You are on page 1of 26

Managerial economics as defined by Edwin Mansfield is "concerned with application of economic concepts and economic analysis to the problems

of formulating rational managerial decision."[1] It is sometimes referred to as business economics and is a branch of economics that applies microeconomic analysis to decision methods of businesses or other management units. As such, it bridges economic theory and economics in practice.[2] It draws heavily from quantitative techniques such as regression analysis and correlation, calculus.[3] If there is a unifying theme that runs through most of managerial economics, it is the attempt to optimize business decisions given the firm's objectives and given constraints imposed by scarcity, for example through the use of operations research, mathematical programming, game theory for strategic decisions,[4] and other computational methods.[5] Managerial decision areas include:

assessment of investible funds selecting business area choice of product determining optimum output determining price of product determining input-combination and technology sales promotion.

Almost any business decision can be analyzed with managerial economics techniques, but it is most commonly applied to:

Risk analysis - various models are used to quantify risk and asymmetric information and to employ them in decision rules to manage risk.[6] Production analysis - microeconomic techniques are used to analyze production efficiency, optimum factor allocation, costs, economies of scale and to estimate the firm's cost function. Pricing analysis - microeconomic techniques are used to analyze various pricing decisions including transfer pricing, joint product pricing, price discrimination, price elasticity estimations, and choosing the optimum pricing method. Capital budgeting - Investment theory is used to examine a firm's capital purchasing decisions.[7]

At universities, the subject is taught primarily to advanced undergraduates and graduate business schools. It is approached as an integration subject. That is, it integrates many concepts from a wide variety of prerequisite courses. In many countries it is possible to read for a degree in Business Economics which often covers managerial economics, financial economics, game theory, business forecasting and industrial economics. Scope of Managerial economics Managerial economics to a certain degree is prescriptive in nature as it suggests course of action to a managerial problem. Problems can be related to various departments in a firm like production, finance, accounts, sales, marketing etc.

1. 2.

Demand decision Production decision

Demand decision Demand refers to the willingness to buy a commodity. Demand, here, defines the market size for a commodity i.e. who will buy the commodity. Analysis of the demand is important for a firm as it's revenue, profits, income of the employees depends on it. [8] Production decision A firm needs to answer four basic questions - what to produce, how to produce and how much to produce and for whom to produce.

What to produce? A firm will produce according to its perception of the customer demand. It can either produce consumer goods like food, clothing etc. (which are for consumption purpose) or it can produce capital goods like machinery etc. (which are for investment purposes). How to produce? Goods can be produced by certain techniques. Firms have the option of producing goods by labour intensive technique and capital intensive technique. Labour intensive technique is the one in which manual labour is used to produce goods. Capital intensive technique is the one in which machinery like forklift, assembly belts etc. are used to produce goods. How much to produce? A firm has to decide its production capacity and also how much of their good a consumer needs and produce accordingly. For whom to produce? A firm has to decide its target population (i.e. to whom they will serve products and/or services). Example, it will not be viable to produce luxurious goods or middle income or low income group if they can't afford it and produce basic necessity goods for rich class if they don't need it. Therefore, a firm needs to match its produce according to the target population it is serving. Managerial Economics: Demand Analysis Demand Demand is the quantity of good and services that customers are willing and able purchase during a specified period under a given set of economic conditions. The period here could be an hour, a day, a month, or a year. income, the price of the related goods, consumers preferences, advertising expenditures and so on. The amount of the product that the costumers are willing to by, or the demand, depends on these factors. There are two types of demand. The first of these is called direct services that directly satisfy consumers desires. The prime determinant of direct demand is the utility gained by consumption of goods and services. Consumers budget, product characteristics, individuals preferences are all important determinants of direct demand. The other type of demand is called derived demand. Derived demand is the demand resulting from the need to provide the final goods and services to the consumers. Intermediate goods, office machines are Mortgage credit demand is not demanded directly, but derived from the demand for housing. 2 Market demand function The market demand function for a product is a function showing the relation between the quantity demanded and the factors affecting the quantity of demand. A demand function for the good X can be expressed as follows: Quantity of product X demanded = Qx = f (the price of X, prices of related goods, expectations of price changes, income, preferences, advertising expenditures and so on. ) For use in managerial decision making, the relation between quantity of demand and each demand determining variable must be specified. To illustrate this, the demand function for automobile industry is .

Production function In microeconomics and macroeconomics, a production function is a function that specifies the output of a firm, an industry, or an entire economy for all combinations of inputs. This function is an assumed technological relationship, based on the current state of engineering knowledge; it does not represent the result of economic choices, but rather is an externally given entity that

influences economic decision-making. Almost all economic theories presuppose a production function, either on the firm level or the aggregate level. In this sense, the production function is one of the key concepts of mainstream neoclassical theories. Some nonmainstream economists, however, reject the very concept of an aggregate production function. Concept of production functions In micro-economics, a production function is a function that specifies the output of a firm for all combinations of inputs. A metaproduction function (sometimes metaproduction function) compares the practice of the existing entities converting inputs into output to determine the most efficient practice production function of the existing entities, whether the most efficient feasible practice production or the most efficient actual practice production.[3]clarification needed In either case, the maximum output of a technologicallydetermined production process is a mathematical function of one or more inputs. Put another way, given the set of all technically feasible combinations of output and inputs, only the combinations encompassing a maximum output for a specified set of inputs would constitute the production function. Alternatively, a production function can be defined as the specification of the minimum input requirements needed to produce designated quantities of output, given available technology. It is usually presumed that unique production functions can be constructed for every production technology. By assuming that the maximum output technologically possible from a given set of inputs is achieved, economists using a production function in analysis are abstracting from the engineering and managerial problems inherently associated with a particular production process. The engineering and managerial problems of technical efficiency are assumed to be solved, so that analysis can focus on the problems of allocative efficiency. The firm is assumed to be making allocative choices concerning how much of each input factor to use and how much output to produce, given the cost (purchase price) of each factor, the selling price of the output, and the technological determinants represented by the production function. A decision frame in which one or more inputs are held constant may be used; for example, (physical) capital may be assumed to be fixed (constant) in the short run, and labour and possibly other inputs such as raw materials variable, while in the long run, the quantities of both capital and the other factors that may be chosen by the firm are variable. In the long run, the firm may even have a choice of technologies, represented by various possible production functions. The relationship of output to inputs is non-monetary; that is, a production function relates physical inputs to physical outputs, and prices and costs are not reflected in the function. But the production function is not a full model of the production process: it deliberately abstracts from inherent aspects of physical production processes that some would argue are essential, including error, entropy or waste. Moreover, production functions do not ordinarily model the business processes, either, ignoring the role of management. (For a primer on the fundamental elements of microeconomic production theory, see production theory basics). The primary purpose of the production function is to address allocative efficiency in the use of factor inputs in production and the resulting distribution of income to those factors. Under certain assumptions, the production function can be used to derive a marginal product for each factor, which implies an ideal division of the income generated from output into an income due to each input factor of production. Specifying the production function A production function can be expressed in a functional form as the right side of

where: quantity of output quantities of factor inputs (such as capital, labour, land or raw materials).

If Q is not a matrix (i.e. a scalar, a vector, or even a diagonal matrix), then this form does not encompass joint production, which is a production process that has multiple co-products. On the other hand, if f maps from Rn to Rk then it is a joint production function expressing the determination of k different types of output based on the joint usage of the specified quantities of the n inputs. One formulation, unlikely to be relevant in practice, is as a linear function:



are parameters that are determined empirically.

Another is as a Cobb-Douglas production function:

The Leontief production function applies to situations in which inputs must be used in fixed proportions; starting from those proportions, if usage of one input is increased without another being increased, output will not change. This production function is given by

Other forms include the constant elasticity of substitution production function (CES), which is a generalized form of the Cobb-Douglas function, and the quadratic production function. The best form of the equation to use and the values of the parameters ( a short run production function at least one of the variable at the discretion of management. [edit]Production function as a graph Any of these equations can be plotted on a graph. A typical (quadratic) production function is shown in the following diagram under the assumption of a single variable input (or fixed ratios of inputs so the can be treated as a single variable). All points above the production function are unobtainable with current technology, all points below are technically feasible, and all points on the function show the maximum quantity of output obtainable at the specified level of usage of the input. From the origin, through points A, B, and C, the production function is rising, indicating that as additional units of inputs are used, the quantity of output also increases. Beyond point C, the employment of additional units of inputs produces no additional output (in fact, total output starts to decline); the variable input is being used too intensively. With too much variable input use relative to the available fixed inputs, the company is experiencing negative marginal returns to variable inputs, and diminishing total returns. In the diagram this is illustrated by the negative marginal physical product curve (MPP) beyond point Z, and the declining production function beyond point C. From the origin to point A, the firm is experiencing increasing returns to variable inputs: As additional inputs are employed, output increases at an increasing rate. Both marginal physical product (MPP, the derivative of the production function) and average physical product (APP, the ratio of output to the variable input) are rising. The inflection point A defines the point beyond which there are diminishing marginal returns, as can be seen from the declining MPP curve beyond point X. From point A to point C, the firm is experiencing positive but decreasing marginal returns to the variable input. As additional units of the input are employed, output increases but at a decreasing rate. Point B is the point beyond which there are diminishing average returns, as shown by the declining slope of the average physical product curve (APP) beyond point Y. Point B is just tangent to the steepest ray from the origin hence the average physical product is at a maximum. Beyond point B, mathematical necessity requires that the marginal curve must be below the average curve (See production theory basics for further explanation.). Stages of production ) vary from company to company and industry to industry. In 's (inputs) is fixed. In the long run all factor inputs are

To simplify the interpretation of a production function, it is common to divide its range into 3 stages. In Stage 1 (from the origin to point B) the variable input is being used with increasing output per unit, the latter reaching a maximum at point B (since the average physical product is at its maximum at that point). Because the output per unit of the variable input is improving throughout stage 1, a price-taking firm will always operate beyond this stage. In Stage 2, output increases at a decreasing rate, and the average and marginal physical product are declining. However, the average product of fixed inputs (not shown) is still rising, because output is rising while fixed input usage is constant. In this stage, the employment of additional variable inputs increases the output per unit of fixed input but decreases the output per unit of the variable input. The optimum input/output combination for the price-taking firm will be in stage 2, although a firm facing a downwardsloped demand curve might find it most profitable to operate in Stage 1. In Stage 3, too much variable input is being used relative to the available fixed inputs: variable inputs are over-utilized in the sense that their presence on the margin obstructs the production process rather than enhancing it. The output per unit of both the fixed and the variable input declines throughout this stage. At the boundary between stage 2 and stage 3, the highest possible output is being obtained from the fixed input. Shifting a production function By definition, in the long run the firm can change its scale of operations by adjusting the level of inputs that are fixed in the short run, thereby shifting the production function upward as plotted against the variable input. If fixed inputs are lumpy, adjustments to the scale of operations may be more significant than what is required to merely balance production capacity with demand. For example, you may only need to increase production by a million units per year to keep up with demand, but the production equipment upgrades that are available may involve increasing productive capacity by 2 million units per year. Homogeneous and homothetic production functions There are two special classes of production functions that are often analyzed. The production function said to be homogeneous of degree n, if given any positive constant If , . . If it is is

, the function exhibits increasing returns to scale, and it exhibits decreasing returns to scale if

homogeneous of degree 1, it exhibits constant returns to scale. The presence of increasing returns means that a one percent increase in the usage levels of all inputs would result in a greater than one percent increase in output; the presence of decreasing returns means that it would result in a less than one percent increase in output. Constant returns to scale is the in-between case. In the Cobb-Douglas production function referred to above, returns to scale are increasing if if , and constant if . , decreasing

If a production function is homogeneous of degree one, it is sometimes called "linearly homogeneous". A linearly homogeneous production function with inputs capital and labour has the properties that the marginal and average physical products of both capital and labour can be expressed as functions of the capital-labour ratio alone. Moreover, in this case if each input is paid at a rate equal to its marginal product, the firm's revenues will be exactly exhausted and there will be no excess economic profit. [4]:pp.412-414 Homothetic functions are functions whose marginal technical rate of substitution (the slope of the isoquant, a curve drawn through the set of points in say labour-capital space at which the same quantity of output is produced for varying combinations of the inputs) is homogeneous of degree zero. Due to this, along rays coming from the origin, the slopes of the isoquants will be the same. Homothetic functions are of the form of is positive ( )), and the function where is a monotonically increasing function (the derivative is a homogeneous function of any degree.

Aggregate production functions

In macroeconomics, aggregate production functions for whole nations are sometimes constructed. In theory they are the summation of all the production functions of individual producers; however there are methodological problems associated with aggregate production functions, and economists have debated extensively whether the concept is valid. [2] Criticisms of production functions There are two major criticisms of the standard form of the production function. On the history of production functions, see Mishra (2007).[5] On the concept of capital During the 1950s, '60s, and '70s there was a lively debate about the theoretical soundness of production functions. (See the Capital controversy.) Although the criticism was directed primarily at aggregate production functions, microeconomic production functions were also put under scrutiny. The debate began in 1953 when Joan Robinson criticized the way the factor input capital was measured and how the notion of factor proportions had distracted economists. According to the argument, it is impossible to conceive of capital in such a way that its quantity is independent of the rates of interest and wages. The problem is that this independence is a precondition of constructing an isoquant. Further, the slope of the isoquant helps determine relative factor prices, but the curve cannot be constructed (and its slope measured) unless the prices are known beforehand. On the empirical relevance As a result of the criticism on their weak theoretical grounds, it has been claimed that empirical results firmly support the use of neoclassical well behaved aggregate production functions. Nevertheless, Anwar Shaikh[6] has demonstrated that they also have no empirical relevance, as long as alleged good fit outcomes from an accounting identity, not from any underlying laws of production/distribution. Natural resources Often natural resources are omitted from production functions. When Solow and Stiglitz sought to make the production function more realistic by adding in natural resources, they did it in a manner that economist Georgescu-Roegen criticized as a "conjuring trick" that failed to address the laws of thermodynamics, since their variant allows capital and labour to be infinitely substituted for natural resources. Neither Solow nor Stiglitz addressed his criticism, despite an invitation to do so in the September 1997 issue of the journal Ecological Economics.[1] For more recent retrospectives, see Cohen and Harcourt [2003] and Ayres-Warr (2009) Production Function The production function relates the output of a firm to the amount of inputs, typically capital and labor. It is important to keep in mind that the production function describes technology, not economic behavior. A firm may maximize its profits given its production function, but generally takes the production function as a given element of that problem. (In specialized long-run models, the firm may choose its capital investments to choose among production technologies.) The EconModel application The Demand for Labor emphasize the role of the production function and marginal product in determining the profit-maximizing demand for labor.

Cost curve In economics, a cost curve is a graph of the costs of production as a function of total quantity produced. In a free market economy, productively efficient firms use these curves to find the optimal point of production (minimising cost), and profit maximizing firms can use them to decide output quantities to achieve those aims. There are various types of cost curves, all related to each other, including total and average cost curves, and marginal ("for each additional unit") cost curves, which are the equal to the differential of the total cost curves. Some are applicable to the short run, others to the long run.

Short-run average variable cost curve (SRAVC) Average variable cost (which is a short-run concept) is the variable cost (typically labor cost) per unit of output: SRAVC = wL / Q where w is the wage rate, L is the quantity of labor used, and Q is the quantity of output produced. The SRAVC curve plots the short-run average variable cost against the level of output, and is typically drawn as U-shaped. Short-run average total cost curve (SRATC or SRAC) The average total cost curve is constructed to capture the relation between cost per unit of output and the level of output, ceteris paribus. A perfectly competitive and productively efficient firm organizes its factors of production in such a way that theaverage cost of production is at the lowest point. In the short run, when at least one factor of production is fixed, this occurs at the output level where it has enjoyed all possible average cost gains from increasing production. This is at the minimum point in the diagram on the right. Short-run total cost is given by STC = PKK+PLL, where PK is the unit price of using physical capital per unit time, P L is the unit price of labor per unit time (the wage rate), K is the quantity of physical capital used, and L is the quantity of labor used. From this we obtain short-run average cost, denoted either SATC or SAC, as STC / Q: SRATC or SRAC = PKK/Q + PLL/Q = PK / APK + PL / APL, where APK = Q/K is the average product of capital and APL = Q/L is the average product of labor.[1]:191 Short run average cost equals average fixed costs plus average variable costs. Average fixed cost continuously falls as production increases in the short run, because K is fixed in the short run. The shape of the average variable cost curve is directly determined by increasing and then diminishing marginal returns to the variable input (conventionally labor). [2]:210 Long-run average cost curve (LRAC) The long-run average cost curve depicts the cost per unit of output in the long runthat is, when all productive inputs' usage levels can be varied. All points on the line represent least-cost factor combinations; points above the line are attainable but unwise, while points below are unattainable given present factors of production. The behavioral assumption underlying the curve is that the producer will select the combination of inputs that will produce a given output at the lowest possible cost. Given that LRAC is an average quantity, one must not confuse it with the long-run marginal cost curve, which is the cost of one more unit.[3]:232 The LRAC curve is created as an envelope of an infinite number of short-run average total cost curves, each based on a particular fixed level of capital usage.[3]:235 The typical LRAC curve is U-shaped, reflecting increasing returns of scale where negatively-sloped, constant returns to scale where horizontal and decreasing returns (due to increases in factor prices) where positively sloped.[3]:234 Contrary to Viner[citation needed], the envelope is not created by the minimum point of each short-run average cost curve.[3]:235 This mistake is recognized as Viner's Error.[citation needed] In a long-run perfectly competitive environment, the equilibrium level of output corresponds to the minimum efficient scale, marked as Q2 in the diagram. This is due to the zero-profit requirement of a perfectly competitive equilibrium. This result, which implies production is at a level corresponding to the lowest possible average cost,[3]:259 does not imply that production levels other than that at the minimum point are not efficient. All points along the LRAC are productively efficient, by definition, but not all are equilibrium points in a long-run perfectly competitive environment. In some industries, the bottom of the LRAC curve is large in comparison to market size (that is to say, for all intents and purposes, it is always declining and economies of scale exist indefinitely). This means that the largest firm tends to have a cost advantage, and

the industry tends naturally to become a monopoly, and hence is called a natural monopoly. Natural monopolies tend to exist in industries with high capital costs in relation to variable costs, such as water supply and electricity supply.[3]:312 Short-run marginal cost curve (SRMC) A short-run marginal cost curve graphically represents the relation between marginal (i.e., incremental) cost incurred by a firm in the short-run production of a good or service and the quantity of output produced. This curve is constructed to capture the relation between marginal cost and the level of output, holding other variables, like technology and resource prices, constant. The marginal cost curve is U-shaped. Marginal cost is relatively high at small quantities of output; then as production increases, marginal cost declines, reaches a minimum value, then rises. The marginal cost is shown in relation to marginal revenue, the incremental amount of sales revenue that an additional unit of the product or service will bring to the firm. This shape of the marginal cost curve is directly attributable to increasing, then decreasing marginal returns (and the law of diminishing marginal returns). Marginal cost equals w/MPL.[1]:191 For most production processes the marginal product of labor initially rises, reaches a maximum value and then continuously falls as production increases. Thus marginal cost initially falls, reaches a minimum value and then increases. [2]:209 The marginal cost curve intersects both the average variable cost curve and (short-run) average total cost curve at their minimum points. When the marginal cost curve is above an average cost curve the average curve is rising. When the marginal costs curve is below an average curve the average curve is falling. This relation holds regardless of whether the marginal curve is rising or falling. Long-run marginal cost curve (LRMC) The long-run marginal cost curve shows for each unit of output the added total cost incurred in the long run, that is, the conceptual period when all factors of production are variable so as minimize long-run average total cost. Stated otherwise, LRMC is the minimum increase in total cost associated with an increase of one unit of output when all inputs are variable. [4] The long-run marginal cost curve is shaped by economies and diseconomies of scale, a long-run concept, rather than the law of diminishing marginal returns, which is a short-run concept. The long-run marginal cost curve tends to be flatter than its short-run counterpart due to increased input flexibility as to cost minimization. The long-run marginal cost curve intersects the long-run average cost curve at the minimum point of the latter.[1]:208 When long-run marginal costs are below long-run average costs, long-run average costs are falling (as to additional units of output).[1]:207When long-run marginal costs are above long run average costs, average costs are rising. Long-run marginal cost equals short run marginal-cost at the least-long-run-average-cost level of production. LRMC is the slope of the LR total-cost function. Cost curves and production functions Assuming that factor prices are constant, the production function determines all cost functions. [2] The variable cost curve is the inverted short-run production function or total product curve and its behavior and properties are determined by the production function.[1]:209 [nb 1] Because the production function determines the variable cost function it necessarily determines the shape and properties of marginal cost curve and the average cost curves.[2] If the firm is a perfect competitor in all input markets, and thus the per-unit prices of all its inputs are unaffected by how much of the inputs the firm purchases, then it can be shown[5][6][7] that at a particular level of output, the firm has economies of scale (i.e., is operating in a downward sloping region of the long-run average cost curve) if and only if it has increasing returns to scale. Likewise, it has diseconomies of scale (is operating in an upward sloping region of the long-run average cost curve) if and only if it has decreasing returns to scale, and has neither economies nor diseconomies of scale if it has constant returns to scale. In this case, with perfect competition in the output market the long-run market equilibrium will involve all firms operating at the minimum point of their long-run average cost curves (i.e., at the borderline between economies and diseconomies of scale). If, however, the firm is not a perfect competitor in the input markets, then the above conclusions are modified. For example, if there are increasing returns to scale in some range of output levels, but the firm is so big in one or more input markets that increasing its purchases of an input drives up the input's per-unit cost, then the firm could have diseconomies of scale in that range of output levels. Conversely, if the firm is able to get bulk discounts of an input, then it could have economies of scale in some range of output levels even if it has decreasing returns in production in that output range.

Relationship between different curves

Total Cost = Fixed Costs (FC) + Variable Costs (VC) Marginal Cost (MC) = dC/dQ; MC equals the slope of the total cost function and of the variable cost function Average Total Cost (ATC) = Total Cost/Q Average Fixed Cost (AFC) = FC/Q Average Variable Cost = VC/Q. ATC = AFC + AVC The MC curve is related to the shape of the ATC and AVC curves: [8]:212

At a level of Q at which the MC curve is above the average total cost or average variable cost curve, the latter curve is rising.[8]:212

If MC is below average total cost or average variable cost, then the latter curve is falling. If MC equals average total cost, then average total cost is at its minimum value. If MC equals average variable cost, then average variable cost is at its minimum value.

Relationship between short run and long run cost curves Basic: For each quantity of output there is one cost minimizing level of capital and a unique short run average cost curve associated with producing the given quantity.[9]

Each STC curve can be tangent to the LRTC curve at only one point. The STC curve cannot cross (intersect) the LRTC curve.[2]:230[8]:228-229 The STC curve can lie wholly above the LRTC curve with no tangency point. [10]:256 One STC curve is tangent to LRTC at the long-run cost minimizing level of production. At the point of tangency LRTC = STC. At all other levels of production STC will exceed LRTC.[11]:292-299 Average cost functions are the total cost function divided by the level of output. Therefore the SATC curveis also tangent to the LRATC curve at the cost-minimizing level of output. At the point of tangency LRATC = SATC. At all other levels of production SATC > LRATC[11]:292-299 To the left of the point of tangency the firm is using too much capital and fixed costs are too high. To the right of the point of tangency the firm is using too little capital and diminishing returns to labor are causing costs to increase.[12]

The slope of the total cost curves equals marginal cost. Therefore when STC is tangent to LTC, SMC = LRMC. At the long run cost minimizing level of output LRTC = STC; LRATC = SATC and LRMC = SMC, [11] :292-299. The long run cost minimizing level of output may be different from minimum SATC,[8]:229 [13]:186. With fixed unit costs of inputs, if the production function has constant returns to scale, then at the minimal level of the SATC curve we have SATC = LRATC = SMC = LRMC.[11]:292-299 With fixed unit costs of inputs, if the production function has increasing returns to scale, the minimum of the SATC curve is to the right of the point of tangency between the LRAC and the SATC curves. [11]:292-299 Where LRTC = STC, LRATC = SATC and LRMC = SMC.

With fixed unit costs of inputs and decreasing returns the minimum of the SATC curve is to the left of the point of tangency between LRAC and SATC.[11]:292-299 Where LRTC = STC, LRATC = SATC and LRMC = SMC. With fixed unit input costs, a firm that is experiencing increasing (decreasing) returns to scale and is producing at its minimum SAC can always reduce average cost in the long run by expanding (reducing) the use of the fixed input. [11]:292-99 [13]:186 LRATC will always equal to or be less than SATC.[1]:211

If production process is exhibiting constant returns to scale then minimum SRAC equals minimum long run average cost. The LRAC and SRAC intersect at their common minimum values. Thus under constant returns to scale SRMC = LRMC = LRAC = SRAC .

If the production process is experiencing decreasing or increasing, minimum short run average cost does not equal minimum long run average cost. If increasing returns to scale exist long run minimum will occur at a lower level of output than SRAC. This is because there are economies of scale that have not been exploited so in the long run a firm could always produce a quantity at a price lower than minimum short run aveage cost simply by using a larger plant. [14]

With decreasing returns, minimum SRAC occurs at a lower production level than minimum LRAC because a firm could reduce average costs by simply decreasing the size or its operations. The minimum of a SRAC occurs when the slope is zero.[15] Thus the points of tangency between the U-shaped LRAC curve and the minimum of the SRAC curve would coincide only with that portion of the LRAC curve exhibiting constant economies of scale. For increasing returns to scale the point of tangency between the LRAC and the SRAc would have to occur at a level of output below level associated with the minimum of the SRAC curve.

These statements assume that the firm is using the optimal level of capital for the quantity produced. If not, then the SRAC curve would lie "wholly above" the LRAC and would not be tangent at any point. U-shaped curves Both the SRAC and LRAC curves are typically expressed as U-shaped.[8]:211; 226 [13]:182;187-188 However, the shapes of the curves are not due to the same factors. For the short run curve the initial downward slope is largely due to declining average fixed costs.[2]:227 Increasing returns to the variable input at low levels of production also play a role, [16] while the upward slope is due to diminishing marginal returns to the variable input.[2]:227 With the long run curve the shape by definition reflects economies and diseconomies of scale.[13]:186 At low levels of production long run production functions generally exhibit increasing returns to scale, which, for firms that are perfect competitors in input markets, means that the long run average cost is falling; [2]:227 the upward slope of the long run average cost function at higher levels of output is due to decreasing returns to scale at those output levels. Market structure In economics, market structure is the number of firms producing identical products. The types of market structures include the following:

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

Monopsony, when there is only one buyer in a market. Perfect competition, a theoretical market structure that features no barriers to entry, an unlimited number of producers and consumers, and a perfectly elastic demand curve.

The imperfectly competitive structure is quite identical to the realistic market conditions where some monopolistic competitors, monopolists, oligopolists, and duopolists exist and dominate the market conditions. The elements of Market Structure include the number and size distribution of firms, entry conditions, and the extent of differentiation.

These somewhat abstract concerns tend to determine some but not all details of a specific concrete market system where buyers and sellers actually meet and commit to trade. Competition is useful because it reveals actual customer demand and induces the seller (operator) to provide service quality levels and price levels that buyers (customers) want, typically subject to the sellers financial need to cover its costs. In other words, competition can align the sellers interests with the buyers interests and can cause the seller to reveal his true costs and other private information. In the absence of perfect competition, three basic approaches can be adopted to deal with problems related to the control of market power and an asymmetry between the government and the operator with respect to objectives and information: (a) subjecting the operator to competitive pressures, (b) gathering information on the operator and the market, and (c) applying incentive regulation. [1]

Quick Reference to Basic Market Structures

Market Structure

Seller Entry Barriers

Seller Number

Buyer Entry Barriers

Buyer Number

Perfect Competition





Monopolistic competition

























The correct sequence of the market structure from most to least competitive is perfect competition, imperfect competition, oligopoly, and pure monopoly. The main criteria by which one can distinguish between different market structures are: the number and size of producers and consumers in the market, the type of goods and services being traded, and the degree to which information can flow freely. Price In ordinary usage, price is the quantity of payment or compensation given by one party to another in return for goods or services. In modern economies, prices are generally expressed in units of some form of currency. (For commodities, they are expressed as currency per unit weight of the commodity, e.g. euros per kilogram.) Although prices could be quoted as quantities of other goods or

services this sort of barter exchange is rarely seen. Prices are sometimes quoted in terms of vouchers such as trading stamps and air miles. In some circumstances, cigarettes have been used as currency, for example in prisons, in times of hyperinflation, and in some places during World War 2. In the black economy, barter is also relatively common. In many financial transactions, it is customary to quote prices in other ways. The most obvious example is in pricing a loan, when the cost will be expressed as the percentage rate of interest. The total amount of interest payable depends upon the loan amount and the period of the loan. Other examples can be found in pricing financial derivatives and other financial assets. For instance the price of inflation-linked government securities in several countries is quoted as the actual price divided by a factor representing inflation since the security was issued. Price sometimes refers to the quantity of payment requested by a seller of goods or services, rather than the eventual payment amount. This requested amount is often called the asking price or selling price, while the actual payment may be called the transaction price or traded price. Likewise, the bid price or buying price is the quantity of payment offered by a buyer of goods or services, although this meaning is more common in asset or financial markets than in consumer markets. Economic Definition Economists sometimes define price more generally as the ratio of the quantities of goods that are exchanged for each other. For example, suppose two people exchange 5 apples for 2 loaves of bread. Then the price of apples could be expressed as 2/5 = 0.4 loaves of bread. Likewise, the price of bread would be 5/2 = 2.5 apples. However in reality prices are usually quoted and paid in currency. Thus it can be argued that the most basic and general definition of price is that expressed in money, and that the exchange ratio between two goods is simply derived from the two individual prices. Price Theory Economic theory asserts that in a free market economy the market price reflects interaction between supply and demand: the price is set so as to equate the quantity being supplied and that being demanded. In turn these quantities are determined by the marginal utility of the asset to different buyers and to different sellers. In reality, the price may be distorted by other factors, such as tax and other government regulations. When a commodity is for sale at multiple locations, the Law of one price is generally believed to hold. This essentially states that the cost difference between the locations cannot be greater than that representing shipping, taxes, other distribution costs etc. In the case of the majority of consumer goods and services, the distribution costs are quite a high proportion of the overall price, so the law may not be very useful. In practice it may well make economic sense to offer a product or service for sale at a higher price in a wealthy area than in a deprived area as the marginal utility of the asset for purchasers will be higher in the former. Price and Value There was time when people debated use-value versus exchange value, often wondering about the paradox of value (diamondwater paradox). The use-value was supposed to give some measure of usefulness, later refined as marginal benefit (which is marginal utility counted in common units of value) while exchange value was the measure of how much one good was in terms of another, namely what is now called relative price. Austrian theory The last objection is also sometimes interpreted as the paradox of value, which was observed by classical economists. Adam Smith described what is now called the Diamond Water Paradox: diamonds command a higher price than water, yet water is essential for life, while diamonds are merely ornamentation. One solution offered to this paradox is through the theory of marginal utility proposed by Carl Menger, the father of the Austrian School of economics.

As William Barber put it, human volition, the human subject, was "brought to the centre of the stage" by marginalist economics, as a bargaining tool. Neoclassical economists sought to clarify choices open to producers and consumers in market situations, and thus "fears that cleavages in the economic structure might be unbridgeable could be suppressed". Without denying the applicability of the Austrian theory of value as subjective only, within certain contexts of price behavior, the Polish economist Oskar Lange felt it was necessary to attempt a serious integration of the insights of classical political economy with neo-classical economics. This would then result in a much more realistic theory of price and of real behavior in response to prices. Marginalist theory lacked anything like a theory of the social framework of real market functioning, and criticism sparked off by the capital controversy initiated by Piero Sraffa revealed that most of the foundational tenets of the marginalist theory of value either reduced to tautologies, or that the theory was true only if counter-factual conditions applied. One insight often ignored in the debates about price theory is something that businessmen are keenly aware of: in different markets, prices may not function according to the same principles except in some very abstract (and therefore not very useful) sense. From the classical political economists to Michal Kalecki it was known that prices for industrial goods behaved differently from prices for agricultural goods, but this idea could be extended further to other broad classes of goods and services. Price as productive human labour time Marxists assert that value derives from the volume of socially necessary abstract labour time exerted in the creation of an object. This value does not relate to price in a simple manner, and the difficulty of the conversion of the mass of values into the actual prices is known as thetransformation problem. However, many recent Marxists deny that any problem exists. Marx was not concerned with proving that prices derive from values. In fact, he admonished the other classical political economists (like Ricardo and Smith) for trying to make this proof. Rather, for Marx, price equal the cost of production (capital-cost and labor-costs) plus the average rate of profit. So if the average rate of profit (return on capital investment) is 22% then prices would reflect cost-ofproduction plus 22%. The perception that there is a transformation problem in Marx stems from the injection of Walrasian equilibrium theory into Marxism where there is no such thing as equilibrium. Confusion between prices and costs of production Price is commonly confused with the notion of cost of production as in I paid a high cost for buying my new plasma television. Technically, though, these are different concepts. Price is what a buyer pays to acquire products from a seller. Cost of production concerns the sellers investment (e.g., manufacturing expense) in the product being exchanged with a buyer. For marketing organizations seeking to make a profit the hope is that price will exceed cost of production so the organization can see financial gain from the transaction. Finally, while pricing is a topic central to a company's profitability, pricing decisions are not limited to for-profit companies. The behavior of non-profit organizations, such as charities, educational institutions and industry trade groups, can be described as setting prices. For instance, charities seeking to raise money may set different target levels for donations that reward donors with increases in status (e.g., name in newsletter), gifts or other benefits. These targets can be seen as prices if they are interpreted as specifying a cost that must be paid by buyers (donors) in order to obtain something of value.[clarification needed] Price Point The price of an item is also called the price point, especially where it refers to stores that set a limited number of price points. For example, Dollar General is a general store or "five and dime" store that sets price points only at even amounts, such as exactly one, two, three, five, or tendollars (among others). Other stores will have a policy of setting most of their prices ending in 99 cents or pence. Other stores (such as dollar stores, pound stores, euro stores, 100-yen stores, and so forth) only have a single price point ($1, 1, 1, 100), though in some cases this price may purchase more than one of some very small items. Price is relatively less than the cost price.

What's the difference between macroeconomics and microeconomics? Microeconomics is generally the study of individuals and business decisions, macroeconomics looks at higher up country and government decisions. Macroeconomics and microeconomics, and their wide array of underlying concepts, have been the subject of a great deal of writings. The field of study is vast; here is a brief summary of what each covers: Microeconomics is the study of decisions that people and businesses make regarding the allocation of resources and prices of goods and services. This means also taking into account taxes and regulations created by governments. Microeconomics focuses on supply and demand and other forces that determine the price levels seen in the economy. For example, microeconomics would look at how a specific company could maximize it's production and capacity so it could lower prices and better compete in its industry. (Find out more about microeconomics in Understanding Microeconomics.) Macroeconomics, on the other hand, is the field of economics that studies the behavior of the economy as a whole and not just on specific companies, but entire industries and economies. This looks at economy-wide phenomena, such as Gross National Product (GDP) and how it is affected by changes in unemployment, national income, rate of growth, and price levels. For example, macroeconomics would look at how an increase/decrease in net exports would affect a nation's capital account or how GDP would be affected by unemployment rate. (To keep reading on this subject, see Macroeconomic Analysis.) While these two studies of economics appear to be different, they are actually interdependent and complement one another since there are many overlapping issues between the two fields. For example, increased inflation (macro effect) would cause the price of raw materials to increase for companies and in turn affect the end product's price charged to the public. The bottom line is that microeconomics takes a bottoms-up approach to analyzing the economy while macroeconomics takes a top-down approach. Regardless, both micro- and macroeconomics provide fundamental tools for any finance professional and should be studied together in order to fully understand how companies operate and earn revenues and thus, how an entire economy is managed and sustained.

Macroeconomics Macroeconomics (from Greek prefix "makros-" meaning "large" + "economics") is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes national, regional, and global economies.[1][2] With microeconomics, macroeconomics is one of the two most general fields in economics. Macroeconomists study aggregated indicators such as GDP, unemployment rates, and price indices to understand how the whole economy functions. Macroeconomists develop models that explain the relationship between such factors as national income, output, consumption, unemployment, inflation, savings, investment, international trade and international finance. In contrast, microeconomics is primarily focused on the actions of individual agents, such as firms and consumers, and how their behavior determines prices and quantities in specific markets. While macroeconomics is a broad field of study, there are two areas of research that are emblematic of the discipline: the attempt to understand the causes and consequences of short-runfluctuations in national income (the business cycle), and the attempt to understand the determinants of long-run economic growth (increases in national income). Macroeconomic models and their forecasts are used by both governments and large corporations to assist in the development and evaluation of economic policy and business strategy. Basic macroeconomic concepts Macroeconomics encompasses a variety of concepts and variables, but three are central topics for macroeconomic research.[3] Macroeconomic theories usually relate the phenomena of output, unemployment, and inflation. Outside of macroeconomic theory, these topics are also extremely important to all economic agents including workers, consumers, and producers.

Output and income National output is the total value of everything a country produces in a given time period. Everything that is produced and sold generates income. Therefore, output and income are usually considered equivalent and the two terms are often used interchangeably. Output can be measured as total income, or, it can be viewed from the production side and measured as the total value of final goods and services or the sum of all value added in the economy.[4] Macroeconomic output is usually measured by Gross Domestic Product (GDP) or one of the other national accounts. Economists interested in long-run increases in output study economic growth. Advances in technology, accumulation of machinery and other capital, and better education and human capital all lead to increased economic output overtime. However, output does not always increase consistently. Business cycles can cause short-term drops in output called recessions. Economists look for macroeconomic policies that prevent economies from slipping into recessions and that lead to faster long-term growth. Unemployment The amount of unemployment in an economy is measured by the unemployment rate, the percentage of workers without jobs in the labor force. The labor force only includes workers actively looking for jobs. People who are retired, pursuing education, or discouraged from seeking work by a lack of job prospects are excluded from the labor force. Unemployment can be generally broken down into several types that are related to different causes. Classical unemployment occurs when wages are too high for employers to be willing to hire more workers. Wages may be too high because of minimum wage laws or union activity. Consistent with classical unemployment, frictional unemployment occurs when appropriate job vacancies exist for a worker, but the length of time needed to search for and find the job leads to a period of unemployment.[5] Structural unemployment covers a variety of possible causes of unemployment including a mismatch between workers' skills and the skills required for open jobs.[6] Large amounts of structural unemployment can occur when an economy is transitioning industries and workers find their previous set of skills are no longer in demand. Structural unemployment is similar to frictional unemployment since both reflect the problem of matching workers with job vacancies, but structural unemployment covers the time needed to acquire new skills not just the short term search process.[7] While some types of unemployment may occur regardless of the condition of the economy, cyclical unemployment occurs when growth stagnates. Okun's law represents the empirical relationship between unemployment and economic growth.[8] The original version of Okun's law states that a 3% increase in output would lead to a 1% decrease in unemployment.[9] Inflation and deflation A general price increase across the entire economy is called inflation. When prices decrease, there is deflation. Economists measure these changes in prices with price indexes. Inflation can occur when an economy becomes overheated and grows too quickly. Similarly, a declining economy can lead to deflation. Central bankers, who control a country's money supply, try to avoid changes in price level by using monetary policy. Raising interest rates or reducing the supply of money in an economy will reduce inflation. Inflation can lead to increased uncertainty and other negative consequences. Deflation can lower economic output. Central bankers try to stabilize prices to protect economies from the negative consequences of price changes. Changes in price level may be result of several factors. The quantity theory of money holds that changes in price level are directly related to changes in the money supply. Most economists believe that this relationship explains long-run changes in the price level. Short-run fluctuations may also be related to monetary factors, but changes in aggregate demand and aggregate supply can also influence price level. For example, a decrease in demand because of a recession can lead to lower price levels and deflation. A negative supply shock, like an oil crisis, lowers aggregate supply and can cause inflation. Development of macroeconomic theory Main article: History of macroeconomic thought

Origins Macroeconomics descended from the once divided fields of business cycle theory and monetary theory.[10] The quantity theory of money was particularly influential prior to World War II. It took many forms including the version based on the work ofIrving Fisher:

In the typical view of the quantity theory, money velocity (V) and the quantity of goods produced (Q) would be constant, so any increase in money supply (M) would lead to a direct increase in price level (P). The quantity theory of money was a central part of the classical theory of the economy that prevailed in the early twentieth century. Keynes and his followers Macroeconomics, at least in its modern form,[11] began with the publication of John Maynard Keynes's General Theory of Employment, Interest and Money.[12] When the Great Depression struck, classical economists had difficulty explaining how goods could go unsold and workers could be left unemployed. In classical theory, prices and wages would drop until the market cleared, and all goods and labor were sold. Keynes offered a new theory of economics that explained why markets might not clear. In Keynes's theory, the quantity theory broke down because people and businesses tend to hold on to their cash in tough economic times, a phenomenon he described in terms of liquidity preferences. Keynes also explained how the multiplier effect would magnify a small decrease in consumption or investment and cause declines throughout the economy. Keynes also noted the role uncertainty and animal spirits can play in the economy.[13] The generation following Keynes combined the macroeconomics of the General Theory with neoclassical microeconomics to create the neoclassical synthesis. By the 1950s, most economists had accepted the synthesis view of the macroeconomy.[14] Economists like Paul Samuelson,Franco Modigliani, James Tobin, and Robert Solow developed formal Keynesian models, and contributed formal theories of consumption, investment, and money demand that fleshed out the Keynesian framework.[15] Monetarism Milton Friedman updated the quantity theory of money to include a role for money demand. He argued that the role of money in the economy was sufficient to explain the Great Depression and aggregate demand oriented explanations were not necessary. Friedman argued that monetary policy was more effective than fiscal policy; however, Friedman doubted the government has ability to "fine-tune" the economy with monetary policy. He generally favored a policy of steady growth in money supply instead of frequent intervention.[16] Friedman also challenged the Phillips Curverelationship between inflation and unemployment. Friedman and Edmund Phelps (who was not a monetarist) proposed an "augmented" version of the Phillips Curve that excluded the possibility of a stable, long-run tradeoff between inflation and unemployment. When the oil shocks of the 1970s created a high unemployment and high inflation, Friedman and Phelps were vindicated. Monetarism was particularly influential in the early 1980s. Monetarism fell out of favor when central banks found it difficult to target money supply instead of interest rates as monetarists recommended. Monetarism also became politically unpopular when the central banks created recessions in order to slow inflation. New classicals New classical macroeconomics further challenged the Keynesian school. A central development in new classical thought came when Robert Lucas introduced rational expectations to macroeconomics. Prior to Lucas, economists had generally used adaptive expectations where agents were assumed to look at the recent past to make expectations about the future. Under rational expectations, agents are assumed to be more sophisticated. A consumer will not simply assume a 2% inflation rate because that has been the average the past few years; he will look at current monetary policy and economic conditions to make an informed forecast. When new classical economists introduced rational expectations into their models, they showed that monetary policy could only have a limited impact.

Lucas also made an influential critique of Keynesian empirical models. He argued that forecasting models based on empirical relationships would be unstable. He advocated models based on fundamental economic theory that would, in principle, be more stable as economies changed. Following Lucas's critique, new classical economists, led by Edward C. Prescott and Finn E. Kydland created real business cycle (RBC) models of the macroeconomy. RBC models were created by combining fundamental equations from neo-classical microeconomics. RBC models explained recessions and unemployment with changes in technology instead changes in the markets for goods or money. Critics of RBC models argue that money clearly plays an important role in the economy, and the idea that technological regress can explain recent recessions is also implausible.[17] Despite questions about the theory behind RBC models, they have clearly been influential in economic methodology. New Keynesian response New Keynesian economists responded to the new classical school by adopting rational expectations and focusing on developing micro-founded models that are immune to the Lucas critique. Stanley Fischer and John B. Taylor produced early work in this area by showing that monetary policy could be effective even in models with rational expectations when contracts locked-in wages for workers. Other new Keynesian economists expanded on this work and demonstrated other cases where inflexible prices and wages led to monetary and fiscal policy having real effects. Like classical models, new classical models had assumed that prices would be able to adjust perfectly and monetary policy would only lead to price changes. New Keynesian models investigated sources of sticky prices and wages, which would not adjust, allowing monetary policy to impact quantities instead of prices. By the late 1990s economists had reached a rough consensus. The rigidities of new Keynesian theory were combined with rational expectations and the RBC methodology to produce dynamic stochastic general equilibrium (DSGE) models. The fusion of elements from different schools of thought has been dubbed the new neoclassical synthesis. These models are now used by many central banks and are a core part of contemporary macroeconomics. Microeconomics Microeconomics (from Greek prefix micro- "" meaning "small" + "economics"- "") is a branch of economics that studies the behavior of individual households and firms in making decisions on the allocation of limited resources. [1] Typically, it applies to markets where goods or services are bought and sold. Microeconomics examines how these decisions and behaviors affect the supply and demand for goods and services, which determines prices, and how prices, in turn, determine the quantity supplied and quantity demanded of goods and services. This is in contrast to macroeconomics, which involves the "sum total of economic activity, dealing with the issues of growth, inflation, and unemployment Microeconomics also deals with the effects of national economic policies (such as changing taxation levels) on the aforementioned aspects of the economy.[4] Particularly in the wake of the Lucas critique, much of modern macroeconomic theory has been built upon 'microfoundations' i.e. based upon basic assumptions about micro-level behavior. One of the goals of microeconomics is to analyze market mechanisms that establish relative prices amongst goods and services and allocation of limited resources amongst many alternative uses. Microeconomics analyzes market failure, where markets fail to produce efficient results, and describes the theoretical conditions needed for perfect competition. Significant fields of study in microeconomics include general equilibrium, markets under asymmetric information, choice under uncertainty and economic applications of game theory. Also considered is the elasticity of products within the market system. Assumptions and definitions The theory of supply and demand usually assumes that markets are perfectly competitive. This implies that there are many buyers and sellers in the market and none of them have the capacity to significantly influence prices of goods and services. In many real-life transactions, the assumption fails because some individual buyers or sellers have the ability to influence prices. Quite often, a

sophisticated analysis is required to understand the demand-supply equation of a good model. However, the theory works well in situations meeting these assumptions. Mainstream economics does not assume a priori that markets are preferable to other forms of social organization. In fact, much analysis is devoted to cases where so-called market failures lead to resource allocation that is suboptimal by some standard (defense spending is the classic example, profitable to all for use but not directly profitable for anyone to finance). In such cases, economists may attempt to find policies that will avoid waste, either directly by government control, indirectly by regulation that induces market participants to act in a manner consistent with optimal welfare, or by creating "missing markets" to enable efficient trading where none had previously existed. This is studied in the field of collective action and public choice theory. It also must be noted that "optimal welfare" usually takes on a Paretian norm, which in its mathematical application of KaldorHicks method. This can diverge from the Utilitarian goal of maximising utility because it does not consider the distribution of goods between people. Market failure in positive economics (microeconomics) is limited in implications without mixing the belief of the economist and his or her theory. The demand for various commodities by individuals is generally thought of as the outcome of a utility-maximizing process, with each individual trying to maximise their own utility. The interpretation of this relationship between price and quantity demanded of a given good assumes that, given all the other goods and constraints, the set of choices which emerges is that one which makes the consumer happiest. Modes of operation It is assumed that all firms are following rational decision-making, and will produce at the profit-maximizing output. Given this assumption, there are four categories in which a firm's profit may be considered to be.

A firm is said to be making an economic profit when its average total cost is less than the price of each additional product at the profit-maximizing output. The economic profit is equal to the quantity output multiplied by the difference between the average total cost and the price.

A firm is said to be making a normal profit when its economic profit equals zero. This occurs where average total cost equals price at the profit-maximizing output. If the price is between average total cost and average variable cost at the profit-maximizing output, then the firm is said to be in a loss-minimizing condition. The firm should still continue to produce, however, since its loss would be larger if it were to stop producing. By continuing production, the firm can offset its variable cost and at least part of its fixed cost, but by stopping completely it would lose the entirety of its fixed cost.

If the price is below average variable cost at the profit-maximizing output, the firm should go into shutdown. Losses are minimized by not producing at all, since any production would not generate returns significant enough to offset any fixed cost and part of the variable cost. By not producing, the firm loses only its fixed cost. By losing this fixed cost the company faces a challenge. It must either exit the market or remain in the market and risk a complete loss.

Opportunity cost Main article: Opportunity cost Opportunity cost of an activity (or goods) is equal to the best next alternative foregone. Although opportunity cost can be hard to quantify, the effect of opportunity cost is universal and very real on the individual level. In fact, this principle applies to all decisions, not just economic ones. Since the work of the Austrian economist Friedrich von Wieser, opportunity cost has been seen as the foundation of the marginal theory of value Opportunity cost is one way to measure the cost of something. Rather than merely identifying and adding the costs of a project, one may also identify the next best alternative way to spend the same amount of money. The forgone profit of this next best

alternative is the opportunity cost of the original choice. A common example is a farmer that chooses to farm his or her land rather than rent it to neighbors, wherein the opportunity cost is the forgone profit from renting. In this case, the farmer may expect to generate more profit alone. Similarly, the opportunity cost of attending university is the lost wages a student could have earned in the workforce, rather than the cost of tuition, books, and other requisite items (whose sum makes up the total cost of attendance). The opportunity cost of a vacation in the Bahamas might be the down payment for a house. Note that opportunity cost is not the sum of the available alternatives, but rather the benefit of the single, best alternative. Possible opportunity costs of a city's decision to build a hospital on its vacant land are the loss of the land for a sporting center, orthe inability to use the land for a parking lot, or the money that could have been made from selling the land, or the loss of any of the various other possible uses but not all of these in aggregate. The true opportunity cost would be the forgone profit of the most lucrative of those listed. One question that arises here is how to determine a money value for each alternative to facilitate comparison and assess opportunity cost, which may be more or less difficult depending on the things we are trying to compare. For example, many decisions involve environmental impacts whose monetary value is difficult to assess because of scientific uncertainty. Valuing a human life or the economic impact of an Arctic oil spill involves making subjective choices with ethical implications. It is imperative to understand that no decision on allocating time is free. No matter what one chooses to do, he or she is always giving something up in return. An example of opportunity cost is deciding between going to a concert and doing homework. If one decides to go the concert, then he or she is giving up valuable time to study, but if he or she chooses to do homework then the cost is giving up the concert. Any decision in allocating capital is likewise: there is an opportunity cost of capital, or a hurdle rate, defined as the expected rate one could get by investing in similar projects on the open market. Opportunity cost is vital in understanding microeconomics and decisions that are made. [Applied microeconomics Applied microeconomics includes a range of specialized areas of study, many of which draw on methods from other fields. Industrial organization examines topics such as the entry and exit of firms, innovation, and the role of trademarks. Labor economics examines wages, employment, and labor market dynamics. Public economics examines the design of government tax and expenditure policies and economic effects of these policies (e.g., social insurance programs). Political economy examines the role of political institutions in determining policy outcomes. Health economicsexamines the organization of health care systems, including the role of the health care workforce and health insurance programs. Urban economics, which examines the challenges faced by cities, such as sprawl, air and water pollution, traffic congestion, and poverty, draws on the fields of urban geography and sociology. Financial economics examines topics such as the structure of optimal portfolios, the rate of return to capital, econometric analysis of security returns, and corporate financial behavior. Law and economics applies microeconomic principles to the selection and enforcement of competing legal regimes and their relative efficiencies. Economic history examines the evolution of the economy and economic institutions, using methods and techniques from the fields of economics, history, geography, sociology, psychology, and political science.

Advertising objective Stimulate an increase in sales Remind customers of the existence of a product Inform customers Build a brand image

How success can be measured - Number of enquiries from advert - Number of enquiries converted into sales - Test customer awareness both before and after the advertising campaign - Number of enquiries - Test customer awareness - Number of requests for further information -Sales -Test customer awareness of brand recognition and

Build customer loyalty and relationship Change customer attitudes

perceived values - Levels of repeat purchase - Levels of customer retention - Measure demographic profile of purchases - Measure type of goods ordered by new purchasers - Compare with previous data

CONCEPTS OF NATIONAL INCOME The important concepts of national income are: 1. Gross Domestic Product (GDP) 2. Gross National Product (GNP) 3. Net National Product (NNP) at Market Prices 4. Net National Product (NNP) at Factor Cost or National Income 5. Personal Income 6. Disposable Income Let us explain these concepts of National Income in detail. 1. Gross Domestic Product (GDP): Gross Domestic Product (GDP) is the total market value of all final goods and services currently produced within the domestic territory of a country in a year. Four things must be noted regarding this definition. First, it measures the market value of annual output of goods and services currently produced. This implies that GDP is a monetary measure. Secondly, for calculating GDP accurately, all goods and services produced in any given year must be counted only once so as to avoid double counting. So, GDP should include the value of only final goods and services and ignores the transactions involving intermediate goods. Thirdly, GDP includes only currently produced goods and services in a year. Market transactions involving goods produced in the previous periods such as old houses, old cars, factories built earlier are not included in GDP of the current year. Lastly, GDP refers to the value of goods and services produced within the domestic territory of a country by nationals or non-nationals. 2. Gross National Product (GNP): Gross National Product is the total market value of all final goods and services produced in a year. GNP includes net factor income from abroad whereas GDP does not. Therefore, GNP = GDP + Net factor income from abroad. Net factor income from abroad = factor income received by Indian nationals from abroad factor income paid to foreign nationals working in India. 3. Net National Product (NNP) at Market Price: NNP is the market value of all final goods and services after providing for depreciation. That is, when charges for depreciation are deducted from the GNP we get NNP at market price. Therefore NNP = GNP Depreciation Depreciation is the consumption of fixed capital or fall in the value of fixed capital due to wear and tear. 4.Net National Product (NNP) at Factor Cost (National Income): NNP at factor cost or National Income is the sum of wages, rent, interest and profits paid to factors for their contribution to the production of goods and services in a year. It may be noted that: NNP at Factor Cost = NNP at Market Price Indirect Taxes + Subsidies.

5. Personal Income: Personal income is the sum of all incomes actually received by all individuals or households during a given year. In National Income there are some income, which is earned but not actually received by households such as Social Security contributions, corporate income taxes and undistributed profits. On the other hand there are income (transfer payment), which is received but not currently earned such as old age pensions, unemployment doles, relief payments, etc. Thus, in moving from national income to personal income we must subtract the incomes earned but not received and add incomes received but not currently earned. Therefore, Personal Income = National Income Social Security contributions corporate income taxes undistributed corporate profits + transfer payments. Disposable Income: From personal income if we deduct personal taxes like income taxes, personal property taxes etc. what remains is called disposable income. Thus, Disposable Income = Personal income personal taxes. Disposable Income can either be consumed or saved. Therefore, Disposable Income = consumption + saving. MEASUREMENT OF NATIONAL INCOME Production generate incomes which are again spent on goods and services produced. Therefore, national income can be measured by three methods: 1. Output or Production method 2. Income method, and 3. Expenditure method. Let us discuss these methods in detail. 1. Output or Production Method: This method is also called the value-added method. This method approaches national income from the output side. Under this method, the economy is divided into different sectors such as agriculture, fishing, mining, construction, manufacturing, trade and commerce, transport, communication and other services. Then, the gross product is found out by adding up the net values of all the production that has taken place in these sectors during a given year. In order to arrive at the net value of production of a given industry, intermediate goods purchase by the producers of this industry are deducted from the gross value of production of that industry. The aggregate or net values of production of all the industry and sectors of the economy plus the net factor income from abroad will give us the GNP. If we deduct depreciation from the GNP we get NNP at market price. NNP at market price indirect taxes + subsidies will give us NNP at factor cost or National Income. The output method can be used where there exists a census of production for the year. The advantage of this method is that it reveals the contributions and relative importance and of the different sectors of the economy. 2. Income Method: This method approaches national income from the distribution side. According to this method, national income is obtained by summing up of the incomes of all individuals in the country. Thus, national income is calculated by adding up the rent of land, wages and salaries of employees, interest on capital, profits of entrepreneurs and income of self-employed people. This method of estimating national income has the great advantage of indicating the distribution of national income among different income groups such as landlords, capitalists, workers, etc. 3. Expenditure Method: This method arrives at national income by adding up all the expenditure made on goods and services during a year. Thus, the national income is found by adding up the following types of expenditure by households, private business enterprises and the government: (a) Expenditure on consumer goods and services by individuals and households denoted by C. This is called personal consumption expenditure denoted by C.

(b) Expenditure by private business enterprises on capital goods and on making additions to inventories or stocks in a year. This is called gross domestic private investment denoted by I. (c) Governments expenditure on goods and services i.e. government purchases denoted by G. (d) Expenditure made by foreigners on goods and services of the national economy over and above what this economy spends on the output of the foreign countries i.e. exports imports denoted by (X M). Thus, GDP = C + I + G + (X M). Difficulties in the Measurement of National Income There are many difficulties in measuring national income of a country accurately. The difficulties involved are both conceptual and statistical in nature. Some of these difficulties or problems are discuss below: 1. The first problem relates to the treatment of non-monetary transactions such as the services of housewives and farm output consumed at home. On this point, the general agreement seems to be to exclude the services of housewives while including the value of farm output consumed at home in the estimates of national income. 2. The second difficulty arises with regard to the treatment of the government in national income accounts. On this point the general viewpoint is that as regards the administrative functions of the government like justice, administrative and defense are concerned they should be treated as giving rise to final consumption of such services by the community as a whole so that contribution of general government activities will be equal to the amount of wages and salaries paid by the government. Capital formation by the government is treated as the same as capital formation by any other enterprise. 3. The third major problem arises with regard to the treatment of income arising out of the foreign firm in a country. On this point, the IMF viewpoint is that production and income arising from an enterprise should be ascribed to the territory in which production takes place. However, profits earned by foreign companies are credited to the parent company. Special Difficulties of Measuring National Income in Under-developed Countries In under-developed countries like India, we face some special difficulties in estimating national income. Some of these difficulties are: 1. The first difficulty arises because of the prevalence of non-monetised transactions in such countries so that a considerable part of the output does not come into the market at all. Agriculture still being in the nature of subsistence farming in these countries, a major part of output is consumed at the farm itself. 2. Because of illiteracy, most producers have no idea of the quantity and value of their output and do not keep regular accounts. This makes the task of getting reliable information very difficult. 3. Because of under-development, occupational specialization is still incomplete, so that there is lack of differentiation in economic functioning. An individual may receive income partly from farm ownership, partly from manual work in industry in the slack season, etc. This makes the task of estimating national income very difficult. 4. Another difficulty in measuring national income in under-developed countries arises because production, both agriculture and industrial, is unorganized and scattered in these countries. In India, agriculture, household craft, and indigenous banking are the unorganized and scattered sectors. An assessment of output produced by self-employed agriculturist, small producers and owners of household enterprises in the unorganized sectors requires an element of guesswork, which makes the figure of national income unreliable. 5. In under-developed countries there is a general lack of adequate statistical data. Inadequacy, nonavailability and unreliability of statistics is a great handicap in measuring national income in these countries.

What Is Business Environment?

Meaning: - The term Business Environment is composed of two words Business and Environment. In simple terms, the state in which a person remains busy is known as Business. The word Business in itseconomic sense means human activities like production, extraction or purchase or sales of goods that are performed for earning profits. On the other hand, the wordEnvironment refers to the aspects of surroundings. Therefore,Business Environment may be defined as a set of conditions Social, Legal, Economical, Political or Institutional that are uncontrollable in nature and affects the functioning of organization. Business Environment has two components: 1. Internal Environment 2. External Environment Internal Environment: It includes 5 Ms i.e. man, material, money, machinery and management, usually within the control of business. Business can make changes in these factors according to the change in the functioning of enterprise. External Environment: Those factors which are beyond the control of business enterprise are included in external environment. These factors are: Government and Legal factors, Geo-Physical Factors, Political Factors, SocioCultural Factors,Demo-Graphical factors etc.It is oft woTypes:1.Micro/Operating Environment 2.Macro/General Environment Micro/Operating Environment: The environment which is close to business and affects its capacity to work is known as Micro or Operating Environment. It consists of Suppliers, Customers, Market Intermediaries, Competitors and Public. (1) Suppliers: They are the persons who supply raw material and required components to the company. They must be reliable and business must have multiple suppliers i.e. they should not depend upon only one supplier. (2) Customers: - Customers are regarded as the king of the market. Success of every business depends upon the level of their customers satisfaction. Types of Customers: (i) Wholesalers (ii) Retailers (iii) Industries

(iv) Government and Other Institutions (v) Foreigners (3) Market Intermediaries: - They work as a link between business and final consumers. Types:(i) Middleman (ii) Marketing Agencies (iii) Financial Intermediaries (iv) Physical Intermediaries (4) Competitors: - Every move of the competitors affects the business. Business has to adjust itself according to the strategies of the Competitors. (5) Public: - Any group who has actual interest in business enterprise is termed as public e.g. media and local public. They may be the users or non-users of the product. Macro/General Environment: It includes factors that create opportunities and threats to business units. Following are the elements of Macro Environment: (1) Economic Environment: - It is very complex and dynamic in nature that keeps on changing with the change in policies or political situations. It has three elements: (i) Economic Conditions of Public (ii) Economic Policies of the country (iii)Economic System (iv) Other Economic Factors: Infrastructural Facilities, Banking, Insurance companies, money markets, capital markets etc. (2) Non-Economic Environment: - Following are included in non-economic environment:(i) Political Environment: - It affects different business units extensively. Components: (a) Political Belief of Government (b) Political Strength of the Country (c) Relation with other countries (d) Defense and Military Policies (e) Centre State Relationship in the Country (f) Thinking Opposition Parties towards Business Unit (ii) Socio-Cultural Environment: - Influence exercised by social and cultural factors, not within the control of business, is known as Socio-Cultural Environment. These factors include: attitude of people to work, family system, caste system, religion, education, marriage etc. (iii) Technological Environment: - A systematic application of scientific knowledge to practical task is known as technology. Everyday there has been vast changes in products, services, lifestyles and living conditions, these changes must be analysed by every business unit and should adapt these changes. (iv) Natural Environment: - It includes natural resources, weather, climatic conditions, port facilities, topographical factors such as soil, sea, rivers, rainfall etc. Every business unit must look for these factors before choosing the location for their business. (v) Demographic Environment :- It is a study of perspective of population i.e. its size, standard of living, growth rate, age-sex composition, family size, income level (upper level, middle level and lower level), education level etc. Every business unit must see these features of population and recongnise their various need and produce accordingly. (vi) International Environment: - It is particularly important for industries directly depending on import or exports. The factors that affect the business are: Globalisation, Liberalisation, foreign business policies, cultural exchange. Characteristics:1. Business environment is compound in nature. 2. Business environment is constantly changing process. 3. Business environment is different for different business units. 4. It has both long term and short term impact. 5. Unlimited influence of external environment factors. 6. It is very uncertain. 7. Inter-related components. 8. It includes both internal and external environment.

Capital budgeting (or investment appraisal) is the planning process used to determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or [1] investment, expenditures. Many formal methods are used in capital budgeting, including the techniques such as Accounting rate of return Payback period Net present value Profitability index Internal rate of return Modified internal rate of return Equivalent annuity

These methods use the incremental cash flows from each potential investment, or project. Techniques based on accounting earnings and accounting rules are sometimes used - though economists consider this to be improper - such as the accounting rate of return, and "return on investment." Simplified and hybrid methods are used as well, such as payback period and discounted payback period.

Net present value

Main article: Net present value Each potential project's value should be estimated using a discounted cash flow (DCF) valuation, to find its net present value (NPV). (First applied to Corporate Finance by Joel Dean in 1951; see also Fisher separation theorem, John Burr Williams: Theory.) This valuation requires estimating the size and timing of all the incremental cash flows from the project. (These future cash highest NPV(GE).) The NPV is greatly affected by the discount rate, so selecting the proper rate - sometimes called the hurdle rate - is critical to making the right decision. The hurdle rate is the Minimum acceptable rate of return on an investment. This should reflect the riskiness of the investment, typically measured by the volatility of cash flows, and must take into account the financing mix. Managers may use models such as the CAPM or the APT to estimate a discount rate appropriate for each particular project, and use the weighted average cost of capital (WACC) to reflect the financing mix selected. A common practice in choosing a discount rate for a project is to apply a WACC that applies to the entire firm, but a higher discount rate may be more appropriate when a project's risk is higher than the risk of the firm as a whole.

Internal rate of return

Main article: Internal rate of return The internal rate of return (IRR) is defined as the discount rate that gives a net present value (NPV) of zero. It is a commonly used measure of investment efficiency. The IRR method will result in the same decision as the NPV method for (non-mutually exclusive) projects in an unconstrained environment, in the usual cases where a negative cash flow occurs at the start of the project, followed by all positive cash flows. In most realistic cases, all independent projects that have an IRR higher than the hurdle rate should be accepted. Nevertheless, for mutually exclusive projects, the

decision rule of taking the project with the highest IRR - which is often used - may select a project with a lower NPV. In some cases, several zero NPV discount rates may exist, so there is no unique IRR. The IRR exists and is unique if one or more years of net investment (negative cash flow) are followed by years of net revenues. But if the signs of the cash flows change more than once, there may be several IRRs. The IRR equation generally cannot be solved analytically but only via iterations. One shortcoming of the IRR method is that it is commonly misunderstood to convey the actual annual profitability of an investment. However, this is not the case because intermediate cash flows are almost never reinvested at the project's IRR; and, therefore, the actual rate of return is almost certainly going to be lower. Accordingly, a measure called Modified Internal Rate of Return (MIRR) is often used. Despite a strong academic preference for NPV, surveys indicate that executives prefer IRR over [citation needed] NPV , although they should be used in concert. In a budget-constrained environment, efficiency measures should be used to maximize the overall NPV of the firm. Some managers find it intuitively more appealing to evaluate investments in terms of percentage rates of return than dollars of NPV.

Equivalent annuity method

Main article: Equivalent annual cost The equivalent annuity method expresses the NPV as an annualized cash flow by dividing it by the present value of the annuity factor. It is often used when assessing only the costs of specific projects that have the same cash inflows. In this form it is known as the equivalent annual cost(EAC) method and is the cost per year of owning and operating an asset over its entire lifespan. It is often used when comparing investment projects of unequal lifespans. For example if project A has an expected lifetime of 7 years, and project B has an expected lifetime of 11 years it would be improper to simply compare the net present values (NPVs) of the two projects, unless the projects could not be repeated. The use of the EAC method implies that the project will be replaced by an identical project. Alternatively the chain method can be used with the NPV method under the assumption that the projects will be replaced with the same cash flows each time. To compare projects of unequal length, say 3 years and 4 years, the projects are chained together, i.e. four repetitions of the 3 year project are compare to three repetitions of the 4 year project. The chain method and the EAC method give mathematically equivalent answers. The assumption of the same cash flows for each link in the chain is essentially an assumption of zero inflation, so a real interest rate rather than a nominal interest rate is commonly used in the calculations.Y