M P BIRLA INSTITUTE OF MANAGEMENT ASSOCIATE BHARATIYA VIDYA BHAVAN

BUSINESS ECONOMICS (MANAGERIAL ECONOMICS)

SYNOPSIS

DR. S. BISALIAH*

* Support for computerising the material by Mrs. R. Kalavathi is gratefully acknowledged. Dr. N. S. Viswanath was of great help in providing the basic framework for developing this material. His help is hereby acknowledged.

ORIENTATION IN ECONOMICS (FOR I YEAR MBA STUDENTS) Instructor: Prof. S. BISALIAH Module 1: Introduction
1. Economics: Science of Scarcity, Choice and Efficiency.

Scarcity of resources Scarcity of resources

Choice. Efficiency. Question: How to organize the system which promotes the most efficient use of resources?
2. Three Fundamental Problems of Economic Systems:

What commodities shall be produced and in what quantities? How shall these commodities be produced? For whom shall these commodities be produced?
3. Micro and Macro Economics:

Micro Economics: Concerned with the behaviour of individual economic units and their interactions consumers and producers/business firms.

Major type of interactions in the market Three major components of Microeconomics: Product pricing Input (Factor) pricing Welfare economics

Major uses of Microeconomics:

Page 2 of 166

 Provides basic tools of economic analysis for application in special areas like Business (Managerial) Economics, Industrial Economics etc. Helps in understanding how the economic units operate, and whether they operate efficiently or not. Helps in making conditional prediction/forecasting.

Macro Economics: Study of aggregates: Deals not with individual income, but with national income, not with individual prices, but with general price levels, not with individual output but with national output. Study of forest rather than of individual trees. Specific issues to be addressed: Rising prices Rising unemployment Falling GDP Balance of payments crisis Macro Economic goals:

Output, employment, price, stability and equity Tools of Management: Macroeconomic Policy and

Fiscal policy Monetary policy Trade policy Etc

4. Ten Principles of Economics

Transferency.

Page 3 of 166

5. Logic of Science and Economics: observations) The Scientific Method: Observation (Newtons apple) Theory (Theory of gravitation) Validation of theory (More

Scientific Method in Economics: The interplay of observation and theory in economics Impossible/difficult to conduct laboratory experiments in economics. But natural experiments of history: The impact of war in Middle East on oil flow, prices, production, employment etc.

Role of assumptions in Physical Sciences and in Economics: Throwing a stone and a feather from the top of a building and in a vaccum. Friction and no-friction. Two-country and two-commodity model to understand the economic benefits of international trade. 6. Model Building in Economics: Model: Simplification of reality Functioning of Planetary System in Physics: Simplification of reality Economic Model: Simplification of economic relationships Example1: Market Equilibrium
Page 4 of 166

 Consumer behaviour (Demand) Producers/sellers behaviour (Supply) Interactions of consumers and sellers in the market.
DX = f (PX, PR, M, T, E .)

DX = f (PX), OR C DX = a b P X DX = 110 10 PX

SX = f (PX, PR, t, E ..)

SX = f (PX), OR C SX = - C + d PX SX = - 100 + 20 PX

Market Equilibrium: DX = S X 110 10 PX = - 100 +20 PX P* = 7 Q* = 40 Diagram Diagram Example 2: The Circular Flow Transferency A visual model of the economy Assumption: Two sectors

Page 5 of 166

Module 2: Mechanics of Individual Prices

1. How are prices of goods/services determined in a

market? The forces of demand and supply. 2. Demand Analysis: Determinants and kinds of demand: DX = f (PX, PS, PC, M, T, E ..) DX = f (PX), OR C DX = f (PS), OR C DX = f (PC), OR C DX = f (M), OR C

Price demand: Cross demand: Income demand:

Price Demand and Law of Demand: Demand: A schedule (Table) which shows various amounts of a product which consumers are willing and able to purchase at various levels of prices during a particular period of time, OR C. Demand Schedule: An individual Buyers demand for X Price/Kg. (Rs.) Q demanded/ week 10 20 35 55 80 Demand Curve: Diagram
Page 6 of 166

(Kg.) 5 4 3 2 1

Law of Demand: An inverse relationship between price and quantity demanded, OR C Why the inverse relationship? Later Giffen Paradox: Direct relationship between price and quantity demanded. Diagram

Movement along a given demand curve (change in quantity demanded) and shift in demand curve (change in demand). Diagrams Market Demand: Summing horizontally the individual demand curves of all consumers in the market. Details Later Price elasticity of demand:

Point E.D: EP = % change in quantity demanded % change in price Change in Q-demanded X 100 Original Price Change in Price X100 Original Price Q QO P PO = Q P PO QO

Arch E. D: EP =Q P = Q P

P1+PO/2 Q1+QO/2 P1+PO Q1+QO

Page 7 of 166

Average price elasticity between two points. Income elasticity of demand:

EM = % change in quantity demanded % change in income Q = QO M MO = M QO Q MO

Cross price elasticity of demands:

EXY = % Change in quantity of X demanded % Change in price of Y = QX QXO PY PYO = QX PY PYO QXO

3. Supply Analysis:

Determinants of Supply:

SX = f (PX, PR, PI, t, E ) SX = f (PX), OR C

Law of Supply: Supply: A schedule (Table) which shows various amounts of a product which producers are willing and able to sell at various levels of prices during a particular period of time, OR C. PX 4 6 8 SX 3 6 9
Page 8 of 166

Supply Schedule:

10 12

12 15 Supply Curve Diagram

Law of Supply: Direct relationship between price and quantity supplied, ORC

Supply Curve can move off in different directions. Diagram Movement along a given supply curve (change in Q-supplied) and shift in supply curve (change in supply). Diagram Market Supply: Summing horizontally the individual supply curves of all firms in the market.

Price Elasticity of Supply:

EPS = % change in quantity supplied % change in price = S SO P PO = S P PO SO

Price and Quantity Effects of Shifts in Supply and Demand Curves: Market Equilibrium Diagram Right and Left Ward Shifts is S and D (Different situations)

Page 9 of 166

Module 3: Theory of Production

1. Factors of Production: Resources or inputs

Four factors of Production: Land, labour, capital and organization.

Fixed and Variable inputs: output. Fixed inputs do not vary with Variable inputs vary with output.

Production Function: PF: Relates inputs to output Y = f (L, K), Maximum quantity of output (Y) with a specific combination of L & K. Total, Marginal and Average Product: Y = f (L), OR C TP = Y MPL = Y L APL = Y L

Observe the behaviour of TP, MP and AP TP, MP AND AP OF Labour, ORC L input 1 2 3 4 5 6 7 TP 15 31 48 59 68 72 73
Page 10 of 166

MP 15 16 17 11 9 4 1

AP 15 15.5 16.0 14.8 13.6 12.0 10.4

8 9 10

72 70 67

-1 -2 -3

9.0 7.8 6.7

Law of Diminishing Marginal Returns Change in Technology including Managerial Technology: Shift in Product Curves => Increased efficiency of labour.

Laws of Returns: Returns to Scale How a proportionate increase in all inputs will affect total production? A business firm: Using: L units of labour K units of capital Producing: Y units of output L+K Y

Increase both L and K by a proportion. By how much Y increases? aL + aK Case 1: b = a Case 2: b > a Case 3: b < a bY Constant Returns to Scale IRS DRS Let Y increase by b:

Output Elasticity: % change in all inputs (I) = Y IO

= % change in Y

Page 11 of 166

 YO

Case 1: >1 % change in Y > % change in I IRS Case 2: =1 % change in Y = % change in I CRS Case 3: <1 % change in Y < % change in I DRS Module 4: Cost Analysis 1. Concepts and Kinds of Costs: Importance of cost estimation and cost control: =PC Profit is the difference between price per unit of product and cost per unit of product. Explicit and Implicit Costs:

E. C: Paid-out or out-of-pocket expenditures incurred to buy/hire inputs. I. C: Costs of inputs owned and used by the business firm. Ex: Cost of equity capital, rent on company owned facilities. To estimate : Which one (ones) should we use? Opportunity Cost: O.C to a firm in using any input is what the input could earn in its best alternatives. Ex 1: Max salary an entrepreneur could earn working for some one else. Ex 2: O.C of attending college includes not only the explicit costs of tuition books, and so on, but also the foregone earnings of not working.

Fixed and Variable Costs: F. C: Also called overhead costs do not vary with output
Page 12 of 166

Ex: Property taxes, insurance. V. C: Vary with output Ex: Payments for raw materials, fuel, excise tax etc. Short Run: Both F.C and V.C incurred. Long Run: All costs are variable. Private and Social Costs: P. C: Incurred by firms in the process of producing goods and services. S. C: Incurred by society as a whole Ex: S.Cs of noise, environmental pollution etc. Q Q

Total and Unit Costs: TFC and TVC TC = TFC + TVC AFC = TFC AVC = TVC AC = AFC + AUC MC = TC

Total and Unit Costs of Production Outp ut (Y) 0 1 2 3 4 5 TFC 55 55 55 55 55 55 TVC 0 30 55 75 105 155 TC 55 85 110 130 160 210 MC 30 25 20 30 50 AFC 55 27.5 18.33 13.75 11 AVC 30 27.5 25 26.25 31 AC 85 55 43.33 40.0 42

Page 13 of 166

6 7 8

55 55 55

225 315 425

280 370 480

70 90 110

9.17 7.86 6.88

37.5 45 53.13

46.67 52.86 60.01

Page 14 of 166

Module 5: Market Structure and Price Determination 1. How to characterize market structure? Number of sellers Degree of product differention Conditions of entry and exit Control over price. 2. Different Market Models: Market Model No. of Sellers Nature of Product Entry Barriers to Sellers Degree of Control Over Price

1. Perfect Large, small, Homogeneou None None Competition independent s Homogeneou 2. s, but no Insurmountab Considerab One Monopoly close le le substitutes Differentiate 3. Many, small d, but very Monopolisti virtually None Some close c Compn. independent substitutes Homogeneou Few, 4. s or interdepende Substantial Some Oligopoly differentiate nt d 3. Kinds of Revenue: T R = P. Q A R = TR = Q Q M R = TR Q

P.Q = P

4. Behaviour of AR (Price), TR and MR under P/C and I/C Quanti ty 1 2 3 Price P/C 16 16 16 I/C 16 15 14 P/C 16 32 48
Page 15 of 166

TR I/C 16 30 42 P/C 16 16 16

MR I/C 16 14 12

4 5 6 7 8 9 10

16 16 16 16 16 16 16

13 12 11 10 9 8 7

64 80 96 112 128 144 160

52 60 66 70 72 72 70

16 16 16 16 16 16 16

10 8 6 4 2 0 -2

Page 16 of 166

Module 6: National Income Accounting 1. Basic Measure of National Output: GDP: Market value of all final goods and services produced during a given year. GDP: Sum of all factor payments. 2. Two Methods of Measuring National Output: Income received approach: Y = Yw + Yr + Yi + Y r + Y d Expenditure approach: Y = C + I + G + (X M) 3. Problems of Measuring GDP Later 4. Nominal and Real GDP Pric NGD Quanti Commodi e P ty ty (199 (199 (1992) 2) 2) X 1 1.0 1.0 Y 1 0.50 0.5 Total 1.50 NGD P (199 8) 4.0 2.25 6.25 RGD P (199 8) 2.0 1.5 3.5

Q P (199 (199 8) 8) 2 3 2.0 0.75

5. Other Measures of National Output: GNP = GDP + Factor payments from abroad - Factor payments to abroad NNP = GNP Depreciation NI = NNP indirect business taxes DPI = PI Personal income tax and non-tax payments. 6. Is GDP an adequate measure of overall Social Welfare? If should be no surprise that national prosperity does not guarantee a happy society, any more than personal prosperity ensures a happy family Still, prosperity is a precondition for success in achieving many of our aspirations Arthur Okun

Page 17 of 166

7. Inflation Measure: (%) = Pt Pt 1 X 100 = Rate of inflation Pt 1 > = Stable P, rising P and falling P. <

Page 18 of 166

Module 7: Two Sector Macroeconomic Model 1. Divide economy into four sectors: Household sector : C Business sector : I Government sector : G Foreign trade sector : X & M.

2. Two Sector Macroeconomic Model: Assumptions:

Only two sectors: Household and Business Sectors Investment already given. The Model:

Y = C + I - - - - - - - - - (1) C = a + bY - - - - - - - - - (2) I = Io - - - - - - - - - (3) Y = N.I C = Consumer expenditure I = Investment expenditure, independent of current income. I Io o I = Io Y Value of output = AD Exogenous variable: I Endogenous Variables: Y & C Consumption Function:

Page 19 of 166

C = f (Y) C = a + bY: Linear function Mathematically: a = intercept b = slope Economic interpretation:

C = a, when Y = o a is the minimum amount of consumer expenditure, even when Y=0 b = MPC = The increase in C per unit of increase in Y C = b dc = b Y dY o<b<1 Consumption demand increases with the level of income.
C = a + bY
Co ns um pti on (C)

a o

Income (Y)

Recall (1), (2) & (3) Y = C + I - - - - - - - - - - (1) C = a + bY - - - - - - - - - (2) I = Io (3)

Substitute (2) and (3) into (1) Y = (a+bY) + Io Y bY = a + Io Y (1-b) = a + Io Y (E) = 1 [a + Io] - - - - - - (4) 1b Equilibrium income: AD = AS Ex: C = 50 + 0.8 Y
I = Io = 50

Page 20 of 166

Find out Y (E) and consumption expenditure. Y=C+I C, I C + I (AD) C Io a

450

Y (E) Can you put numerical values to a, Io and Y(E), using the values from the previous example? Investment Income Multiplier:

Y (E) = 1 [a + Io] 1b Let I = Change in investment expenditure Y = Corresponding change in income

Y (E) + Y = 1 1b
Y (E) + Y = 1 1b
Y =

[a + Io + I] [a + Io ] + 1 1b
I

1 1b

Y = 1 = Investment/Income Multiplier = K. I 1-b

K = Ratio of changes in equilibrium income to changes

in I

K > o, because o < b < 1 Can you get the value of K, by using: C = 50 + 0.8 Y K=?
Page 21 of 166

 Interpretation of value of K?

Page 22 of 166

BUSINESS (MANAGERIAL) ECONOMICS Module 1.1: Nature and Scope of Managerial Economics. 1. Business Issues and Economic Theory
o

Operational or Internal Issues: Choice of business (What to Choice of size of the firm produce?)
o

(How much to produce) Choice of technology (How to produce ie choice of factor/input combinations) o How to price the commodity, how to promote sales, how to face price competitions, how to decide on new investments, how to manage profits, how to manage inventory etc.
o

Microeconomic theory: Deals with some of these operational issues theory of demand, theory of production and cost, market structure and product/factor pricing, profit management etc.

Environmental or External Issues: Economic system of the country. General trends in production, employment, income, price level, saving and investment. o Structure of financial institutions. o Nature and magnitude of foreign trade. o Monetary and fiscal policies, and industrial and labour policies. o Social factors like the value system of the society, property rights, and political environment.
o

Page 23 of 166

o Degree of openness of the economy and the influence of MNCs on the domestic market. These are all the macroeconomic issues relevant to business decision making: Trends in GDP, price trends, saving, investment, consumption, foreign trade, other economic policies. Hence: Prominent role of micro and macro economics in the process of business decision making.

2. B/M Economics: Subject Matter. o B/M Economics: Economics applied to decision making.
Use tools of economics to identify the problems, to

organize and evaluate information, to compare alternative courses of action, to choose the best course of action, and to implement it. Provides the link between traditional economics and the decision sciences (Mathematics and Statistics) in management decision making. Also relevant to the management of non-profit organisations: Hospitals etc. Microeconomics in character, but macroeconomics, equally important for decision making by the business firm. More normative than positive: More prescriptive than descriptive.

3. Association of B/M Economics with other Sciences:

Mathematical Tools:

o Cost minimization, sales maximization and profit maximization etc.

Statistical Tools:

Page 24 of 166

Most of business decisions based on probable economic events. o Use theory of probability and forecasting techniques.
o

Operational Research Theory:

o An interdisciplinary solution finding techniques. o Combines economics, mathematics and statistics to

build models for solving specific business problems. o Ex: L.P widely used in business decision making. Management Theory: objectives. Accountancy: Data on functioning and performance of the firm.
4. Functions of a Managerial / Business Economist:

o Behaviour of the firm to achieve certain predetermined

Demand forecasting by formulating econometric models. Cost analysis and supply forecasting focusing on input prices, product prices, technology flow etc. Product pricing and competitive strategies. Study and anticipation of government policies and planning business strategies accordingly. Risk analysis to suggest alternative courses of action to cope with. Capital Budgeting: Investment criteria and decisions, and profitability analysis.

Module 1.2: Basic Concepts, Principles, Decision Rules and Tools of Analysis in B/M Economics.
1. Time Perspective in B-Decision-Making.

Decision Making: A task of coordination along the time scale, past, present and future.

Page 25 of 166

 Maintain the right balance between the long-run, short-run and intermediate-run perspective. Building inventories of finished products: Need short-run time perspective. Investment in plant, building, land and introduction of a new product: Need long-run time perspective. 2. Opportunity Cost Principle:

Have opportunity costs scarcity and alternative use of the resources opportunity costs.

Most economic resources have more than one use

Opportunity cost of a decision: Sacrifice of the alternatives. O. C of availing an opportunity is the expected income foregone from the second best opportunity of using the resources. O. C Concept: Can be applied to all kinds of business decisions where there are at past two alternative options involving costs and benefits.

Examples: Interest that could have been investment in other ventures. earned through

Invest ones own capital in once own business O. C:

The O. C of managing once own business: Salary that

be could have earned in other occupations.

The O. C of watching cricket match by a student? 3. Discounting and compounding principle:

Time Value of money and decision analysis Compounding

Page 26 of 166

Future value of the present sum:

Let PV = Rs.95.24 = 0.05 FV1 = 95.24 + (95.24 X 0.05) = 100 at the end of first year.
o

o To generalize: PV = present value = rate of interest FV1 = amount received at the end of first year FV1 = PV + PV() = PV (1+) FV2 = PV (1+) (1+) = PV (1+)2 FVn = PV (1+)n If = 0 FVn = PV. Present value of future sum: Discounting PV = Present Value FV1 = Amount receivable at the end of one year from now (Rs.100) = 0.05 = Rate of discount PV = FV1 = 100 = 95.24 (1+) 1+0.05 FV2 = Amount receivable two years from now (Rs.100) PV = FV2 = 100 = 90.70 2 2 (1+) (1+0.05) For N Years: PV = FV1 + FV2 + + FVN (1+) (1+)2 (1+)N
Relationship between PV and

PV
Higher , Lower PV

Lower , higher PV If = O, PV of Rs.100 receivable one year from now: Rs.100 NO time value for money. If , PV O.
Page 27 of 166

 Suppose

a company is considering buying a new machine. It should estimate the discounted value of net added earnings from that machine before venturing to buy it.

4. Marginal Principle and Decision Rule: Concept of M.P widely used in business decision making: M U, M C, M R, M P and M . M C = TCn TCn 1 TCn = total cost of producing n units TCn-1 = total cost of production of n-1 units M C = TCn TCn 1 = 2550 2500 = 50 Similarly: MR = TRn TRn -1 The decision rule: MR > MC: Carry on business activity MR < MC: ? MR = MC Necessary Condition for maximization.

To apply Marginal Principle: Need TC and TR data for each and every unit of output.

Equi Marginal Principle: A rational decision maker: Decision Rule The ratio of marginal returns and marginal costs of various uses of a given resource or Various resources in a given use is the same.
Ex1: Consumption basket

MU1 = MU2 = = MUn Equi marginal MC1 MC2 MCn MU1 > MU2 Decision Rule? MC1 < MC2

Page 28 of 166

 Ex2: Input use

MRP1 = MRP2 = = MRPn MC1 MC2 MCn MRP1, MRP2: MRP1 from input 1 (say labour) MRP2 from input 2 (say capital) MC1, MC2: Marginal cost of Labour and Capital MRP1 > MRP2 Decision Rule? MC1 < MC2 Contribution Analysis and Incremental Concept: IC = Change in total cost due to a specific decision IR = Change in total revenue caused by a decision IR > IC Decision, profitable
The contribution of a business decision: Difference

between IR and IC. Difference between marginal and incremental concepts:

M Principle: Change in revenue, cost or profit with

respect to change in output only. Change in output is infinitesimally small. IC: Applicable with respect to any variable and for any extent of change. 5. Profits: Accounting Profit and Economic (pure) Profit:
AP = TR Explicit Costs. EP = TR (Explicit Costs + Implicit Costs).

EP: Makes provision for insurable risks, depreciation, and necessary minimum payment to shareholders to prevent them from withdrawing their capital.
Page 29 of 166

 Theories of Profit: Sources of Profit. Innovation Theory: o Innovation in new products, new production techniques, new marketing strategies o Cost of innovations o Profits: Reward for innovation. Risk Bearing Theory: o Companies bear risks Non-availability of inputs and adequate market for products. o Profit: Reward for risk-bearing Monopoly Theory of Profit: o Powers to control supply & price o Powers to prevent the entry of competitors o Sole ownership of certain crucial raw materials o Legal sanction and protection. Monopoly is the source of pure profit. Friction Theory of Profit: Ex: Severe and prolonged winter companies producing woolen garments, and those producing items like ice cream and fans. Managerial Efficiency Theory: o Profits Reward for exceptional managerial skills o Hence profit for good performance.
Same element of truth in all these theories. Profit is a

reward for innovation, risk bearing, monopoly power and managerial efficiency. 6. Plant, Firm and Industry: Plant: A technical unit of production Technical similarity in the production processes of goods production within a plant A body of persons working at a given place.
Page 30 of 166

 Firm: May own one or more than one plant Exercises a unified control over its plants Separate legal entity Undertakes production to maximize profits. Industry: A group of firms Some common factor among all the firms: o The raw material used and production technique employed supply side. o Products produced Demand side. o Firms compete more for same raw material raw material use criterion to classify industries. o Firms compete more for capturing the market for their goods substitutability of goods. o Standard industrial classifications (SICs): Raw material used and similar production processes rather than the substitutability among products. Ex: Plastic buckets in the plastic industry, and metal bucket in metal working industry. But: On the demand side, these two are substitutes. To identify degree of competition among the firms in the market, define industry as a group of firms producing closely substitutable products. Concept of cross elasticity of demand EXY = % change in quantity of X demanded % change in price of Y How do you decide degree of substitutability? Can we use cross elasticity of supply also to classify industries? Module 1.3: Demand Analysis:

Page 31 of 166

Read Section 2 of Module 2 in the hand out on Orientation In Economics. Importance of demand analysis to a decision maker: Existing potential demand for the product of the company Business strategies to augment the demand for the companys product. Demand Effective demand.

Three characteristics of effective demand: Desire for the product Ability to pay for the product Willingness to pay for the product. See Module 2 in the handout on Orientation In Economics for definition of demand, demand schedule, demand curve and law of Demand. Types of Demand: Demand for consumers goods and producers goods o Goods/services used for final consumption Consumers goods o Producers goods: Machines, buildings, raw materials etc. o Study consumers goods under demand and producers goods under supply. Perishable and durable goods o Perishable goods: Can be consumed only once. Ex:? o Durable goods: Only services are consumed. Ex:? o Implications to business decision-analysis. Autonomous (Direct) and Derived (Indirect) Demand: o A (D) Demand: Demand not tied down with demand for some other goods. o D (I) Demand: All produced goods. Individual and Market Demand.

Page 32 of 166

Milk Price Rs/Lit 8 7 6 5 4 3

Milk Demand (Litr.) B B B 1 2 3 5 10 0 8 12 4 12 15 7 20 19 12 30 25 20 45 30 30

Market Demand 15 24 34 51 75 105

Assignment: Draw individual and market demand curves. Demand by Market Segments and Total Market: o Domestic and Foreign Markets o Rural and Urban Markets. Firm and Industry Demand: o Demand facing an industry (Say car industry) o Demand facing a firm (Demand for Maruti Car) o Refrigerators Industry and Godrej Refrigerator firm. Price, Income and Cross Demand: Refer to Section 2 of Module 2 in the hand out on Orientation In Economics. Determinants of Demand and Demand Function: Determinants of Market Demand: DX = fCPX, PS, PC, M, T, E, A.E, C.F, NB, POP. ID o PX, PS, PC, M, T, E: As in orientation handout o A.E = Adv. expenditure o C.F = Credit facility o N.B = Member of buyers o POP. = Population of the country o I.D. = Income distribution pattern in country.

the

Page 33 of 166

 Postulate

demand for Explanatory Variables. For Ex: DX < O PX : DX < ? PS < : DX > ? PC < :---------:----------

and

determinants

i.e

Individual Consumer Demand Function: DX = fCPX, PS, PC, M, T, E, A.E ) Three Kinds of Demand: o Recall: PD, CD & ID
o P. D:

DX = f(PX), OR C o C. D: DX = f(PS), OR C DX = f(PC), OR C Substitutes, Complements and independent goods Draw diagrams. o I. D: DX = f(M), OR C Normal, inferior and neutral goods.
Why

the inverse relationship quantity demanded?

between

price

and

Substitution effect: o PX, prices of its substitutes remaining constant o Hence more of X is demanded with a fall in its price o PX, PS o Hence less of X is demanded with a rise in price of X, because the substitutes are cheaper.
Income Effect:

Page 34 of 166

o PX RI An increase in his purchasing power. Buy

more of X, if it is a normal good. o PX RI A decrease in his purchasing power. Buy less of X, if it is a normal good. o Note: In case of inferior goods: PX RI - Buy less of X. PX RI - Buy more of X. Because still cheaper compared to other goods. Exceptions to Law of (Price) Demand: o Giffen Goods o Articles of snob appeal o Speculation. Movement (Change in equality demand or extension and contraction of demand) and shift in demand (change in demand or increase and decrease in demand).
Why movement and why shift?

Module 1.4: Price Elasticity of Demand: Recall from the handout on Orientation in Economics.
EP = Price Elasticity of D = % change in quantity of X

demanded % change in price of X

o Point EP = Q . PO

P
o Arc EP = Q

QO . P1 + P2
Average price elasticity

between P Q1 + Q2 two points Also called Mid Point Formula

o Sign of price elasticity coefficient: Negative, but

consider the size and ignore the sign, i.e EP .

o Five Kinds of Price Elasticity of Demand: Elastic D: EP> 1 % Q >% P

QO

PO

Page 35 of 166

 Inelastic D: EP< 1 % Q <% P

QO PO Unitary el. D: EP= 1 % Q =% P O PO Perfectly ine. D: EP= 0 % Q = 0 for a QO given % P PO Perfectly /infinitely el. D: EP = All output is sold at the same price % P = 0 PO
o o

Draw diagrams for all five kinds of PED.

Total Revenue (Total Expenditure) Test and Price el. of D: Recall: EP> 1 A Price change leads to more than proportionate change in Q demanded. EP= 1 Price and quantity change in the same proportion. EP< 1 A price change leads to a less than proportionate change in Q demanded. Price Elasticity and Revenue Relations MR Price Quantity TR MR= TR Arc. E (P) (Q) = P.Q EP Q 100 1 100 90 2 180 80 6.33 80 3 240 60 3.40 70 4 280 40 2.14

Page 36 of 166

60 50 40 30 20 10 Observe:

5 6 7 8 9 10

300 300 280 240 180 100

20 0 -20 -40 -60 -80

1.44 1.00 0.69 0.47 0.29 0.16

Q: 1 to 5: EP>1 PTR MR > 0 __ Q: 5 to 6: EP=1 PTR MR = 0 Q: Greater than 6: EP< 1 PTRMR < 0 Effect of P On TR >1 =1 <1 Constant MR >0 =0 <0 Effects of P on TR Constant MR <0 =0 >0

EP

Do you agree with this analysis? Module 1.5: Determinants of Price Elasticity: Nature of the commodity:
Luxury/Comforts: Price Elastic Necessary Goods: Price Inelastic.

Availability of substitutes:
More number of substitutes: More Elastic

Ex: Beverages Less/no substitutions: Less elastic/inelastic Ex: Salt, Onion.

Page 37 of 166

 Number of uses: Single use commodities: Less elastic Ex: ? Multi use commodities: More elastic Ex: Aluminum used in Construction of airplanes automobiles, boats and buildings. Consumers income: Poor Consumers: More elastic Rich Consumers: Less/inelastic. The products position in buyers Budget: The proportion of income spent on the commodity. Module 1.6: Practical Significance of the Concept of P. E. D: Questions facing a business firm:
5% P Expected impact on sales? Sales to increase by 10% How much of reduction in

price?
Whether reduced prices attract sufficient additional

customers to offset lower revenue per unit.

o Discounts

to different customer groups like in airlines, restaurants etc to students, senior citizens, vacation travelers.

Taxation.
Demand for higher wages: can be met when E P for the

product is inelastic.
International trade: Decision to devalue a countrys

currency is based primarily on the price elasticities of imports and exports.

Page 38 of 166

 Product pricing strategy by business firm: o Does it pay to reduce the price of a product the

demand for which is inelastic or demand for which is elastic?

o Does a price rise yield a rise in TR when demand is

elastic or inelastic? Module 1.7: Cross Elasticity of Demand: Recall: DX = f (PR) Let related good by Y DX = f (PY) d DX = 0 X & Y are .. ? d PY d DX > 0 X & Y are . ? d PY d DX < 0 d PY
X & Y are . ?

Draw diagrams for all the three situations:

EXPY = QX PYO PY QXO EXPY O <

when?

Consider the following examples: Monthly Demand of a Household Commodit y Tea Coffee Original P 3 4 Q 50 30 P 3 5 New Q 60 20

Page 39 of 166

Bread Butter

2 75

80 30

2 6

90 40

Question: Calculate cross elasticity efficients for Tea & Coffee and Bread and Butter and interpret results with respect to nature of relationships between commodities. Cross Elasticity of Demand in Transport System Daily No. of Passengers Rail Bus 500 400 200 300

Fare (Rs) Rail 1. Before fare change 2. After fare change 3. Percentage change 45 45 Bus 40 35

Compute: ERFB = % change in Rail Service % change in Fare of Bus Service Significance of C E D in Business Management: To define substitutes: o C E Coefficient > 0 Goods are substitutes o Greater the C E C Closer the substitutes o Smaller the C E C - - - - - Similarly to define complements: o C E C < 0 Goods are complements o Higher the negative C E C Higher the degree of

complementarily. To define independent goods? To measure the degree of threat due to competition in the market. To define market structure:
Page 40 of 166

o Lower the value of CEC, higher the monopoly power o Higher the value of CEC? To forecast demand for its products, consider price change by competing firms. To define cluster of products: Substitutes, compliments and independ goods? Module 1.8: Income Elasticity of Demand: Recall: DX = f (M), OR C d DX O Normal Good dM < Neutral Good Interior Good. Draw diagrams to illustrate three kinds of goods.

EM = QX MO M QO EM O < EM EM EM EM EM = = > < < M Curve in the same diagram. 450

Q

N. G

Neu. G I. G. Unitary I. E Zero I. E I D curve flatter Steeper I D Curve Downward sloping I D curve.
IDC (EM=1)

1 0 1 1 0

Draw

other

types

of

ID

Page 41 of 166

 Business Applications of IED:

Long term business planning for luxuries & comforts:

High IED.
High IED: A major determinant of construction industry

and real estate business. Taxation policy: High IEC Luxury goods Impose higher excise or sales tax. Sectoral Production Plans: Usefulness of estimates of IED coefficients.

Module 1.9: Additional Demand Elasticity Concepts:

Advertising elasticity.

Interest rate elasticities to forecast demand for housing, automobiles etc. Weather elasticity of demand for public utilities like electricity. Module 1.10: Demand Estimation and Forecasting:

Methods of Estimating Demand Function: Consumer interviews (Surveys) o Interview consumers on their consumption habits o Census and sample methods o Information on quantities of the concerned good bought at different periods at various prices of the product, prices of related goods, income of the consumer .. Market Experiments Method:

Page 42 of 166

o Actual Experiment: Record consumers reactions in different shop locations with respect to income, estimated religion, sex, age group etc. o Market simulation (Consumer clinic or laboratory experiment) method: Provide token money to a set of consumers. Vary prices of various goods, their quality, packaging etc and record shopping behaviour of consumers. Too costly and consumers may not take the experiment seriously. Regression Method: Identify variables which influence demand for a particular commodity Collect data Select appropriate functional form Estimate the function Ex: Demand Function for Groundnut Oil Dg = f (Y, Po, Pv, Pg, U) Where: Dg = demand for groundnut oil Y = national income Po = price of groundnut oil Pv = price of vanaspathi Pg = price of pure ghee U = other determinants of g.n.o Time series or cross section data. Demand Forecasting
D. Forecasting: An estimate of the future demand,

based on laws of probability. Levels of D. F: o Micro Level: Forecast by an individual business firm. o Industry Level: o Macro Level: Ex: Country consumption function. Why D. F?
Page 43 of 166

o o o o

Production planning Sales forecasting To control business and inventory To plan long term growth programmes.

and

investment

Demand Forecasting Methods:

o Consumers survey o Experts opinion

Simple expert opinion poll Delphi Method: An extension of the simple expert opinion poll Use Delphi Method (DM) to consolidate the divergent expert opinion and to arrive at a compromise estimate of future demand. Under DM: Collect opinions from experts. Instead of taking averages, try to match the opinions by bringing experts to-gether and to arrive at a consensus. Statistical Methods: Trend method to extrapolate Dg = f (T) Where: Dg = demand for groundnut oil T = Time (Years) Barometric Method of Forecasting o Meteorologists use the barometer to forecast weather conditions on the basis of movements of mercury in the barometer. o So use relevant economic indicators such as GDP, prices, lending rate for loans.
Econometric Method: Regression Method

Page 44 of 166

o Simple or Bivariate Regression Technique: Y = f (X) Y = Sugar consumed Y = Population

o Multivariate Regression

Dx = f (Px, Ps, M, A) Where: Dx = Quantity of x demanded Px = Price of X Ps = Price of substitutes M = Consumers income A = Advertisement expenditure Module 1.11: Theoretical Foundation of Consumer Behaviour:
1. Cardinal and Ordinal numbers and C and O Utility

Concepts Cardinal numbers: 1, 2, 3, 4, - - - - o The number 2 is twice the site of number 1 o Measure utility of commodities A & B by utilis: A: 20 utils B: 40 utils B Yields twice the utility of it. Ordinal numbers: I, II, III, . . . . . . . . o II > I, but II less than III o Dont know, by how much size relation of number not known o Rank utility, and explain consumer behaviour without the assumption of measurable utility. 2. The Marshallian Cardinal Utility Theory: Assumptions: o Maximization of satisfaction.

Page 45 of 166

o Rationality: Buys the commodity yielding highest

amount of utility per rupee.

o Utility is cardinally measurable. Measurable by the

price that the consumer is prepared to pay. o Utility function exists: TU = (G, S) TU = M U of G, S G TU = M U of S, G S
o Constant marginal, utility of money: Sine, money is

used as a measure of utility. o Diminishing M U. Law of Diminishing M U: No. of oranges consumed 0 1 2 3 4 5 6 7 8 9 10 TU 0 20 35 45 50 53 55 56 56 55 53 MU 20 15 10 5 3 2 1 0 -1 -2

o Develop both TU and MU curves from this data. o Observe how behaviour of TU and MU related.

Page 46 of 166

o The LDMU: As an individual increases consumption of a given product (say orange) holding consumption of other products constant, MU derived from consumption eventually diminishes. o What are the implications of this law to a business manager?

Consumer Equilibrium and the Marshallian Proportionality Rule: MUA = MUB = MUZ = K PA PB PZ
o

Can we say that K is the MU of money i.e MUM? How does a consumer behaviour when: MUA MUB ? PA < PB

LDMU and Demand Curve: o Co MU P D Co MU P D o Hence inverse relationship between P and Quantity demanded. o Consumer Equilibrium: MUX = PX
o If MU of X is measured in terms of money, then the

MU curve becomes the demand curve of the good. P MU/Price P1 P2 MU/Demand Q O Q1 Q2 At P1 Q1

Page 47 of 166

At P2 Q2
o MU curve could enter IV Quadrant whether D. C

could enter IV Quadrant?

3. Ordinal Utility Theory: The Hicksian Theory of

Indifference Curve

Assumptions of O. U Theory: U is Ordinal:

o Measurement of U Unrealistic and not needed to

explain consumer behaviour. o Ordinal ranking to rank preferences according to the satisfaction of each basket. Rationality:
o Maximize satisfaction, given income and product

prices. The Axiom of consistency and transitivity:

o Consistency: of A > B, then B > A o Transitivity: of A > B, B > C, then A > C. Axiom of non satiability:

The Consumer: Not oversupplied with either commodity. Consumers do not have enough of all things. Indifference Schedule and Indifference Curve: Combinati on A B C D E Units of X 25 15 8 2 Units of Y 3 6 9 30 Total Utility U1 U1 U1 U1 U1

4 17 Page 48 of 166

Five different combinations of X & Y yielding the same level of satisfactory (U1) Indifferent towards different combinations.
o Indifference

Curve: Diagramatic indifference schedule. Y 30 E 25 20 15 10 5 O 5 10

representation

of

Uni ts of Y
o

D C B

A IC1 (U1) X

15 20 25 Units of X

Indifference Map: Y

IC3 IC2 IC1 IC0 O X IC0 U0 IC1 U1 IC2 U2 Different satisfaction levels IC3 U3 o U3 > U2 > U1 > U0
Page 49 of 166

Properties of I. Curves: Along an IC: -(MUX) (X) = (MUY) (Y) - MUX = X = MRS = Slope of an IC MUY Y
o Why not positive slope? Why not horizontal? Why not

Negative Slope:

vertical?
Convex X to the origin: o Marginal rate of substitution (MRS) between two

goods decreases as a consumer moves along a given I. C. The slope of an I. C curve decreases as we move from point E to A DMRS.
o Consider the following indifference schedule:

MRS Y X a 1 - 4/1 = b 2 8 4 - 3/1 = c 3 5 3 - 2/1 = d 4 3 2 - 1/1 = e 5 2 1 DMRS: The consumer assigns a lesser and lesser significance of the extra unit of a commodity in a larger stock, and relatively a higher significance for the one which is a smaller stock. Movement from a to e quantity of X becomes larger and that of Y smaller. Each time, the consumer will sacrifice a lesser and lesser amount of Y in exchange for X. Combinatio Apples n (X) Banana s (Y) 12

Page 50 of 166

o Why not an Indifference curve be concave to the

origin? o Why not an I. C a straight line? I. Cs do not intersect: Y

A IC2 (U2)

IC1 (U1) X U2 > U1, but at A, U2 = U1 o Can one I. C tangent to another?

Upper I. Cs represent a higher level of satisfaction than

the lower ones. Y

b

Y*

c d IC2 IC1 X

X* o Vertical movement from a to b More of Y, same amount of X o Horizontal movement from a to d: Same amount of Y, more of X o Diagonal: Larger quantity of X & Y.

Budgetary constraint and Budget Line:

B = PY Y + PX X = Exp. on Y + Exp. on X

Page 51 of 166

 Solving for Y: Y = B - PX X Eqn. for B. Line PY PY o B = Qy that can be purchased PY When QX = ?

o

B = QX ?

PX
o Slope of B. Line: dY = - PX

dX PY Price ratios of two commodities. o Diagram: Y

B/PY

QY O

B A

B. L or Price Line X

QX B/PX B.L: The market opportunities available to consumer, given his income and the prices of X and Y. Feasibility Area: Budget line and area under B. L (A) Non-feasibility Area: Area beyond the B. L (Ex. B).
Shifts in B. L: B = PYY + PXX

__ __ PY, PX, B B Parallel shift in B. L no change in slope __ __ o PY, B, PX PX Change in slope of B.L. But shift in B.L? __ __ o PX, B, PY PY Change in slope of B.L. But shift in B.L?
o

Page 52 of 166

PX and PY change proportionately No. Change in slope P PY An increase in B P PY A decrease in B. PX and PY change disportionately Draw diagrams to illustrate all these

o
o

cases. Total Effect of a Price Change = I.E + S.E __ __ o Let PY, B and PX o Buy more of Y o Reasons: S.E: Substitute cheaper Y for X __ I.E: With B, PY Real I Inducement to buy more of Y (of Y is a . Good). The consumers Equilibrium o I. Map: Preference of taste factors o B.L or P.L: Power to satisfy them o The point of consumer equilibrium or utility maximizing rule:
B/PY Q

IC4(U4) R IC3(U3) IC2 (U2) IC1(U1) O X B/PX Q, P, R: 3 of the infinite number of attainable combinations on B.L Q: Move towards right point P on U3 Move towards left: Lower IC R: Move upward to hit point P

Page 53 of 166

Shift from U2 to U3 Point of C Equilibrium at P IC3 (U3) tangent to B.L Slope of IC (U3) = slope of BL MRSXY = Price Ratio MRSXY: Rate at which consumer is willing to substitute X for Y Price Ratio: Rate at which he can substitute X for Y Point P: Two sets of forces those of the market operating through BL and those of tastes operating through IC are brought into balance.
o MRSXY = Price Ratio

X = - MUX = - PX Slope of IC = Slope of BL Y MUY PY MUX = MUY Does this imply the Marshallian PX PY Proportionality Rule? Deriving Demand Curve from Price Consumption Curve (PCC): P C C:
o Keep money income (M) constant

o Keep price of Y constant o Allow decrease in PX. Y M

Mo ne y Inc om e

E1

E3 E2 IC2

PCC IC3 O

IC1

X
Page 54 of 166

X1 N3

N 1 X2

N 2 X3

Quantity of X consumed.
o Original BL: MN1 Quantity of X bought X1 Point of o o o o

equilibrium: E1 Allow PX New BL: MN2 Q of X bought: X2 New point of equilibrium: E2 Allow further fall in PX New BL: MN3 Q of X bought: X3 New point of equilibrium: E3 Connect successive equilibrium points E1, E2 and E3: called PCC Thus, PCC is a locus of points of equilibrium on indifference curves, resulting from the change in the price of a commodity. In this case, PCC shows the change in consumption basket due to fall in PX. demand curve for

Derive individual consumer commodity X from PCC. PX

P O X1 X2 X X3 D for X o Slope of B. Line: MN1 Quantity of X bought: X1 o Fall in PX New BL: MN2 Q of X bought: X2 o Further fall in PX New BL: MN3 Q of X bought: X3 When price consumption relations are taken out and plotted separately, that gives the demand curve depicting inverse relationship between price and quantity demanded, ORC. Distributed Lag Models demand function: Qt = f (Pt, Pt-1, Pt+1, Yt, Yt-1, Yt+1, Qt-1, Qt-2)

Page 55 of 166

for

estimating

Qt = Quantity purchased in period 1 Pt = Actual present price of the item Pt-1 = Observed past price of the item Pt+1 = Expected future price of that item Yt = Current income Yt-1 = Past income (generating savings) Yt+1 = Future income (expected capacity to pay back) Qt-1 = Quantity of item purchased earlier in t-1 Qt-2 = Quantity of item purchased earlier in t-2. o Why Qt-1 and Qt-2: In case of consumer durables (Music set) o Why Qt-1 and Qt-2: Non-durable items (like cigaretters): Proxy for habit.

Linear Ex-penditure System: Reinterpretation of Budget Constraint (B.L or P.L) B = PX X + PY Y Budget constraint, reinterpreted as LES PX X = The expenditure on purchase of X PY Y = The expenditure on purchase of Y B PX X = Surplus to be spent on Y B PY Y = Surplus to be spent on X Consider X as a subsistence item or a basic necessity Then consider Y as comforts or luxuries The buyers pattern depends on the proportion spent on X & Y in total budget Implications to Strategic Sales Management.

Different dimensions of Demand:

Demand as seen by the buyer Demand as seen by the seller Demand for goods and for services Retailers demand, wholesalers manufactures demand for products.

demand

and

Page 56 of 166

Module 2: Production and Cost Analysis 1. Fundamental Questions Facing Business Managers: How to maximize output from a given quantity of inputs? How to minimize cost for producing a given level of output? How does output behave with a change in inputs? Does technology matter in cost minimization or output maximization? How to achieve least cost combination of inputs? Theory of production and theory of cost to address these questions. 2. Production Analysis (Theory): The concept of production: P: A process of transforming inputs into output (goods and services) Ex: Manufacturing, farming, transportation, packaging, wholesaling, retailing, legal/medical/consultancy services etc. Four factors of production Fixed and variable inputs Short-Run: Increase production by increased use of variable inputs Long-Run: Increase production by increased use of both variable and fixed inputs. Very Long Run: Change in technology also More output from a given quantity of inputs or same amount of output from less quantity of inputs. 3. Production Function: P.F: Technological relationship between inputs and output o P.F: determined by technology, labour, materials, equipment and so on
Page 57 of 166

o Any

improvement in technology (including managerial technology) would create a new P.F. Diagram

o Y = f (L,K), O R C (including T) Max quantity of output (Y) with a specific combination of L & K o S.R.P.F: Y = f (L), Single Variable P.F, O R C o L.R.P.F: Y = f (L,K), Multi Variable P.F o Widely used P.F: Y = A L K Y = Quantity of output L = Quantity of labour K = Quantity of capital = output elasticity of labour = % change in Y = Y L % change in L L Y = output elasticity of capital = % change in Y = Y K % change in K K Y Hint: Given your knowledge of MPL, MPK, APL and APK (Recall from orientation course), prove that: Output elasticity of Labour = Output elasticity of Capital = o TP, MP, AP: TP = Y Y , Y = Marginal Products of L and K L K Y , Y = Average Products of L and K L K 4. Laws of Production:

Page 58 of 166

 L O P: Relationship between output and input Output can be produced by: o Keeping one/some inputs constant, by changing other inputs o Changing only one input and keeping other inputs constant Law of Diminishing Marginal Returns (LDMR) or Law of Variable Proportions o Changing quantities of all inputs Law of Returns to Scale. 5. The Law of Variable Proportions (LDMR): Vary only one input (say labour), and keep other inputs (Ex: Capital) constant o Keep technology constant o All units of input varied are homogeneous All units have identical characteristics.
o

LVP (LDMR): Stages of Production Labo ur Input 1 2 3 4 5 6 7 8 TP 20 50 90 120 135 144 147 148 MP 20 30 40 30 15 9 3 1 AP 20 25 30 30 27 24 21 18.5 Stages of Production S I: TP at an increasing rate MPL APL Max MPL APL, but lower than MPL S II: TP at a decreasing rate. Then Max. MPL, but +ve, APL, but +ve MPL = APL, then APL > MPL

Page 59 of 166

9 10

148 145

0 -3

16.4 14.5

TP constant, MPL=0 APL, +ve S III: TP MPL, -ve APL, +ve

Note: S I: Fixed input (K), under utilized : S II: Fixed input (K), properly utilized : S III: Fixed input (K), inadequate : S I: Increasing Marginal Returns : S II: Diminishing Marginal Returns : S III: Negative Marginal Returns Draw diagram to illustrate the behaviour of TP, MP and AP. The LDMR (LVP): As more and more of the input (L) is employed, OR C, a point will eventually be reached, where additional quantities of variable input (L) will yield diminishing marginal returns. LVP (LDMR) and Business Decisions o How much to produce? o How many units of V-inputs to employ? o Would a business firm like to operate either in S I or S III? Why or why not? o Do you consider S I or S III as rational zones? Why or why not? o Do you consider S II as the rational zone? Why or why not? o Once you decide rational zone (stage), how many workers to be employed and how much of output to be produced? 6. Optional ( - maximizing) use of Variable Input: How many units of V I (Self Labour) should the business firm employ for profit maximization? Recall the Decision Rule: MRPL = MCL (Necessary Condition)

Page 60 of 166

o Extra revenue generated from the sale of the output

produced by extra labour equals the extra cost. o MRPL = The extra revenue generated by the use of an extra unit of labour = MPL (MR) = MPLX price of output per unit o MR = Price = AR, if all the units of output are sold at the same price (as under P/C market) o MCL = W (Price of Labour) if all the units of labour are employed at the same wage rate. MRP & MCL

MRP = MCL MCL = W L L* (units of L) MRP

7. P. F with Two V Inputs: Isoquant Approach:

L & K: Two inputs vary quantity of both LRPF

Two-Input and one output (Y) Model Isoquant Approach: Assumptions o Two-input and one-output production system o Isoquant (Iso-product curves) Iso equal, Quant Quantity (of output) Different input combinations to produce a specified quantity of output Two inputs (L&K) can substitute each other, but at a diminishing rate Constant technology.

Isoquant and Isoquant Map o Combinations of L and K to produce equal amount of Y (say 5 units of output)
Page 61 of 166

Combinati on 1 2 3 4 5 6

Unit of L 1 2 3 4 5 6

Units of K 16 11 7 4 2 1

MRTSLK = K L 5 4 3 2 1

Isoquant and Isoquant Map K

O
o

Y = 15 Y = 10 Y=5 L

Different combinations of L & K producing the same levels of Y. Isoquant Curve: Locus of all input combinations to produce a given level of Y.
o

8. Properties (characteristics) of Isoquants: o Isoquants have ve slope Substitutability between L & K Employ more of L and less of K and Vice-Versa to produce the same level of Y. o Isoquants are convex to the origin

Page 62 of 166

 Convexity Not only the substitution between L & K,

but also diminishing marginal rate of technical substitution (MRTS, Column 4 of the above Table).
DMRTS As quantities of one input (say labour) is

increased, the less of another factor (say K) will be given up.

Thus

MRTS The amount of one input (K) substituted for one unit of another input (L) for producing a constant level of output. MRTSLK = - K = Slope of an I.Q. L As we move down an isoquant (towards right) MRTS of L for K diminishes
Refer to Table:

Combination 1: K is too much in comparison to labour Combination 6: K is less in comparison to L MRTSLK: Diminishes from 5 to 1 from combination 1 to 6
Loss = Gain

Loss: Loss in output by using less amount of K: K(MPK) Gain: Gain in output by using a larger dosage of L input: L(MPL) - K(MPK) = L(MPL) MPL = - K = (Negative) slope of an I.Q MPK L or - MPL = K = Slope of an I.Q = -ve slope MPK L o Isoquants cannot intersect o Isoquants cannot be tangent to other o Upper isoquants represent higher level of output: K

Page 63 of 166

K* O

c d Y = Y1 Y = Y0 L

L*

Point a on Y0: OL* & OK* Point b: More of K (a b) and Point c: More of both K & L Point d: More of L (a d), but

same an out of L

same about of K Y1 > Y0, Point a on Y0, but points b c d on Y1 Hence a represents Y0, but b, c & d represent Y1 with different combinations of L & K. 9. Different Kinds of Isoquants: o Linear Isoquant: L & K are perfect substitutes K MRTSLK remain constant throughout

L A given quantity of Y can be produced by using only K or L or by using both Linear I.Q not realistic o L shaped (Fixed proportion) Isoquants: L& K are perfect complements K B K2 K1 Y1 Y2

Page 64 of 166

L 1 L2 Zero substitubility between L & K A given quantity of Y can be produced by one and only combination of L & K (L1+K1 for Y1, and L2+K2 for Y2) If quantity of K is increased holding L constant, no change in Y Y can be increased by increasing both inputs proportionately Ex: Car and Driver. o Why not Isoquants be concave to the origin? Why not vertical or horizontal? 10. Isocost Lines: The Budgetary Constraint and Budget Line: o Isocost Line or curve represents a line of constant cost C = L + K Where: C = Total cost = Wage rate of labour L = Quantity of labour = Rental price of K K = Quantity of K L = ----------------------K = ---------------------- Solving for K: K=C - L C = Maximum quantity of K, which can be purchased, when L = 0 = Slope of I-C-Line = K L -ve slope, and the slope of BL is the ratio of input prices (viz & )
Page 65 of 166

 C/

K= C - L Slope: = Relative input prices. O

C/ Let C = 1,000 = 250 = 500 Buy K = 4, L = 0 Buy L = 2, K = 0 Slope = - = - 500 = - 2 250 Multiple combinations in between C/ (intercept for K), and C/ (intercept for L) What happens to location of I C Line (B.L) when: C alone changes (, ), OR C , ( proportionately and disproportionately), OR C
When the parallel shift in I C L, and change in

slope of I C L? When change in slope and when no change? 11. Optimal Input Equilibrium of The Firm: (Factor) Combinations:

o Bring to-gether I.Q map and B.L or I.C.L to determine the optimal input combinations for the firm to reach equilibrium o I.Q: Various combinations of L & K to produce a given level of Y

Page 66 of 166

o I.C.L: Various combinations of L & L that a firm can purchase at a given cost o Superimpose the budget line (I.C.L) on I.Q map to determine optimal input combination for minimizing cost or maximizing output: K A Are points A, B, C and D points of equilibrium of the firm? B K*
E

Y3
C

Y2

D L

Y1

L* Fig: Least cost input combination.

Point E: Point of equilibrium

of the firm Point of tangency between ICL and I.Q Equal slope of both I.C.L and I.Q (Y3) - MPL = slope of I.Q MPK - = slope of I.C.L Rule for optimal input combination: Ratio of marginal products of inputs in equal to ratio of input prices: - MPL = - or MPK MPL = or MPK MPL = MPK Optimal input combination (for the firm to attain equilibrium) when: an additional unit of money on any input by the business firm yields the same increase in output.

Page 67 of 166

Is this rule for optimal input combination comparable to that of MU1 = MU2 under consumer equilibrium i.e equi-marginal P1 P2 utility principle? Are the following situations optimal or suboptimal? MPL > MPK MPL < MPK If suboptimal, what changes a business firm should effect to reach the optimal point of input combination? MPL = MPK Is this rule, a rule of maximization?

o Optimal input combination: cost minimization or output maximization. MPL = MPK : Considers only: input prices and marginal productivities of inputs. o Rule for Profit Maximization: MC = MR MC = Supply related factor MR = Demand related factor Hence consider both supply related and demand related factors to optimize . o Hence optimal input combination (cost minimization/output maximization) is a necessary but not a sufficient condition for max. sufficient conditions come from demand related MR of output (Y). 12. Expansion Path:
o Case of a firm: Y1 = 1000 = 2

K = 10 units

=2

Page 68 of 166

L = 10 units K C3 C2 C1 a 10 O 10 C1 C2 b c Y3 = 1750 Y2 = 1500 Y1 = 1000 L C3

o Point a: Y = 1000 L = 10 K = 10 C = (2) (10) + (2) 10 = 40 C1C1 = 40 Iso cost line tangent to Y1 = 1000 Optimal input combination to produce Y1.
o Expand output to Y2 and Y3:

New I.C Lines: C2C2 and C3C3, assuming & remain constant (parallel shift) New points of optimal input combinations: b and c. o The firm expands by moving from one tangency or efficient production point to another (a b C). o Connect all these efficient production points to represent expansion path. 13.

Returns to Scale:

To explain the behaviour of output in response to proportionate and simultaneous changes in input use Expansion/Contraction in the scale of production.

Technical possibilities of proportionate and simultaneous increase in the use of both L & K: o Y (output) increases more than proportionately IRS o Y increases proportionately CRS o Y increases less than proportionately DRS o Y = (L, K) o Firm uses L units of Labour in combination with K units of capital to obtain an output of Y: L + K Y
Page 69 of 166

o Let us change both L and K by a proportion, call it .

By how much Y increases?

Let output increase by b: L + K bY bY b = CRS b > IRS b < DRS Diagram:

Total output

IRS (Increasing Slope Curve) CRS (Constant Slope

Curve)

DRS (Decreasing Slope Curve) Units of L & K

Why

IRS?: Due to specialization use of specialized labour and machinery (Details later under Economics of Scale).

Why DRS?: With increased scale of operation, increased problems of co-ordination (Details later under Economies of Scale). Output elasticity and R to S: = % change in output (Y) % change in all inputs (L & K) = Y . IO I YO Case1: > 1 % change in Y >% change in inputs IRS Case2: = 1 % change in Y = % change in inputs CRS Case3: < 1 % change in Y < % change in inputs DRS

Page 70 of 166

R to S In Iso Quant Framework: K 6 A 3 O 3 K 6 A 3 O 3 K 6 A 3 O 3 6 Y1 = 100 L ? D Y2 = 1500 6 Y1 = 100 L ? C Y2 = 300 6 Y1 = 100 L 3L + 3K Y1 = 100 B 6L + 6K Y2 = 200 Y2 = 200 CRS

14.

Technology and P.F:

Technical Change: Economic Interpretation Y, I Y, I

Technical change for facing global competiveness.

Page 71 of 166

Labour intensive technology: L ratio K Capital intensive technology: L ratio K Neutral technology: L ratio remains constant. K

Impact of technology change on TP, MP and AP: TP with same amount of input. MP and AP with same amount of input. Upward shifts in product curves & shifts in iso-quant. Embodied technology change & P.F shift: Embodied in inputs (say a new and more efficient machine).

Disembodied technology change: P.F shifts due to improved efficiency in input-combination, and improved managerial efficiency etc. Do you contest this difference?

15. Derivation of cost functions from production function: Duality Theorem. 16. Production Theory and Managerial Decision Making: Careful planning by a company to use its resources in a rational manner. (Recall three stages of production where do you want the company to operate) Managers must understand the marginal benefits and cost of each decision on resource allocation. Use the concept of trade offs in decision making: Ex: K L trade off: Install a new voice messaging system Reduce the need for receptionists, operators or secretaries

Page 72 of 166

Cost of installing such a system outweighed by cost of saving resulting from the elimination of certain support personnel. Ex: Similarly, L L trade off, K K trade off, etc. 17. Theory of Costs: Role of Cost Management in Profit Maximization: = P C. C o P provides the floor to pricing. A basis for managerial decision on product pricing Whether to abandon an old product line or establish a new one Whether to increase the volume of output or not Whether to use idle capacity or rent facilities to outsiders. Proper calculation of costs: Basis for decision making. 18. Kinds and concepts of costs:

Question:

Historical and Current Costs: o H.C: Market value of an asset at the time of purchase o C.C: Market value of an asset at the present time Current Costs: Determined by replacement cost outlay required for replacing an old asset. o Usually C.Cs exceed historical costs but in case of computers and electronic equipments, C.C<H.C due to technological progress. Explicit and Implicit Costs (Imputed Costs): o E.C: Actual expenditure of the firm to hire, rent or purchase the inputs required in production. Ex: Wages to hired labour, rental price (interest) of capital, equipment, purchase of raw materials. o I.C: Costs of input owned and used by the business firm Imputed Costs. Ex: Cost of equity capital, rent on company owned facilities. o To estimate : Which one (ones) should we use.

Page 73 of 166

o Usually, I.Cs, not considered while calculating the loss or gains of the company. o E Costs: Also called paid-out costs. I.Cs: Book Costs o Economic Costs = E.Cs + I.Cs o Accountants consider Explicit Costs (E.Cs also called Accounting Costs), but economists consider both for profitability analysis. Opportunity Cost (Alternative Cost): o O.C: Value of a resource/input in its next best alternative use o Ex 1: Maximum salary an entrepreneur could earn working for some one else. Ex 2: O.C of attending college includes not only the explicit costs of fees, books and so on, but also foregone earnings of not working. o O.C and efficient resource allocations A producer with some amount of resources he can produce either scooters or cars. Let O.C of one Car is 6 Scooters PS = 30,000 PC = 2,00,000 Which one should be produced? Basis for efficient use of resources. o O.C: Relevant for managerial decision making. Consider the O.Cs of all the inputs-purchased and used and owned and used. Production and Selling Costs: o P.Cs: Costs of all inputs used in production o S.Cs: Expenditure on advertisement, display, cost of transport etc. Incremental and Sunk Costs: o I Costs: Change in cost due to a given managerial decision. Ex 1: An additional departure of an air career. Ex 2: I.Cs due to introduction of a new product, replacement of old technique of production. o S.Cs: Cannot be altered, these S.Cs due to prior commitment. o I.Cs vary with the decision.
Page 74 of 166

S.Cs are not variable with the present decision. o I.Cs: Relevant for decision-making. S.Cs: Do not depend on the decision at present. Private and Social Costs: o P.Cs: Incurred by firms in the process of producing goods and services. P.Cs internalized costs incorporated in the firms total cost of production. o S.Cs: Incurred by society as a whole. Ex 1: Mathura Oil Refinery discharging its wastage in Yamuna River water pollution. Ex 2: Factories located in a city causing air pollution. o An alternative interpretation of S.C: Social Costs to include both private and external costs (Costs of Water, Air Pollution etc). S.C: Total cost borne by the society due to production of a commodity. Fixed and Variable Costs: o F.C: (overhead, prime or supplementary cost): Do not vary with output. Ex: Property taxes, insurance etc. o V.C: Vary with output. Ex: Payments for raw materials, fuel, excise tax etc. o S.R: Differentiate between F.C and V.C. o L.R: All costs are variable. Engineering Costs: o Important from the view point of project management. o Pre-investment Phase: Planning costs. o Investment Phase: Project execute on costs including drawing/designing, procurement and construction, commission etc. o Post-investment (operation phase): Running/operation costs, maintenance costs, replacement costs etc. Total and Unit Costs: o TFC and TVC o TC = TFC + TVC

Page 75 of 166

o AFC = TFC

Q o AVC = TVC Q o AC = AFC + AVC o MC = TC Q. 19. Short Run Cost Output Relations:

S.R: Some costs are fixed (TFC) and some costs variable (TVC). AFC, AVC, AC and MC: Relevant Unit Costs. Cost Function: Symbolic statement of the technological relationship between the cost and output. TC = f (Q) T. Costs, Unit Costs and Output Relations. Outp ut (Y) 0 1 2 3 4 5 6 7 8 TFC 55 55 55 55 55 55 55 55 55 o TVC 0 30 55 75 105 155 225 315 TC 55 85 110 130 160 210 280 370 MC 30 25 20 30 50 70 90 AFC 55 27.5 18.33 13.75 11 9.17 7.86 AVC 30 27.5 25 26.25 31 37.5 45 AC 85 55 43.33 40.0 42 46.67 52.86

425 480 110 6.88 53.13 60.01 TFC, TVC and TC: TFC: Constant (55) althrough in the short run, even thought output (Y) . TVC: Increases althrough with an increase in output (Y). TC: Increases althrough with an increase in output (Y).
Page 76 of 166

 TVC and TC do not increase at the same rate

with Y althrough. Can you observe the rate of change in TVC and TC with an increase in Y. Diagrammatic Representation of TFC, TVC and TC. TFC, TVC & TC TC TVC

TFC O TC = TFC + TVC Output

o Behaviour of unit costs with change in Y: AFC: Decreases althrough with an increase in Y, because.... constant AFC

AFC Y (output) AVC: First decreases, reaches the minimum and then increases. AVC AVC point of

O Y*
Page 77 of 166

Y (output)

Relate AVC to APL: APL = Y L AVC = TVC = PL.L = PL (L) = PL ( Y Y Y APL AVC Max. APL Min. AVC APL AVC curve.

1 ) APL

AVC curve is the mirror image of the shape of APL AC: First decreases, becomes minimum and then increases. AC AC

Y (output) o The behaviour AC depends on the behaviour of AFC and AVC: When AFC and AVC fall, AC When AFC falls, but AVC increases, change in AC depends on the rate of change in AFC & AVC If Decrease in AFC > Increase in AVC, then AC - ---- If Decrease in AFC = Increase in AVC, AC - - - - - If Decrease in AFC < Increase in AVC, AC - - - - - MC: First decreases, becomes minimum and then increases MC
Page 78 of 166

MC

O MC Y* MC

Y (output)

Behaviour of MC related to behaviour of MPL: MPL = Y L MC = TC = TFC + TVC , but TFC = O Q Q Q Q MC = TVC = PLL = PL (L) Q Q Q MPL MC Max MPL Min MC MPL MC MC curve is the mirror image of the shape of MPL curve.

Assignment: Use Data on Total and Unit Costs of page 16 Plot TFC, TVC and TC in one graph sheet Plot all Unit Costs in an other graph sheet Record the behaviour of each one of Total and Unit Costs Record how AFC, AVC, AC and MC related. 20.

Long Run Cost Output Relations:

L R: All inputs are variable scale of the firm changes. The length of the time of the LR depends on the industry Ex1: Service industry like dry cleaning LR may be a few months or weeks Ex2: Construction of a new electricity generating plant LR may be many years.

Page 79 of 166

 The firms LR total cost (LTC) is derived from the firms expansion path LR is composed of a series curve of short run production functions. LTC shows the min LR costs of producing various levels of output. The firms LAC and LMC curves derived from the LTC. Expansion Path, LTC, MC and LAC. Capital (K) Expansion Path IQ5 IQ3 IQ4 IQ2 IQ1 Labour (L) LTC LTC

Derived from Expansion Path

Y (output) LMC & LAC

LMC LAC LAC = LTC

Page 80 of 166

Y LMC = LTC Y Y (output) o LTC: To produce different levels of output indicated by Iso-Quants. o LAC: First decreases, becomes min and then increases. Does this have relationship with returns to scale. LMC: Slope of the LTC curve intersects the LAC curve from below at the lowest point on LAC curve.
o

Possible Shapes of LAC Curve: LAC LAC O Fig. A LAC Y (output)

O Fig. B LAC

LAC Y

Y
Page 81 of 166

Fig. C Fig A: IRS (LAC) and DRS (LAC) Fig B: IRS (LAC) Constant CRS (LAC) DRS (LAC) Fig C: Althrough decreasing with an increase in Y. Plant size, SRAC Curve (SRAC) and Long RAC Curve (LRMC): LRAC Curve derived from SRAC Curves.
LRAC Curve is also called Planning Curve or Envelope

Curve. Average cost in SRAC1 SRAC2 SRAC3 SRAC4 SRAC5 LRAC

O Q1 output per period of time The Long Run Average Cost Curve for Alternative Plant Sizes Wants to produce OQ1 level of output plant size represented by SRAC1: The most efficient.
o

Q2

Q3

Q4

Quantity

of

Forecast more demand for output OQ2 plant represented by SRAC2: the most efficient. OQ2 could
o

Page 82 of 166

reproduced with SRAC1 also, but AC with SRAC1 > AC with SRAC2. Level of demand, further to OQ3 go for plant size SRAC3. Why not to stay with SRA2?
o

Level of demand, further to OQ4 go for plant size SRAC4. Why not to stay with SRA3?
o

SRAC4 plant size is called the optimum or least cost (least AC) size.
o

The LRAC curve is an envelope of the SRAC curves and is tangent to each of the SRAC curves.
o

LRAC curve is not tangent to the SRAC curves of their minimum points except in the case of optimum plant size i.e SRAC4.
o

o Note: LRAC curve is U-shaped due to economies and diseconomies of scale. 21. Economics and Diseconomics of Scale: Real and Pecuniary Economics. o Economics of Scale: Decreasing segment of LRAC curve. o Diseconomics of Scale: Increasing segment of LRAC curve. Economics of Scale: o Internal (internal to the firm) Economies: Economies of Production: Technological advantages and advantages of division of labour and specialization. Economies in Marketing: Large scale purchase of inputs and sale of output.

Page 83 of 166

 Managerial Economies: Specialised management in production, HRD, Marketing, Finance etc. Economies in Transport and Storage: Fuller utilization of transport and storage facilities. o External or Pecuniary Economies of Scale: Large scale purchase of inputs: Concessions and discounts. Large scale acquisition of external finance. Massive advertisement campaigns. Declining portion of LRAC due to economies of scale due to output expansion. Diseconomics of Scale: Rising portion of LRAC curve: o Overcrowding of labour o Managerial inefficiencies o With full in demand for the product, underutilization of capacity. Impact of Technological Change on LRAC Curve. Economies of Scope: o Not the same as economics of scale.

o Many times, companies/firms produce more than one product to lower the cost of each operation alone. Ex1: Automobile companies producing cars and trucks product diversification. Ex2: A smaller commuter airline providing cargo services. Ex3: Use the byproducts arising from the production of the first product sugar industry. o Economies of Scale: Total of point production of cars and trucks < Total cost of producing cars and trucks independently by different firms.
Page 84 of 166

TC(C,T) < TC(C) + TC(T) Less expensive to produce jointly. Diseconomies of Scale: TC(CT) > TC(C) + TC(T) Less expensive to produce independently.
o

22.

Learning of Curves (Experience Curves).

Decline in AC of inputs with rising cumulative output over time.

Take 1,000 hours to assemble the 100th aircraft, but only 700 hours to assemble 200th aircraft workers and managers become more efficient with passage of time.

AC
F

G Learning Curve

O Qt 2Qt

Cumulative Total Output

o Otth output (like 100th aircraft) o 2Qtth output (like 200th aircraft)

Economies of Scale: Declining AC of input due to output expansion. But Learning Curve: Cumulative experience and decling AC of input for different units of output. Learning Curve: Experienced in manufacturing airplanes, appliances, ship building, refined petroleum products and operation of power plants.
Page 85 of 166

 Learning Curve: Used to forecast the requirement of personnel, machinery and raw materials and scheduling product and determining the price at which to sell output. Ex: Texas instruments has followed an aggressive price policy for computer chips, based on the learning curve. Comparison of E of S and Learning Curve: Know: o Technical Progress: Downward shift in LRAC Curve. o Managers and workers gaining experience: Downward shift in LRAC Curve. LRAC C B A O Qt Qt+1 LRACt LRACt+1 Output

Observations: o Two periods: t and t+1 o Qt and Qt+1 levels of output during t and t+1 o LRAC at t: OC for Qt level of output o LRAC at t+1: OB Lower LRAC during t+1 period BC = Unit cost saving. o Expand output from Qt to Qt+1 Economics of Scale: LRAC at Qt+1: OA OA < OB < OC o Learning Curve Effect: BC o E of Scale Effect: AB o Downward shift due to learning and movement along a given LRAC curve due to E of scale

Page 86 of 166

o Remember: Downward shift in LRAC curve (AC reductions) may be due to Learning Experience, Economies of Scale, technology and input price decline. Hold other things constant to sort out net effect of L.C (Previous Diagram) 23. Cost Value Profit Analysis: Break Even Point and Operating Leverage. Examine the relationship among TR, TC and total profit at various levels of output (Q). C V P analysis or B E A: used by business executives to determine volume of sale required for the firm to break even and the total profits and losses at other sales levels. At what output level B E, Losses and Profits? Use C V P or B E Analyse. B E Analysis: Linear Cost and Revenue Function CF: TC = 100 + 10 Q RF: TR = 15 Q. 100 = TFC V.C varies with output (Q) and varies at a constant rate of 10 per unit. Sale Price = 15 Algebraic Calculation of B E P: TR = TC 15Q = 100 + 10Q Q = 20 20 is the B E output Beyond 20: operating profit Below 20: operating loss. Diagrammatic Representation: Costs Revenue 700 600
Page 87 of 166

TR Operating >0 TC TVC

500 400 Operating 300 loss B 200 100 <0 O 10 20 30 40

TFC Q (output)

o TFC = 100 o TVC: Variable Cost o TC = TC function i.e TFC + TVC o TR = Total Revenue: P.Q o Point B: Point of intersection between TR & TC lines Q=20, B.E level of output o Thus Point B: B E Point o Below Q=20, TC > TR operating loss o Above Q=20, TR > TC operating profit o B.E.P: TR=TC =0 losses cease to ever and profits yet to begin. Limitation of L C and L R functions o C and Revenue functions may be non linear: Because AVC and price of output vary at different rates with variations is output. o Under non linear conditions, there might be two B E points, instead of one. B E Analysis: Non Linear Cost and Revenue Functions. Costs and Revenue TC B1

B 2

TR TFC

Page 88 of 166

O o o o
o o

Q (output)

Q1 Q2 TFC = Total Fixed Cost (OA) TVC = TC TFC = The vertical distance between TC and TFC TC = Total Cost = TFC + TVC B1 & B2: Points of intersection between TR & TC TR = TC B1: Lower B E point at Q1 output level B2: Upper B E point of Q2 output level Firm, producing more than OQ1 and less than OQ2 will make profit Profitable range of output: More than OQ1 Less than OQ2. Producing less than OQ1 more than OQ2 losses. Contribution Analysis: Recall: IC = Incremental Cost of a business decision IR = Incremental Revenue from a business decision. Contribution: TR TVC, TFC not considered At B E Point Contribution = Fixed Costs.

Uses of B E Analysis: o To Know: Level of sales required to cover all costs o To Know: What happens to overall profitability, when the company incurs higher or lower fixed or variable costs o To Know: Between two alternative investments, which one offers the greater margin of profit o To Know: What happens to overall profitability when a new product is introduced o To forecast , when revenue and cost estimates are available. o To Know: Margin of safety o Useful for production planning

Page 89 of 166

o Useful for deciding when to start paying dividend to its share holders.

Degree of operating leverage: Percentage change in profits that results from percentage change in number of units sold i.e elasticity of profit with respect to output sold. DOL = % = o = . Qo %Q Q Q o Qo

24.

Estimation of Cost Function:

Forward Planning: Basis for decision making. SR Cost Function: Necessary for the firm determing the optimum level of output and the price to charge.
LRC Function: Essential in planning for the optimal

scale of plant for the firm. Methods for obtaining appropriate information of its future cost output relationship. o Engineering Method: Based directly on the production function, input prices and the optimum input combination for producing a given quantity of output. Using this information, engineers provide least cost estimates. Based on given technology and input prices. When technology and input prices are changing, difficult to obtain accurate estimates. Survivorship Method (Survival Technique)

Page 90 of 166

 Classify various firms of an industry into size groups: small, medium and large Most efficient size group: share in the industry in creases Least efficient size group: share in the industry decreases Site group S M L Industry Share (%) Base Year Current Year 10 12 30 50 60 38

M Size group: Most efficient L Size group: Most inefficient Competition will eliminates inefficient firms Firms with lower average cost will survive. Limitation: The method does not yield the cost function. Does not allow the measurement of degree of economies and diseconomies of scale. Statistical Method: Regression Method Short Run Cost Function: C = TC = f (Q) C = total cost = TFC + TVC Q = output

Linear Cost Function: TC = a + b Q TC = 100 + 0.5 Q TFC = 100 TVC = 0.5 Q Let Q = 10 TVC = (0.5) (10) = 5 TC = 100 + 5 = 105 AC = -----------------

Page 91 of 166

MC = --------------- Quadratic Cost Function:

TC = a + b Q + CQ2 TC = 100 + 60Q + 3Q2, TFC = 100 TC = a + b Q CQ2 + dQ3 TC = 100 + 60Q 5Q2 + 0.7 Q3, TFC = 100

Cubic Cost Function:

Long Run Cost Functions: o To determine the best scale of plant for the firm to build in order to minimize the cost of producing the anticipated level of output in the long run. o Can use either time series data or cross section data. o Can estimate L R Cost Functions with engineering and survival techniques. Managerial Uses of Estimated Cost Functions: o To determine the optimum scale or size of the fixed plant and equipment. o To determine the optimum output for a given plant size. o To determine the supply schedule/curve.

Page 92 of 166

MODULE 3: Market Structure and Theory of Firm. 1. Markets and Market Structure: Markets: o Four components of a market: Buyers, sellers, a commodity and a price. o Personal contact between buyers and sellers: Not necessary. o Contact between buyers and sellers: May be through telephonic conversion or teleprinter or any such modern device. o Does not necessarily mean a place. Structure Conduct Performance Paradigm:
Market Structure Business Conduct or Industry Behaviour Corporate Performance (Price Profit Output etc)

Definition of Market Structure: Use market characteristics. o In terms of number and size of the buyers and sellers of the product. o In terms of type of product sold (standardized/homogeneous or differentiated products). o The degree of mobility of resources: Entry and exit of firms. o The degree of knowledge of economic agents (firms, suppliers of inputs and consumers): About prices and costs and demand and supply conditions. Two Broad Market Models: o Perfect Competition o Imperfect Competition Monopoly Monopolistic Competition

Page 93 of 166

Oligopoly.

Nature of industry where prevalent: P/C: Financial markets (to some extent) and some farm products Monopoly: Public utilities M/C: Manufacturing: Toothpaste, TV sets, Refrigerators etc Oligopoly: Aluminium, Cigarettes etc.

Different Market Models: Some Broad Characteristics Market Model No. of Sellers Nature of Product Entry Barriers to Sellers None Degree of Control Over Price None PED Infinit e Very Small CED

1. Perfect Competitio n

Large, small, Homogeneou independent s

Infinit e

Homogeneou 2. s, but no Insurmountab Considerab One Monopoly close le le substitutes Differentiate 3. Many, small d, but very Monopolisti virtually None Some close c Compn. independent substitutes Homogeneou Few, 4. s or interdepende Substantial Some Oligopoly differentiate nt d

Zero or Very Low

Large

Very High

Small

Low

Kinds of Revenue and Their Behaviour under P/C and I/C T R = P. Q A R = TR = P.Q = P Q Q M R = TR Q

Page 94 of 166

Behaviour of AR (Price), TR and MR under P/C & I/C: A Test of Market Structure Quanti ty 1 2 3 4 5 6 7 8 9 10 Price P/C 16 16 16 16 16 16 16 16 16 16 I/C 16 15 14 13 12 11 10 9 8 7 P/C 16 32 48 64 80 96 112 128 144 160 TR I/C 16 30 42 52 60 66 70 72 72 70 P/C 16 16 16 16 16 16 16 16 16 16 MR I/C 16 14 12 10 8 6 4 2 0 -2

Assignment: Draw diagrams and interpret the Behaviour of Revenues. Algebraic Presentation of Behaviour of TR, AR and MR under P/C and I/C: o TR = P.Q o Let TR = 55Q MR = d(TR) = 55 dQ AR = TR = 55Q = 55 Q Q MR = AR under P/C
o Let TR = 55Q 2Q2

MR = d(TR) = 55 4Q dQ AR = TR = 55Q 2Q2 = 55 2Q Q Q

o AR = 55 2Q Falling AR (P) with an increase in Q

MR = 55 4Q2 Falling MR at twice the rate of AR under I/C.

Page 95 of 166

Assignment: Consider the following TR and TC functions: 1) TR = 55Q. TC = 100 5Q + Q2 under P/C 2) TR = 55Q 2Q2. TC = 100 5Q + Q2 under I/C 3) Definition: = TR TC Max : MR = MC: Necessary Conditions 4) Calculate maximizing output (Q) and volume of under P/C and under I/C. 2. Pricing Under Perfect Competition: Characteristics of P/C: Small share of each buyer and seller in total demand and total supply. No individual buyer and seller can influence the price. A firm: price taker and not a price maker.

o A large number of sellers and buyers of the product.

o Homogeneous Products: Product of each firm is a perfect substitute for the product of other firms.
o Perfect mobility of factors of production: No control of

any firm on factors of production. Inputs can respond to incentives.

o Free entry and free exit of firms. No restriction on

entry or exit. No patents or copy rights. o Perfect knowledge among buyers and sellers about costs, prices, quality of products etc. Price differences, quickly eliminated Prevalence of a single price Resources sold to the highest bidder. o Absence of collusion: No sellers union or buyers associations. Each buyer or seller acts independently.

o No government intervention: No licensing system, no control over inputs, no fixation of lower or higher prices etc.

Page 96 of 166

P/C: uncommon

o May be in stock market and agricultural commodities o Even though uncommon, useful as a reference point for an ideal market situation. Can evaluate the efficiency of other market models with the characteristics of P/C as denominators. Price Determination under P/C:

Price Determined by Market Demand and Market Supply: A Firm Price Taker Industry Price S P Firm P* MR=P=AR P O Q* Market Supply Curve facing and Demand firm
o Price Determined by MS and MD: P = P*

Q Demand an individual Q = Q*.

o A perfectly Competitive Firm: A price taker.

o Hence, a P/C firm has to determine quantity to sell at P* MR = P* = AR When P is constant, TR changes proportionately to change in Q MR is constant and equal to price.
Page 97 of 166

o AR curve is the demand curve facing of a firm. A firm

faces horizontal or infinitely elastic demand curve. Pricing in Market Period:

o Each firm has fixed stock of commodity to be sold. The

stock with all the firms. Fixed Supply in the market vertical supply curve.
o Given fixed supply, price determined by demand.

P S P2 P1 D2 D1 O Q* o Examples: Pricing in Short Run and Equilibrium of a Firm: Case 1: Supernormal Profit Case 2: Belownormal Profit Case 3: Normal Profit. Case 1
Pri ce, Co sts

SMC

SAC AR=MR

P T

E C

O Q Output
Page 98 of 166

Case 2
Pri ce, Co sts Pri ce, Co sts

SMC

SAC AVC AR=MR

T P

C E

O Q Output

Case 3 P

SMC

SAC AR=MR

E C

O Q Output o Observations:

Case 1: ECTP = Supernormal , because P

> SAC. Excess supply of output in the market P. Excess demand for inputs . An increase in input prices. The process of adjustment till normal profit is restored.

Case 2: ECTP = Belownormal Exit of firms

Page 99 of 166

Excess supply of inputs, decreasing

input prices Excess demand for products, increasing product price The process of adjustment, till normal profit is reached.

Case 3: Normal profit situation P = SAC = SMC Normal profit is included in cost of production. Reproduce Case 3 by relabelling cost/revenue curves to create long run equilibrium conditions. Pricing in Long Run: Equilibrium Conditions o LR : All inputs and costs of production variable. : Optimum plant size to produce least cost output i.e the best level of output. Condition for BLO: AR = P = MR = LMC = lowest LAC. : All supernormal profits and losses eliminated, only normal profit accrued. : Firm produces at the lowest point on its LAC. : The firm operates the scale of plant given by SATC at its lowest point SMC = LMC. Conditions of equilibrium of a firm in the LR: P = AR = MR = LMC = LAC Price & Costs E AR = MR LMC LAC P

O Output E = Point of equilibrium

Page 100 of 166

 P = AR: By definition AR = MR: By the nature of market (P/C) MR = MC: By equilibrium condition MC = AC: By optimum output scale. o Normal Profit: Free entry and exit of firms critical to the operation of a highly competitive market. Supernormal profit and losses in the short run Normal profit in the LR, due to process of market adjustment. o LR Equilibrium at the point E: P = AR = MR = LMC = LAC: Both the individual firms and industry are in Long run equilibrium.

3. Pricing and Output Determination Under Monopoly: Meaning of M: A single firm to produce and sell a product. No close substitutes for the firms product. Cross elasticity of demand: Zero for a monopoly product. Firm and industry: Identical. A monopolist: Price maker. Downward sloping demand curve for the monopoly product Downward sloping AR Curve MR Curve, below AR Curve. Bilateral Monopoly: One seller and one buyer. Reasons for Monopoly Market Power:

Control over key raw materials: Called raw material monopolies. Before II World War: Aluminium company of America: Monopoly in Aluminium production, because of control over bauxite supply. Patent or copy right ownership: Ex: Polaroid on instant camera.
Page 101 of 166

 Economies of scale and efficiency: Ex: Public utilities (water, gas etc.) called natural monopoly. Monopoly established by government franchise i.e by Government Law called franchise monopolies. Ex: Indian Railways. Barriers to entry of new firms. But even though a sole producer and distributor of service, regulated by government. Pure monopoly power rare monopolist faces indirect competition. Substitutes still exist. (Steel, plastics as substitutes for aluminium).

Short Run Price and Output Determination under Monopoly: Recall price and output are determined based on revenue and cost conditions under P/C. Under monopoly, AC and MC Curves are generally identical with that of P/C, but AR and MR Curves differ. AR Curve (same as demand curve) slopes downward To sell more reduce price MR Curve lies below the AR Curve. Slope of the MR: Twice the slope of AR Curve. AR function: P = a b TR function: TR = Q.P = Q (a b Q) = a Q b Q2 MR = dTR = Q 2bQ dQ Slope of AR: - b Slope of MR: - 2b.
C o s t s & R e v e n u e s

Short Run Price Output Determination: SMC P

Page 102 of 166

 Does a monopoly firm always earn economic or supernormal ? o Not necessary, depends on AR and AC levels: AR = AC Normal AR > AC Economic or supernormal AR < AC Losses. o Scope for earning economic or super normal profit: High in case of monopoly. o Assignment: Draw diagrams to illustrate all the three conditions. Long Run Monopoly Pricing and Output Determination:

U n

P1 P2 M N MR O Q* o
o

SAC

AR = D Output

o o o o firm: MR = SMC Same as that of P/C firm. o O Q* = maximizing output. o P Q* = Price per unit of output. o M Q* = Average cost. o Profit per unit of output: PQ* - MQ* = PM o Total : O Q* X PM O Q* = P2M : P1 P M P2 Shaded area.

AR = Average revenue curve or D C. MR = Marginal revenue curve. Observe = MR < AR. Reason? SAC = Short run AC curve. SMC = S R MC curve. Profit maximization decision rule for a monopoly

Page 103 of 166

Monopolist: An opportunity to expand the size of its firm to increase its long run profits. o Utilization and size of the plant: Determined by market demand. o Market demand: Determines whether to operate at minimum LAC, falling part of LAC, or increasing part of LAC. o Equilibrium condition: MR = LAC. o Three possible cases: Case 1: Monopolist operating at falling segment of LAC Case 2: Operating at increasing segment of LAC Case 3: Operating at minimum point of LAC. o But in all these cases: Makes supernormal profit. o Which of these cases: Determined by market demand, given the technology.
o

U n it C o s t s & R e v e n u e s

Case 1: Operating at falling segment of LAC.

LMC A P C

LAC B

M AR (D) Output

E Q* MR

Observe: MR = LMC at Point E point of

equilibrium O Q* = Equilibrium output LAC per unit of output: B Q* Price per unit of output: A Q* (= O P) per unit of output: A B (AQ* - BQ*) Total for O Q*: A B C P shaded area

Page 104 of 166

 Operating at falling segment of LAC: Market size does not permit to expand to the minimum point of LAC (Point M) There is excess capacity.

U n it C o s t s & R e v e n u e s C o s t s & R e v e n u e s

Case 2: Operating at increasing segment of LAC. LMC LAC P C O Q* MR = LMC at Point E Point of equilibrium o O Q* = Equilibrium level of output o Price per unit of output: AQ*(= O P) o per unit of output: AB (AQ* - BQ*) o Total for O Q*: A B C P Shaded area o Operating at increasing segment of LAC the minimum LAC at M, earlier to O Q* Market demand permits to expand output beyond the point of minimum LAC (M) Capacity, over utilized.
o

A E M B MR AR (D) Q (output)

Case 3: Operating at minimum point of LAC. LMC LAC

Page 105 of 166

 Compared
o

U n

P C O

A E MR Q* AR (D) Q (output)

M R = LMC at point E Point of equilibrium o O Q* = Equilibrium level of output o A Q* (= O P): Price per unit of output o E Q* (= O C): LAC per unit of output o A E: per unit of output o A E P C: Total for O Q* level of output (shared area) o Operating at minimum point of LAC Market size enough to permit the optimum plant size Optimal capacities utilization.
o

Monopoly & Perfect Competition: MR = AR = P under P/C. But MR < AR

under Monopoly AR curve is a straight line to the horizontal axis under P/C . Demand is perfectly elastic. AR curve is downward sloping under Monopoly Elastic demand. o Monopoly price, higher than competitive price, generally o Monopoly output, lower than competive output o P/C firm: Normal in the LR M: Supernormal even in the LR o Monopolist: Slow to introduce technological change P/C: Efficient or exit introduce technological change as and when possible.
o

Page 106 of 166

 Price Discrimination Under Monopoly (Discriminating Monopolist): monopoly Simple versus discriminating

o S M: Same price for all consumers, in all markets and for all uses of the same commodity. o D M: Different prices for different consumers, in different markets and for different uses of the same commodity. Ex 1: Physicians, Lawyers, Consultants charging different rates for customers Ex 2: Railways charging different tariffs for senior citizens, students and others Ex 3: Different prices in domestic and international markets Ex 4: Electricity tariff for commercial purposes and for domestic use. o Some other basis for P.D: Size discrimination Ex: Retail and wholesale Sex discrimination Special service or comfort Ex: In Railways Age Quality variation discrimination Ex: Price of deluxe edition and paper back of a book. Conditions essential for P.D o Must be a Monopolist: Only a necessary condition

Page 107 of 166

o Market segmentation o Different Markets: Separable to prevent resale or reexchange of goods o Different elasticity of demand in different markets. Same price elasticities in different markets. Reduction in by reducing demand in the high price markets. P.D by Degrees:

o First Degree P.D (perfect P.D):

Charge different prices to different buyers for

each different unit of the same product. Price charged for each unit, in each buyers case, is set in accordance with the marginal utility to the buyer and charges maximum price be is willing to pay for it. The entire consumer surplus is converted into monopoly revenue and profit. Difficult to implement. o Second Degree P.D: Block wise different prices Blocks: Rich, middle and low income blocks of consumers. Charge higher price to the rich, lower to middle class and still lower to the poor. Ex: Public utilities like electricity supply. o Third Degree P.D: Set different prices in different markets with different demand curves and elasticities. Possible in markets separated from each other by geographical distance, transport barriers, legal barriers etc. Third Degree P.D: Very practical method.

Page 108 of 166

 The practice of P.D in foreign trade is called dumping. o Necessary conditions for Monopoly equilibrium under P.D: Two separate markets with different elasticities of demand. MR from all the markets must be the same: MR1 = MR2 = = MRn. Marginal revenue of all markets must be equal to M C of producing entire output: MR1 = MR2 = = MRn = MC MC = M.C of producing entire output. The Measures of Degree of Monopoly

Power:
o

Triffins cross elasticity criterion: Lower the value of C.E coefficient, greater the degree of monopoly power. Higher C-E Coefficient smaller degree of monopoly market power. o Lerner index of M-Power:

Measure M-Power by the deviation between price and MC. Under Monopoly: P=AR AR>MR MR=MC P > M C. Degree of M-Power (MP) MP = P MC , MP = Lerner Index P Under P/C: MP = O Larger the value of L-Index, greater the market power. Recall: Under monopoly: P > MC. Measure of monopoly power.

Page 109 of 166

 Higher the degree of price elasticity of demand for a firms product, lower is the degree of monopoly power. Question: When do you expect higher price elasticity of demand? When there are large number of firms in the industry? o Bains Excess Profit Criterion.

Excess profit profit in excess of opportunity cost. Higher the excess profit, greater the monopoly power. MP = R OC R MP = The Degree of Monopoly Power R = Actual Profit OC = Opportunity Cost MP = O No Monopoly Higher the value of MP, greater the degree of monopoly power. Is Bains criterion comparable to that of Lerners index? o Refer Dwivedi (PP 320 321) for other two measures of monopoly power: Number of Firms criterion Concentration Ratio.

4. Pricing and output Determination under Monopolistic Competition: Features of M/C:

o Blend of both competition and monopoly.

o Large/many sellers/firms in the market. scope for

competition.

Page 110 of 166

o Product

differentiation: Products similar, but not identical. Product of each seller branded. Limited degree of monopoly over a group of consumers.

o Product differentiation may be real or imaginary. o Large number of Buyers: But preference for a particular brand. o Free entry: No barriers for entry, but produce a differentiated product with a new brand name.
o Selling Costs: Product differentiation Adversement

and other forms of sales promotion.

o Downward sloping demand curve (A R Curve) as under

monopoly. But flatter Demand is more elastic than under monopoly, because of the availability of close substitutes. o A firm under M/C does not lose all consumers by increasing price as under P/C. This firm is like a monopolist over a brand loyal consumers. o Two Dimensional Competitions: Price Competition and Non-Price Competition (product variation and selling costs for sales promotion). o The Group: Non homogeneous products Difficult to define industry. A group is a cluster of firms producing very related but differentiated products. Ex. of product groups: Automobiles, computers, soap, footwear, cosmetics, vegetable oil etc. Price and Output Determination: Short and Long Run Equilibrium. o Theory of M/C: Essentially a long run theory.

Page 111 of 166

o In the short run: Virtually no difference between monopoly and M/C, excepting flatter AR & MR curves under M/C. o Short Run Equilibrium. MC AC P C

o Long Run Equilibrium: LMC LAC A P*

Uni t Co sts & Re ve nu es Uni t Co sts & Re ve nu es

A B EM AR (D) MR O Q (output)

Q* MR = MC at point E Equilibrium OQ* = Equilibrium level of output AQ* (=OP) = Price per unit of output BQ* (=OC) = AC per unit of output AB = per unit of output ABCP = Total for OQ* level of output (shaded area) A firm under M/C: Supernormal when: P > AC Normal when: P = AC Loss when: P < AC. May not be operating at the point of minimum AC Excess Capacity Socially suboptimal level of output.

Page 112 of 166

AR (D) LMR O Q* Q**

LMR = LMC at point E Equilibrium

Q (output)

OQ* = Equilibrium level of output OP* = Price per unit of output AQ* = LAC per unit of output OP* = AQ* No supernormal Supernormal profits competed away. Not operating at M i.e minimum average cost, and not producing socially optimum level of output (OQ**). Excess output capacity even in the long run (Q* Q**).
o Wastes of M/C: Excess output capacity

Waste through advertisements, fancy packaging etc Wastes due to freedom of choice of consumers for variety Not operating at minimum AC even in the long run Excess output capacity Socially suboptimal level of output underemployment of resources and lesser output. Wastes due to selling costs Define Combined Average Costs: Combined AC (ACC) = Production Cost (APC) + Selling Costs A firm under M/C has to cover both APC and selling costs to remain in business.

Page 113 of 166

A
Co sts

B ACC Selling Costs C APC Q (output) Q*

D O

APC = Average Production Cost Curve ACC = Average Combined Cost Curve Vertical distance between APC and ACC: Selling Costs For OQ* level of output: CQ* = APC per unit of output BQ* = ACC per unit of output BC = Average Selling Cost. OQ* CD = Total Product Cost OQ* BA = Total Combined Cost ABCD = Total Selling Cost. 5. Pricing and Output Decisions Under Oligopoly: Oligopoly Market: Characteristics/Features of

o A few sellers or a few big sellers if there are many. Ex: 15 industries out of 84 surveyed in India have 75% of market share. o Homogeneous or differentiated products Ex: Oligopoly with homogeneous or almost homogeneous products (Homogeneous Oligopoly): Steel, Aluminium, Copper etc. Ex: Oligopoly with differentiated products (Heterogeneous Oligopoly): Kitchen Appliances, Cigarettes, Specialists in Medical Service, Five Star Hotels, Management Consultants etc. o Interdependence: In business policies about fixing of price and determining output. o High cross elasticity of demand: Fear of retaliation by rival firms. o Excessive expenditure on adversement.

Page 114 of 166

o Constant struggle to survive: Because of unique competition. o Difficult, but possible entry/exit. o Lack of uniformity in size of firms. o Indeterminate price and output: Interdependence of Oligopoly firms, derivation of demand curve difficult. But price and output are derminate under collusive oligopoly. Ex: OPEC Organization of Petroleum Export Countries. Oligopoly is a market which contains the features of the most other market structures, particulars P/C and M/C. Demand Function for a firm under oligopoly market structure: Major determining variables: Product price Prices of rival firms goods Advertising budget of rival firms Style and qualities of rival firms goods Ex.1: The impact of price reduction on Godrej Refrigerator on Kelvinator brand. Ex.2: The impact of price cut by Maruti Udyog on demand for Ambassodor, Fiat etc. Reaction of rivals to Godrej and Maruti Udyog. Sources of Oligopoly:

o Huge capital investment. Possible barrier to entry.

o Economies of scale. Huge investment cost advantage due to economies of scale. o Patent rights under differentiated oligopoly. Limited number of firms under oligopoly. o Control over certain raw materials. o Merger and takeover: Oligopolistic tendency in modern industries. The Oligopoly Models:

Page 115 of 166

o Complicated behavioural patterns of actions, reactions and counteractions. Difficult to undertake a systematic analysis of price and output determination under oligopoly. Hence variety of oligopoly models. MODELS

Perfect Collusion Model (Cartels)

Non Collusion Models

Cournot Model

Tacit Collusion Models Leader Follower Models

Cost-based Pricing Model

Game Theory

Fixed Market Share Model

Residual Market Share Model

Models:

Some of the Major Oligopoly Perfect Collusion Model:

o All firms producing a homogeneous product like Petrole to form a Cartel. Ex: O P E C for pricing. o Pricing similar to monopoly with multiplant operations. o One market demand function and as many AC and MC functions as number of firms in the cartel. Sum of MC curves of various firms to get combined MC curve (CMC)
o
Page 116 of 166

o Determine joint maximizing output for the industry by following the rule: MR = CMC o Given the equilibrium level of output, AR curve would give the equilibrium price Decide distribution of output equating MR to each of the MC curve
o

to

firms

by

o All firms of the cartel sell at the same price, but output and profits not equal o Cost efficient firms will make more profits than others o To prevent breakdown of the cartel, the more cost efficient firms to transfer part of their profits to the less efficient firms o The cartel system of pricing can prevail even under differentiated oligopoly. Analytically, difficult to handle. Advantages of perfect collusion:

o To avoid price wars among rivals o Gain to members of cartel, but higher price to consumers. Difficulties of perfect collusion:

o Problems of high price to consumers and restricted quantity o If number of firms in cartel larger, greater difficulty in arriving at consensus on output and pricing o Hence cartels, rare. Cournot Model of Oligopoly: Behavioural Assumptions:

Page 117 of 166

o o o o

Only two firms (Duopoly), owning mineral water wells Wells operated at Zero MC Demand curve facing both: negatively sloping Each seller acts on the assumption that his rival will not react to his decision to change price and output.

But different to accept the assumptions of non-reaction.

Zero MC assumption: Unrealistic.

Cournot Solution: Each seller ultimately supplies one-third of the market and price charged by both the firms is the same. One-third of the market remains unsupplied. Stable equilibrium in Cournots Model. Sweezys Kinked Demand Curve Analysis of Price Stability: o Two segments of kinked d.c or AR curve: Relatively elastic and inelastic segments. D

D O o DD = Demand Curve o OP = Price per unit of output o K = Kink on the d.c o DK = Elastic segment of d.c Q (output)

Page 118 of 166

o KD = Inelastic segment of d.c

o DC=AR

curveKinked AR Kinky MR curve (Discontinuous MR curve) Indeterminate: To sell at the prevailing price or to increase Raising of price: Reduction in demand due to elastic nature of demand loss of market to rivals who would not raise their prices Lowering of price: An immediate retaliation by rivals. Hence not much of increase in his sales with price reduction Price rigidity over a period of time due to price interdependence implied in Kinky d.c (AR curve).

o The K D Curve: Does not deal with price and output determination o Once a price quantity combination is determined, an oligopolistic firm does not find it profitable to raise prices Price rigidity Desirable to maintain price and output at the existing level. o S Model does not explain how one price is determined. It explains stability of output and price o S Model: Does not pass the test of empirical verification. Monopoly prices: Found to be more stable than oligopoly prices. Follower Models o Tacit Collusion Models: Leader

Based on agreement: Live and Let Live.

o Two versions of leader follower model Fixed Market Share Model (Efficient Firm Model)

Page 119 of 166

 Residual Market Share Model (Dominant Firm Model). Fixed M Share or Efficient Firm Model: o Elect the efficient firm as the leader o Follower firms to take a fixed share of the total market o The residual to the leader. Residual M Share or Dominant Firm Model: o o o o o Elect the dominant firm as the leader Leader to set the price Allow each follower to sell as much as he wishes Leader to inherit the residual market only Strategy possible under homogeneous oligopoly (Ex: Steel, Aluminium). Cost Based Pricing Model:

o When failed to form a Cartel or to agree on leader follower model, go for Cost Based Pricing Model or Game Theory Model o Under C B P Model, each oligopolist to recognize mutual inter dependence o Each firm not to aim at profit maximizing price for itself o Each firm to determine floor price based on its A C, and experiments with alternative margins over cost o Depending on competition from rivals, raise or lower its price. No equilibrium price for any oligopolists product. Game Theory:

o Oligopolists to set their prices through the business game they play o An extreme case of non-cooperation among rivals o Each firm decide its business strategy by ascertaining the alternative strategies of its rivals
Page 120 of 166

o Depending on the strategies each adopt, there will be pay-offs (say market share). Concluding Remarks: o Difficult to determine profit-maximizing prices under oligopoly. o Instead of competing through price, compete through non-price means-product quality, service to the customers, fancy packaging, selling on credit, guarantee against their products. o Good things about oligopoly: Availability of variety of products R & D activities to face competition from rivals. o Undesirable things about oligopoly Socially suboptimal output: P > MC Excess capacity: P > min AC Wastes through promotional activities. Pricing Methods In Practice:

o Profit Maximizing Price: MR = MC o But difficult to follow this Rule: Difficult to get accurate knowledge of demand and cost conditions facing the firm o Hence to follow alternative pricing methods PRICING METHODS

Cost Strategy Based Based

Competition Based

Demand Based

Page 121 of 166

Full Cost Marginal Going Price Price Price Cost Plus Cost Rate Penetra- Skim -ming

Sealed BidPricing

Dual Disoci-

minoty tion o Cost Based Pricing: Three Methods Full Cost or Break Even Pricing P = ATC (AC) Cost Plus Pricing or Mark Up Pricing or Full Cost Pricing P = AC + mark up (Fair profit i.e a fixed percentage) Marginal Cost Pricing: P = MC C Based Pricing: Ignores consumers preference and demand. Do not realize difficulties of estimating cost. But, simple and acceptable. o Competition Based Pricing: Two Methods Going Rate Methods: Pricing according to the prevailing prices of comparable products. Price: Less than AC or more than AC. Sealed Bid Pricing Method: Ex: Construction activities and disposal of used products. Prospective buyers (sellers) to quote their prices through a sealed cover Open the bids in sealed covers in the presence of all the competitors Usually, to accept the one who quotes the least in case of buyers and most in case of sellers. o Demand Based Pricing: Dual Pricing and Price Discrimination: Possible when the market of a commodity is distinctly

Page 122 of 166

divisible into two or more segments. Each segment with different price elasticities of demand. o Strategy Based Pricing: Two Methods of Pricing a New Product
Price Penetration: To sell more of a new product,

low price (even less than cost of production) in the beginning. Jack up the price once product credibility is established. Ex: Rin Washing Soap Low price in the beginning. Now quite an expensive brand. Price Skimming Method: Price a new product high in the beginning Reduce price gradually as it faces dearth of buyers Ex: Fancy products, but of poor quality. o Bains Limit Pricing Theory A monopolist or an oligopolist to charge a price lower than the profit maximizing price to discourage new firms entering the market. But difficult for incumbents to make credible commitment to limit prices.

o Peak Load Pricing: Ex. Telephone Service higher rates during the peak load period and lower rates during period of peak. o Prudent Producer: To follow a good mix of various pricing methods, depending on the situation. 6. Alternative Theories of Firm: Consider some models/theories of firms economic behaviour.

Page 123 of 166

 of firm: o o o o o o o
o

Three broad groups of theories

Economists Theory of Firm Behavioural Models of Firm Managerial Models of Firm All the three groups are mutually related. Economists Theory of Firm: A firm: Transforms inputs/factors into products A firm: Rational economic unit Aims at profit maximization Perfect knowledge about market conditions Max Rule: MR = MC. But: 1) Firms: Aim at satisfactory level of 2) tenable 3) tenable. The assumption of certainty: Not Perfect knowledge assumption: Not

profit

o
o

Behavioural Models of Firm: Underplay the economic content of the firm.

Consider the behaviour content to explain firms conduct and performance. o Ex: Simons Behavioural Model of Rational Choice, Banmols Sales Maximizing Firm, Stacklebergs Reaction Oriented Firm, Cyert and March Behavioural Model. o Critical Ideas of Behaviourist Model: A firm: Coalition of various vested interest groups: Different departments, different levels of management, different groups of workers, shareholders, suppliers, consumers etc.

Page 124 of 166

Multiple objective of the firm: Production Goal: Output to be in certain satisfactory range Sales: Satisfactory levels of sales Market Share: Satisfactory size of market Profit Goal: Still import, but one of the multiple goals.

Study of human behaviour in terms of their relationship with the environment. Behaviour: Compromise views and interests. between conflicting

Hence satisfying behaviour: More realistic than maximizing behaviour. Managerial Models of Firm:

o Consider the difference between organization behaviour and managerial behaviour. o Organization: An entity. o Professional Managers: Individual personalities. o Organizational Goals: Aim at profit, net worth, growth and diversification. o Managers: Aim at pay, perks, promotions job security and career progression. o Managers: One of the vested interest groups. But there are others like owners, workers, suppliers, financiers and so on.
o Conflicts

of managers interests with others: organisation to satisfy all coalition partners, instead of maximizing any goal variable.

Page 125 of 166

o Ex: Marris Model of Managerial Enterprise Williamsons Model of Managerial Discretion.

1.

and

Some Important Models of Firm Behaviour: Baumols Maximization: Theory of Sales Revenue

o Sales maximization rather than profit maximization as the goal. o Modern Business: Management separated from ownership. Hence Managers discretion to pursue goals other than profit maximization. o o Managers: Choose sales maximizations. Why Sales Maximization Goal: To financial institutions: Sales as index of firms performance. Salaries and slack earnings of top management: Linked more closely to sales than to profits Sales maximization: Positively linked to market share Profits known at the end of the year. Hence sales: A better performance indicators. and

Baumol considers both static dynamic models with and without advertising.
o

2. Rate:

Marriss Theory of Maximization of Growth

o Maximize the firms balanced growth rate of demand for the firms product and of the growth of its capital supply. o Define growth rate maximization as follows:

Page 126 of 166

Gr = GD = GC Gr = Firms growth rate GD = Growth rate of demand for firms product GC = Growth rate of capital supply to the firm. A firm achieves a balanced growth rate when the growth rate of demand for its product equals the growth rate of capital supply to the firm. Maximize firms growth rate subject to two constraints viz managerial constraints (managers ability to achieve efficiency and managers own job security) and financial constraints (conflict between managers own utility function and owners own utility function). Managers Utility Function: Um = f (Salary, Power, Status, Job Security) Owners U Function: Uo = f (Profit, Capital, Output, Market Share, Public Reputation) Observe divergence between Um and Uo. But convergence into one variable viz a steady growth in the size of the firm. For Managers: GD, important For Owners: GC, important Um = f (GD) Uo = f (GC).

o Under Oligopolistic Condition: Interdependence of firms decision. When all firms try to maximize their growth rate simultaneously, limitation on the growth in demand for firms product and the supply of capital. 3. Williamsons Model: Managerial Utility Function. Maximization of

o Recall: In modern business companies, management separated from ownership.

Page 127 of 166

o Owners look for high dividends, interested in profit

maximization.

o Managers have different motives: Their own interest. o Since management is divorced from ownership, managers set the goals of the firm they manage. o Managers: To maximize their own utility function rather than maximizing profit. o Managerial utility function: Max. Um = f (S, M, ID), subject to a minimum profit S = Staff Salary M = Managerial Emoluments ID = Discretionary Investment S, M & ID are important decision variables in managerial utility function (Um).
o ID = o T

= Actual Profit o = Owners Minimum Profit T = Tax Payment ID = Balance of actual profit available for the purpose of discretionary investment (ID) ID = D = Discretionary Profit. o Simple Version of Williamsons Model: Recall: Um = f (S, M, ID) Assume: M = O Um = f (S, D), since ID = D Substitutability between S and D S can be increased only by reducing D and vice versa Select an optimum combination of S & D point of firms equilibrium. o Model holds good: When rivalry (from other firms) is not strong. Cannot deal satisfactorily with the problem of interdependence as under oligopoly.
Page 128 of 166

4.

The Behavioural Model of Cyert and March: firms satisfying behaviour model.

o This Model: An extension of Simons hypothesis of

o Recall: A firm is a coalition of different but related interest groups: Owners, managers, workers, input suppliers, customers, bankers and tax authorities. o All these groups have their own interests. o Conflicting interests/goals. o Managers to formulate a goal for the firm that reconciles the conflicting interests, by considering aspiration levels of partners. o Hence top management to set the following 5 diversified goals Production goal Inventory goal Sales goal Market share Profit goal. o Top management to achieve an overall satisfactory performance, called satisfying behaviour. o Question: How does a firm read its equilibrium level in its satisfying behaviour? The model is silent about this question. Conclusion:

o Conventional Theory of Firm: Maximizing Goal. Has greater explanatory and predictive power.

Page 129 of 166

o Alternative Theories of Firm: Not much of empirical evidence available. Still in the stage of testable hypothesis. Not possible to replace totally the conventional theory of firm, emphasizing profit maximization behaviour.

Page 130 of 166

MODULE 4: Macro Economic System and its Management. 1. Macro Economic Concerns: Micro vs Macro Economics. Major Building Blocks of Macro Economics: 1) AD & AS 2) Four Sectors: HHS, BS, GS & FTS 3) Two Markets: Commodity Market and Money Market. o o o o Specific issues to be addressed in Macro Economics: Rising Prices Rising Unemployment Falling GDP Balance of Payments Crisis.

Tools of Macro Economic Policy and Management: o Fiscal Policy o Monetary Policy o Other Policies: Trade, Price and Labour Policies.

2. The Key Macro Economic Concepts: Aggregate Supply (AS) Curve: o Describes, for each given price level, the quantity of output firms are willing to supply. AS: Upward Sloping Firms willing to supply more output at higher prices.
o

P
Pri ce Le ve l

AS

Page 131 of 166

Y Output

o ADC: Shows the combinations of the price level and level of output at which the goods and money markets are simultaneously in equilibrium. ADC: Downward Sloping At higher prices, reduction in the Value of money supply, demand for output is reduced.
o

P
Pri ce Le ve l

AD O Y Output level of output and the

o Equilibrium equilibrium price level.

AS P0 E AD O Y0 Output P0 = Equilibrium Price Level Y0 = Equilibrium Level of Output. Y

Pri ce Le ve l

Shifts in ADC and ASC:

Case 1: A Rightward shift in ADC due to an increase in nominal money stock.

Page 132 of 166

AS P1 P0 E1 E AD1 AD O Y0 Y1

Pri ce Le ve l

Pri ce Le ve l Pri ce Le ve l

Y Output

Observe new point of equilibrium (E1) and new levels of equilibrium price (P1) and output (Y1). Case 2: A leftward shift in ASC due to oil price hike or due to drought. P E1 P1 P0 E AD O Y1 Y0 Output an increase in P and Observe decrease in output. Y AS1 AS

The Keynesian and Classical ASC: Short run horizontal ASC (The Keynesian): P Assumption: Unemployment of resources

AS
Page 133 of 166

O Output

The Classical vertical ASC: P AS AS* Assumption: Full employment of resources Y Y* Y** Output ASC: Shifts right right due to growth of output overtime.
Pri ce Le ve l

Consider shifts in AD due to an increase in money supply (monetary expansion) and an increase in government expenditure (G) fiscal expansion. Case 1: The Keynesian Case: P
Pri ce Le ve l

AS AD1 AD O Y0 Y1 Y Output

An increase in output, but no change in price level

Case 2: The Classical Case: P AS P1 E1

Pri ce Le ve l

An increase in P, but no

Page 134 of 166

P0

E11 AD

change in output

AD O Y Y* Output If prices fixed(P0)horizontal supply curve, economy would move to E11 The Keynesian Equilibrium. o Long run, medium run and short run situations: Long run: Growth of productive capacity.

o MR: Output determined by a given productive capacity. Prices determined by fluctuations in AD. o SR: AD determines the use of available productive capacity. o P AS P0 AD O Y0 Y depends depends on of Output The position of ASC productive capacity of the economy. The position monetary and fiscal policies. o of ADC
Pri ce Le ve l Pri ce Le ve l

Medium run: AS and AD Diagram:

Long run AS AD Diagram: AS

Page 135 of 166

P0 AD O Y0 Output Vertical ASC: employment of resources. Assumption Full Y

ADC with ve slope. AS alone,

Output determined by prices determined by both AS and AD.

Given vertical ASC, high inflation rate due to changes in AD alone. Changes in AD due to changes in monetary and fiscal policies. o P
Pri ce Le ve l

Short Run AS AD Diagram:

P0 AD O Y0

AS

Y Output Prices constant

Assumptions: horizontal AS curve. employment.

AD: Determines level of output and

Page 136 of 166

 Growth of unemployment:

output

(say

GDP),

Inflation

and

o Potential output (Trend level of real GDP): Max amount of output that an economy can produce while maintaining price stability. o Output fluctuates around potential output or the trend level of real GDP. o >
o

Output Gap (O G) = PO AO PO = Potential Output AO = Actual Output. OG = O < ?

= Pt Pt-1 Pt-1 < = O ? > o Inflation rate and output gap: Inverse relationship? o inflation:
Rate of cha nge in Infla tion

Inflation and output gap: = Inflation rate

Rate

of

unemployment

and

rate

of

Philips Curve U E Rate (%)

o Unemployment rate and GDP relationship: Okuns Law

Gro wth Rate of real GDP

Page 137 of 166

 Inverse relationship. Vital link between output and labour market. O rate (%) U E R (%) = No. Unemployed X 100 Labour Force o Labour Force = No. Employed + No. Unemployed. 3. National Income Accounting:
o

Change in unemployment

Formal structure for Macroeconomic Models: o Production Side: AS o Demand Side: AD A measure of overall price level: Study of inflation.

A measure of performance of Macroeconomy: GDP The most comprehensive measures of total output in the economy. Two definitions of GDP: o GDP: Market value of all final goods and services and total expenditure on nations output. o GDP: Sum of all factor payments Total income. Two amplifications to the definition of GDP: o Value of output currently produced o Include only the value of final goods and services value of intermediate goods not included. Sale Value added Income Value by each generat (Rs./Uni industry ed t) (Rs.)

Product

Page 138 of 166

Bread Baking industry Flour Milling industry Wheat Agriculture Fertilizers, seeds etc. Chemical industry Total definitions of GDP.

20 11 6 1 38

9 5 5 1 20

9 5 5 1 20

Value of output = 20 Value of income = 20. Compare this with two

Three Methods of Measuring National Output: o Income Received Approach: Y = Y + Y + Yi + YR + YD o Expenditure Approach: Y=C+I+G+XM Aggregate Demand. o Value of Product Approach: Y = P1Q1 + P2Q2 + - - - + PnQn n = PiQi i=1

Nominal and Real GDP: o NGDP: GDP at current prices 1992 P NGDP 1.00 1.00 0.5 0.50 1.50
Page 139 of 166

Commodit y X Y

Q 1 1

Q 2 3

1998 P NGDP 2 4.00 0.75 2.25 6.25

 to 6.25?

Why change in NGDP from 1.50 Quantity effect Price effect.

To make valid comparisons between 1992 and 1998, compute GDP at constant prices called Real GDP. Commodit y X Y Total Q (1998) 2 3 P (1992) 1.00 0.50 RGDP (1998) 2.00 1.5 3.50

Change in GDP in 1998 due to price increase is eliminated by estimating GDP at constant prices viz price of 1992. GDP Deflator: A useful measure of inflation. GDPD = (NGDP) 1998 = 6.25 = 1.785 (RGDP) 1998 3.50 = 1998 GDP at current prices 1998 GDP at constant prices GDPD:Measures the change in prices79% increase in NGDP is due to inflation. Other Measures of National Output/Income

o GNP = GDP + factor payments from abroad factor payments to abroad o NDP = NNP = GDP Depreciation o NI = NDP = NNP indirect business taxes (Sales Tax, Excise Tax, Custom Duties) o PI = NI Corporate Social Insurance Contributions + Dividends + Government Transfer Payments + Personal Interest Income

Page 140 of 166

o DPI = PI Personal Income Tax and NonTax Payments. 4. Building Blocks of Macroeconomics: A D and A S Four Sectors: Household, Business, Government and Foreign Trade Sectors Two Markets: Commodity Market and Money Market Simultaneous equilibrium both in C M and M M. 5. Macroeconomic Models: Two, Three and Four Sector Models: Divide economy into four sectors: Household sector : C Business sector : I Government sector : G Foreign trade sector : X & M. Two Sector Macroeconomic Model: Assumptions: o Only two sectors: Household and Business Sectors o Investment already given.

The Model: Y = C + I - - - - - - - - - (1) C = a + bY - - - - - - - - - (2) I = Io - - - - - - - - - (3) o Y = N.I o C = Consumer expenditure o I = Investment expenditure, independent of current income. I Io I = Io

Page 141 of 166

o o o

O Y Value of output = AD Exogenous variable: I Endogenous Variables: Y & C

Consumption Function: C = f (Y) C = a + bY: Linear function Mathematically: a = intercept b = slope Economic interpretation:

C = a, when Y = o a is the minimum amount of consumer expenditure, even when Y=0 b = MPC = The increase in C per unit of increase in Y C = b dc = b Y dY o<b<1
Consumption demand increases with the level of

income. C = a + bY
Co ns um pti on (C)

a o

Income (Y)

Recall (1), (2) & (3) Y = C + I - - - - - - - - - - (1) C = a + bY - - - - - - - - - (2) I = Io (3)

Substitute (2) and (3) into (1)

Page 142 of 166

Y Y Y Y

= (a+bY) + Io bY = a + Io (1-b) = a + Io (E) = 1 [a + Io] - - - - - - (4) 1b

Equilibrium income: AD = AS

Ex: C = 50 + 0.8 Y I = Io = 50 Find out Y (E) and consumption expenditure. Keynesian Cross Y=C+I C, I C + I (AD)

Io a
450

Y (E) Fig: Equilibrium Income under Two Sector Model. Can you put numerical values to a, Io and Y(E), using the values from the previous example? Investment Income Multiplier: Y (E) = 1 [a + Io] 1b Let I = Change in investment expenditure Y = Corresponding change in income

Y (E) + Y = 1 1b
Y (E) + Y = 1 1b
Y =

[a + Io + I] [a + Io ] + 1 1b
I

1 1b

Page 143 of 166

Y = 1 = Investment/Income Multiplier = K. I 1-b

K = Ratio of changes in equilibrium income to changes

in I

K > o, because o < b < 1 Can you get the value of K, by using: C = 50 + 0.8 Y K=? Interpretation of value of K? The Impact of Change in I on Y (E): Diagramatic Repretation
C&I

E1

Y=C+I C+I1 (AD2), I1>I0 C+I0 (AD1)

E1 AD2 > AD1, since I1 > I0 Y

a O Y(E) Y(E) Fig: Change in equilibrium Income with change in I under Two Sector Model. Three Sector Model:
o Government Sector: G, Tx, Tr influence the economy.

Aggregate Demand: Y=C+I+G-----C = a + bYd - - - - - - Yd = Y Tx + Tr - - - - I = Io - - - - - - - - - - - - - G = Go - - - - - - - - - - - Tx = Txo - - - - - - - - - - -

(1) (2) (3) (4) (5) (6)

Page 144 of 166

Tr = Tro - - - - - - - - - - G, Tx & Variables: Y, C and Yd Tr:

(7) Variables. Endogeneous

Fiscal

Exogeneous Variables: I, G, Tx and Tro Equilibrium Income Equation: Substitute (3) into (2) C = a + b (Y Tx + Tr) C = a + bY bTx + bTr - - - - - (8) o Substitute (8), (4) and (5), into (1) Y = a + bY bTx + bTr + Io + Go - - - - - - (9) Simplify (9) Y bY = a bTx + bTr + Io + Go Y (1-b) = a bTx + bTr + Io + Go Y (E) = 1 [a bTx + bTr + Io + Go) - - - (10) 1-b Equilibrium Income Equation Value of Y = AD. AS C,I&G C+Io+Go(AD2)

E2 C+Io(AD1)

E1

Go C+Io 0 45 O Y

Y(E)1 Y(E)2 Fig: Equilibrium Income under Three Sector Model. Impact Multiplier: Y = 1 = Investment/Income Multiplier = KI
Page 145 of 166

I 1-b Y = 1 = Government Expenditure Multiplier = KG G 1-b Y = -b = Tax Multiplier = KTx Tx 1-b Y = b = Transfer Payment Multiplier = KTr Tr 1-b Observations: KI = KG Change in G affects Y
KTr > O Tr Y. Tr Y the same way as I. KG > KTr G brings about increased production of goods

and services, whereas transfer payments do not.

KTx < O Tx Y

Tx Y (Argument of supply side Economics) b = KTr 1-b Difference only in sign.

Symmetry between KTx and Tr

-b = KTx. 1-b

Change in Y(E) with change in G: Diagrammatic Representation: AS C,I&G C+Io+G1(AD2) C+Io+Go(AD1)

G1 > G0 G O
450

Y(E) Y(E)1 Fig: Impact of change in G, keeping C & I constant.

Page 146 of 166

6. Aggregate Demand and Aggregate Supply Curves: Recall the definitions of A D and A S Curves: o A D C: ADC depicts the level of output (Y) for each given price (P) level. The level of output (Y) at which commodity and money markets are in equilibrium. P and Y are inversely related.

o A S C: ASC depicts the quantity of output (Y) firms are willing to supply at each given price level. P P* AD Y Y* Output o The classical AS and AD curves: Vertical AS curve, because of assumption of full employment of resources in the long run. P P1 P0 AD1
Page 147 of 166

P and Y are directly related. AS

AS

AD0 O Yf Y Output

In the long run, output is determined by AS alone, and prices are determined both both AS and AD. Inflation, due to rightward shifts in AD, and deflation due to leftward shifts in AD. In the classical case, shifts in AD due to change in money supply. Inflation/deflation due to change in money supply. o The Keynesian Case: AD and AS in the Short Run. Horizontal Supply Curve: Price pegged at a particular level, and output can take any value. P Downward Sloping AD Curve:

P0
AD0

AS
AD1

O Y0

Y Y1 Output

Fluctuations in output due to shifts in AD curve alone. Prices are unaffected by the level of output in the S. R. Establishes the dominant role of AD (in the Keynesian Macroeconomic Model) in influencing output and employment. 7. IS LM Analysis:

Page 148 of 166

 Two main markets in Macroeconomic System commodity or goods market and Money Market.

Commodity Market Equilibrium: Value of national output = Value of spending by functional sectors.

Money Market Equilibrium: Demand for real money balances = Supply of real money balances. Composition of Money Stock. o M1 = Can be used directly and instantly for making payments. M1 corresponds mostly closely to the traditional definition of money as the means of payment M1 is perfectly liquid.

Needed

for

day

to

day

transactions. M1 = Currency + demand deposits (non-interest bearing checking accounts) + travellers checks + other checkable deposits (interest-earning checking accounts). o M2 = M1 + claims not instantly liquid (Ex: time deposits, mutual fund shares etc). o change. Now stock of money undergoing

o Commodity Market Equilibrium Curve (IS-Curve) and Money Market Equilibrium Curve: Simultaneous General Equilibrium: * IS
Page 149 of 166

LM

Ra te of int ere st

Y Y* Output (Income)

* = Equilibrium rate of interest Y* = Equilibrium output/income.

IS Curve Shifters and LM Curve Shifters: IS Curve Shifters: O R C

I, G and Tx: Major ones

An increase in I, due to optimistic expectations of business firms R.W.S in IS Curve (IS1). A decrease in I, due to pessimistic expectations of business firms LWS in ISC (IS2). ** * *** E2 E1

LM0

E3 IS1 IS0 IS2

O Y*** Y* Y**

Observe: Shifts in points of equilibrium and changes in and Y. in G alone:

An

increase/decrease

RW/LW shift in IS Curve Changes in and Y. Draw Diagrams

Page 150 of 166

 in Tx alone:

An

increase/decrease

LW/RW shifts in IS Curve Changes in and Y. Draw Diagrams

o LM Curve Increase/Decrease in Stock of Money money alone

Shifts:

An

An increase in stock of RWS in LMC A decrease in stock of LWS in LMC

money alone

*** * **

LM2 LM0 LM1 E3 E1 E2 IS0 Y Y** Y* Y**

Observe: Shifts in points of equilibrium and changes in and Y. o Policies. LM0 LM1
Page 151 of 166

Changes in both Fiscal and Monetary

E1 * IS1 IS0 O Y Y* Y* Fig: Expansionary F P and M P LM1 LM0 ** * IS1 IS0 O Y Y* Fig: Expansionary F S and contractionary M P E2

8. Crowding Model: AD curves: P

Out

In

The

Classical

Macroeconomic

Recall the classical AS and

AS P** P* AD1 AD Y

Page 152 of 166

Y*
o

Output

Y* = Full employment level of output output does not change at f. E. level. With fiscal expansion (G), AD shifts to right side AD .
o
1

o With an increase in G, private sector spending less private spending fallen by precisely the amount that government spending has risen. Full crowding out effect. Every rupee increase in G is offset by a rupee reduction in private spending.
o

Model: 1 E 0 E1 LM

Crowding out in IS LM

E11 IS1 IS

O Y0 Y1 Y2

o Let there be an increase in G Expansionary fiscal policy.

o Rightward

shift in IS curve (Commodity Market Equilibrium Curve) Increase in Y from Y0 to Y1 (E1= New equilibrium point).
o Increase in from 0 to 1. o If remains at 0, increase in Y from Y0 to Y2. But Y

increase from Y0 to Y1 only.

Page 153 of 166

o Reason:

spending.

I crowding out of investment

o Why crowding out effect?

o Expansionary fiscal policy causes to rise, thereby

reducing private spending, particularly investment.

o How to prevent fall in investment by business sector?

Keep constant at 0 by shifting LM curve (Money Market Equilibrium Curve) to right side Increase in Y from Y0 to Y2.
o Message:

Expansionary fiscal policy to be accompanied by expansionary monetary policy to realize the full impact of expansionary fiscal policy. 9. Supply Side Economics: The Keynesian prescription for changing GDP Employment: Management of aggregate demand. S S Economics: Shift in emphasis from AD to AS. o Make the suppliers (corporate sector) happy to make the economy better. Lower taxes Less government spending Less government regulation Less labour union power in wage determination. Every thing that promotes profit. and

o S.S.E: Possible to lower rates of inflation and unemployment. o Ex: Lower tax rates

Page 154 of 166

 An increase in consumer demand due to increased disposable income Lower corporate tax rates inducement to increase AS.

o Diagrammatic representations of S.S.E: P AS AS1 Lower price level Higher R G D P More employment Okuns Law). AD O Y* Y** Y Output/R G D P Keynesian

P* P** (Recall

o Similarity and dissimilarity between prescription and the S.S.E prescription:

Both Keynesian and S.S.E prescription: Government policy needed. Difference: K Model: Emphasise AD Management SSE Model: Emphasise AS Management. 10. Unemployment:

Unemployment and GDP growth: Types of U. E: o Voluntary U. E: Lack of willingness to accept the available jobs More of a psychological problem than an economic problem.

Page 155 of 166

o Involuntary U. E:

Lack of jobs Occurs during the period of U. Also called cyclical U. E or E. Also called Keynesian Deficiency of AD: Cause of

economic depression

depressionary unemployment

this kind of U. E.

Kinds of Involuntary U. E: o Structural U. E: Deficiency of stock of capital in relation to needs of growing labour force Capital formation lags behind availability of labour force. o Seasonal U. E: Seasonal character of certain production activities like agriculture, rice mills etc. Not sufficient work available during slack season.

o Frictional U. E: Out of work, due to lack of perfect mobility of workers Also called unemployment between jobs Due to decline in some activities and expansion of some other activities. Ex: Earthern pot / Vessel makers.

o Disguised U. E or underemployment: Common in overpopulated countries Low/zero marginal productivity of labour Underemployment due to underdevelopment
Page 156 of 166

Ex: Labour Agriculture: Not fully employed.

force

in

11.

Inflation: Kinds, Causes and Remedies:

The Concepts: o Inflation: Persistent general rise in price level or persistent fall in purchasing power of money. o Rate of Inflation: The percentage change in overall level of prices. Recall: = o Hyper Inflation: Rate of inflation exceeds 50% per month. In 1923, rise in price by 500% per moth in Germany. o Deflation: Persistent fall in price level or persistent rise in purchasing power of money. o Creeping Inflation: A single digit inflation Encouraging to faster growth of output. o Galloping Inflation: Double or treble digit rates per annum say from 20% to 100% per annum. o Stagflation: Combination of high and accelerating inflation and high unemployment and low GDP. Causes and Kinds of Inflation: o May get generated either from demand or supply side or both. o On the demand side: Due to availability of more money income (expenditure) for a given volume of output. o On the supply side: Due to wagepush, profitpush and supply shocks (like drought and oil price hike by OPEC). o Price expectations also contribute for inflation: Higher the elasticity of price expectations, larger the marginal rate of inflation. Demand Pull Inflation:
o AD > AS P due to excess demand

o An increase in AD: Due to G , C or I

Page 157 of 166

o A diagrammatic representation of D P I: P AS P2 P1 AD1 AD0 O YF Output Y

Observe two segments of AS curve:

First segment: +ve relationship between output (Y) and price level Second segment: Vertical AS curve Full employment level of output (YF) Shift in AD to right side (AD1) (Due to an increase in: G or I or decrease in Tx) P from P1 to P2. o Monetarist view of D P I: M > M AD P P S P D Supply of real money balances > Demand for real money balances. Milton Friedman: Inflation is always and every where a monetary phenomenon. It can be produced only by a more rapid increase in the quantity of money than in output. Cost Push Inflation: o No increase in AD, still P when wage rate without any corresponding increase in productivity. Wage push inflation.

Page 158 of 166

o Aggressive increase in wage rates and or material

prices. o Diagrammatic representation of Cost-push inflation: P AS1 AS0

P** P* O Y** Y* AD0 Y Output

o Profit-push inflation under monopolistic and oligopolistic

market situations cost-push inflation occurs due to non-wage factors also. Effects of Inflation: o Erosion of real income or purchasing power o Effects on debtors and creditors o Effects on fixed income group (pensioners) o Effects on wealth holders of cash, deposits etc o Effects on government income: An increase in tax income both personal and corporate income taxes o Inflation and labour productivity: Inflation Labour unrest Low labour productivity o Inflation and Marketing: Consumers, becoming more sensitive to rise in price A reduced rate of growth in real demand for goods and services A shift in expenditure away from non-essential goods and services. o Inflation and interest rate: Inflation High rate of interest. Control of Inflation:

Page 159 of 166

o Monetary Policy: Use bank rate policy, open market operations, cash reserve ratio and selective credit controls to control inflation. Credit Squeeze. o Fiscal Policy: Reducing Budget Deficit G Tx o Income Policy: Wage Control o Price Control: of essential commodities o Increase utilization of productive capability to raise A S o Enlarge imports to tide over shortage of some commodies All these measures to bridge the gap between AS and AP. o Indexation: Make adjustments in monetary returns to offset losses in real income due to inflation (Indexing introduced in Brazil for wages etc.).

Page 160 of 166

MODULE 5: Indian Economy 1. Economic Reforms and Structural Adjustments In India Since 1991. Paradigm Shifts In Macroeconomic Policy: Adam Smith: Laissez faire Market Economy Alfred Marshall: Glorification of capitalism and market economy Karl Marx: Destruction of capitalistic system and market economy J. M. Keynes: Market economy with government interference 1950s and 1960s: Planning and public sector fundamentalism 1970s: Decade of the development of the poor 1980s onwards: Revival of market economy paradigm Back to Adam Smith?

Four Decades of Economic Policy Regime In India: 1950 1990: Planning Public Sector Regulation Fundamentalism Planning: A panacea Public sector dominance Protection of agriculture, industry and trade Self reliance and import substitution Inward looking development strategy. Performance Record During Old Policy Regime: Respectable GDP growth Good performance in agriculture: Green Revolution India: On the industrial map of the world Development of science and technology and a large pool of scientific and technological manpower But three dark spots of development.
Page 161 of 166

Economic Reforms During 1980s: The First Wave: Improvement in productivity Absorption of modern technology Fuller utilization of production capacity Larger scope to private sector Foreign equity capital Remove controls and restrictions gradually.

Economic Reforms Since 1991: The Second Wave: U turn from planning Public Sector Fundamentalism to Market-Private Sector Fundamentalism. Huge budget deficit Balance of payments crisis: Foreign exchange reserves (About $15 billion) to meet two weeks imports Low global credit rating Over 13 rate of inflation Western ideologies and propaganda Collapse of planned economies in the Soviet Block Problem of demand management in developed economies Prescriptions of IMF & World Bank Ideology of Indian elite Disenchantment with 40 years of inward looking development strategies Hence change of track in July, 1991. Contours of New Economic Policy Since July, 1991: Stabilization and Demand Management: Reduce budget deficit Control inflation Reduce deficit in balance of payments.

Page 162 of 166

 Structural Adjustment Programme (SAP) and Supply Management: Liberate economic agents Delicense, dereserve and deprotect industry, agriculture and trade Dismantle import license Reduce tariff rates and remove quantitative restructions Privatize and allow FDI Disinvest in public sector industries Reduce taxes Allow market forces to govern Exchange Rates. Performance of Indian Economy Since 1991: Major Performance Variables: GDP growth rate Employment generation Reduction of population living below poverty

line Promotion of equity leading to a better deal for the poor and less well-off sections of our society Reduction in regional disparities between the rich and the poor states of India. GDP Growth Rate: 1993 94 to 1997 98: More than 7% growth rate per annum. GDP growth rate slowed down after: 2000 01: 5.2% 2001 02: Around 5% 2002 03: 4.3 After: Some recovery Alternatively: 1980/81 1990/91: 5.6% GDP growth rate 1990/91 2000/01: 5.6% GDP growth rate

Page 163 of 166

Question: Has substantially.

E.R

accelerated

GDP

growth

rate

Economic Reforms and Employment Growth

Rate of unemployment: 6.03% (1993 94)

Rate of unemployment: 7.32% (1999 00)

Employment Elasticity of Output:

1980s and early 1990s: 0.52% Late 1990s: 0.16 Job creation per unit of output has decreased
Downsizing of public sector Increased capital intensity per unit of output Growth

pattern intensive sectors.

moving

in

favour

of

capital

Economic Reforms and Reduction of Poverty Poverty reduction over 1983 to 1990/91: 3.1% per annum Poverty reduction in 1990s: 1% per annum In rural sector the rate of reduction in poverty: Almost zero and in urban sector higher rate of reduction in poverty RuralUrban divide.

Neglect of Agriculture Sector The emphasis of reform process, more on service and manufacturing sectors and lesson agricultural sector. 3.8% growth rate in agriculture during eighties and 1.73% during nineties. HD Report (2003): Indias rank 127th out of 175 Countries

Foreign Exchange Reserves: $5.83 billion in 1990 91. Now: $143 billions Rate of inflation: From about 13% in 1990 91 to a little over 4% now.

Page 164 of 166

 Economic Reforms and increased development disparities between states Economic Reforms: Mixed Results. LPG regime: Profit motive dominant, equity goal less emphasised. To illustrate:
Millions of Indians are connected to the internet,

but millions more are not yet connected to fresh water: India accounts for 30% of the Worlds software engineers but also 25% of the Worlds malnourished.
India has one of the Worlds largest reservoirs of

technical personnel but also the Worlds largest pool of illiterates and poor people.
Paradox: Proud of 311 Indian billionaries? But

about 300 million people below poverty line A Country of super rich and super poor.
Hence the Challenge:

o Tap the benefits of LPG regime, but address the problems of equity such as unemployment, poverty and inequalities. Any development paradigm which ignores the many poor for the few rich is not sustainable.
o

o Remember: Micro level success stories would obscure the macro picture the picture of dark spots of Indian development.

Page 165 of 166

Page 166 of 166