Economics, and Economic Terminology: BITS Pilani

BITS Pilani
Work Integrated Learning

Programmes Division
Economics, and Economic

Terminology
“The purpose of studying economics is not to acquire a set
of ready-made answers to economic questions, but to
avoid being deceived by economists”
- Joan Robinson
76% of senior executives say that it is important they have

the knowledge and skills to respond to trends like
resource scarcity, the low carbon economy and doing
business in emerging markets
1/13/21 Dr. Rahul Pratap Singh Kaurav, PIMG 2 BITS Pilani, WILPD
What is Economics?
Economics is defined as body of knowledge or study that

discusses how a society tries to solve the human
problems of unlimited wants and scare resources.
– Unlimited wants and scarce resources
– Science [methodology] or Art [Application]…?
What is Economics?
Father of Economics
Economics is the
study of nature
and uses of
national wealth.
Adam Smith (1723-1790)
Basic Assumptions
I. Ceteris Paribus- Other things remaining equal
 It is a Latin word means ‘with other things (being) the

same’
“ The existence of other tendencies is nor denied, but their

disturbing effect is neglected for a time” - Marshall
Basic Assumptions
II. Rationality
 Implies that consumers and producers measure and

compare costs and benefits before taking decisions
Consumers: Maximising utility and minimising sacrifice

Producers : Maximising profits and minimising costs
Types of Economic Analysis
A. Micro(individual consumers and firms)

Macro (Aggregates- Industry, not firm)
B. Positive (factual statements- “What is”) – The distribution

of income in India is unequal.
Normative (Value judgments- “What ought to be”) – The
distribution of income in India should be equal.
C. Time period
 Short run -A time period not long enough for consumers

and producers to adjust to a new situation- K/L
 Long run- Planning horizon- A time period long enough

for consumers and producers to adjust to a new
situation- All inputs can be varied- K and L- Whether to
change product lines, build new plant etc.
C. Time period
 Short run -A time period not long enough for consumers

and producers to adjust to a new situation- K/L
 Long run- Planning horizon- A time period long enough

for consumers and producers to adjust to a new
situation- All inputs can be varied- K and L- Whether to
change product lines, build new plant etc.
Kinds of Economic Question
1. What to Produce? (Micro)

2. How to Produce? (Micro)
3. How much to produce? (Micro)
4. For Whom to Produce? (Micro)
5. Are Resources Used optimally? (Micro)
6. Are Resources fully employed? (Macro)

7. Is the economy Growing? (Macro)
8. In what phase of business cycle is the economy?
(Macro)
A Big Case !
Introduction to
Managerial Economics
Rahul Pratap Singh Kaurav
BITS Pilani +91.9826569573
rsinghkaurav@gmail.com
Programmes Division
BITS Pilani
Programmes Division
What is Managerial Economics?

“Application of economic theory and tools of analysis of
decision science to examine how an organization can
achieve its objectives most efficiently”
- Salvatore
Spencer and Siegelman: “… Integration of economic theory
with business practice for the purpose of facilitating
decision making and forward planning by management”
Evan Douglas: “Application of economic principles and

methodologies to the decision-making process within the
firm or organization…under conditions of uncertainty”
Conceptualization of ME
Economics –
Theory &
Methodology
Managerial
Economics –
Application of
economics to
solve business
problems
Business
Management
– Decision
Problems
Relationship with other
Disciplines
Nature of M. Economics
 Microeconomics
 Normative economics
 Uses theory of firm
 Takes the help of macroeconomics
 Aims at helping the management

 A scientific art
 Prescriptive rather than descriptive
Scope of ME
 Theory of demand  Theory of capital and

Demand Analysis investment
Demand Theory
 Environmental issues
 Theory of production
Business cycles
Variable factor of production
Industrial policy of the
Fixed factor of production
country
 Theory of exchange or Trade and fiscal policy of
price theory the country
 Theory of profit Taxation policy of the
country
Price and labour policy
Solution
1. Economic Theory & Tools of c. Salvatore

Decision Science
2. Conditions of uncertainty a. Douglas
3. Application of economics to solve d. Managerial
business problems Economics
4. Variable factor of production e. Theory of

production
5. Labour policy b. Environmental
Issues
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Problems in Decision Making

Euro Disney
Which factors most affect the success of the park?

How would you go about collecting and analyzing the
information needed to make forecasts regarding these
factors?
Disney should gather information on:

– the likely number of European visitors to the new park and the amount these
visitors will spend on amusements, food, and lodging,
– costs of operating the park, and
– macroeconomic forecasts for the European economy.
Building a New Bridge
Building a bridge is usually a public responsibility (paid for out

of public funds raised via taxes).
Why is this the case?
How might a public planner determine the need for a new
bridge?
How should tolls (if any) be set?
The authority should estimate usage of the bridge over its

useful life, the likely cost of building and maintaining the
bridge, and other important side-effects, pro and con --
including positive effects on business activity and the
impacts on air pollution and traffic congestion.
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Principles of Decision Making

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The crucial step in tackling almost all important

business and government decisions begins
with a single question: What is the alternative?
Conventional Decision Rules
A. Concept of Scarcity
– Human wants are unlimited, but human capacity to

satisfy such wants is limited.
– Business is also same.
Resources
Demand
for
Resources
Conventional Decision Rules
B. Concept of Opportunity Cost
– It is the benefit foregone from the alternative that is not

selected.
– The economist has to make rational choice in all aspects of

business by sacrificing some of the alternatives, since
resources are scarce and wants are unlimited.
Decision Making Process
Who is the decision maker?

What is the problem?
Maximum Profit or other Goal?
Uncovering and
maximizing Options
Forecasting Revenues
and Costs
Marginal Analysis,
D-Trees, Game Theory
What About New Conditions?

What Drives Decision?
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Let us Analyse Something???

Problem 4.a Page 20
Mr. and Mrs. Gupta recently bough a house, the very first one
they viewed.
Discussion:
A couple who buy the first house they view have probably
sampled too few houses. Housing markets are notoriously
imperfect. Houses come in various shapes, sizes,
conditions, neighborhoods, and prices. Personal
preferences for houses also vary enormously. The couple
is likely to get a “better” house for themselves if they view a
dozen, two dozen, or more houses over the course of time
before buying their “most-preferred” house from the lot.
Problem 4.a Page 20
Discussion (Cont.)
Circumstances justifying the first-house purchase include:
(1) the house is so good that viewing others is a waste of
time,
(2) the house is so good and the commitment must be
made now or another buyer will claim the house,
(3) the couple must buy now (a job transfer has brought
them to the area and schools open tomorrow),
(4) they already have full information about the types of
other houses available (the wife's best friend is a real
estate agent).
Problem 4.e Page 21
A couple, nervous about boarding their airline flight on time,

patiently wait together in one of three baggage check-in
lines.
Discussion:
The frantic couple should choose separate lines to take
advantage of whichever line is quicker. Whoever gets
served first should check the baggage. The lesson here:
DIVERSIFY.
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Theory of the firm and demand

analysis - I
Agenda of the Class
Module 2: Theory of the firm and demand analysis - I

– Session 2:
• Theory of the firm: A simple model
• Sensitivity Analysis
• TR, AR and MR
• Basics of demand, Determinants of demand
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Theory of Firm
Theory of Firm
Managerial Economics is primarily concerned with the application of

microeconomic principles for the effective management of business
firms
In order to do this in an effective manner we need an overarching

“Theory of the Firm” that explains why firms exist, their structure,
how they behave, and what their goals are, etc.
Firms are complex organizations that are difficult to model but as with
any modelling the key is to focus on the important factors and
eliminate the unimportant factors
Nature of the firm
Two fundamental questions:

– What are organizations?
– Why do they exist?
Economic organizations
– Organizations occur at many different levels
Business organizations
– Sole proprietorships
– Partnerships
– Joint stock company
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Lets decide a place/ site for a

shopping mall
Siting the Shopping Mall
What location Minimizes Total Trip Miles?
The important factors in the real estate business are

Location, Location, and Location.
Siting the Shopping Mall
Point X TTM:
(5.5)(15)+(2.5)(10)+(1.0)(10)+(3.0)(10)+(5.5)(5)+(10.0)
(20)+(12.0)(10)+(16.5)(15) = 742.5 Miles
Point E TTM:
….. = 635 Miles, will be a better decision
Drawing a demand function
Qdx = 120 – 5 (P) P Q

0 120
When,
P=0
Qdx = 120 – 5 (0)
Qdx = 120 – 0
Qdx = 120
Qdx = 120 – 5 (P) P Q

0 120
When, 24 0
Q=0
0 = 120 – 5 (P)
5 (P) = 120
P = 120/5
P = 24
P Q
0 120
24 0
P Q
0 120
24 0
Formulating Linear Demand
Equation
300
Y = a + b (X)
Q = a + b (P),
Where, Q – Independent, a-autonomous and intercept of
Q, b-inverse of slope ‘del Q’/’del P’, and P-independent
Equation
300
Q = a + b (P),
b= ‘del Q’/’del P’ = q2-q1/p2-p1
b= 300-400/1.5-1 = -100/0.5 = -200
Q = a + (-200 P),
Equation
300
Q = a + (-200 P),
a: 200 = a – 200 (2)
200 = a – 400 | a = 600
Qb = 600 - 200 P
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TR, MR, AR
TR, MR, AR
Total Revenue
“Total revenue is the sum of all sales, receipts or income of

a firm.”
– Dooley
“product of planned sales (output) and expected selling

price.”
– Clower and Due
“Total revenue at any output is equal to price per unit

multiplied by quantity sold.”
– Stonier and Hague
Total Revenue
Average Revenue
Average revenue refers to the revenue obtained by the

seller by selling the per unit commodity. It is obtained by
dividing the total revenue by total output.
“The average revenue curve shows that the price of the

firm’s product is the same at each level of output.”
– Stonier and Hague
Average Revenue
Marginal Revenue
Marginal revenue is the net revenue obtained by selling an

additional unit of the commodity.
“Marginal revenue is the change in total revenue which
results from the sale of one more or one less unit of
output.”
– Ferguson
Thus, marginal revenue is the addition made to the total

revenue by selling one more unit of the good.
In algebraic terms, marginal revenue is the net addition to
the total revenue by selling n units of a commodity
instead of n – 1.
Marginal Revenue
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Exercises
Question 2, Page no. 52
The revenue function is R = 170Q - 20Q2. Maximizing
revenue means setting marginal revenue equal to zero.
Marginal revenue is: MR = dR/dQ = 170 - 40Q.
Setting 170 - 40Q = 0 implies Q = 4.25 lots.
By contrast, profit is maximized by expanding output only to
Q = 3.3 lots.
Although the firm can increase its revenue by expanding
output from 3.3 to 4.5 lots, it sacrifices profit by doing so
(since the extra revenue gained falls short of the extra
cost incurred.)
Demand and Demand
Analysis
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Agenda
Module 3: Demand Analysis – II and Elasticities

– Session 3:
• Price Elasticity of Demand
• Income Elasticity of Demand
• Cross Elasticity of Demand
• Economic Forecasting: The Basic Idea
Chapter 3 and 4 of your text book
The Circular Flow of Economic Activity
Input Markets and Output Markets: The
Circular Flow
Input and output markets are connected through the

behavior of both firms and households.
Firms determine the quantities and character of

output produced and the types and quantities of
input demanded.
Households determine the types and quantities of

products demanded and the quantities and types of
inputs supplied.
Demand in Product/Output Markets
A household’s decision about what quantity of a particular

output, or product, to demand depends on a number of
factors, including:
 The price of the product in question.
 The income available to the household.
 The household’s amount of accumulated wealth.
 The prices of other products available to the household.
 The household’s tastes and preferences.
 The household’s expectations about future income,
wealth, and prices.
Quantity Demanded ?
The amount (number of units) of a product

that a household would buy in a given
period if it could buy all it wanted at the
current market price.
Demand
 The process to satisfy human wants/ needs/desires.

 Want: having a strong desire for something
 Need: lack of means of subsistence
 Desire: an aspiration to acquire something
 Demand: effective desire
 Demand is that desire which backed by willingness and
ability to buy a particular commodity.
 Things necessary for demand:
 Time
 Price of the commodity
 Amount (or quantity) of the commodity consumers are
willing to purchase at the price
Types of Demand
 Direct or Autonomous and
Derived Demand
 Direct demand is for the goods as
they are such as Consumer goods
 Derived demand is for the goods Consumer Direct
which are demanded to produce
some other commodities; e.g.
Capital goods Capital Derived
 Recurring and Replacement Goods
Demand Consumable Recurring
 Recurring demand is for goods
which are consumed at frequent
Durable Replacement
intervals such as food items,
clothes.
 Durables are purchased to be
used for a long period of time
Types of Demand
 Complementary and Competing Demand

 Some goods are jointly demanded hence are complementary
in nature, e.g. software and hardware, car and petrol.
 Some goods compete with each other for demand because
they are substitutes to each other, e.g. soft drinks and juices.
 Demand for Perishable and Durable Goods
 Durables: Last for a relatively long time and can be
consumed multiple times
 Demand can be postponed
 Non-durables: Perishable, Non-perishable.
 Individual and Market Demand
 Individual demand: Demand for an individual consumer
 Market demand: Demand by all consumers
Determinants of Demand
 Price of the product
 Single most important determinant
 Negative effect on demand
 Income of the consumer
 Normal goods: demand increases with increase in consumer’s income
 Inferior goods: demand falls as income rises
 Price of related goods
 Substitutes
 If the price of a commodity increases, demand for
its substitute rises.
 Complements
 If the price of a commodity increases, quantity
demanded of its complement falls.
Determinants of Demand
 Tastes and preferences
 Very significant in case of consumer goods
 Expectation of future price changes
 Gives rise to tendency of hoarding of durable goods
 Population
 Size, composition and distribution of population will influence demand
 Advertising
 Very important in case of competitive markets
Factors determining demand
 Interdependence between demand for a product and its
determinants can be shown in a mathematical functional
form
Dx = f(Px, Y, Py, T, A, N) …….. [Multivariate fx]
Demand Function
 Independent variables: Px, Y, Py, T, A, N

 Dependent variable: Dx
 Px: Price of x
 Y: Income of consumer
 Py: Price of other commodity
 T: Taste and preference of consumer
 A: Advertisement
 N: Macro variable like inflation, population growth, economic
growth
LAW of DEMAND
Law of demand As price

rises, quantity demanded
decreases. As price falls,
quantity demanded
increases.
Demand Schedule
Anna’s Demand Schedule

for Telephone Calls
QUANTITY
PRICE (PER CALL) DEMANDED
Demand schedule A table (CALLS PER MONTH)
showing how much of a $ 0 30
given product a household .50 25

3.50 7
would be willing to buy at
7.00 3
different prices. 10.00 1
15.00 0
Demand Curve
A graph illustrating how much

of a given product a
household would be willing to
buy at different prices.
Anna’s Demand Curve

Exceptions to the Law of
Demand
Law of demand may not operate due to the following
reasons:
 Giffen Goods: Sir Robert Giffen, Ireland
 Snob Appeal: Veblen Goods, Thorstein Veblen
 Demonstration Effect: Fashion
 Future Expectation of Prices (Panic buying)
 Addiction
 Neutral goods
 Life saving drugs
 Salt
 Goods with no substitute
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Elasticity of Demand
“Elasticity” is a standard measure of the degree of

responsiveness (or sensitivity) of one variable to
changes in another variable.
price of the commodity, price of the other commodities,

income, taste, preferences of the consumer and other
factors.
Mathematically, it is the percentage change in quantity

demanded of a commodity to a percentage change in
any of the (independent) variables that determine
demand for the commodity.
Four major types of elasticity:
– Price elasticity,
– Income elasticity,
– Cross elasticity
– Advertising (or promotional) elasticity.
ceteris paribus
Price Elasticity of Demand
Price is most important among all the independent

variables that affect the demand for any commodity.
Hence price elasticity of demand (“ep”) is considered to be

the most important of all types of elasticity of demand.
Degrees of Price Elasticity
Perfectly elastic demand
ep=∞ (in absolute terms). Price
Horizontal demand curve

Unlimited quantities of the commodity can P D
be sold at the prevailing price
A negligible increase in price would result O
in zero quantity demanded Q
1
Q
2
Quantity
D
Price
Perfectly inelastic demand
ep=0 (in absolute terms) P1
Vertical demand curve P2
Quantity demanded of a commodity

remains the same, irrespective of any O
Q Quantity
change in the price 1
Such goods are termed neutral.
Highly elastic demand
Proportionate change in quantity demanded is more than a
Price
given change in price D
ep >1 (in absolute terms) P
Demand curve is flatter 1
P D
2
O
Unitary elastic demand Q
1
Q
2
Quantity
Price D
Proportionate change in price brings about an equal
proportionate change in quantity demanded P
1
ep =1 (in absolute terms). P
2
Demand curves are shaped like a rectangular hyperbola, D
asymptotic to the axes O
Q Q Quantity
Price 1 2
D
Relatively inelastic demand P
Proportionate change in quantity demanded is less than a 1
P
proportionate change in price 2
ep <1 (in absolute terms) O D

Q Q
Demand curve is steep 1 2
Quantit
y
Price Elasticity: Impact of Revenue
Elastic Unitary Inelastic

Elastic
Price rises TR falls No change TR rises
in TR
Price falls TR rises No change TR falls

in TR
PRICE ELASTICITY OF DEMAND
SLOPE AND ELASTICITY
Slope Is Not a Useful Measure of Responsiveness

PRICE ELASTICITY OF DEMAND
price elasticity of demand The ratio of the

percentage of change in quantity
demanded to the percentage of change in
price; measures the responsiveness of
demand to changes in price.
%chang
in
quan
dem

price
elasticity
of
demand
%
chang
in
pric
CALCULATING ELASTICITIES
CALCULATING PERCENTAGE CHANGES
To calculate percentage change in quantity demanded using

the initial value as the base, the following formula is used:
chang
in
quan
dem
% 
change
in
quantity
demand10
x
Q
1
Q-Q
2 1 x
100%
Q 1
We can calculate the percentage change in price in a similar way. Once again, let us use the initial
value of P—that is, P1—as the base for calculating the percentage. By using P1 as the base, the
formula for calculating the percentage of change in P is simply:
change
in
price
%in
change
price100%
x
P
1
P-P
2 1 x
100%
P
1
ELASTICITY IS A RATIO OF PERCENTAGES
Once all the changes in quantity demanded and price have been converted into percentages,
calculating elasticity is a matter of simple division. Recall the formal definition of elasticity:
%change
in
quant
dem

price
elasticity
of
demand
%
chang
in
price
THE MIDPOINT FORMULA

midpoint formula
A more precise way of calculating percentages using the value halfway between P1 and P2 for the
base in calculating the percentage change in price, and the value halfway between Q1 and Q2 as
the base for calculating the percentage change in quantity demanded.
change
in
quant
dema
% 
change
in
quantity
demand 100
x
(
Q
1
Q
)
22/
Q -
Q
 2 1 x 100%
(Q
1Q)
2 2
/
Using the point halfway between P1 and P2 as the base for

calculating the percentage change in price, we get
change
in
price
%in
change
price 100%
x
(
P
1P)
22/
P-P
 2 1 x 100%
(P
1P
2) 2
/
Problem
• You are given market data that says when the price of pizza is
Rs. 4, the quantity demanded of pizza is 60 slices and the
quantity demanded of cheese bread is 100 pieces. When the
price of pizza is Rs. 2, the quantity demanded of pizza is 80
slices and the quantity demanded of cheese bread is 70
pieces.
a. Can the PED be calculated for either good? Why?

b. If so, what is the PED?
Solution
• In order to calculate PED we need two (quantity,

price) pairs for one good (two points along a
certain good’s demand curve). We are given this
information for pizza. We are never given this
information for cheese bread.
• We have two (quantity, price) pairs for pizza.

Specifically,
– (QD1 , P1 ) = (60, $4) and
– (QD2 , P2 ) = (80, $2) .
The simple Formula of PED
% change in quantity
Dx 
% change in price
Dx = (Q2-Q1)/Q1*100
(P2-P1)/P1*100
Dx = (80-60)/60*100
(4-2)/2*100
Dx = 20/60*100
2/2*100
Dx = 33.33
Dx = 0.33
100
94
Problem
• A fruit vender was selling the mangos for 20 INR per KGs. And
was selling 50 KGs of mangos per day. Someone has advised
him to increase the price and you can increase your revenue.
He has increased the price 25 INR per KGs and was able to
sell 40 KGs per day.
a. Calculate the price elasticity of demand.

b. Was he able to increase the revenue?
The simple Formula of PED
% change in quantity
Dx 
% change in price
Dx = (Q2-Q1)/Q1*100
(P2-P1)/P1*100
Dx = (40-50)/50*100
(25-20)/20*100
Dx = -10/50*100
5/20*100
Dx = -20
Dx = -0.8
25
96
ELASTICITY AND TOTAL REVENUE
In any market, P x Q is total revenue (TR) received by producers:
TR = P x Q
total revenue = price x quantity
When price (P) declines, quantity demanded (QD) increases. The two
factors, P and QD, move in opposite directions:
Effects of price changes P  QD 

on quantity demanded: and
P  QD 
Determinants of Price Elasticity of Demand
• Nature of Commodity
• Availability and proximity of Substitutes
• Proportion of Income spent on the Commodity
• Time frame
• Durability of the Commodity

Income elasticity of Demand
• Income elasticity measures the

responsiveness of quantity demanded to
changes in income, holding the price of
the good & all other demand determinants
constant.
(Q2 - Q1)/Q1
ey =
(Y2 - Y1)/Y1
• Positive for a normal good

– Demand rises as income rises and vice versa
• Negative for an inferior good

– Demand falls as income rises and vice versa
• Zero for a neutral good

• Luxury goods: Income elasticity is greater than 1
• Normal goods: Income elasticity is between 0 and 1
• Inferior goods: Income elasticity is negative

Cross elasticity of Demand
• Cross-price elasticity of demand (EXY) measures the
responsiveness of quantity demanded of good X to changes in
the price of related good Y, holding the price of good X & all other
demand determinants for good X constant
Cross-price elasticity of demand in the real world
Positive : Two goods are substitutes

Negative: Two goods are complements
Commodity X Commodity Y Cross-price elasticity
Tea (India) Coffee (India) 0.0385
Entertainment (US) Food (US) -0.72

Margarine (US) Butter (US) 1.53
INCOME AND SUBSTITUTION EFFECTS
THE INCOME EFFECT
When the price of

something we buy falls,
we are better off. When
the price of something
we buy rises, we are
worse off.
Indifference Curves - Assumptions
1. We assume that consumers have the ability to choose among the combinations of
goods and services available.
2. We assume that consumer choices are consistent with a simple assumption of

rationality (to maximize his satisfaction).
Deriving Indifference Curve
An indifference curve is a set

of points, each point
representing a combination
of goods X and Y, all of which
yield the same total utility.
FIGURE An Indifference Curve

Indifference Curves - Properties
1. It slopes downwards from left to right
2. It is convex to the origin
3. It cannot intersect with another indifference curve

Consumer Equilibrium
CONSUMER CHOICE
FIGURE: Consumer Utility-Maximizing

Equilibrium
As long as indifference curves are convex to the origin, utility maximization will take place at the point at
which the indifference curve is just tangent to the budget constraint.
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Economic Forecasting
Meaning of Demand
Forecasting
• “An estimate of sales in dollars or physical units for a
specified future period under a proposed marketing
plan.”
- American Marketing Association
• Demand forecasting is the scientific and analytical
estimation of demand for a product (service) for a
particular period of time.
• It is the process of determining how much of what
products is needed when and where.
Techniques of Demand Forecasting
• Subjective (Qualitative)  Quantitative

methods: rely on human methods: use
judgment and opinion. mathematical or
– Buyers’ Opinion simulation models
– Sales Force Composite based on historical
– Market Simulation demand or
– Test Marketing relationships between
– Experts’ Opinion variables.
 Trend Projection
• Group Discussion
 Smoothing Techniques
• Delphi Method
 Barometric techniques
 Econometric techniques
Subjective Methods of Demand Forecasting
Consumers’ Opinion Survey
• Buyers are asked about future buying intentions of products, brand
preferences and quantities of purchase, response to an increase in the
price, or an implied comparison with competitor’s products.
– Census Method: Involves contacting each and every buyer
– Sample Method: Involves only representative sample of buyers
• Merits
• Simple to administer and comprehend.
• Suitable when no past data available.
• Suitable for short term decisions regarding product and
promotion.
• Demerits
• Expensive both in terms of resources and time.
• Buyers may give incorrect responses.
Contd…
Sales Force Composite

• Salespersons are in direct contact with the customers. Salespersons
are asked about estimated sales targets in their respective sales
territories in a given period of time.
• Merits
– Cost effective as no additional cost is incurred on collection of data.
– Estimated figures are more reliable, as they are based on the
notions of salespersons in direct contact with their customers.
• Demerits
– Results may be conditioned by the bias of optimism (or pessimism)
of salespersons.
– Salespersons may be unaware of the economic environment of the
business and may make wrong estimates.
– This method is ideal for short term and not for long term forecasting
Contd…
Experts’ Opinion Method

i) Group Discussion: (developed by Osborn in 1953) Decisions may be taken
with the help of brainstorming sessions or by structured discussions.
ii) Delphi Technique: developed by the Rand Corporation at the beginning of
the Cold War, to forecast impact of technology on warfare.
– Way of getting repeated opinion of experts without their face to face interaction.
– Consolidated opinions of experts is sent for revised views till conclusions converge on a
point.
• Merits
– Decisions are enriched with the experience of competent experts.
– Firm need not spend time, resources in collection of data by survey.
– Very useful when product is absolutely new to all the markets .
• Demerits
– Experts’ may involve some amount of bias.
– With external experts, risk of loss of confidential information to rival firms.
Contd…..
Market Simulation
• Firms create “artificial market”, consumers are instructed to shop with some
money. “Laboratory experiment” ascertains consumers’ reactions to changes in
price, packaging, and even location of the product in the shop.
– Grabor-Granger test (1960s)
Merits
– Market experiments provide information on consumer behaviour regarding a
change in any of the determinants of demand.
– Experiments are very useful in case of an absolutely new product.
• Demerits
– People behave differently when they are being observed.
Contd….
Test Marketing
• Involves real markets in which consumers actually buy a product without the
consciousness of being observed.
• Product is actually sold in certain segments of the market, regarded as the “test
market”.
• Choice and number of test market(s) and duration of test are very crucial to the
success of the results.
• Merits
– Most reliable among qualitative methods.
– Very suitable for new products.
– Considered less risky than launching the product across a wide region.
• Demerits
– Very costly as it requires actual production of the product, and in event of failure of the
product the entire cost of test is sunk.
– Time consuming to observe the actual buying pattern of consumers.
Quantitative Methods of Demand Forecasting
Trend Projection
Statistical tool to predict future values of a variable on the basis
of time series data.
• Time series data are composed of:
– Secular trend (T): change occurring consistently over a long time and
is relatively smooth in its path.
– Seasonal trend (S): seasonal variations of the data within a year
– Cyclical trend (C): cyclical movement in the demand for a product
that may have a tendency to recur in a few years
– Random events (R): have no trend of occurrence hence they create
random variation in the series.
118
Quantitative Methods :
Barometric Techniques
• Barometric Technique alerts businesses to changes in the

overall economic conditions.
• Helps in predicting future trends on the basis of index of
relevant economic indicators especially when the past data
do not show a clear tendency of movement in a particular
direction.
• Indicators may be
– Leading indicators: economic series that typically go up or down
ahead of other series
– Coincident indicators: move up or down simultaneously with the
level of economic activities
– Lagging series : which moves with economic series after a time
lag.
Quantitative Methods
• Simple (or Bivariate) Regression Analysis:
– deals with a single independent variable that determines the value of a dependent
variable.
– Demand Function: D = a+bP, where b is negative.
– If we assume there is a linear relation between D and P, there may also be some
random variation in this relation.
• Nonlinear Regression Analysis

– Log linear function log D =A + B log P + e
where A and B are the parameters to be estimated and e represents errors or
disturbances.
– Linear form of log linear function D* = a + b P* + e
where D*= log D and P*=log P
Quantitative Methods
Multiple Regression Analysis:
D = a1+a2.P+a3.A+e
(where A = advertising expenditure incurred).
D^ = a^1 + a^2P + a^3A,
(where a1, a2 and a3 are the parameters and e is the random error
term (or disturbance), having zero mean).
• Similar to simple regression analysis, multiple regression
analysis would aim at estimation of the parameters a1,
a2 and a3.
• Choose such values of the coefficients that would
minimize the sum of squares of the deviations.
Limitations of Demand Forecasting
• Change in Fashion
• Consumers’ Psychology
• Lack of Experienced Experts
• Lack of Past Data
– Accurate
– Reliable
Economic Forecasting
BITS Pilani +91.9826569573
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Agenda
Module 4: Economic Forecasting

– Session 4:
• Why forecasting
• Various forecasting methods
• Trend projection and constant growth models
• Regression analysis
Quotes
To count is a modern practice, the ancient method was to

guess; and when numbers are guessed, they are always
magnified.
~Samuel Johnson
I know half the money I spend on advertising is wasted, but I can never
find out which half.
~Lord Leverhulme of Unilever
Estimating Movie Demand
Estimating Movie Demand
Why forecasting?
Helps in Production Increasing customer

Planning satisfaction
Helps in Financial Reducing inventory stock
Planning outs
Helps in Economic Lowering safety stock
Planning requirement
Reducing product
Helps in Workforce
obsolescence costs
Scheduling
Managing transportation
Helps in Decisions Making better
Helps in Controlling Improving pricing and
Business Cycles promotion management
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4.2 Various forecasting methods

Qualitative methods
Subjective: rely on human judgment and opinion.
– Buyers’ Opinion
– Sales Force Composite
– Market Simulation
– Test Marketing
– Experts’ Opinion
• Group Discussion
• Delphi Method
Buyer’s opinion/ Consumer’s
Survey
Pitfalls:
– Sample bias
– Response bias
– Response accuracy
– Cost
Quantitative methods
Use mathematical or simulation models based on historical
demand or relationships between variables.
– Trend Projection
– Smoothing Techniques
– Barometric techniques
– Regression Method
Trend Projection
Regression
Regression analysis is set of statistical

techniques using past observations
to find (or estimate) the equation that
best summarizes the relationships
among key economic variables.
Slope and Intercept:
Every straight line can be represented
by an equation: y = mx + b. The
coordinates of every point on the line
will solve the equation if you
substitute them in the equation for x
and y.
Basics
Multiple R. This is the correlation coefficient. It tells you how strong the
linear relationship is. For example, a value of 1 means a perfect positive
relationship and a value of zero means no relationship at all. It is the square root
of r squared (see #2).
R squared. This is r2, the Coefficient of Determination. It tells you how many points
fall on the regression line. for example, 80% means that 80% of the variation of y-
values around the mean are explained by the x-values. In other words, 80% of
the values fit the model.
Adjusted R square. The adjusted R-square adjusts for the number of terms in a
model. You’ll want to use this instead of #2 if you have more than one x variable.
Standard Error of the regression: An estimate of the standard deviation of the
error μ. This is not the same as the standard error in descriptive statistics! The
standard error of the regression is the precision that the regression coefficient is
measured; if the coefficient is large compared to the standard error, then the
coefficient is probably different from 0.
Observations. Number of observations in the sample.
Complete idea on Regression
http://www.statisticshowto.com/excel-regression-analysis-o
utput-explained
/
Potential problems in
regression
Omitted Variables
Multicollinearity
simultaneity and identification
Potential problems in
regression
Heteroscedasticity
Durbin Watson Statistic
Serial correlation
Lets Play: 1
The table below lists the Neebok Company’s sales in each of its five
department stores. Management expects total sales to increase 10
percent in the coming year.
Store A Store B Store C Store D Store E Total
2004 8 9 10 11 12 50
2005 ? ? ? ? ? 55
a. Provide forecasts of each store’s sales in the coming year. What
assumptions underlie your forecasts?
b. A fellow manager points out that last year’s sales pattern is typical;
sales vary considerably across stores for unpredictable reasons.
Sales at a particular store may vary up or down by 10 to 20 percent
from year to year. A store may be a leader one year and a laggard the
next. What effect might this have on your 2005 forecasts? Explain.
Lets Play: 1 Answer
a. Most students’ predictions are: 8.8, 9.9, 11.0, 12.1, and

13.2 for the respective stores. This assumes that last
year’s differences in sales carry over exactly in the
current year.
b. The possibility of random fluctuations would call for more
cautious predictions. For example, if differences were
completely random, the best prediction for each store
would be 11.0 (the overall average). Most likely, we
would expect some “regression toward the mean” –
Store E would have somewhat greater than average
sales, and so on.
1. Which of the following can one expect to get from a
sound forecast?
a) A precise numerical forecast (one with a minimal margin
of error).
b) The relationship between the forecast and the economic
variables that influence it.
c) An assessment of the accuracy of the forecast.
d) A numerical estimate based on extending the past time
trend into the future.
e) Answers b and c are both correct
Response bias occurs when
a) Responses do not reflect the true preferences and
attitudes of respondents.
b) Insufficient sample size tends to bias the cross-section
of responses.
c) Questions are framed in ways that biases the answers.
d) Different question versions are targeted to different
segments of respondents.
e) Answers b and c are both correct.
In estimating a regression equation,
a) The main objective is to determine whether there is a
valid correlation between two variables.
b) One or more independent variables are contained on
the right-side of the equation.
c) Forecasts of one or more independent variables are
statistically estimated.
d) It is good practice to keep the number of explanatory
variables to a minimum.
e) Answers b and c are both correct.
In contrast to simple regression, multiple regression uses
a) Several dependent variables rather than one.
b) Several independent variables rather than one.
c) Several dependent variables and several independent
variables.
d) Multiple equation specifications in order to find the best
statistical fit.
e) Both times-series data and cross-section data.
What is the best definition of R2, the coefficient of
determination?
a) The slope of the regression equation.
b) The proportion of the variation of the dependent variable
left unexplained by the regression.
c) The variation in the dependent variable normalized to be
between zero and one..
d) The standard error of the coefficient associated with an
independent variable.
e) The proportion of the variation of the dependent variable
that is explained by the regression.
When multicollinearity occurs
a) Dependent and independent variables change in a
common pattern.
b) Two or more explanatory variables tend to move
together.
c) Multiple independent variables enter linearly in the
regression equation.
d) The explanatory variables vary independently of one
another.
e) None of the answers above is correct.
Some examples of economic variables that display
seasonal variations include
a) Tourism.
b) Air travel.
c) Clothing.
d) New housing construction.
e) All of answers above are correct.
Production Analysis
BITS Pilani +91.9826569573
Programmes Division
Agenda
Module 5: Production Analysis

– Session 5:
• Basic production concepts
• Production with one variable input and production
in the long run
• Measuring production function
Production decisions
Chapter 5 of your text book
Quotes
One-tenth of the participants produce over one-third of the

output. Increasing the number of participants merely
reduces the average output.
~Norman Augustine, Augustine’s Laws
Knowledge is the only instrument of production that is not

subject to diminishing returns.
~ J.M. Clarke
Let us case: Allocating a Sales
Force
Production
 The process of transformation of resources (like land,

labour, capital and entrepreneurship) into goods and
services of utility to consumers and/or producers.
 The process of creation of value or wealth through the
production of goods and services that have economic
value.
 process of adding value may occur
 by change in form (input to output, say steel into car), or
 by change in place (supply chain, say from factory to
dealers/retailer), or
 by changing hands (exchange, say from retailer to consumer).
Factors of production
 Land
 Gift of nature and not the result of human effort
 Reward is called as rent
 Labour
 Physical or mental effort of human beings - Skilled as well as unskilled.
 Reward is called as wages
 Capital
 Wealth used for further production as machine/ equipment/
 Reward is called as interest
 Enterprise
 The ability and action to take risk for uncertain economic gains
 Reward is called as profit
 Organization
 Managerial aspect of business.
 Reward is called as salary
The Production Process
The organization of production

– Inputs
• Fixed inputs
• Variable inputs
Transformation of inputs into output
Transformation for
Hospital Process
The Three Decisions That All
Firms Must Make
Firm: An organization that comes into being when a
person or a group of people decides to produce a good
or service to meet a perceived demand.
All firms must make several basic decisions to achieve
what we assume to be their primary objective—
maximum profits.
The Behaviour of Profit
Maximizing Firms
Optimal method of production - The production method

that minimizes cost.
Short-run vs. Long-run
decisions
Short run: The period of time for which two conditions hold:
• The firm is operating under a fixed scale (fixed factor) of
production, and
• Firms can neither enter nor exit an industry.
Long run: That period of time for which there are no fixed
factors of production:
• Firms can increase or decrease the scale of operation,
and
• New firms can enter and existing firms can exit the
industry.
Production Function
Production function with two inputs:

Q = f (K, L)
– Output = Number of the units of commodity

– Labour = Number of workers employed
– Capital = Amount of equipment used in the production
Assumption: both L and K are homogeneous

This principle can apply to firms using more than two inputs and
delivering more than one output
Production Function
 A mathematical relationship between physical inputs
and physical outputs over a given period of time.
 It can be said that production function is:

 Always related to a given time period
 Always related to a certain level of technology
 Depends upon relation between inputs.
 Normally a production function is written as:
Q = f (L,K,I,R,E)
Where, Q is the maximum quantity of output, and L=labour;

K=capital; I=land; R=raw material; E= efficiency parameter.
The Production Process
Production technology The quantitative relationship between inputs and

outputs.
Labor-intensive technology that relies heavily on human labor instead of
capital.
Capital-intensive technology: Technology that relies heavily on capital

instead of human labor.
While choosing the most appropriate technology, Firms choose the one that
minimizes the cost of production.
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Production with one variable input

and production in the long run
Production Function with One
Variable Input
Law of Variable Proportions
 As the quantity of the Labour Total MP AP Stages

(’00 Product
variable factor is units) (’000
tonnes)
increased with other 1 20 - Increasing
20
fixed factors, MP and AP 2 50 30
returns
25
of the variable factor will 3 90 40 30
eventually decline. 4 120 30 Diminishing
30 returns
 Therefore law of variable 5 140 20 28
proportions is also called 6 150 10 25
as law of diminishing 7 150 0 21.5
marginal returns. 8 130 -20 16.3 Negative
returns
9 100 -30
11.1
200
150
Total Product
(’000 tonnes)
100
Output
Marginal
Product
50
Average
Product
0
1 2 3 4 5 6 7 8 9
-50
Labour
{Labour Curves}
Total
Output C
 First stage
 Increasing Returns to
B TPL
the Variable Factor
 MP>0 and MP>AP A
 Second stage
 Diminishing Returns to
a Variable Factor
O
 MP>0 and MP<AP Labour
 Third Stage Total
Output
 Negative Returns Stage I Stage II Stage III
 MP<0 while AP is A*
falling but positive B
 Technically inefficient *
stage of production
APL
 A rational firm will
C
never operate in this O
*L
MP Labour
stage
Law of Diminishing Return
As we use more and more units of the variable input with a given
amount of the fixed input, after a point we get diminishing
returns from the variable input
Production Function with Two
Variable Inputs
 All inputs are variable in long run Capital Labour
and only two inputs are used (Rs. crore) (’00 units)
 Firm has the opportunity to 40 6
select that combination of inputs
which maximizes returns 28 7
 An isoquant is the locus of all 18 8
technically efficient 12 9
combinations of two inputs for
producing a given level of output 8 10
 Represented as:
Q  f (L, K )
Isoquant and Isocost
Isoquant: shows all the combinations of capital and labor

that can be used to produce a given amount of output.
Isocost: shows all the combinations of capital and

labor available for a given total cost
Characteristics of Isoquants
 Downward sloping
 Convex to the origin
 A higher isoquant represents a higher output
 Two isoquants do not intersect
Capital Capital
C
A
B A Q1
B C
Q2
Q1
Q0 Q2
O
O Labour Labour
ISO Cost
Total Cost is sum of Labour cost

(wL) and Capital cost (rK)
where wage (w) and interest (r) The (absolute) slope of
this line is equal to the
C  wL  rK ratio of the input prices.
The isocost line represents the Capital
locus of points of all the A2
different combinations of two
A
inputs that a firm can procure,
given the total cost and prices A1
of the inputs.
O B1 B B2 Labour
Returns to Scale
 Returns to Scale show the degree by which the level of output changes in
response to a given change in all the inputs in a production system.
Panel a Panel b Panel c

Capital Capital Capital
C2
C
B2 C1
B 400Q B
A 200 A2 A
Q 1 125Q
100Q 150Q
50Q
1
90Q
50Q 50Q
O O O
Labour Labour Labour
 Constant Returns to Scale : (Panel a)

 Increasing Returns to Scale : (Panel b).
 Decreasing Returns to Scale : (Panel c).
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Measuring Production Function

Measuring production
Function
Linear Production
Q = aL+bK+C
Production with fixed proportions

Taxi and Taxi Driver
Polynomial functions
Q = aLK – bL2K2
The Cobb-Douglas Function
 Proposed by Wicksell and tested against statistical

evidence by Charles W. Cobb and Paul H. Douglas
in 1928
 
Q  AK L
 where α, β are constants.
 A is the technological parameter,
 α is the elasticity of output with respect to capital, and
 β is the elasticity of output with respect to labour.
 Properties
 Homogeneous of degree (+)
 The returns to scale is immediately revealed by the
sum of the two parameters  and 
 ( +) = 1
Constant Returns to Scale:
 Increasing Returns to Scale: ( +) > 1
 Decreasing Returns to Scale: ( +) < 1

 Isoquants are negatively sloped and convex to the
origin
 Elasticity of substitution is equal to 1
Q1
The main task of a production manager is to determine

a) Which goods to produce.
b) The markets in which to sell finished products.
c) When and how to increase production capacity.
d) Profitable prices for finished products.
e) How to produce a given level of output at minimum total
cost.
Q2
For a given combination of inputs, a production function

indicates the associated
a) Average cost of production.
b) Marginal cost of production.
c) Maximum output level.
d) Minimum cost.
e) Profit-maximizing output level.
Q3
The best definition of the short run is the period of time in

which
a) Management cannot change its decisions.
b) The amount of output cannot be varied.
c) One or more inputs are fixed
d) All inputs can be varied but at a high marginal cost.
e) Economic conditions are relatively stable and
unchanging.
Q4
If marginal product is zero, then total product is

a) At a minimum.
b) Necessarily being produced at minimum total cost.
c) At a maximum.
d) Increasing at a maximum rate.
e) Uncertain. More information is needed.
Q5
In the long run, can a firm change its scale of operation?

a) Yes. This is a key decision in the long run.
b) Yes, but only if technology changes.
c) No. Scale cannot be changed in the long run.
d) No, unless there are returns to scale.
e) Uncertain, depends on the nature of the production
function.
Cost of Production
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Programmes Division
Agenda
Module 6: Cost of Production

– Session 6:
• Relevant costs
• The cost of production
• Cost analysis and optimal decision
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Relevant costs
Quotes
Delete each element of capability until system capability is

totally gone and 30 percent of the cost will still remain.
~Norman Augustine, Augustine’s Laws
Allocating Cost
Cost Analysis Context
Harley Davidson – motor cycle company
Stiff competition from Japanese in the 1980’s
Due to decreasing market share and lower profits, Harley Davidson introduced a
number of steps to increase manufacturing efficiency and reduce costs
Instead of machining parts in house it began to purchase ready made parts from
suppliers using just in time principles
This reduced work-in-process inventory by $24 million thereby saving significant costs
If we assume an interest rate of say 15% then the annual cost savings from interest
expense would amount to 15% x $24 Mil = $3.6 Million
Metric 1985 1995

Net Sales $288 Million $1.35 billion
Net Income $3 Million $112 Million
Earnings per Share $0.09 $1.50
Relevant Costs
 Opportunity Costs:
 What is the opportunity cost of pursuing and MBA
degree?
 What is the opportunity cost of using excess factory
capacity to supply specialty orders?
 What is the opportunity cost of that should be imputed
to city-owned land that is to be the site of public
parking garage downtown?
The Costs of Production
There are different types of costs.

Invariably, firms believe costs are too high and try to lower
them.
– Fixed Costs,
– Variable Costs, and
– Total Costs
Fixed Costs, Variable Costs,
and Total Costs
The sum of the variable and fixed costs are total costs.
TC = FC + VC
Costs of Production: Average
Costs
Average Total Cost, Average Fixed Cost, and Average Variable Cost
Average costs are costs per unit of output
Average total cost (often called average cost) equals total cost divided
by the quantity produced.
ATC = TC/Q
Average fixed cost equals fixed cost divided by quantity produced.
AFC = FC/Q
Average variable cost equals variable cost divided by quantity
produced.
AVC = VC/Q
Average Costs
Average total cost can also be thought of as the sum of

average fixed cost and average variable cost.
ATC = AFC + AVC
Marginal Cost
Marginal cost is the increase (decrease) in total cost of

increasing (or decreasing) the level of output by one unit.
In deciding how many units to produce, the most important
variable is marginal cost.
Cost Function
Determinants of cost:
– Price of inputs
– Productivity of inputs
– Technology
– Level of output
Mathematically we can express the cost function as:
C= f(Q, T, Pf)
Where,
C=cost;
Q=output;
T=technology;
Pf = price of inputs.
Kinds of Costs
Accounting Costs/ Explicit Costs/ Out of Pocket Costs

– Which can be identified, measured and accounted for; e.g.
cost of raw materials, wages and salary and capital costs like
cost of the factory building.
Real Costs
– More or less social and psychological in nature and non
quantifiable in money terms; e.g. cost of sacrificing leisure
and time.
Opportunity Costs
– Help in evaluation of the alternative uses of an input other
than its current use in production
Kinds of Costs
Implicit Costs
– Do not involve cash outflow or reduction in assets, or increase in liability; e.g.
owner working as manager in own building
Direct Costs
– Which can be attributed to any particular activity, such as cost of raw material,
labour, etc.
Indirect Costs
– Costs which may not be attributable to output, but are distributed over all
activities are indirect costs – Also known as overheads.
Kinds of Costs
Replacement costs
– Current price or cost of buying or replacing any input at present. Like buying new
machines for old plant.
Social Costs
– Costs to the society in general because of the firm’s activities. E.g. pollution
caused by industrial wastes and emissions.
Controllable Costs and Uncontrollable Costs
– Controllable Costs are subject to regulation by the management of a firm; e.g.
fringe benefits to employees, costs of quality control.
– Uncontrollable Costs are beyond regulation of the management; e.g. minimum
wages are determined by government, price of raw material by supplier.
Comparisons of Costs
Type of Cost Relevant to Relevant to

Accountant? Decision Maker?
Fixed Cost Yes No

Sunk Cost Yes No
Variable Cost Yes Yes
Opportunity Cost No Yes
Costs in Short Run
Fixed Costs
– Do not vary with output; e.g. Costs
plant, machinery, building.
– Total Fixed Cost (TFC) curve
is a straight line, parallel to C TFC
the quantity axis, indicating
that output may increase to
any level without causing any O
Quantity
change in the fixed cost.
– In the long run plant size Costs
may increase hence FC TFC
curve may be step like,
where each step showing FC
in a particular time period.
O
Quantity
Costs in Short Run
Costs Variable Costs

TC  Costs that vary with level of output
TVC
and are zero if no production; e.g.
cost of raw materials, wages.
TFC  Normally TVC is like a straight line
starting from origin.
O
Quantity  TVC may be an inverse S shaped
Costs TC upward sloping curve, due laws of
TVC variable proportions.
 Total cost (TC)
 Sum of TFC and TVC
 Slope of TC curve is determined
TFC
by that of the TVC.
O
Quantity
Costs in Long Run
All costs are variable in the long run since factors of

production, size of plant, machinery and technology can
be varied in the long run.
The long run cost function is often referred to as the
“planning cost function” and the long run average cost
(LAC) curve is known as the “planning curve”.
As all costs are variable, only the average cost curve is
relevant to the firm’s decision making process in the long
run.
The long run consists of many short runs, therefore the long
run cost curve is the composite of many short run cost
curves.
Costs in Long Run
o In the long run the firm may increase plant size to
increase output.
o It shows scalloping curve as the plant costs are not
smoothened.
AC, MC MC1 SAC3

SAC1 MC2
SAC2 MC3
LAC
O q0 q1 q2 Quantity
Cost Analysis Significance
In order to make wise decisions on how much to produce and

what price to charge, managers need to understand the
relationship between a firm’s output rate and its costs.
Cost has multiple impacts:
– Current level of profitability
– Competitive advantages
– Expansion of output
Determining the level of output (frequently pose questions)
– What would be the cost of increasing production by 25%
– What is the impact on cost of rising input prices?
– What production changes can be made to reduce costs?
Output and costs are interrelated
India’s Low Cost Airline
Air Asia –Perhaps world’s best low-cost airline

Started in February 2013
Foreign direct investment -49%
– Joint venture –Tata Sons
– Focuses on the southern part of India
– Headquarters in Chennai
Major focus of the airline: keep costs low and increase

revenue
– Counted the number of papers that they print –reduced significantly
– The number of coffee cups that they use in their offices-Reduced
– Charge for extra luggage
Air Asia: Model Features
Single class, no-frills

– Passengers do not receive meals, entertainment, amenities such as pillows
– Cabins were designed to minimize the wear and tear, cleaning time, and cost
High aircraft utilization and Efficient operations

– Reduced the overhead and fixed costs associated with the aircraft
– Absence of in-flight services (loading of food and drinks)
Low distribution costs (via e-ticketing)

Negotiations and contracts
– Staff and training needs reduced
– Better purchase terms
– The new A-320 would lower fuel usage by about 12 per cent (fuel costs -50 % of
the total operating costs)
– Low lease rates for its aircraft (outcome of negotiation)
The shut down rule
In the short run the firm

should continue to
produce at Q* (even
if it is suffering loss)
so long as price
exceeds average
variable cost. In the
long run, the firm
should shutdown if
price falls short of
average cost.
Q1
Accounting profit typically exceeds economic profit because

a) Accounting profit includes intangible revenue sources.
b) Economic cost includes all relevant opportunity costs.
c) Accounting cost contains implicit costs.
d) Accounting practice is to allocate fixed costs to other
activities.
e) This is incorrect. Economic profit is usually greater than
accounting profit.
Q2
The opportunity cost of investing all of your savings in a

new business is equal to
a) The potential profits from the business.
b) The discounted present value of future profits.
c) The rate of return on your savings you could have
earned in a comparable investment.
d) The risk of losing all your savings.
e) The growth rate of your savings in the business.
Q3
The total economic cost of pursuing a three-year Masters

degree after college is equal to
a) The total cost of tuition, books, and living expenses
during the program.
b) The total cost of tuition and books.
c) All expenses incurred during the program.
d) All educational expenses during the program plus three
years of wages that the individual would have earned if
she had not elected the program.
e) None of the answers above is correct.
Q4
A manager considering alternative courses of action should

a) Not consider costs that are fixed with respect to the
alternatives.
b) Include both variable and fixed costs.
c) Consider all past, present, and future costs.
d) Incorporate only accounting cost in the decision-making
process.
e) Include only a portion of sunk costs.
Q5
A law firm will be paid $500 to send one of its lawyers to take a routine
deposition. The firm can send a 2nd-year lawyer whose usual billing
rate is $150 per hour and who will lose a half day from working on a
lucrative tax deal. Or it can send a 4th-year associate (billing rate
$200 per hour) who is currently overseeing the selection and hiring
of law students as summer associates. The firm should
a) Assign the 2nd-year lawyer because his billable rate is lower.
b) Assign the 4th-year lawyer because her billable rate is higher.
c) Assign the 2nd-year lawyer because he is currently more
productive.
d) Assign either one since the firm receives the same $500 fee.
e) Assign the 4th-year lawyer because her current work is less
valuable to the firm.
Q6
Fixed costs
a) Must be allocated among different activities of the firm.
b) Are incurred regardless of the firm's level of output.
c) Are identical to overhead expenses.
d) Are reduced to zero if the firm produces no output.
e) Represent the full costs of production.
Q7
After stopping production of its only product, the firm’s total

cost is
a) Zero.
b) Its total fixed cost.
c) Its total variable cost.
d) Its opportunity cost.
e) There is not enough information to answer.
Q8
In the long run,

a) All costs are fixed.
b) All costs are variable.
c) Some costs are fixed and others are variable.
d) The firm can expand or contract as long as it changes
all inputs in the same proportion.
e) Marginal cost will eventually increase due to diminishing
returns.
Q9
Mexico is capable of producing 20 auto tires or 16

microcircuits per labor hour. Brazil is capable of
producing 24 auto tires or 24 microcircuits per labor
hour.
a) Brazil has an absolute advantage in both goods.
b) Brazil will be expected to export both goods to Mexico.
c) Mexico has a comparative advantage in tires.
d) Answers a and c are both correct.
e) Answers a and b are both correct.
Profit and Revenue
Maximization
BITS Pilani +91.9826569573
Programmes Division
Agenda
Module 7: Profit and Revenue Maximization

– Session 7:
• Profit Maximization
• Break Even Analysis
• Incremental Profit Analysis
Topics of Discussion
Profit Maximization
– Mathematical Understanding
– Numerical Examples
Shut-Down Point
Breakeven Analysis
Incremental Profit Analysis
Rules of Maximisation
total revenue
Profit
(TR) and total
maximization costs (TC)
MR=MC
Profit = Revenue - Cost
Total Profit = Total
5
$4.54 TC
Revenue – Total 3.5
Cost 3
2.5 T
Total profit for small 2
R
and large quantity 1.5
production is 0.5
negative with two

0
0 5 10 15 20 25 30 35
Q
zero crossings. $
2
Total profit is maximum 1 Tp

when the slopes of
Q
both TR and TC 0
0 5 10 15 20 25 30 35
MR MC
curves are equal and
parallel
-1
-2
MR = MC
0.5
Marginal Revenue
0.4
 Marginal Cost 0.3 M

C
Marginal Profit
0.2

0.1
MR
M  MRMC 0
0 5 10 15 20 25 30 35
Maximum Profit 0.2

0.1
does not occur at 0

0 5 10 15 20 25 30 35
Maximum Marginal
-0.1
-0.2 Maximu Mp
Profit but at zero. -0.3
m Profit
-0.4
-0.5
-0.6
Profit Maximisation in Brief
Slope of the TR curve is equal to the slope of the TC curve

– Slope of the TR curve = Marginal curve
– Slope of the TC curve = Marginal cost
When both are equal, slope of the total profit is zero
This can be stated in another way
– MR-MC = 0 so that MR = MC
It states that additional revenue generated from a unit of
output must be equal to the additional costs of producing
it
Profit maximization Rule:
Example
Q P TR TC T Arc Arc Arc

MR MC M
0 200 0 200 -200
5 190 950 1200 -250 190 200 -10
10 180 1800 2050 -250 170 170 0
15 160 2400 2450 -50 120 80 40
20 140 2800 2700 100 80 50 30
25 120 3000 2850 150 40 30 10
30 105 3150 2950 200 30 20 10
35 93 3255 3055 200 21 21 0
40 80 3200 3180 20 -11 25 -36
MR-MC Rule: Example
• Marginal revenue from producing another TV set is Rs.

200 and marginal cost is Rs. 100. in this transaction, the
firm will add Rs. 100 to the profit
• Even if MR is Rs. 175 and MC is Rs. 174, the firm will
add Rs. 1 to the total profit
• If the firm produces an additional unit when MR is Rs.
160 and MC is Rs. 180, then profit will decrease by Rs.
20.
• The condition is that marginal profit is zero, profit is
maximized
The Shutdown Point
Example: the fixed costs of a restaurant is Rs. 4000, average price is

Rs. 4, average variable cost Rs. 4.50 for each meal. The total
sales revenue would be Rs. 40,000 if the restaurant sells 10,000
meals per month. But the total variable cost will be Rs. 45000.
What should the firm do?
If the firm continues to produce then the loss would be Rs. 9,000
If the firm does not produce then the loss would only be Rs. 4000 per
month (fixed cost)
Hence, the option for the firm is to shut down its operation
temporarily
The Shutdown Point
In the short-run
– If the average price of a meal is Rs. 4.60 and average
variable cost is Rs. 4.40 and firm sells 9000 meals, then the
total revenue would be Rs. 41,400, and total cost would be
Rs. 39,600.
– Without considering the fixed cost, the profit would be Rs.
1,800. If fixed cost are included, the loss would be Rs. 2,200.
– In the short-run, the firm would rather continue its operation
as long as it covers variable cost and some part of fixed
costs.
In the long-run, the firm should try to recover all of its costs, if it
wants to stay in business. (few exceptions to this rule).
Live: The Shutdown Point
The possibility that a firm may earn losses raises a

question: Why can the firm not avoid losses by shutting
down and not producing at all? The answer is that
shutting down can reduce variable costs to zero, but in
the short run, the firm has already paid for fixed costs.
As a result, if the firm produces a quantity of zero, it would
still make losses because it would still need to pay for its
fixed costs.
So, when a firm is experiencing losses, it must face a
question: should it continue producing or should it shut
down?
As an example, consider the situation of the Yoga Center, which has

signed a contract to rent space that costs $10,000 per month. If the
firm decides to operate, its marginal costs for hiring yoga teachers is
$15,000 for the month. If the firm shuts down, it must still pay the rent,
but it would not need to hire labor. Let’s take a look at three possible
scenarios.
In the first scenario, the Yoga Center does not have any clients, and
therefore does not make any revenues, in which case it faces losses
of $10,000 equal to the fixed costs.
In the second scenario, the Yoga Center has clients that earn the center
revenues of $10,000 for the month, but ultimately experiences losses
of $15,000 due to having to hire yoga instructors to cover the classes.
In the third scenario, the Yoga Center earns revenues of $20,000 for the
month, but experiences losses of $5,000.
In all three cases, the Yoga Center loses money. In all three cases, when
the rental contract expires in the long run, assuming revenues do not
improve, the firm should exit this business. In the short run, though, the
decision varies depending on the level of losses and whether the firm can
cover its variable costs.
In scenario 1, the center does not have any revenues, so hiring yoga
teachers would increase variable costs and losses, so it should shut down
and only incur its fixed costs.
In scenario 2, the center’s losses are greater because it does not make
enough revenue to offset the increased variable costs plus fixed costs, so
it should shut down immediately. If price is below the minimum average
variable cost, the firm must shut down.
In contrast, in scenario 3 the revenue that the center can earn is high
enough that the losses diminish when it remains open, so the center
should remain open in the short run.
Should the Yoga Center
Shutdonw – Now or Later?
Scenario 1
If the center shuts down now, revenues are zero but it will
not incur any variable costs and would only need to pay
fixed costs of $10,000.
profit = total revenue – (fixed costs + variable cost)
profit = 0 – $10,000 = –$10,000
Shutdown – Now or Later?
Scenario 1
If the center shuts down now, revenues are zero but it will
not incur any variable costs and would only need to pay
fixed costs of $10,000.
profit = 0 – $10,000 = –$10,000
Scenario 2
The center earns revenues of $10,000, and variable costs
are $15,000. The center should shut down now.
profit = $10,000 – ($10,000 + $15,000) = –$15,000
Scenario 3
The center earns revenues of $20,000, and variable costs
are $15,000. The center should continue in business.
profit = $20,000 – ($10,000 + $15,000) = –$5,000
Breakeven Analysis
• Breakeven: relationship among the total revenue, total costs, and total
profits of the firm at various levels of output
• A firm breaks even when TR = TC
• The firm incurs losses at smaller outputs and earns profits at higher
output levels
• Often used by business executives
• Real world examples
– Nano: Took four years to break even with an estimate of 8 lakh units
– Air Asia-(February 2013), Initially, it was expected to break even by
May or June (Original break even was in November 2015) (Source:
Live Mint, Air Asia India to break even by May June, Says CEO, 20th
August 2015)
Breakeven Analysis
PROFI
T
Product Cost is 3.60. 200
TR
180 TC
Product Price is 6.00.
$(1000's)
160
Total Fixed Costs are 140 TV
60,000/mo. 120 C
 Total Variable Cost 100
 Total Cost 80 TFC
 Total Revenue 60
 Break-even point at 25,000 40
products / month 20 BEP
 Profit at higher sales 0
0 10 20 30 40
volumes grows without
bound
Q(1000's)
Breakeven - Algebraically
TR  TC
TR  (P)(Q)
TC  TFC  ( AVC)(Q)
(P)(QB )  TFC  ( AVC)(QB )
(P)(QB )  ( AVC)(QB )  TFC
(QB )(P  AVC)  TFC
TFC
QB 
P  AVC
(P - AVC) is known as the unit contribution
margin
Breakeven -
Algebraically
Suppose, if a firm wishes to earn a specific
profit and wants to estimate the quantity it
must sell to earn that profit
Determine the target output (Q) at which a
target profit can be achieved
TFCT
QT 
P AVC
Incremental Profit
Analysis
To determine the effect on total profit that
will result from a particular action, given
that the firm is already generating a
certain level of profit (based on its
existing business)
– Open a new territory
– Sell on credit
– New technology or Equipment change, etc.
Identify the relevant costs and revenues

for the various options being considered
Analyze whether these activities contribute
more to total revenue than to total cost
Conclusion
Profit maximization conditions

– MR=MC
– Second derivative should be negative
Shutdown Point
Incremental Profit Analysis
Market Structure and
Competition
BITS Pilani +91.9826569573
Programmes Division
Agenda
Module 8: Market Structures and Competition

– Session 8:
• Perfect Competition
• Monopoly and its setting
• The perfect competition versus pure monopoly
• What is monopolistic competition?
• Oligopoly model
• Other dimensions of competitions
Chapter 7, 8, and 9 of your text book
Typologies of Market
Structure
Number of
buyers
One A few Many
Number suppliers
One Bilateral Monopoly

Monopoly
A few oligopoly
Monopolistic
Many monopsony /
2
Perfect 4
2
1/13/21 Dr. Rahul Pratap Singh Kaurav, PIMG Competition
242 BITS Pilani, WILPD
Market Structure and Pricing
Methods
Market Morphology
 Markets may be characterized on the basis

of:
 Number, size and distribution of sellers in any market
 Whether the product is homogeneous or differentiated
 Number and size of buyers:
 large number of buyers but small size of individual buyer, the market will be evenly
balanced between buyers and sellers.
 small number of buyers but their size is large, the market is driven by buyers’
preferences.
 Absence or presence of financial, legal and

technological constraints
 Thus we have:
 Perfect Competition  Monopolistic
 Monopoly competition
1/13/21
 Oligopoly
Dr. Rahul Pratap Singh Kaurav, PIMG 244 BITS Pilani, WILPD
Morphology Cont…
Type of Numbe Nature of Numbe Freedom Examples
market r of product r of of entry
firms buyers and exit
Perfect Very Homogeneous Very Unrestricte Agricultural
competition Large (undifferentiated) Large d commodities,
unskilled
labour
Monopolistic Many Differentiated Many Unrestricte Retail stores,
competition d FMCG
Oligopoly Few Undifferentiated Many Restricted Automobiles,
or differentiated computers,
universities
Monopoly Single Unique Many Restricted Indian
Railways,
Microsoft,
Intel
Monopsony Many Undifferentiated Single Not Arms
or differentiated applicable manufacturer
1/13/21 Dr. Rahul Pratap Singh Kaurav, PIMG
s245
andBITS Pilani, WILPD
Market Structure forms:
Competitiveness
Perfect Competition
More Competitive
Less Competitive
Monopolistic
Competition
Oligopoly
Monopoly
Perfect competition
Large number of buyers and sellers

Homogeneity in the products
Free enterprise
Perfect knowledge
Free entry and exit
Example: Stock market
Normal profit is that necessary for the firm
to be willing to produce its product over the
long run, and is considered a cost of
production
The features of Perfect
Competition
Perfect competition may be defined as that market
where infinite number of sellers sell homogeneous good
to infinite number of buyers while buyers and sellers
have perfect knowledge of market conditions
 Features
 Presence of large number of buyers and sellers
 Homogeneous product
 Freedom of entry and exit
 Perfect knowledge
 Perfectly elastic demand curve
 No governmental intervention
 Price determined by market and firm is a price taker.
Perfect Competition: Stock
market
The market for stocks traded on the stock exchanges
The price of a particular stock is determined by the market forces
Individual buyers and sellers of the stock have an insignificant effect
All stocks within each category are more less homogeneous
Information on prices and quantities traded is readily available
Price of a stock-reflects all the publically known information about

the present and expected future profitability of the stock
Equilibrium Price and demand level
faced by a perfectly competitive firm
Perfect Competition: Price
Determination
QD  625  5P QD  QS QS  175  5P
625  5P  175  5P
450  10P
P  $45
QD  625  5P  625  5(45)  400
QS  175  5P  175  5(45)  400
Lets Play 1
Demand is given by QD = 100 – P and supply by QS = .5P –

20. Equilibrium price and output under perfect
competition are
a) P = $60 and Q = 10 units.
b) P = $80 and Q = 20 units.
c) P = $70 and Q = 30 units.
d) P = $100 and Q = 30 units.
Lets Play 1
Demand is given by QD = 100 – P and supply by QS = .5P –

20. Equilibrium price and output under perfect
competition are
a) P = $60 and Q = 10 units.
b) P = $80 and Q = 20 units.
c) P = $70 and Q = 30 units.
d) P = $100 and Q = 30 units.
Short-run analysis of a perfectly
competitive firm
Long-run equilibrium of the perfectly
competitive firm
Monopoly
The earnings of many in the hands

of one.
~Eugene Debs
Monopoly
Single seller and many buyers

No close substitutes for product
Significant barriers to resource mobility
– Control of an essential input
– Patents or copyrights
– Economies of scale: Natural monopoly
– Government franchise: Post office
Features of monopoly
 Single seller
 The entire market is under control of a single firm.
 Single product
 A monopoly exists when a single seller sells a product which
has no substitute or, at least, no close substitute in the market.
 No difference between firm and industry
 There is a single firm in the industry
 Independent decision making
 Firm is regarded as a price maker
 Restricted entry
 Existence of barriers leads to the emergence and/or survival of
a monopoly
Barriers to Entry
Economies of Scale
Capital requirements (Chemical, Pharma, electronics,
automobiles, defence, oil refining, deep-sea drilling)
Pure quality and cost advantages (Intel, Wall-mart) 
Coca-Cola
Product differentiation (Software industry – Switching cost)
Control of resources (DeBeers – Diamond)
Patents, copyrights, and other legal barriers (Publishing,
Toool designing)
Strategic barriers (Reliance Jio, Android)
Types of Monopoly
 Legal Monopoly
 Created by the laws of a country in the greater public
interest.
 Economic Monopoly
 Created due to superior efficiency of a particular player.
 Natural Monopoly
 Formed when the size of the market is so small that it
can accommodate only one player.
 Regional Monopoly
 Geographical or territorial aspects also help in creation
of monopolies.
The Social Costs of Monopoly
MC reflects the
marginal cost of the
resources needed.
The triangle ABC

roughly measures
the net social gain of
moving from 2,000
units to 4,000 units
(or the loss that
results when
monopoly decreases
Inefficiency and Consumer Loss
output from 4,000
units to 2,000 units).
6
Price and Output Decisions in

Short Run
Price, AR>
Revenu AC M
 In order to maximize profit a e, Cost C
monopoly firm follows the rule B AC
of MR=MC when MC is rising. PE
 A monopoly firm may earn
supernormal profit or normal A
E A
profit or even subnormal profit R
in the short run. MR
 In the short run, the firm would O QE Quantity
reap the benefits of supplying a
product which unique.
Firm maximizes profit where
(i) MR=MC (ii) MC cuts MR from below, at point
E.
Supernormal profit= AEBPE,
since price (AR) > AC
Price and Output Decisions
in Short Run
Price,
Revenu AR= Price, AR<
e, AC Revenu
Cost e, AC
M M A
Cost
C A C C
C A B
P B PE C
E
E
E A
A M R
M R R
R
O QE O Q Quantit
Quantit
y E y
Firm makes normal Firm makes loss.

profit.
Centralized Cartels
• Assuming the case of a cartel with
two firms facing same MR and AR
Price,
Cost, M ∑ • MCA = Firm A’s marginal cost
Reven CB M M • MCB = Firm B’s marginal cost
ue CA C
• ∑MC = industry marginal cost
• OQ = profit maximizing output
P because (MR=∑MC).
• OQA = A’ output
• OQB = B’s output
AR • OQ=OQA + OQB; OQA > OQ B
M =D • OP = price at which both firms can
R
sell their output. Price will be
O determined by summation of all
Q Q Q Quant
firms’ costs and demand.
B A
ity
• In a cartel an individual firm is just
a price taker.
Market Sharing Cartels
• Firms decide to divide the
market share among them and
Price, fix the price independently.
Cost, • All firms have the same cost
Reven
ue
functions because they are
M A producing a homogenous
C C product but have different
P demand functions.
A
P • Due to different demand
B
functions, at equilibrium total
output = OQA+ OQB, where
A
RA OQA> OQB.
M
A • The quantity of output
RA
M RB produced and sold would
RB depend upon the terms of
O
Q Q Quanti agreement among the firms in
B A
ty the cartel.
Factors Influencing Cartels
• Number of firms in the industry: Lower the number of firms in

the industry, the easier to monitor the behaviour of other members.
• Nature of product: Formed in markets with homogenous goods
rather than differentiated goods, to arrive at common price. But if
goods are homogeneous, an individual firm may gain larger
market share by cheating, i.e. by lowering the price.
• Cost structure: Similar cost structures make it easier to
coordinate.
• Characteristics of sales: Low frequency of sales coupled with
huge amounts of output in each of these sales make cartels less
sustainable, because in such cases firms would like to undercut
the price in order to gain greater market share.
– with large number of firms and small size of the market some
firms may deviate from the cartel price and thus cheat other
members.
Summary
Points of Comparison Perfect Competition Monopoly

Relationship between AR = MR AR > MR
AR and MR
Profit in the long run Normal profits Supernormal profits

Number of sellers Large Single
Barriers to entry and exit Free entry and exit Strong barriers
Control on Price The seller is only the Monopolist is the price
price taker maker
Nature of demand curve Perfectly elastic Inelastic

Relationship between Each firm is a part of the Firm and industry are
firm and industry industry one and the same
Monopoly: Barriers to entry
Economies of Scale
Capital requirements
Pure quality and cost advantage
Product differentiation
Control over resources
Patents, copyrights, and other legal barriers
Introduction
A blend of competition and monopoly

Many sellers of differentiated (similar but not
identical) products
– May be real or imaginary (same ingredients)
Limited monopoly power
Downward-sloping demand curve
Increase in market share by competitors causes
decrease in demand for the firm’s product
Most common in the retail and service sectors
Characteristics of Different
Markets
The Monopolistically Competitive
Firm in the Short Run
Each firm faces a downward-sloping demand curve

The monopolistically competitive firm follows the
monopolist's rule for maximizing profit
– It chooses the output level where MR is equal to MC
– It sets the price using the demand curve to ensure that
consumers will buy the amount produced
We may compare price and average total cost to decide
whether a firm is making a profit or loss
– If P > ATC , the firm is earning a profit
– If P < ATC , the firm is earning a loss
– If P = ATC , the firm is earning zero economic profit
Features of Monopolistic Competition
Chamberlin:
“Monopolistic competition is a challenge to the traditional
viewpoint of economics that competition and monopoly are
alternatives…By contrast it is held that most economic
situations are composites of both competition and monopoly.”
Features:
• Large number of buyers and sellers:..
– Heterogeneous products.
• A differentiated product enjoys some degree of uniqueness in the
mindset of customers, be it real, or imaginary.
– Selling costs exist.
– Independent decision making.
•Imperfect knowledge.
•Unrestricted entry and exit.
Advertising
• The Critique of Advertising
– Manipulate people's tastes
– Advertising reduces competition because it increases the
perception of product differentiation
• The Defence of Advertising
– Firms use advertising to provide information to consumers.
– Advertising increases competition because it allows
consumers to be better informed about all of the firms in
the market.
– Advertising is a complementary good. Advertising
increases the pleasure one gets from purchasing a good
Price and Output Decisions in Short Run
• Joan Robinson said: Each firm has a monopoly

over its product.
• Firms have limited discretion over price, due to
the existence of consumer loyalty for specific
brands.
• The reason for supernormal profit in short run, is
supplying a product which is differentiated, or at
least perceived to be different by the consumer.
Price & Output Decisions in
Short Run
Firm maximizes profit where (i) MR=MC; (ii)
MC cuts MR when MC is rising.
Profit maximising output OQE and Price OPE
Price,
Reven
ue, M
Cost C A Total revenue = OPEBQE
C
P B Total cost =OAEQE
EA E Supernormal profit
A =APEBE
R since price OPE > OA
M
O R (AR>AC)
Q Quan
E
tity
Price & Output Decisions in Short Run
Price,
Reven
ue, M
Cost C
Total revenue =
A
A E OPEBQE
C
P B Total cost =OAEQE
E
Loss =APEBE
AR
since price OPE <
M OA
R
O
Q Quanti
(AR<AC)
E ty
Price & Output Decisions in Long Run
Price
,
Reve M
nue, C
Total revenue =
A
Cost
C
OPEBQE
P B
Total cost =OAEQE
E
Normal profit =
A No loss no gain
R since AR=AC
M
O R
Q Qua
E
ntity
Price & Output Decisions in Long Run
•Just like perfect competition, in monopolistic competition

too all the firms would earn normal profits in the long run.
• In the long run supernormal profit would attract new
firms to the industry till all the firms earn only normal
profits.
• Losses, will force firms to exit the industry till
remaining firms in the market earn only normal
profits.
•If all the firms earning only normal profit there will be no
tendency to enter or exit the market.
Features of Oligopoly
• Derived from Greek word: “oligo” (few) “polo” (to sell)
• Few Sellers: small number of large firms compete
• Product: Some industries may consist of firms selling
identical products, while in some other industries
firms may be selling differentiated products.
• Entry Barriers: No legal barriers; only economic in
nature
– Huge investment requirements
– Strong consumer loyalty for existing brands
Five-Forces Framework
Entry
Supplier Power Internal Rivalry Buyer Power
• Michael Porter
Substitutes and
Complements
Duopoly
• Duopoly is that type of oligopoly in which only
two players operate (or dominate) in the market.
– Used by many economists like Cournot, Stackelberg,
Sweezy, to explain the equilibrium of oligopoly firm, as
it simplifies the analysis.
Price and Output Decisions
• No single model can explain the determination of
equilibrium price and output
– Difficult to determine the demand curve and hence the
revenue curve of the firm
Kinked Demand Curve
• Paul Sweezy (1939) introduced concept of kinked demand curve to explain ‘price
stickiness’.
• Assumptions
– If a firm decreases price, others will also do the same. So, the firm initially
faces a highly elastic demand curve.
– A price reduction will give some gains to the firm initially, but due to similar
reaction by rivals, this increase in demand will not be sustained.
– If a firm increases its price, others will not follow. Firm will lose large number of
its customers to rivals due to substitution effect.
– Thus an oligopoly firm faces a highly elastic demand in case of price fall and
highly inelastic demand in case of price rise.
• A firm has no option but to stick to its current price.
• At current price a kink is developed in the demand curve
• The demand curve is more elastic above the kink and less elastic below the kink.
Kinked Demand Curve
(price and output determination)
Price, • Discontinuity in AR (D1KD2)
Reven D
ue, 1
creates discontinuity in the MR
Cost K M curve.
P C1
MC
• At the kink (K), MR is constant
A 2 between point A and B.
S
• Producer will produce OQ,
T D
whether it is operating on MC1
B
2 or MC2, since the profit
O Q Quanti maximizing conditions are
M ty being fulfilled at points S as
R well as T.
• D1K = highly elastic portion of the
demand curve (AR) when rival firms • If MC fluctuates between A and
do not react to price rise B, the firm will neither change
• KD2 = less elastic portion, when rival its output nor its price.
firms react with a price reduction. • It will change its output and
• Kink is at point K.
price only if MC moves above
A or below B.
Centralized Cartels
• Assuming the case of a cartel with
two firms facing same MR and AR
Price, • MCA = Firm A’s marginal cost
Cost, M ∑
M M • MCB = Firm B’s marginal cost
Reven CB
ue CA C • ∑MC = industry marginal cost
• OQ = profit maximizing output
because (MR=∑MC).
P
• OQA = A’ output
• OQB = B’s output
• OQ=OQA + OQB; OQA > OQ B
AR • OP = price at which both firms can
M =D
R sell their output. Price will be
determined by summation of all
O
Q Q Q Quant firms’ costs and demand.
B A
ity • In a cartel an individual firm is just
a price taker.
Market Sharing Cartels
• Firms decide to divide the
market share among them and
Price, fix the price independently.
Cost,
Reven • All firms have the same cost
ue M A functions because they are
C C producing a homogenous
P product but have different
A
demand functions.
P • Due to different demand
B functions, at equilibrium total
A output = OQA+ OQB, where
M RA OQA> OQB.
A
RA • The quantity of output
M RB
RB
produced and sold would
O depend upon the terms of
Q Q Quanti agreement among the firms in
ty
B A the cartel.
Factors Influencing Cartels
• Number of firms in the industry: Lower the number of firms in the
industry, the easier to monitor the behaviour of other members.
• Nature of product: Formed in markets with homogenous goods
rather than differentiated goods, to arrive at common price. But if
goods are homogeneous, an individual firm may gain larger market
share by cheating, i.e. by lowering the price.
• Cost structure: Similar cost structures make it easier to coordinate.
• Characteristics of sales: Low frequency of sales coupled with huge
amounts of output in each of these sales make cartels less
sustainable, because in such cases firms would like to undercut the
price in order to gain greater market share.
– with large number of firms and small size of the market some firms
may deviate from the cartel price and thus cheat other member
Price Leadership
• Dominant Firm: a leader in terms of market share, or

presence in all segments, or just the pioneer in the particular
product category.
– Either a benevolent/ kind firm or an exploitative firm.
• Benevolent leader
– Allows other firms to exist by fixing a price at which small
firms may also sell.
• so that it does not have to face allegations of monopoly
creation;
• Earns sufficient margin at this price and still retains
market leadership
Price Leadership
• Exploitative leader: fixes a price at which small

inefficient players may not survive and thus it gains
large share of the market.
• Barometric Firm: has better industry intelligence and
can preempt (being pioneer) and interpret its external
environment in a more effective manner than others.
– No single player is too large to emerge as a leader,
but there may be a firm which has a better
understanding of the markets.
– Acts like a barometer for the market.
Lets guess the market structure
Decision Making
Applications
BITS Pilani +91.9826569573
Programmes Division
Agenda
Module 9: Decision Making Applications

– Session 12:
• Uncertainty, Probability, and expected value
• Decision tree
• Risk aversion
I was expecting this but not so soon.
(Written on a Tombstone in Boot Hill)
You can get more with a kind word and a gun than you
can get with a kind word.
(Gangster Al Capone on the virtues of diversification)
I never knew what true happiness was until I got

married. But by then it was too late.
Decision Maker Should begin by:
• Listing the available alternatives

• Listing the outcomes
• Evaluating the chances
• Deciding how well they likes each
possible outcome.
UNCERTAINTY
• Uncertainty (or risk) is present when there

is more than one possible outcome for a
decision.
• The greater the dispersion of possible
outcomes  the higher the degree of
uncertainty.
• Recognize the range of possible outcomes
and assess the likelihood of their
occurrence.
PROBABILITY
• The probability of an outcome is the odds

or chance that the outcome will occur.
• Probabilities rang between 0 and 1.
• Whatever the probability, the relevant

question is:
– What is the basis for this assessment?
EXPECTED VALUE
• A probability distribution is a listing of the possible

outcomes concerning an unknown event and their
respective probabilities.
– For example, the manager might envision the probability distribution
shown in the table for the first year’s outcome of a new-product launch.
Decision Tree
• The dt is a convenient way to represent decisions, chance events,
and possible outcomes in choices under risk and uncertainty.
• Simple diagram can incorporate all the information needed to
“solve” the decision problem once the specific objectives of the
decision maker have been established.
• The actual choices, the potential risks, and the appropriate objective
to pursue may all be far from clear.
• The structure of the tree emphasizes the ingredients (choices,
outcomes, and probabilities) necessary for making an informed
decision.
Decision Tree
• The decision tree provides a
visual explanation for the
recommended choice.
• One easily can pinpoint the
“why” of the decision: which
circumstances or risks
weighed in favor of which
course of action.
• Decision trees can be simple
or complex, spare or “bushy,”
small enough to evaluate by
hand or large enough to
require a computer.
An Oil Drilling Decision
• A More Complicated
Drilling Decision
• This decision tree

contains multiple
risks that generate
19 possible
outcomes.
The Perils of International Business
• ECONOMIC CONDITIONS
• UNCERTAIN COSTS
• DIFFERENT CULTURES
• POLITICAL RISK
• EXCHANGE-RATE RISK
Let us learn drawing a dt
Let us draw a dt
• A Indian Company has spent a considerable amount of time and money
developing a new Ultrasound machine. The machine gets high marks on
all performance measures except noise. They think that may be because
of noise few hospitals will not allow this machine..
• Management judges a 50–50 chance that there will be some restrictions.
Without restrictions, management estimates its (present discounted)
profit at `125 million; with restrictions, its profit would be only ` 25 million.
• Management must decide now, before knowing the government’s
decision, whether to redesign parts of the machine to solve the noise
problem. The cost of the redesign program is ` 25 million.
• There is a .6 chance that the redesign program will solve the noise
problem and a .4 chance it will fail. Using a decision tree, determine the
consortium’s best course of action, assuming management is risk
neutral.
• According to the decision tree below, the company’s
most profitable decision (on average) is to redesign the
machine.
Success
.6 $100
Redesign
80 $100
.5
Failure
50
.4
80
$0
.5
No Restrictions
$125
Do Not .5
75
Restrictions
$25
.5
Let us draw a dt
• The film is not worth launching. High Demand 80
.4
38
Low .6
Cost 10
Low Demand
Produce .5
-4 High Demand
.5 0
.4
High -42
0 Cost .6
-70
Low Demand
Do Not
0
BITS Pilani
Programmes Division
Entertainment
The degree of uncertainty depends on
• a) The expected value of an unknown
event.
• b) The chance that a particular outcome
occurs.
• c) The number of possible outcomes.
• d) The unpredictable nature of life.
• e) The future trend of an economic variable.
Expected value is defined as
• a) The value of the outcome with the highest
probability.
• b) The mid-point of the extreme (high and low)
possible values.
• c) The benchmark scenario or most-likely scenario.
• d) The sum of the products of the probabilities of all
outcomes and their values.
• e) The equally-weighted average of all outcomes.
An individual is uncertain whether to bet on a football game.
He believes that the probability of his team winning is 40%.
If his team wins, he will receive $180. If his team loses, he’ll
pay $130. If the decision is made based exclusively on the
expected value criterion then this person should
• a) Take the bet.
• b) Not take the bet.
• c) No clear-cut decision can be made.
• d) The expected value criterion cannot be applied in this
situation.
• e) Be exactly indifferent to the bet.
A manager who chooses among options by
applying the expected value criterion is
• a) Risk neutral.
• b) Risk averse.
• c) Risk seeking.
• d) A risk minimizer.
• e) Answers a and d are both correct.
An individual is risk neutral if her utility curve
for money is
• a) Linear.
• b) Concave.
• c) Convex.
• d) Decreasing.
• e) Increasing at an increasing rate.
BITS Pilani
Programmes Division
Risk Aversion
Risk Aversion
• A Coin Gamble
• The Demand for Insurance
• Risk Management at Microsoft
Factor Market Analysis
BITS Pilani Rahul Pratap Singh Kaurav
+91.9826569573
Pilani Campus rsinghkaurav@gmail.com
Agenda
Module 10: Factor Market Analysis
Session 10
• Introduction
• Profit maximizing employment of one variable input
• Quantity
• Price
•Multiple variable inputs
•Determination of Equilibrium prices for inputs
• Monopsony – Only one buyer
• Bilateral Monopoly
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

BITS Pilani
Pilani|Dubai|Goa|Hyderabad
Factor Markets and Profit
Maximizing Employment of
Variable Inputs - Part 1
What is factor market?
https://www.youtube.com/watch?v=J0LigIdph8I
In a factor market, you can be BOTH a buyer (of resources)

AND a seller (of output).
https://study.com/academy/lesson/factor-market-definition-e
xamples.html
1/13/21 BITS Pilani, WILPD

Introduct
ion Profit =
Revenue -
Cost
 To achieve profit maximization, the firm needs to produce
at its optimal level and at the lowest possible cost
 I n order to achieve this managers need to know how
much of each input to use and what price to pay for these
inputs Q|P
 This is the focus of this lesson, which addresses questions
such as:
 Can a business operate at the least cost
combination of inputs?
 How input prices are determined?
 In the short run, can we adjust our inputs to Market Structure
maximize profit?
 What questions does management face in the short
run?
Least cost combination of inputs
 We noted earlier that the least cost
combination of inputs L and K associated
with a given level of output requires
M M
PP L

P
LK
 as long as the firm cannot affect P(L) and P(K)

 In the short-run, the firm
K P
may not be able achieve
the least-cost combination of inputs for its optimal
level of output because of fixed inputs
 Question: How can the firm maximize profits in

the short run by utilizing the inputs that are Labour ||
variable? Capital
(MBA 416)
Profit maximizing employment of one variable input
 Let us consider a manufacturing plant with fixed inputs in the form of
land, building and capital equipment
 In order to maximize profits - how much labor should be employed and
what level of output should be produced
 Amount of labor and level of output will impact decisions regarding raw
materials and intermediate goods
 In the real world, the combinations of these may vary per unit of output
produced
 But for our discussion we will make two simplifying assumptions:
 Inputs are used in fixed proportions (to the level of output)
 When the level of labor force and the firm’s output level are
determined, the required amounts of raw materials and intermediate
good inputs are automatically decided
(MBA 416)
Optimal labour force
 How does the firm determine the optimal labor force and level of
production in the short-run
 How is the profit-maximizing quantity determined?
 Profits will be maximized, if the firm follows the marginal rule
 There is only one variable factor of production, which is the labor
 Rule of determining the optimal labor force:

 Continue using additional units of the input until the last unit just pays
for itself
 Additional revenue resulting from employment of one more unit of the
input is just equal to the amount the input adds to the costs of the firm
 Marginal revenue product is equal to the input’s marginal cost
(MBA 416)
Marginal Revenue Product
 The arc marginal revenue product of input L (MRPL) is defined
as the arc net marginal revenue the firm can obtain by selling an
additional unit of output produced by input L multiplied by number of
additional units of output produced per additional unit of input L, i.e.
 MRP(L) = NMR(L) x MP(L)
 Marginal product of L is the additional output that the firm can produce
by adding one more unit of L: MP(L) = delta Q/delta L
 Arc Net Marginal Revenue (NMR) = it is the additional total revenue
by selling one more unit of output less the cost of raw materials and
• Marginal
intermediate goods required for each additional unit of output revenue
product
 NMR  MR  MCM
• Marginal
 Where MC(M) = marginal cost of raw materials/ intermediate goods per revenue
unit of output = MC – MC(L) • Marginal
 For example, additional revenue is Rs 5, additional cost is Rs 3 per product
unit of output, NMR would be equal to Rs. 2 per unit output
(MBA 416)
Marginal
Cost
 Marginal Cost (MC) is the increase in cost
caused by a unit increase in input.
 If the input price (L) is constant, then the
marginal cost is simply the price of the
input.
T
MC L 
C
PL
 If MRP ofa labourLis Rs 10 per hour, and
marginal cost is Rs 10, the firm can
maximize profit holding employment at that
level
(MBA 416)
Profit Maximization Rule
In the real world, the process of finding the optimal amount of an input
faces two problems:
 Marginal product of an input does not stay constant as more units of
input are added (law of diminishing returns)
 Marginal revenue may change (may become lower) since most firms
may need to lower price in order to sell large quantities of output
 This requires an additional condition to insure maximum profit.
RULE: Add input as long as MCi < MRPi, stopping when MRPi
equals MCi, provided MCi > MRPi for greater use of the input.
• In other words we should employ the input until the last unit
just pays for itself but additional units will cost more than the
revenue they generate
(MBA 416)
Multiple Variable
Inputs
• If two inputs are related, the quantity of

one will affect the productivity of other,
which will affect the optimum level
The Two scenarios are:
• If inputs are substitutes: an increase in
quantity of one results in a decrease in the
productivity (MP) of the other.
• If inputs are complimentary: An increase
in quantity of one results in a increase in
the productivity (MP) of the other.
(MBA 416)
BITS Pilani
Programmes Division
Production with one variable input

and production in the long run
Production Function with One
Variable Input
 As the quantity of the Labo Total M AP Stages

variable factor is ur Product P
(’00 (’000
increased with other units) tonnes)
fixed factors, MP and 1 20 - 20 Increasi
2 50 30 25 ng
AP of the variable returns
factor will eventually 3 90 40 30
4 120 30 30 Diminish
decline. 5 140 20 28 ing
returns
 Therefore law of 6 150 10 25
variable proportions 7 150 0 21.
5
is also called as law 8 130 - 16. Negativ
of diminishing 20 3 e
marginal returns. 9 100 - 11. returns
30 1
200
150
Total Product
(’000 tonnes)
100
Marginal
Output
Product
50
Average
Product
0
1 2 3 4 5 6 7 8 9
-50
Labour
{Labour Curves}
Total
 First stage Outp C
 Increasing Returns ut
to the Variable B TP
Factor L
 MP>0 and A
MP>AP
 Second stage
 Diminishing Returns
to a Variable Factor O
 MP>0 and MP<AP Labou
Total r
 Third Stage Outpu
 Negative Returns t Stage Stage Stage
 MP<0 while AP is I II III
falling but positive A*
B
 Technically
inefficient stage of
*
production
 A rational firm will
AP
never operate in this C
O L
stage M* Labour
PL
Law of Diminishing Return
As we use more and more units of the variable

input with a given amount of the fixed input,
after a point we get diminishing returns from
the variable input
Production Function with Two
Variable Inputs
 All inputs are variable in Capital Labour
long run and only two inputs (Rs. (’00
are used crore) units)
 Firm has the opportunity to 40 6
select that combination of
inputs which maximizes 28 7
returns
18 8
 An isoquant is the locus of
all technically efficient 12 9
combinations of two inputs
for producing a given level 8 10
of output
 Represented as:
Q  f (L, K )
Factor Market Analysis
+91.9826569573
BITS Pilani
Factor Markets and Profit
Maximizing Employment of
Variable Inputs - Part 2
Agenda
• Introduction
• Profit maximizing employment of one variable
input
• Quantity
• Price
•Multiple variable inputs
•Determination of Equilibrium prices for inputs
• Monopsony
• Bilateral Monopoly

Perfect competition in the Input Market
 The structure of an input market is important

 This affects the determination of its price
 Consider the case of perfect competition
 There are many buyers and sellers of that input

 Price of an input is given for an individual firm
 The amount demanded of an input by an individual firm is
too small relative to the total market demanded and supply
of the input to influence its price significantly
 Marginal cost of a unit of input is constant and equal its
price
(MBA 416)
Selling output and buying
input
Selling output in a Buying input in a
perfectly competitive perfectly competitive
market market
The price of its output is given The input price is given
Demand curve for its Supply curve of the input to
product was a horizontal line the firm is horizontal
Output price is equal to Input price equals the input’s
marginal revenue marginal cost
(MBA 416)
Perfect Competition in the input market
 When a firm is buying an input in a perfectly competitive
market
 The input price is given
 The supply curve of the input to the firm is horizontal
 The input price equals the input’s marginal cost
 Profit-maximising condition: employ input L up to point

where
MRPL  PL 
MCL
 Firm should employ input L up to the point where MRPL
=PLas long as MRPL is decreasing
(MBA 416)
Optimal Employment of an input in a
Perfect Competition
 Market Supply and
price our unaffected by
20
this firm’s 18
purchasing activity. 16
14
The input demand curve 12 MRP L =
indicates the quantity of input 10 a that DL
will be employed at any price. S
L
4
The
P intersection ofequilibrium
indicates the Qa and Equilibrium
Point
0
a
Q
L
poi 0 10 20 30 40 50
nt. 60 70
(MBA 416)
Price determination of the input
How is the price of the input determined?
In a perfectly competitive market: demand
for and supply of the input
Two aspects
Market demand for the input: sum of the
quantity of the
input that each firm demand at each price
Market supply for the input: quantity of the
input that will be supplied at each price
(MBA 416)
Monopsony Input
Market
 A monopsony market is one in which there is only one
buyer.
 In a monopsonistic input market the buyer knows that the price of the
input will be determined by the quantity purchased.
 Market supply curve of the input is upward sloping
 The more he(she) buys: The more he(she) pays.

 Employ the input until its marginal revenue product is equal to its
marginal cost
 Unlike perfect competition,
 Here, the price of an input is not equal to its marginal cost
 The marginal cost of another unit of an input is greater than its price
( he has
to pay higher price to get an additional unit of the input per time period)
 If a firm pays a higher price for one more unit of the input, it must pay
the same price for all units of the input
(MBA 416)
A simple
example
Number of Hourly wage Marginal cost of
mechanics rate labour
0 4
MC > Price
1 6 6
2 8 10
3 10 14
4 12 18
5 14 22
If firm hires the second mechanic for Rs 8 an hour, the first

mechanic will be unhappy unless his/her wage rate is raised to
Rs 8 per hour.The marginal cost of the second mechanic is Rs 10.
(Rs 8 is the wage of the second mechanic and Rs 2 per hour of the
first mechanic)
(MBA 416)
Sample Problem
35
 A single garage exists in
town with three 30 MR
mechanics.To employ PM Golden Rule
25
another mechanic they  MRP =
will have to pay rs2/hr 20 M
more or Rs12/hr. CM MC
 The MRP for mechanics 15 M SM
at this garage is given as
shown on the P
graph.What should the
garage do? 10 QM
 Hire one more 5
1 2 3 4 5 6
mechanic to bring MRP 0
= MC.
Managerial Economics 2
(MBA 416) 2
Bilateral Monopoly Input Market
 In a bilateral monopoly there are
only one buyer and one seller in the 3
market. 0 MRPB
2 =DS
 Seller behaves like a monopolist and 5
buyer behaves like a monopsonist 2 M
 Added one more curve: marginal 0 CB
1
revenue to the supplier 5
1
SM=
 The mechanics would wish to offer their 0 MCS
5
services at Rs 22/hr.
0
1 2 3 4 5 6
 The firm would like to buy its - M
workers at Rs12/hr 5
RS
-
 The final result depends on the 1
relative bargaining strength of the 0
firm and the mechanics
Summary
• Quantity • Price
MRPL = MCL – Perfect competition
• To maximise profit – Monopsony
– Bilateral Monopoly
06/03/2016 MBA ZC416

Session 12
Perspectives on !ndia | Macro
Economics
+91.9826569573
Agenda
•Module 11: Perspectives on India

Session 11:
1. Introduction
2. Macroeconomic perspective
3. Different economic laws/ principles/
rules

BITS Pilani
National Income
National Income
"National income or product is the final
figure you arrive at when you apply the
measuring rod of money to the diverse
apples, oranges, battleships and machines
that any society produces with its land,
labour and capital resources."
- Paul A.
Samuelson
National Income
Calculation of national income requires adding together
all final goods and services produced in a country in a
given year.
Various goods and services produced in the economy
cannot be added together in their physical form; hence
they need to be converted into monetary terms.
Thus National income is defined as the money value of
all the final goods and services produced in an economy
during an accounting period of time, generally one year.
Concepts of National Income
• Gross Domestic Product (GDP)
– Gross Domestic Product at factor cost
– Gross Domestic Product at market price
• Gross National Product (GNP)
• Net Domestic Product (NDP)
• Net National Product (NNP)
• Per Capita Income
• Per Capita Disposable Income
Gross Domestic Product
Gross Domestic Product (GDP): GDP is the sum
of money value of all final goods and services
produced within the domestic territories of a
country during an accounting year.
GDP (at market price)= C+I+G+(X-M)
Gross Domestic Product at factor cost
= GDP at Market Prices –Indirect
Taxes+ Subsidies
Gross National Product
Gross National Product (GNP): GNP is the aggregate
final output of citizens and businesses of an economy in
a year.
GNP may be defined as the sum of Gross Domestic
Product and Net Factor Income from Abroad.
GNP = GDP + NFIA
GNP = C+I+G+(X-M)+NFIA
Net Factor Income from Abroad: difference between
income received from abroad for rendering factor
services and income paid towards services rendered by
foreign nationals in the domestic territory of a country
Net Domestic Product and Net
National Product
Net Domestic Product
= GDP-Depreciation
Net National Product (NNP)
= GDP–Depreciation +NFIA
Or =GNP–Depreciation
Thus NNP is the actual addition to a year’s wealth and is the

sum of consumption expenditure, government expenditure,
net foreign expenditure, and investment, less depreciation,
plus net income earned from abroad.
= C+I+G+(X–M)–Depreciation + NFIA
National Income
• NNP at Factor Cost is the sum total of
income earned by all the people of the
nation, within the national boundaries or
abroad
• It is also called National Income.
• NNP at Factor Cost = NNP at Market
Prices –Indirect Taxes+ Subsidies
Real and Nominal National Income
• National income estimated at the prevailing
prices, is called national income at current
prices or Nominal National Income, or Money
National Income or national income at
current prices.
• National income measured on the basis of
some fixed price, say price prevailing at a
particular point of time, or by taking a base
year, is known as Real National Income or
national income at constant prices
Real National Income
Real GDP measures changes in the physical output in an
economy, between different time periods, by valuing all
goods produced in the two periods at the same prices
Nominal GDP
Real GDP =
GDP deflator
•GDP deflator is the ratio of nominal GDP in a year to

real GDP of that year.
•GDP deflator measures the change in prices between
the base year and the current year.
Per Capital Income
The average income of the people of a country in a
particular year is called per capita income. In simple
words it is income per head of a country for a year.
National Income
Per Capita Income =
Total Population
•Per capita income for the year 2006-07 may be
calculated at the market price prevailing during the
financial year 2006-07, i.e. current prices or at prices of
a base year say 1999-2000, i.e. constant prices
Personal Disposable Income
Personal income is the total income received by the individuals
of a country from all sources before direct taxes in one year.
Personal Income = National Income – Undistributed Corporate
Profits – Corporate Taxes – Social Security Contributions +
Transfer Payments + Interest on Public Debt
Personal Disposable Income is the income which can be spent
on consumption by individuals and families.
Personal Disposable Income
= Personal Income – Personal Taxes
Methods of measuring national income
In equilibrium
Output=Income=expenditure
Hence there are three approaches to the measurement
of GDP:
Product (or Output) Method: National Income by
Industry of Origin
 Final Product Method
 Value Added Method
Income Method or National Income by Distributive
Shares
Expenditure Method
Product (or Output) Method
 The market value of all the goods and services produced in the
country by all the firms across all industries are added up together.
 Process
 The economy is divided on basis of industries, such as agriculture, fishing,
mining and quarrying, large scale manufacturing, small scale manufacturing,
electricity, gas, etc.
 The physical units of output are interpreted in money terms
 The total values added up. (GDP at market price)
 The indirect taxes are subtracted and the subsidies are added. (GDP at factor
cost)
 Net value is calculated by subtracting depreciation from the total value (NDP
at factor cost).
Limitations of Product Method
Problem of Double Counting:
 unclear distinction between a final and an
intermediate product.
Not Applicable to Tertiary Sector:
 This method is useful only when output can be
measured in physical terms
Exclusion of Non Marketed Products
 E.g. outcome of hobby or self consumption
Self Consumption of Output
 Producer may consume a part of his production.
Income Method
 The net income received by all citizens of a country in a particular year, i.e. total of net
rents, net wages, net interest and net profits. (GDP at factor cost).
 It is the income earned by the factors of production of a country.
 Add the money sent by the citizens of the nation from abroad and deduct the
payments made to foreign nationals (individuals and firms) (GNP at factor cost) or
Gross National Income (GNI).
Process:
• Economy is divided on basis of income groups, such as wage/salary earners, rent
earners, profit earners etc.
• Income of all the groups is added, including income from abroad and
undistributed profits.
• The income earned by foreigners and transfer payments made in the year are
subtracted.
GNI = Rent + Wage + Interest +Profit + Net Income from Abroad- Transfer
payments
Limitations of Income Method
• Exclusion of non monetary income: Ignores the non-

monetized section of economic activities.
– Economic activities that contribute to national income, but
due to their non monetary nature, they go unrecorded. For
e.g. a farmer and family working in their own field.
• Exclusion of Non Marketed Services: People
undertake a particular activity that are difficult to
ascertain in money value. E.g. mother’s services to
the family.
Expenditure Method of Measuring National Income
 The total expenditure incurred by the society in a particular

year is added together to get that year’s national income.
 Components of Expenditure:
 personal consumption expenditure
 net domestic investment
 government expenditure on goods and services, and
 net foreign investment
Limitations
 Ignores Barter System
 Affected by Inflation
Uses of National Income Data
 National income is the most dependable indicator of a
country’s economic health.
 Difference between GDP and GNP indicates the contribution
of net income earned abroad
 Necessary for Economic planning: useful aid in judging which
sectors should be given more emphasis
 A measure of economic welfare.
 higher aggregate production implies more and more goods and
services being available to people
 Helps in determining the regional disparities, income
inequality and level of poverty in a country.
 Helps in comparing the situations of economic growth in two
different countries.
Difficulties in Measurement of National
Income
 Non monetized transactions: Exchange of goods and services which
have no monetary payments, like services rendered out of love,
courtesy or kindness are difficult to include in the computation of
national income.
 Unorganized sector: Contribution of unorganized sector are
unrecorded. It is very difficult to identify income of those who do not
pay income tax.
 Multiple sources of earnings: Part time activity goes unrecognized
and such income is not included in national income.
 Categorization of goods and services: In many cases categorization
of goods and services as intermediate and final product is not very
clear.
 Inadequate data: Lack of adequate and reliable data is a major
hurdle to the measurement of national income of underdeveloped
countries.
BITS Pilani
Inflation
Inflation
• it is a state of “too much money chasing too
Coulborn
few goods”.
• Two broad categories:
• price inflation
• money inflation
• Both have cause and effect relationship, i.e.
money inflation leads to price inflation.
• Money inflation is increase in the amount of
currency in circulation.
• Foreign exchange inflows in the form of capital, tourism and
other incomes from abroad.
Concepts of Inflation
 Headline Inflation:
 Measure of the total inflation within an economy
 Affected by the areas of the market which may experience
sudden inflationary spikes such as food or energy.
 Inflationary Spikes occurs when a particular
section of the economy experiences a sudden
price rise, possibly due to external factors.
 Hyperinflation:
 Prices increase at such a speed that the value of money
erodes drastically and the economy is trapped between
rising prices and wages.
 This is also known as galloping inflation or runaway
inflation.
Concepts of Inflation
• Stagflation:
• A typical situation when stagnation and inflation coexist.
• Suppressed Inflation:
• When inflationary conditions exist, but the government makes such
policies which temporarily keep prices under check
• as soon as these checks are removed, inflation bursts out.
• Deflation:
• just opposite to inflation;
• a state when prices fall persistently.
• Disinflation
• It is a well planned process to bring down prices moderately from a
very high level.
Inflation
Prices
Inflationary Gap
 represents rise in price due to a
gap between effective demand
and supply. Wages
 The term was coined by Keynes Wages
to describe a situation when

there is an ‘excess of
Prices
anticipated expenditure over
available output at base prices’.
Wage Price Spiral
 Wages chase prices and prices
chase wages and thus create a
wage price spiral.
Causes of Inflation
• Excess Money Supply.
• Demand Pull Inflation.
• Increase in money supply
• Increase in disposable income
• Increase in aggregate spending
• Increase in population of the country
• Cost Push Inflation: An increase in price of any
of the inputs, will increase in the cost of
production.
• Any inflationary pressure created i.e. prices pushed up by
cost.
Causes of Inflation
• Low Increase in Supply: if supply falls short
of demand, prices will increase.
• Obsolete technology
• Deficient machinery
• Scarcity of resources
• Natural calamities
• Industrial disputes and external aggressions
• Built in Inflation: Built in inflation is a type of
inflation that has resulted from past events
and persists in the present.
• It is also known as hangover inflation.
Inflation and Decision Making
Impact on Consumers:
• Increase in price of one commodity affects purchase
decisions for many other things of daily need.
• Changes in consumer prices upset daily budget.
• Increase in price of eatables may force a cut down on
purchase of many other items.
Impact on Producers (or Suppliers):
• Higher the prices, higher are their profits.
• The critical aspect is that producers gain as sellers of
the final (or intermediate) goods but when they have
to buy raw material, hire workforce, buy technology or
machine, they are adversely affected by inflation.
Inflation and Decision
Making
Impact on Government:
• Government is committed to take the economy to
higher levels of growth by encouraging production and
investment,
• It is duty bound to see that taxpayers’ money is not
eroded by hyperinflation.
• It acts as the balancing force between consumers and
sellers.
Indexation:
• It is automatic linkage between monetary obligations
and price levels.
• It applies to wages, interest and taxes.
Measuring Inflation
• A price index is a numerical measure designed to help to compare

how the prices of some class of goods and/or services, taken as a
whole, differ between time periods or geographical locations.
• Price Index= Current
Year's Price
100
BaseYear's Price
Various Measures
• Producer Price Index (PPI): measures average changes in prices received by
domestic producers for their output.
• Wholesale Price Index (WPI): inflation is calculated on the basis of wholesale
prices of a wide variety of goods (including consumer and capital goods),
• Consumer Price Index (CPI): measures the price of a selection of goods
purchased by a "typical consumer.“
Measuring Inflation
• Cost of Living Indices (COLI): are similar to the
CPI; these are often used to adjust fixed
incomes and contractual incomes to maintain
the real value of such incomes.
• Service Price Index (SPI): With the growing
importance of service sector across the world,
many countries have started developing
services price indices (SPI).
Lastyear's Index
-Current Year's Index
 100
Inflation Rate Current Year's Index
BITS Pilani
Theories of Profit
Profit as a Reward for Market Imperfection and
Friction in Economy (Dynamic Theory of Profit)
• In a static economy neither demand nor supply

changes. The demand for a commodity depends upon
the size of population, incomes, consumer's tastes,
substitutes of commodities, price and the price of
related goods.
• In a static equilibrium, the supply of the commodity
does not change. When demand and supply do not
change, the price as well as the cost of production
remain constant.
387
Profit as a Reward for Market Imperfection and Friction in
Economy (Dynamic Theory of Profit) (Contd…)
• According to Prof. Clark, profits belong

essentially to economic dynamics and not
to economic statics where the economy is
frictionless and full competition pervades.
In a static economy, pure profit would be
eliminated as fast as they could be
created.
• A war, an inflation, a business depression
are all factors in a modern economy
which lead to profit or losses. 388
Innovation Theory of Profits
• Prof. J A Schumpeter's theory of profits is
almost akin to the theory of profits enunciated
by Prof. J B Clark.
• Prof. Schumpeter, in his innovation theory,
attributed profits to dynamic changes in the
productive process due to the introduction of
modern science and technology of production
techniques.
• Risk plays no part in this theory and profits are
solely attributed to dynamic development.
389
Profit as a Reward for Organising other
Factors of Production
• A proportionate combination of the various
infrastructures, men, material, money,
machinery, marketing is quite indispensable to
produce the desired output.
• Entrepreneur takes this responsibility to
coordinate these infrastructures to produce
products. He not only takes unforeseen risks
but also, in the midst of uncertainties, combines
the factors of production to produce output.
390
• A disproportionate combination of factors only
increases cost of production and reduces profits.
• It is here that the entrepreneurial skill and wisdom
play a very important part.
• All profits, in a sense, are complementary, since many
factors like risk, uncertainty, innovation and monopoly
powers, etc., affect every business activity in profit
earning.
391
• In general, it could be argued that under perfect
competition, when the price is equal to the
average and marginal costs, the entrepreneur gets
only "normal profits" and not supernormal profits.
• Under imperfect competition, which includes
monopoly, duopoly, oligopoly and monopolistic
competition the entrepreneur, by exercising
control over the supply and price of his product
and by creating artificial scarcity in the availability
of products, can earn supernormal profits.
392
Summary of Profit Theory
• In the real world, there is imperfect competition.
• No single theory is capable of explaining the cause for
the emergence of profit. All the theories are
interrelated.
• Innovations cause dynamic changes leading to
economic progress. Uncertainty is the hallmark of
dynamic changes and innovation is uncertainty tied up
with risk. Thus, all the causes of profit are interrelated
and interdependent. The result is that profit is always
uncertain, profits are non-calculable and cannot be
accurately estimated.
393
Theories of Profit
• Lack of agreement
• Profits as Residual Income left after
394
payment of contractual rewards to other
factors of production
• Risk bearing theories:
Profits As Dynamic Surplus
1. J. B. Clarke’s Dynamic Theory of Profits
In competitive long run equilibrium, P= AC
395
(including normal profits) and therefore,
there is no pure profit.
But profits will emerge if P > AC due to
changes(disequilibrium) either in
demand or supply
1. Clarke’s Dynamic Theory
5 changes that occur in a dynamic economy
and give rise to profits:
396
Changes in
- Quantity & quality of human wants
- Methods of production
- Amount of capital
- Forms of organization
- Growth of population
Clarke’s Dynamic Theory
• In addition, 2 more changes:
– Innovation and External change
397
• According to Knight, it is not change which leads
to profits, but dynamic changes give rise to
profits ONLY if changes and their consequences
are unpredictable- because of uncertainty of
Future.
• “In an economy where nothing changes, there
can be no profits; there is no uncertainty about
the future, so there is no risk and no profit”-
Stonier & Hague
2. Schumpeter’s Innovations Theory of
Profits
Main function of entrepreneur is to introduce
innovations in the economy and profits are a
398
reward for this function.
2 types:
A. Innovations that reduce cost of production
( those which change the production function)
Include new machinery, new processes and
techniques of production, new source of raw
material, new ways of organising business
Schumpeter’s Innovations Theory
B. Innovations that increase the demand for
the product ( those which change the
399
demand or utility function- to sell more or
at a better price)
Include:
New product, new variety, new design of
product, new method of advertising,
discovery of new market
• Profits accrue not to those who conceived
the innovation or financed it or to the one
400
who introduced it
• Profits from a particular innovation are
temporary- (He is in a monopoly position
for sometime- transitional unless he can
construct a permanent monopoly)
• With patents, he can continue to make
profits for a long time
In a competitive economy without patents,
existing competitors will soon adopt any
401
successful innovation and profits
disappear.
In a progressive, competitive economy
entrepreneurs continue to introduce new
innovation and earn profits.
“The successful innovator can continuously seek
new equilibrium profits since the horizon of
conceivable innovations is unlimited”- Stigler
3. Knight: Risk, Uncertainty &Profits
Uncertainty is a permanent feature of the

economic system
402
“So long as entrepreneurs start production
with imperfect knowledge of the market,
anticipated marginal product of hired factors
deviate from their actual product, so long a
surplus would persist”
Knight: Risk, Uncertainty & Profits
• Causes of Uncertainty
– Changes in fashions & taste
403
– Changes in incomes
– Changes in Government policies (Taxation,
wage and labor laws, export policies)
– Movement of prices as a result of inflation and
deflation
– Changes in production technology
– Competition from new firms
Insurable & Non insurable Risks
• Insurable: fire, theft, accident etc- may cause huge
404
losses but by paying premium, can insure- Premium
becomes part of cost of production
• Non Insurable Risks: Relate to the outcome of price-
output/product design/advertisement expenditure
decisions made by the entrepreneur -Can’t be insured-
Involve uncertainty and give rise to economic profits,
positive or negative
• The theory explains why supernormal
(economic) profits arise in fields like
405
petroleum exploration (have higher risks)
• Expected returns on stocks is higher than
the interest on bonds because of higher
risks.
4. Managerial Efficiency Theory
• Some firms are more efficient than others
in terms of productive operations/ higher
406
managerial skills- Hence need to be
compensated with supernormal profits.
5. Monopoly Theory Of Profit
• Due to Monopoly
– Through
407
– Patents
– Licenses
– Economies of scale
– Exclusive control over raw materials which
prevent competitors from entering
6. Frictional Theory
• In the long run, in a perfectly competitive

equilibrium , firms tend to earn only a
408
normal return or zero profit.
• At any time firms are not likely to be in
such long run equilibrium and earn profit
or loss

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BITS Pilani

Work Integrated Learning

Economics, and Economic

76% of senior executives say that it is important they have

Economics is defined as body of knowledge or study that

– Unlimited wants and scarce resources

– Science [methodology] or Art [Application]…?

Adam Smith (1723-1790)

I. Ceteris Paribus- Other things remaining equal

 It is a Latin word means ‘with other things (being) the

“ The existence of other tendencies is nor denied, but their

 Implies that consumers and producers measure and

Consumers: Maximising utility and minimising sacrifice

A. Micro(individual consumers and firms)

B. Positive (factual statements- “What is”) – The distribution

 Short run -A time period not long enough for consumers

 Long run- Planning horizon- A time period long enough

 Short run -A time period not long enough for consumers

 Long run- Planning horizon- A time period long enough

1. What to Produce? (Micro)

6. Are Resources fully employed? (Macro)

What is Managerial Economics?

Evan Douglas: “Application of economic principles and

 Aims at helping the management

 Theory of demand  Theory of capital and

1. Economic Theory & Tools of c. Salvatore

4. Variable factor of production e. Theory of

Problems in Decision Making

Which factors most affect the success of the park?

Disney should gather information on:

Building a bridge is usually a public responsibility (paid for out

The authority should estimate usage of the bridge over its

Principles of Decision Making

The crucial step in tackling almost all important

– Human wants are unlimited, but human capacity to

B. Concept of Opportunity Cost

– It is the benefit foregone from the alternative that is not

– The economist has to make rational choice in all aspects of

Who is the decision maker?

Maximum Profit or other Goal?

What About New Conditions?

Let us Analyse Something???

A couple, nervous about boarding their airline flight on time,

Theory of the firm and demand

Module 2: Theory of the firm and demand analysis - I

Managerial Economics is primarily concerned with the application of

In order to do this in an effective manner we need an overarching

Two fundamental questions:

Lets decide a place/ site for a

What location Minimizes Total Trip Miles?

The important factors in the real estate business are

Qdx = 120 – 5 (P) P Q

Qdx = 120 – 5 (P) P Q

“Total revenue is the sum of all sales, receipts or income of

“product of planned sales (output) and expected selling

“Total revenue at any output is equal to price per unit

Average revenue refers to the revenue obtained by the

“The average revenue curve shows that the price of the

Marginal revenue is the net revenue obtained by selling an

Thus, marginal revenue is the addition made to the total

Module 3: Demand Analysis – II and Elasticities

Chapter 3 and 4 of your text book

Input and output markets are connected through the