money income
iv. Utility is cardinally measurable
v. Diminishing marginal utility
vi. Constant marginal utility of money
vii. Utility is additive

Cardinal Utility Approach: Consumer’s Equilibrium

A consumer reaches his equilibrium position when he has maximized the level of his satisfaction,
given resources and other conditions.
Technically, a utility maximizing consumer reaches his equilibrium position when allocation of
his expenditure is such that the last rupee spent on each commodity yields the same utility.
To explain consumer equilibrium we will take two cases:
(i) Consumer’s Equilibrium: One commodity Model
(ii) Consumer’s Equilibrium : Multiple commodity Model (The law of Equi-Marginal
Utility)

Consumer’s Equilibrium: One commodity Model

 Suppose that a consumer with a given money income consumes only one commodity, X.
 Since both his money income and commodity X have utility for him, he can either spend
his money income on commodity X or retain it in the form of asset.
 If the marginal utility of commodity X, (MUx) is greater than marginal utility of money
(MUm), a utility maximizing consumer will exchange his money income for the
commodity.
 By assumption, MUx is subject to diminishing returns, whereas marginal utility of money
(MUm) remains constant.
 Therefore, the consumer will spend his money income on commodity X so long as MUx
> Px (MUm) Px being the price of commodity X, MUm = 1

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  The utility maximizing consumer reaches his equilibrium, i.e., the level of maximum
satisfaction where
 MUx = Px (MUm)

The Law of Equi-Marginal Utility

 Marshall gave his famous Principle of Equi-Marginal Utility also known as law of
substitution or the law of economy in expenditure or the law of maximum satisfaction.
 Marshall has defined this law in the following manner:
 “If a person has a thing which he can put to several uses, he will distribute it among these
uses in such a way that it has the same marginal utility in all. For, if it had a greater
marginal utility in one use than another he would gain by taking away some of it from the
second use and applying it to first.”
 Thus, a consumer attains maximum total utility from his available resources only when
the marginal utilities of all the goods consumed are equal.
 Symbolically MU1 = MU2 = MU3…….Mun
 Marshall stated that in a barter economy, equalization of marginal utilities is not possible
because there is no common measurement of value.
 In a money income, price becomes a common denominator of value. Hence, the law of
equi-marginal utility is useful only in money income.
 If the prices of all the commodities are equal, the consumer attains maximum total utility
when MU1 = MU2 = MUn
 If the prices of various goods are different, then the consumer will attain maximum total
utility only when the following conditions hold : MU1/ P1 = MU2/P2 = MU3/P3……
MUn/Pn

Assumptions of The Law of Equi-Marginal Utility

 Utility is measurable in terms of money
 The income of the consumer is limited and remains constant.
 There is perfect competition in the market.
 The marginal utility of money remains constant.
 The utility schedule of a commodity is independent of the utility schedules of the other
commodities.
 The law of diminishing marginal utility holds.

Example - The Law of Equi-Marginal Utility

 Suppose that the  Money Units  MU for  MU for

consumer Spent Commodity X Commodity Y
purchases two (MUx) (MUy)
commodities X and Y  1st rupee  50 (1)  38 (4)
the prices of which are  2nd  45 (2)  36 (5)
Px and Py.  3rd  40 (3)  32 (7)
 As long as Px  4th  35 (6)  25 (10)
and Py are  5th  30 (8)  18
fixed or constant, a
 6th  25 (9)  15
rupee’s
 7th  20  10
 8th  15  5
 9th  10  2
 10th  5  1
12
worth of X or a rupee’s worth of Y represents a certain
quantity (utility) of X or Y.

Example - The Law of Equi-Marginal Utility

 MUx / Px = MUy / Py = 25
 It satisfies the consumers’ objective of getting maximum total utility.
 In this example, the total utility of Rs 10 spent on X and Y is equal to the sum of total
utility derived from the consumption of Commodity X and Commodity Y
TUx +y = TUx + TUy
= (50+45+40+35+30+25)+(38+36+32+25)
= 225+131
= 356 units

• DEMAND ANALYSIS

Ordinal Utility Approach : Indifference Curve Analysis

Assumptions of Ordinal Utility Theory

 Rationality : Rationality means that a consumer aims at maximizing his total satisfaction
given his income and prices of the goods and services .
 Ordinal Utility : Customer is only able to express the order of his preference.
 Transitivity and consistency of choice : Transitivity of choice means that if a consumer
prefers A to B and B to C, he must prefer A to C. Consistency of choice means that if he
prefers A to B in one period, he does not prefer B to A in another period or even treat
them as equal.
 Nonsatiety : Consumer has not reached the point of saturation in case of any commodity.
Therefore, a consumer always prefers a larger quantity of all the goods.
 Diminishing marginal rate of substitution : MRS goes on decreasing when a consumer
continues to substitute one good for another.

The Indifference Curves

 A consumer possesses a definite scale of preferences for goods and services. Each scale
of preference consists of a number of alternative combinations of two or more goods,
which give the consumer the same amount of satisfaction, so that if he chooses any out of
many alternative combinations, he is neither better nor worse off.
 He is therefore found indifferent towards these various combinations. Such combinations
of commodities as between which an individual is indifferent are called indifference
combinations.
 An Indifference curve may be defined as the locus of points each representing a different
combination of two substitute goods, which yield the same utility or level of satisfaction
to the consumer. Therefore, he is indifferent between any two combinations of two goods
when it comes to making a choice between them.

13
 For example let us suppose th
and Y and he makes five com
substitute commodities X and
same level of satisfaction.
 An indifference schedule show
between which a consumer is
Combination Units o
Commod
a
The combinations = b, c, d,
a, 25
and e arebplotted and
= 15
joined by a smooth curve
known ascindifference
=
C8
curve. 14
o
d = m4
 The space between X and Y axes is kn
space. This plane is full of finite point
different combination of goods X and
 It is always possible to locate
Marginal Rate of Substitution

any two or more points on

 An indifference curve is formed by substituting one good for another.
 MRS is the rate at which one commodity can be substituted for another, the level of C
indifference plane indicating
satisfaction remaining the same.
 The MRS between two commodities X and Y may be defined as the quantity of X which
is required to replace one unit of Y or quantity of Y required to replace one unit of X in
o
different combination X and Y
the combination of the two goods so that the total utility remains the same.
 This implies that the utility of X (or Y) given up is equal to the utility of additional units m
yielding same level of
of Y (or X) added to the combination.
 The MRS is expressed as ∆Y / ∆X, moving down the curve.
 MRS goes on Diminishing: The basic postulate of ordinal utility is that MRS y,x (or
m
satisfaction.
MRS x,y) decreases.
 MRS diminishes along the IC curve because, in most cases, no two goods are perfect o
substitutes for one another.
 It is thus possible to draw a
 If two goods are perfect substitutes, the indifference curve will be a straight line having a
negative slope showing a constant MRS.
d
number of indifference curves
 Since, goods are not perfect substitutes, the subjective value attached to the additional
quantity of a commodity decreases fast in relation to the other commodity whose total
quantity is decreasing.
i
without intersecting or being
 There is an observed behavioural rule that the consumers’ willingness and capacity to
sacrifice a commodity is greater when its stock is greater and it is lower when the stock t
y
of a commodity is smaller.
tangent to one another.
 The set of indifference curves
IC1, IC2, IC3 and IC4 make the15 Y
Properties of Indifference Curve

 Indifference Curves have a negative slope:

The negative slope of an indifference curve implies (a) that the two commodities can be
substituted for each other (b) that if the quantity of one commodity decreases, quantity of the
other commodity must increase so that the consumer stays at the same level of satisfaction. If
quantity of the other commodity does not increase simultaneously, the bundle of commodities
will decrease as a result of decrease in the quantity of one commodity.
 Indifference Curves are Convex to Origin:
The convexity of the indifference curves implies two properties: (i) the two commodities
are imperfect substitutes for one another (ii) the MRS between the two goods decreases as a
consumer moves along an indifference curve.

 Indifference Curves
Nor be Tangent with
Application of Indifference Curve Analysis

• TYPES OF DEMAND

Types of Demand
If two indifference curves inter
• ELASTICITY OF DEMAND

will yield two impossible conclu

The demand for various goods and services are generally classified on the basis of the
consumers of the product, suppliers of the product, nature of the product, seasonal nature of the
two goods yield two different le
demand, interdependence of demand for two products, etc.

different combinations – one b

same level of satisfaction. 16
Major types of demand:
 Individual Demand and Market Demand
 Demand for Firm’s Product and Industry’s Product
 Autonomous and Derived Demand
 Demand for Durable and Non-durable Goods
 Short-term and Long-term Demand

1) Individual Demand / Market Demand

 Individual Demand : Refers to the quantity of product demanded by an individual at a
point in time or over a period of time given the price of the product, given his income,
price of the related goods, consumer’s taste and preferences, price expectations and
external influences.
 Market Demand : The total quantity which all the consumers of a commodity are willing
to buy at a given price per unit, given their money income, taste and prices of other
commodities is known as ‘Market Demand for the commodity.

2) Demand for Firm’s Product / Industry’s Product

 The quantity that a firm can dispose of at a given price over a time period connotes the
demand for the firm’s product.
 The aggregate of demand for the product of all the firms of and industry is known as the
market demand or demand for industry’s product.
 Distinction between the two demands is not of much use in highly competitive market,
monopoly. It is useful from managerial point of view in Oligopolistic Market.

3) Autonomous Demand / Derived Demand

 An autonomous demand or direct demand for a commodity is one that arises on its own
out of a natural desire to consume or possesses a commodity . It is independent of the
demand for any other commodity.
 The demand for a commodity that arises because of the demand for some other
commodity, called ‘parent product’ is called derived demand.
 The conceptual distinction between autonomous demand and derived demand is useful
from the business point of view to the extent that Autonomous Demand can serve as an
indicator of the Derived Demand.

4) Short-term Demand / Long-term Demand

 Short-term Demand refers to the demand for goods that are required over a short period.
Mostly Fashion consumer goods, goods of seasonal use, inferior substitutes during the
scarcity period of superior goods.
 Long-term Demand on the other hand, refers to the demand which exists over a long
period. Most generic goods have long term demand.
 Short term demand depends, by and large, on the price of commodities, price of their
substitutes , current disposable income of the consumer, their ability to adjust their
consumption pattern and their susceptibility to advertisement of a new product.
 Long-term demand depends by and large, on the long-term income trends, availability of
better substitutes, sales promotion, consumer credit facility, etc.
 Short-term and Long-term concepts of demand are useful in designing new products for
established producers and choice of products for new entrepreneurs, in pricing policy and
in determining and phasing the advertisement expenditure.

17
Elasticity of Demand

From managerial point of view, the knowledge of nature of relationship alone is not sufficient. It
is more important to know the extent of relationship or the degree of responsiveness of demand to
the changes in its determinants. The degree of responsiveness is called elasticity of demand.
The concept of elasticity of demand is important in decision making regarding maneuvering of
prices with a view to making larger profits. But raising the price will prove beneficial or not on :
(a) The price elasticity of demand for the product, i.e. how high or low is the proportionate
change in its demand in response to a certain percentage change in its price
(b) Price-elasticity of demand for its substitute, because when the price of a product
increases, the demand for its substitutes increases automatically even if their prices
remain unchanged.

Price Elasticity of Demand

Price elasticity of demand is generally defined as the responsiveness or sensitiveness of demand

for a commodity to the changes in its price. It is a percentage change in demand as a result of one
per cent change in the price of the commodity.
Ep = Percentage change in quantity demanded
Percentage change in price
A minus sign is generally inserted in the formula before the fraction in order to make the
elasticity coefficient a non-negative value.
The elasticity can be measured :
• Between any two points on a demand curve called Arc Elasticity
• At a point called Point Elasticity

18
Price Elasticity
Arc Elasticity :
The measure of elasticity of
finite points on a demand c
• Measureof elasticity between points

Price Elasticity
the measure of Arc elasticity. The m
from point J and K on the demand c
shows a fall ininthe price from
Problems Using Arc Rs. 20 t
Elasti
So ∆ P =20-10 =10 and ∆ Q =43-75 =
Arc elasticity coefficients
• Using elasticity formulaelasticity be
diff
points
and on afrom
K moving demand
J and Kcurve
can beifc
reversed.
using elasticity formula.
For
• Ep isInstance,
1.49 which the elasticity
means betweeni
1% decrease
K – movingXfrom J toinKaequals
1.49 %1.49.
19
commodity results incr
 Price Elasticit
Point Elasticity on a linear
The concept of point elast
elasticity where change in
Price Elasticity of Demand and Total Revenue

Point elasticity is the elasticity of

A firm aiming at enhancing its Total Revenue would like to know whether increasing or
decreasing the price would achieve its goal.

Elasticity Co-
efficient
finitepoint on a demand curve, e.
Change in Price Change in TR

e=0 or B on MN demand curve.

Increase
Decrease
Increase
Decrease
e<1 Measuringelasticity for an infinit
Increase
Decrease
Increase
Decrease
e=1 changein price is the same as mea
Increase
Decrease
No change
No change
e>1 elasticityat a point.
Increase
Decrease
Decrease
Increase
e=œ Increase Decrease to Zero
Decrease Infinite Increase

Formulafor measuring point elas

Cross Elasticity of Demand

below :
 It is the measure of responsiveness of demand for a commodity to the changes in the
price of its substitutes and complementary goods.

20

Ep =P/Q . ∂Q / ∂P
  For instance, cross elasticity of demand for tea is the percentage change in its quantity
demanded with respect to the change in the price of its substitute, coffee.
 The formula for measuring cross elasticity of demand for tea et, c is given below:
 Et,c = Percentage change in demand for tea Qt
 Percentage change in price of coffee Pc
 = Pc / Qt . ∆Qc / ∆Pt
 When two goods are substitutes for one another, their demand has positive cross-
elasticity because increase in the price of one increases the demand for the other.
 Demand for complementary goods has negative cross-elasticity.

Uses of Cross-Elasticity:
 To define substitute / complementary goods
 The greater the cross-elasticity, the closer the substitute or complementary.
 Important in changing prices of products having substitutes and complementary goods.
 If accurate measures of cross-elasticity are available, the firm can forecast the demand for
its product and can adopt necessary safeguards against fluctuating prices of substitutes
and complements.

IncomeElastic
Theresponsiveness of deman
Cont:
known asincome -elastici
Ey = Percentagechangein
 Price and cross elasticity of demand are of greater significance in the pricing of a product
aimed at maximizing the total revenue in the short run.
 Income elasticity of a product is of a greater significance in production planning and
management in the long run, particularly during the period of a business cycle.

Percentagechangein
 The concept can be used to forecast the future demand using the expected rate of change
in income and the income elasticity of demand for the products.

 Advertisement or Promotional Elasticity of Sales

Consumer Co-
Goods 21
incom
1. Essential
 The expenditure on advertisement and on other sales-promotion activities does help in
promoting sales, but not in the same degree at all levels of the total sales and total-ad
expenditure.
 The concept of Advertisement Elasticity of sales is important in determining the optimum
level of advertisement expenditure particularly when govt imposes restriction on ad exp
or there is competitive advertising by the rival firms.
 Advertisement elasticity of sales may be defined as
eA = ∆ S/S
∆ A/A

 For example, a company increases its advertising expenditure from Rs 10 million to Rs.
20 million and as a result its sales increase from 50,000 units to 60,000 units.
In this case Ea = 10,000/10 * 10/50,000
= 0.2
It means that a one per cent increase in ad-expenditure results in only 0.2 per cent
increase in sales.

• THEORY OF PRODUCTION

Basic concepts: Meaning of production

 In general sense, Production means transforming inputs (labour, capital, raw materials,
time, etc.) into an output.
 In economic sense, the term ‘Production’ means a process by which resources (men,
material, time, etc.) are transformed into a different and more useful commodity or
service.
 It may take a variety of forms other than manufacturing. For example, transporting a
commodity in its original form from one place to another where it can be consumed or
used in the process of production is production.
 It not only includes physical conversion of inputs to tangible output, but also creation of
intangible output.

Basic concepts: INPUT / OUTPUT

 An input is a good or service that goes into the process of production. In the words of
Baumol, “An input is simply anything which the firm buys for use in its production of
other processes”
 Output is any good or service that comes out of production process.
 Production processes requires a wide variety of inputs but in economics inputs are
classified as : i) Labour ii) capital iii) land iv) raw materials v) entrepreneurship.
 Technology and Time are also included as input as per modern concept.

Basic concepts : Fixed / variable inputs

 Inputs are classified as Fixed and Variable Inputs
 In economic sense, a fixed input is one whose supply is inelastic in the short-run.

22
 In technical sense, a fixed factor is one that remains fixed or constant for a certain level
of output.
 A variable input is defined as one whose supply in the short run is elastic, e.g., labour and
raw material, etc. All the users of such factors can employ a larger quantity in the short
run as well as in the long run.
 Technically, a variable input is one that changes with the change in output. In the long
run all inputs are variable.

Basic concepts : SHORT RUN / LONG RUN

 The reference to time period involved in production process is another important concept
used in production analysis.
 Two reference periods are Short-run and Long-run.
 The short-run refers to a period of time in which the supply of certain inputs (plant, land
and building etc) is fixed or inelastic.
 Long run refers to a period of time in which the supply of all the inputs is elastic, but not
enough to permit a change in technology.
 Very long run refers to a period in which the technology of production is also subject to
change.
 Short run and long run are economic jargons. They do not refer to any specific time
period. While in some industries short run may be a matter of few weeks or few months,
in some others it may mean three or more years.

Production function

 Production Function is a mathematical presentation of input-output relationship. A

production function states the technological relationship between inputs and output in the
form of an equation, a table or a graph. Each of these can be converted into its other
forms.
 A real life production function is generally very complex and includes a wide range of
inputs viz., (i) land and building (ii) labour including manual labour, engineering staff
and production manager (iii) capital (iv) raw material (v) time and (vi) technology
 The long run production function is generally expressed as
Q = f (LB, L, K, M, T, t)
 The economists have however reduced the number of input variables used in a production
function to only two, Capital and Labour for the sake of convenience and simplicity in
analysis of input-output relationship.

 Production function with two variable inputs K and L is expressed as:

Q = f(L, K)
 Short run production function may also be termed as ‘single variable input production
function’, can be expressed as :
Q = f ( K, L) where K is constant
 For example, a production function is expressed as : Q = bL where b = ΔQ/ ΔL
gives constant return to labour.
 Consider for example, the Cobb-Douglas production function – the most famous
and widely used production function – given in the form of an equation as
Q = A KaLb

23
  If numerical values of parameter are estimated as A = 50, a = 0.5 and
b = 0.5.

 Since the numerical values

Q =50 K0.5 L0.5
THE LAW OF DIMINSHING RETURNS TO A VARIABLE INPUT

10 158 223
 The law of diminishing returns states that when more and more units of a variable input
are used with a given quantity of fixed inputs, the total output may initially increase at 274
increasing rate and then at a constant rate, but it will eventually increase at diminishing
rates.
 Assumptions : 9 150
(i) labour is the only variable input, capital remaining constant;
212 260
(ii) labour is homogeneous

8
(iii) the state of technology is given; and
(iv) input prices are given 141 200 245
 The law explains three stages of production.
 Marginal Productivity of Labour MPL shows the trend in the contribution of the marginal
7
labour and Average Productivity of Labour APL
is the average contribution of labour.
132 187 229
 Let us assume that the labour-output relationship in coal production is given by a
6 122
hypothetical production function of the following form.
Q = - L3 + 15 L2 + 10L 173 212
 Marginal Productivity of Labour = TPL – TPL-1

5 112
 Average Productivity of Labour = TPL / No of Labour inputs
158
 Putting values of labour from 1 to 12 we will get the table drawn on next sheet: 194
4 100 141 173
3 87 122 24
150
No of Workers TotalProduct M
(N) (TPl)

1 24
2 72
3 138
4 216
5 300
6 384
7 462
8 52825
 The three stages in production
 Stage I :
TPL increases at increasing rate. This is indicated by the rising MPL till the
employment of the 5th and 6th workers. The output from the 5th and 6th workers represents
an intermediate stage of constant returns to the variable factor, labour.
 Stage II :
TPL continues to increase but at diminishing rates, i.e., MPL begins to decline.
This stage shows the law of diminishing returns to the variable factor. Total output
reaches its maximum level at the employment of the 10th worker.
 Stage III :
Beyond the level of 10th worker, TPL begins to decline. This marks the
beginning of state three.
 Given the employment of the fixed factor, when more and more workers are
employed, the return from the additional worker may initially increase but will
eventually decrease.

 Factors behind the Laws of Returns:

 One of the important factors causing increasing returns to a variable factor is the
Indivisibility of fixed factor. The minimum size of capital is given as it cannot be divided
to suit the number of workers. Therefore, if labour is less than its optimum number,
capital remains underutilized. When more and more labour input is used, utilization of
capital increases and also the productivity of additional labour.
 Second factor for increase in labour productivity is the Division of Labour. It becomes
possible with the employment of additional labour, until optimum capital-labour
combination is reached.
 Once the optimum capital-labour ratio is reached, employment of additional workers
amounts to substitution of capital with labour. But technically, there is a limit to which
one input can be substituted for another.
 With increasing number of workers, capital remaining the same, capital-labour ratio goes
on decreasing. As a result productivity of labour begins to decline. This marks the
beginning of the second stage.

26
 Application of the Law of Diminishing Returns
 This law may not apply universally to all kinds of productive activities since it is not as
true as the law of gravitation.
 In some productive activities, it may operate quickly, in some its operation may take a
little longer time and in some others, it may not operate at all.
 The law of Diminishing Returns and Business Decisions: If it has been presented
graphically has a relevance to the business decisions. The graph can help in identifying
the rational and irrational stages of operations. It can also tell the business managers the
no of workers (variable inputs) to apply to a given fixed input so that, given all other
factors, output is maximum.

Production function with two variable inputs

 In long run all inputs are variable, so the firm has the opportunity to select that
combination of inputs which maximises return.
 Long run production function with two variable inputs gives the concept of
ISOQUANTS.
 An Isoquant (from the Greek word “iso” meaning equal and “quant” meaning quantity) is
the locus of all technically efficient combinations (or all possible factors of production)
for producing a given level of output.
 Isoquants are similar in concept to indifference curves. The only distinction being that
isoquants are different combinations of two inputs that correspond to the same level of
output.
 Since they render the same level of output, isoquants are also referred to as isoproduct
curves.
 Taking the production function as Q = f(L, K) and fixing level of output Q at some given
quantity, and there is an implicit relationship between units of labour L and capital K.
This defines an isoquant as:
Q = f(L, K)
 It is possible to produce the same amount of output by using different combinations of
inputs; if these combinations are being plotted on graph, we get a downward sloping
curve, which is an isoquant.

Characteristics of Isoquants

27
  Taking the production function as Q = f(L, K) and fixing level of output Q at some given
Capital(Rs. Labour(‘00
quantity, and there is an implicit relationship between units of labour L and capital K.
This defines an isoquant as:

Crore)
Q = f(L, K)
units)
 It is possible to produce the same amount of output by using different combinations of
inputs; if these combinations are being plotted on graph, we get a downward sloping
curve, which is an isoquant.
40 6
Characteristics of Isoquants

28
 Downward Sloping: Technological efficiency connotes that an isoquant must slope
downwards from left to right, which implies that using more of one input to produce the 7
same level of output must imply using less of the other input. Slope of the isoquant is
equal to - ∆ K / ∆ L.

18
 A higher Isoquant Represents a Higher Output : A greater quantity of any one of the two
inputs will render a higher level of output. Using more of both inputs and more of either8
of the inputs must increase output given the state of technology. Hence, a higher isoquant
would represent a higher output than isoquant.

12 9
 Isoquants do not intersect: An isoquant represents the same level of output with different
units of two inputs. Intersection of two isoquants would signify a single input
combination producing two levels of output.

8 10
 Convex to the Origin: Given substitutability between factor inputs, as the firm continues
to employ more of one input say labour and less of other capital are not perfect
substitutes, therefore as Capital K is kept fixed to produce additional units of output only
by increasing labour L, it would require successively increasing units of labour.

Marginal Rate of Technical Substitution

28
  Marginal Rate of Technical Substitution measures the reduction in per unit of one input,
resulting in increase in the other input that is just sufficient to maintain the same level of
output.
 Thus, for the same quantity of output, marginal rate of technical substitution of labour L
for capital K(MRTSLK) would be the amount of capital that the firm would be willing to
give up for an additional unit of labour. Similarly, marginal rate of technical substitution
of capital for labour (MRTSKL) would be the amount of labour that the firm would be
willing to give up for an additional unit of capital.
 MRTS is expressed as the ratio between rates of change in L and K, down the isoquant.
Thus:
MRTSLK = - ∆ K / ∆ L

Isoquant Map and Economic Region of Production

 An isoquant map is a set of isoquants presented on a two-dimensional plane. Each
isoquant shows various combinations of two inputs that can be used to produce a given
quantity of output.
 In the isoquant map each upper isoquant indicates a larger input combination than the
lower ones, and each successive upper isoquant indicates a higher level of output than the
lower ones.
 Economic region is that area of production plane in which substitution between two
inputs is technically feasible without affecting the output. This area is marked by locating
the points on the isoquants at which MRTS = 0. A zero MRTS implies that further
substitution between inputs is technically not feasible.
 It also determines the minimum quantity of an input that must be used to produce a given
output. Beyond this point, an additional employment of one input will necessitate
employing additional units of the other input. Such a point on an isoquant may be
obtained by drawing a tangent to the isoquant and parallel to the vertical and horizontal
axes.

Special Shapes of Isoquants

 The most common type of isoquants is downward sloping and convex to the origin.
 The assumption is that the two inputs are substitutes but not perfect. Hence, there may be
other shapes of such curves as well, where inputs are either perfect substitutes or perfect
complements i.e. no substitutability.
 Linear Isoquants : Where there is perfect substitutability between two factors, the
isoquants would be linear.
 Right Angled Isoquants : The other extreme case of isoquants is of perfect complements;
this is the case in which capital is a perfect complement for labour, implying non
existence of any substitutability between the two factors. Such isoquants are right angled
or L shaped.
 The most common type of isoquants is downward sloping and convex to the origin.
 The assumption is that the two inputs are substitutes but not perfect. Hence, there may be
other shapes of such curves as well, where inputs are either perfect substitutes or perfect
complements i.e. no substitutability.
 Linear Isoquants : Where there is perfect substitutability between two factors, the
isoquants would be linear.
 Right Angled Isoquants : The other extreme case of isoquants is of perfect complements;
this is the case in which capital is a perfect complement for labour, implying non

29
 existence of any substitutability between the two factors. Such isoquants are right angled
or L shaped.
Elasticity of Factor Substitution
 MRTS refers only to the slope of an isoquant, i.e., the ratio of marginal changes in inputs.
It does not reveal the substitutability of one input for another with changing combinations
of inputs.
 The economists have devised a method of measuring the degree of substitutability of
factors called the Elasticity of Factor Substitution.
 It is formally defined as “The percentage change in the capital-labour ratio (K/L) divided
by the percentage change in marginal rate of technical substitution (MRTS)
σ = Percentage change in K/L
Percentage change in MRTS
σ = ∂ (K/L) (K/L)
∂ (MRTS) (MRTS)
• Since all along an isoquant, K/L and MRTS move in the same direction, the value of σ is
always positive. Besides, the elasticity of substitution (σ) is 'a pure number, independent
of the units of the measurement of K and L, since both the numerator and the
denominator are measured in the same units.'

Isocost Lines
 The isocost line is the locus of points of all the different combinations of labour and
capital that a firm can employ, given the total cost and prices of inputs.
 If the price of labour is wage (w) and the price of capital is interest (r), the total cost
incurred by the firm is summation of labour cost (wL) and capital cost (rK) and can be
presented as : C = wL + rKe
 The intercept of the isocost line on the capital axis is the maximum amount of capital
employed, when labour is not used in the production process and is given by C/r.
Similarly, the intercept on the labour axis gives the maximum amount of labour used in
the production process when capital usage is zero and is given by C/w.
 We can deduce the slope of the isocost line as:
Slope = ∆ K/ ∆L = C/r = w/r
C/w

Producer’s Equilibrium
 An isoquant would show all technically efficient combinations of two inputs. But when
producers are faced with several technically efficient combinations the decision is taken
on the basis of economic efficiency, i.e., use that combination which minimizes the cost
of production. Hence, to be economically efficient, a producer must determine the
combination of inputs that produces that output at minimum cost.
 The maximum output level for any firm is determined by isoquants, but they would not
give the minimum cost of production; for this isocost line is needed. Combining the
isoquants and isocost lines will help to understand the producer’s equilibrium.
 Necessary condition for producer’s equilibrium : Slope of isoquant = Slope of isocost
line.

Expansion Path
 Expansion path is defined as the line formed by joining the tangency points between
various isocost lines and the corresponding highest attainable isoquants.

30
  It can alternatively be defined to be the locus of equilibrium points of the isoquant with
the lowest possible isocost line.
 An expansion path is a long run concept and each point on the expansion path represents
a combination of inputs that minimises cost.

Laws of Returns to Scale

 The laws of returns to scale explain the behaviour of output in response to a proportional
and simultaneous change in inputs. Increasing inputs proportionately and simultaneously
is, in fact and expansion of the scale of production.
 When a firm expands its scale, i.e., it increases both the inputs proportionately , then
there are three technical possibilities:
i. Total output may increase more than proportionately
ii. Total output may increase proportionately
iii. Total output may increase less than proportionately

 Accordingly, there are three kinds of returns to scale:

Increasing Returns to Scale, Constant returns to scale, Diminishing returns to scale.

 Increasing Returns to Scale:

The factors behind Increasing Returns to Scale: 1) Technical and managerial
indivisibilities 2) Higher degree of specialization 3) Dimensional relations
 Constant Returns to Scale:
The constant returns to scale are attributed to the limits of the economies of scale. With
expansion in the scale of production, economies arise, but there is a limit to the economies of
scale.
 Decreasing Returns to Scale:
The decreasing returns to scale are attributed to the diseconomies of scale. The
diminishing return to management’, i.e., managerial diseconomies. As the size of firm expands
managerial efficiency decreases. Another factor is limitedness or exhaustibility of the natural
resources.

Theory of Cost and Break Even Analysis

Introduction
• We have discussed the input-output relations in terms of physical quantities of input and
output. However, business decisions are generally taken on the basis of money values of
the inputs and outputs. Inputs multiplied by their respective prices and added together
give the money value of the inputs, i.e., the cost of production.
• The cost of production is an important in almost all business analysis and business
decision-making, pertaining to a) locating the weak point in production management b)
minimizing the cost c) finding the optimum level of output d) determining price and
dealers, margin; and e) estimating or projecting the cost of business operation.

• COST CONCEPTS
• The cost concepts that are relevant to business operations and decisions can be grouped
on the basis of their nature and purpose under two overlapping categories (i) cost
concepts used for accounting purposes and (ii) analytical cost concepts used in economic
analysis of business activities.

31
Accounting Cost:
• Opportunity Cost : The opportunity cost is the opportunity lost. An opportunity to make
income is lost because of scarcity of resources. Income maximizing resource owners put
their scarce resources to their most productive use and thus they forego the income
expected from the second best use of the resources. Thus, opportunity cost may be
defined as the expected returns from the second best use of the resources that are
foregone due to the scarcity of resources. It is also called alternative cost.
• Business Cost and Full costs: Business costs include all the expenses that are incurred to
carry out a business. The concept of business costs is similar to the actual or real costs.
Business costs “include all the payments and contractual obligations made by the firm
together with the book cost of depreciation on plant and equipment”. They are used for
calculating business profits and losses and for filing returns for income-tax and also for
legal purpose.
• The concept of full cost, includes business costs, opportunity costs and normal profit.
Normal profit is a necessary minimum earning in addition to the opportunity cost, which
a firm must receive to remain in its present occupation.

Actual or Explicit Costs : The actual or Explicit costs are those which are actually
incurred by the firm in payment for labour, material, plant and building, machinery,
equipment, travelling and transport, advertisement, etc. The total money expenses,
recorded in the books of accounts are, for all practical purpose, the actual costs.
• Implicit Costs: In contrast to explicit costs, there are certain other costs that do not take
the form of cash outlays, nor do they appear in the accounting system. Such costs are
known as implicit or imputed costs. e.g. opportunity cost.
• Implicit cost are not taken into account while calculating the loss or gains of the business,
but they form an important consideration in deciding whether or not to retain a factor in
its present use. The explicit and implicit costs together make the economic cost.

• Out-of-pocket and Book Costs:

The items of expenditure that involve cash payments or cash transfers, both
recurring and non-recurring, are known as out-of-pocket costs. All the explicit costs (e.g.,
wages, rent, interest, cost of materials and maintenance, transport expenditure, electricity
and telephone expenses, etc.) fall in this category.
• On the contrary there are certain actual business costs that do not involve cash payments,
but a provision is therefore made in the books of account and they are taken into account
while finalizing the profit and loss account. Such expenses are known as book costs.

Analytical Cost

• Fixed and Variable Costs: Fixed costs are those that are fixed in volume for a certain
quantity of output. In other words, costs that do not vary or are fixed for a certain level of
output are known as fixed costs.
• The fixed costs include (i) costs of managerial and administrative staff (ii) depreciation of
machinery, building and other fixed assets (iii) maintenance of land etc.
• Variable costs are those which vary with the variation in the total output. It includes cost
of raw material, running cost of fixed capital, such as fuel, repairs, routine maintenance
expenditure, direct labour wages associated with the level of output and the costs of all
other inputs that vary with output.

32
• Total, Average and Marginal Costs: Total cost is the total actual cost incurred on the
production of goods and services. It refers to the total outlays of money expenditure both
explicit and implicit, on the resources used to produce a given level of output. It includes
both fixed and variable costs.
• Average Cost is of statistical nature- it is not actual cost. It is obtained by dividing the
total cost by the total output. TC/Q
• Marginal Cost is defined as the addition to the total cost on account of producing one
additional unit of the product. MC = TCn – TCn-1

• Short-run and Long-run Costs: Short-run and long-run cost concepts are related to
variable and fixed costs, respectively.
• Short run costs are those that have a short-run implication in the process of production.
Such costs are made once e.g., payment of wages, cost of raw materials etc. From
analytical point of view, short run costs are those that vary with the variation in output,
the size of the firm remaining the same. Therefore short run costs are treated as variable
costs.
• Long run costs are those that have long-run implications in the process of production, i.e.,
they are used over a long range of output. The costs that are incurred on the fixed factors
like plant, building, machinery are known as long-run costs.
• Broadly speaking, ‘the short run costs are those associated with variables in the
utilization of fixed plant or other facilities whereas long-run costs are associated with the
changes in the size and kind of plant.

• Incremental Costs : Incremental costs are closely related to the concept of marginal cost
but with a relatively wider connotation. Incremental cost refers to the total additional cost
associated with the decisions to expand the output or to add a new variety of product.
When firm expands its operations it has to incurred additional costs which is incremental
cost.

• Sunk Costs : The sunk costs are those which are made once and for all and cannot be
altered, increased or decreased, by varying the rate of output, nor they can be recovered.

• Historical Cost & Replacement Cost: Refers to the cost incurred in past on the acquisition
of productive assets, e.g. land, building, machinery etc., whereas replacement cost refers
to the outlay that has to be made for replacing an old asset.
• The concepts are of significance for the unstable nature of price behavior.
• Historical cost of asset is used for accounting purpose, in the assessment of the net worth
of the firm. The replacement cost figures in business decisions regarding renovation of
the firm.
• Private and Social Costs : The cost concepts that are related to the working of the firm
and that are used in the cost-benefit analysis of business decisions. Such costs fall in the
category of private costs.
• There are other costs that arise due to the functioning of the firm but do not normally
figure in the business decisions and not borne by the firms. Such costs are known as
Social Costs. E.g water / air pollution, rivers, lakes, public utility services like roadways,
drainage system etc.

COSTS IN THE SHOR RUN

33
• Fixed Costs : These are costs that do not vary with output. Before a firm actually starts
producing, it needs to spend on plant, machinery, fittings, equipments, etc., in fact the
firm has to bear these costs even if there is no output. These represent fixed costs. Since
such costs do not vary with the level of output, any decision regarding volume of output
does not depend upon fixed cost. Hence these are also referred to as subsidiary costs. The
shape of the Total Fixed Cost (TFC) is a straight line from the origin, parallel to the
quantity axis, indicating that output may increase to any level without causing any change
in the fixed cost.

Cost Cur
Cost 400
(Rs per
year)
COSTS IN THE SHOR RUN

• Variable Costs: These are the costs that vary with output and are incurred in getting more
and more inputs; variable costs are equal to zero if there is no output.
• TVC curve should be a straight line, but TVS is an inverse S shaped upward sloping

• 300
curve, starting from origin. This shape is determined by the law of variable proportions.
This leads to fall in per unit cost in the beginning; if the variable input is increased
beyond a certain level, its marginal productivity starts diminishing. Hence, TVC
increases at an increasing rate.
• Slope of the TVC curve is less steep in the beginning; as we increase the variable input,
with the other input fixed, productivity of the variable input fall because of diminishing
rate of technical marginal substitution between two inputs. Hence it is steeper on the
upper side.
• Average and Marginal Cost Functions: Average Cost is cost per unit of output; One can
derive Average Fixed Cost AFC, Average Variable Cost AVC and Average Cost AC

200
from total fixed, total variable and total costs respectively. AFC is fixed cost per unit of
output and is thus equal to the ratio of TFC and units of output; AC is total cost per unit

34
 of output and is thus equal to the ratio of TVC and units of output; AC is total cost per
unit of output and is thus equal to the ratio of TC and units of output.
• Marginal Cost is the change in total cost due to a unit change in output. Since the fixed
component of cost cannot be altered, MC is virtually the change in variables cost per unit
change in output. Therefore it is also known as rate of change in total cost.
• Average and Marginal Cost Curves: AFC can be plotted as a rectangular hyperbola,
asymptotic to the axes. As the number of units of output is increased, Fixed Cost
remaining the same, AFC falls steeply at first and then gently.
• AVC curve and the AC curve are both U shaped. This can be explained with the law of
variable proportions. Costs decline when there are increasing returns, stabilise with
constant returns and increase with diminishing returns.
• AC being the sum of AFC and AVC at each level of output lies above both AFC and
AVC curves in. The AC curve is U shaped; initially AC falls with increase in output,
reaches a minimum, and then increases.
• When both AFC and AVC fall, AC also falls. AVC soon reaches a minimum and starts
rising, while AFC continues to fall.

A Firm’s

35
 Cost
120

COSTS IN LONG RUN

100
• All costs are variable in the long run since factors of production, size of plant, machinery
and technology are all variable. This in turn implies radical changes in the cost structure

•
of the firm.
80
The long run cost function is often referred to as the ‘planning cost function’ and the long
run average cost LAC curve is known as ‘planning curve’. As all costs are variable, only
the average cost curve is relevant to the firm’s decision making process in the long run.
• The long run consists of many short runs, e.g., a week consists of seven days and a month
consists of four weeks and so on. Therefore the long run cost curve is the composite of

60
many short run cost curves.
• Long Run Average Cost: When the plant size and other fixed inputs of the firm increase
in the long run, the short run cost curves shift to the right.
• In the long run, the firm operates with different plant sizes and can switch over to a
different plant size, depending on cost considerations.
• Thus SAC1 relates to average cost of the firm when its plant size is, say I; when plant

40
size increases to II, the corresponding SAC curve is SAC2 and so on.
• As output increases from a to b in the short run, the firm can continue to produce along
n
/u
i) C
o
t($
s

SAC1, utilising its installed capacity of I. Further ahead, at an output level of a, this
capacity is overworked.
• Hence, it would be cost effective for the firm to shift to a higher plant size, say II, thus
switching over from SAC1 to SAC2. This shift would lower the average cost of the firm.

20

0 36
 COSTS I

• A firm may have multiple alternate plant sizes. So it may have multiple SACs
corresponding to different plant sizes..
• LAC function is an envelope of the short run cost function and the LAC curve envelopes
the SAC curves; hence the LAC curve is also known as “envelop curve”.

CONCEPTS OF REVENUE
•
Total Revenue : TR is the total amount of money received by a firm from goods sold ( or
services provided ) during a certain time period.
TR = Q . P
• Average Revenue : AR is the revenue earned per unit of output sold. It is equal to the
ratio of TR and output. That means AR is nothing but price.
AR = TR/Q = Q.P / Q = P
• Marginal Revenue : MR is the revenue a firm gains in producing one additional unit of a
commodity. It is calculated by determining the difference between the total revenues
earned before and after a unit increase in production.
MR = TRq – TRq-1
• MR is the slope of TR. When TR is maximum when MR is zero and beyond which MR
becomes negative.
• Chart related to Revenue curves

Rules of Profit Maximization

• The profit function shows a range of outputs at which the firm makes positive or
supernormal profits. Economists differentiate between normal profit and supernormal
profit.

37
• Normal profit is that amount of return to the entrepreneur which must be earned to keep
him/her in that business activity. Anything over and above this is supernormal profit.
• In other words, normal profit is a part of total cost and supernormal profit is the
accounting profit that occurs when TR>TC.
• A firm maximizes profit at the point where MR equals MC.
• Under the assumption of rationality a firm will continue to produce till MR is greater than
MC and will stop production only when MR is just equal to MC.

BREAK EVEN ANALYSIS

• Break Even Analysis examines the relation between total revenue, total costs and total
profits of a firm at different levels of output.
• Break Even point is the point where total cost just equals the total revenue; it is the no
profit no loss point.
• BE Analysis is about determining profit at various projected levels of sales, identifying
the break even point and making a managerial decision regarding the relationship
between likely sales, and the breakeven point.

Break Even Analysis : Graphical Method

• Under graphical method the breakeven chart is constructed by plotting firm’s total
revenue and total cost on the vertical axes and output on the horizontal axis.
• Break even chart assumes constant AVC for a given range of output. Hence, a firm’s total
cost function is given as a straight line.
• The chart would be helpful to find out Breakeven point.
• It would also throw light on the profit or loss resulting from each level of sales by the
firm. It can provide valuable information on projected effect of output on costs and
profits and firm can ascertain the volume of sales it would need to breakeven.
• To draw a break even chart following steps need to be followed:
• Label the vertical axis ‘revenue and costs in rupees’ and the horizontal axes
‘output/production units’.
• Assuming constant price, plot at least two points from the revenue data and draw the
upward moving TR line starting from the origin.
• Draw a horizontal line for total fixed costs starting at the point on the vertical axis at the
level of fixed costs
• At the same point on the horizontal axes draw the total costs line.
• The point where the revenue line crosses the total costs line is the break even point.
• The gap between the total costs line and revenue line beyond the breakeven point
represents the level of profit or loss.

Chart

• Super Computers Ltd. Sells personal computers, laptops and peripherals. The following
information (in Rs. Crores) was obtained from the chief Accountant of Super at the end
of March 2006. It was also assumed that wages are fixed cost, since the company did not
lay off any worker and also that 20% of the overheads are variable. Consider yourself to
be a managerial economist and analyse the information, especially the BEP.

38
 PCs Laptops Peripherals
Sales 2,500,000 600, 000 120,000
Materials 2,300,000 300,000 100,000
Wages 55,000 300,000 60,000
Overheads 50,000 50,000 20,000
Profit/Loss 95,000 50,000 60,000

• From the assumptions, the modified information is presented in below table:

PCs Laptops Peripherals

Sales 2,500,000 600, 000 120,000

Variable cost 2,310,000 310,000 104,000
Contribution 1,90,000 290,000 16,000
Fixed Cost 95,000 340,000 76,000
Profit/Loss 95,000 -50,000 -60,000
PV Ratio 0.076 0.483 0.133
BEP 1,250,000 704,000 570,000
Contribution = Sales – Variable Cost
PV ratio = Contribution / Sales
BEP = FC / PV Ratio

Break Even Analysis : PV Ratio

• Profit volume ratio is the ratio of contribution margin and sales. It is also defined as the
ratio of marginal change in profit and marginal change in sales.
• PV Ratio = Contribution / Sales
• Using PV Ratio also, we can calculate BEP as:
BEP = FC / PV Ratio

ECONOMIES OF SCALE

• “Economies” refer to lower costs; hence economies of scale would mean lowering of
costs of production by way of producing in bulk.
• Economies of scale refers to the efficiencies associated with large scale operations; it is a
situation in which the long run average costs of producing a good or service decrease
with increase in the level of output.
• Firms are often concerned about a minimum efficient level of production, which is
nothing but the amount of production that spreads setup costs sufficiently for firms to
undertake production profitably.

• There are two types of economies of scale: Internal economies (in which cost per unit
depends upon the size of firm)
External economies (in which cost per unit depends upon the size of industry)

• Internal Economies:
• Specialization
• Greater efficiency of machines
• Managerial Economies
• Financial Economies
• Production in stages

39
 • External Economies: As an industry grows in size, it would create various economies for
the firms in the industry.
• Technological advancement
• Easier access to cheaper raw materials
• Financial institutions in proximity
• Pool of skilled workers

• Diseconomies of Scale : Refers to decrease in productivity when there are equal

increases of all inputs, assuming that no input is fixed.
• If some cost of a business rises with an increase in size by a greater proportion than the
increase in size of operations, it is known as a diseconomy of scale.
• Diseconomies may arise if the size of operations becomes unwieldy by size; coordination
among different work groups and units may become complex; too much specialization
may lead to boredom and monotony among workers; management may become less
effective and thus indirectly impose costs.
• Economies of scope refer to a situation in which average costs of manufacturing a
product are lowered when two complementary products are produced by a single firm,
than when they are produced separately.
• It is applicable to firms that produce more than one product and obtain production or cost
advantages.

LEARNING CURVES

• LAC declines as the scale of production increases to a certain level and beyond this level
of production, LAC begins to rise. Economies of scale provide the reasoning why LAC
decreases with increasing scale of production and diseconomies of scale provide reason
for increase in LAC beyond minimum point.
• Economists and business analysts have discovered another factor that causes a continuous
decrease in average cost of production over a large scale of production. The factor is
called learning by doing or learning by experience.
• Firms engaged in the production of a commodity or service over a long period of time
gain experience. They learn by performing the same activity repeatedly.
• Along with that factors like technological know-how, mgnt style, organizational
behaviour help firms in getting work done at least cost.

Learnin
• Thus,firm ’saveragecostof
productioncontinuesto
fall withincreasein 40
• The learning curve is widely used by business managers, economists and engineers to
foresee the possible trend in long run average cost of production and plan production
accordingly.
• Learning curve is different from the conventional LAC curve. While LAC give the
average cost of plant-wise production, learning curve gives the average cost of
cumulative output, i.e., the total output right from the beginning of production of a
commodity or service.

MARKET STRUCTURE: PRICING DECISION

Market Structure
 Market structure identifies how a market is made up in terms of :
 Number of firms in the industry
 Nature of the product
 Nature of competition
 The extent of barriers to entry
 The degree to which the firm can influence price

Forms of Marke

PERFECT COMPETITION
Features of Perfect Competition
E.g. Agricultural Commodities, Share market, Unskilled Labour
 Presence of Large Number of Buyers and Sellers
 Homogeneous Product
 Freedom of Entry and Exit
 Perfect Knowledge

Perfect
 Perfectly Elastic Demand Curve
 Perfect Mobility of Factors of Production
 No Governmental Intervention
 Firm is a Price Taker

Competition 41
Price and Output Decision under Perfect Competition

 Market price in a perfectly competitive market is determined by the market forces –

market demand and market supply. Market demand refers to the demand for the industry
as a whole.
 A seller in a perfectly competitive market is a ‘price-taker, not a ‘price –maker’.
 In a perfectly competitive market, therefore, the main problem for a profit maximizing
firm is not to determine the price of its product but to adjust its output to the market price
so that profit is maximum.
 The mode of price determination – price level and its variation – depends on the time
taken by the supply position to adjust itself to the changing demand conditions.
Therefore, price determination under perfect competition is analyzed under three
different time periods:
i. Market period or very short-run
ii. Short run
iii. Long run

Price Determination in Market Period

 In the market period (very short period), the total output of a product is fixed. Each firm
has a stock of commodity to be sold. The stock of goods with all the firms makes the total
supply. Since the stock is fixed, the supply curve is perfectly inelastic.
 In this situation price is determined solely by the demand conditions.
 Very short-run markets may be daily fish market, stock markets, daily milk market,
certain essential medicines during epidemics, agricultural products due to droughts ,
floods etc.

Rs. Price Rs. Price

S S1

P1
Price Determination in the Short-Run

 A short-run is a period in which firms can neither change their scale of production or
quit, nor can new firms enter the industry.
P 1
P
 While in the market period supply is absolutely fixed; in the short-run, it is possible
change the supply by changing the variable inputs. In short run supply curve is therefore
elastic.
P
D1
 Once market price is determined, it is given for all firms. No firm is large enough to
influence the prices.
 Only option for a firm is to produce as much as it can sell at the given price.

42 D
Q1
 Price Determina
Short -Run
Price Determination in the Long-Run

 In contrast to the short-run conditions, in the long-run, the firms can adjust their size or
quit the industry and new firms can enter the industry. If market price in the long run is
such that AR>AC, then the firms make economic or super normal profit. As a result, new
firms get attracted towards the industry causing increase in market supply at the given
price.
 Increase in market supply causes rightward shift in supply curve. Similarly, if AR<AC
firms make losses. Marginal firms quit the industry causing decrease in market supply.
Hence, leftward shift in supply curve. This continues until price is determined such that
AR=AC.

Price Determin
Run
43
 MONOPOLY

 The term monopoly means an absolute power of a firm to produce and sell a product that
has no close substitute.
 Single Seller : A monopolized market is one in which there is only one seller of a product
having no close substitutes.
 No difference between Firm and Industry : A monopolized market is a single firm
industry. Firm and Industry are identical in a monopoly setting. Equilibrium of the
monopoly firm signifies the equilibrium of the industry.
 Independent Decision Making
 Restricted Entry

Causes and Kinds of Monopoly

The emergence and survival of a monopoly firm is attributed to the factors which prevent
the entry of other firms into the industry and eliminate the existing ones.
The barriers to entry are the major sources of monopoly power. The main barriers to
entry are:
i. Legal restrictions
ii. Sole control over the supply of scarce and key raw materials
iii. Efficiency in production
iv. Economies of Scale

Diamonds Are Forever :

De Beers Consolidated Mines was incorporated by Cecil Rhodes about 110 years ago and
it is the largest and most successful diamond company in the world. In its early years the
company produced over 90% of the entire world’s diamonds; it was then able to
“control” the production and hence the supply of diamonds. This however was reduced
with the entry of many new players. Many are of opinion that the company still enjoys a
virtual monopoly in diamond supply to the rest of the world. In fact, De Beers now owns
about 70 per cent of the diamond mines in South Africa and produces nearly 40 per cent
of world’s diamond in terms of value.

Exclusive Marketing Rights Create Monopoly :

The concept of Exclusive Marketing Rights owes its origin to US legislation, namely the
Hatch-Waxman Act, 1984, which granted a five year market exclusively period for an
innovative drug. This provision was subsequently meant to protect drugs that either did
not have any patent protection, or had less than five years of protection left at the time of
approval. EMRs were introduced as an effective way to stop the imitation of patented
products by the local industry. EMR is also recognized under Trade Related Intellectual
Property Rights (TRIPS) Agreement of WTO as one of the alternatives to product
patents.
One instance of EMR that evoked a lot of controversy in India was that of pharmaceutical
major Novartis, which was granted EMR to exclusively sell or distribute its patented anti-
cancer drug Glivec containing the active ingredient Imatinib mesylate. At the same time,
EMR to Eli Lilly was delayed. This move affected six Indian pharmaceutical companies
which have been manufacturing Imatinib mesylate at one-tenth its price, under different
trade names.

44
 Pricing and Output Decision : SHORT RUN

 Cost conditions, i.e., AC and MC curves, in a competitive and monopoly market are
generally identical, revenue conditions differ.
 Revenue conditions, i.e., AR and MR curves are different under monopoly.
 A monopoly firm faces a downward sloping demand curve. The reason is a monopolist
has the option and power to reduce the price and sell more or to raise the price and still
retain some customers.
 When a demand curve is sloping downward, MR curve lies below the AR curve and
technically the slope of the MR curve is twice that of AR curve.

Pricing&Output Decision
Short run

Pricing&OutputDecision
Long run

 The decision rules regarding optimal output and pricing in the long run are the same as in
the short-run.
 In the long-run however a monopolist gets an opportunity to expand the size of its firm
with a view to enhance its long-run profits.

Pricing &Output Dec

Long run

45
 PRICE DISCRIMINATION

 When a seller discriminates among buyers on the basis of the price charged for the same
good or service, such a practice is called price discrimination.
 Why a seller would do this? When is it possible? How it is done?
 A seller charges different prices with an objective of maximizing his revenue.
 There are certain prerequisites due to which it is possible .

Prerequisites to Price Discrimination

 Market Control : The greater the imperfection in the market, the higher is the possibility
of price discrimination. Monopolist is a price maker. So ideal condition for PD is
monopoly.
 Division of Market : Possible only when the whole market can be divided into various
segments, whereas the product would be identical. It must also not be possible to transfer
goods from the cheaper market to costlier market.
 Different Price Elasticities of Demand in Different Markets : Sufficient condition is that
price elasticities of demand should be different in these market segments. Price elasticity
of demand helps in determination of appropriate price.

Bases of Price Discrimination

 Personal : Personal price discrimination may be on ground of demography, paying

capacity or need. E.g. senior citizens, physically challenged persons get certain
concessions on rail fare (Demographic separation of market) Lawyers may charge higher
fees from a person who has a case of life and death as against a client who has a small
issue. (need based segmentation) Doctors treat poor patients free or may charge a
concessional fee. (Paying capacity)
 Geographical : People living in different areas are required to pay different prices for the
same product. E.g. edible oils and many packaged food items are sold at different prices
in different states of India.
 Time : Markets may also be divided on the basis of time, i.e. which time of the day or
month or year is the product being purchased.
 Purpose of Use : Customers are segregated on the basis of their purpose of use, e.g.
electricity rates are lower for domestic purpose and higher for industrial purpose.
Different rates of loans for car and education.

Degrees of Price Discrimination.

 Pigou has identified three degrees of price discrimination on the basis of seller’s
estimation of consumers’ paying capacity and their willingness to pay. The seller can
make a good assessment of consumer surplus and can discriminate on that basis.
 First Degree: When the seller is able to charge different prices for different units of the
same product from the same consumer, such a practice is called price discrimination of
first degree.
 In this case, the firm charges the maximum price from the buyer for each unit sold in a
‘take it or leave it’ kind of situation and thus takes away the entire consumer surplus.

46
 Second Degree : In case of second degree of price discrimination the seller divides
consumers in groups on the basis of their paying capacities and discriminates on the basis
of consumer surplus. In such discrimination the firm takes away the major (not entire)
portion of consumer surplus.
 Third Degree : This is that degree of price discrimination in which the seller manages to
take away only a small portion of consumer surplus. Firm segregates consumers on
different bases such that each group of consumers is a separate market and then charges
the price on the basis of different price elasticities of the different groups.

• MONOPOLISTIC COMPETITION
Features of Monopolistic Competition

 Monopolistic competition is a market situation in which a relatively large number of

producers offer similar but not identical products.
E.g. Retail Stores, detergents
 One can identify groups of differentiated products in this type of market by clubbing
close substitutes from the same industry and regard them as ‘product groups’. Such a
product group would ideally comprise of products that are “good”, but not “perfect”
substitutes of each other. Ariel, Surf, Nirma and Tide can be clubbed in the product group
of “detergents”, while Lux, Lifebuoy, Cinthol and Dove can be put in the product group
of soaps.
 While in service sector in India, institutions of primary and secondary education and
organizations of healthcare are good examples of monopolistic competition.

 Large number of Buyers and Sellers

 Heterogeneous Products
 Selling Costs
 Independent Decision Making
 Imperfect Knowledge
 Unrestricted Entry and Exit

Features of Monopolistic Competition

 Heterogeneous Products: A product is said to be differentiated if there are even minor
changes in the same generic product, such as in colour, or packaging, or brand name, on
the basis of which, the sellers can convince their customers that what they are selling is
not the same as what their rival firms are offering; hence they are able to charge different
prices for the differentiated product.
 Such differentiation can also be on the basis of differences in qualities, after sales service,
packaging, design, trade marks, location of selling and even advertising.

 A differentiated product enjoys some degree of uniqueness in the mindset of customers,

be it real or imaginary.
 Whatever be the basis of differentiation, because of such differences among products,
producers have some control over prices like monopoly but such control is usually small,
because the products offered by rivals are very similar to each other and are very close
substitutes.
 Thus one can say that products of different sellers in Monopolistic competition have a
very high, cross elasticity of demand.

47
 Price and Output Decisions in Short-run
 Monopolistic Competition faces a downward sloping demand curve due to reasons such
as : (i) a strong preference of a section of consumers for the product (ii) the quasi-
monopoly of the seller over the supply.
 The strong preference or brand loyalty of the consumers gives the seller an opportunity to
raise the price and yet retain some customers.

Price and Output D

Short -run

Price and Output Decisions in Long-run

 In long run, the supernormal profit bring about two important changes in a monopolistically
competitive market.
 First, the supernormal profit attracts new firms to the industry. So, the existing firms lose a part of
their market share to new firms. Consequently, their demand curve shifts downward to the left
until AR is tangent to LAC.
 Second, the increasing no of firms intensifies the price condition between them. Price competition
increases because losing firms try to regain or retain their market share by cutting down the price
of the product and new firms to penetrate in the market charge low prices. This makes the demand
curve more elastic. So AR2 n MR2 has greater slope than AR1 n MR1 respectively.

 Once all the firms reach the stage where firms make only normal profits in the long run, there is
no attraction for the new firms to enter the industry, nor is there any reason for the existing firms
to quit the industry. This signifies the long run equilibrium of the industry.

48
 Price and Output D
Long -run

• OLIGOPOLY

Features of Oligopoly

 Oligopoly is a kind of market where a few dominant sellers sell differentiated or

homogenous products under continuous consciousness of rivals’ actions. E.g. Cars,
computers, universities etc.
 Few Sellers
 Product
 Entry Barriers
 Huge Investment Requirements
 Strong Consumer Loyalty for Existing Brands
 Economies of Scale
 Interdependent Decision Making

 Interdependent Decision Making : Most distinctive feature of oligopoly is that, one firm
cannot take any decision independent of other firms.
 Is it possible that Maruti changes the price of WagonR without a fear of retaliation by
Santro?
 A new advertisement would attract counter strike by rivals. E.g. The advertisement war
between cola majors. If one company engages film celebrities to endorse its product,
others also follow suit. If Shah Rukh Khan and Sachin promote Pepsi, then Akshay
kumar is roped to promote Thums Up and Aamir Khant to sell Coca Cola.
 When the national leader in economic and financial news Economic Times became pink,
Financial Express too had to adopt the same colour.

 Non Price Competition : Although firms under oligopoly are continuously watching each
step of their rival but mostly avoid the incidence of a price war.
 In most of the cases the prevailing price is fixed after a series of such price wars and
firms know that price war benefits only consumers and not the firms, hence they keep the
price untouched.

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 They resort to other strategies like highly aggressive advertising, product bundling,
influencing value perception of consumers, branding and offering better service
packages.

 Indeterminate Demand Curve : An oligopolist’s demand is not only affected by its own
price or advertisement or quality, but is also affected by the price of rival products, their
quality, packaging, promotion and placement.
 Due to this fact, in oligopoly each firm faces two demand curves, this makes price and
output determination a very complex phenomenon.

Price and Output Decisions

Price Leadership

 The agreed upon price under collusion may have been fixed on the basis of going rate of
the price charged by the largest or the most sophisticated player. Such kind of price
determination is known as price leadership.
 Dominant Firm : Oligopoly market is dominated by few firms, among which one may be
the largest player. E.g. Google among search engines, Intel in the micro chips market,
IBM in PC segment, Godrej in steel furniture.
 Important part of this is that other companies acknowledge the leadership of this largest
firm for price determination.
 A dominant firm is a leader in terms of market share or presence in all segments or just
being pioneer in the particular product category.
 The leader firm is very large in size and earns economies of scale.
 A benevolent leader is one which allows other firms to exist by fixing a price at which
small firms may also sell.
 The price is higher than the marginal cost of the overall market in the industry so that
high cost firms can also survive.
 Two major reasons behind the creation of benevolent firm :
 It lets others exist so that it does not have to face allegations of monopoly creation
 It earns sufficient margin at this price and still retains market leadership.
 Limitation is that it is successful only when other firms will follow the leader.

 Barometric Firm : Some markets may be such that no single player is so large to emerge
as a leader, but there may be a firm which has a better understanding of the markets.
 This firm acts like a barometer for the market.
 Having better industrial knowledge
 Preempt and interpret its external environment effectively
 E.g. if it foresee that appreciation of rupee will occur causing increase in cost of
production, barometric firm will initiate a price rise with the declaration that due to rise in
cost the price is increased. Since all the firms face the same threat they will also follow
the barometric firm.

Collusive Model : Cartel Arrangement.

 A cartel is an association of business firms formed by an explicit agreement between

them.

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  Under cartel agreements, “the firms jointly establish a cartel organization to make price
and output decisions, to establish production quotas for each firm, and to supervise
market activities of the firms in the industry.”
 Cartel type of collusions are formed with a view to (i) eliminating uncertainty
surrounding the market (ii) restraining competition and thereby ensuring monopolistic
gains to the cartel group.
 Cartel works through a Board of Control. One of the main functions of the board is to
determine the market share for each of its members.
 The board calculates the MC and MR for the industry. MC for industry is the summation
of MCs of individual firms.

 On the basis of industry’s MR and MC, the total output for the industry is determined.
The total output is then allocated between the member firms on the basis of their own
MC.

Game Theory

 Game theory approach explains the strategic interaction among the oligopoly firms.
 Game theory is a mathematical technique to show how oligopoly firms play their game of
business. It is the choice of the best alternative from the conflicting options.
 Game theory can be understood by the widely used example of ‘prisoners’ Dilemma’.

The Nature of the Oligopoly Problem : Prisoners’ Dilemma

 The nature of the problem faced by oligopoly firms is best explained by the Prisoners’
Dilemma Game.
 Let us suppose that there are two persons, A and B, who are partners in an illegal activity
of match fixing. On a tip-off, the CBI arrests A and B, on suspicion of their involvement
in fixing cricket matches. They are arrested and lodged in separate jails with no
possibility of communication between them. They are being interrogated separately by
the CBI officials with following conditions disclosed to each of them in isolation.
i. If you confess your involvement in match fixing, you will get a 5-year imprisonment.
ii. If you deny your involvement and your partner denies too, you will be set free for lack of
evidence.
iii. If one of you confesses and turns approver, and the other does not, then one who
confesses gets a 2-year imprisonment and one who does not confess gets 10 year
imprisonment.

• PRODUCT PRICING

1) Cost Based Pricing

 A firm must earn profits to survive in the long run, irrespective of the market structure or
its objective; the natural basis of determination of price should be the cost of production
with some margin.
 Cost Plus or Mark up Pricing :
 Total cost is considered as the basis of price. A firm will consider total cost per unit of
output that is average cost for price fixation.
 Price = AC + m

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 m is a percentage of mark up, determined by considering target rate of return, degree of
competition, price elasticity and availability of substitutes.
 Helps to determine BEP, simple & convenient
 Not suitable when competition is tough or it is trying to enter the market
 Marginal Cost Pricing :Used when demand is slack and market is highly competitive
 To fix the price only variable cost is considered instead of full cost.
 Price is the sum of variable cost and profit margin.
 Target Return Pricing : Under this kind of pricing a producer rationally decides the
minimum rate of return that the product must earn.

2) Competition Based Pricing

 Degree of competition is a very significant determinant of pricing.
 Penetration Pricing : When a firm plans to enter a new market which is dominated by
existing players, its only option is to charge a low price, even lower than the ongoing
price. This price is called penetration price.
 E.g. Air Deccan had entered civil aviation market with its low cost air fare, Nirma had
used such a pricing strategy against big brands like HLL and P&G.
 Short term in perspective and success depends on price elasticity of demand.
 Entry Deterring Price : One entry barrier may be created by a large player to eliminate or
reduce competition, by keeping the price low, thus making the market unattractive for
other players.
 If prevailing price is very low, new entrants with high fixed cost will not be able to enter
the market.
 Preventing entry of new players is just opposite to penetrating a new market, but pricing
strategy is the same in both.
 Success depends on the fact that firm earns economies of scale and can afford to charge
low price.
 When price is higher there is possibility of increase in competition.

3) Going Rate Pricing

 Under going rate pricing most of the players do not indulge in separate pricing but prefer
to follow the prevailing market price.
 Normally the price is fixed by the dominant firm and other firms accept its leadership and
follow that price.
 Success depends on the fact that most of the firms do not want enter into price war.
 Small firms or new firms may not be sure of shift in demand by charging a price different
from the prevailing market price.
 The products sold by the players are very close substitutes, hence their cross elasticity is
very high.

4) Product Life Cycle Based Pricing

 Refers to different pricing for a product at different stages of its lifecycle.
 Different stages of a product are : Introduction, Growth, Maturity, Saturation, Decline
 Pricing in each of these phases is different : Price Skimming, Product Bundling,
Perceived Value Pricing, Value Pricing, Loss Leader Pricing

5) Price Skimming
 Producers know that there is a segment of consumers who have deep pockets and who
would like to be among the first few proud possessors of the latest product.

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 These consumers have very low price elasticity of demand and are mostly governed by
the status symbol factor and not by the intrinsic value of the product.
 Hence, producers charge a very high price in the beginning to skim the market.
 In the introduction stage the mark up on cost is normally very high.
 When the product is established sellers reduce their profit margin and charge lower price
for the same product.
 Price discrimination of first degree.

6) Product Bundling (or Packaging)

 In this method, two or more products are bundled together for a single price.
 This strategy is used as a double edged weapon, for propagating a new product, as well as
for selling a product in its stage of decline.
 It may be adopted at the time of introduction as well as during growth and maturity.
When a product is new and needs to be popularized, sellers adopt packaging of various
products together and charge one price for the same.
 It saves cost of spreading awareness.
 it captures part of consumer surplus, since the consumer gets the satisfaction of the
additional good at no extra cost.

7) Buy one, Get Two

 The FMCG bug of product bundling has bitten the publication majors in their search for
growth triggers. Since June 2003 many industry leaders have launched combo-packs in
quick succession. The strategy is to push in a regional language (mostly Hindi) edition
with a widely read English one. The result is that, at Rs 75 a month, one can read The
Times of India and Navbharat Times or Hindustan Times and Hindi Hindustan. Those
interested in business/financial news can now buy TOI and The Economic Times (ET) as
a combo at the same price of Rs 75 a month.

8) Perceived Value Pricing

 The underlying philosophy of this pricing is that a product is as good as a consumer finds
it. Value of goods for different consumers depends upon their perception of utility of the
good. Therefore, the price a consumer is willing to pay would reflect the value of that
product to him/her.
 A segment of buyers believe that higher the price, better the quality; hence they would be
willing to buy anything that is tagged at high price.
 Sellers identify the perceived value of the good on the basis of their knowledge of market
forces.
 Sellers may try to influence perceived value through brand awareness and emphasis on
quality.
 Perceived value pricing is adopted during the growth and maturity stage so as to
differentiate the product from that of competitors’ and retain the quality conscious
customers.
 Titan watches, Philips products, Tanishq Jewellery and Parker pens are some of the
brands which have consistently resorted to perceived value pricing by creating hype
about high quality. Here the price of the good is not at all governed by the cost of
production.

Titan : Watches for one and all

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 Titan’s portfolio of products span 3 distinct price brands, defined in general as premium,
mid and popular using benefit and income levels as the bases.
 The first segment consists of the high income elite group of consumers who perceive
watches as fashion accessory. The next segment consists of consumers who prefer some
fashion in their watches but to them price does matter. The third segment consists of the
lower income consumer who buy a watch mainly for time keeping and their buying
decision is mainly on the basis of price.
 Titan provides watches for all segments, from the low end Sonata for a first time user to
Fast Track for the trendy young, to PSI for those who turned on by technology, to Dash
for kids, and the higher priced Raga, Regalia, Nebula and the World Watch.

9) Value Pricing
 In Value Pricing sellers try to create a high value of the product but keep the price low.
The assumption is that price should represent value for money to consumers, in other
words the price charges should be lower than perceived value of product for the
consumers.
 In this method, seller allows some consumer surplus to the buyer.
 It is a suitable strategy for the maturity and saturation stage when demand can be
maintained by keeping focus on higher quality and lower cost.
 This becomes possible with large scale of production and operations.

10) Loss Leader Pricing

 It’s a strategy adopted by companies which produce or sell multiple products of selling
one product at a lower price and compensate the loss by other products. The assumption
is that buyers would buy multiple products of the same firm.
 Success of this strategy depends upon a combination of goods which are complementary
in nature and one product can not be utilized without the other product.
 E.g. Pen and Ink, Printer and Cartridge, Photocopier and Toner etc.
 Firms charge low price for the good which is durable and has high value and high price
for the product which is consumable and has low value and has recurring demand.
 E.g. HP

11) Multi Product Pricing

 There are firms who produce a large number of goods which have some kind of
interdependence either in terms of production or of demand.
 Here we shall talk about Multi product companies producing related goods or goods that
have interdependence.
 There are three types of Interdependence between products : Demand Interdependence,
Supply Interdependence and Input output relationship
 Demand Interdependence :
 In case of Substitutes the optimal output for each good would be less than when there was
no demand interdependence. The reason is that these goods compete with each other.
Hence sale of one can be increased at the expense of the other. So firm can not sell
maximum of either of these products.
 Such a seller has two options (i) charge the same price for the two goods as coca cola has
adopted for Coke and Thums Up brnads. (ii) differentiate the products from each other
and take advantage of perceived value pricing as in case of Surf Excel (Premium ) and
Surf ( Economy) by HLL.

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 Demand Interdependence :
 In case of complementary goods and increase in demand for one product increases
demand for the other. Therefore optimal output is greater than when there was no demand
interdependence. Here an increase in price of one good will result in fall in demand of
both the goods.
 Therefore, a suitable strategy would be either product bundling or loss leader, depending
upon company’s objectives and market condition.

 Input Output Relationship : There may be firms which produce multiple products bearing
input output relationship.
 There may be the case when a company undertakes all the stages of production involved
in bringing out the final product.
 E.g. a soft drink manufacturer also owns a bottling plant, TATA produces iron and steel
and also car, truck and other vehicles.
 Pricing in this case is called transfer pricing.

Multi Product Pricing :Ramsay Pricing

 Economist Frank Ramsay gave a model of taxation which became very useful for pricing
decisions of a multi product firm.
 He suggested that govt should levy high tax on the goods which had low price elasticity
and low tax on goods which had high price elasticity.
 According to Ramsay pricing, the firm should fix the price close to marginal cost for the
product which has highly elastic demand and should charge substantial margins for the
product with low elasticity.
 Price deviations from marginal cost should be inversely proportional to price elasticity of
the product.

12) Transfer Pricing

 Transfer prices are the charges made when a company supplies goods, services or
financials to another company to which it is related as its subsidiary or sister concern.
 Here, the firm encounters the problem of fixing the price of a product demanded for
internal use.
 It has gained significant importance with the growth of MNC.
 MNCs have to set transfer prices for the supply of goods, technical know how and
marketing rights from the parent to a subsidiary or from one subsidiary to another. Such
prices for transacted items would go to the cost of production of the final goods. Hence it
is often misused to evade taxes on net profit.
 Govts keep strict check on transfer pricing.
 It helps related entities to reduce global incidence of tax by transferring higher income to
low tax jurisdictions or greater expenditure to those jurisdictions where the tax rate is
high.
 The mechanism is such that MNCs charge higher transfer price for goods from a low tax
country when these goods have to be used for final production in a country of high tax
regime and are thus able to minimise their tax payment.

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 13) Peak Load Pricing

 Under peak load pricing different prices are charged for the same facility used at different
points of time by the same consumers.
 The time zone is divided into peak load and off peak load. Customers using product at
peak load time pay a higher price (say, mark up price) and users at off peak load pay a
lower price.
 E.g. Hotel charges, Telephone charges after evening

14) International Price Discrimination and Dumping

 Normally firms do not charge same price in the international market as in the domestic
market, because the market conditions are not similar.
 The firm may segregate its market on the basis of that particular country’s paying
capacity and price elasticity of demand.
 One very common form of such pricing is called as Dumping. It is a strategy adopted by
a country where a product is exported in bulk to a foreign country at a price which is
either below the domestic market price or below the marginal cost of production.
 Normally firms do not charge same price in the international market as in the domestic
market, because the market conditions are not similar.
 The firm may segregate its market on the basis of that particular country’s paying
capacity and price elasticity of demand.
 One very common form of such pricing is called as Dumping. It is a strategy adopted by
a country where a product is exported in bulk to a foreign country at a price which is
either below the domestic market price or below the marginal cost of production.

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