Yashwantrao
Chavan
Maharashtra
kmZJ§Jm KamoKar Open University
MGM 224
Managerial Economics
Book 1 : Managerial Economics : Nature and Concepts
Book 2 : Markets and Price Determination
Book 3 : Principles of Business Firms and Investment Analysis
Yashwantrao Chavan Maharashtra Open University, Nashik
Vice-Chancellor : Prof. E. Vayunandan
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Dr. Pandit Palande
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Y.C.M.O.U., Nashik
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Y.C.M.O.U., Nashik
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Social Sciences, Y.C.M.O.U., Nashik
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Reader, School of Humanities and
Social Sciences, Y.C.M.O.U., Nashik
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MGM 224 : MANAGERIAL ECONOMICS : BOOK 1 TO 3
Book
Writer
No.
Translator, Editor
Co-ordinator
Pub. No.
ISBN
& Co-Editor
1
Prof. N. B. Kulkarni
H.P.T. Arts & R. Y. K.
Sciences College, Nashik
Prof. S. P. Deo
C.P. & Berar College
Nagpur
Prof. S. R. Karandikar
C.D. Deshmukh College of
Commerce, Sangli
Prof. V. G. Godbole
C.T. Bora College, Shirur
(Ghodnadi)
Prof. S. G. Bhanushali
Head, Department of
Economics Commerce
College, Kolhapur
Prof. A. R. Padoshi
Department of Economics
University of Goa, Goa
Translator
Dr. S. N. Kulkarni
15, Chandraban, Excellency
Society, Vinay Nagar
Nashik - 10
Editor
Dr. Ravindra Doshi
Head, Department of
Economics Shivaji
University, Kolhapur
Co-Editor
Dr. Pramod Biyani
Reader, School of Commerce & Management
YCMOU, Nashik
Dr. Umesh Rajderkar
Lecturer
School of Humanities &
Social Sciences, YCMOU,
Nashik
Mrs. Madhulika Pitre
Lecturer, School of Commerce & Management
YCMOU, Nashik
1393
81-8055-222-5
2
Prof. N. B. Kulkarni
H.P.T. Arts & R. Y. K.
Science College, Nashik
Prof. S. P. Deo
C.P. & Berar College
Nagpur
Prof. S. R. Karandikar
Chintaman College of
Commerce, Sangli
Prof. V. G. Godbole
C.T. Bora College, Shirur
(Ghodnadi)
Prof. S. G. Bhanushali
Head, Department of
Economics Commerce
College, Kolhapur
Prof. A. R. Padoshi
Department of Economics
University of Goa, Goa
Translator
Prof. Azhar A. Khan
M.U. College of Commerce
Pimpri, Pune - 17
Mrs. Radhika V. Deshpande
11, Moreshwar Apt. 1/3
Dharmpeth Extension
Nagpur - 10
Ms. Renuka Chitale
Chitale Niwas, Ingle Nagar
Jail Road, Nashik Road
Nashik - 422101
Editor
Dr. Ravindra Doshi
Head, Department of
Economics, Shivaji
University, Kolhapur
Co-Editor
Dr. Pramod Biyani
Reader, School of
Commerce & Management
YCMOU, Nashik
Dr. Umesh Rajderkar
Lecturer
School of Humanities &
Social Sciences, YCMOU
Nashik
Mrs. Madhulika Pitre
Lecturere, School of
Commerce & Management
YCMOU, Nashik
1394
81-8055-223-3
Book
Writer
Translator, Editor
No.
3
Co-ordinator
Pub. No.
ISBN
1395
81-8055-224-1
& Co-Editor
Prof. N. B. Kulkarni
H.P.T. Arts & R. Y. K.
Science College, Nashik
Prof. S. P. Deo
C.P. & Berar College
Nagpur
Prof. S. R. Karandikar
Chintaman College of
Commerce, Sangli
Prof. V. G. Godbole
C.T. Bora College, Shirur
(Ghodnadi)
Prof. S. G. Bhanushali
Head, Department of
Economics Commerce
College, Kolhapur
Prof. A. R. Padoshi
Department of Economics
University of Goa, Goa
Translator
Smt. Renuka Chitale
Chitale Niwas, Ingle Nagar
Jail Road, Nashik Road
Nashik
Mr. Ajay Date
Ganeshsmruti, Prabhat
Road, Galli No.10,
Shivajinagar, Pune
Editor
Dr. Ravindra Doshi
Head, Department of
Economics, Shivaji
University, Kolhapur
Co-Editor
Dr. Pramod Biyani
Reader, School of Commerce & Management
YCMOU, Nashik
Dr. Umesh Rajderkar
Lecturer
School of Humanities &
Social Sciences, YCMOU
Nashik
Mrs. Madhulika Pitre
Lecturere, School of
Commerce & Management
YCMOU, Nashik
Production
Shri. Anand Yadav
Manager, Print Production Centre
Y. C. M. Open University, Nashik - 422 222
(First edition developed under DEC development grant)
© 2006, Yashwantrao Chavan Maharashtra Open University, Nashik - 422 222
n PublicationNo.: 1393
n First Publication : Nov. 2006
n Cover Design : Shri. Avinash Bharane
n Typesetting : Neelesh Enterprises, Nashik
n Printer : Shri. Narendra Shaligram, M/s. Replica Printers, 2 Citco Centre, Wakilwadi, Nashik - 422001
n Publisher : Dr. Dinesh Bhonde, Registrar, Y. C. M. Open University, Nashik - 422 222
ISBN : 81-7171-222-5
(MGM 224-1, 2, 3)
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Managerial Economics (MGM 224)
Syllabus
Book 1 : Managerial Economics : Nature and Concepts
Unit 1 (A) : Managerial Economics : Nature, Objectives and Scope
Unit 1 (B) : Economical Analysis
Unit 1 (C) : Methods of Economic Analysis
Unit 1 (D) : Basic Concepts
Unit 2 (A) : Nature of Managerial Decisions
Unit 2 (B) : Methods of Studying Managerial Economics
Unit 2 (C) : Some Basic Concepts : Plant, Firm, and Industry
Unit 2 (D) : Size of the firm
Unit 2 (E) : Business Decisions
Unit 3
: Concept of Demand
Unit 4
: Demand Analysis
Unit 5
: Elasticity of Demand
Unit 6
: Demand Forecasting
Book 2 : Markets and Price Determination
Unit 7
: Cost of Production : Concept, Types and Curves
Unit 8
: Production Function
Unit 9
: Break-even Point of Production
Unit 10
: Supply
Unit 11
: Market Conditions and Price-Output Decisions
Unit 12
: Market Structure Analysis – 1
Unit 13
: Market Structure Analysis – 2
Unit 14
: Price Determination Techniques
Book 3 : Principles of Business Firms and Investment Analysis
Unit 15
: Firm : The Basic Concept
Unit 16
: Behavioural Theory of Firm
Unit 17
: Business Behaviour of firm
Unit 18
: Profit - Concept and Analysis
Unit 19
: Capital Budgeting
Unit 20
: Risks, Certainty and Uncertainty
Unit 21
: Decisions of public Investments
Yashwantrao
Chavan
Maharashtra
Open University
MGM 224
Managerial Economics
Book One
Managerial Economics : Nature and Concepts
Writers
: Prof. N. B. Kulkarni, Prof. S. P. Deo
Unit 1 (A) : Managerial Economics : Nature, Objectives and Scope
1
Unit 1 (B) : Economical Analysis
11
Unit 1 (C) : Methods of Economic Analysis
18
Unit 1 (D) : Basic Concepts
27
Unit 2 (A) : Nature of Managerial Decisions
33
Unit 2 (B) : Methods of Studying Managerial Economics
39
Unit 2 (C) : Some Basic Concepts : Plant, Firm, and Industry
44
Unit 2 (D) : Size of the firm
50
Unit 2 (E) : Business Decisions
57
Unit 3
: Concept of Demand
63
Unit 4
: Demand Analysis
82
Unit 5
: Elasticity of Demand
100
Unit 6
: Demand Forecasting
115
Unit 1 (A) : Managerial Economics : Nature,
Objectives and Scope
Index
1.0
1.1
1.2
Objectives
Introduction
Subject Description
1.2.1 Managerial Economics: Definitions
and Nature
1.2.2 Managerial Economics: Objectives
1.2.3 Managerial Economics: Scope
1.2.4 Managerial Economics: A Branch
of Economics
1.3
1.4
1.5
1.6
1.7
Words and their Meanings
Answers to Questions for Self Study
Summary
Exercises
Books for Further Reading
1.0 Objectives
After studying this unit, you will be able
to :
« State the definitions of Managerial
Economics,
« Explain the nature of Managerial
Economics,
« Explain the scope of Managerial
Economics,
« Explain how Managerial Economics is a
branch of Economics.
1.1 Introduction
‘Managerial Economics: Nature and
Concepts’ is the first book in the course of
Managerial Economics. In this course, we shall
study how economic theory is used in
Management. A number of problems may arise
while running a business. The mechanism to
solve such problems and allow the enterprise to
work smoothly is called ‘Management’.
Whenever economic problems arise,
Management has to find solutions to them.
Economic theory is a useful tool in finding the
solutions. As such, a need to apply jointly the
sciences of Management and Economics arise.
Such a system is called ‘Managerial Economics’.
One important feature of Managerial Economics
is that Economics is used in managerial decisionmaking. Economics, in general, considers the
problem of an economic unit lays down the
principles, assuming other conditions to remain
unchanged. Assuming given conditions, logical
conclusions are drawn. However, when we turn
to a specific economic unit from that of a
general unit, we have to modify the economic
theory according to the needs of that specific
unit. Economics, therefore, gets divided into
different branches. Whenever management of
a business needs to find solution to its economic
problems, the tools devised by economic theory
can be of great help. The branch of ‘Managerial
Economics’ is developed out of using Economic
theory as a tool of solving economic problems
of business. Keeping in view the objectives of
business and the present situation of the
business, Managerial Economics guides how
best the objectives could be achieved. Managerial
Economics uses economic terminology such as
demand, supply, market etc. In recent times, the
conventional economic theory is being modified
to accommodate the changes in the behaviour
of the firms. New theories have been developed
and included in economic theory about behaviour
of the firms. We can thus see that ‘managerial
economics’ is not merely a part of general
economic theory but has been developed as a
branch of Economics.
Managerial Economics : Nature and Concepts : 1
In this unit, we shall study the nature of
managerial economics, objectives of managerial
economics, other areas of study included in
managerial economics and the relationship
between managerial economics and the general
economic theory.
1.2 Subject Description
1.2.1 Managerial Economics :
Definitions and Nature
Definitions of Managerial
Economics
While speaking about a company, we
usually say the management of the company is
good. This implies that the mechanism of
decision-making in that company is efficient, the
decisions taken by the management are in the
interest of the company. The interests of an
individual or a group do not guide the decisions
but the interests of the company and its future
were the prime considerations. Whenever we
say that a company falls sick or closes down, it
implies that the decision-making mechanism in
that company did not work in the interest of the
company. The process was guided by the vested
interests of a particular individual at the cost of
loss to the company. Right management only
takes decisions in the interest of the company
that brings in prosperity.
We read about general meetings of the
companies. The shareholders are informed of
the affairs of the company in these meetings.
How much profit the company has earned,
whether the profit of this year is less than or
more than the previous year, how is profit
distributed, if the profit is less, what are the
reasons, what are the future plans of the
company etc. Company’s management is
composed of the Board of Directors elected by
the shareholders of the company and the salaried
Executive Managers working under them. Every
day, new problems crop up before the
management. Scarcity of raw material at one
time or a slack in the transport service at another
time makes it impossible to deliver finished goods
to the markets. Workers’ unrest, at one time
and refusal of the bankers to extend loans and
advances at another time generate problems
before the company. Good Management is
always needed in any enterprise to find solutions
to such problems in order to avoid losses.
Management should work in such a way as to
achieve the objective of business within given
business environment. After analysing the facts
about the problem a series of alternative
solutions to the problem under study can be
devised. Management has to choose the best
alternative from those devised. To the extent
this task is performed well, the business achieves
more success. In our country, there are hundreds
of mills in Textile Industry, but very few of them
are running successfully. These mills seem to
have adjusted well with changing environment
and making best use of available opportunities.
On the contrary, those mills, which turned sick
and ultimately closed down can be said to have
been badly managed. Same type of business by
various firms in the same industry shows
different levels of achievement on account of
differences in the efficiency of management.
Management has a number of aspects.
Economic aspect of Management is taken into
account in Economics. We shall now look for
the meaning of ‘Managerial Economics.’
According to D. C. Hague, “The subject
matter of understanding a problem in
decision-making and attempting to analyse
it, is the basic academic discipliner in
Managerial Economics.”
According to Spencer and Sigel Gun
“Managerial Economics is an integration of
Economic Theory with business practices with
a view to create an ease in decision-making
and future planning”
Clarkson defines Managerial Economics
“...that studies all or at least a few of the
economic factors that are required in
managerial decision-making.”
It is quite clear from the definitions
mentioned above that Managerial Economics is
concerned with taking business decisions.
Decision-making involves how to utilise available
resources in the best possible manner for
achieving the objectives of business. Each of
the business firm has different objectives.
Objectives could be maximisation of profit,
maximisation of output, maximisation of revenue,
Managerial Economics : Nature and Concepts : 2
to accumulate maximum assets, to accelerate
the rate of output or revenue and so on. Each
firm determines one of these objectives as most
important. Manager decides as to how best the
available resources are utilised in order to
achieve the predetermined objectives. To do this,
he has a number of alternatives. Choosing one
of these alternatives means decision-making.
From economic point of view, two factors
assume importance in the process of decisionmaking.
(1) Optimum Allocation of Resources
A firm cannot have unlimited resources.
Right personnel are required to perform different
functions. In addition, man-made resources like
buildings, machinery, and means of transport are
also required. Money need to be spent on buying/
hiring these resources. How much money an
individual firm can raise has limitations. Limit
on availability of resources poses the problem
of proper utilisation of resources. How much
out of limited money could be spent on land,
how much on salaries and how much on plant
and other appliances has to be decided. This
process is called ‘allocation of resources.’
Similarly, there are number of instances when a
firm has to make a choice. If the business is to
be advertised, there are newspapers; radio,
television and hoardings are the alternative
sources of advertising. How much to spend on
each of these media is also to be decided. If a
product is to be sold, how much to sell in
different markets has also to be decided. In each
of such situation, decision becomes necessary.
(2) Present and Future Uncertainty
The problem of decision-making by the
management arises because of uncertainty in
business. Some businesses have built-in
uncertainty. Mining Industry is most uncertain.
We do not know the quantity of minerals we
would extract from mines, and the quality is also
uncertain. In agriculture, environment and crop
conditions are most uncertain. Further more,
future prospects in any business are uncertain.
Choices and preferences of people may change
Policies of government may change. Decisions
are necessary in order to adjust with changing
situations and to enjoy the opportunities created
by changed situations. Assuming the scarcity
of raw materials, alternative arrangements are
to be made. Nature of the product has to be
changed, taking into account the possibility of
change in demand. Forecasting technological
changes that may come has to be prepared for
technological up gradation. The science of
Management thus, provides the techniques
required in decision-making. The theories and
concepts in Economics are used to analyse the
situation. Such analysis helps in understanding
the implications of different alternatives. It
enables us to decide which one of the
alternatives is the best for achieving the
objective. In such a way, Economics is used in
solving specific problems of business. Economics
provides tools of analysis. Elasticity, production
function, cost, market, market competition,
equilibrium and many other concepts are
developed in economic theory. These concepts
are freely used as tools in solving practical
problems of business.
Since the economic analysis can be of
great use in solving the problem of managing
the business, Managerial Economics can be said
to be an applied branch of Economics.
Nature of Managerial Economics
Nature of Managerial Economics can be
explained with the help of following points:
(a) Micro Nature : Managerial
Economics is a study of micro nature. Economic
theory is used here for solving the problems of
an individual business unit. It studies the situation
in a firm and the possible alternative actions to
correct the situation. External economy is
concerned with business unit only in respect of
limiting the scope of alternative actions. Only a
single firm at a time is considered in
microeconomics and so also in Managerial
Economics.
(b) Optimum Utilisation of Scarce
Resources : Managerial Economics is
concerned with optimum utilisation of scarce
resources. Managerial Economics helps in
allocating limited resources to different activities
of the firm. If the firm is the one that takes multiproducts, then the resource allocation must
provide for each of the product. In addition,
resources also have to be allocated to different
functions of management such as production,
distribution, promotion, transport etc. Such
resources allocation is necessary to achieve the
Managerial Economics : Nature and Concepts : 3
objectives of business to maximum extent.
(c) Use of Economic Theory : One
peculiarity of Managerial Economics is to make
use of economic theory in solving the practical
problems in business. Answers to a number of
problems such as what to produce, how to
produce, what should be the size of the firm;
whether large or small, how much to produce in
a given time period, are sought through economic
theory and concepts.
(d) Aid from Mathematics and
Statistics : Use of mathematical and statistical
tools as an aid to economic analysis is common
in managerial economics. These tools are used
in collection of business statistics, analysing the
statistics and to draw inferences there from.
Price elasticity of demand, Income elasticity of
demand, cross elasticity of demand, production
function and the like concepts can best be
understood through the study of these sciences.
Various equations can be developed to estimate
business forecasting. This helps in accomplishing
the process of decision-making.
(e) Specific to a Firm : Managerial
Economics limits its scope to the study of a
specific firm. Macroeconomic analysis for the
rest of the economy is not done.
(f) Useful to Private and Public
Enterprises : Managerial economics can be
used by the state enterprises and non-profit
enterprises as well. To maximise performance
within the available resources is necessary for
such enterprises also. In Public Finance, an
attempt was made to introduce ‘Zero
Budgeting’. Initially, the concept was developed
for private sector enterprises.
(3)
The problem of optimal allocation of
resources arises because of limited stock
of resources. ( )
(4)
Managerial Economics takes into account
all the firms. ( )
(5)
Management process becomes easy
because there is no uncertainty at present
and in future. ( )
(6)
Managerial Economics is useful only to
private firms motivated by profits. ( )
(7)
Different firms under the same condition
may earn varied profits because of
differences in the efficiency. ( )
1.2.2 Managerial Economics :
Objectives
After understanding the definitions and
nature of Managerial Economics, we shall now
turn to the objectives of Managerial Economics.
(1) To help in Achieving the Objectives
of the Firm
We have already studied in an early subunit that Managerial economics concerns a single
firm. As such, to help the firm in achieving her
objectives proves to be the first objective of
managerial economics. If the objective is to
maximise profit, then the decisions as to what
to produce, how much to produce, what price to
be charged etc. will be motivated by profit
consideration. Then which one of the
alternatives shall give the firm maximum profit
will be found out. Accordingly, a right decision
will be recommended. Similarly, with regard to
any other objective, Managerial Economics can
help the firm to choose right decision.
Questions for Self Study - 1
(2) Optimal Allocation of Resources
(A) State whether the following
û)
statements are true or false. Put (û
ü ) in brackets.
or (ü
(1)
Managerial Economics studies all or at
least a few of the economic factors that
are required in managerial decisionmaking. ( )
(2)
There is no relationship, whatsoever,
between Managerial Economics and
General Economics. ( )
Another objective of Managerial
Economics is to help the firm in optimal
allocation of resources. An individual firm may
have limited resources. Each one of these
resources has alternative uses. Under such
condition, how much of each resource should
be diverted to each of the alternative uses has
to be decided. If the firm produces more than
one commodity, then for each of the commodity,
how much space, how many machines, how
Managerial Economics : Nature and Concepts : 4
much manpower and other resources would be
needed will have to be decided. Even though a
single commodity is to be produced, how much
of resources for each of the production,
inventories, distribution, transport and promotion
shall be used, have to be decided. Managerial
Economics studies resource allocation within the
frame of firm’s objectives draws conclusions
and recommends the firm optimal allocation of
resources.
(3) To Help Solving Day to Day
Problems
A firm may face immediate problems
while running routine business. A competitor in
the market reduces price or spends more on
advertising to boost his sales. How to react in
this situation becomes a problem. Exports of
finished goods or imports of raw material stop
due to war or strained relationship with foreign
countries. How to overcome such difficulties
has to be decided. Some times, workers go on
strike for their unfulfilled demands. Production
suffers thereby and solution to this problem must
be found. A number of alternative solutions are
possible. Which one among these is the best
has to be decided. Managerial Economics can
help the firm in choosing the right solution.
(5) To Help in Future Planning
One more objective of Managerial
Economics is to help the firm in planning for the
future. Business must grow over time.
Production of the existing product can be
expanded or some another product can be added
to expand the business. Appropriate alternative
among these two can be chosen with the help
of Managerial Economics. Further more, for the
expansion so planned, it has also to be decided
that whether the expansion should be carried
over with the help of existing plant and machinery
or to be replaced by modern machinery with
less number of workers. How to raise additional
capital required for expansion of output, whether
the expansion has to be carried on the existing
location or an independent new department is
to be developed at a new location are some of
the problems in which Managerial Economics
can help to solve.
Questions for Self Study - 2
(A) Write brief answers to the following
questions.
(1)
(2)
(3)
(4) Recommending Solutions under
Dynamic Conditions
This is one more objective of Managerial
Economics. Business conditions change over
time. New products enter into market and old
ones are thrown out of market. Tastes and
preferences of consumers change. Government
policies change and techniques of production may
also change. These dynamic changes may create
hurdles for the firms or may offer opportunities
for growth. Managerial Economics is useful in
finding out the effects of such changes on
business firms. It can suggest the firms how to
react in a dynamic situation, what changes the
firm should introduce. If the demand for existing
product of a firm is falling, which alternative
product the firm can introduce with given
resources. A number of alternative products can
be developed. However, the best among the
available alternatives has to be decided and the
firm can be advised accordingly.
How does Managerial Economics guides
optimal allocation of resources?
Why has a business firm to adjust with the
dynamic conditions?
How does Managerial Economics help the
firm in planning for future?
1.2.3 Managerial Economics:
Scope
Managerial Economics studies the
economic aspect of the firm. We shall now
understand the areas in which Managerial
Economics studies.
(1) Study of Demand
Managerial economics considers the
nature of demand for the product or service the
firm is producing or supplying. It studies the
effect of price and income of the people on
demand. Further more, it also forecasts the
prospective demand for the product in the
market.
(2) Product Study
Analysis of the conditions under which
a firm produces is a part of the study of
Managerial Economics : Nature and Concepts : 5
Managerial Economics. It studies input output
relationship; how does a change in input affects
the output is traced. On the basis of such study,
cost of production can be studied further. This
study enables the firm to take decisions
regarding production. Similarly, if the prices of
input change, it can be decided to change the
use of inputs.
(3) Inventory Management
It is necessary to hold the inventories of
raw material, semi finished goods, finished goods
and spares of machinery etc. The study aims at
minimum investment in inventories and the
maximum benefits derived from holding
inventories. Inventories are necessary to
maintain the chain of production smooth, to boost
sales, if there is a sudden rise in demand, to
take advantage of price fall of the materials held
in stock. Proper management of inventories
makes the firm more successful.
(4) Analysis of Price and Pricing
Policy
There are theories in Economics to explain
how the price of a commodity is determined.
Where the firms are at no liberty to fix the price,
prices are determined by the current prices
probable prices in future. Most of the times, firms
themselves fix the price. Under such
circumstances, appropriate prices are required
to be charged by taking into account all the
possible effects of prices. Study of Managerial
Economics enables us in formulating price policy.
(5) Study of Policy Regarding Profit
To earn profit is an important objective of
any firm. Even though some firms may have
the objectives other than profit, some profit is
considered reasonable. At times, if loss is
inevitable, an attempt has to be made to minimise
the loss. From this point of view, Managerial
Economics studies the technique of profit
maximisation. A short-term profit maximisation
policy may have adverse effects in the long run.
Considering long-term gains to firms, a policy
of low profit proves to be reasonable. Managerial
Economics studies the impact of excess profit
on future prospects and a policy of reasonable
profit.
(6) Promotional Study
Promotion of a product is necessary
before its production actually takes place, when
the product is in process and even when it is
finished. Promotion is required to boost sales of
the product in the market. Advertising is an
important source of promotional expenses.
There are different media of advertising.
Newspapers, Journals, Audio-visuals such as
Radio, television, Telefilms and the Hoardings
that could be displayed at all important places.
Any of these media can be used. Decisions on
which media to use and with which firm to
contract for advertising are required to be taken
with reference to cost and revenue implications
of the media. Managerial Economics helps in
making such decisions.
(7) Capital Budgeting
Firms need capital in the form of money
to run the business. The problem here is how to
minimise expenses to satisfy this need. The firm
must first estimate its capital requirement and
then to think of the sources from which the capital
can be raised. Total capital required is classified
by different time periods. A comparative study
of the different sources of capital has to be done.
A timetable for raising capital has to be
determined. Laws and theory of Managerial
Economics is of great use in this work.
(8) Allocation of Resources
Each of the firm is faced with the basic
problem of how to use available resources for
different purposes and how much for each of
the purpose. Managerial Economics uses
principles of Economics for the purpose.
Questions for Self Study - 3
(A) State whether the following
û)
statements are true or false. Put (û
ü) in bracket.
or (ü
(1)
Demand forecasting for a commodity is
done in Managerial economics. ( )
(2)
For a firm, it is necessary to have
appropriate inventories of raw materials
and finished goods. ( )
(3)
A firm must, forever, earn maximum profit.
( )
Managerial Economics : Nature and Concepts : 6
(4)
The main object of product promotion is
to boost sales. ( )
(5)
The economic problem of utilisation of
resources does not necessarily arise to all
firms. ( )
1.2.4 Managerial Economics: A
Branch of Economics
We have so far studied definition and
nature, objectives and scope of Managerial
Economics. Though it is a creation out of a
combination of Management and Economics,
use of economic theory in solving the problems
of management, it can be said that Managerial
Economics is a part of study of economics.
Certain principles of economics have been
developed to help government in formulating
policies of development of the country. For
Example, economic freedom to individuals, open
foreign trade, minimum state interventions in
economic transactions are some of the policy
measures already discussed in the beginning.
With the development of economics, studies of
more and more specialised areas were assuming
importance. Theories of production, consumer
behaviour, money, International trades, public
finance are some of the areas that were viewed
from economic aspect. Economics was
distributed into different branches.
Macroeconomics and the theories of business
cycles, economic growth, National Income
estimation there under were being studied as
special issues. Almost simultaneously, the
industrial structure was changing rapidly thereby
running a business unit, firm, became a special
work. Economics contains a number of theories
that are useful to firms. Theory of Demand,
Returns to scale, Theory of price as well as the
concepts such as elasticity, cost of production,
profit, revenue, which are useful to firms in
solving their practical problems. It is, therefore,
a great help to firms in arriving at right decisions
by using economic concepts and theories.
‘Managerial Economics’ has been developed as
a new branch of Economics to make use of
economic analysis in managerial problems.
Scarcity of resources and their alternative
uses has been a problem all firms face. Some
objectives of firms are of economic nature. Profit,
revenue, sales, market share in sales, growth,
creation of assets can be regarded as economic
objectives. In addition to these, there can be some
non-economic objectives as well. To contribute
our mite in country’s economic development, to
develop our own city, to gain leadership of the
industrial sector, to create influence in country’s
politics can be said to be non-economic
objectives. Though study of such objectives may
not be studied in economics but such objectives
may influence the decisions taken purely on
economic considerations. An entrepreneur, even
though he is convinced about an economically
viable location for his unit/s, he decides to
develop his own town/area for the sake of
development, he may setup industrial unit/s in
his own area by keeping aside the economic
norms.
Managerial Economics uses essential
concepts in economics. The concepts are used
to analyse business environment and the effects
of alternative decisions are found out. Such
analysis is usually quantitative, For example,
pricing decision is to be taken with a profit
motive. Under such circumstances, the
relationship between price and average revenue,
price and average cost is determined. From this
relationship, the profit-maximising price could
be found. In the study of firm, external factors
affecting the firm must also be studied. Effects
of commodity taxation by the government,
effects of changes in the international market
on prices of products can be taken into account
with the help of economic theory. There are so
many other economic theories, which are not
considered in Managerial economics.
Theories developed in economics and the
tools developed for studying different problems
are used to solve economic problems of the firm.
This is attempted in Managerial Economics.
Economics states the relationship between
different economic variables and finds the
effects of a change in one variable on others.
The same method is used in Managerial
Economics. If how to boost sales is the problem
and we assume three possible solutions, namely,
to reduce the price, to improve the quality of the
product and to spend more on sales promotion.
Impact of each of the alternative measure on
sales can be stated in terms of equation. This
will help in choosing the best alternative solution
to the problem. Such equations can be developed
only because of economic theory. Economic
analysis is taken as a base in Managerial
Managerial Economics : Nature and Concepts : 7
Economics. For this reason, it is said that
Managerial Economics is a branch of
economics.
Questions for Self Study - 4
1.4 Answers to Questions for
Self Study
Questions for Self Study - 1
(A) Write brief answers to the following
questions.
(1)
Which of the theories and Principles of
economics prove useful in Managerial
economics?
(2)
What are the economic objectives of a
firm?
(3)
What are the non-economic objectives of
a firm?
(4)
What are the external factors affecting a
firm?
(5)
(1) (ü),
(5) (û),
(4) (ü),
(1)
Productive resources available with a firm
are limited. These can be used for various
alternative purposes. Managerial
economics helps in making use of
resources at right place and for right
alternative uses, (proper allocation of
resources) through its theories and
principles.
(2)
Market conditions do not remain
unchanged permanently. There are often
changes in markets. Tests and preferences
of consumers change, New techniques of
production develop, thereby cost of
production falls, nature of commodities
change. A change in consumers’
preference results in decreased demand
for old products. Considering all these
changes, firm has to change their technique
of production, nature of product and the
business policy in general. Otherwise, the
firm fails to cope up with changing time; it
may remain at the backdrop and suffer
heavy losses. Business firms, therefore,
have to adjust with changing environment.
(3)
A firm must not think of short run profit
and survival but has to think of long-term
gains. Economics helps the firms to
increase current output, decision making
on introduction of a new product, to
increase business and efficiency of the
firm in the long run, to create goodwill in
the industrial world, to adopt new
techniques of production and thereby
reduce cost of production to benefit the
customers, to find new sources of funding,
to implement the plans of expansion, etc.
1.3 Words and their Meanings
Management :An authority or system that
guides, controls the activities of an
organisation with a view to achieve predetermined objectives.
Micro : Economics is studied in two parts;
Micro and Macroeconomics. In
Microeconomics, we study a single unit
such as one individual, a single firm,
demand and supply of a single commodity,
income of an individual, price of a
commodity
are
studied.
In
Macroeconomics, national aggregates like
total population, National Income, all firms
in the country, aggregate demand and
aggregate supply, price level, inflation, level
of employment etc.
(3) (ü),
(7) (ü)
Questions for Self Study - 2
Why is it said that Managerial Economics
is a branch of economics?
Uncertainty : The events or happenings in
business that cannot be predicted but often
take place. Business had to accept risks
and uncertainties. Some risks are
predictable and insurable (for example, fire
insurance of a factory). Uncertainties such
as decrease in demand cannot be insured.
(2) (û),
(6) (û),
Questions for Self Study - 3
(1) (ü),
(2) (ü),
(4) (ü),
(5) (û).
Managerial Economics : Nature and Concepts : 8
(3) (û),
Questions for Self Study - 4
(1)
Economic theories such as theory of
production, Returns to scale, theory of
value, theory of demand, and the concepts
of cost of production, profit, revenue etc.
help the business firms to take decisions
regarding production, supply, cost and profit
policies.
(2)
Economic objectives of a firm can be
maximisation of profit, maximisation of
sales, to make the customers habituated
with the product to earn more profit, to
increase market share of the product and
to undertake production on large scale.
(3)
Non-economic objectives of a firm can be
to contribute mite in the economic
development of the nation, to develop
backward regions, hometown, to gain
prestige in the society through business, to
develop social and political relations, to
serve the society, to create respect,
prestige and importance in business world
etc.
(4)
External factors influencing a firm are
changes in commodity taxes by the
government, nature of the commodity in
international market, effects on production
system and on demand, changes in
government policies etc.
(5)
Theories developed in economics such as
law of demand, laws relating to production,
cost concepts, finding the functional
relationship between two or more
variables and the impact of change in one
variable on others are widely used in
Managerial Economics. In order to boost
sale of a commodity produced by the firm,
whether the price be reduced or the
product be advertised, to the quality of the
product be improved and customers be
convinced of improved quality? One of the
best alternatives from those given above
can be chosen to boost sales. In this way,
economic theory is extensively used in
making business decisions. It is, therefore,
said that Managerial Economics is a branch
of Economics.
1.5 Summary
Managerial Economics provides
theoretical and applied aid to the Management
of firm in taking decisions on economic issues.
With a view to make the process of decision
making and future planning easy for business
firms easy, business practices are integrated with
economic theory in Managerial Economics and
it is defined as such. Limited resources with
alternative uses and uncertainty about future
pose problems before the firm. First problem is
how to allocate scarce resources among
different purposes? Second, uncertainty due to
change in tests and preferences of the
consumers or change in the government policies,
entry of a new product affect the demand for
the existing product. Management of a firm has
to take appropriate decisions because of the two
factors mentioned above. Business goals have
to be attained within these two constraints.
Under such circumstances, Demand Theory,
Laws of Production provided by Economics and
the economic concepts like cost of production,
profits etc. are also used in Managerial
Economics. Managerial Economics is used to
solve economic problems of a typical business
firm. That means, Managerial economics is a
micro study. Resources are limited but have
alternative uses. This raises a question, for
which of the purposes and how the resources
can be put to use? Which technique of production
to use? How large or small the size of firm should
be? Managerial Economics proves to be of much
help to the firm in arriving at decisions on such
issues. Mathematical and statistical techniques
are used in Managerial Economics in demand
forecasting, measurement of price elasticity of
demand, to study the production function etc.
Managerial Economics is equally useful to private
and Public sector enterprises. Each firm has
some specific objectives. Main objective of
managerial economics is to help firms in
achieving these objectives such as optimal use
of scarce resources through proper allocation,
to help solving day-to-day problems of firms, to
help managers in decision-making under dynamic
changes, adjusting with them and to help in
formulating long-term policies.
With regard to scope of managerial
economics, demand for the product that firm
Managerial Economics : Nature and Concepts : 9
produces, input-output relationship, raw
materials and finished goods inventory
management, price policy, study of policies
relating to profit and product promotion, Optimum
allocation of resources and capital budgeting are
the major areas of study. Many theories and
concepts in economics are used in Managerial
Economics to assist firms in the process of
decision-making. Examples are Law of demand,
Laws of returns, theory of value (theories) and
cost of production, profit, Revenue (concepts).
Objective of firm is not merely to maximise the
profit but also some non- economic objectives
like to contribute to nations economic
development, development of backward area,
to gain social and political prestige. Managerial
Economics helps firms in arriving at right
decisions in economic and non-economic
matters. Managerial Economics also helps firms
in gaining control over external factors
influencing the firm like government policies,
status of international trade etc. Managerial
Economics helps firms in finding the solutions
to such problems. Important economic theories
and concepts in economics relating to the study
of relationship between various economic
variables and deciding appropriate sales policy
are used in Managerial Economics. For this
reason, Managerial Economics is considered as
a branch of economics.
1.6 Exercises
(1)
Explain the definition and nature of
Managerial Economics.
(2)
Write the information on the objectives of
Managerial ‘Economics’.
(3)
Explain the areas of study that are covered
under Managerial Economics.
(4)
Discuss the statement that ‘ Managerial
Economics is a branch of Economics’.
1.7 Books for Further
Reading
(1)
D. Gopal Krishna: A Study in Managerial
Economics; Himalaya Publishing House,
1985
(2)
Sirayya K.V.M, Gangadhar Rao and V.S.
P. Rao, Managerial Economics, Delhi,
Manas Publications, 1989.
Managerial Economics : Nature and Concepts : 10
Unit 1 (B) : Economical Analysis
« Explain the principle of preferences in
democratic and command economies,
Index
1.0
Objectives
1.1
Introduction
1.2
Subject Description
« Explain, what is meant by an economic
activity.
1.2.1 Economics : Definitions
1.2.2 Economic Problem
1.2.3 Unlimited Ends, Limited Means of
Alternative Uses
1.2.4 Methods of Solving Economical
Problem
1.2.5 Economic Activities
1.3
Words and their Meanings
1.4
Answers to Questions for Self Study
1.5
Summary
1.6
Exercises
1.7
Books for Further Reading
1.0 Objectives
After studying this unit, you will be able
to :
« State the definitions of Economics by Adam
Smith, Alfred Marshall and Lionel Robinson,
« Explain what is meant by an ‘economic
problem’,
« Explain as to how an economic problem
arises,
« State the information about productive
resources needed to satisfy consumer’s
wants,
« Explain the measures to solve economic
problems,
1.1 Introduction
We have considered the relationship
between Economics and Managerial Economics
in unit 1 (A). Assuming Managerial Economics
as a branch of economics, it is necessary to know
what exactly we study in economics. It was
believed in old days that economics is a science
of wealth. However, it was discovered later that
Economics is a study of individual and social
behaviour of human beings in satisfying their
unlimited wants with limited resources at their
disposal. Further more, the resources have
alternative uses that complicate the nature of
economic problem. Economic problem arises
because of unlimited human wants and scarce
means to satisfy them. Which of the unlimited
wants to satisfy first, out of limited resources
with alternative uses, poses economic problem.
Human attempt in how to strike a balance
between the two necessitate a decision on fixing
the priorities among the unlimited wants to be
satisfied first. Resources are natural, human and
man-made. These can be put to best possible
alternative use when priorities of wants are
fixed. Priority wants can be satisfied first by
diverting scarce resources for purchasing them.
Economic activities take place because of an
attempt so satisfy human wants. Consumption
is an end of economic activity.
In this unit, we shall study in detail,
definition of economics, nature of an economic
problem and the reasons behind it, the types of
productive resources and economic activity.
Managerial Economics : Nature and Concepts : 11
1.2 Subject Description
problem of optimum utilisation of means crop
up. Such a problem is essentially an ‘economic
problem’, which we shall study a little later.
1.2.1 Economics : Definitions
Questions for Self Study - 1
We shall be thinking of Managerial
Economics as a branch of economics. It is,
therefore, important to understand the nature of
economics. Economics was formerly related to
political policies. Economics was referred to as
‘political economy’. Adam Smith is said to be
the father of Economics. He considered
economics as a “science that studies production
and distribution of wealth”. Alfred Marshall
explained that Economics studies only a part of
human behaviour. A part of Economics is the
study of acquiring and utilising the means of
material for well-being and the second, more
important part is the study of man. Definition of
economics by Marshall gave new turn to
Economics. Human welfare concept was
accepted for the first time in Economics.
Attempts were made to find out whether there
is an increase or decrease in human welfare.
The relationship between individual welfare and
social welfare had been examined. The concept
of utility was stated in cardinal a term that means
utility can be measured in cardinal numbers.
Utility of two individuals can be totaled. Utility
experienced by one individual can be the basis
for predicted utility of other person. This concept
is based on a number of such unrealistic
assumptions. It was also assumed that utility is
uniform for all persons or for deriving utility out
of income, all persons are equal. Such ideas are
called value judgments. Value judgments enable
us to understand the difference between good
and bad, right and wrong.
Prof. Lionel Robinson, while expressing
his views about the nature and importance of
economics has attempted to make economics a
pure science. According to him, Economics has
nothing to do with ethics and hence, answers to
certain problems must be found through scientific
study. Lionel Robins defines “Economics studies
human behaviour in balancing unlimited ends
(wants) and scarce means (resources), which
have alternative uses, to satisfy them.” What
type of problems is studied in economics can be
clear from this definition. Where means are
scarce in relation to ends, the problem how to
meet maximum end arises. Here, one more
(A) State whether the following
û)
statements are true or false. Put (û
ü) in bracket.
or (ü
(1)
Adam Smith thought of Economics as a
science of producing and distributing
wealth. ( )
(2)
Alfred Marshall thought of Economics
from the viewpoint of welfare of the
society. ( )
(3)
Lionel Robins stated “Economics studies
human behaviour in balancing unlimited
ends (wants) and scarce means
(resources), which have alternative uses,
to satisfy them.” ( )
(4)
Limited resources of alternative uses and
unlimited wants do not pose any problem
of resource allocation. ( )
(5)
Individuals and the society too face
economic problem.
1.2.2 Economic Problem
According to Prof. Lionel Robins, ‘economic
problem’ arises in balancing between unlimited
ends and limited means to satisfy them. Ends,
from economic point of view means satisfaction
of human wants. Means are the medium through
which human wants are satisfied but means are
scarce in relation to wants to be satisfied. Further
more, the scarce means have alternative uses
but can be used for a single purpose at a time.
Under the circumstances, for which purpose the
means to use gives rise to economic problem.
Economic problem can be thought of for an
individual or for the society as a whole. For an
individual, money income in his hand is limited
and how to meet all the ends is an economic
problem before him. For the society, how to
utilise scarce productive resources to produce
goods required is the economic problem. Let us
now understand the nature of economic problem
for the society as a whole.
Managerial Economics : Nature and Concepts : 12
Questions for Self Study - 2
(A) Write brief answers to the following
questions.
(1)
What is an ‘economic problem’?
(2)
Why does economic problem arise?
(3)
Why is it said that means are of alternative
uses?
(4)
What is the nature of economic problem
for an individual?
(5)
What is the nature of economic problem
for the society?
for usable water and wastewater were also
separate. Today, a number of families live in a
single building. If one family uses more water,
some other family faces shortage of water. If
one of the families is unclean, rest of the families
suffer. Playing loud music by one, troubles
hundreds of people around. Disputes arise
because of encroachment of one person on the
rights of some other person/s. Laws have to be
enacted to prescribe the rights and duties of the
people. This is how wants go on increasing. We
can rightly say that wants are endless. Even in
a richest country, it is not possible to satisfy all
wants.
1.2.3 Unlimited Ends, Limited
Means of Alternative
Uses
Productive resources with the society to
satisfy wants of the people are of three types:
(1)
Natural resources
With reference to Society, ends means
acquisition of goods for satisfaction of the
individual and collective wants of the society.
Every individual has wants, namely food, clothing
and shelter as necessities of life. Education and
health are the wants for enhancing efficiency
and capability and can be termed as ‘comforts’.
Auto-vehicles reducing stress of an individual
in travel can be a want of comfort or luxury. As
the time passes, wants go on adding. In a country
like India, use of TV, Refrigerator, Taperecorder, Washing machine, cooking gas, Mixer,
Oven and many other new products has been
started as a demonstration effect of consumption
in rich countries. In modern age creation of
wants through effective advertising has become
common. First, the product is brought into
market and then advertised. This technique
succeeds in speedy growth of wants.
(2)
Human Resource
(3)
Man-made Resources
Like individual wants, collective wants also
arise and these are to be satisfied. When people
organise in society, such wants do arise. To
protect people from aggression by enemies, to
maintain law and order in the country, to pass
laws to protect the rights of individuals and a
judiciary system to enforce the law in case the
rights are violated by other individuals, to set up
transport and communication systems, to create
facilities for public health, etc. Society has to
provide for all these collective wants. Collective
wants are expanding over time. Behaviour of
the people is affecting each other more than
before. In olden days, people were residing
independently at far distances. Arrangements
(1) Natural Resources
Natural resources are those provided by
nature to mankind. Rainfall, weather, forests,
mineral wealth, seashore, suitable locations for
harbor are the free gifts of nature to man. Fertile
land and appropriate weather are the important
factors in food production. In some countries,
total area is quite large but the cultivable area is
rather small. Deserts, fallow land, hills and
valleys occupy major area, leaving a small
cultivable area. Some countries became rich due
to ample of mineral wealth such as iron, coal,
and mineral oil. Natural wealth like gold, silver,
diamonds pearls etc. is also important natural
resource. More the availability of natural
resources, larger could be the production.
(2) Human Resource
Supply of human resource in a country
depends on the population size and its quality.
The population in the age group 15-60 is
considered as working population. In a country
where population grows rapidly, proportion of
children (0-14 years) is high and that of working
population, low. When the proportion of children
is high, the burden of dependent population on
working population is naturally high. All the
persons in the age group of working population
do not necessarily get a chance to participate in
productive activity. In addition to quantity, quality
Managerial Economics : Nature and Concepts : 13
aspect of population is also equally important,
which is determined by physical capacity,
intellectual level, education and skill etc. A small
population with intense desire to work, better
physic, education and skill can prove to be more
productive. Honesty, patriotism, and tendency
to cooperate with others, are such qualities of
population that help rise in production. Countries
like Germany, Japan, Israel could prosper mainly
because of quality of their populations.
a factory; similarly it can be used for irrigation
of agricultural land through electrical pumps. For
which of these two purposes electricity is used
becomes a problem. Water can be used for
drinking, irrigating farm and for running a factory.
Human resource can also be utilised for a number
of purposes. How much manpower for each of
the work has to be used must be decided. Thus,
alternative uses of resources pose a problem,
for which of the work, how much resources will
have to be allocated.
(3) Man-made Resources
Production in a country also depends on
man-made resources. Among the man-made
resources, education research, innovative
techniques of production are of top most
important. Steam engine was invented in 18th
century. Since then, machines running on steam
were being manufactured. In recent times,
electric machines are operated that has enabled
production on large scale. In addition to
machines, factory buildings, means of transport
are also important resources of production. Raw
materials and semi-finished goods are also manmade resources. Further more, roads, railways,
electric generators, irrigation projects can also
be said to be productive resources.
How much of the above three resources
could be available has limitations. Man could
not increase natural resources. These are used
to the extent provided by the nature. Human
resource is limited by the quality of population.
In spite of her vast population, India remained
underdeveloped because of limited quality of
population. On the contrary, large population
leads to increase in wants.
It is possible to increase man-made
resources to a greater extent. If a country is
lacking resources, these can be imported from
foreign countries or could be brought in through
foreign investment. Even then, by increasing a
single type of resource, production cannot
increase up to desired level. We need all types
of resources to increase production. Mere
increase in human resource or capital resource
would not serve the purpose. Since the wants
are unlimited, resources are scarce in relation
to wants.
Resources available with the society are
not only scarce but are also usable for more
than one purpose. Electricity can be used to run
Questions for Self Study - 3
(A) Write brief answers to the following
questions.
(1)
How do wants change over time?
(2)
On which factors the quality of productive
human resource depend?
(3)
Write in brief, the importance of man-made
resources.
1.2.4 Methods of Solving
Economic Problem
After studying why an economic problem
arises, we shall now think of how the problem
can be resolved. Means are scarce in relation
to wants. It is, therefore, not possible to satisfy
all the wants. We have to make a choice among
the wants. If the choice is rights, we can say
that the resources are put to maximum use.
Though wants are unlimited, all the wants are
not equally important. Some are more important
than others. We can grade them in order of
importance we attach to each of the want. We
first satisfy our most preferred want and then
we turn to less preferred wants. We utilise our
resources accordingly. This ensures the best use
of all resources. There are two methods how to
grade our wants. One of the methods can be
said to be democratic method. This method is
practiced in private sector or in capitalistic
countries. Second method can be said to be
dictatorship, used in socialistic countries.
(1) Democratic System- Capitalism
Under democratic system, each individual
is at liberty to satisfy his wants according to his/
her choice or preference. Each individual spends
money on purchase of various goods according
to his sweet will. Such liberty creates demand
Managerial Economics : Nature and Concepts : 14
for goods. It is beneficial for the firm to produce
more goods for which demand is also more.
Firms divert more resources to the production
of goods in greater demand. The goods, which
are not demanded, resources are not utilised for
production of such goods. This is how; the
production is directed by the democratic choice
of the people and the resources are allotted
accordingly.
(2) Dictatorship - Command or
Socialist Economy
A Board appointed for the purpose does
grading of wants in a socialist economy. This
Board first collects information of the available
resources and decides the grading of wants
(order of priorities) and allocates resources for
each of the wants under the guidance of the
political party in power. In general, essential
commodities are assigned top priority in resource
allocation. Larger amount of resources are
diverted to acquisition of capital goods needed
for higher output in future. In addition, provisions
are made for an industry strengthening the
military power, raising the standard of living of
the people on the desire of the leaders.
satisfy wants. Money income is earned through
accepting service or running a business to have
economic power to purchase goods.
Consumption is an end of any economic activity.
Producers, who produce for consumers use
resources to produce goods for satisfaction of
consumers’ wants. To acquire productive
resources or factors of production arrange for
production is the responsibility of producers.
They raise capital required for cost of production,
buy factors of production and organise
production.
Owners of factors of production earn
remuneration through sale of their factor
services and buy goods they require. Among
those who supply factor services, the group of
workers is largest one. Farmers and
manufacturers supply natural and capital
resource respectively. Factors are supplied to
that economic activity that pays maximum
reward. Factor payments results in functional
distribution of National Income. Various services
such as trade, finance, insurance,
communication, and administrative services etc.
are also supplied alongside the manufacturing
activity. Such activities of the service providers
also constitute economic activities.
1.2.5 Economic Activities
Economic activities take place in an
attempt to solve economic problem. We shall
study economic activity as a part of general
activities. Before doing that we must first decide,
which of the activities can be called economic
activities. It can be agreed that use of resources
to satisfy human wants is within the purview of
economic activity. All such activities can be
termed as economic activities. Goods and
services are exchanged in economic activities
in expectation of economic gain. Different
individuals in a society undertake different
economic activities for economic gains. The
activities in which there are no economic gains
are not regarded as economic activity. For
example, a donation to a poor person, lending
interest free money to a friend when he is in
need, or working as a volunteer in a social work
are such activities, which are not economic by
character.
The largest group involved in economic
activities is that of consumers. Each person has
his personal wants. He has to acquire goods to
Questions for Self Study - 4 & 5
(A) State whether the following
û)
statements are true or false. Put (û
ü) in bracket.
or (ü
(1)
Wants are to be graded because of limited
resources. ( )
(2)
In grading the wants, first luxuries and
comforts and finally the necessary wants
are satisfied. ( )
(3)
In democracy, every individual has a liberty
to satisfy his wants according to his wishes
and preferences. ( )
(4)
The Central Board in a Command or
Socialistic economy decides the grading
of wants. ( )
(5)
Economic activities take place out of an
attempt to solve economic problem.( )
(6)
Consumption is an end of economic
activity. ( )
Managerial Economics : Nature and Concepts : 15
(7)
To supply all the factors of production and
to produce is the responsibility of the
manufacturer. ( )
(8)
The proportion of workers among the
suppliers of factor services is the largest.
( )
(9)
Factor services are diverted to the uses or
purposes in which the reward is maximum.
( )
of land can be used to erect a factory or
can also be used to produce food grains.
Limited amount of capital can be used to
produce goods and services required by
the society or could be used to satisfy luxury
needs of rich people. Limited human
resource could be used in the projects of
social utility or can be used merely as an
aid to machines.
(4)
Individuals get income per day, per week
or per month. But that income is limited.
Wants of individuals are, however,
unlimited. For example, consumption,
education, entertainment, provision for
future needs etc. An individual has to
decide how much to spend out of limited
resources (income) to satisfy all these
wants create economic problem.
(5)
Resources available with the society such
as land, manpower, capital, education and
skill are limited. It is impossible to use these
resources to satisfy all the wants of the
society. It is, therefore, necessary to decide
the priorities with regard to the order of
satisfying the needs. This is the reason
society faces economic problem.
1.3 Words and their Meanings
Utility: Want satisfying capacity of a
commodity
Economic Problem :The problem of balancing
between unlimited wants and scarce
means with alternative uses, to satisfy
them.
Economic Activity : Any activity undertaken
with an intention to earn profit, income or
economic reward.
1.4 Answers to Questions for
Self Study
Questions for Self Study - 3
(1)
Money income of the people increase as
the economy develops. This leads to rise
in demand for goods and services. New
and new products, comforts and luxuries
enter the market. Due to demonstration
effect of rich countries, many new
products are demanded. Manufacturers
advertised to stress the importance of their
products on the consumers that increases
demand. Desire is created for luxury
goods and that increases demand.
(2)
Quality of human resource depends on the
proportion of working population to total
population, physical and intellectual
capacity of the people, education and skill,
desire and capacity to work, tendency to
cooperate with others and the like.
(3)
The man-made productive resources
comprise of machines, buildings and means
of communication, raw material etc.
Inventions, research and innovation are of
great importance in man-made resources.
Questions for Self Study - 1
(1)
(ü)
(4) (û)
(2)
(ü)
(5) (û)
(3)
(ü)
Questions for Self Study - 2
(1)
Economic problem means the problem of
balancing between unlimited ends and
limited means.
(2)
Ends or wants are unlimited, and the
means to satisfy them are scarce, limited.
Under the circumstances, which of the
wants be satisfied with limited resources
becomes an economic problem.
(3)
Productive resources are limited and are
of alternative uses. For example, a piece
Managerial Economics : Nature and Concepts : 16
Questions for Self Study - 4 & 5
(1) (ü)
(6) (ü)
(2) (û)
(7) (û)
(3) (ü)
(8) (ü)
(4) (ü)
(9) (ü)
economy, the central body takes decisions on
allocation of resources. Individual freedom has
no place.
Economic activities take place in an
attempt to solve an economic problem. Any
activity that is undertaken with an intention to
earn profit, income or other reward is an
economic activity.
(5) (ü)
1.5 Summary
Economics was defined earlier by Adam
Smith as a science of production and distribution
of wealth. Alfred Marshall has added welfare
of individuals and society to economics. Prof.
Lionel Robins mentioned that economics is a
science that studies human behaviour in striking
a balance between unlimited ends and scarce
means with alternative uses, to satisfy these
ends.
Unlimited ends or wants and limited
resources of alternative uses cause economic
problem. Individuals and society face economic
problems. How to meet unending wants out of
limited income is a problem before individuals.
Similarly, how to fulfill collective wants of the
society from the available limited resources has
to be decided by the society or government.
Natural resources include air, water, land, rainfall
etc. Human resource constitutes available
working population in the country out of total
population, its education and skill level,
willingness and capacity of the working
population to work. Alongside these two types
of resources, man-made resources such as
machines, roads, canals, dams etc. are also
important. Productive resources are scarce but
with alternative uses. A preference order of
wants to be satisfied has to be decided upon so
that priority wants can be satisfied first, followed
by low preference wants. All resources have to
be used in this manner. In a capitalist system,
people have freedom to choose the preference
order and consume accordingly. Structure of
production can be decided according to the scale
of preference. In a command or socialist
Consumption is an end of economic
activity. Owners of land, labour and capital
empower the producers to use their services
for rewards in return. Factor services are
diverted to those uses where the rewards are
high. Services too, like transport, banking and
insurance, communication etc. are also supplied
side by side the commodity supply.
1.6 Exercises
(1)
Explain the definitions of economics given
by Adam Smith, Alfred Marshall and Prof.
Lionel Robins.
(2)
What is an economic problem? Why does
it arise?
(3)
Explain the methods of solving economic
problem.
(4)
What are economic activities? How do
these arise?
1.7 Books for Further Reading
(1)
Sahasrabuddhe, V. G. Principles of
Economics (Marathi), for Maharashtra
Vidyapeeth Granth Mandal, Sanyukta
Sahitya Prakashan, Pune-30
(2)
Bodhankar
Sudhir,
Saidhantik
Arthashastra (Marathi), Nagpur, Vidya
Prakashan.
(3)
Deo, S. P., Shastri, S. D., Shelke Madhav,
Jahagirdar D. V., Arthashastra
(Marathi), Nagpur, Pimplapure
Publishers.
Managerial Economics : Nature and Concepts : 17
Unit 1 (C) : Methods of Economic Analysis
Index
1.0 Objectives
1.1 Introduction
1.2 Subject Description
1.2.1 Micro and Macro Analysis
1.2.2 Static and Dynamic Analysis
1.2.3 Positive and Normative Approaches
1.2.4 Partial and General Equilibrium
1.3 Words and their Meanings
1.4 Answers to Questions for Self Study
1.5 Summary
1.6 Exercise
1.7 Books for Further Reading
1.0 Objectives
After studying this unit, you will be able
to :
« Give information about the micro and
macroeconomic analysis.
« The nature, scope and assumptions in the
microeconomic and macroeconomic
studies.
« Give information about static analysis in
economics.
be studied for economy as a whole. Study of
economics is, therefore, divided into two parts,
Micro and Macro studies. Microanalysis is
related to a single individual, single firm whereas
macro analysis is concerned with economy as a
whole. Aggregate output in the economy, level
of employment, price level and similar
aggregates are the subject matters of
macroeconomics. While studying an aggregative
problem, we can conveniently assume that other
things remain unchanged. Alternatively, current
problem can also be studied in relation to
happenings in the past and possible changes that
may take place in future. A comparative study
can also be undertaken to study the problem.
Another problem in economic studies is
that of whether to analysis the things ‘as they
are’ or in should cover ‘what aught to have’ be
undertaken. From both the points of view,
economics is said to perform an altogether
different role.
Economics considers the situation of
equilibrium. Equilibrium of a firm or an
equilibrium of the economy as a whole is also
considered in Economics. In this unit, we shall
study micro and macro economic approaches,
static and dynamic analysis, positive and
normative analysis and partial and general
equilibrium.
« Give information on dynamic economic
analysis.
« Explain positive and normative
approaches in economics.
1.2 Subject Description
« Explain the concepts of partial and
general equilibrium.
1.2.1 Micro and Macro Analysis
1.1 Introduction
Economic problem of an individual or a
single firm can be studied. Similarly, it can also
One important classification of economic
analysis seems to be micro and macro economic
analysis. We shall now think over the meaning
of these concepts, difference between the two,
and interrelationship between them.
Behaviour of macro units in an economy
is studied in microeconomics. It studies the
Managerial Economics : Nature and Concepts : 18
behaviour of an individual as a consumer, or a
firm and their role in an aggregative economy is
studied in “microeconomics”. It studies various
markets independently and then understanding
the interrelationship of markets, finds economy’s
equilibrium position. This is the method of
microeconomic study. Microeconomics studies
as to how an individual would utilise available
purchasing power for various commodities he
need. Available purchasing power is assumed
to predict how much will he distribute the same
on each of the commodity to maximise his
satisfaction. Demand for each of the commodity
by a household is, thus, determined. Summation
of demand from all individual households shall
give us market demand for the product.
On the other side, an individual or a firm
uses resources available with them to produce
various goods. This is studied in
microeconomics. Firms decide how much
resources are to be utilised for each of the
product with an objective of profit maximisation.
Thereby total output of each of the commodity
is determined. Output of all firms together
determines market supply of each commodity.
The price, at which the demand for and supply
of a commodity equal, is market equilibrium
price. It is also called market-clearing price.
Equilibrium can be explained by
considering a single market at a time. While
doing so, it is assumed that other things remain
unchanged. Since a single market constitutes a
very negligible part of the economy, changes
therein may have insignificant impact on
aggregate economy. Microeconomics enables
us to concentrate our attention on a single
market, which makes our study easy. Some
times, problem arises in a single firm, single
industry or a single market. Microeconomics
helps to solve these problems. Furthermore, with
a view to study more complicated issues, study
of microeconomics, as a first step, is of great
use.
Prices determined in different market
gives us a relative price structure that distribute
the resources in the different productive sectors
of the economy. How the scarce resources are
getting distributed in their alternative uses is
studied in microeconomics. Theories of demand
and supply are of great use in deciding the
relative price structure.
We can study economic problems at
different levels. Microeconomics studies one
level. If an individual, a household is assumed to
be the lowest level, then many individuals and
many households shall constitute a higher level.
These can be grouped, into different groups, for
the convenience of study. A group can be formed
of those individuals or households purchasing a
particular commodity. Similarly, a group of sellers
of a particular commodity can be made.
Microeconomics is useful up to this level only.
We call this a study of specific market. When
we expand the scope of our study to economy
as a whole, then we need to use different type
of analysis that is known as macro analysis.
According to Gardner Ackley ‘
macroeconomics is concerned with aggregative
terms such as aggregate level of output in a
country, proportion of utilisation of resources,
National income, general price level etc. In
macroeconomics, gross, average and
aggregative tendencies are studied. Considering
the national aggregates and the interrelationship
between them, equilibrium level is found. For
example, equilibrium level of National Income
is attained at a level, where ex ante savings and
ex ante investment are equal with each other.
When we get the equilibrium national income,
we can find the status resource utilisation, level
of unemployment and measures to reduce it.
We also study in macroeconomics as to how
the general price level is determined, why do
business cycles occur, the factors determining
economic growth, effect of foreign trade and
government policies on economic growth. These
are the areas of study in macroeconomics.
Limiting assumptions in microeconomics
places limits on its use. The relationship between
the issue under study and ‘other conditions’ is
ignored for the sake of convenience. Hence,
using some of the inferences drawn in
microeconomics for macroeconomic analysis
prove wrong. For example, classical theory of
employment assumed that the level of
employment depends on real wage and a
reduction in wage rate increases level of
employment. Labour market was distinct from
commodity market. Wage rate would be
determined by the demand for and supply of
labour in labour market. The simple rule of ‘high
demand at low price’ was applied to labour
market. However, labour market constitutes
Managerial Economics : Nature and Concepts : 19
major part of the aggregate economy, it was
wrong to assume that the changes in labour
market do not have any effect on rest of the
economy. In case the wage rates are cut down,
workers shall reduce their purchases of goods
followed by cutting down the output by firms.
Workers will be given lay-off. Thus, the rule of
equilibrium price in microeconomics proved
useless in labour market. Hence, the problem
of employment is required to be resolved through
macroeconomic analysis.
Similarly, a rule true about an individual at
a particular point of time may not be true for
society as a whole. Saving, for example, is a
virtue for an individual. However, if all the
individuals in a country save more demand for
goods and services would fall, production shall
be less. Such a situation may call for recession
in the economy. However, if saving increases
during inflation, it would reduce price level that
may be beneficial to the society. From this point
of view, it is said that ‘saving is a private virtue
but is a social vice’.
Similar
to
microeconomics,
macroeconomics too has some limitations. Rise
in aggregates, we assume, is welcome. To find
how good the growth is we must go into details.
First, we have to group the aggregates by
categories. For example, national income rises
significantly in a particular year. It is advisable
to study which of the sectors of the economy
has contributed more to national income.
Favourable monsoon may have contributed more
output from farm sector. This rise may not stay
next year. Excess capacity utilisation in
manufacturing sector in a particular year may
have resulted in larger contribution of industries
to national output. But a rise in industrial output
by creating new capacity is still better.
Furthermore, how is the additional income gets
distributed is also an equally important problem.
Growth that benefits a few persons is improper
from social point of view.
While analysing inflation, it must be seen
as to how prices fluctuate by various groups of
commodities. A general inflation at 5 percent
can be with a price rise of 5 percent, for all or
majority of commodities. In case of some
commodities prices may rise much more than 5
percent and less than 5 percent in case of few
other commodities. Some prices may remain
unchanged whereas some others may increase
significantly. Inflation may have different
meaning in each of the cases. Microeconomics
and macroeconomics are briefly compared
below:
Nature
Assumptions
Objectives
Main
Principles
Subject
matter of
study
Microeconomics
Study of a micro
Part of an
economy
Fixed resources,
Static conditions
of demand and
supply
To find
conditions for
maximum
efficiency in
relative prices
and allocation of
resources
Demand
and
Supply principle
Price
determination
factor, prices
consumer
equilibrium,
equilibrium of
the firm
microeconomic
policy etc.
Macroeconomics
Study of macro
variables in an
economy
Propensity to
consume, MEC
and liquidity
preference all
fixed.
To find out
determination of
National Income
level
Circular flow of
National Income
Determination of
general price
level,
distribution of
resources among
saving and
investment,
Monetary Policy
Fiscal Policy,
Growth, External
sector, Theory of
employment etc.
Questions for Self Study -1
(A) Fill in the blanks and rewrite complete
sentences.
(1)
(2)
(3)
(4)
(5)
(6)
(7)
In microeconomics, a ——————of
the economy is studied.
A consumer tries to maximise
his_______within the purchasing power
in his hand.
A change in one market affect————
——rest of the economy.
Macroeconomics studies the structure of
——————prices.
In macroeconomics, variables relating to
———————are studied.
Saving is a ———— from individual point
of view but a —————— from social
point of view.
Classical theory of employment stated that
a cut in the wage rate increases ______.
Managerial Economics : Nature and Concepts : 20
1.2.2 Static and Dynamic Analysis
After having study of micro and macro
economic analysis, we shall now consider
another type of analysis, known as static and
dynamic analysis.
Static Analysis
Under this analysis, conditions prevailing
at a single point of time are taken into account
while analysing a particular event. Other things
remaining unchanged, given the functional
relationship between the two variables, a change
in one variable affects the value of another
variable. Timbergen described such an analysis
as ‘static.’
In static analysis, taking into account the
relationship between the variables, their values
are found in such a way that adjustment becomes
easily possible.
As an example of static analysis, price in
a particular commodity market can be quoted.
We study three variables; the price, demand and
the supply of the commodity. We write down a
demand schedule showing quantities demanded
at various prices. Similarly, we prepare a supply
schedule showing quantities supplied at each
price. Here, we assume that other factors
affecting demand and supply of the commodity
remain unchanged. Thereby, we find the relation
between price and quantity demanded, price and
quantity supplied. If we add the condition of
equilibrium price as a price that equates demand
and supply, we get equilibrium price. If it is
assumed that a specific condition prevails in the
market, equilibrium is immediately established.
Static analysis explains the things as they are.
Static analysis is easy to handle, and hence,
initially this analysis is used. Some complicated
issues such as how do values of variables change,
how much time it takes to note the effects of
variables on each other need not be thought over
in this analysis. Static analysis is like a photo
snap, a still position at a point of time. It doesn’t
show what happened in the past nor it tells us
what will happen next.
Comparative Static Analysis
This analysis is a step ahead of static
analysis. The comparative static analysis is the
analysis of markets or economies in terms of
different equilibrium positions, without any
reference to the process by which adjustments
in equilibria takes place. Only equilibrium
positions are compared under different set of
conditions. For example, equilibrium price of
sugar at Rs. 10 per kg. increases to Rs. 14 per
kg. because of a decrease in the supply of sugar.
Supply of sugar decreases because conditions
of supply, other than the price of sugar, change.
Demand and supply are now equated at a price
of Rs. 14/- instead of Rs. 10/- before.
Comparative static merely describes the two
equilibrium positions, without any reference to
conditions behind. We simply know the quantities
and prices in these two equilibriums.
Dynamic Analysis
Dynamic analysis is being widely used in
recent times. This analysis was being used to
explain business cycles. Later on it was extended
to the analysis of economic growth,
determination of national income and also to the
theory of price. Since the mathematical tools
were being used in economic analysis, economic
models are being developed and used in
economics. Thereby, economic analysis proved
to be more useful with dynamic models.
According to Schumpeter, ‘analysis that
aims to trace and study the behaviour of various
variables over time, and determine whether
these variables tend to move towards equilibrium
is said to be dynamic analysis’.
According to Frisch ‘determination of an
analysis of behaviour of a system through time
shown by an equation that contains variables in
different time periods is said to be a dynamic
system. From these definitions, it is clear that
the relationship between the variables must have
a reference of time and therefore, such analysis
is relative to time. The equations used in this
analysis show the relationship between the
values of variable at a point of time as well as in
different time periods. For example, supply of a
commodity at current price might be dependent
upon price in the past. An equation showing the
relationship between current price and past price
can be developed. Such equation may help to
describe the future tendency of price change.
Cobweb Theorem developed to comment upon
instable prices of agricultural produce uses such
an equation.
Managerial Economics : Nature and Concepts : 21
Dynamic analysis is like a video film that
records changes over time. We can tell with the
help of dynamic analysis what is happening at
every moment of time. Changes in dynamic
analysis are built-in, from within the system,
without the help of external forces. Some times,
fluctuations may disturb the existing equilibrium
position. Wide fluctuations occur in the beginning,
then slow down and ultimately end with a new
equilibrium. Direction and speed of fluctuations
is unpredictable. We can draw a graph of
changes over time with the help of dynamic
analysis. It also helps to frame laws about the
situation that might be in future depending upon
current events. Such laws are useful in dealing
with the issues in growth.
Normally, dynamic analysis is concerned
with a disequilibria situation. It is a live
telecasting of the happenings during the
movement from one equilibrium position to
another. At times, however, in spite of remaining
continuously in equilibrium, conditions may
change. The rate of changes in different
variables and interrelationship between them do
help in finding out the conditions of balanced
growth. Such equilibrium is known as ‘Dynamic
Equilibrium’.
1.2.3 Positive and Normative
Approaches
Positive and normative are the two
approaches in the study of economics. Positive
economics studies facts and frames scientific
laws. It studies what happened in the past, what
is the present state and what is likely to happen
in future. However, positive economics never
thinks of what is good and what is bad. It is
argued that this is an issue of ethics and it is
outside the purview of economics. Economics
must think of achieving maximum goals with
given resources is the subject matter of
economics. Whether the ends are good, ethical
or not need not be studied in economics. This is
positive approach towards economics. For
example, rich people save more and poor people
save a little. If the objective of economic policy
is to encourage more saving, then rich persons
should have more money. A more unequal
distribution of income will have to be accepted.
In other words, more saving needs more uneven
distribution. Whether it is just or unjust is not
thought over in positive economics. Study of
economics aims at maximum satisfaction of
wants within limited resources but does not think
of whether the wants are good or bad. People
may wish to consume wine or other drugs and
they use resources at their disposal to do so.
There is no need to comment upon whether
consumption of intoxicants is good or bad.
Positive approach limits the scope of economics
to study factual events without any consideration
of ideas beyond the purview of economics and
to draw logical conclusions on effects of that
event. If a theory is developed stating that when
government spends more than its revenue, or
tends to deficit financing, it will lead to inflation.
This is a logical answer that can be tested by
studying similar tendencies in the past or in
foreign countries at the same time. If many
countries are studied to support this proposition,
a general theory can be developed.
If any difference of opinion arises about
a theory, it can be resolved through analysis of
information.
In addition to positive approach, a
normative approach is also used in economics.
This approach thinks of what is good and what
is bad. Ideas about what is ‘good’ and what is
‘bad’ differ from individual to individual and are
called ‘value judgment’. If we add value
judgments to pure economics, the economic
theory and conclusions differ. We have already
referred to the example of saving that is possible
with inequality in income. A dispute may arise
on the issue whether we should go for rise in
saving or reduction of inequality. If it is accepted
that reduction of inequality is more important,
measures to reduce inequality shall be preferred.
In case the saving is preferred, reduction in
inequality will be set aside.
Normative approach depends on
philosophical, cultural and religious thinking of
the people. Ideas about good and bad are
developed out of such thinking. Each society
has its own ideas but what is held to be good in
one society may not necessarily be true in
another society. Such differences of opinion may
also occur in the same society. Such differences
could not be mitigated through a positive study.
Though positive and normative approaches
differ, it cannot be said that these are not related.
If an issue in normative approach has a
Managerial Economics : Nature and Concepts : 22
reference of positive aspect that can also be
studied in positive approach. A positive study of
effects of consuming alcohol such as deceases
or illness of drunkards and increase in the
resulting cost of medical care, decrease in work
efficiency, increase in crime etc. can be
undertaken. Logical approach cannot help in
drawing inferences of normative approach from
the assumptions of positive economics. Even
though we can trace all the negative effects of
consuming alcohol through positive approach, it
would be difficult to establish that prohibition is
justifiable. The people who trust in personal
freedom may strongly resist the decision on the
ground that it will limit their freedom. Many a
times, a variety of approaches on a single issue
may appear in a society and it becomes difficult
to decide which approach is correct and which
is wrong. Local octroi is such a controversy in
our country. Employees of local-self government
on one side and traders and transporters on the
other hold altogether opposite views. Though it
is agreed that octroi has adverse effect, the first
group strongly apposes to remove octroi. If
freedom, financial autonomy and the problem
of employment are assigned more weight, then
employees demand is justifiable. In the same
manner, conclusions in positive approach could
not be drawn on the basis of normative
assumptions.
Questions for Self Study - 2
(A) State whether the following
û)
statements are true or false. Put (û
ü) in bracket.
or (ü
(1)
Theory of price in a commodity market is
an example of static analysis. ( )
(2)
Static analysis portrays the situation
prevailing at different time periods. ( )
(3)
Business cycles, economic growth,
determination of national income are the
major subjects of study of dynamic
analysis. ( )
(4)
Dynamic analysis helps in studying
different situations prevailing at different
times. ( )
(5)
Positive and normative approaches are
altogether different from each other. ( )
1.2.4 Partial and General
Economics
In economics, the phrase equilibrium is
often used. We have seen that static analysis
explains the equilibrium position. We shall now
try to understand the meaning of the concept
‘equilibrium’ and also know about some types
of equilibrium.
The word equilibrium is derived from the
science of physics. If different powers applied
to a matter, it gets drawn to the side, which is
applied more power. However, if equal power
is applied to both the sides, the matter or object
remains stable. It is, then said that the power
applied to the matter is in equilibrium. You might
have observed a shopkeeper weighing the
commodities in a balancer. The weight of the
two trays of the balancer equals and therefore
an empty balancer always balances. Its rod is
parallel to earth. If we put a 1 kg. weight in the
right tray, the rod shall be pulled down that will
slope upwards to the left. Right tray shall go
down. Now, if we go on putting sugar in the left
tray, the rod shall be pulled down to the left
because of weight of sugar. When the weight
of sugar becomes exactly 1 kg. the powers to
full the rod shall be equal to both the sides and
the rod shall again be parallel to earth. When
weight in both the trays equals we can say that
there is an equilibrium of powers at both the
sides. To remain in a stable position can be a
feature of equilibrium.
The concept of equilibrium is used in
economic analysis in this sense only. Equilibrium
is a position in which there is no tendency to
move in any direction. When we say that price
of a commodity is in equilibrium, it means that
price shall remain stable. In a market, consumers
and seller exchange goods. Consumer tries to
obtain good at minimum possible price. Seller
tries to sell at as high a price as is possible. The
two forces of demand and supply work in the
process of price determination. Demand side
pushes the price up and supply side, down.
Equilibrium price is set up at a point where
demand for and supply of a commodity are equal
with each other. Once this equilibrium price is
determined, there will be no tendency of the
price either to move upwards or downwards. In
addition, there is consumer equilibrium; firm’s
equilibrium, industry equilibrium, equilibrium level
Managerial Economics : Nature and Concepts : 23
of national income, equilibrium level of general
price level etc. are also used in economics.
Equilibrium is classified by different
methods. On the basis of level, micro equilibrium
and macro equilibrium are the two types. In micro
equilibrium, only a single element is considered
whereas in macro equilibrium, economy as a
whole is considered. On the basis of stability,
there are again two types, static equilibrium and
unstable equilibrium. An equilibrium, if
disturbed, automatically gets adjusted with
some changes and reestablished is called
Stable Equilibrium. Conversely, equilibrium
once disturbed deviates from the original
equilibrium more and more is called unstable
equilibrium.
If we classify equilibrium by the time
element, we have instant, short-run long run and
secular period equilibriums. An equilibrium that
occurs instantly or in a very short period is called
instant equilibrium. It is a situation where there
is no time to adopt changes. In short-run,
situation can change to some extent. In the long
run, major changes in the situation are possible.
Finally, in the secular period, every thing can
change beyond prediction but the probable
changes can be gauged.
In microeconomics, only a single part of
the economy is studied. Equilibrium of such a
part is called ‘partial equilibrium’. When almost
all the parts of economy are covered in a single
equilibrium, it is called ‘general equilibrium’. We
shall study this classification now.
Partial Equilibrium
In microeconomic, we mainly study the
problems of a small fraction of aggregate
economy. Equilibrium of a micro unit is called
partial equilibrium. How equilibrium is attained
in commodity market is found in partial
equilibrium. Equilibrium of each of the markets
when worked out separately is the case of partial
equilibrium. When each of the market is so
studied, it cannot be a complete study. In partial
analysis, we do not study the interrelationship
between different markets. Thus, it can be
considered as first stage of study. Understanding
fully the interrelationship among different
markets and drawing conclusions is a further
stage. This is done while finding ‘general
equilibrium’ of the economy.
General Equilibrium
When all the markets in an economy are
simultaneously in equilibrium, such equilibrium
is called ‘general equilibrium’. While finding this
equilibrium, relationship among different markets
need be determined. These relations could be
from demand side or supply side. For example,
sugar market is concerned with other markets
from demand side and supply side. Consumers
usually demand more sugar while the demand
for gur is less. Accordingly, consumers shall also
demand more of the products using sugar
component such as sweets, milk products and
fruit juices. From supply side, while increasing
the production of sugar, output of sugarcane shall
have to be increased by reducing some area
under other crops. This will reduce supply of
the products using other crops as inputs, e.g.
cloth, cotton seed oil, oil cake etc. On the other
hand, output of byproducts of sugar such as
molasses, wine, alcohol, paper etc. If we know
the relationship of one commodity market, we
will understand that changes in one market
induces changes in other markets and the
reflections of these changes in the first
commodity market can also be seen. After a
limit, these changes shall stop and a new
equilibrium will be established.
While studying the general equilibrium,
interrelationship among the markets is put in the
form of equations. A simultaneous equation is
found from a series of different equations.
Prices and quantities of each commodity
transacted are to be found out through the
products of the equations. We should have
sufficient number of equations to analyse and
the prices and quantities of the commodities
should not show negative values. In practice, it
is a complicated process. The same technique
is used in preparation of production plan by
choosing selected interrelated sectors of
economic transactions.
Questions for Self Study - 3
(A) Choose correct alternative from those
given.
(1)
Which one of the following is the meaning
of ‘equilibrium’?
(a)
Existence of working of any power.
Managerial Economics : Nature and Concepts : 24
(2)
(3)
(4)
(5)
(b)
Stabilization through the working of
different powers
(c)
Working of all powers in the same
direction.
(d)
Working of all the forces in an
opposite direction.
What is a stable equilibrium?
(a)
Stable according to situation
(b)
Equilibrium in stable factors
(c)
Coming back to equilibrium after it
is disturbed.
(d)
Equilibrium not disturbing at all.
Partial equilibrium means(a)
Equilibrium of a part of the economy
(b)
Equilibrium determined by one
economic point of view.
(c)
Equilibrium of incomplete nature.
(d)
Equilibrium of some specific types
of factors.
Static Analysis : A condition in which the
functional relationship between the
variables is fixed. It is relative to time
period.
Comparative Static Analysis : A science that
analyses the change in equilibrium position
when situation changes.
Dynamic Analysis : An analysis that concerns
the changing relationship between the
variables at different time periods.
Positive Approach : An approach based on
ground realities without any regard to what
is good and what is bad.
Normative Approach : An approach
commenting on what is good and what is
bad and drawing conclusions accordingly.
1.4 Answers to Questions for
Self Study
With which the general equilibrium is
concerned?
(a)
Some part of the economy
Questions for Self Study - 1
(b)
All sectors of the economy
(A) (1) Micro part
(c)
Some markets in an economy
(2) Satisfaction
(d)
All individuals and firms in an
economy.
(3) Negligible
The concept of general equilibrium is—
——than that of partial equilibrium.
(4) Relative
(5) Entire economy
(6) Merits, demerits
(a)
Much easier
(b)
More practical
(c)
More complicated
(d)
More in use.
(7) in employment
Questions for Self Study - 2
(A) (1) (ü), (4) (ü),
(2) (û), (5) (û),
(3) (ü), (6) (û).
1.3 Words and their Meanings
Questions for Self Study - 3
Microeconomic Analysis : An analysis used
in smallest of the small part of an economy
(A) (1) (b),
(4) (d),
(2) (c),
(5) (c).
Macroeconomic Analysis : An analysis
concerned with the or considering economy
as a whole
(3) (a),
Managerial Economics : Nature and Concepts : 25
approach and inferences are drawn accordingly.
1.5 Summary
We have discussed in this unit the methods
used in analysis. In microanalysis, we study a
small part of the economy at a time. Since we
neglect the relationship with other parts of the
economy, analysis becomes easy. When we are
interested in studying only a fraction of the
economy, microanalysis is sufficient. However,
it will not always be proper to draw inferences
from the same for the entire economy. Some
issues are beyond the purview of microanalysis.
It is useful in the studies relating to relative prices
of resources and their allocation.
Macro economic analysis studies
aggregates relating to the entire economy;
mainly, the national aggregates such as
determination of national income, employment
and the general price level. In order to have
better understanding of the observation in macro
analysis, it is better to distribute the aggregates
by economic sectors.
Static analysis studies the equilibrium that
sets up at a particular point of time. Element of
time is not considered in such analysis. Dynamic
analysis takes care of changes over time. How
a situation prevalent at one time develops in
future is studied and rules are framed through
macro analysis. Such analysis also describes the
development through the changes in the
equilibrium position.
Positive economics studies the things as
they are and draws conclusions without giving
thought as to what is good and what is bad. Such
normative ideas are accepted in normative
Equilibrium is thought under static
conditions. Different forces so work that static
conditions are created. Partial equilibrium takes
into account only a part of the economy rest
parts are ignored. General equilibrium is a
simultaneous equilibrium of all the sectors of
economy at one and the same time.
1.6 Exercises
(1)
Explain the concept of microeconomics
with its limitations.
(2)
Explain the concept of macroeconomics.
Which subjects are studied in
Macroeconomics?
(3)
Explain static analysis with suitable
example.
(4)
Explain the concept of dynamic analysis.
(5)
Differentiate between partial equilibrium
and general equilibrium
1.7 Books for Further
Reading
(1)
Dewett, K.K., Adarsh Chand, Modern
Economic Theory, Shyamlal Charitable
Trust, New Delhi
(2)
Bodhankar S. Saiddhantik Arthashastra
(Marathi), Nagpur, Vidya Prakashan.
Managerial Economics : Nature and Concepts : 26
Unit 1 (D) : Basic Concepts
Index
1.0
Objectives
1.1
Introduction
1.2
Subject Description
1.1 Introduction
1.2.1 Scarcity: Concept
1.2.2 Element of Time : Market Period,
Short Period, Long Period and
Secular Period
1.2.3 Assumptions of Economic Theory
1.3 Words and their Meanings
1.4
Answers to Self study questions
1.5
Summary
1.6
Exercises
1.7
Books for Further Reading
1.0 Objectives
After studying this unit, you will be able
to :
In an earlier unit, we have considered
methods of economic analysis. After discussing
economics in general, we shall be studying
managerial economics. Before we do it, it is
necessary to know important concepts in
economics. Scarcity is one of the basic concepts
in economics. Meaning and importance of
scarcity attaches much importance in economic
thought. Element of time is very much important
in economics, because this element helps
deciding stable and unstable conditions. Business
decisions of the firms depend on time period.
We must have detailed knowledge of time
periods from market to secular period.
Every economic theory is based on certain
assumptions. Assumptions make the statement
of the theory easy. The situation commonly
observed in the society is stated as assumption.
If some major answer is to be found, certain
minor things can be assumed with a view to
minimise complications. On what type of
assumptions economic theories are based will
also be studied in the sections that follow.
« Explain the concept of scarcity from
economic point of view.
« Explain what is meant by a ‘market
period’ from the point of view of a firm.
1.2 Subject Description
« Explain what is meant by a ‘short period’
from the point of view of a firm.
1.2.1 Scarcity : Concept
« Explain what is meant by a ‘long period’
from the point of view of a firm.
« Explain what is meant by a ‘secular
period’ from the point of view of a firm.
« Explain the assumptions mentioned while
making a statement of the economic
theory.
In economics, the term scarcity denotes
less availability of a commodity in relation to its
want. You may feel that this meaning is different
from what we commonly conceive. We feel a
commodity to be scarce when it is totally
unavailable or has to be obtained after great
efforts. In economics, however, Scarcity is a
relative concept. A commodity is scarce when
its availability is less than demand. If a
Managerial Economics : Nature and Concepts : 27
commodity is not at all demanded, then
howsoever-small availability of it may be, it will
not be called scarce. We have in our country a
number of medicinal plants. Uses of many plants
we don’t know and therefore, we do not even
think of such plantation. Though a few naturally
grown plants are available in forests, nobody
uses them. Some plants are uprooted and thrown
away. Even then, the plant cannot be scarce in
economic sense. On the other hand, in spite the
output being enormous, some commodities are
scarce in economic sense. India produces more
than ten million tones of sugar each year but
our demand for sugar is more than that, sugar is
scarce in India.
Scarcity adds value to a commodity.
Because it is scarce, people are ready to
exchange commodities with them to obtain it.
Higher the degree of scarcity of a commodity,
more the volume of other commodities it will
receive in return. Nothing need be exchanged
for a commodity that is not scarce. If demand
for a commodity is far less than the ample
availability of a commodity, there will be no
demand even though the commodity is offered
free. Some products go waste for no one uses
these.
Scarcity is the root of economic problem.
Since the resources are scarce, their optimum
utilisation need be need be thought over. Had
not the resources scarce, many resources would
have been remained unutilised after satisfying
all the wants of society. Resources wouldn’t
have fetched any value because they are not
scarce. Commodities produced by using
resources too could have been free. Assume
that an uninhibited island has a number of trees
of delicious fruits. You can get any variety and
quantity of fruits in all seasons. This was true in
Robinson Cruso economy. Robinson was left
over an uninhibited island for years that could
fulfill all his needs from free gift of nature. This
is an extreme case of total lack of scarcity.
1.2.2 Element of Time: Market
Period, Short Period, Long
Period and Secular Period
Element of time has a great importance in
economic discussions. While studying a problem,
it has to be decided for what period the problem
is to be studied. Longer the period, greater is
the possibility of change in variables under study.
Marshall has assumed four time periods:
(1)
Market period (very short period)
(2)
Short period
(3)
Long period
(4)
Secular period
(1) Market Period
Market period is a specific time period
during which no changes in situation are assumed
to take place. Further, conditions affecting
demand and supply also assumed to be constant,
and that only price of the commodity influences
demand and supply. Commodity is produced in
advance of demand for the same. Market period
is too short to bring in new product to market.
Seller has only to decide whether to or not to
sell his existing stock at market price.
Consumers’ income is also limited and remains
unchanged during market period and this has to
be spent on commodities available in the market.
Thus, the sellers and consumers have limited
scope in decision making.
(2) Short Period
Short run or short period is such a period
that allows changes in some of the productive
resources. Variable factors such as labour, raw
material, fuel etc. can be varied to some extent
for increase in output. However, fixed assets
like machines and buildings could not be
increased or decreased in the short run. Supply
in the short run is relatively elastic as compared
to market period because output could be
increased in the short-run by adding some
variable factors of production. From demand
side, consumers’ income can vary that allows
greater flexibility in making choice of
commodities. Producers decide their output
depending upon consumers’ choice and also
decide how much output is to be sold at each
price. Consumers decide how much to buy at
each of the prices. The decisions of sellers and
consumers to sell and buy respectively guide
the determination of price in the market.
(3) Long run (Long period)
Major changes in supply are possible in
the long run. New firms can enter the industry,
Managerial Economics : Nature and Concepts : 28
start production or change their product line by
closing old plants. Fixed assets like machines
and buildings can also be increased in the long
run. Scope of the decision-making by firms can
expand. Whether to continue output, can new
one replace the existing product, whether to
expand or reduce the existing plant are the
crucial decisions in the long run the firm must
take. How much to produce is one more decision
that needs information on current demand and
forecasts for the future. From consumer’s side,
decisions regarding purchase of durables,
probable changes in income, nature of
commodities available in the market, possible
changes in the prices of commodities, availability
of credit for purchase of consumers’ durables
etc. must be decided by the consumers. Such
decisions create demand for commodities in the
market. Firms can arrange supply according to
demand. New firms may enter and existing
firms may quit in the long run. This process helps
in equating supply with demand. Firms attempt
to produce output with maximum efficiency.
Resources are used in such a manner that
maximisation of output becomes possible.
extensive production. New products are
satisfying wants of the people in a better way.
Stainless steel, artificial fiber, radio, TV and host
of other new products are developed and more
sophisticated consumer goods are made
available to the people. In addition, new
techniques of production are being innovated.
This leads to reduction in costs and substantial
increase in output. Such technological changes
have a positive effect on supply of commodities.
On demand side, consumers’ tests and
preferences improve and their standard of living
rises. Consumers’ tests regarding clothing,
housing, vehicles, furniture etc. go on changing
over time. Accordingly, all such secular changes
in demand and supply must be considered while
working on secular period equilibrium and
developing models for secular growth.
Questions for Self Study - 1
(A) Choose correct alternative from those
given.
(1)
(4) Secular Period
Secular period was never thought of in
olden days. In recent times, however, this term
is used to discuss secular trends in economic
growth, business cycles etc. The term was used
before to explain limits to growth but then, the
concept was incomplete; especially the impact
of technological changes was not taken into
account. Marshall has referred to secular period
with reference to demand and supply but has
tacitly explained only market period, short-run
and long run periods.
Every possible change in the secular period
must be considered. From supply side, inventions
of new resources, development of new
products, innovations in new techniques of
production are some major changes that must
be taken into account in secular period.
Availability of mineral deposits in India was too
small just two decades before. Search of this
resource under sea resulted in increased deposits
today. Use of solar energy bestowed on mankind
a new source of energy for increasing output.
Bauxite is a new mineral in use, which has
enabled production of new metal, aluminum.
New resources added over time enabled
(2)
In Economics, scarcity means(a)
Total non-availability of a thing.
(b)
Availability of a thing less than
required
(c)
Getting a thing in less quantity
(d)
Getting a thing more in quantity
Sugar is scarce in India because(a)
Production of sugar is less in India
(b)
Availability of sugar in India is less
(c)
Demand for sugar in India is less than
availability
(d)
Availability of sugar in India is less
than demand
(3) Which one of the following economists has
given four time periods for economic
analysis?
(a)
Adam Smith
(b)
J. M. Keynes
(c)
Alfred Marshall
(d)
Fredrick Benham
(4) Which one of the following time periods is
not considered in the theory of value
(a)
Market period
(b)
Short period
Managerial Economics : Nature and Concepts : 29
(c)
Long period
(d)
Secular period
(B) Write brief answers to the following
questions.
(1)
What is meant by market period?
(2)
What is meant by short period?
(3)
What is meant by long period?
(4)
What is meant by secular period?
1.2.3 Assumptions of Economic
Theory
In any statement of theory in economics,
certain situations are assumed. Real world
situation is so much complicated that its study is
practically impossible. Similarly, study of all the
aspects of a problem is not necessary in
economics. Under the circumstances, it is
necessary to focus attention on the real aspect
of the problem and to make some convenient
assumptions about other aspects of the problem.
If we assume that certain factors do not change,
then we need not to think of those factors. Under
what circumstances the theory holds well and
can make us aware about the limitations of the
theory. It is, therefore, necessary to make clear
assumptions while stating a theory. Types of
assumptions are given below.
(1) About Individual Behavior
Economic theory assumes two groups of
persons. First, consisting of consumers who, it
is assumed, behave rationally. They decide their
objectives and utilise their disposable income
accordingly. One important assumption in
economic theory is that ‘main objective of a
consumer is maximisation of satisfaction’.
Consumer decides his scale of preference from
varieties of goods and goes on purchasing goods
in order of their preference. Consumer gets more
satisfaction from those goods, which scale high
in his preferences and he spends more on such
goods. While purchasing more than one good,
consumer spends on each of those and distributes
his total expenditure on all goods in such a way
that his total satisfaction maximises. One more
assumption about consumer behaviour is that
his preferences do not change. Theory of
consumers’ choice is based on this assumption.
Second group of individuals is that of
producers or firms. Objective of this group is
assumed to be ‘maximisation of profit’. This
objective sounds realistic. In practice, however,
some firms may have objectives other that ‘profit
maximisation’; to increase market share, to
maximise total revenue, to accelerate rate of
growth in output or profit are some examples of
other than profit objectives. After all, any
business is operated mainly for profit and that,
this assumption is most suitable.
Economics is concerned mainly with the
economic behaviour of the people. We have a
concept of ‘economic man’ in economics. In
practice, however, man cannot think merely
from economic point of view. He also has
religious, ethical, social ideas by which his
behaviour is guided. Religious ceremonies,
festivals though cause wasteful expenditure from
economic point of view, these are necessary from
socio-cultural point of view.
(2) About Physical Structure of the
World
This type of assumptions need not be
explicitly expressed. Geographic, Life sciences
and environmental conditions are known to all;
such as, certain crops grow in a specific season,
workers need rest in between the interval on a
working day, output depends on the technique
used etc. Economic theory accepts such facts
and uses these as assumptions of the theory.
Most important concept in economics is
scarcity and also backbone assumption in
economic theory. A commodity that is not scarce
has no value from economic point of view.
(3) About Socio-economic
Institutions
It is also assumed that the law and order
situation in a country is good and all economic
activities are performed legally. It is assumed
that economic institutions like markets work
within the framework of laws, rules. Existence
of monetary and financial institutions to supply
money and credit for economic transactions is
also assumed. Number of such assumptions can
be stated about various other institutions.
Managerial Economics : Nature and Concepts : 30
Questions for Self Study - 2
(A) State whether the following
û)
statements are true or false. Put (û
ü) in bracket.
or (ü
(1)
In statement of an economic theory,
certain specific conditions are
assumed ( )
(2)
It is assumed in economic theory that the
objective of a consumer is to maximise
satisfaction. ( )
(3)
To earn profit is the only objective of every
firm. ( )
(4)
In secular period, all possible changes in
the situations are covered such as,
innovation of a new technique,
development of new product, use of
improved technique in commodity
production executed during secular period.
These changes have far reaching effects
on production and market supply. For
consumers, their income, tests and
preferences change, which affects
production, demand for the commodity, its
quality etc.
Questions for Self Study - 2
(1) (ü), (2) (ü), (3) (û).
1.3 Words and their Meanings
Scarcity : Inadequacy of goods in relation to
demand for them.
1.5 Summary
Variable Factors : Factors, which can vary
with the level of output. Labour, raw
material, energy, fuel are the examples of
variable factors.
Root cause of economic problem is in
scarcity. Scarcity means inadequate supply of a
commodity in relation to demand for the same.
Productive resources have to be used carefully
because they are scarce. Element of time has a
great significance in economic thinking. Alfred
Marshall has, for the sake of convenience,
classified time periods in four categories; namely,
market period, short period, long period and
secular period. Market period is too short to
make any changes in supply. Short run is such a
period to allow some change in supply by
changing at least some variable factors of
production. Rise in consumer’s income may lead
to increase in demand. Long period is
sufficiently flexible to allow changes in all the
factors of production including fixed assets.
Similarly, new firms may enter and existing firms
may quit. Every possible change in the secular
period must be considered. From supply side,
inventions of new resources, development of
new products, innovations in new techniques of
production are some major changes that must
be taken into account in secular period. On
demand side, consumers’ tests and preferences
improve and their standard of living rises.
1.4 Answers to Questions for
Self Study
Questions for Self Study - 1
(A) (1) (b), (2) (d), (3) (c).
(B)
(1)
Market period is such a period during which
supply of commodity could not be changed
in response to price, couldn’t be increased
when price rises nor could it be reduced
with decline in price.
(2)
Short period is that during which only
variable factors like labour, raw material,
fuel energy could only change when output
is to be increased. Fixed factors could not
be increased in the short run.
(3)
Long run is a period during which all the
factors; variable as well as fixed factors
can also be changed. If the profit is more,
new firms can enter and loss-sustaining
firms may quit in the long run.
Some assumptions are usually made in
every statement of economic theory, such as,
consumers wish to maximise their satisfaction
by spending on goods and services out of their
limited income. Firms aim at profit maximisation.
Managerial Economics : Nature and Concepts : 31
Biological structure is constant in geographic
conditions, economic activities work within legal
framework in a specific economic system, etc.
(3)
Explain what types of assumptions used
in the statements of economic theory.
1.6 Exercises
1.7 Books for Further
Reading
(1)
Explain the concept of ‘scarcity’ and its
significance in economics.
(1)
Marshall Alfred,
Economics.
(2)
Explain the meaning and types of different
time periods with reference to economic
analysis.
(2)
Lipsey R. G., An Introduction to Positive
Economics
(3)
Stonier and Hague, A Text book of
Economic Theory.
Managerial Economics : Nature and Concepts : 32
Principles
of
Unit 2 (A): Nature of Managerial Decisions
Index
2.0 Objectives
2.1 Introduction
2.2 Subject Description
2.2.1 Economic Nature of Managerial
Decisions
2.2.2 Internal Factors Influencing
Managerial Decisions
2.2.3 External Factors Influencing
Managerial Decisions
be studying how the decisions are arrived at after
studying the problems before a business firm.
Decisions are taken before commencement of
the firm’s business and also thereafter from time
to time on diverse issues. A firm has to setup a
mechanism for the purpose. In larger firms,
functional managers take decentralized decisions
and the top management reviews all such
decisions. In the present unit, we shall see that
how is the nature of decisions is basically
economic and also study the factors influencing
the decisions.
2.3 Words and their Meanings
2.4 Answers to Questions for Self study
2.5 Summary
2.2 Subject Description
2.6 Exercises
2.7 Books for Further Reading
2.2.1 Economic Nature of
Managerial Decisions
2.0 Objectives
After studying this unit, you will be able
to :
« Explain the nature of managerial
decision.
« Explain the difference between the
economic and non-economic managerial
decisions.
« Explain the internal factors influencing
managerial decisions.
« Explain the external factors influencing
managerial decisions.
2.1 Introduction
So far, we have studied the meaning of
managerial economics and methods of studying
it in earlier units. From here onwards, we shall
A number of problems can crop up while
running a firm. Initially, what shall be the name
of the firm? Where should it be located? Which
product or service it must provide? Which
technique of production to use? and the like,
problems arise. When the firm starts functioning,
new problems such as how to keep the inflow
of raw material, spares, workers, energy and
water supply, transport system etc. to maintain
the chain of output smooth? Each problem is to
be solved after studying the same thoroughly. A
number of alternative solutions could be
available. The manager can choose the best of
the solution. We shall consider now the decisions
of this type.
Choosing the best of alternative from
among so many means decision-making. It is a
continuous process while running a business.
Most of such decisions are mainly concerned
with economic matters. Decision on upward
revision of wage rate is an economic decision
because it has cost implications. In case the price
could not increase sufficient to absorb the rise
Managerial Economics : Nature and Concepts : 33
in cost, profit declines. If the firm has a control
over price, then wage hike, though it may add to
cost, firm can recover the same by charging
higher price to customers. Profit may remain
unaffected or it may increase. Similarly, if a
firm’s wage cost may be an insignificant
component of total cost, in this case also rise in
wage rate may not affect profit. Demand for
wage hike can be refused in absence of a strong
workers’ union but if it is strong, the demand
could not be refused. If industrial relations are
strained, workers may stop working. Production
shall decline. To avoid such ill effects, it is better
to accept workers demand. Manager has to
make a choice of right decision depending upon
the situation before the firm.
Decisions regarding naming the firm,
holidays and cultural programmes for the
workers are not economic by nature. Very few
of the decisions may not be on economic issues.
Since we assume that firms are motivated by
profit, then to make a profit is an economic
matter, and decision thereon is mainly economic
in character. Naturally, all problems relating to
profit are economic problems. Similarly, the
managerial decisions on allocation of scarce
resources are basically economic problems.
When there is a problem of efficient
utilisation of resources to achieve maximum
goals of business, it is an economic problem,
and the nature of managerial decision thereon
is also economic in character. There are various
sources of product promotion. A problem arises
as to the choice of the media for promotion.
Next problem is how to select from among
different media such as newspapers, journals,
radio, and TV or cinema houses and distribute
resources accordingly. This is an economic
decision because it has to be taken with an
objective of profit maximisation. Amount set
aside for promotional expenses is limited and
hence, how to distribute it among different media
of promotion becomes a problem. Various
alternative distributions are possible. Each of the
alternatives has some costs and some benefits.
Which of the alternative shall give highest net
gain, is found and a decision is taken to choose
that alternative which offers highest gain.
If we analyse a number of such decisions,
the economic nature of these decisions will be
quite clear to us. The decision on size of the
firm is related to another decision whether to
utilize available resources for capital goods or
other productive resources. It also depends on
the decision to have more ownership capital or
borrowed capital for running the firm. If more
borrowed funds are raised, the fixed burden of
interest and principal repayment would be too
high. At the same time, the decision making firm
shall be in a position to enjoy the benefits of
large-scale production and allows greater profit.
All these things must be taken into account while
taking a decision. Some other types of decisions
such as whether to produce a single commodity
or more, which technique to use, how much to
produce, where and on what scale the output is
to be sold are also the decisions associated with
allocation of resources. These are essentially
economic decisions.
Questions for Self Study - 1
(A) State whether the following
û)
statements are true or false. Put (û
ü) in bracket.
or (ü
(1)
Selecting the best of alternative after
analysing a number of alternatives is
decision-making. ( )
(2)
Management of a firm needs to take
economic decisions only. ( )
(3)
To grant a rise in wages to workers is an
economic decision. ( )
(4)
A rise in wage level always increases cost
of production. ( )
(5)
Any business firm can start functions
either by raising owned capital or borrowed
capital. ( )
2.2.2 Internal Factors Influencing
Managerial Decisions
For management, the process of decisionmaking is continuous. We shall now think over
the factors that influence managerial decisions.
These are classified as (i) internal factors and
(ii) external factors. The structure of business
firm and the system of decision making are
called the internal factors. Other conditions
before the firm also influences decision-making
by the firm. These conditions cannot be changed
by the firm and therefore, has to adjust with
Managerial Economics : Nature and Concepts : 34
these conditions. Such conditions are referred
to as external factors influencing managerial
decisions.
(a) Objectives of Firms
Firms can have more than one objective
of running a business. Maximisation of profit, to
earn sufficient profit, to boost sales, to increase
market share in output or sales, to maximise
sales, accelerated growth in output/profit, to
expand in size and so on. The firm has to decide
first, how many objectives to be held. Next, what
should be the order of preference among
objectives, because some of these might be
conflicting? Suppose, a firm with an objective
of profit takes some decision. The same decision
may not be taken if the objective is to maximise
output.
(b) Size of the Firm
Some decisions also depend upon the size
of the firm; whether the firm is small or large.
Small firms adopt cautious policies. It cannot
take aggressive decisions. In a business, where
small and large firms are competitors, small firm
is unable to compete, but accepts a secondary
role. A cutthroat competition between firms of
varied sizes is always at the loss of small firms.
Careful decisions help survival of small firms.
Large firms, on the other hand, can take
independent decisions.
(c) Available Resources with the
Firm
Decisions also depend upon the volume
and types of resources the firm has. Larger the
available resources, larger would be the available
alternatives open to the firm. Whether to
produce a single product on large plant or to
take multi-products on many small plants; can
also be a decision on making a choice. Where
the resources are plenty, choice becomes easy.
More skilled labour, expert managers can be
hired. Collection of necessary data and research
work becomes possible, purchase of computers
and other sophisticated office aids can be used
in the process of decision-making.
(d) Form of Business Organisation
Form of business organisation adopted by
the firm also affects decision-making. The
decision-making process is simple in
proprietorship and partnership firms. Quick
decisions are possible. In Joint stock companies,
however, the decision-making process has to
pass a number of stages. In State Enterprises,
there is an element of state intervention. It takes
much longer time to arrive at a decision through
various stages. If the activities of the organisation
are spread over many locations, then the works
like collection of data from all centers, decide
the resource needs of these centers are added.
Decisions are complicated when the organisation
produces multi-products and each product has
to pass through many processes.
(e) Degree of Liberty in Decisionmaking to the Management
How much liberty is given to the
management in decision-making also influences
decisions. Divergence between ownership and
management under Joint Stock Company
organisation has raised the issue of autonomy in
decision-making. Same is the problem with state
enterprises. Professional managers are educated
and trained in the art of management, which
may not be true of the owners and government
officers. Rule of thumb adopted by such persons
may not hold respect for professional managers.
Their suggestions for right decisions may not be
honored. Under such circumstances, wrong
decisions might be taken.
Questions for Self Study - 2
(A) Write brief answers to the following
questions.
(1)
What are the internal factors influencing
managerial decisions?
(2)
How does the objective of the firm affect
managerial decisions?
(3)
How does the form of business
organisation adopted by the firm affect
managerial decisions?
2.2.3 External Factors Influencing
Managerial Decisions
We have so far discussed the influence of
internal factors on decisions by a firm. Now,
we shall study the external factors influencing
Managerial Economics : Nature and Concepts : 35
the decisions. The factors that are beyond the
control of a firm are called ‘external factors’
influencing decisions. These are-
(a) Natural Factors
Natural factors are very much important
in some of the businesses. Success in agriculture
depends much upon fertility of land,
temperature, rainfall, and humidity in the climate
etc. that are external factors. In some regions,
production is impossible during winter.
Production of cotton textile needs humid climate.
Many industries in a region depend mainly on
local mineral wealth. Hilly tracks and deserts,
forestlands are useless to undertake any
productive activity.
(b) Government Controls and
Regulations
In each country, there is a legal frame in
which business can work. All business decisions
must adhere to the rules and regulations made
by the government for the purpose. In addition,
there are laws framed according to the economic
and political policies of the country. Factories
Act, Minimum Wages Act, Social Security
obligations, Industrial relations Act, Trade Unions
Act are very much useful or industrial
organisations. Separate rules and regulations for
road traffic, banking and insurance are also
made. Business houses must follow the
provisions contained in these rules. More the
rules more are the restrictions and more difficult
is to arrive at a correct decision.
(c) Tax System and Tax Structure
Taxation policy of a country, the rates of
taxes and the tax concessions are the factors
affecting business policies of the firms. In India,
small industry, industries located in backward
area and industries with low turnover are allowed
some tax concessions. Policies of the firm with
regard to the location, size of the firm and the
level of output, the influence of taxation is great.
New investment out of profit is encouraged
through tax concessions. Certain industries in
the priority sector were given such concession
in the past. Interest on borrowed capital is
allowed as a deduction from taxable income.
Hence, investment through borrowed capital
proves beneficial. In recent years, a tendency
to show pant and machinery on hire instead of
owned is growing, because the rent can be
shown as deductible expenditure. Leasing
finance is a growing industry because of this
reason.
(d) Economic / Industrial Policy of
the Government
Business decisions of the firms are also
influenced by the policies of government relating
to industries, private sector, financial facilities
to industries, special assistance to industries in
trouble and overall growth efforts etc. If proper
investment environment is offered, more
investment is encouraged. If industries are free
from the fear of nationalization, decisions
regarding starting of new enterprises,
improvement in the technique of production and
new investment are encouraged. However, if
such environment is absent, no such decisions
would be taken.
(e) Nature of Market Competition
A firm must consider the nature of market
in which it supplies the products. If the market
is perfectly competitive, the firm needs no
expenditure on sales promotion. Decisions on
quality of the product are also not needed.
However, if the market is monopolistically
competitive, the decisions on promotion and
quality of the product are called for. A monopoly
firm decides her own price. Appropriate
decisions are required to be taken to preserve
monopoly power in the market. As such, the
nature and scope of managerial decisions change
according to extent of competition in the market.
(e) Risk and Uncertainty in Business
Each firm accepts some risk and
uncertainty by running a business. Fire, accident
and theft are insurable risks that may cause loss.
On the other hand, there are certain uncertainties
in business those could not be predicted; change
in consumer tests, introduction of a substitute
product, improvement in the technique of
production, changes in the supplies of raw
material and other inputs etc. are the examples
of some uncertainties. Risks can be insured
whereas uncertainties cannot. Management of
Managerial Economics : Nature and Concepts : 36
a firm has to give serious thought to uncertainties
and take decisions to provide for. If the product
of a firm is in seasonal demand, an average
monthly output be worked out so that through
the demand may fluctuate, output remains stable
throughout the year. During slack season,
inventories grow and during busy season,
inventories deplete. Proper inventory
management solves the problem of seasonal
demand fluctuations. If change in consumers’
test is likely, the nature of product may suitably
be modified. Survey of consumer tests may be
undertaken before introducing changes in
production. Machinery to produce new products
or multi-products can be developed so that lack
of demand for one product can be compensated
by increase in the demand for other products.
This is how; the external factors
mentioned above do influence managerial
decisions.
2.4 Answers to Questions for
Self Study
Questions for Self Study - 1
(A) (1) (ü)
(4) (û)
(2) (û)
(5) (ü)
(3) (û)
Questions for Self Study - 2
(A)
(1)
(a) Objectives of business firm (b) size of
the firm (c) resources available with the
firm (d) form of organisation of the firm
(e) autonomy of the firm in decisionmaking.
(2)
A business firm may have many objectives
such as maximisation of profit,
maximisation of sales/output, to increase
market share etc. Which objective a firm
prefers has a bearing on her decisionmaking. If the objective is to maximise
profit, then the objective of larger sales is
relegated to lower priority.
(3)
Decisions in sole proprietorship and
partnership firms are quickly taken and
executed. The process is slow in joint stock
company and government enterprises, as
it has to pass a number of stages.
Questions for Self Study - 3
(A) Write brief answers to the following
questions.
(1)
What are the external factors influencing
managerial decisions?
(2)
How does the government policies
influence on managerial decisions?
(3)
How does the extent of market competition
influences managerial decisions?
Questions for Self Study - 3
(A)
(1)
The external factors influencing
managerial decision-making are natural
conditions, government controls, taxsystem and tax structure economic/
industrial policies of the government, nature
of competition in the market, risks and
uncertainties in business etc.
(2)
If the policies of the government are not
conducive to industrial growth, industries
are under controls and regulations,
industrial finance is not adequately provided
for, extra profit making by industries is
threatened of nationalization, decisionmaking by the management becomes
difficult. In opposite cases, decisionmaking is as easy process.
2.3 Words and their Meanings
Uncertainty : Certain unforeseen events which
cannot be insured for getting
compensation; such as decrease in demand
due to change in tests, entry of a
competitor.
Risk: Risk is predictable and can be insured
against losses. Fir, accidents and theft are
such instances that can be insured to avoid
losses get protection from insurance cover.
Managerial Economics : Nature and Concepts : 37
(3)
Sales promotion as no place in a
competitive market where product is
homogeneous. Further more, the sellers
and buyers have perfect knowledge of the
market conditions. Pricing decisions by firm
are not required. Sellers are mere price
takers. In monopoly, however, the pricing
decision of the firm is necessary. But then
price should not be too high to finish the
monopoly itself. Nature and scope of
decision-making depends on the extent of
competition in the market.
« Decisions of the firms also influenced by
the external factors, which include:
« Government controls and regulationsslow down the process of decisionmaking.
« Tax structure and Tax system- If the tax
system does not provide concessions and
the rules are too punitive, the decision
process becomes difficult.
« Economic/Industrial policy of the
government, if conducive to industrial
growth, decisions relating to new
investment, expansion of output will be
taken.
2.5 Summary
« Extent of competition in market also
influences business decisions.
Decision making means choosing the best
of alternative measures from those available. A
business firm has to take a number of decisions.
Some of these decisions are on economic issues,
e.g. giving a rise in workers wage. A few of
such decisions can be non-economic, e.g. giving
holiday to workers on a particular day. Decisions
relating to profit are essentially economic in
character. The process of decision-making in
influenced by the form of business organisation
adopted by the firm and the system of decisionmaking. The conditions under which the business
is run also affect the process of decision-making.
Such condition is called external factors in
decision making.
« Nature of competition in the market has
a greater impact on decisions of the firm,
and finally;
Following are the internal factors
influencing decisions of the firms:
« Nature of risk and uncertainty in business
greatly influences decision-making by the
firms.
2.6 Exercises
(1)
Explain with suitable example that
managerial decisions are of economic
nature.
(2)
Explain how does the internal factors
influence Managerial decisions.
(3)
Describe the external factors influencing
managerial decisions.
« Objectives of the firm- there can be
numerous objectives of firms. Decision
of the firm shall depend upon what
objective the firm is trying to achieve.
« Size of the firm- as well as the command
over the resources the firm has influence
decisions.
« Form of business organisationproprietorship and partnership firms can
take quick decisions whereas companies
and government enterprises cannot
because of divergence between
ownership and management.
« The degree of autonomy in decisionmaking, Autonomy allows quick
decisions.
2.7 Books for Further Reading
(1)
Dewett, K. K. and Adarsh Chand,
Modern Economic Theory, Shyamlal
Charitable Trust, New Delhi
(2)
Mahajan Mukund, Puravathyacha
Abhyass (Marathi), Book No. 4,
Y.C.M.O.U. Macro Economics ECO-261,
Book No. 4, Publisher, Registrar,
Y.C.M.O.U., Nashik
Managerial Economics : Nature and Concepts : 38
Unit 2 (B) : Methods of Studying Managerial
Economics
Index
2.0
Objectives
2.1
Introduction
2.1 Introduction
2.2. Subject Description
2.2.1 Statement of the Problem
2.2.2 Collecting Data Relating to the
Problem
2.2.3 Analysing the Information Relating
to the Problem
2.2.4 Choosing the Right Alternative
2.3
Answers to Questions for Self Study
2.4
Summary
2.5
Exercises
2.6
Books for Further Reading
By now, we have understood the nature
of Managerial Economics. Managerial
economics helps to solve the problems of
business firms. We shall now see, how it is done.
Theoretical analysis in economics explains the
general nature of relationship between the
variables. A firm may be in need of knowing
such relationship in quantitative terms. Empirical
data based on the past experiences of the firm
is being used for the purpose. What information
from the data to use, depends on the nature of
problem. Economic theory and concepts help in
analyzing the data, which enables establishment
of relationship between the variables in such a
way that it is useful to the firm. The effect of
managerial decisions can be found with the help
of relationship between the variables. It helps in
arriving at a right decision.
2.0 Objectives
After studying this unit, you will be able
2.2 Subject Description
to :
« Say how much important it is to make a
systematic statement of the problem
before any decision by the firm.
« Once the nature of the problem is cleared,
the need for collecting essential data can
be emphasised.
« Explain the need for analysing the
information relating to problem.
« State the need for choosing the right
alternative from those available to arrive
at a decision.
2.2.1 Statement of the Problem
Every firm has to take decisions from time
to time. Whether to or not to change the product
price? How much should be the price change?
How much output next year and so on. Such
decisions need be taken. These decisions are to
be definite and in quantitative terms.
Mathematical and statistical tools are needed
as an aid in decision-making.
The problem before the firm must be
specific. While studying a problem, the conditions
under which the firm is working and the details
of resources at hand with the firm must be
Managerial Economics : Nature and Concepts : 39
clearly known. Related data has to be collected.
This data helps to assess the possible impact of
a decision. To state with details the problems
faced by a firm from the point of view of
decision-making means ‘statement of a
problem’.
Whether to increase or not the price of
her product and if yes, how much to increase is
a problem before a firm. Before thinking over
on this problem, first we need to know is the
prices on similar products charged by the
competitors, changes in price they have recently
made, market demand for the product and her
own market share in that product, present profit
of the firm, likely demand for wage increase by
the workers after price rise, probable rise in the
cost of raw material and other inputs and the
selling costs commitment in order to retain
demand at rising price are the related matters
need be studied. This gives a definite shape to
the problem under study. Suppose, a firm is
producing a commodity. There are two more
firms producing the same product. Share of all
the three firms in market supply is equal, which
means market share of each firm is 1/3. There
is no possibility that other two firms shall change
their prices. Workers demand for rise in wages
is pending with an assurance that if income of
the firm increases in future, their demand will
be considered. The commodity is in good demand
and even if the price is increased, demand is not
likely to be affected much. Suppliers of raw
materials and other inputs could not find an
alternative outlet and therefore, could not charge
higher prices. Most of the factors seem to favour
the decision to increase the commodity price.
How much to increase the price so that neither
the workers would justify their demand for wage
increase nor the competitors would not think of
sales promotion efforts? A proper pricing
decision is to be taken by considering all these
factors.
In a situation explained in the above
paragraph, the firm needs to collect vast data,
analyse it, and trace out a series of alternative
prices with their implications.
2.2.2 Collecting Data Relating to
the Problem
Empirical data on the impact of decisions
is to be collected to study a problem and draw
inferences based on past experiences. From the
example given in earlier section, a pricing
decision is to be evaluated on the basis of what
happened in the past. The effect of a change in
price and advertising on demand, the relationship
between price and wage rise, impact of wage
cost on cost of production, rise in the cost of
inputs consequent upon rise in the final product
cost are the problems in which past experiences
may provide guidance. Past record of the firm
is useful in applying to current situations.
Secondary data published by the organisation
of the firms can be used. Such data can be
supplemented by conducting surveys, whenever
necessary. Impact of a price change or
advertising expenses on consumer demand could
be estimated. Some government publications
also publish official statistics relating to industry,
business and finance. Institutional research
produce research report, journals etc.
Information useful for firm’s decision-making
can be picked up and used. At times, experiences
of businesses abroad and published in journals
also help in comparing the experiences.
Thus, there are innumerable sources of
data collection for firms. Inferences backed by
database can be precise, to the point.
Questions for Self Study - 1
(A) State whether the following
û)
statements are true or false. Put (û
ü) in bracket.
or (ü
(1)
Description of a problem with full details
from the point of view of decision-making
means ‘statement of the problem.’ ( )
(2)
While deciding on whether to increase the
price of a product, a firm must consider
first, the prices of other products, supply
of raw materials etc. ( )
(3)
Before arriving at a decision, a firm must
take into account past experience and the
current market situation. ( )
(4)
Grant of higher wages to workers does
not affect the cost of production. ( )
(5)
Decisions of a firm regarding price and
output may not affect at all other firms
producing the same product. ( )
Managerial Economics : Nature and Concepts : 40
2.2.3 Analysing the Information
Relating to the Problem
The most important part of managerial
economics is the analysis of information.
Economic theory and concepts are used in
analysis. Before we actually analyse, we have
to choose the variables relating to decisions. We
should also determine some ideas about the
relationship between the variables. Economic
theory is useful in this task.
A number of variables such as the price
of the commodity, prices of other products, total
demand for the commodity in the market, market
share of the firm, wages of workers, prices of
raw materials and other inputs, income of the
people, tendency of general price level etc. are
concerned with decision-making process. If a
single firm increases price, which is not followed
by other firms, would face a decreased demand.
If the general price level is rising, it is
automatically followed by wage hike and
increase in the prices of inputs. Such interrelationship between the variables in economics
is rather broad. To make it situation specific, a
quantitative analysis should be used. For
example, if the general price level increases by
1 percent and a firm increases its price by 2
percent, the demand for firm’s product shall drop
by 2 percent. If other firms keep their prices
unchanged, then the drop in demand for our
firm’s product would be 5 percent. Analysing
the information can draw such an inference. ‘1
percent rise in the income of the people leads to
3 percent increase in the demand’ or ‘1 percent
increase in advertising expenditure leads to 2
percent increase in demand’ can be the results
of analysing the information. Such inferences
can be used in finding out the effects of price
change on demand.
Some quantitative techniques such as
correlation analysis and mathematical techniques
like ‘linear Programming’ are used to analyse
the information. Knowing these techniques is
beyond the scope of managerial economics.
Larger the database and longer the period for
which the data is available, greater would be
the dependability of the analysis. Correlation
between price and demand can be found on the
basis of data for 3-4 years, but if price varies
even slightly during this period, the analysis may
not be of any use. Correlation analysis is useful
only when sufficient database, say 20-25
quantitative figures and adequate other
information is available. Such analysis may
produce an equation;
D = 50 - 2P,
Where,
D= demand
And
P= price
In this equation, we can substitute any
price and can find the demand at that price. For
example, if the price is Rs. 10/-, demand would
beD= 50 - 2P, by substituting price, we get
= 50 - 2 x10
= 30
This functional relationship between
demand and price gives us quantities demanded
at any price. However, this is just a forecast
because there are also factors affecting demand
other than price and actual change in demand
may vary from the forecast.
In linear programming, equations are
developed from the point of view of profit
maximisation but also shows the limitations on
working of the firm. Using this programme, we
can formulate appropriate production function.
In the same way, programmes on minimising
the cost of transport or deciding upon various
sources of inputs to be tapped, different market
segments where the product would be sold
quantities for each of the segment can be
planned.
This is how, statistical and mathematical
tools are used in addition to economic theory to
analyse the information.
2.2.4 Choosing the Right
Alternative
Final stage in the process of decisionmaking is to choose correct alternative from
those many available. This is possible only when
we compare cost-benefit of each of the
alternatives. Choice has to be made with
reference to the objectives before the firm. We
shall assume for simplicity that maximisation of
profit is the sole objective before the firm.
Profit is defined as difference between the
revenue and cost of the firm and both, revenue
Managerial Economics : Nature and Concepts : 41
and cost are related to the output that firm
produces. What is important to know is what
will be the impact of firm’s decisions on sale of
her product in the market? In principle, it is
possible to vary price slightly. In practice,
however, prices are allowed to vary by a certain
minimum amount or a multiple thereof. Changing
price frequently is troublesome. Once the price
is determined, it is allowed to remain constant
for some time. Suppose this minimum is 5 percent
and firm decides to vary price in the multiple of
it. Rise in price should not be beyond a maximum
so as to face consumers’ resistance. Suppose
further that this maximum limit is 25 percent.
Now, the firm has five alternative price
increases; 5 percent, 10 percent, 15 percent, 20
percent, and 25 percent. We can find the
implications of each price change for demand
and sales revenue by using the above analysis.
Similarly, we can take into account the possibility
of higher wage demand and rise in the cost of
inputs because these factors lead to increase
the cost of production. Cost will increase to the
extent price of product is increased. It would be
true of advertising cost as well. Considering all
the factors, we shall be in a position to determine
the relationship between output, revenue and
Objectives
Details of Business
cost. Analysis of revenue and cost tell us what
would be the profit at each of the price change.
That price, which maximises profit, can be
recommended to the firm. However, it would
be advised not to change the price, if after a
change is price profit is likely to be less than the
current profit. Suppose, we have following
alternatives:
o
Existing profit
Rs.1, 50,000
o
Profit after 5% rise in P
Rs.1, 75,000
o
Profit after 10% rise in P
Rs.2, 25,000
o
Profit after 15% rise in P
Rs.3, 00,000
o
Profit after 20% rise in P
Rs .2,00,000
o
Profit after 25% rise in P
Rs. 1,00,000
Under the circumstances, the alternative
of 15 percent price rise could be recommended.
Above illustration will make us aware the
method of studying managerial economics. In
next sections, we shall consider in detail how to
study different economic problems. Chart given
below is a narrative of how to study managerial
economics.
Chart showing methods of studying
Managerial Economics
Details of Problem
Details of Business
Statement of the Problem
Determination of
Related Information
Information through Survey /
Internal Sources
Other
Information
Collection of data
Economic Analysis
Statistical Analysis
Choice of the Variables
Mathematical Analysis
Analysis of Data
Probable Decision
Effect of a decision on objectives
Choice of the Right Decision
Managerial Economics : Nature and Concepts : 42
Questions for Self Study - 2
(A) State whether the following
û)
statements are true or false. Put (û
ü) in bracket.
or (ü
(1)
Before analysing any information, it is
necessary to select variables concerning
the decision. ( )
(2)
If other firms producing the same product
do not follow a rise in the price by one
firm, demand for the first firm’s product
decreases. ( )
(3)
After analysing the information, effects of
alternatives open to the firm can be
found. ( )
(4)
For a firm, making frequent changes in
product price is possible. ( )
(5)
Objective of the firm and the choice of an
alternative measure are closely
associated. ( )
When deciding about an important issue like rise
in the product price, the firm has to see likely
effects on demand for the product, prices of
raw materials, workers demand for wage rise,
reaction of the other firms to price change and
such other factors must be considered before
finalising the pricing decision. While making a
decision, experiences of the past, market survey,
survey reports published by the media on market
and consumers’ choice are useful. It is necessary
to analyse information so collected. Variables
relating to decision need be selected and to
develop ideas about functional relationship
between these. Correlation analysis in statistics
and linear programming technique in
mathematics are used in analyzing quantitative
information. Longer the period, for which data
is available, more reliable would be the analysis.
It is possible to think over the effects of a
decision only after analyzing the cost-benefits
of various alternatives. Decisions of the firm
need evaluation with reference to the objective
before the firm. Accordingly decision-making
by a firm becomes easy.
2.3 Answers to Questions for
Self Study
2.5 Exercises
Questions for Self Study - 1
ü), (3) (ü
ü),
(A) (1) (ü
ü), (2) (ü
û ),
(4) (û
û ).
(5) (û
Questions for Self Study - 2
(1)
Explain in detail the various stages in the
process of decision-making.
(2)
Explain, how is the information needed by
a firm is collected.
(3)
Write a note on analysis of information
relating to a problem.
ü), (2) (ü
ü), (3) (ü
ü),
(A) (1) (ü
(4) (û
û ),
(5) (ü
ü ).
2.6 Books for Further
Reading
2.4 Summary
Every firm has to take decisions from time
to time. While taking any decision, the resources
available with the firm and the external
environment before the firm must be considered.
(1)
Allen R. G. D. Statistics for Economics
(2)
Reddy P. N., Appannaiah H. R.
Managerial Economics Bombay,
Himalaya Publishing House
Managerial Economics : Nature and Concepts : 43
Unit 2 (C) : Some Basic Concepts : Plant, Firm,
and Industry
Index
beginning of our study.
2.0 Objectives
The system of production prior to 18th
century was not developed one. Number of
products taken was not only less, but also the
scale of output was small. Machinery used in
production of goods was not modern. Number
of firms in the market was also small and their
activities were not coordinated. Most of the
firms were independent Supplies of factors of
production like the firms themselves managed
labour, capital and organisation. Above all, the
firms themselves also managed the sales.
2.1 Introduction
2.2 Subject Description
2.2.1 The Plant
2.2.2 A Firm
2.2.3 An Industry
2.3 Words and their Meanings
2.4 Answers to Questions for Self Study
2.5 Summary
2.6 Exercises
2.7 Field Work
2.8 Books for Further Reading
2.0 Objectives
After studying this unit, you will be able
to :
« Explain the concept of plant.
« Explain the concept of firm.
« Explain the concept of industry.
« Distinguish between plant and a firm.
However, this situation changed altogether
over time. Nature of products changed and
types of products increased, scale of output went
on expanding, and technique of production was
continuously improving. Separate agencies
supplying factors like labour capital etc. came
into existence. Transport of inputs and finished
goods and storage services for such goods
emerged. Producing firms, firms supplying inputs
and firms selling the products were linked with
each other. In brief, we can say that a simple
productive system was replaced by a muchcomplicated system of production and
distribution of goods and services. Even if we
think of producing firms, there is a variety of
them producing various products. The concepts
‘plant’, ‘firm’ and ‘industry’ emerged out of
these complications.
2.1 Introduction
Many common concepts in economics are
also used in managerial economics, e.g. ‘plant’,
‘firm’, ‘industry’, ‘market’, ‘stock’, etc. Many
of these concepts we use in our day-to-day
activities rather loosely, but in a science like
managerial economics, these have specific
meaning. It is, therefore, necessary to understand
some of the terms in scientific meaning at the
2.2 Subject Description
2.2.1 The Plant
In order to understand modern productive
system in a better way, it is necessary to
understand precisely the important concept of
‘plant’.
Managerial Economics : Nature and Concepts : 44
A factory is called plant. We have heard
about Bhilai Steel Plant, Durgapur Steel Plant
from which we do know the meaning of the
concept ‘plant’. A factory, a mill or a mine that
provides all facilities of manufacturing a product
is a plant in this sense. To make the meaning of
‘firm’ crystal clear, it is necessary to take a
couple of examples:
(a)
(b)
There is a famous coalmine in Dhanbad in
the state of Bihar. Mines contain raw coal;
and the mine processes raw coal with
machines; there are tunnels to carry raw
coal. There are also roads on surface,
storages to store coal, factory buildings,
and residential quarters for the managers,
workers and other staff. In brief, almost
all the facilities required for manufacturing
of coal are available in the area of mine.
If these facilities are not available at a
single place, production of coal would have
been impossible. Thus, coal plant is a
technical unit that provides all facilities for
manufacturing of coal at a single location.
Famous Steel Pant at Bhilai in India
represents identical situation where
location of steel plant is associated with
provision for storage of raw iron, furnaces
to convert iron into steel, machinery,
buildings and host of other services needed
in manufacturing steel. Technically, it is
necessary to have all these facilities
available in the plant. This is an example
of a ‘Plant” producing steel.
After considering the two examples, we
shall now define plant.
Plant is a composite name given to a set
of machines, laboratories, equipment, buildings,
roads, and storage facilities required in the
production of a commodity.
From the above discussion, we can say
that ‘plant’ is a technically self-sufficient unit.
It is concerned with the technical aspect of
production. Technical self-sufficiency is,
therefore, an essential character of a plant.
We must remember that plant is just a part
of a firm because a firm may have more plants
at one and the same time. Each firm must have
at least one plant. If a firm undertakes multiproducts, then a separate plant for each product
can be convenient. For example, HMT,
Hisdustan Machine Tools in India produces a
variety of machine tools. Each of the products
is produced on a different plant. One plant
produces HMT tractors, the second produces
wristwatches and the third plant produces
machine tools. Size of plants in a single firm
may differ. The plant manufacturing tractors may
be quite large whereas the plant producing
wristwatches may be very small. Similarly,
various plants under a single firm can be located
(disbursed) at different locations; in different
parts of the country or in different countries
around the world.
One more thing must be remembered while
thinking about a plant. A plant has to work within
the policy framework prescribed by the
government or the firm. The responsibility to
execute these policies rests with the plant.
Labour policy of the state, for example, is
applicable to all plants. Plant must strictly adhere
to the rules relating to labour policy. Private firms
have their own policies relating to workers.
Plants under the firm have to execute these
policies through their local managers, wherever
these are located.
Similar to labour policy, certain other
policies regarding technical change, expansion
plans etc. plants are authorised to execute
policies. Of course, the autonomy in such policy
decisions can never be with the plants, except
up to advisory level.
Each of the products passes through a
number of processes and there is a technical
relationship among all these processes. In
production of cotton textile, for example,
spinning, thread-making, weaving, dying are the
processes that follow one after another. There
is a technical link among all these processes.
We can thus say that plant is a technical unit
wherein there is a close relationship between
all the processes.
2.2.2 A Firm
Now, let us understand the concept of a
firm clearly.
Firm is always at the center of aggregate
productive activity in any nation. Each firm uses
its owned resources to produce any product.
Some times, hired resources are used in addition
to owned resources. Land, labour and capital
Managerial Economics : Nature and Concepts : 45
can be hired, if owned factors are not sufficient.
Firm is said to be the ‘managerial or
organisational unit’. Main objective of a firm is
usually to maximise profit through mobilisation
of resources to produce a product. In other
words, we can say that profit maximisation is
the sole objective of any firm. Any decision of a
firm is motivated by this objective only. We have
discussed this in detail little later.
Managerial economics looks at a firm from
two points of view: (a) Theoretical aspect and
(b) Practical aspect.
(a)
Theoretical Aspect : Theoretically
speaking firm is a basic unit in production.
The firm takes all-important decisions
relating to production. What to produce,
how much to produce, which location to
choose, which resources to be used and
how to coordinate resource uses, which
technique of production to use, where and
at what price to sell etc. are all the
decisions to be taken by the firm.
Theoretically, firm is a decision-making unit
with regard to mobilisation and utilisation
of resources. We must remember our
assumption that the firm has a sole
objective of profit maximisation.
(b) Practical Aspect : If we look at the term
from practical point of view, the concept
seems to be broader; because in practice,
every firm operates with the objective of
profit maximisation. Firm mobilises
resources, manages production, sales etc.
with this objective. Scope of functions of
a firm is much wider in practice. Larger
the size of the firm, more complicated is
the functions and hence more important
are the functions of managing and
organising a firm.
A firm may have multiple plants; may be
located in different regions of the same country
or spread over different countries in the world.
Management and control over all such plants
basically rests with the firm. We shall make this
point clear with suitable example. The plants of
famous TELCO (a firm) are located in Pune,
Jamshedpur, Lucknow and other places.
Ownership and control of all these plants is with
TELCO. Management, coordination and control
of these plants are done by TELCO. Oil India
Ltd. is another firm in public sector. Its plants
are spread over Barrowni, Vishakhapattanam,
Koyali, Cochin, and several other places in the
country. However, the firm manages and
controls all these plants as a ‘managerial unit’.
Coca-Cola Firm has its plants in many countries
in the world.
Thus, we can say that firm is a unit at the
center of productive system. This unit takes
decisions, planning; managing and controlling the
plants are the main functions of a firm.
Since a firm performs a variety of
functions at one and the same time, it becomes
difficult to present a commonly acceptable
definition of firm. Different definitions based on
different functions of firm are available. Some
of these definitions are as under.
(1) Florence : ‘Firm is a controlling unit’.
(2) Jorge Watch : ‘The concept of firm
suggests ownership and control.’
(3) Spite : ‘Firm is a controlling and
administrative unit. In a capitalist economy,
firm is a unit that suggests ownership and
control.’
All the three definitions mentioned above
clearly emphasise the functions of ownership
and control. Of course, ownership is related to
finance and also control is a corollary of
ownership. We can also say that a firm is a
financial unit. Financial arrangements are
necessary to acquire ownership and gain control
over the firm. Entrepreneur himself raises
owned funds and borrows funds on his own
responsibility. It is less important that how a firm
raises funds, more important is that the firm has
a liberty to raise funds.
Financial function of the firm is neglected
in the above definitions. Though finance is one
of the important aspects of the firm’s functions,
certain other aspects also need attention. Some
definitions covering other aspects are given
below:
(4) Beacham : ‘Firm is a primary unit in
organising productive resources for
production of wealth.’
The ownership and control of a firm are
not only important aspects. It will be a one sided
view. Each firm produces one or another
commodity or service. Factors of production like
land, labour, capital are required to be brought
Managerial Economics : Nature and Concepts : 46
together and organised. In absence of such
organisation, production of wealth in the form
of goods and services becomes impossible. Each
firm has to organise in addition to making
financial provision that is equally important to
finance. Florence, Watch and Spite have
neglected this aspect. Beacham makes this
deficiency good.
Industry’. Similarly, Bhilai and Durgapur
Steel Plants in the public sector and Tata
Iron and Steel Company (TISCO) in
private sector together are called Indian
Steel Industry. Other similar examples are
‘sugar industry’, ‘Jute industry’ ‘Coal
industry’ and ‘Paper industry’ that suggest
all firms producing the same product.
(5) Penrose : ‘A firm is an administrative unit.
Such unit has a variety of functions.
Considering the likely effects on business
as a whole, the various functions are
coordinated.’ The scholar Ms. Penrose
stated this definition in her book ‘Growth
of firms.’
From the above discussion, we can say
that an industry contains all firms in an
economy producing the same or identical
product. The firms in an industry produce
close substitutes to each other’s products,
or the products satisfying the same want.
(b) Same Raw Material : Some times, use
of the same raw material is taken as a
norm for grouping the firms in an industry.
For example, ‘Rubber Industry contains
firms producing tubes and tiers; rubber
footwear, rubber wires to cover electric
wires using mainly rubber as a raw
material.
If we observe any firm, we will see that
various functions are simultaneously performed;
raising capital, distribution of output among the
factors of production, advertising, sales,
expansion etc. Though all these functions appear
to be independent, in fact, these are closely
correlated. For example, raising of capital
depends on scale of output; volume of sales
depends on scale of output, if a firm succeeds
in boosting sales, it can execute the programme
of expansion. It is, therefore, necessary to
coordinate all the functions in such a way as to
obtain maximum positive results for the business.
To coordinate the activities of business is also a
function of the firm. Penrose has rightly
emphasised this function in her definition.
(c)
2.2.3 An Industry
Questions for Self Study - 1
After grasping the precise meanings of a
plant and firm, it is not much difficult to
understand the concept of ‘industry’. Industry
can be said to be a cluster of firms producing
the same product. Of course, different norms
are used in grouping of the firms in an industry.
Let us have a look at some of these norms.
(a)
Identical or Same Product : At times,
firms producing the same or identical
product are grouped together in an industry.
Let us make this point clear with suitable
examples. Textile is a common final
product and all firms producing textile are
commonly called as ‘Textile industry’.
Kohinoor Mills, Arvind Mills, Rajabahadur
Mills, Mafatlal Mills and so many others
together constitute ‘Indian Textile
Same Production Process : Similarity
in the processes of production is,
sometimes considered as a norm in
determining the firms in an industry.
Chemical Industry for example, contains
firms producing a variety of chemicals.
However, the process of manufacturing is
more or less identical in all firms.
(A) State whether the following
û)
statements are true or false. Put (û
ü) in bracket.
or (ü
(1)
Plants of a firm can be scattered in
a country and also in foreign
countries. ( )
(2)
A plant can take independent
decisions regarding production of a
commodity. ( )
(3)
A firm controls and plans a plant.( )
(4)
An industry means a cluster of firms
using same raw material. ( )
(5)
Plant is concerned with all the
processes of production relating to a
single product.( )
Managerial Economics : Nature and Concepts : 47
(B) Fill in the blanks and complete
sentences.
(1)
Plant is a technically—————
unit.
(2)
Objective of a firm is to ————.
(3)
There can be many—————in a
firm.
(4)
Clubbing of many firms producing
the same product means _______.
(5)
The concept of ___________
suggests ownership and control.
2.3 Words and their Meanings
Plant : Technically independent unit.
Firm : Unit of ownership and control.
Industry : A Cluster of firms producing the
same or identical product.
2.4 Answers to Questions for
Self Study
Questions for Self Study - 1
(A) (1)
(ü),
(2) (û),
(3)
(ü),
(4) (ü),
(5)
(ü).
(B) (1) Self-sufficient
(2) Profit
(3) Plants
(4) Industry
(5) Firm
2.5 Summary
Plant is a technically independent unit,
where limited freedom of action is allowed within
the policy frame of the firm. All the processes
of production, either of a single product or multiproducts, are conducted in a plant.
Any firm has multi-facets such as
financial provision, ownership, control,
coordination, administration and the like. Firm is
defined by using any one or more of its facets.
Therefore, none of the definitions of firm is
complete. Industry is a cluster of firms. It is a
wider concept than a firm. Different criteria are
used to define industry as a cluster of firms.
Plant is a technical unit of production. A
firm coordinates the activities of plants. Firm is
a unit that coordinates, controls and administers
the activities of the plants. Industry is a cluster
or group of firms. Thus, we can say that the
plant, firm and the industry are the three stages
in the same productive system. Among these,
Industry is at the top, followed by firms and plants
are at the bottom. Production system is thus a
three-tier system.
Plant, firm and industry are the three
important concepts in managerial economics.
Plant is a technical unit and the firm is an
organisational unit. Plant and machinery,
buildings, storages and transport system together
are called a plant. Each firm must have at least
one plant. Size of the plant can be small or large;
plants can be geographically dispersed and can
be used to produce a single or more than one
product/multi- products. Firm is an organisational
primary unit. It concerns with mobilisation of
resources, management and control, sale of
finished goods, accounting and coordination etc.
are the functions of the firm. Industry is a wider
concept that encompasses the cluster of all firms,
small and large, producing the same or identical
products.
Managerial Economics : Nature and Concepts : 48
your village or taluka or district. Information
should relate to the type of product, number of
firms and plants.
2.6 Exercises
(1)
Explain the meanings of the concepts plant,
firm and industry.
(2)
Distinguish between plant, firm and
Industry.
2.8 Books for Further Reading
(1)
2.7 Field Work
Singh Amarjit and Sadhu A. N. Industrial
Economics, Mumbai, Himalaya Publishing
House, First Ed. 1988, Section I PP 25-50
Collect information of an industry in
which, single or identical product produced in
Managerial Economics : Nature and Concepts : 49
Unit 2 (D) : Size of the Firm
Index
2.0 Objectives
2.1 Introduction
2.2 Subject Description
2.2.1 Cottage Industries
2.2.2 Tiny Industry
2.2.3 Small Industry
2.2.4 Large Industry
2.3 Words and their Meanings
2.4 Answers to Questions for Self Study
2.5 Summary
2.6 Exercises
2.7 Books for Further Reading
2.0 Objectives
A specific size of the firm is considered
as ideal, which is known as ‘optimum firm’. It is
believed that in order to obtain maximum
productive efficiency, a firm has to be of
optimum size. Optimum firm can be large or
small, depending upon business requirements of
the firm. Different techniques of production can
be used in the same industry. This causes firms
to differ in size and work efficiently. In India,
there is a co-existence of traditional industries
coming from generations before and those
modern industries entered in with British rule.
A natural classification of ‘cottage industry’ and
‘other industries,’ thus automatically followed.
In the category of other industries, some are on
small scale that needed special attention and
hence are termed as ‘small scale industry’.
Further, a part of small industry was classified
as ‘tiny industry’, being very small by size.
Accordingly, Industry is now classified into four
categories; Cottage Industry, Tiny Industry, Small
Industry and Large Industry
After studying this unit, you will be able
to :
« Explain the concept of cottage industry.
« Explain the characteristics and
importance of cottage industry.
« Explain the concept of tiny industry.
« Explain the meaning of small industry.
« Explain the meaning of large industry.
2.1 Introduction
So far, we have discussed various aspects
of studying managerial economics. The unit that
takes business decisions is named as firm. We
have also understood classification of firms by
size and that the complexity of the managerial
function increases with growing size of the firm.
2.2 Subject Description
2.2.1 Cottage Industry
Industry in India is classified into four
categories by size. However, measuring size of
the firm is not easy. Many norms such as, size
of the output, investment in fixed assets, use of
energy /horsepower can be applied in measuring
the size. We shall discuss these terms hereafter.
Prior to invention of steam power, by using
tools production was done. Human energy and
skill had immense importance. Many industries
producing goods prospered in India those days.
A part of the product was also being exported
to foreign countries. Machines and energy were
not used. Skill of the workers was much
important in production. Production was a
Managerial Economics : Nature and Concepts : 50
household activity as workers were producing
in their houses. Such industry was termed as
“cottage industry’’.
The National Planning Committee
appointed by the National Congress prior to
independence, defined Cottage Industry as
‘When a worker produces in his own house with
his own tools along with family members and/or
hired labour, less than 5 workers, it is a cottage
industry’.
In 1940, Bombay Economic and Industrial
Survey Committee appointed by Bombay
Province has elaborated the meaning of cottage
industry as-an industry that does not use energy,
production is taken in worker’s house, where
the number of workers is not exceeding 9.
From the above two definitions, we can
derive following characteristics of cottage
industry.
(a)
Energy is not used in cottage industry. Only
hand-operated tools are used to support
human labour. Occasionally animal power
is used in production.
(b)
Entrepreneur of a cottage industry
normally operates in his own house and is
assisted by his family members. Small
factory employees limited number of
workers.
(c)
The entrepreneur owns productive
resources. Resources are low priced and
therefore, less capital is required. The
artisan uses owned funds.
In addition, a few more characteristics of
cottage industry can be stated.
(1)
Cottage industries produce for a limited
market, preferably for local villagers or the
residents of nearby area.
(2)
Raw material is locally available. By
processing the local raw material, goods
are produced.
(3)
Production of consumers’ goods is
generally undertaken. The concept of selfsufficient village was true as all the goods
required by villagers were produced by
local cottage industry. Each household
specialised traditionally in a separate
commodity.
Classification of Cottage Industry
Cottage industry is classified into two
types:
(a) Classification based on the Nature
of Vocation
(1) Industries Allied to Agriculture:
Making thread from cotton, weaving cloth, basket
making, hand pondered rice, making flour from
grains, silk thread making are all the activities
allied to agriculture. Farmers can perform these
activities during slack season for farming.
(2) Rural Vocations : Generally, the
products sold in rural markets are supplied by
the skilled arisen. Pottery, tool-making
consumables made from iron and wood, tanning
leather are similar allied activities.
(3) Rural-urban Vocations : This type
of vocations needs specialised skill to produce
goods. Such vocations can run in villages as well
as in urban areas. Weaving handloom cloth,
carpet making, making glass bangles, carving
work on wood and elephant-teeth, making brass
articles, toy-making, dying cloth and printing
vocations fall in this category.
(b) Classification based on Nature of
Raw Material
Industries can also be classified on the
basis of nature of raw material they use. Making
cloth by using different types of threads, makings
articles from wood, making leather goods, pot
making by using mud and sand, making metal
goods, food industry, allied industries like
maintenance and repairs and miscellaneous
industries shall be a classification of this type.
In India, cottage industry has a great
significance. Provision for employment to a large
number, raise the standard of living of the rural
masses, utilization of local resources local skill
make these industries important for India.
Management of such industries is also not easy.
Production, purchase of raw material, sales
management and finance are the problems of
cottage industries.
Managerial Economics : Nature and Concepts : 51
Questions for Self Study - 1
(A) Answers the following questions in
brief.
(1)
What is meant by ‘cottage industry’?
(2)
Briefly narrate the characteristics of
cottage industry.
(3)
How are the cottage industries classified?
(4)
Why are cottage industries important in
India?
proprietorship or partnership firms. Their small
size makes management relatively easy.
However, all the problems faced by modern
industries are also faced by tiny industries. To
maintain the supply chain of raw material intact,
to find customers for finished products, to remain
in touch with financial institutions for financial
assistance, to look after maintenance and repair
for keeping the machines working, to make
arrangements for regular supply of water and
electricity, to supervise the workers, to maintain
accounts are some examples of the problems.
2.2.2 Tiny Industry
It is the policy of the government to help
small industry like cottage industry. Small units
from modern industry are known as small
industry. One more sub-class of industries was
added by the declaration of government of India
of the Industrial Policy, 1977, namely, ‘Tiny
Industry’. The policy aimed at industrial dispersal
in villages and rural areas instead of being
concentrated into urban agglomeration. The
population norm was included in the definition
of tiny industry.
An industry located in the places where
population is less than 50,000 and investment
in fixed assets is less than Rs. 1,00,000 were
covered in tiny sector. Industries in which
investment in fixed assets is less than Rs. 10
lakhs were included in the small sector.
Population norm was not applicable to them.
Definitions of Small and tiny industries have been
changed from time to time. At present,
investment in fixed assets up to Rs. 5 lakh are
included in tiny industries.
Main difference between cottage
industries and tiny industry lies in the fact that
tiny industries are modern industries, which use
machines and consume energy. Hired labour is
used and production is essentially for market.
These characteristics are similar to those of
modern industry excluding the size. Capital
requirement of tiny unit is relatively much
smaller. Persons with moderate financial position
can also initiate these industries. Ownership of
tiny industries can be dispersed to many persons.
This can be a justification in favour of tiny
industries. Furthermore, these industries can be
setup in rural area only that may help rural
development of the area concerned.
Tiny industries are mainly run as a sole
2.2.3 Small Industry
Tiny industry is just a sub-section of small
industry. Basic classification of industries is small
industries and large industries. A number of
norms were initially applied to define a small
industry. Now, investment is the only criteria.
Bombay Economic and Industrial Survey
Committee appointed in 1940 by Bombay
Province applied following norms while defining
small industry. The units using power and
employing less than 50 workers be called small
industry. Industries where power is not used and
more than 9 workers are employed could be
included in small industry.
After independence, National Planning
Research Committee applied following norms
to qualify as a small unit.
«
Those units using power and employing
less than 10 workers, and
«
Those units without use of power and
employing less than 20 workers
Board of Small Scale Industries prescribed
following norms for small units. Units investing
less than Rs. 5 lakh, using power and employing
less than 50 workers.
Since 1959, only investment criterion was
retained. Units with less than Rs. 5 lakh were
treated as small industry. In the beginning,
investment included cost of land and building,
but the cost of land and construction was rapidly
increasing. It was, therefore, necessary to take
into account investment in plant and machinery
only while defining a small unit. A further
classification of small industry into independent
SSI and ancillary SSI came into existence.
Ancillaries produce only components that could
Managerial Economics : Nature and Concepts : 52
be used as inputs in large industry. In 1997,
investment limit in plant and machinery for
independent SSI was fixed at Rs. 3 crore and
the same limit was prescribed for ancillaries as
well. This limit is raised from time to time.
It will be quite clear from the above
analysis that small industry is of the nature of
modern industry. They produce essentially for
larger markets, domestic and foreign markets.
Output is taken with the help of machines.
Labour is hired at wage and they are used in
production. Machines run on energy. Goods of
all type are produced; consumers’ goods, small
machines and tools, spares and various types of
equipments are generally produced in small
sector.
From the foregoing analysis, it will be clear
that there is a fundamental difference between
cottage industry and small industry. The
difference is presented briefly in the form of a table.
Table 2.1 : Comparative picture of cottage, tiny and small industries
Basis for
Comparison
Cottage Industry
Tiny Industry
Small
Industry
Investment
Very small
Less than Rs. 25 lakhs
Rs. 3 Crore
Type of output
Traditional consumer
goods
Modern consumer
goods
All types of modern
goods
Productive Resources
Simple tools
Modern machines
Modern Machines
Source of Energy
Human or animal power
Electricity
Electricity
Workers
Mainly family members
Paid workers
Paid workers
Market
Local
Domestic
Domestic & foreign
Location
Small villages
Small town
Large towns &
cities
Type of organisation
Sole proprietor
Proprietor or partnership firm.
Any up to Private
limited Company
Questions for Self Study – 2
(A) Answers the following questions in
brief.
(1)
Why was the new class of tiny industry
created?
(2)
What is the difference between cottage
industry and tiny industry?
(3)
What is the investment limit for tiny
industry?
(4)
What problems tiny industry faces?
(5)
What is the current investment limit for
small industry?
(6)
What is the nature of small industry?
2.2.4 Large Industry
Industries other than cottage, tiny and
small industries are classified as large industries.
Small industry is eligible for certain facilities from
government. Certain norms have, therefore been
prescribed to determine whether they can be
classified as small industry or not.
Main difference between small and large
industry lies in the size of their output. Broadly,
the industries employing more factors of
production and producing larger output are called
large industries. Industries using less factor input
and producing small output are called small
industries.
Large industries entered into India along
with British rule. Machines working on steam
power were the peculiarity of earlier large
industry. Later on, electricity was invented and
since then machines run on electric power is
being used. Machines are useful in producing
standardised goods. Accuracy in appropriate size
can be achieved with machines and not in hand
made products. Commodities with a number of
components can be easily produced. Timing and
Managerial Economics : Nature and Concepts : 53
motion of a machine can be so arranged that a
variety of production processes can be put to
work simultaneously. In printing of a newspaper
all the work of printing, joining the pages and
folding the paper is done by machines. It was a
time consuming work when a part of the work
was done manually. Human skill differs from
person to person. Various machines, on the other
hand perform all functions in a standardised way.
Owing to this advantage of machines,
mechanisation process progressed. Nature of
commodities changed over time, so also the size
of machines grew. Machines can produce cars,
buses, commercial vehicle carrying goods, metal
sheets, strips and bars, railway equipment,
electric poles and a host of other products. Size
of machines in such cases has to be much larger.
Machinery goods industry needs still larger
machines to produce new machines. This is how,
with changing nature of product, size of the firm
continue to increase. At the same time, size of
the plant also grew. Steel, petroleum purification,
machines and means of transport, generation
and distribution of electricity plants are ‘giant
plants’.
Large industries are organised as public
limited companies. Salaried managers are
employed to execute the policies of the firm.
Board of Directors elected from amongst the
shareholders supervises the general working of
the company. Principles of modern management
are followed in large industries. Large company
has a team of professional managers specialised
in different areas. An engineer looks after
production management; an expert in labour
laws/welfare assumes charge of personnel
department. An expert in marketing is asked to
take care of the marketing department and so
on. Problems of management become
complicated as the size of firm grows. Each of
the problems has to be considered from different
angles. Opinion of the team of managers is often
sought and the difference of opinion, if any, has
to be mitigated. The managing director performs
this task.
Size of the firm has continued to grow over
the years. Generally, new technology favours
larger size. There was a time when a sugar
factory with a daily capacity of crushing 500
tons sugar cane was supposed to be ideal. Today,
this ideal is 5,000 tons. It is true of other industries
as well. There are certainly advantages of largescale production but are not free from limitations.
Readymade clothes are, no doubt, cheap but
many people prefer cloth of their choice and
tailor made dresses though it costs more. In spite
of the fact that readymade building material
make homes cheap. Still there are persons who
spend more and get their homes built by using
material of their choice. Ornaments and artistic
articles are hand made. A small firm can easily
adjust with demand fluctuations than a large firm.
Due to such reasons, small firms prove suitable
in certain types of products. It is quite natural
that firms of different sizes coexist in different
products.
Questions for Self Study - 3
(A) State whether the following
û)
statements are true or false. Put (û
ü) in bracket.
or (ü
(1)
Use of factor inputs and the size of output
in large industry is more than small
industry. ( )
(2)
Use of machines on large scale led to
spread of large industry. ( )
(3)
Size of the firm continued to expand with
changing nature of the product. ( )
(4)
Large firms, because of their large size,
are organised as proprietorship or
partnership firm ( )
(5)
Specialisation is possible in large
industry. ( )
(6)
Machine made goods are not suitable
where consumer choice and convenience
are important.
( )
2.3 Words and their Meanings
Cottage Industry : A unit that produces goods
by using labour of family members and
local inputs without using power.
Tiny Industry : A unit investing up to Rs. 5
lakh but using machines, energy and
workers in production.
Small Industry : An industrial unit investing up
to Rs. 3 crore and using machines and
workers in production.
Managerial Economics : Nature and Concepts : 54
2.4 Answers to Questions for
Self Study
Questions for Self Study - 1
(A)
(1)
(2)
(3)
Cottage industry is the one where
production is taken in the house of the
artisan without use of power. The number
of workers is less than nine.
(6)
SSI produces with the help of human
labour and machines Main products are
consumers’ goods, small machines and
tools, spares etc.
Questions for Self Study - 3
(2) (ü),
(5) (ü),
(a)
Production is mainly for the village
and the nearby locality
(3) (ü),
(6) (ü).
(b)
Inputs are locally available
(c)
Products are essentially consumer
goods.
2.5 Summary
Classification of cottage industries.
Cottage industries are important because
of the use of local manpower and skill, local
resources, etc. More important is the
overall rural development that follows
when industries grow.
(A)
(3)
Present investment limit for SSI is Rs. 3
crore.
Characteristics of cottage industries are-
Questions for Self Study - 2
(2)
(5)
(4) (û),
Based on nature of Product
(i) Industries allied to agriculture
(ii) Rural vocations
(iii) Rural an urban vocations
(b) Based on nature of raw material.
(1)
All the problems of modern industry are
also faced by tiny industries.
(A) (1) (ü),
(a)
(4)
(4)
It has been the policy of the government
to help small industries alongside cottage
industries. Industrialisation and
development should not be concentrated
in cities alone but should also be spread
over villages and rural areas. Hence, the
tiny sector is added to our industrial
structure through Industrial Policy
Statement.
Tiny industries are of modern nature where
machines, energy and workers all are used.
Production is done for market. On the other
hand cottage industry produces using more
of human labour and for local market only.
Investment limit for tiny industry is up to
Rs. 5 lakh.
Firms are classified by their sizes as
cottage, tiny, small and large industries.
Cottage industry generally does not use
power and the plant is located in the house of
the artisan. Members of the family contribute
their labour in production. Number of workers
is less than nine. Production is for a limited local
market and local resources are used to produce.
Cottage industries constitute activities allied to
agriculture. Vocations suitable to rural and urban
needs are operated as cottage industries.
Units in which investment is up to Rs. 5
lakh are called tiny industries. Workers and
machines, both are used in tiny units. It is
necessary to promote tiny units in villages and
rural area. Tiny units are run as proprietorship
or partnership firms.
The units in which the investment limit is
Rs. 3 crore are considered as small industry.
Machines and human labour are used in small
units to produce for domestic and foreign
markets. Main products of this sector are
consumers’ goods, small machines, tools and
spares.
All other industries excluding the above
three categories are called large industry. Main
characteristics of large industries are large
machines, huge investment, large-scale output,
etc. Large industries can specialise. Different
functions of management can be assigned to
Managerial Economics : Nature and Concepts : 55
the specialists in their respective field. Since the
scale of output is large, cost of production is
low.
However, where the consumer choice and
convenience is more important, small units are
at advantage as compared to large industries.
2.6 Exercises
(1)
(2)
Explain the meaning of the concept
‘cottage industry’ and elaborate its
significance.
Explain the meanings of ‘tiny industry’ and
‘small industry’.
(3)
Write in detail about large industries.
2.7 Books for Further Reading
(1)
Kuchhal S. C. Industrial Economy of
India, Allahabad, Chaitanya Publishing
House, 1987
(2)
Mutalik Desai, Bhalerao, Bharatatil
Udyoganche Sanghtan Va Vitta
Vyavastha (Marathi) Pune, Nirali
Prakashan
(3)
Sahasrabuddhe S. G. Bharatachi
Audyogik Arthavyavastha.
Managerial Economics : Nature and Concepts : 56
Unit 2 (E) : Business Decisions
Index
2.0 Objectives
2.1 Introduction
2.2 Subject Description
2.2.1 Production Decisions
2.2.2 Financial Decisions
2.2.3 Personnel Decisions
2.2.4 Marketing Decisions
2.2.5 Expansion Decisions
to classify the decisions. When management of
a firm is distributed between various functions,
the process of decision-making has to be
decentralised among functional managers. A
decision may have many facets. Under the
circumstances, many alternative decisions might
be suggested, when the top management is
expected to coordinate the decisions. We are
going to study the types of decisions a firm has
to take. How a final decision is arrived at will
be studied in the further part of the course.
2.3 Answers to Questions for Self Study
2.4 Summary
2.2 Subject Description
2.5 Exercises
2.6 Books for Further Reading
2.2.1 Production Decisions
2.0 Objectives
After studying this unit, you will be able
to :
«
Explain the Production decisions of a firm.
«
Explain the Financial decisions of a firm.
«
Explain the Personnel decisions of a firm.
«
Explain the marketing decisions of a firm.
«
Explain the expansion decisions of a firm.
2.1 Introduction
We have already studied the nature of
decisions a firm has to take. We shall study in
this unit, the types of decisions and the decisions
under each of the type. A firm has to perform a
variety of functions and each of the functions
demand decision. If we look at a firm from
functional point of view, we shall be in a position
While running any firm, decisions need be
taken from time to time. This process starts from
the very idea of initiating a business. Whether
to close down an existing business is also a
decision. We shall classify such decisions and
shall get information about each of the decision.
Once the firm is established, first decision
required is about production. To begin with, what
to produce must be decided. Where to produce,
of which quality, which technique to be used,
how large should be the size of the firm is such
decisions, which must be taken in the beginning.
Decisions are to be taken on the basis of existing
conditions in the market and the position of
available resources. If the resources are scarce
the goods requiring more resources could not
be produced and the size of the firm has to be
kept small. Instead of most sophisticated
automatic machines, simple machines will have
to be used. Once the firm stats functioning,
production decisions are required from time to
time. Machines have a specific capacity but
production cannot be kept at full capacity level
all the times. Target of output is to be fixed for a
specific time period. Object behind the decision
Managerial Economics : Nature and Concepts : 57
of fixing the target is to find out profit maximising
level of output. Production plan has to be
prepared on the basis of current demand position
in the market. At times, production has to be
kept below the full capacity level and rarely;
production has to be stopped altogether. Some
times, production exceeds full capacity level,
however, this cannot be continued for a longer
period.
Furthermore, innovations in production
must be a continuous process. Research is
necessary for improving the quality of the
product, finding alternatives to the existing raw
material or changing the nature of product
according to changing demand conditions. Those
firms, which neglect research lag behind the
market and ultimately shut down. Indian textile,
sugar and jute industries have experienced this
situation. It is necessary for success of any
business to make sufficient provision for
research and development that helps to find ways
and means during difficulties. If a scarcity of
raw material is experienced, alternative raw
material can be used. Nature of the product has
to be changed from time to time so as to make it
more useful to the consumers. While doing so,
consumers’ choice must be accounted for.
2.2.2 Financial Decisions
Though the resources required by the firm
are in real terms, in a modern society, we can
get these in exchange of money. Sufficient
provision of finance has to be made at the time
of commencement of a business. After starting
of the business, finance is needed to continue
production process. In addition, careful planning
of the allocation of profit need be done. All such
decisions fall in the category of financial
decisions.
If a firm is a ‘company’, certain
preliminaries such as registration, obtaining
license, wherever necessary, are to be
completed. The promoters of the company
provide finance required for such works. The
company out of share capital pays these
preliminary expenses of the promoters.
Capital of the company is raised after
commencement of business of the company.
Owned capital is raised to meet expenses of
permanent nature to raise permanent assets of
the company such as land, buildings, plant and
machinery etc.
A decision on ‘how to raise required
finance’ is to be taken. Large firms can raise
funds through share capital, debentures and term
loans. These are the three major sources of
finance. How much capital to be raised from
each of these sources is a financial decision. If
it is decided to raise share capital, then the next
decision would be whether to sell in open market
directly or to appoint underwriters to assume
this responsibility or a direct sale to financial
institutions. Decisions also sought on when to
sell shares or debentures and what should be
the terms of sale.
After commencement of the business of
the firm, a number of financial decisions are
needed from time to time. Old pant and
machinery has to be replaced by purchasing new
one, modern sophisticated machines in place of
outdated machines, expansion of existing plants
are such cases involving financial decisions.
Many alternatives are available to raise finance
including the depreciation reserve and plough
back of profit.
Apart from long-term financial
requirements, firms also need finance to meet
expenses of recurring nature. Payment of
wages, electricity and water charges, transport
are some of the items of recurring expenditure.
Banks can arrange finance for working capital
requirements. Raw material can be purchased
on credit. In recent years, companies issue their
own deposits and issue commercial papers to
meet their current expenses. Proper estimation
of shot-term credit requirement is essential as
excess credit may add more to the cost of the
company and underestimate of credit may create
a hurdle in sooth production.
A decision as to how the profit be allocated
is also needed. It appears quite natural to
distribute entire profit among shareholders. But
considering the long-term gains, a different
distribution of profit can be justified. A part of
the profit can be set aside as reserve to meet
unforeseen contingencies. Expansion
programmes of the company can also be
financed out of reserves. Now, in place of cash
dividend, shareholders are issued bonus shares.
This adds to the real assets of the company as
Managerial Economics : Nature and Concepts : 58
well as of the shareholders. A part of the profit
is distributed amongst workers as bonus.
sufficient work. Excess work given to workers
adds to his fatigue. Inadequate work to some
workers adds to cost of the firm.
Questions for Self Study -1
Remunerating workers is an equally
important decision. How much to pay workers
in the form of wages and perks? Which facilities
are covered under perks? These are the
decisions, which the firms have to take. There
are certain statutory obligations on firms to pay
certain facilities to the workers such as; holidays,
leave, contributory provident fund, compensation
for disability by accident while on duty, provision
for canteen, dispensaries and hospitals. Firms
are bound by law to provide these facilities to
workers. Bonus is also to be paid and dearness
allowance has to be paid according to the cost
of living Index Number.
(A) State whether the following
û)
statements are true or false. Put (û
ü) in bracket.
or (ü
(1)
A firm has to take decisions from time to
time. ( )
(2)
It is not always possible for any firm to
take full capacity output all the times. ( )
(3)
Undertaking research is not needed for
improvement in the quality of product and
finding the sources of raw material. ( )
(4)
Share-capital, debentures and term loans
are the sources of financing a large
firm. ( )
(5)
Raising more loans than requirement is
beneficial for the firm. ( )
(6)
A decision on allocation of profit is a
financial decision. ( )
2.2.3 Personnel Decisions
Worker is one of the most important
factors. Being a live factor, he has to be treated
well to induce him to work. All types of
employees are paid workers of the firm. In order
to create in them interest in firm’s work they
must be properly awarded.
What should be the proportion of different
types of workers in a firm, how should they be
recruited, how should the work be distributed
among them are the decisions to be taken in the
beginning. Managerial staff, technocrats, skilled,
semi-skilled and unskilled workers are the types
of workers a firm has to employ. Proportion of
workers required depends on the size of output.
As far as possible, local workers are preferable.
If workers of desired knowledge and skill are
not locally available, applications from a wider
area are invited by issuing an advertisement.
Among the unskilled workers, some are
permanent and remaining workers are seasonal.
As and when, there is a temporary need to
increase production or a number of existing
workers are on leave, then temporary workers
are employed. Work has to be distributed among
workers in such a way that each worker has a
Most important issue with reference to
workers is that of industrial relationship; the
relationship between the trade union and the
management. If reasonable demand of workers
are accepted are creative suggestions of
workers are duly acknowledged, peaceful
industrial relations are possible. There can be
no adjustment with regard to discipline among
workers. Stringent action is necessary against
undisciplined workers. Workers must be asked
to follow the rules of discipline failing which;
they shall be subject to legal action.
One more decision regarding personnel is
whether to employ fresh workers to increase
the production or the existing workers to be
asked to work for more time. If increase in the
demand is temporary, existing workers can be
given over time. If increase in demand is
expected to persist for longer time, it is advisable
to hire additional labour. In such cases, plant is
also expanded.
In addition to major decisions mentioned
above, a number of routine decisions about
personnel are to be taken every day. Some
personal problems of the workers crop up, to be
settled instantly. Promotions, termination,
punishing for misbehaviors and the like decisions
management has to take. Larger the number of
workers more would be the personnel problems.
A personnel manager is appointed to look after
all the matters relating to personnel. An
independent department of Personnel
Management is set up with some assistants to
help the manager. A Labour Welfare Officer in
Managerial Economics : Nature and Concepts : 59
small firms performs same function. Managers
take all spot decisions within the policy frame
prescribed by the top management. Board of
Directors frames the policy.
2.2.4 Marketing Decisions
Once the output is ready, next task is to
find market and see that the product is sold at a
profitable price. Firm enters market as a seller
when it sells final goods and as a buyer when it
purchased inputs from other firms. Both the
functions are demanding decisions.
In case of sales, where to sell and how
much in each of the market has to be decided.
Selling nearby reduces the cost of transport.
Selling at a single point makes provision for
supply easy. However, there is a danger of
selling at a single point. In case, that market
lacks demand, firm has to suffer heavy loss.
A decision whether to sell directly to the
market or selling agents be appointed is also
needed. If the product to be sold is in large
quantity and the selling points are few, it is
advisable for the firm to sell directly. A
combination of direct sales where the quantities
demanded is large and at all other placed, through
sales agents can also be adopted.
Where the firm is at liberty to change price,
pricing decision is needed. Similarly, whether the
price once decided be kept intact or be changed
from time to time is also need be decided.
Sales promotion has assumed much
importance now a day. To emphasise the
importance of the product in the mind of the
customer by any media is sales promotion. It
includes giving attractive name to the article, to
advertise the product on various media. In
addition, door-to-door sales are also a
promotional strategy. Initially selling the product
at a low price, offer free gifts along with the
product giving demonstration of the product use
are some ideas of sales promotion. How much
to spend on sales promotion and how much on
each of the media is a further decision regarding
promotion. Whether to prepare the advertise in
house or to get it done through an advertising
agency, when to declare free gifts or reduced
price are the decisions required with reference
to sales.
Firm may also have to take decisions on
supply side. Firm has to make purchases of raw
materials, semi-finished goods, fuel and spares
The sources of these supplies have to be
decided. How much and at what time to
purchase are crucial decisions. Marketing
department arranges both, purchases and sales.
In much larger companies, purchase department
has an independent identity. Elementary study
before arriving any decision is done by the
concerned department and recommendations
are forwarded to the Board of Directors that
takes final decisions.
Questions for Self Study - 2
(A) State whether the following
û)
statements are true or false. Put (û
ü) in bracket.
or (ü
(1)
Worker is as live factor and hence he must
be given proper treatment. ( )
(2)
It is necessary for the management to have
cordial relationship with the trade unions
with a view to achieve rise in
production. ( )
(3)
Any management has to adjust with the
workers discipline and it is proper also. ( )
(4)
Marketing decisions include boosting of
sales and obtaining viable price to the
product. ( )
(5)
Promotion is most essential for boosting
sales. ( )
2.2.5 Expansion Decisions
At an initial stage of the business, size of
the plant and firm is kept small because of
resources constraint. Once the firm takes off
and becomes successful, it can grow with
retained profits and other sources of funds.
Expansion programme can be planned
accordingly. Decisions are taken from time to
time regarding timing, direction and sources of
expansion.
One of the ways of expansion is to expand
the size of existing output. Same machinery that
was purchased earlier is added to increase
production. Another option available is to replace
old machines by more sophisticated new
machines. Many times, existing plant is retained
as it is and new plant is located at a new location.
Managerial Economics : Nature and Concepts : 60
In latter case, a new center is developed that
opens new market for the product.
(3)
Consumers’ choices and demand for a
product do not change over time. ( )
Expansion is carried out with new product
is another way. Consumer choices change over
time. Old products are thrown out of market
under the impact of new products. Firms always
prefer products that are in good demand. As far
as possible, the existing machinery is utilised to
produce new products or alternatively, plant is
expanded or a new plant is set up. A firm can
expand with multi-products and multi-plants.
TATA group of industries started with Iron and
Steel but later on expanded in textile, soap,
engines, Air Ways, Investment Company and
host of other products.
(4)
It is better that two large firms must
compete with each other. ( )
(5)
Mergers protect the interests of a small
firm. ( )
Some times, a firm takes over another firm
to expand its business. A single individual handles
small firms. If there is no one else to look after
the affairs of such business, firm lags behind. It
is advisable for such small firm to get merged
into a large firm. Large firms with ample
resources can allow such merger with an
objective of expansion. Two large companies
agree to amalgamate into each other as a single
identity with a view to avoid competition. It is
true that when two firms with uneven economic
power merge or amalgamate, the rich firm gain
more because of its strong bargaining power.
(A) (1) (ü),
(4) (ü),
(2) (ü),
(5) (û),
(3) (û),
(6) (ü).
How to raise funds for expansions
programme is also a decision to be taken. There
are four alternative sources; ask the shareholders
to contribute additional share capital, use reserve
funds, issue new debentures and obtain loans
from financial institutions. After a cost-benefit
analysis of all these sources, the alternative giving
highest return (low cost of financing) must be
decided. Similarly a timetable of raising funds
shall also have to be prepared.
Questions for Self Study - 3
(A) State whether the following
û)
statements are true or false. Put (û
ü) in bracket.
or (ü
(1)
A firm must retain its size and scope of
work within the limits of its resources. ( )
(2)
One of the ways of expansion of capacity
is to increase output of a single product
and improve the market share in the same
product. ( )
2.3 Answers to Questions for
Self Study
Questions for Self Study - 1
Questions for Self Study - 2
(A) (1) (ü),
(4) (ü),
(2) (ü),
(5) (ü).
(3) (û),
Questions for Self Study - 3
(A) (1) (ü),
(4) (û),
(2) (ü),
(5) (ü).
(3) (û),
2.4 Summary
A business firm has to take decisions from
time to time. Decisions are to be taken on various
issues such as what to produce, where to
produce, which technique of production to use.
Similarly a production target has to be fixed for
a specific period of time with a view to earn
profit. Nature of product has to be changed to
withstand market competition and nature of
demand for the product. Research is essentially
undertaken for the purpose.
From where to bring the capital required
for business is a financial decision a firm has to
take. Various sources of owned and borrowed
Managerial Economics : Nature and Concepts : 61
funds are available. Which of the sources to
use is also an important decision a firm must
take? Distribution of profit is also a financial
decision.
Labour is a live factor in the process of
production. At work place the worker has to be
treated well. Management has to take a number
of personnel decisions such as recruitment,
wages, holidays and other perks. It is essential
that the industrial relations must be peaceful.
Workers’ participation in management and
maintenance of discipline by workers is essential.
Once the output is ready, decisions
regarding marketing of the product need be
taken. Sales promotion efforts through
advertising and other media are required.
Customers are to be attracted through different
plans.
Initial size of the firm and the size after
years of successful working of the firm differ.
Firms have to decide on expansion plans. Existing
size of output and market share must increase
over time. Expansion plans include
modernization, undertaking new products,
merger in a big firm or amalgamation with a
firm of equal strength are some of the ways of
executing expansion plans open to a firm.
Decisions are also sought on financing of the
expansion plans.
2.5 Exercises
(1)
Describe the production decisions of a firm.
(2)
Write in brief various sources of financing
a firm.
(3)
What are the promotional measures to
boost sale of a product?
(4)
What are the various ways of expansion
of a firm?
2.6 Books for Further Reading
(1)
Dewett, K. K. and Adarsh Chand,
Modern Economic Theory, Shyamlal
Charitable Trust, New Delhi
(2)
Mahajan Mukund, Purvathyacha
Abhyass (Marathi), Book No. 4,
Y.C.M.O.U. Macro Economics ECO-261,
Book No. 4, Publisher, Registrar,
Y.C.M.O.U., Nashik
Managerial Economics : Nature and Concepts : 62
Unit 3 : Concept of Demand
Index
« Explain the various sources of demand.
3.0 Objectives
« Explain the aggregative concepts with
regard to demand.
3.1 Introduction
3.2 Subject Description
3.2.1 Importance of Demand Analysis
3.2.2 Concept of Demand
3.2.3 Specification of Demand
3.2.4 Demand Function and Demand
Curve
3.2.5 Changes in Demand
3.2.6 Types of Demand
3.2.7 Demand for Product
3.2.8 Sources of Demand
3.2.9 Aggregative Concepts of Demand
3.3 Words and their Meanings
3.4 Answers to Questions for Self Study
3.5 Summary
3.6 Exercises
3.7 Field Work
3.8 Books for Further Reading
3.0 Objectives
After studying this unit, you will be able
to :
« Tell the importance of demand analysis
« Explain the concept of demand
« Explain the Demand Function
« Explain the Theory of Demand.
« Explain the concepts of expansion and
contraction of demand and increase and
decrease in demand.
« Explain the types of demand.
« Explain the nature of demand according
to market structure.
3.1 Introduction
Demand is one of the variables in
economic decisions. Demand tells us about size
and types of markets. Business activity is always
determined in market. Investment of an investor
in a particular sector is limited by the size of
market. If the overall market situation is
favourable to profitability, firm decides to start
manufacturing. Raw material is transformed into
finished goods in the process of production.
Finished goods then are sold into market. Firm
receives revenue when product is sold.
Expenditure on inputs to be used in production
has to be incurred. It is called ‘cost.’ The
difference between revenue and cost is either
profit or loss. When revenue is greater than cost,
there is a profit. When revenue is less than cost,
firm suffers a loss. Profit depends on the
conditions of demand for and supply of inputs
and output. Main objective of the firm is to make
profit. Various demand concepts are very
important in managerial decision- making.
We shall understand in this unit, the basic
concept of demand; in which we shall come to
know what is ‘demand’, what the demand
theory states, and why does the demand
changes. Next, we shall study the types of
demand and the nature of demand from various
angles. At the end, we shall get information as
to how the nature of demand changes according
to the types of markets. We have considered so
far, the demand of an individual or a group of
individuals. It is also necessary to think over the
aggregate demand of an economy as a whole.
Managerial Economics : Nature and Concepts : 63
3.2 Subject Description
3.2.1 Importance of Demand
Analysis
Demand is a very important factor for
running of an enterprise and its survival and
growth. Demand is almost important in
managing an enterprise. Production is
undertaken for sale in the market. Society needs
a number of goods for consumption and the
demand is generated out of these needs.
Demand of the society is the driving force behind
production. Consumption is, therefore, the cause
of production. It is the beginning as well as end
of any economic activity. An enterprise has
updated information about the demand for any
product on the basis of which, the firm plans
production. Business cycle is a common feature
of a capitalist economy. Demand increases
during boom and decreases during depression.
An enterprise has to forecast demand and has
to frame production policies. Techniques and
strategies of sales has to be determined taking
into account the nature of competition in the
market, demand for the product and possible
fluctuations therein. Production has to be
increased or decreased, depending upon market
demand conditions.
In brief, demand analysis is very much
important in production decisions of a firm. Each
firm has to plan in different ways; such as
product planning, inventory planning, cost
planning, input planning, profit planning etc.
Demand is of immense importance and deciding
factor in all such types of planning. We must
remember that all business decisions of a firm
are mainly dependent upon demand for the
product.
Demand analysis helps clearing a number
of things. The extent of demand for a firm’s
product can be known and also the factors
determining the demand can be understood. An
appropriate demand analysis helps in
understanding alternative methods of demand
creation, control and management. Right
decisions can be derived from the available
alternatives.
3.2.2 Concept of Demand
The concept of demand is very important
in an economy. Man needs an innumerable
goods and services in his daily routine life. That
creates ‘demand’. Now let us go for the precise
meaning of the term ‘demand’.
Human desire and the demand are
different. Desire to have a particular commodity
means mere desire. Even a poorest person may
desire to have a car, a furnished bungalow and
a host of luxurious items. However, rarely such
desires transform into demand. Desire backed
by willingness to buy and ability to pay only can
be transformed into demand. If a desire is not
associated with economic power, it will not be
transformed into demand. Therefore,
Demand for a product means desire of
a buyer backed by willingness to purchase
at a specific price and for specific time
period, backed by economic power to buy
it.
From the above statement, following are
the elements of demand:
(1)
Desire to purchase goods.
(2)
Sufficient purchasing power to back the
purchases.
(3)
Knowledge about the price of the goods.
(4)
Quantity demanded with reference to
price.
When all the four elements are present,
then only we can call it a demand. Absence of
any one element would convert it into mere
desire and not the demand. For example, a poor
person has a desire to purchase a good house
but no money to buy it, will not be a ‘demand’ in
economic sense. On the contrary, a rich but miser
person may have ample money to buy a house
but no willingness to buy, then, his desire will
not be transformed into demand.
In short, when there is a willingness
supported by sufficient money power to buy a
commodity, we can say that there is a demand
for that commodity. When a person demands a
product, it becomes a statement of demand that
includes price, quantity to be purchased and the
time period for which demand is made.
Managerial Economics : Nature and Concepts : 64
Demand for a particular commodity
means the quantity of a commodity the
buyer is willing to purchase at a price for
a specific time period.
Suppose, a person X is ready to buy today
20 kg. Sugar at a price of Rs. 10/- per kg., for a
month. This is his demand for sugar. Like an
individual’s demand, there will be a market
demand for sugar in which all the buyers of Sugar
in the market are included. Suppose, in Nagpur
market today, such demand is 2-lakh kg sugar, it
will be market demand for sugar.
A statement of demand must contain(1)
Price of the commodity.
(2)
Quantity demanded, and
(3)
The market and the time period
If any one of the elements is missing, the
statement of demand would be incomplete.
Suppose, a statement like ‘ There is a demand
for Bajaj Scooter at a price of Rs. 20,000’ is an
incomplete statement, because there is no
mention of quantity demanded and the time
period of demand. Similarly, “500 scooters are
demanded in Nagpur city” is also not a statement
of demand as there is no mention of price as
well as of time period. Again “Demand for
scooters is 500 at a price of Rs. 20,000” is also
not a statement of demand because a reference
of time period and market is missing. A complete
statement of demand would be “ Today, the
demand for Bajaj Scooters in Nagpur market is
500 per month at a price of Rs.20, 000.”
Questions for Self Study - 1
(A) State whether the following
û)
statements are true or false. Put (û
ü) in bracket.
or (ü
(1)
Mere desire to have a commodity in itself
is the demand. ( )
(2)
Possession of a sufficient purchasing
power to buy a commodity is demand. ( )
(3)
Demand should be associated with price,
quantity, time period and the market. ( )
(4)
‘Ten bananas at Rs. 5’ is a statement of
demand. ( )
(B) State with reasons, whether following
could be the statements of demand.
(1)
Air India has to buy ten airplanes.
(2)
TATA Iron and Steel Company shall
employ workers on a monthly wage of Rs.
3, 000.
3.2.3 Specification of Demand
Why does an individual demand a product
is a question. He needs the commodity for
consumption and therefore he demands it.
Consumption is, thus, reason behind demand.
Consumption leads to creation of demand. A
commodity, from economic point of view means
is source of satisfying human want. A
commodity possesses utility. Utility means
human want satisfying power of a commodity.
So long as a commodity has no want satisfying
power, no person shall value it. We pay a good
price for quality mango, but no one shall buy a
spoiled mango even at zero price. This is because
good mango possesses utility whereas the spoiled
mango does not. Consumption of good mango
satisfies his want. In brief, only those
commodities are bought that possess utility and
therefore demanded.
Consumption is the process of using a
commodity. Whenever an individual consumes
a commodity, two things happen: As one goes
on consuming a commodity, utility contained
therein decreases. At the same time, the person
who consumes it, goes on adding to his
satisfaction. During the process of consumption,
utility derived goes on diminishing until it reaches
zero. Human want goes on satisfying. Man has
to sacrifice for gaining satisfaction. He has to
spend money on consumption. Under the
circumstances, every individual has to strike a
balance between the satisfaction derived from
consumption and sacrifice by spending money
on consumer goods.
A person buys a mango at a price of Re.
1/-. He gets satisfaction from consumption of
mango. This satisfaction is nothing but the utility
derived from consumption of mango. Re. Spent
on buying a mango is the sacrifice he undergoes
for consumption of mango.
Intensity of demand is expressed through
price. A person would be willing to pay more if
the intensity of demand is more. We are ready
Managerial Economics : Nature and Concepts : 65
to pay a price because of the utility in the
commodity. Food grains, clothing, houses,
medicine, auto-vehicles etc. possess utility. Food
grains satisfy human hunger, clothing protects
us from cold weather and houses protect us
from rains, sun and chilling cold weather.
Medicines protect us from deceases, Vehicles
save our time and energy in traveling longer
distances. Each of these commodities possesses
ability to satisfy human wants. We call it utility.
More the utility of a commodity, higher would
be the price a consumer is willing to pay. Lesser
the utility, lower would be the price of that
commodity. ‘‘Scarcity” is another important
factor in addition to utility. Greater the scarcity
of a commodity higher would be the price and
vice-versa. Prices of iron, silver and gold differ
greatly because of the difference in the degree
of their scarcities. Silver is more scarce than
iron and gold is more scarce than silver.
The mathematical relationship of all these
factors with demand is called Demand Function.
In simple words, demand for any commodity
depends upon all these factors.
Effects of these factors on demand can
briefly be explained as under:
(1)
Demand for a commodity changes
inversely with a change in price. That
means, when price of a commodity
increases, its demand falls and when price
falls, demand increases. This is ‘demandprice relationship’
(2)
When prices of substitute products or
complementary products change, demand
for the commodity under study does not
remain unaffected. Suppose, X and Y are
two substitute commodities. If price of Y
increases, it leads to increase in the demand
for X. Sugar and Gur satisfy the same
want. When price of Sugar increases,
people would naturally buy more of Gur
and less of Sugar.
In general, we find that demand changes
with a change in price. Demand is relative to
price. However, this does not mean that demand
for a commodity depends only on price. There
are other factors also affecting demand for a
commodity. For example, income of the
consumer, his/her choices, fashion, habits
customs and usages etc. also affect demand.
3.2.4 Demand Function and
Demand Curve
Now suppose that X and Y are
complementarities. A car and petrol, or pen
and paper etc. If price of X increases, not
only the demand for X would fall but the
demand for Y also will fall. A hike in petrol
price leads to fall in the demand for cars
as well.
(3)
Demand for a product is sensitive to
consumers’ expectations about future
prices. If consumers feel that price is
expected to rise in future, their current
purchases of product are likely to increase.
Suppose, sugar price is Rs. 13/- per Kg.
today but it is expected to increase up to
Rs. 14 shortly. People would buy more
today to avoid future price rise. On the
contrary, if prices were expected to fall in
near future, people would postpone their
current purchases. Their current demand
would fall.
(4)
Consumer’s income is one more factor
influencing demand. Income expresses
economic status of the consumer.
Whenever income of the consumers
increases, demand for ‘normal goods’
increase and that of ‘inferior goods’
decrease. Converse is true when income
decreases. This is called ‘Income effect’.
Demand function is a concept that takes
into account the factors determining demand. It
studies the factors influencing the demand for a
product. These factors are given in a flow-chart
below:
Price of the Commodity
Consumer’s income
Tests & preferences of the
consumer
Prices of substitutes
Prices of complementary
goods
Population
Future expectations about
prices
Government Policies
Advertisements
Other factors
D
E
M
A
N
D
Managerial Economics : Nature and Concepts : 66
(5)
(6)
(7)
Demand also depends on consumers past
income, his total saving, future expected
income etc. Holding of ‘real wealth’ by
an individual also affects his demand. This
is called ‘real income effect’.
Advertising influences demand for a
commodity. Advertising boost demand for
a firm’s product up to a limit. This is called
‘promotional effect’. After a limit,
however, advertising becomes ineffective.
Consumers tests and preferences do
influence their demand for a product.
Apart from this effect, customs and usages
of a society also affect demand. Such
socio-cultural factors affecting demand
create hurdles in forming a scientific theory
of demand. These factors are known as
‘non-economic’ or ‘factors ‘beyond
market’. These factors are very uncertain.
Some times, an individual expresses his
preference or choice, at times; he
expresses his order of preference.
It will be clear from the above analysis
that the factors determining demand are
numerous. All such factors are considered in
‘demand function’. On the contrary, when we
think of a demand curve, only the relationship
between the price and quantity demanded is
taken into account, assuming other factors to
remain unchanged. A table showing prices and
quantity demanded at each of the prices is
necessary to draw a demand curve. We can
easily draw a demand curve when a demand
schedule (table) is given.
In brief, demand function is a multi-variant
function that takes into account a number of
factors determining demand. As against this,
while drawing a demand curve, we consider
price as a single variable determining demand.
We consider price as a single variable that
affects demand. Demand function is, therefore
called a single variable function.
Le us now consider demand curve.
Suppose a consumer demands sugar. His
demand for sugar decreases with every increase
in price and decreases with every increase in
price. It is called ‘Law of Demand’. We must
remember that this law is true only under given
conditions. Our assumption here is that demand
for sugar depends only on price of sugar. This is
shown in the demand schedule given in table
3.1 below
Table 3.1: Demand Schedule for Sugar
Price of sugar
(Rs. per kg.)
Quantity of sugar
demanded (kg.)
10
10
12
8
14
6
16
4
18
2
Table 3.1 clearly shows that the quantity
of sugar demanded decreases as the price of
sugar increases and the quantity demanded
increases as the price of sugar falls. Here, the
demand is related only to price. This means
demand is assumed to be the function of price.
We can draw a diagram on the basis of above
demand schedule.
Y
22
20
18
Price (Rs.)
It is observed some times that a change in
demand does not occur merely by a change
in absolute income of a consumer. Change
in one consumers demand takes place in
the relative income and consumption habits
of his neighbour. Impact of neighbour’s
consumption spreads over others. This is
called ‘demonstration effect’.
16
14
12
10
8
6
4
2
A
X
2
4
6
8
10
12
Demand for Sugar (kg.)
Figure 3.1 : Demand Curve
In figure 3.1, quantity of sugar demanded
is measured along OX axis and price in
measured along OY axis. DD is the demand
curve sloping down to the right. Since there is
Managerial Economics : Nature and Concepts : 67
an inverse relationship between prices, the DD
curve slopes downwards. In brief, quantity
demanded changes inversely with every change
in price. The demand curve shows inverse
relationship between price and quantity
demanded and that the demand is solely the
function of price.
Questions for Self Study - 2
(A) Write brief answers to the following
questions.
(1)
What is Utility?
(2)
What do you mean by ‘consumption’?
(3)
Which two main things take place in the
process of consumption?
(4)
What is a ‘demand function?
(5)
What is a ‘demonstration effect’?
(6)
On which factors, demand for a
commodity depends?
(7)
What type of relationship is there between
price of a commodity and its demand?
(8)
What is the nature of demand curve for a
product?
complementary goods, tests of the consumers,
fashion etc. change that affects demand. When
demand changes, not because of change in price
of the commodity concerned but because of
changes in ‘other things’, it is called increase’
or ‘decrease’ in demand. Demand may increase
even through the price is constant on account
of increase in population or income of the people.
Converse will be true when population and/or
income of the people decrease.
When demand increases, the consumer
shall not move the given demand curve, but shall
shift to anew demand curve to the right or
upwards. In case there is a decrease in demand,
the consumer shall shift on a new demand curve
that falls below or to the left of original demand
curve. We shall now explain these concepts with
the help of appropriate diagrams.
Expansion and contraction of demand is
shown in figure 3.2
Y
D
Price (Rs.)
n
Many times, price of a commodity is
constant but other things such as population,
consumers’ income, prices of substitute or
io
ns
When demand increases only on account
of decrease in price, “other things remaining
unchanged, it is called ‘expansion of demand’.
On the other hand, when demand reduces only
on account of rise in the price, other things
remaining unchanged, it is called ‘contraction
of demand’. Both the concepts can be made
clear with the help of a single demand curve.
See figure 3.1. Movement of the consumer along
the given demand curve from 2 units to 4 units
when price decreases from Rs. 18 to Rs. 16 is
an expansion of demand. On the contrary,
movement of a consumer from 4 units to 2 units
on account of rise in price from Rs. 16 to Rs. 18
is the contraction of demand.
pa
Contraction of demand.
P
Ex
(2)
n
io
Expansion of Demand and
t
ac
(1)
tr
Two concepts are important in the Law of
Demand.
on
3.2.5 Changes in Demand
C
P2
P1
D1
0
X
Q2
Q
Q1
Demand
Figure 3.2 : Expansion and Contraction of Demand
We have measured units of commodity X
along the horizontal axis OX and the price of X
along vertical axis OY. DD is the demand curve.
At a price OP, quantity of X demanded is OQ.
When price decreases from P to P1, demands
from OQ to OQ1, a net addition of Q-Q1 in
quantity demanded.
On the contrary, if price increases from
OQ to OQ2, demand contracts from OQ to OQ2.
An increase in price by PP2 leads to contraction
of demand by QQ2.
The concept of increase in demand is made
clear in figure 3.3.
Managerial Economics : Nature and Concepts : 68
DD is the original demand curve. Demand
is OQ when price was OP. Now, due to change
in ‘other things’, (say, rise in the income) people
would demand larger quantities, ‘OQ’ at original
price OP or would be willing to pay higher price,
‘OP’ for buying the same quantity, OQ. At
original price OP, net addition to quantity
demanded would be QQ’.
Y
D1
Price (Rs.)
D
P1
P
D1
D
0
X
Q1
Q
Demand
Figure 3.3 : Increase in demand
Horizontal distance between the original
demand curve DD and the new demand curve
D1D1 show increase in demand at a given price
or for purchase of the same quantity as before,
consumer is prepared to pay a higher price OP1
as against OP before increase in demand.
Price (Rs.)
Y
along OX and OY axes respectively. DD is the
original demand curve. OQ quantity of X is
demanded when price was OP. Demand
decreases due to change in ‘other things’,
thereby new demand curve D 1 D 1 shifts
downwards to the right of the original demand
curve DD. Quantity demanded decreases to
OQ1. There is a net decrease in demand by QQ 1 when price remains unchanged. If the
consumer is willing to buy the same quantity
OQ now, he shall be prepared to pay a lower
price OP’
You must have understood by now from
the foregoing analysis that the concepts
expansion and contraction of demand and
increase and decrease in demand are basically
different. This difference is very much important
in demand analysis. Former concepts tell us the
impact of change in the price of the commodity
concerned on its demand, assuming other things
to remain unchanged. Latter concepts tell us
the impact of changes in the other conditions or
the ‘other things’ on the demand for a commodity,
assuming the price of that commodity remain
unchanged.
When a rise or fall in the price of one
commodity affects the demand for another
commodity, we can guess that the other
commodity must be a substitute to first
commodity or a complementary to first
commodity. When a fall in the price of X leads
to fall in the demand for Y, X and Y must be
substitutes of each other. On the contrary, when
price of Y falls, demand for X increases, we
can infer that Y and X are complementary
goods.
D
Questions for Self Study - 3
D1
(A) State whether the following
û)
statements are true or false. Put (û
ü) in bracket.
or (ü
P
P1
D
D1
0
X
Q
Q1
Demand
(1)
(2)
(3)
Figure 3.4 : Decrease in demand
The concept of decrease in demand is
presented graphically in figure 3.4. Quantity
demanded and price are measured, as usual,
(4)
Demand for any commodity merely
depends on its price. ( )
Demand curve slopes downwards from
left to right. ( )
When demand increases due to fall in the
price of the commodity, it is called
‘increase’ in demand
When demand decreases, demand curve
shifts upwards. ( )
Managerial Economics : Nature and Concepts : 69
(5)
Power of a commodity to satisfy human
want means utility. ( )
(6)
Each individual attempts to strike a balance
between the satisfaction derived from
consumption and sacrifice involved in
obtaining the commodity. ( )
3.2.6 Types of Demand
We have already studied the concept of
demand, demand function, demand schedule and
demand curve. Nature and types of demand and
decisive factors have special significance in
determining demand for a product. We shall
discuss in this unit in detail, the types of
demand.
(1) Direct Demand and Derived
Demand
A commodity in a finished stage of
production is supposed to be ready for
consumption. Consumption goods have direct
demand. Food grains, clothing, house, medicine
etc. are final consumption goods having direct
demand. Generally, consumers demand such
goods.
Those commodities used in the process
of production as input are in derived demand.
Plant and machinery, raw material, tools, energy,
labour etc. are the examples of inputs. Demand
for these inputs is derived because they are not
required for direct consumption but because they
help production of those goods required for direct
consumption. Consumers demand consumers’
goods such as food grains, clothing medicines
and auto vehicles. Producers try to satisfy these
consumption needs. Producers demand factor
services and other inputs to produce consumers’
goods in direct demand. Therefore, demand for
such inputs is a derived demand.
It is difficult to classify goods into
consumers’ goods and producers’ goods simply
by the nature of product. Such classification
depends on the uses to which the product is
utilized. A household purchases a car and uses
it for family enjoyment. It will be a consumer
good. On the other hand, if the same car is used
as a taxi, it will be a business asset or a producer’s
good. Suppose, a farmer purchases 10 quintals
of wheat, keeps 9 quintals for domestic
consumption and set aside 1 quintal as seeds
for the next season. Wheat is distributed
between consumer good, 9 quintals and capital
good 1 quintal. Demand for consumers’ goods
depend on income of the consumers as against
this demand for capital goods depends upon the
volume of output of consumers’ goods and the
state of technical know-how.
(2) Domestic and Industrial
Demand
We demand a number of goods for
domestic consumption; such as fans, coolers,
radio, TV, freeze etc. Demand for such products
is called domestic demand. On the contrary, the
goods required in industrial production such as
electricity, water, coal, machinery human
resource etc. are classified as goods in industrial
demand.
(3) Autonomous and Induced Demand
Demand for some commodities is
autonomous whereas for some other
commodities, it is induced.
When a commodity is finally ready for
consumption, demand for such
commodities is called Autonomous
Demand.
This type of demand does not depend upon
the demand for other goods. However, in real
world today, such a good is rarely found. Every
person needs a number of goods or a group of
goods simultaneously. Even then, any commodity
in direct demand is broadly classified as a good
in autonomous demand.
When the demand for a commodity
depends on or related to demand of other
commodity, it is called a commodity in
‘derived demand’.
In general, demand for producers’ goods
is ‘derived demand’. If the related commodities
are substitutes, then a change in the demand for
one commodity affects the demand for the
substitute product as well. Similar to substitute
products, demand for complementary goods too
is interdependent. Change in the price of one
commodity induces demand for another
commodity. In this sense, demand for substitute
Managerial Economics : Nature and Concepts : 70
goods and complementary goods can be a good
example of derived demand. We can broadly
say that the demand for house by an individual
is autonomous but the demand for building
material required such as cement, steel, sand,
bricks etc. is ‘derived demand’
(4) Demand for perishable and
durable goods
Goods are classified according to their
durability. Some goods are perishable and some
others are durable. Perishable goods are those,
which can be used only once. Food, vegetables,
milk, fruits etc. are examples of perishable goods
Durable goods, on the other hand can be
repeatedly used. Clothing, house, TV and Freeze
etc. are the examples of consumer durables.
Perishable goods satisfy only current
demand. Durable goods satisfy not only the
current needs but also satisfy future needs.
Perishable goods are consumed at a particular
point of time. On the contrary, durable goods
could be consumed over a longer period of time.
Purchases of durables add to the asset holding
of the owner. Durables such as house, furniture,
and vehicles machinery can be repeatedly used
and hence get depreciated over time. These
durables are required to be replaced after their
working life is over. There are two elements in
the consumption of durables; replacement of old
durables and adding new durables to the existing
stock. Demand for durable goods is influenced
by future expectations about prices, business
conditions etc. and therefore, it is likely to
fluctuate more.
Generally, when a new durable asset is
purchased to replace old and obsolete
asset, it is a replacement demand.
Such type of demand is associated with
depreciation cost of fixed assets. Demand for
spares is, of course, a replacement demand.
However, an addition of a computer to office
equipment is a new demand. A machine stops
working for want of spares. The demand for
spares in this case would be a replacement
demand. Replacement of a most sophisticated
modern machine in place of old is a new demand
because the type of new machine is altogether
different from the old one. Replacement demand
depends on the size and quality of stock of capital
assets. New demand, on the contrary, is
autonomous.
(6) Demand for Final Goods and
Intermediate Goods.
This type of demand depends on the
nature of the commodity. Type of demand is
determined on the basis of the type of the
commodity. Food grains, clothing, TV, Freeze
etc. are final goods that consumers demand.
Some intermediate goods are required to
produce final goods. For example, cotton is
demanded to produce cloth. Steel, cement, and
wood are required to construct a house. Such
goods are called ‘intermediate goods’, used in
production of final goods. Demand for
intermediate products is derived, because it
arises out of demand for final goods. The
classification demand for final and intermediate
goods is used in input-output analysis.
(5) New and Replacement Demand
When commodities are purchased with
a view to make an addition to existing
stock, it is ‘New Demand’
Suppose, affirm needs 10 additional
machines to expand the business, it will be ‘new
demand’ of the firm. If, on the other hand, 10
machines are required to replace old worn out
machines, it will be a replacement demand
because there will be no addition to existing
machines after purchase. We can simplify the
meaning of ‘replacement’ –
(7) Individual Demand and Market
Demand
Individual demand is by an individual and
market demand is the aggregate of all individuals
demand in the market. Different individuals
record their demand in the market. Age, sex,
income and tests of each individual are different.
Therefore, demand from all the individuals is
likely to differ. Their reactions to price change
may also be different. If current price of the
commodity is very high, a poor consumer may
not demand at all. A rich person would reduce
the quantity demanded by a small number.
Managerial Economics : Nature and Concepts : 71
Suppose, there are three consumers in a market;
A, B, and C and they are from the categories of
rich, middle class and poor respectively.
Individual demand for commodity X by all the
three consumers and the market demand for X
are shown in table 3.2 below:
Table 3.2 : Individual and Market demand
Price of X
Individual demand
Market
Rs. Per unit
A
B
C
Demand
10
20
0
0
20
8
40
20
0
60
6
50
40
10
100
5
70
60
30
160
Individual and market demand for a
commodity necessarily behave according to the
law of demand. We shall, however, find a
difference in individual demand because
economic condition of each individual is different.
For example, when the price is Rs. 10/-, only A
can demand the commodity. As against this,
when the price is Rs. 5/-, every consumer buys
X but within each one’s ability to pay. Firms,
therefore have to think of individual and market
demand for commodities.
(8) Aggregate Market Demand and
Market Segment Demand
Aggregate demand from all the
consumers in a market is called market
demand for a product.
However, there are different segments in
a market. Demand from each of the market
segment is a component of market demand. If
we consider aggregate demand for readymade
garments in India, it will be a total market
demand. Instead, if we separate the demand
for male garments for men women and children,
it will be demand from each of the segment.
We have a national market for food grains when
we think of India as a whole. Indian grain market
has state-wise market segments such as
Maharashtra, Gujrat, MP, UP, etc. Indian Maruti
car has a worldwide market today. By the size
of market, we can call it a global market with a
number of segments by countries. In brief,
market demand is a much wider concept than
the market segment demand because it
constitutes just a part of market demand. Firms
follow different marketing strategies for
different market segments because economic
ability, tests and preferences, fashions, utility of
the product differs from segment to segment.
Consumers in different segment are prepared
to pay different prices for an identical product.
Market segmentation may have different bases;
such as domestic and foreign markets, rural and
urban market, wholesale and retail market,
market for rich and for poor and so on.
(9) Short Run and Long Run
Demand
Classification of demand can also be based
on time period. Element of time is very much
important in demand analysis. Depending up on
time period, demand is classified as short-term
demand and long-term demand. Short-term
demand is concerned with current demand. This
type of demand is influenced by tests and
preferences of the consumers and available
technology. In the long run, tests of the people
and technology may change, quality of the
product may improve, scale of output may
change and production can adjust with changing
demand conditions. Deciding factors in shortterm demand are change in the price and
fluctuations in the income level of the people.
On the other hand, changes in the consumption
habits of the people, urbanization, life style and
work culture are the deciding factors in longterm demand.
Modern economics considers production
and cost of production with reference to time
period. Demand is not so clearly classified into
different time periods. Even then, such a
classification is useful in controlling and
managing the demand in the short and long run.
(10) Firm’s Demand and Industry
Demand
Firm is an independent decision making
unit whereas industry is composed of a large
number of firms in the same product line. Each
of the firm engaged in production textile is a
Managerial Economics : Nature and Concepts : 72
part of Textile Industry. For example, each of
the sugar factory in India is controlled by an
independent firm and India’s sugar industry is
composed of all the firms engaged in sugar
production. Thus the demand of the firms in
sugar industry for inputs or factor services is
like an individual demand. Industry demand is
similar to market demand from the industry.
Similarly, demand for sugar of a firm is just a
small part of market demand for sugar; whereas
aggregate demand for sugar with all the firms
in the country can be said to be market demand
for sugar. Individual firms in an industry may
differ in the degree of efficiency such as quality
of the product, production technique, financial
position market share in industry sales, leadership
in the market and capacity to withstand
competition. In order to understand the
correlation between demand of a firm and
industry demand, we must have sufficient
information of the various market structures.
Questions for Self Study - 4
(A) State whether the following
û)
statements are true or false. Put (û
ü) in bracket.
or (ü
(1)
Consumers demand commodities of
derived demand. ( )
(2)
Demand for a computer is classified as
Industrial demand. ( )
(3)
(4)
A commodity, demand for which is
dependent upon the demand for other
products is said to have induced demand.
( )
Hemant Printers has purchased a new
printing machine to expand the business.
This demand can be termed as ‘new
demand’. ( )
(B) Fill in the blanks in following
sentences, using the appropriate
words given in brackets.
(1)
A new scooter Honda Activa is sold
in Indian market. Its countrywide
demand is __________demand.
(market segment/market)
(2)
Demand for cotton is a demand for
___________ goods (Final/
Intermediate)
(3)
Demand for milk is a
________________ demand.
(Direct/Derived)
(4)
Tea
powder
and
sugar
are___________goods. (Substitute/
complementary)
3.2.7 Demand for Product
Market structure has an important place
in demand analysis. Unless we study the market
structure, demand analysis would be incomplete
and meaningless. The place of a firm in an
industry must also be taken into account. Market
structure can be viewed from different angles.
If we look at market structure from the point of
view of variety of the product and the number
of sellers in the market, market structure would
appear as follows.
Number
of
Sellers
Nature of the product
Homogeneous
Product
Differentiated
Product
Single
seller
Monopoly
-
Few
sellers
Oligopoly
Oligopoly
Many
sellers
Perfect
Competition
Monopolistic
Competition
Demand for Monopoly Product
There is a single seller in pure monopoly.
There is a single firm in the industry and
therefore, the firm and the industry is a single
identity. As a result, Firm’s demand is also the
demand for industry product. In other types of
markets, demand for the product of a firm and
industry are different. Figure 3.5 shows a
downward sloping demand curve DD for the
firm as well as for the industry. The slope of the
curve suggests that the firm can sell larger output
at lower price and higher output at lower price.
Managerial Economics : Nature and Concepts : 73
Demand for the Product of a Firm in
a Perfectly Competitive Industry
Y
Price (Rs.)
D
D
X
0
Demand
Figure 3.5 : Demand Curve for the Product of a
Monopoly Firm
Demand for the services such as railway,
post and telegraph, telephones etc. is of such
type.
There are large number of buyers and
sellers in a competitive market. There is a
perfect competition among the buyers and
sellers. Demand curve for an individual firm is
a very small and negligible part of market
demand. Price is determined in the market by
the intersection of market demand curve and
market supply curve. Once an equilibrium price
is determined in the market, buyers and sellers
as an individual become ‘price takers’. No one
has a choice to alter the market price his
individual action through changes in demand and
supply. In figure 3.6 (a), downward sloping
market demand curve DD and upward rising
market supply curve intersect in point E. A
perpendicular from point E to OY axis give us
point P on price axis, which shows OP as market
equilibrium price. If we continue the same
perpendicular up to panel B of figure 3.6, we
get an infinitely elastic demand curve for all firms
at OP market equilibrium price.
Y
Y
(A) Industry
E
X
0
Demand
D1
D1
P
Price (Rs.)
Price (Rs.)
(B) Firm
S
D
P
X
0
Demand
Figure 3.6 : Demand for the Industry and Firm’s Product under Perfect Competition
Panel B shows demand curve for firm’s product D1D1, an infinitely elastic demand curve at
market equilibrium price OP. The firm can sell any quantity of X at market price but not a single unit
above the market price. Perfect competition, however is a theoretically limiting case that is rarely
found in real world.
Demand for Product of Monopolistically Competitive Firm and Industry.
Number of sellers in a monopolistic competition is quite large. Product of the firms is
differentiated. Commodities such as soaps, toothpaste, tea, though same with all firms, there is some
difference in quantity, quality, wrapping etc. It is, therefore, said that the product is differentiated.
Demand curve of the firm under monopolistic competition is relatively more elastic than the industry
demand curve. (See figure 3.7)
Managerial Economics : Nature and Concepts : 74
Y
Y
(A) Industry
(B) Firm
Price (Rs.)
Price (Rs.)
S
D
P
D1
P
P1
P1
D
0
D1
X
Q
Q1
Demand
X
0
Q
Q1
Demand
Fig. 3.7: Demand curves of a firm and Industry in a Monopolistic competition market.
In panel A of the figure 3.7, DD is the
industry demand curve for product
X and is downward sloping according to the law
of demand. However, it is less elastic as
compared to the demand curve of a firm In Panel
B, D1D1 is the demand curve of the Firm. It is
relatively more elastic than that of industry
demand curve. Since the curve is downward
sloping, it suggests that more units could be sold
at power price.
It will be quite clear from both the figures
3.6 and 3.7 above that the quantity demanded
increases by QQ1, if the price decreases by PP’.
However, the increase in the demand for firm’s
product is relatively more as compared to
industry. Demand for a firm’s product could be
easily and all of a suddenly increases. This
because a competitive firm can make changes
in the price of the product, quality, colours,
wrapping etc. from time to time for increasing
demand. A slight change in the price leads to
larger change in the demand for the product of
the firm as compared to industry.
Homogeneous Oligopoly
When sellers in the market are a few and
the product is homogeneous, the market is called
‘homogeneous oligopoly’. Under such a
situation, business can be easily transferred to
competitive firms. Demand for the product of a
firm is influenced by each action of the
competitive firm. Homogeneous monopoly has
been observed in industries like Iron and Steel,
Cement, and Petroleum Products.
Differentiated Oligopoly
In a differentiated oligopoly market,
demand for firms product is related to industry
demand curve. However, this relationship is not
similar to homogenous oligopoly. Some
consumers prefer specific brands. Some
consumers prefer Godrej freeze, some others,
voltas. Some prefer ONIDA TV and others
BPL.
Demand curve of an oligopoly firm, as
stated by Paul sweezee is kinked. This view is
widely accepted. Price rigidity is a special
feature of kinked demand that suggests that
once the price is determined, any change therein
shall be resisted. It one of the firm increases
product price, other firms will not increase their
prices. On the other hand, if a firm cuts down
its price, other firms shall also cut their prices
further. Under the circumstances, we need to
consider two demand curves simultaneously,
because reaction of a competitive firms on the
action of a firm differ under different situations.
Figure 3.8 shows reactions of competing firms
in two different situations.
If any of the firm increase price above
‘OP’, this act will reflect on PS part of the
demand curve DD. Other firm will not change
their price. On the other hand, if any firm reduces
price below ‘OP’, It will reflect in SD part of
the “DD” demand curve. This time competing
firm shall also decrease their prices. It we take
into account both the reactions together, demand
curve of the firm shall be ‘DSD3’ kinked in
points.
Managerial Economics : Nature and Concepts : 75
curve.
Price MR & MC
Y
(B) State whether the following
û)
statements are true or false. Put (û
ü ) in brackets.
or (ü
D
B
MC
In monopoly,
discriminated. ( )
(2)
Consumers decide the price in
perfect competition. ( )
(3)
Demand for a product comes from
household only. ( )
(4)
Demand curve of a firm is more
elastic in oligopoly. ( )
D1
MR
D2
0
(1)
X
MR
Quantity
product
is
(C) Fill in the blanks.
Figure 3.8 : The Kinked Demand Curve in
Oligopoly
Under the condition, price is determined
at ‘OP’ and that remains fixed, rigidly. DS part
of the kinked demand curve is more elastic and
SD2 part, less elastic.
Demand function is an oligopoly depends
on a number of variables. Other factors
influence oligopoly demand even though the price
remains unchanged. A firm can forecast future
demand based on experiences in the past, but a
number of difficulties may arise in doing so.
Market situation changes rapidly. Therefore,
demand forecasting may prove we less in making
a decision. The firm has to take into account
changing business environment and to correct
demand function from time to time.
Questions for Self Study - 5
(A) Answers the following questions in
brief.
(1)
Demand function of an oligopoly
depends on —— variables.(a single,
many)
(2)
Kinked demand curve is found in —
market. (oligopoly, monopoly)
(3)
Industry demand in an oligopoly is
——elastic (less ,more)
(4)
Demand curve of a firm in perfect
competition is always ________
(downward sloping, parellel to OX
axis.)
3.2.8 Sources of Demand
While considering the demand for the
product of a firm, we must take into account
the sources of demand. Classical economic
theory emphasises demand for final consumer
goods. In fact, consumer demand is just a part
of aggregate product. Major part of aggregate
product is demanded by other firms, business
houses, wholesale and retail traders, who, then
pass it on to the ultimate consumers. In such a
business world, we must know the deciding
factors in demand and the groups of individuals
influencing demand. These are;
(1)
Write briefly about Monopoly.
(2)
Write briefly
competition.
(3)
Write briefly about Monopolistic
competition.
(4)
Write about Homogeneous oligopoly
and discriminated oligopoly.
(1) Consumer Demand : Consumer
demand is of special significance in demand
analysis. Consumers tests and preferences,
fashions, etc. has a special place in demand. A
demand analysis must consider the price of the
commodity, consumer’s income, socio,
psychological factors etc. in analysing the
demand.
(5)
Write briefly about kinked demand
(2) Demand from other Firms : Some
firms work as subsidiaries of other firms. Such
about
perfect
Managerial Economics : Nature and Concepts : 76
firms produce goods according to orders of other
firms. The type of the product, size is determined
by the main firm. Demand for the products of
subsidiary firms is thus assured.
(3) Wholesalers’ Demand : Wholesalers demand products. There demand depends
on expected sales, storage facility and cost,
financial capacity, rate of profit, etc.
(4) Retailer’s Demand : Retailers are
middlemen between the producer/ wholesaler
and the consumers. Consumers get their demand
satisfied through retailers. Demand from
retailers depend on expected sales, capital,
goodwill in the market cost of storing the goods,
fluctuations in prices and consumer demand size
and proportion of profit, etc.
(5) Suppliers own Demand : In modern
age, we do not consume what we produce and
the products we consume, we do not produce
our self. Some times, opposite can happen. A
part of our own product we retain for self
consumption. Farmers retain a part of their farm
products for their own consumption, and rest
they sell. The part that is retained for self
consumption is called ‘reserved demand’.
In brief, when we think of demand for a
product, we need to study the market structure,
sources of demand as uses of the product
concerned. It is observe that the views of buyers
and sellers regarding demand basically differ.
From the point of view of buyers, their
preferences and purchasing power are the
important factors. From sellers point of view
existing market condition and its impact on
revenue are the important factors.
3.2.9 Aggregative Concepts of
Demand
There are two approaches to study
economics;
(1) Micro approach and
(2) Macro approach.
To study a single industry, a firm or an
individual or a part of an economy means
micro approach.
In microeconomic we study demand,
supply price of a single commodity, production
of a single commodity etc. Each manager of a
firm has not only to study micro approach but
also has to study macro approach.
Assuming entire economy as a unit to
analyse aggregative concepts such as
aggregate demand ‘aggregate supply’
‘national income and output’ general price
level’ aggregate saving and investment in
an economy ‘total imports and export’ etc.,
means macro approach.
Suppose that National income of a country
increases or decreases. Such aggregative event
shall not leave a micro unit like a firm or a single
industry unaffected. Manager of a firm must
study these aggregative concepts and frame his
business policies accordingly.
Some Aggregative Concepts of
Demand
(1) Effective Demand : Effective
demand is an aggregative concept. Effective
demand is determined by the point of intersection
between aggregate demand function and
aggregate supply function as described by J.M.
Keynes. Aggregate expenditure in an economy
on consumption and investment and aggregate
expected revenue from sale of goods and
services to the firm when equals, it is called
effective demand.
Effective demand depends on the volume
of aggregate expenditure in the economy. It
determines the size of market. Effective demand
is the determinant of level of income and
employment. Higher the effective demand, more
is the size of output, income, employment and
vice-versa. The concept of effective demand is
of great significance in Keynesian analysis
(2) Consumption Demand : Effective
demand in an economy can be distributed in two
parts.
(a) Demand for consumer’s goods and
(b) Demand for capital goods.
Consumption demand in an economy
depends on the level of national income, because
consumption is the function of income.
Symbolically,
C = F (Y)
Managerial Economics : Nature and Concepts : 77
(3) Investment Demand : Economy’s
demand for capital goods is demand for
investment. This is second important component
of aggregate demand. Investment depends upon
profitability of capital. Effective demand is
determined by the aggregate income or
aggregate expenditure in an economy.
Aggregate expenditure of the economy on
consumption and investment can further be
classified as; household expenditure, private
expenditure and public expenditure.
(4) Demand for Money : Money is a
liquid wealth. Everyone desires to hold money,
which is called ‘Liquidity preference. Entire
economy demand money to hold. Demand for
money is an aggregate (macro) concept. People
demand money for three motive.
(a) Transaction motive
incomplete, if we consider any single approach.
Classical and neo-classical economists have
emphasized the micro approach. However, J.M.
Keynes has preferred macro-approach. The
principle that every macro event has a base of
micro-factor is now accepted in economic
literature.
Questions for Self Study - 6
(A) State whether the following
û)
statements are true or false. Put (û
ü) in bracket.
or (ü
(1)
India’s import-export is a subject of macro
economics. ( )
(2)
Effective demand is concerned with
National income of the economy. ( )
(3)
People demand for consumer goods
depends on their income. ( )
(4)
People hold money merely by speculative
motive. ( )
(b) Precautionary motive and
(c) Speculative motive.
Many payments are required to be paid in
cash for day to day purchases of goods and
services. A part of income held in cash for this
motive is called ‘demand for transaction motive.’
Further more, a number of contingencies, such
as sickness education of children, accident, old
age and death may arise in future. To face such
emergencies, people hold a part of their income
as ‘precautionary motive’ behind holding cash.
Third motive behind holding money is
speculative motive’. Values of shares and
debentures often fluctuate in capital market.
Whenever interest rate changes, prices of shares
in stock-market fluctuate. Some people in the
society hold money to earn quick profit by taking
advantage of fluctuating share prices.
The object of speculative holding is to buy
shares when prices drop and to sell when prices
are high. This activity generates profit. People
hold a part of their income in the form of money
which is called speculative demand for money.
In brief, it has been necessary to study
macro concepts in analysing the demand. The
concept of demand has to be viewed from both,
the micro approach and macro approach. These
approaches are complementary to each
other.
3.3 Words and their Meanings
Market Demand : Aggregate demand from
all the consumers.
Consumption : The process of using a
commodity or service.
Demand Function : Functional relationship
between the demand and factors
influencing it.
Expansion of Demand : Increase in demand
only due to decrease in price.
Contraction of Demand : Decrease in demand
only on account of rise in price.
Increase in Demand : Price remaining
unchanged an increase in demand due to
changes in other conditions.
Decrease in Demand : Decrease in quantity
demanded, not because of price but other
conditions change.
Direct Demand : Autonomous demand for
consumer goods.
Derived Demand : Demand for inputs
required in production process.
The study of demand analysis would be
Managerial Economics : Nature and Concepts : 78
Autonomous Demand : Demand for any
commodity independent of demand for
other goods.
(6)
Demand for a commodity depends on
current and past income of the consumer,
his saving and future expected income.
Induced Demand : Demand for a commodity
is related to demand for another
commodity.
(7)
There is an inverse relationship between
price of a commodity and its demand. A
rise in price leads to fall in the demand
and vice-versa.
(8)
Demand curve for a commodity is
downward sloping. It shows negative
relationship between price and quantity
demanded.
New Demand : Demand for making an addition
to existing stock.
Replacement Demand : A commodity
demanded to replace existing one.
Semi-finished Goods : A product of
incomplete stage, in the process of
production.
Kinked Demand Curve : A curve that has a
kink in between.
Oligopoly : A market in which there are a few
sellers.
Questions for Self Study - 3
(A) (1) (û), (2) (ü), (3) (û), (4) (û),
(5) (ü), (6) (ü), (7) (ü).
Questions for Self Study - 4
(A) (1) (û), (2) (ü), (3) (û), (4) (ü).
3.4 Answers to Questions for
Self Study
(B) (1) Segment of a market, (2) Derived,
(3) Semi-finished, (4)Complementary.
Questions for Self Study - 5
Questions for Self Study - 1
(A) (1)
There is a single seller in monopoly,
and a single firm. Firm and Industry
are one end the same thing.
(2)
Number of buyers and sellers in a
perfectly competitive market are
numerous. Product sold is
homogeneous. Demand curves of a
firm and industry are different.
(3)
Number of sellers in a
monopolistically competitive market
is large. They differentiate product
and therefore it is said that it is a
product differentiation.
(4)
When there are a few sellers in the
market and product is homogeneous,
it is called homogeneous oligopoly.
There is product differentiation in
‘deferentiated oligopoly.’ Consumers
usually prefer a particular brand.
(5)
Demand curve in an oligopoly is
kinked. The concept of kinked
demand curve was developed by
Paul Sweezee. When a firm in
oligopoly reduce price, other firms do
not follow. However, if a firm cuts
price of its product, other firms also
(A) (1) (û), (2) (û), (3) (ü), (4) (û).
(B) (1) No. No reference of price.
(C) (1) No mentioned number of workers.
Questions for Self Study - 2
(A)
(1)
Utility means want satisfying power of a
commodity.
(2)
The process of using a product/service is
consumption.
(3)
Consumer get satisfaction of consuming a
commodity at the cost of sacrificing money
as a price. As an individual goes on
consuming more and more units of a
commodity, his satisfaction from each
additional unit goes on diminishing
ultimately, it becomes zero.
(4)
Demand function states the relationship
between demand for a product and factors
influening it.
(5)
Demonstration effect is the influence of
demand by others on demand of a person.
Managerial Economics : Nature and Concepts : 79
cut their prices. Because of this, there
is a kink in oligopoly demand curve
at a particular point.
(B) (1) (û), (2) (û), (3) (ü), (4) (û)
(C) (1) many, (2) Oligopoly, (3)Less,
(4) Parallel to ox axis.
3.5 Summary
Demand is a variable concerning
economic decision. Demand can help in judging
the size and type of the market. Demand means
desire to have anything backed by purchasing
power in absence of which, demand can not be
materialize. Consumption is the process of using
a product. The relationship between price and
quantity demanded is negative. Demand for a
commodity depends on consumer’s income, his
preferences, price of the product, prices of
substitutes and complementaries, future
expectations about prices etc. Demonstration
effect also influences demand for a product.
The law of demand states, ‘other things
remaining unchanged, arise in the price of the
product leads to reduction in quantity demanded
and vice-versa. When demand expands on
account of decline in the price, it is called
‘expansion’ of demand . In opposite case, it is
called ‘contraction of demand. In spite of price
remaining unchanged, demand changes due to
changes in population, income of the people,
increase or decrease in the prices of substitutes,
demand changes due to such ‘other factors’. In
such a situation, changes in demand are known
as ‘increase’ or decrease in demand. In case of
expansion or contraction, a consumer moves
along a given curve; but when demand increases
or decreases, the consumer shifts to a new
demand curve. On upward curve to the right,
when demand increases and downward curve
to the left when demand decreases.
Commodities ready for ultimate consumption
have a direct demand. Intermediate products,
on the other hand, have derived demand.(for
example, machinery, shares, raw material, factor
services, etc.) When demand for a commodity
depends on the demand for certain other
commodity such a demand is called ‘induced
demand. When a new machine is added to the
existing stock of machines, it is a ‘new demand’.
But demand for a machine to replace old one is
called ‘replacement demand’ considering the
element of time, we can classify demand as
short-term demand and long term demand.
Similarly one more classification; individual
demand and market demand is frequently used.
Market structure has immense importance
in demand analysis. In monopoly market, a single
firm operates. There is no difference between
a firm and industry. Firm’s demand and Industry
demand are identical. Demand curve slopes
downward to right. Number of buyers and sellers
in a perfectly competitive market are numerous,
and they compete with each other. Product sold
in the market is homogeneous. Demand for a
firm’s product and industry demand are different.
Price is determined by demand for and supply
of the product in market. Firms are just ‘price
takers’.
Number of sellers in a monopolistically
competitive market is large. Product of the firm
is differentiated .The demand curve of a firm in
this market is relatively more elastic than the
Industry demand curve.
In oligopoly market, the shape of demand
curve is kinked, because of the varied responses
to price change by one firm to other competing
firms.
Sources of demand are – consumers,
other firms, suppliers, wholesale and retail
traders demand firm’s product.
Demand is also viewed from micro and
macro approaches. In micro approach we
consider individual demand, demand from a firm,
a single industry, etc. Micro approach on the
other hand. Considers national aggregates such
as ‘aggregate demand’, ‘aggregate supply’,
‘effective demand’ national output/income and
so on. Whatever an economy spends on
aggregate consumption and investment during
a given time period determines effective
demand. Effective demand is determined by the
point of intersection between aggregate demand
curve and aggregate supply curve. It is very
important concept in macroeconomics.
People’s desire to hold money is called
‘liquidity preference. It has three motives.
(1) Transaction motive, for which people
hold a part of their income in the form of money.
Managerial Economics : Nature and Concepts : 80
It enables the holder to carry on routine
transactions. Some money is held as (2)
Precautionary motive, to take care of unforeseen
contingencies. Rest of the money is held to enjoy
speculative benefits of higher returns in future.
Money held under all the three motives
together is called demand for money.
3.7 Field Work
(1)
Make a list of 20 commodities you regularly
use. Classify them according to type of
demand.
(2)
Visit a factory in your close vicinity. What
type of input it use? Classify by type of
demand.
(3)
Choose a commodity you commonly
observe. Make a list of factors on which,
its demand depends.
Micro and Macroeconomic analysis both
are important in demand analysis.
3.6 Exercises
(1)
Explain the importance of demand in
managerial economics.
3.8 Books for Further Reading
(2)
Why a firm must be continuously watchful
to the happenings in market?
(1)
(3)
‘Consumption is the beginning as well as
end of production’ Explain.
Mote V.L., Samuel Paul and Gupta G.S.,
Managerial Economics-concepts and
cases, Tata MC-Graw Hill Publishing
Company Bomaby. (1987) Ch.2.
(4)
Explain the factors determining demand.
(2)
(5)
Explain with the help of diagram, the shape
of firm’s demand curve in a competitive
market.
Koutsoyiannis A. (1979), Modern
Microeconomics, 2nd Ed. London, The
Macmillan Press Ltd. Section IV, Ch.2.
(3)
Stories A.W. and Hague D.C., A Text.
Book of Economic Theory, 12th Edn. Chs
1, 2, 4, 5, 8 and 9.
(4)
Indira Gandhi National Open University,
New Delhi, Managerial Economics(Demand Decision-2).
(6)
Explain kinked demand curve in oligopoly.
(7)
Describe the demand curve in monopoly.
(8)
How is it determined whether a commodity
is a consumer good or capital good?
(9)
Distinguish between ‘Final’ and
‘intermediate’ product.
Managerial Economics : Nature and Concepts : 81
Unit 4: Demand Analysis
Index
« Explain Consumer equilibrium.
4.0 Objectives
« Tell, what is meant by ‘Income effect’
and ‘Substitution effect’.
4.1 Introduction
« Explain MRS effect.
4.2 Subject Description
4.2.01 Cardinal Utility Approach
4.2.02 Equi-Marginal Utility
« Explain revealed preference approach to
demand.
4.2.03 Indifference Curve Approach
« Explain recent trends in demand analysis,
and .
4.2.04 Marginal Rate of Substitution
« Explain exceptional demand curve.
4.2.05 Consumer’s Equilibrium
4.2.06 Price Effect
4.2.07 Income Effect
4.1 Introduction
4.2.08 The Substitution Effect
4.2.09 Revealed Preference Approach
4.2.10 Recent Trends in Theory of
Demand
4.2.11 Exceptional Demand Curve
4.3 Words and their Meanings
4.4 Answers to Questions for Self Study
4.5 Summary
4.6 Exercises
4.7 Field Work
4.8 Books for Further Reading
4.0 Objectives
After studying this unit, you will be able
to :
« State the significance of demand
analysis.
« Explain cardinal utility approach to
demand.
« Explain the law of equi-marginal utility.
« Tell, what is ‘substitution effect’.
« Tell what is ‘marginal rate of substitution.
In the last unit, we have studied the
concept of demand and factors affecting it in
detail. Price of the product is foremost important
factor influencing demand. Demand for a
product varies inversely with any change in price.
When we draw a diagram, we get a downward
sloping demand curve to the right. Demand
function when given as D=F (p) we mean
demand is a function of price, assuming other
factors influencing demand to remain
unchanged. A demand function can be linear or
non-linear.
We must remember that in drawing a
demand curve, we consider demand-price
relationship only. We assume that other factors
influencing demand such as income prices of
other goods, preferences of the consumer to
remain unchanged. Therefore, the demand
curve shows negative relationship between price
and quantity demanded. We know two types of
demand as (1) Individual demand and (2) Market
demand.
The latter is a sum total of demand from
all individuals in the market. Individual and
market demand curve, both slope downwards
from left to right that shows negative relationship
between the variables price and quantity
demanded ‘Why is it so? We must be able to
Managerial Economics : Nature and Concepts : 82
analyse the reasons behind it. We have studied
law of demand in Unit 3. There are different
approaches to explain the law of demand. In
this unit, we are going to study following
approaches.
(1) Cardinal Utility Approach
(2) Indifference Approach
(3) Revealed Preference Approach, and
(4) Recent trends in the theory of Demand.
4.2 Subject Description
4.2.1 Cardinal Utility Approach
Demand analysis has changed over time.
There is unanimity of opinion about negative
relationship between price and quantity
demanded. However, tools used in analyzing the
theory have been changing. New and new
approaches are comming forward to explain the
phenomenon . It has, therefore, been possible
to make more realistic analysis of demand . We
shall, hereafter study these approaches.
Alfred Marshall has developed cardinal
measurement approach. His demand analysis
is based on utility. Utility means human want
satisfying power of a commodity. A basic
question that arise is, Why a consumer wants to
have a commodity? Marshall’s answer to this
question is that commodity provides satisfaction
to consumer of consuming the commodity. His
want satisfies by consumption, that is called
utility. A hungry person enjoys rice. Plate in a
hotel and satisfies his hunger. Rice plate must
have some power to satisfy human hunger. To
that power, Marshall called utility. Utility is a
subjective phenomenon. It is imaginary.
However, utility can be measured in cardinal
numbers through the measuring rod of money.
Such measure is imaginary.
According to classical economist
Bentham, utility means the difference between
the satisfaction one derives from an act and the
sacrifice undergone in attaing the same. He
believed that utility can be measured, like any
other weight and measures. Not only this, but a
comparison between utilities enjoyed by different
persons can also be compared. After Bentham,
Walras, Johans, Menjor and other economists
made invaluable contributions to the utility
analysis. Whan a consumer derives satisfaction
by consuming a commodity, utility is
experienced. However, utility enjoyed by one
person cannot be measured by another person.
It is a subjective concept. Marginal school of
thought believes that the person who consumes
can only measure his utility. Marshall has
accepted this view in analysing the demand
theory. This approach is known as ‘Cardinal
utility Approach’.
Marshall’s demand analysis is based on
following assumptions.
(1) Consumer is Rational : Every
consumer tries to obtain maximum utility. His
choice of commodities is guided by self interest.
Each consumer thinks of the demand function
that is influenced by his tests and preferences.
Such a demand function shows relationship
between utility and quantity and quality of the
commodity.
(2) Utility is a Cardinal Measure :
Utility can be quantitatively measured. When
we say it is measurable, we need to have a unit
to measured. According to Marshall, utility can
be measured in terms of money. A consumer is
prepared to pay price in money rather than to
go without a commodity can act as a measure
of utility. If we ask to consumer how much
maximum he is willing to pay for an orange, and
he answers Re.1/- per unit, this money price is
equal to the utility consumer derives from
consumption of one orange. Once we accept
that utility is measurable, we can easily compare
the utilities derived by different persons.
(3) Value of Money Remains
Constant : Once we accept that money is a
unit to measure utility. We must assume that
value of money remains constant. It the value
of money is unstable, it cannot be a correct
measure of utility. Marshall, therefore, assumed
that marginal utility of money remains constant.
This means consumer feels the same value of
Re 1/- for all the times. In spite the fact that the
stock of money with the consumer may increase
or decrease, his income may rise or fall, he feels
same utility of Re.1/-.
(4) Small Expenditure on a
Commodity : Expenditure of a consumer on a
Managerial Economics : Nature and Concepts : 83
(5) Utility of a Commodity is
Independent : Utility derived from a commodity
depends on consumption of units of the same
commodity. It is not concerned with the utility
of other commodities. Utility derived from X is
independent of utility derived from Y. These are
not related.
(6) An Individual consumer may not
be Satisfied : It is called an assumption of nonsatisfaction. If a consumer consumes more units
of a commodity, he derives more total
satisfaction. This means his want was not fully
satisfied by consumption of earlier units.
(a)
So long as the marginal utility is positive,
total utility continues to rise.
(b)
When marginal utility is zero, total utility is
at its maximum.
(c)
When marginal utility turns negative, total
utility declines.
Suppose a person is consuming oranges
one after another, his marginal and total utility
shall change the way as shown in figure 4.1
Y
U1
Utility
single commodity may be a small fraction of his
income. A change in price of one commodity
may not affect real income of the consumer.
Further more, marginal utility of money is
assumed to be constant.
(8) Consumer’s Income is Constant :
It is assumed that income of the consumer is
constant and that the same is fully spent during
the same time period.
(9) Individual Consumer is a Small Part
of Market : Place of an Individual consumer
in market is neglegible. He / she therefore,
cannot influence market price by making
changes in his individual demand.
(10) Consumer behaves According to
the Law of Diminishing Marginal Utility :
As a consumer goes on consuming units of a
commodity, his satisfaction from each additional
units goes on diminishing, This experience of
consumer is called the Law of Diminishing
Marginal Utility. Marginal utility is defined as
net addition to total utility by consuming one
more (marginal) unit of a commodity.
Total Utility
Utility derived by a consumer through all
the units of a commodity is called total utility.
As a person goes on consuming more and more
units of a commodity, his total utility goes on
increasing, but at a diminishing rate. After some
units, it reaches maximum and thereafter starts
diminishing. The relationship between total and
marginal utility can be stated as follows:
Tu
U
(7) Consumer’s Tests Remain
Unchanged : Consumer ’s tests and
preferences remain constant at a particular point
of time.
II
I
0
III
X
U
U1
Units of Oranges
Mu
Figure 4.1 : Marginal and Total Utility
In figure 4.1, units of oranges consumed
are measured along ‘OX’ axis and utility along
‘OY’ axis. ‘MU’ is marginal utility curve and
‘TU’ is total utility curve.
We can easily grasp from the figure that
total utility is rising at an increasing rate upto
point U on TU curve. Between points U and
U1, total utility increases but at a diminishing
rate. At point U1, total utility is maximum and
marginal utility is zero. After point U1, marginal
utility becomes negative and thereby, total utility
starts declining. Total utility continues to
increase until 5th unit. Between 2nd and 5th units,
total utility increases at diminishing rate. When
marginal utility becomes zero at 5th unit,
consumer’s want gets fully satisfied. Any
consumption beyond 5th unit would give the
consumer negative satisfaction or dissatisfaction.
Figure 4.1 shows three stages of returns.
1st stage between zero to 2 units represents
increasing utility. The law of diminishing marginal
utility applies in II stage, between 2 to 5 units.
III stage shows negative marginal utility and
declining total utility. The law of diminishing
Managerial Economics : Nature and Concepts : 84
marginal utility is true, only when marginal utility
is declining and positive. This law is also known
as ‘Theory of Satiable Wants.’
Logic behind the Law of Diminishing
Marginal Utility
If a person has a limited units of a
commodity, he is likely to use it to satisfy his
most urgent wants. As the number of units with
him increase he will divert additional unit to
satisfy less urgent needs, which give lesser
utility to him. Suppose, a person has a bucket
full of water. He will use that water only for
drinking, being his most urgent need. As more
water becomes available, he will use additional
water for cooking, cleaning, washing and
gardening.
The law of diminishing marginal utility has
some important limitations that we must bear in
mind. These are –
(1)
(2)
(3)
All units of the commodity must be of
uniform size; such as a bucket of water,
orange, a pear of shoes, etc. A spoonful of
water or a small peace of cake would not
be of appropriate size of experience
diminishing utility.
Commodity should be divisible. If we can
distribute the commodity into small pieces,
it is said to be divisible. If it is not divisible,
a continuous curve of marginal utility could
not be drawn.
Consumer’s tests and preferences should
not change during consumption period.
Otherwise, the law will not operate.
Marshall’s demand analysis is based on
the law of diminishing marginal utility.
Money income of the consumer must be
constant at the time of purchase. It is assumed
that consumer consumes only one commodity
at a time. A commodity that gives utility is an
economic good and those having no utility are
non-economic goods. A consumer maximises his
utility only form consumption of economic
goods. Utility function explains the consumer’s
choice. The effect of price on consumption is
not taken into account. Consumer’s desire to
consume a commodity is independent of price
consideration. Price quantity relation is taken
into account in demand function. It is emerged
out of consumer’s utility function.
Questions for Self Study – 1
(A) Write brief answers to the following
questions.
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
Who presented cardinal utility approach
relating to demand?
How has Bentham defined utility?
What is the main principle of cardinal utility
approach?
Write in brief, the main assumptions of
cardinal utility approach.
What is total utility?
What is marginal utility?
Write briefly on relationship between total
utility and marginal utility.
Complete the following table.
Units of
Commodity
Total
Utility
1
100
2
150
3
270
4
310
5
340
6
360
7
350
Marginal
Utility
4.2.2 Law of Equi-Marginal
Utility
Income of any consumer is limited and
that, he has to spend it on a number of goods
and services. The problem before every
consumer is how to spend this limited income
on a variety of goods and services in such a
way as to attain maximum satisfaction?
Suppose, a consumer has a limited amount
of Rs. 1,500, which he wants to spend on food,
housing and clothing. He will distribute his
expenditure on all the three wants in such a way
as to obtain maximum total utility. By distributing
equal amount on all the three wants Rs. 500
each may not give him maximum satisfaction.
However, if he distributes his expenditure that
the marginal utility on rupee spend on food,
housing and clothing is equal, then and then only
the consumer could maximise his satisfaction.
This principle is called ‘The Law of Equimarginal utility’.
Managerial Economics : Nature and Concepts : 85
Suppose house gives utility equal to Rs.
700, Food 500 and clothing 300, then our
hypothetical consumer can distribute his
expenditure as Rs. 500 on food, Rs. 700 on
housing and Rs. 300 on clothing spending all his
income. Such a distribution shall give him
maximum total utility.
We can present the law of equi-marginal
utility in the form of an equation.
(1) Equi-MU = MarginalUtilityX = MU of Y
Price of X
Price of Y
Tea
Rupee
MU t
1st
2 nd
3rd
4 th
5 th
TU
100
80
60
40
20
300
P
x = x
P
MU
y
y
MU
MU s
Σ MU
1 st
100
120
220
2 nd
80
110
190
3rd
-
80
80
180
310
490
Total Utility
Suppose a person has Rs. 5, which he
wants to spend all on Tea and Sugar. Utility that
can be derived from each rupee on tea and sugar
is given in following table.
By spending Rs. 2 on Tea and Rs. 3 on
sugar, the person maximises his total utility at
490. No other combination would give him more
than this total utility. This is maximization of
satisfaction according to the law of equimarginal utility. We can analyse the law with
the help of a suitable diagram. This is done in
figure 4.2(a) and (b).
Y
Y
Tea
Sugar
120
Marginal Utility (Sugar)
120
Marginal Utility (Tea)
120
110
80
50
25
385
MU t
Rupee
In other words, the ratio of marginal
utilities of X and Y must be equal to the price
ratios of these commodities X and Y.
1st
2 nd
3rd
4 th
5 th
TU
If the person spends all the Rs. 5 on tea,
his total utility would be 300 or if he spends all
on sugar, his total utility would be 385. instead,
if he spends Rs. 3 on sugar and Rs. 2 on tea,
because marginal utilities of last rupee spend on
both the commodities are equal, the person can
maximise his total utility.
alternatively
(2) Equi-MU =
Sugar
Rupee
MU s
(a)
100
80
60
40
20
X
1
2
3
4
Rupees
5
6
90
80
D1
70
60
50
40
30
MU S
20
MU t
0
(b)
110
100
0
X
1
2
3
4
Rupees
5
6
Figure 4.2 : Equi-marginal Utility of Tea and Sugar
Figure 4.2 is presented in panel (a) and Panel (b). Along horizontal axis in both the panels is
measured rupee spent on tea and sugar respectively. Vertical axis measure marginal utilities of each
rupee spent on tea and sugar.
Managerial Economics : Nature and Concepts : 86
MUt is the marginal utility curve for tea in
panel (a) and in Panel (b), the marginal utility
curve for sugar. Marginal utility of both the
commodities is equal at 80 at an expenditure of
Rs. 2 on tea and Rs. 3 on sugar maximization of
utility is achieved by this distribution of
expenditure.
A ≥ B : Combination ‘A’ is more preferred
to combination ‘B’ (A>B) or both the
combinations are equally preferred. (A=B)
Demand curve of a commodity slopes
downwards from left to right. This is because
marginal utility curve too slopes downwards from
left to right.
In brief, when a consumer considers
various combinations of commodities, he must
be in a position to express his preference or
indifference between any two or more
combinations.
Questions for Self Study – 2
(2) Transitivity : Suppose, three
combinations of consumption are given. If
(A) Write brief answers to the following
questions:
(1)
What is the main principle of the law of
equi-marginal utility?
(2)
Why has a consumer to spend his income
rationally?
(3)
Write the equation of the law of equimarginal utility that gives maximization of
satisfaction.
(4)
Why is a demand curve downward sloping
from left to right?
4.2.3 Indifference Curve Approach
This is second approach to explain demand
theory. This is called ‘ordinal utility approach’.
According to this approach, when consumer
goes to market, he does not purchase a single
commodity. He purchases a bundle or group of
commodities. When we enter a grocer’s shop,
we purchase a host of commodities like wheat,
rice, edible oil, ghee, salt, sugar, tea, etc. In
indifference approach suggests that consumer
chooses various combinations of two groups in
such a way as to maximise satisfaction. A
consumer, however, has to prepare his
‘preference model’. This needs consideration
of prices of goods and consumer’s income.
Consumer’s preference model helps in choosing
the appropriate combinations of goods.
Properties of Consumer’s Preference
Ordering
(1) Completeness : A consumer can
express his prefers about combinations ‘A’ and
‘B’ as follows :
B ≥ A : Combination B is more preferred
to A (B>A) or both are equally preferred
(B = A).
A ≥ B and
B ≥ C then
A≥C
In other words, there should be a
consistency in consumer behaviour. If consumer
prefers ‘A’ to ‘B’ combination and between ‘B’
and ‘C’ if he prefers combination ‘B’ then,
between ‘A’ and ‘C’, he must prefer combination
‘A’. Because of this characteristic, no two
indifference curves would ever intersect each
other.
(3) Reflexivity : Consumer chooses a
small combination or is indifferent about different
combinations. This means each combination
must tall atleast in one of the indifference
combinations.
(4) Non-Satiation : Suppose ‘A’ and ‘B’
are two consumption combinations. Combination
‘A’ is preferred to ‘B’ only when ‘A’ is grater
atleast by one unit than ‘B’. There is a no
reduction in combination ‘B’. In other words, a
national consumer is never satisfied about any
commodity.
(5) Continuity : There are no gaps or
breaks in indifference combinations. Whenever
there is a reduction in one of the commodities in
the combination, howsoever be small reduction,
it is compensated by a parallel increase in the
quantity of other commodity. The loss of
satisfaction by reduction in the quantity of
commodity ‘Y’ is compensated through addition
of commodity X. A result consumer remains in
his original indifference combination, enjoying
equal satisfaction.
Managerial Economics : Nature and Concepts : 87
Indifference Curve
Indifference technique is not a cardinal
measure of utility, but the consumer can tell that
which of the combinations would give him equal
satisfaction. any point on an indifferent curve
shows a set or combination of two goods. Any
point on a given difference curve gives the same
level of satisfaction as on any other point.
However, different indifference curves in an
indifference map show different satisfaction
levels. A higher indifference curve shows higher
level of satisfaction than those at lower level
indifference curves.
Properties of Indifference Curve
(1) Indifference Curve Slopes Downward
from Left to Right : Consumption of one
of the commodities increase when that of
another commodity decreases. Such
negative relationship between consumption
of two commodities can be shown by a
downward sloping curve only.
(2) Indifference Curve does not Touch
OX and OY Axes : Because any
combination of commodities include some
combination of both the goods.
(3) Consumer’s Test is Express through
Indifference Curve : Two indifference
curves never intersect each other. If so
happens, transitivity assumption would
prove wrong. Let us make this point clear
with the help of figure 4.3.
Y
Rice
The combinations of commodities, about
which consumer indifferent, that can be shown
on a single curve is called an ‘Indifference
Curve’. Various sets of combinations of two
commodities giving the same level of
satisfaction. Each set contains uneven
combinations of two commodities but equal
satisfaction. Consumer, therefore, indifferent
about choice of any combination. All such
combinations plotted on a graph paper and joined
by a continuous line (Locus of points), we get
an indifference curve.
IC1
c
IC
0
X
Wheat
Figure 4.3 : Two Indifference Curves Intersecting
Each Other
In figure 4.3, two commodities, wheat and
rice are measured along OX and OY
respectively. IC and IC1 are two indifference
curves assumed to show different level of
satisfaction. We have chosen three points along
the indifference curves, ‘a’, ‘b’ and ‘c’. Both
the curves intersect in point ‘a’.
‘a’ ‘b’ are the points on IC 1 and are
expected to provide same level of satisfaction
to the consumer, who is indifferent about
combinations of wheat and rice on points ‘a’
and ‘b’. Similarly, points ‘a’ and ‘c’ are on IC
and are expected to provide equal satisfaction
to consumer. Point ‘a’ is common on both the
curves. Consumer is indifferent about the choice
of combinations on points ‘a’ and ‘b’.
Since the combinations on points ‘a’ and
‘b’ and ‘a’ and ‘c’ give the consumer equal
satisfaction.
a = b and
a = c then
b=c
Satisfaction derived from combinations on
points ‘b’ and ‘c’ must also be equal, making,
consumer indifferent about a choice between
the two. This is absurd. Consumer can make a
larger combination of wheat and rice on point
‘b’ than point ‘c’. He will choose point ‘b’ and
will not be indifferent, because point ‘b’ falls on
Managerial Economics : Nature and Concepts : 88
a higher indifference curves never intersect each
other. If they do, it will be against the principle
of transitivity.
4.2.4 Marginal Rate of
Substitution (MRS)
Marginal Rate of Substitution is the ratio
of change in the quantity of commodity X and
commodity Y. In the form of equation, we can
explain MRS as
∆Y
Orange
(4) Indifference Curves are Convex to the
Origin : In order to remain on the same
level of satisfaction, when a consumer
increases some quantity of one commodity,
he must decrease some units of other
commodity. Suppose, a consumer
increases the quantity of wheat in his
combination, thereby cutting down some
quantity of rice. As the stock of wheat
goes on increasing, its marginal
significance to consumer must fall. On the
other hand, as the stock of rice with the
consumer goes on decreasing marginal
significance of rice to consumer must
increase. This means consumer shall
sacrifice smaller and smaller quantities of
rice to obtain a unit of wheat. This is
possible not only by a downward sloping
indifference curve, but also the curve must
be convex to the origin.
Y
∆X
M
∆Y
∆X
∆Y
M1
∆X
∆Y
IC
∆X
0
X
1
2
3
4
5
Apples
Figure 4.4 : Marginal Rate of Substitution of X
for Y
In this figure, apples are measured along
OX axis and oranges along OY axis. IC is the
indifference curve. Points ‘a’ and ‘b’ are on
the same indifference curve. IC, representing
same satisfaction. When consumer moves along
IC from Point ‘a’ to ‘b’ he sacrifices ∆Y quantity
of Oranges to obtain ∆X quantity of apples. The
ratio of =
∆Y
is the MRS of X for Y. It goes on
∆X
decreasing as the consumer continues to move
rightwards along the same indifference curve.
Declining MRS of X for Y or Y for X can only
be shown with the help of a convex indifference
curve. The relation between MRS and marginal
utility can be made clear with the help of figure
4.5.
Y
Change in Qy
X for Y = Change in Qx
Symbolically
MRS X for Y =
Orange
Marginal Rate of Substitution of
a
∆X
∆Y
and
∆X
b
+∆Y
IC
∆X
MRS Y for X =
∆Y
X
0
We can make the MRS concept clear with
the help of a diagram given as figure 4.4.
Apples
Figure 4.5 : MRS X for Y and Marginal Utility
Managerial Economics : Nature and Concepts : 89
Consumer moves from point ‘a’ to point
‘b’ on IC. To compensate his loss of utility of Y
(oranges), he increases the quantity of X by ∆X.
Increase in his total utility would be equal to
MUx.∆X. Inspite of changes in total utility of X
and Y. Consumer is on the same indifference
curve, IC because loss in the utility of Y is fully
compensated by gain of additional utility in X.
In the form of equation;
Y
A
Oranges
In the above figure, units of apples and
oranges are measured along OX and OY axes
respectively. IC is the indifference curve.
Suppose, consumer reduces quantity of oranges
by ∆Y, it leads to reduction in utility. Decrease
in utility shall be equal to the multiple of marginal
utility of Y and change (decrease) in the quantity
of Y. Total utility would decrease by MUy ∆Y
E
Y1
IC2
IC1
IC
X
0
X1
B
Apples
Figure 4.6 : Consumer’s Equilibrium
MUy.∆Y = MUx.∆X
∆Y MUx
=
∴
∆X MUy and
MUx
MRS X for Y = = MUy
In brief, MRSx for y is equal to the ratio
between MUx and MUy.
Questions for Self Study – 3
(A) Answers the following questions.
(1)
What is indifference curve?
(2)
Write in brief the characteristic of
preference ordering.
(3)
Write the characteristic of indifference
curve.
(4)
What is marginal rate of substitution?
4.2.5 Consumer’s Equilibrium
Consumer’s preference order could be
known through indifference map. If we know
the prices of commodities measured along OX
and OY axes and the income of the consumer,
we can draw ‘Price line’ or ‘Budget line’ or
Real income line’ of the consumer.
Slope of the budget / price line is the ratio
of commodity prices. Figure 4.6 shows
consumer’s choice of a combination of X and
Y commodities, given the prices and income.
In figure 4.6, units of apples and oranges
are measured along OX and OY axes
respectively. IC, IC 1 and IC 2 are three
indifference curves showing different levels of
satisfaction. AB is the price line that suggests,
if the consumer spends entire income on
oranges, he would get OA units of oranges and
nothing of apples conversely, if he spends entire
amount on apples, he would get OB units of
apples and nothing of oranges. He can make
any combinations of apples and oranges (X and
Y) on any point falling on price line AB, beyond
which a consumer cannot reach because of
income constraint.
For example, point E1 on IC2 consumer,
however, can reach on a point like E2 that falls
on a lower indifference curve, which a rational
consumer shall not prefer. Under the
circumstances, consumer would prefer point E
falling on IC1, which is the highest curve within
his budget limit. He makes a combination of OX1
units of apples and OY1 units of oranges that
gives him maximum satisfaction. Consumer
equilibrium is determined by the point of tangency
between the price line and the IC (point E).
Slope of the price line is equal to the ratio
of prices of two goods (Px/Py). Similarly, the
slope of indifference curve is equal to MRS of
X for Y, therefore,
∆Y Px
MRS x for Y = ∆X = Py
Managerial Economics : Nature and Concepts : 90
4.2.6 Price Effect
Now, let us assume that the consumer is
in equilibrium. The price of oranges and income
of the consumer are constant, but the price of
apple falls. under the condition, price line shall
shift upwards to right. Consumer shall be in a
position to reach a higher indifference curve.
Consumer shifts from one equilibrium point on
a lower / or higher indifference curve on account
of a change in relative prices of X and Y is
called ‘Price Effect’. The concept of price effect
is made clear in figure 4.7.
commodities are stable? An increase in income
shall enable him to reach on a higher indifference
curve. He will have larger combinations of both
the commodities X and Y. His level of
satisfaction would increase. On the contrary,
when income falls, consumer may drop down
to a lower indifference curve with lesser degree
of satisfaction. This effect of change in income
is called Income effect. Figure 4.8 gives clear
idea of price effect.
Y
A3
Y
A2
Oranges
Orange
A
Y1
A1
Y3
E
E1
E2
IC1
B
E1
PCC
IC2
B1
IC3
IC2
IC1
0
X1
ICC
E3
Y2
Y1
Y2
0
D
X
X1
X2 B1 X3
B2
B3
Apples
X
X2
Apples
Figure 4.7 : Price Effect
In figure 4.7, AB and AB1 are two price
lines tangent to IC1 and IC2 respectively. AB is
the price line before change in the price of X.
Consumer was initially in equilibrium in
point E on IC1 and price line AB when his
combination of X and Y commodities was OX1
and OY1 respectively.
When price of X falls relative to Y,
consumer has a new price line AB1. This price
line is tangent to IC2 in point E1. This is the new
consumer equilibrium in which consumer adds
XX1 quantity of X by sacrificing a small quantity
of Y, Y1Y2. Locus of the points E and E1 when
joined by a dotted line, we get price consumption
curve ‘PCC’. Shift of the consumer equilibrium
from point E to E1 is a price effect favouring
commodity X.
4.2.7 Income Effect
What will be effect of change in income
of a consumer when relative prices of
Figure 4.8 : Income Effect
In the above figure, IC1, IC2 and IC3 are
indifference curves showing different levels of
satisfaction. A2B2 is the initial price line when
the consumer’s income was low, say Rs. 40.
Consumer was in equilibrium at point E1, where
price line A1B1 is tangent to IC2. Consumer shall
make a combination of two goods, OX2 units of
X and OY2 of Y commodity.
Now, consumer’s income rises to Rs. 60.
He will now be on IC3. the new price line is
AB3 which is tangent to IC3 at point E3 by
making a larger combination of X and Y
commodities. Consumer shall have OX3 units
of X and OY3.
When the income of the consumer falls,
(say Rs. 20), the new price line would be A1B1
and would touch the IC1 at point E1, representing
new equilibrium. The consumer shall have
smaller combination of X and Y units. His level
of satisfaction drops as he switches over to a
lower indifference curve.
The locus of points passing through E1, E2
and E3 is called ICC or ‘Income Consumption
Curve’.
Managerial Economics : Nature and Concepts : 91
He can utilize money saved on account of
fall in price to purchase more quantities of
either or both the goods. This is real income
effect.
4.2.8 The Substitution Effect
When income of the consumer is constant
but price of one of the commodities decreases,
a rational consumer shall increase the
consumption of the commodity price of which
is decreased. In simple words the consumer shall
reduce consumption of relatively costly
commodity and increase purchase of relatively
cheap commodity. By substituting cheap
commodity for relatively costly commodity,
consumer remains on the same indifference
curve. This is called substitution effect.
(2)
When commodity X becomes cheap
relative to price of Y, consumer would
prefer to substitute more of X for Y.
We can show these effects with the help
of figure 4.9.
Increase in the consumption of X from
OX1 to OX2 or movement of consumer from
point E1 to E2 along the same IC1 is ‘substitution
effect’.
Y
Further increase in consumption of X by
X2X2 or a movement of the consumer from E2
to E3 is the real income effect of price change.
Thus,
Orange
A
A1
Y1
Price Effect = Income Effect +
Substitutions Effect
ICC
E1
X1X3 = X2X3 + X1X2
E3
Y2
PCC
IC2
E2
Y3
IC1
0
X1
X2 B 1 X3
B2
B3
X
Apples
Figure 4.9 : Substitution Effect
In figure 4.9, AB is the price line which is
tangent to IC1 at point E1, where the consumer
was in initial equilibrium. His commodity
combination contained OX1 of X and OY1 of
Y.
Now, the price of X falls, but that of Y
remains unchanged. New price line AB2 is
tangent to IC2 at point E3. Consumer increases
the quantity of X by X 1X 3 at the cost of
sacrificing Y1Y3 quantity of Y. He is better off
due to fall in the price of commodity X and that
he could reach a higher indifference curve. In
other words, he has a larger combination of X
and Y together.
Price, Income and Substitution Effect
Price effect is the sum total of income
effect and substitution effect. It is because effect
of change in the price of any one or all
commodities have two effects.
(1)
When price falls, consumers real income
in terms of purchasing power increases.
We must, however, remember that
commodities in which positive income effect is
experienced are normal goods. But some
commodities show negative income effect, their
demand decreases with rise in income are
inferior goods or Giffen goods.
Income and substitution effects are
positive and the move in the same direction in
case of normal goods. These effects move in
opposite direction in case of inferior goods.
Demand curve of normal goods slopes
downward, but if may be upward rising to the
left for inferior or Geffen goods. If substitution
effect of an inferior good is more powerful than
the income effect, its demand curve would slope
downwards. On the other hand, if negative
income effect is stronger than the substitution
effect, demand curve would slope backwards
to the left. This is true of Geffen goods.
Questions for Self Study – 4
(A) State whether the following
û)
statements are true or false. Put (û
ü) in bracket.
or (ü
(1)
How much of the two commodities a
consumer can buy at a given price out of
his limited income is shown on price
line. ( )
Managerial Economics : Nature and Concepts : 92
The point at which indifference curve
touches shows maximization of satisfaction
and equilibrium. ( )
(3)
Income effect means effect of increase
in income on demand for a commodity. ( )
(4)
When price of a commodity decreases, the
consumer can purchase more goods and
thereby reaches on a lower indifference
curve.
(5)
When an increase in income leads to an
increase in the demand, the commodity
must be normal. ( )
(6)
In case of inferior goods, it is observed
that rise in income leads to reduction in
demand. ( )
4.2.9 Revealed Preference
Approach
So far, we have analysed theory of
demand from the point of view of two
approaches. Both the earlier approaches are
utility based. According to Marshall, utility can
be quantitatively measured. Indifference
approach emphasizes ordinal measurement of
utility. Thus, both the approaches are based on
imaginary concept of utility. Hence, the demand
analysis is more psycho-based rather than a
positive statement. Considering this drawback
of both the approaches, an attempt has been
made to develop alternative approach. Utility
and preference can not be measured nor can it
be shown. What we can observe is consumer
behaviour. Which group of commodities a
consumer could buy? What was his income at
that time? What are the prices of commodities?
These are the things we could know by observing
human behaviour. Alternative approach to
demand is not based on utility or consumer
preferences, but directly on human behaviour.
In a nutshell, the new approach suggests that
the choice of a commodity or group thereof by
a consumer reveals his preference. This theory
known as ‘Revealed Preference Approach’ is
developed by modern American economist, Paul
A. Samuelson.
Assumptions of the Revealed
Preference Theory are as under :
(1)
Consumer spends all of his income during
a specific time period.
(2)
Given income and prices, consumer
chooses only a single group of
commodities.
(3) A single group of commodities once chosen
will not be changed by the consumer so
long as the price income condition remains
unchanged.
(4) There is a consistency of choice by the
consumer.
Figure 4.10 would help understanding
analysis of the theory.
Y
Commodity Y
(2)
A
Y1
C
B
0
X1
X
Commodity X
Figure 4.10 : Revealed Preference
In figure 4.10, commodities X and Y1 are
measured along horizontal and vertical axes
respectively. AB is the price line. Consumer is
free to make choice of any group falling within
the triangle OAB. However, a rational consumer
shall choose a group falling on price line AB.
Any point below this line would mean he is not
spending his entire income. This is against the
assumption. Conversely, though the consumer
can choose a group outside the triangle OAB,
but it will be beyond his reach.
Suppose, consumer chooses a group given
by point ‘e’ on AB price line. He will have OX1
of commodity X and OY1 of commodity Y in
this group. His entire income is spent and that,
his satisfaction maximises.
The consumer was free to choose only
group falling on the line AB, but he chooses the
group given by point ‘C’. That means he is
indifferent about all other attainable groups. in
brief consumer preference is revealed by his
choice. This is called ‘Revealed Preference
Approach.’
Managerial Economics : Nature and Concepts : 93
Explanation of the Theory of Demand
Questions for Self Study – 5
We shall now analysis theory of demand
under revealed preference approach.
(A) Write brief answers to the following
questions.
(1)
Who developed the ‘Revealed Preference
Approach’?
(2)
On which principle, the revealed
preference approach to demand is based?
(3)
Write in brief, the assumptions of revealed
preference theory.
Commodity Y
Y
A
Y1
ICC
4.2.10 Recent Trends in the
Theory of Demand
E
E2
PCC
E1
IC2
B2
B
0
X
X1
IC1
B1
X
X2
Commodity X
Figure 4.11 : Explanation of Demand Theory
under Revealed Preference Approach
In figure 4.11, commodities X and Y are
measured along OX and OY axes respectively.
AB is the original price line. Consumer chooses
point E on price line AB. Suppose further that
price of X falls, but price of Y and income of the
consumer remained unchanged. AB1 is the new
price line after change in price of X. consumer
will choose combination or group of commodities
at point E1. Since commodity X is now cheap
consumer shall buy XX2 more units of X.
Movement of consumer from point E to E1 is
the price effect, equal to XX2 units of the total
price effect, shift of the consumer from point
EE1 or XX1 units of X is substitution effect on
account of decline in price of X. Remaining part
of increase in consumption of X by X1X2 is the
income effect.
All the three effects influence demand as
stated above. Negative relationship between
price and quantity demanded is also accepted in
this new approach. Demand curve slopes
downward sloping. In the theory of revealed
preference, existence of positive income effect
is sufficient condition to prove the law of
demand. In case of inferior goods, income effect
and substitution effects change in opposite
direction.
So far we have studied demand theory
under three different approaches : utility,
indifference and revealed preference
approaches. However, these approaches have
limited utility and applicability to solve complex
problems of real world. Some economists
therefore, presented a ‘Pragmative Approach’
to demand theory. In some cases, demand
function is taken into account on the basis of
actual statistical information from markets.
Demand is a function of many factors.
Such a function need be studied with the help of
statistical data. In recent times, demand function
is studied with reference to ‘consumer group’
and ‘commodity group’. Instead of a single
individual, a group of consumers and for a single
commodity, group of commodities is considered
such as food grains, (instead of wheat, rice etc.)
soft drinks, consumer durables and so on.
Empirical studies on demand often face
difficulties. How to compose total demand from
the groups of individuals and commodity groups
also poses problems. Under such circumstances,
demand forecasting becomes difficult. Index
numbers could be used for the purpose, but this
measure has some limitations. Factors affecting
market demand may all of a sudden change
simultaneously. How much is the impact of each
factor on demand is difficult to determine.
Improved econometric tool may be of some use
in solving such complicated problems.
Another recent trend in demand analysis
is the study of demand function under dynamic
conditions. In dynamic demand function,
consumer behaviour in the past affects current
buying decisions. Current consumption
expenditure depends on income of the previous
Managerial Economics : Nature and Concepts : 94
income and past level of demand. Purchases of
durables in the past creates stock that affects
current and future purchases.
(1) Subsistence Income : This income is
spent on minimum units of different
commodity groups.
Purchases of highly durable goods in the
past cultivate consumption habits in current
period. Purchases and level of consumption
during immediate past affects demand structure
of today and tomorrow. Impact of human
behaviours in too old a period has negligible
impact on current demand trend. The demand
function, which consider lagged values of price,
income and demand etc. is called ‘Distributed
Lag Model’.
(2) Supernumerary Income : If subsistence
income is subtracted from total income of
the consumer, remaining income is
supernumerary income.
One more recent trend in demand analysis
is ‘Linear Expenditure System’. This model
considers commodity group, when clubbed
together, we get the expenditure of all
consumers. Richard Stone, an economist, was
the first to bring up this idea. Linear expenditure
model is based on the concept of utility and a
demand function has been prepared accordingly.
In this respect, the model is similar to
indifference approach. However, the linear
model applies to commodity group and therefore
substitution is not possible. Utility function is a
sum total of utilities derived from various
commodity groups. Suppose, all goods
purchased by consumer are distributed in five
groups.
F = Food and drinks
C = Clothing
D = Consumer durables.
H = Household expenditures, and
S = Services.
Consumer derives utility from each of the
commodity group and total utility is the sum total
of utilities of all commodity group. If we put it in
equation from –
Tu = Fu + Cu + Du + Hu + Hu
No substitution is possible between
commodity groups. However, substitution is
possible within a commodity group. Consumer
purchases some units from each of the
commodity groups. price is not an important
factor in this process. Minimum commodity units
are termed as ‘commodities essential for
survival’. Income of the consumer is distributed
over different commodity groups on the basis
of prices. Income is distributed in two parts.
This approach to demand theory has
assigned special meaning to the income effect.
Consumers Choice Under Risk
Expectations about price act as a deciding
factor and therefore, perform an important role.
Expected prices in future are as important as
the current and past prices. When we think of
the future expected prices with reference to
current demand, we surely think of risks and
uncertainties in future.
Fon Newman and Margenstern,
Economists have developed a theory
‘consumers choice under risk’. According to this
theory, if a consumer could follow important
principles, (such as a complete preference order
continuously, independence, uneven possibility
and complexity) he gets two sets of results.
Definite results and a combination of two
uncertain results. He will have a serious of
choices to workout his utility function. Such a
utility function shall be unique. Available
alternatives can be arranged in order. Further
more, there is no risk. Consumer maximises his
expected utility. Such utilities are cardinal and
can be used to compare utility differences.
Expected utility measured by this method can
be used in consumer choice and demand
decisions.
Questions for Self Study – 6
(A) Write brief answers to the following
questions.
(1)
How is demand function viewed in recent
times?
(2)
Explain in brief the dynamic approach to
the theory of demand.
(3)
Explain the ‘Linear expenditure Approach’
to the theory of demand.
(4)
What is the formula of consumers’ choice
under risk?
Managerial Economics : Nature and Concepts : 95
4.2.11 Exceptional Demand Curve
Normally, demand curve for a product
slopes downwards to the right to show negative
relationship between price and quantity
demanded. However, in some exceptional cases,
consumer purchases less when price declines,
purchases larger quantities when price increase.
Figure 4.12 shows an exceptional demand
curve.
Law of Demand does not operate in
following cases.
(1) Inferior goods : It a commodity is
inferior, and its negative income effect is
grater than the substitution effect, demand
curve shall have an abnormal slope as
shown in figure 4.12. Such commodities
are called “Geffen Goods”. Demand for
such goods increases when price
increases. Inferior goods, such as Jawar,
Bajra, Millo and similar coarse food grains
face such demand conditions.
Price (Rs.)
D
N
P
D
0
X
Q
(3) Derived demand for factor Services:
Factor services such as skilled labour are
demanded because products it produces
is in demand. Electronic industry demands
skilled labour and its demand increases as
the demand for electronics goods
increases. Under the circumstances, even
though the wage rates increase, industry
demands more workers.
(4) Prestigious Goods : Some times, it is
observed that precious stones, gold rare
paintings and similar symbols of prestige
are in grater demand when their prices
touch sky hight. Such goods are within the
reach of a few persons who buy more
when price increases. Holding of such
goods distinguishes them from common
man, who is unable to purchase. Such
goods are called goods of conspicuous
consumption.
Y
P1
(2) Speculative Demand : Speculative
demand is the second exception to the Law
of demand. Such demand is observed in
stock market. If it is expected that stock
prices would rise in future, more stock will
be demanded even though their current
prices are high. Same is also true of
essential commodities like food grains,
edible oil and a host of other commodities.
If prices of these goods are expected to
rise tomorrow, people by more quantities
though current prices are high.
Q1
Inferior Goods (Jawar)
Figure 4.12 Demand for Inferior Goods
In figure 4.12, Quantity of inferior good is
measured along OX axis and price is measured
along OY axis. DD is an upward rising and latter
backward benting demand for inferior good,
from point N.
Initially, price was OP when quantity
demanded was OQ. Latter, when price
increases to OP1 quantity demanded increases
to OQ1. Any further increase in price, would
reduced demand. This is shown by backward
sloping demand curve above point ‘N’. This is
an exception to the Law of demand.
(5) Complementary Goods : In case of
complementary goods, the price of the
product concerned may not be a
determinant of demand but price of other
complementary product influences
demand. An increase in the price of fuel
may lead to decrease in the demand for
car, even though prices of cars are
constant.
Questions for Self Study - 7
(A) Answers the following questions in
brief.
(1)
What is an exceptional demand curve?
(2)
In which types of commodities we observe
exceptional demand curve?
(3)
What are the other factors in which we
Managerial Economics : Nature and Concepts : 96
observe exceptional demand curve?
4.3 Words and their Meanings
in obtaining the commodity.
(3)
Utility is measurable in terms of money or
other units.
(4)
(a) Each consumer chooses goods with
a view to maximise satisfaction.
Cardinal Approach : A thought that believes
in cardinal measurement of utility.
Total Utility : Utility derived for all the units of
a commodity consumed.
(b)
Yes, utility can be cardinally
measured in terms of money.
(c)
It is assumed that value of money
remains constant.
(5)
Utility derived from all the units consumed.
Ordinal Approach : A though believing in
measurement of utility in relative terms.
(6)
Change in total utility due to change in
consumption by one units.
MRS : Marginal Rate of substitution. In order
to obtain one unit of X, number of Y units
are required to be sacrificed.
(7)
(i)
Total utility increases so long as
Marginal Utility is positive.
(ii)
When Marginal Utility is zero, Total
Utility reaches to its maximum.
Price Line : A line showing the maximum
number of combinations of X and Y a
consumer could buy within his limited
income.
Price Effect : Change in consumption of a
commodity on account of a change in
price, assuming income to remain
constant.
(iii) When Marginal Utility turns negative,
Total Utility starts falling.
(8)
Questions for Self Study - 2
(1)
Income Effect : Assuming prices of X and Y
commodities to remain constant, the impact
of change in income over demand.
Substitution Effect : A simultaneous change
in income and prices of goods leading to
change in demand of a commodity
Giffen Good : An inferior good in relation to
other superior good as believed by the
consumer.
Revealed Preference : Preference revealed
by consumer through choice of commodity
groups.
4.4 Answers to Questions for
Self Study
Questions for Self-Study-1
(1)
Alfred Marshall
(2)
According to Bentham, utility is the
difference between satisfaction derived
from consumption and sacrifice involved
MU = 50, 120, 40, 30, 20, and 20.
Maximization of satisfaction under the
concept of equi-marginal utility.
Emu =
MU X MU Y MU Z
=
=
PX
PY
PZ
(2)
A consumer has to be careful in spending
money because it is scarce and wants to
be satisfied by money are unlimited.
(3)
Equation =
(4)
MU curve slopes downward to the right
because as the consumption of a
commodity goes on increasing, MU
derived from each additional unit goes on
deminishing.
MU X MU Y
=
PX
PY
Questions for Self Study - 3
(1)
A curve that shows equal satisfaction level
from the combinations of X and
commodities on any point, is called
indifference curve.
(2)
(a)
A consumer can express his
preference or indifference between
two sets of combinations.
(b)
There has to be consistency in
consumer’s choice.
Managerial Economics : Nature and Concepts : 97
(3)
(4)
(c)
Each of the combinations of X and
Y good must fall in any of the
indifference groups.
(3)
Linear expenditure model presented by
Richard Stone - Commodity Group sum
total of group totals as total utility.
(d)
No rational consumer is satisfied by
consumption of a commodity.
(4)
(e)
When quantity of X decreases in a
combination there is a corresponding
compensatory increase in Y.
Newman and Margenstern- consumer
choice under risk. A unique utility function
based on certain assumptions- without risk.
(a) Indifference curves are downward
sloping (b) Two indifference curves never
intersect (c) Indifference curves are
convex to the origin.
Questions for Self Study - 7
(1)
Exceptional slope of demand curve, where
the Law of Demand does not operate.
(2)
Exceptional demand curve is observed in
case of inferior (Giffen) goods. Negative
income effect is stronger than substitution
effect.
(3)
Shares / stock, demand for skilled Labour,
demand for complementaries and
prestigeous goods are other examples of
exceptional demand.
MRS X for Y means units o Y that must
be sacrificed to obtain one unit of X.
Questions for Self Study - 4
(1) (ü),
(2) (ü),
(3) (ü),
(4) (û),
(5) (ü),
(6) (ü).
Questions for Self Study - 5
(1)
Paul A Samuelson.
(2)
Utility concept and preference ordering are
imaginary and psychological. Demand
analysis, therefore, becomes imaginary
rather than a positive statement. We can
only observe consumer behaviour.
Revealed preference theory is based on
practical behaviour of consumer.
(3)
Assumptions of revealed preference
theory-(a) Consumer spends all of his
income during a given period. (b)
Consumer chooses a single product when
specific price and income is given. (c)
There is consistency in consumer choice.
(d) Consumer demand increases as his
income increases.
Questions for Self Study - 6
(1)
With reference to consumer group and
commodity group.
(2)
Dynamic analysis of demand theory
believes in the impact of past behaviour
on current purchases - current expenditure
is based on past income demand. Past
consumption level and purchases influence
current demand. Income of the near past
and so on.
4.5 Summary
Many approaches stating the negative
relationship between price and quantity
demanded came forward - such as utility cardinal measurement is possible in terms of
money. Operation of the law of diminishing
marginal utility - Assumptions - consumer is
rational, value of money stable etc. Equi-marginal
utility-maximization of satisfaction with more
than one commodity =
MU X MU Y
=
PX
PY
Indifference curve approach to demand
theory - superior to cardinal measurement of
utility approach. Instead of cardial measurement
- preference ordering consumer equilibrium by
the point of tangency between IC curve and the
price line. Any point on a given IC curve such
combination of X any Y goods given equal
satisfaction to the consumer, who in indifferent
about choice of a particular combination.
MRS : Marginal Rate of Substitution.
An Indifference Map : A series of ICs
showing different levels of satisfaction.
Price line / Budget line / Income line:
is the budgetory limit, given income and prices
of X and Y, a consumer cannot cross.
Managerial Economics : Nature and Concepts : 98
A rational consumer tries to reach the
highest indifference curve within his income
limits.
(6)
Price effect : Effect of change in price
of atleast one commodity on demand when
income is constant.
Substitution effect : Consumer
behaviour to switch over to relatively cheaper
goods when price of one product changes.
Income effect : Effect of change in
income of the consumer on demand - shifts in
income line - shifting of the point of equilibrium.
Effect of change in relative prices on demand.
Revealed preference Approach : Paul
A. Samuelson - consumer behaviour reveals the
choices an prices of commodities. Consumer
spends all of his income and maximises
satisfaction.
Recent trends in demand theory considers
consumer groups and commodity groups.
Dynamic analysis of demand theory takes into
account dynamic factors such as changes in
prices, income and consumption over time and
its impact on current demand. Linear
Expenditure Model also considers commodity
groups and the sum total of group utility as total
utility. Newman and Morgenstern have
developed the theory of consumer choice under
risk.
Exceptional demand curves are also
observed in some cases. These are exceptions
to the Law of Demand.
4.7 Field Work
(1)
See whether you experience diminishing
marginal utility while consuming a product.
Prepare your own MU Table.
(2)
Think cautiously on how you purchase a
number of goods out of your income. See
whether you experienced the law of equimarginal utility.
(3)
Suppose, disposable income with you
increases and you spend more. See
whether you experience income effect.
(4)
If relative prices of sugar and gur change
does this make any difference to you? If
yes, will you experience substitution
effect?
(5)
Price of edible oil is increasing. In near
future, it is likely to rise more sharply.
Watch the behaviour of 10 households
around you and note the changes in
behaviour.
4.8 Books for Further Reading
(1)
Baymol, W. J., Economic Theory and
Operations Analysis,(Fourth Edition).
(2)
Kastsoyiannis A. (1979), Modern
Microeconomics, 2nd Ed. London, The
Macmillan Press LTD. Section IVCH.2.
(3)
Fergusson, C. E. and Gould, J. P., Microeconomic Theory, (Fifth Edition)
(4)
Stories A.W. and Hague D.C., A Text.
Book of Economic Therory, 12th Edn.
CHS 1, 2, 4, 5, 8 and 9.
(5)
Indira Gandhi National Open University,
New Delhi, Managerial Economics(Demand Decision-2).
4.6 Exercises
Answers following questions in 20-25 lines.
(1)
Explain cardinal utility approach to the
theory of demand.
(2)
Explain the law if equi-marginal utility.
(3)
Explain detail, the indifference approach.
(4)
Explain with figures, the price effect,
income effect and substitution effect.
(5)
Explain Revealed Preference Approach
to Demand.
Explain exceptional demand curve with
the help of a figure. In which types of goods
we experience exceptional demand
curves?
Managerial Economics : Nature and Concepts : 99
Unit 5 : Elasticity of Demand
Index
5.1 Introduction
5.0 Objectives
5.1 Introduction
5.2 Subject Description
5.2.1 Elasticity of Demand: Meaning
5.2.2 Types of Elasticity of Demand
5.2.3 Measurement of Elasticity of
Demand
5.2.4 Factors Determining Elasticity of
Demand
5.2.5 Managerial Uses of Elasticity of
Demand
5.2.6 Empirical Demand Estimates
5.3 Words and their Meanings
5.4 Answers to Questions for Self Study
5.5 Summary
In the last two units, we have studied the
concepts and analysis of demand respectively.
We also discussed the factors influencing
demand, consumer behaviour, demand function
and demand curve, expansion and contraction
of demand, increase and decrease in demand,
and various approaches to the demand analysis.
In this unit, we have to discuss one
important concept relating to demand, the
‘elasticity of demand’. From the law of demand,
we know that the relationship between the price
and quantity of a commodity demanded is
negative. But it doesn’t tell how much quantity
demanded would change in response to a change
in price. The concept of elasticity helps us in
knowing how much. Let us study this concept
in detail.
5.6 Exercises
5.7 Field Work
5.8 Books for Further Reading
5.2 Subject Description
5.0 Objectives
5.2.1 Elasticity of Demand :
Meaning
After studying this unit, you will be able
to :
« Explain the meaning of elasticity.
« Explain the types of elasticity of demand.
« Explain the methods of measuring the
elasticity of demand.
« Explain the factors determining the
elasticity of Demand.
« Explain the managerial uses of elasticity
of demand.
Capacity of anything to expand and
contract is called elasticity. Rubber is elastic,
whereas a strip of metal is not. We say that
rubber is elastic and metal is inelastic. Same
rule applies to demand for a commodity.
Demand expands when price falls and contracts,
when price increases. Here, we assume that
the price is the only variable influencing demand.
‘Other things’ such consumer’s income, prices
of other goods, expectations about future prices
etc. remain unchanged. Similarly, demand
changes due to change in income even though
the price of the commodity is constant. Some
times, price of a commodity and consumer’s
Managerial Economics : Nature and Concepts : 100
income remain stable but demand for a
commodity changes because of changes in other
goods; may be substitute to or complementary
to original commodity. Thus, elasticity is a
‘measure’, to measure the impact of a change
in one variable on another variable.
5.2.2 Types of Elasticity of
Demand
We know that a change in the price of
the commodity, income of the consumer or prices
of other goods leads to change in the quantity
demanded of a commodity. The ratio of change
in quantity demanded to a change any of these
variables is called elasticity of demand. Type of
elasticity, thus depends on the factor that is
responsible for bringing about a change in
quantity demanded. , When price alone is a
factor influencing the demand, we estimate price
elasticity of demand. Similarly, income elasticity
and cross elasticity of demand for a product is
estimated. Let us now, go into the details of each
type of elasticity.
(a) Price Elasticity of demand
Price elasticity of demand, (Ep) measures
the impact of change in the price of X, Px, on
the quantity of X demanded by the consumer,
Qdx.
The ratio of change in quantity of X
demanded to a change in the price of X,
Px is called price elasticity of demand.
According to K. E. Bolding, the ratio of
percentage change in quantity of the commodity
to percent change in its price is called price
elasticity of demand.
Elasticity of demand differs from
commodity to commodity. Assume that prices
of salt and sugar are doubled. There shall be
insignificant decrease in the demand for salt but
the demand for sugar shall fall by larger quantity.
Demand for sugar is said to be highly elastic
and that of salt, inelastic. Following is the formula
for finding price elasticity of demand.
Epx =
% Change in Qdx
% Change in Px
We shall use this formula for measuring
price elasticity of demand with a simple
numerical example.
%
Px
Qdx
%
change
price
Number change
Rs.
in Qdx/
of Units in Px
Per unit
Px
Value of
elasticity
10
1000
-
-
-
12
700
20
-30
− 32
= −1.5
20
Above table shows that as a result of 20
percent increase in price, quantity of X
demanded decrease by 30 percent. Demand is
sensitive to change in price. Therefore the value
of elasticity is –1.5. Value of price elasticity of
demand is essentially negative because price and
quantity demanded always change in opposite
direction.
When price elasticity of demand is greater
than one, (Ep>1) the demand is said to be elastic.
If, on the other hand, value of elasticity is less
than one, (Ep<1) demand is said to be inelastic.
When change in quantity demanded and change
in price are exactly proportionate, demand is said
to be unitary elastic, where Ep= 1.
It is generally observed that the demand
for essential commodities like salt, medicine, and
kerosene is less elastic (inelastic). Demand for
TV, air conditioners, cars etc. is highly elastic.
Price elasticity of demand is dependent only on
changes in the price, assuming other conditions
to remain unchanged.
In addition to three types of elasticity
discussed above, (Ep>1, Ep>1 and Ep=1), three
are two more types of price elasticity; namely,
Price elasticity of demand= 0 (Ep=0) and equal
to infinity (Ep=µ). When in spite of a radical
change in the price of commodity in any
direction, quantity of X demanded remains
unchanged, the elasticity is said to be zero.
Infinitely elastic demand is a term carrying
opposite meaning to that of zero elasticity. A
small change in the price of the commodity leads
to unlimited increase in the quantity of that
commodity demanded.
Managerial Economics : Nature and Concepts : 101
In real world, however, above three types
of elasticity are rarely seen. Only two types of
elasticity can be observed in practice, Ep > 1
and Ep<1.
In brief, types of price elasticity of demand
can be classified into five types:
(1)
Infinitely inelastic demand,
(2)
Zero elastic demand,
(3)
Unitary elastic demand,
(4)
More elastic or elastic demand and
(5)
Less elastic or inelastic demand.
In figure 5.1 is shone zero elasticity of
demand, where DD is the demand curve that
remains unchanged whatever may be the
change in price. It is horizontal to vertical axis,
OY.
Figure 5.2 shows infinitely elastic demand
curve. It is parallel to OX, horizontal axis when
price is OP. That means at Op price or any price
below it, consumers can demand an infinite
quantity of x but not s single, if the price is slightly
higher than OP.
We can show all these types of price
elasticity of demand with the help of figures.
Y
D
Price (Rs.)
Y
Price (Rs.)
D
D
X
0
Quantity
0
X
D
Quantity
Figure 5.3 : Unitary Elastic Demand Curve
Figure 5.1 : Zero Elasticity
Demand curve in figure 5.3 is unitary
elastic, in the sense that a proportionate change
in price brings about proportionate change in the
quantity of X demanded. This is shown by the
ratio of change in the quantity demanded to
change in price :
Y
D
Price (Rs.)
D
Ep =
% Change in Quantity of X Demanded
% Change in Pr ice of X
=
100
− 50
X
0
Quantity
= -2
Figure 5.2 : Infinite Elasticity
Managerial Economics : Nature and Concepts : 102
Y
Y
D
6
Price (Rs.)
D
5
E>1
P
∆P
∆P
4
P1
3
∆Qx
∆Qx
2
D
1
D
X
0
X
X1
0
X
X
X1
Quantity of X Demanded
Quantity
Figure 5.5: Inelastic (less elastic) demand.
Figure 5.4 : Highly Elastic or Elastic Demand
Demand curve in figure 5.4 is gradually
sloping to the right, because demand is highly
price elastic. A sight decrease in price leads to
more than proportionate increase in quantity
demanded of X. (∆Q is greater than ∆Q).
Suppose, for example, price of a commodity
decreases from Rs.10 to Rs.5 percent. Quantity
of X demanded by the consumer increases, say
by double the original price recording a 50
percent decline in price of X leads to 100 percent
increase in quantity (∆Q is greater than ∆P) of
X demanded. Using elasticity formula-
In figure 5.5, DD is a sharply declining
demand curve that shows great change in price
would lead to only a small change in quantity
demanded. Here, ∆Q is smaller than ∆P. That
means a 100 percent decline in price leads to 50
percent increase in quantity demanded. ∆P > ∆Q
means change in price is greater than the change
in quantity demanded and thus, the value of price
elasticity works out to –0.5.
In brief, we can estimate the value of
elasticity just by looking at the slope of the
demand curve.
Questions for Self Study - 1
(A) Write brief answers to the following
questions.
(1)
What is the meaning of elasticity of
demand?
(2)
Which are the types of elasticity of
demand?
(3)
What is meant by ‘elasticity greater
than One’ ?
(4)
What is meant by ‘elasticity less than
One’?
– 50
(5)
What is meant by ‘elasticity equal to
One’?
Value of elasticity in this example come
(6)
What is meant by zero elasticity of
demand?
(7)
What is meant by infinite elasticity
of demand?
%Change in quantity of X demanded
Ep=
———————————————
%Change in price of X
100
= ———— = – 2
to –2
Managerial Economics : Nature and Concepts : 103
(B) State whether the following
û)
statements are true or false. Put (û
ü) in bracket.
or (ü
(1)
(2)
Ey =
Theory of demand and elasticity of demand
carry same meaning. ( )
Demand for slat is more elastic and that
of sugar less elastic. ( )
(3)
Demand for wine, cigarettes and tobacco
is inelastic. ( )
(4)
Demand for ornaments is more elastic.
( )
(5)
If changes in demand and price are
proportionate, the elasticity of demand
must be greater than one. ( )
(C) Fill in the blanks using appropriate
words:
% Change in Quantity of X Demanded
% Change in Income of Consumer
=
50
= 2.5
20
It is observed in case of normal goods that
there is a positive relation between income and
quantity of a commodity demanded. Hence, value
of income elasticity is positive. General
observations about income elasticity of demand
are as under:
(1)
If the proportion of change in the demand
is greater than the change in income, value
of income elasticity of demand is greater
than one. (E>1)
(2)
If the proportion of change in the demand
is lesser than the change in income, value
of income elasticity of demand is less than
one. (E<1)
(1)
Demand for essential commodities is——
—-——— elastic. (greater than one/ less
than one)
(2)
If quantity of a commodity changes by 8
percent due to a change in price by 8
percent, the elasticity of demand must be
equal to ————— (one/zero)
(3)
If there is a proportionate change in
quantity demanded and the income, income
elasticity of demand must be equal to unity.
(E=1)
(3)
Demand changes in the ——— direction
in which price changes. (same/opposite)
(4)
(4)
If the elasticity of demand is zero, demand
curve must be parallel to——axis (OX/
OY)
If demand remains unchanged, regardless
of any changes in income, the income
elasticity of demand is said to be zero.
(E=0)
(5)
If, on the other hand, a small change in
income when leads to infinite change in
quantity demanded, income elasticity of
demand is said to be infinite. (E=µ)
(b) Income Elasticity of Demand
Income elasticity measures the responses
of demand to changes in income.
Income elasticity of demand is the ratio
of changes in the quantity demanded to a
change in income:
Ey =
% Change in Quantity of X Demanded
% Change in Income of Consumer
Suppose, income of a consumer increases
from Rs.1, 000 to Rs. 1,200 and his demand for
commodity X increases from 10 units to 15 units,
increase in demand for X would be 50 percent
in response to 20 percent increase in consumer’s
income. The value of income elasticity would
be-
Income elasticity of demand for a normal
good is positive because income and quantity
demanded change in the same direction. The
relationship between income and demand is
positive. In price elasticity of demand, however,
the relationship between price and quantity
demanded is negative. In exceptional cases like
Giffen goods (inferior goods), income elasticity
of demand can be negative and that the price
elasticity, positive.
(c) Cross Elasticity of demand
One more variable in determining the
elasticity of demand is the price of ‘other goods’.
These are ‘substitutes’ or complementary’ goods
to original good. Substitute goods satisfy the
same want as the original good and therefore
are competitive products. Examples are tea and
Managerial Economics : Nature and Concepts : 104
coffee, drama and cinema, Jawar and Bajra,
wheat and rice etc. We can use sugar and gur
to satisfy the same need.
Some goods are complementary to each
other, and together these satisfy human wants.
Examples are tea and sugar, car and petrol, pen
and ink or boll pen and refill etc.
When the price of a commodity is
constant and that of ‘other goods’
(substitutes or complementary goods)
change, the responsiveness of demand for
the commodity is called cross elasticity of
demand.
The same formula we can use to find the
value of cross elasticityE =
% Change in Quantity of X Demanded
% Change in the Pr ice of Com mod ity Y
Commodity Y may be a substitute product
or a complementary to the commodity X. Let
us now find the cross elasticity of demand for
tea, when price of its complementary good, sugar
change.
E =
% Change in Quantity of Tea Demanded
% Change in the Pr ice of Sugar
Suppose that the price of sugar increases
by 10 percent, leading to decline in the demand
for tea by 15 percent, cross elasticity of demand
for tea would be-
=
15
= 1.5
10
Demand for tea, when its price is constant,
changes in the opposite direction of any change
in the price of sugar. The relationship between
the two is negative. Hence, we get negative
cross elasticity of demand for tea in relation to
price of sugar.
Now, using the same formula, we shall find
the cross elasticity of demand for coffee, when
price of tea, a substitute commodity, changes.
Suppose, price of tea increases by 10 percent,
leading to a fall in the demand for coffee by 5
percent. The cross elasticity of demand would
be-
=
5
= 0. 5
10
We can thus conclude that the cross
elasticity of demand for complementary goods
is negative and that of substitute goods, positive.
If the cross elasticity of demand between
two goods is negligible or zero, we can say that
the goods concerned are totally unrelated. Gold
and a piece of land are such unrelated
commodities. Closer the substitutes and closer
the complementariness between two goods,
larger is the likely cross elasticity of demand.
(d) Advertisement Elasticity
Present age is known as the age of
advertisement. Unless the seller advertises his
product, he could not sell more. Advertising has
a positive effect on sales. However, cost is
involved in advertising.
The ratio of change in the demand for
a commodity and a change in
advertisement cost is called ‘Advertisement
Elasticity of Demand’. It is also called
‘Promotional Elasticity of Demand’.
Following formula is used to find
‘advertising elasticity of demand’.
E =
% Change in Quantity of X Demanded
% Change in the Cost of Advertisin g X
The concept of advertising or promotional
elasticity has a special significance for the sales
manager in deciding his marketing policies. He
has to spend on advertising taking into account
the promotional elasticity of demand.
Suppose, demand for a product was 10,000
units, when the cost of advertising was Rs. 1,000.
If an amount of Rs. 1,500 is spent as a second
dose of advertising, total sales reach 20,000
units. In other words, if we spend 50 percent
more on advertising, we can increase our sales
by 100 percent. Then, promotional elasticity of
demand will beE =
% Change in Quantity of X Demanded
% Change in the Cost of Advertisin g
=
100
=2
50
Managerial Economics : Nature and Concepts : 105
The relationship between the demand and
promotional expenditure is normally positive and
hence, both change in the same direction.
We shall see one after another how is
elasticity measured through these methods.
Questions for Self Study - 2
(1) Ratio Method
(A) Fill in the blanks using appropriate
word:
An economist Flux introduced this method.
According to him, elasticity is the ratio of
percentage change in quantity demanded/
supplied to percentage change in price of a
commodity. We have already used the formula
of this method while explaining various concepts
of elasticity. We shall again try a numerical
example. Suppose, original demand for umbrellas
was 100 when the price per piece was Rs. 100.
If the price were reduced to Rs. 50 per unit,
demand for umbrellas would rise to 200 units.
This means, a 50 percent cut in price would lead
to 100 percent increase in demand. Using the
formula-
(1)
While estimating income elasticity of
demand for a commodity, its price is
assumed to remain ——————
———— (stable/variable)
(2)
Demand for inferior goods is———
——(Positive/ negative)
(3)
—————————goods can be
used in place of each other.
(Complementary/Substitute)
(4)
Generally, demand for a product
changes in the ———————
direction of advertising cost.
(Opposite / Equal)
(2) State whether the following
ü)
statements are true or false. Put (ü
û ) in brackets.
or (û
(1)
Cross elasticity of demand for sugar
and gur is zero. ( )
(2)
Cross elasticity of demand for
complementary goods is positive ( )
(3)
Cross elasticity of demand for
substitute goods is negative. ( )
(4)
If advertising expenditure on soap is
doubled resulting in doubling the
demand for soap, advertising
elasticity is equal to unity. ( )
5.2.3 Measurement of Elasticity
of Demand
So far, we have discussed various types
of elasticity at length. It is now time to study the
methods of measuring elasticity. Among the
various elasticity, price elasticity is of foremost
importance. We shall, therefore, concentrate our
attention of measuring price elasticity. It applies
to supply as well. Major methods of measuring
price elasticity are:
(1)
Ratio Method
(2)
Total Outlay Method
(3)
Geometric Method
E =
100
= 2 is the elasticity of demand.
50
(2) Total Outlay Method
This method of measuring elasticity of
demand was proposed by Alfred Marshall, in
which elasticity is determined by the total outlay
on purchasing a commodity. Let us see how is it
measured:
(a) Elastic Demand (E>1) : If an
increase in the price of a commodity leads to
decrease in the total outlay (expenditure) on the
commodity, or a decrease in price may lead to
increase in the demand the demand is said to be
elastic, elasticity greater than 1.
(b) Unitary Elastic Demand (E=1) :
When a change in the price of commodity in
any direction does not bring any change in total
outlay, it remains unchanged; demand is said to
be unitary elastic.
(c) Inelastic Demand (E<1) : When
arise in price leads to increase in total outlay
and a decrease in price to reduction in total outlay,
demand for the commodity is said to be inelastic,
elasticity less than 1.
Following table illustrates a numerical
example of the types of elasticity described
above:
Managerial Economics : Nature and Concepts : 106
Units
Total
Elasticity
Demanded Outlay Rs.
1
1,000
1,000
2
400
800
4
150
600
1
1,000
1,000
2
500
1,000
4
250
1,000
1
1,000
1,000
2
600
1,200
4
400
1,600
geometric method of measuring elasticity of
demand at a point is used. If the demand curve
is linear, we can easily find out point elasticity.
This is shown in figure 5.7. < >
E=1
Y
E= ∝
D
E>1
a
Price (Rs.)
Price
Of X
E<1
Let us now draw a curve showing the
three types of elasticity shown in the table above.
See figure 5.6
b
E>1
c
E=1
E<1
d
E<1
e
0
E=0
X
D
Total Outlay
Y
Figure 5.7: Point Elasticity of Demand
D
a
In figure 5.7, units of commodity X
demanded are measured along OX axis and
price of X along OY axis. DD is the demand
curve. Different points along the demand curves
shown by arrows indicate different price
elasticity.
E>1
Price (Rs.)
b
E=1
There are five points along the demand
curve of which elasticity is found by geometric
method using the following formula.
c
E<1
d
D
X
0
Total Outlay
Ed Point =
Distance of the Point from X - axis
Distance of the Point from Y - axis
Figure 5.6: Total Outlay and Elasticity
In figure 5.6, total outlay on commodity X
is measured along OX axis and price of X along
OY axis. The three parts of the bent curve
together show three types of elasticity; between
‘a’ to ‘b’, the demand is elastic, between ‘b’ to
‘c’, demand has a unitary elasticity and between
‘c’ and ‘d’, demand is inelastic.
Using this formula, point elasticity of
various points is worked out as under.
Sr.
No.
Elasticity formula
Point
Elasticity
1
Elasticity at Point ‘a’ = ea/0
E=∝
2 Elasticity at Point ‘b’ = eb/ba
E>1
(3) Elasticity of Demand at a Point:
(Geometric Method)
3
Elasticity at Point ‘c’ = ec/ca
E=1
4 Elasticity at Point ‘d’ = ed/da
E<1
So far we have assumed that a demand
curve has the same elasticity throughout. But
elasticity differs from point to point along a given
demand curve. To find out elasticity of demand
along different points of a demand curve,
5
E=0
Elasticity at Point ‘e’ = 0/ea
In brief, elasticity of point ‘a’ is infinite,
point ‘c’, it is unity and at point ‘e’, it is zero. All
these are theoretically limiting cases we shall
Managerial Economics : Nature and Concepts : 107
rarely come across. Most practical cases are
points ‘b’ and ‘d’, where elasticity is greater
than 1 and less than 1 respectively.
Point Elasticity on a Non-Linear
Demand Curve
How to measure elasticity at a point on a
non-linear demand curve? It is bit difficult to
carry on this exercise. A tangent has to be drawn
from OY axis to Ox axis in such a way that it
touches the point, of which we wish to measure
elasticity. This is done in figure 5.8. In this case
also, point elasticity may differ among different
points. When a tangent touches a particular
point, we can measure the distances between
the points of tangency to each of the two axes.
We can then find the ratio of distance of the
point from OX axis and OY axis. The ratio shall
be the point elasticity of demand for that
particular point. We shall understand this better,
when we observe figure 5.8.
=
A' e
= E >1
eA
Similarly, we can draw another tangent
that touches the demand curve in point ‘f’ and
to both the axes at the end. We get tangency
line BB’. We now find elasticity at point ‘f’.
Distance from Tangent ' f' to X - axis
EP ‘f’ = Distance from Tangent ' f' to Y - axis
=
B' e
= E <1
eB
Questions for Self Study - 3
(A) Fill in the blanks using appropriate
word from brackets.
(1)
Even though the price of a
commodity changes, the total outlay
on purchases remain unchanged,
elasticity of demand is—————
——(zero, unity, greater than 1)
(2)
Elasticity of demand is—————
on different points along a demand
curve. (identical/different)
(3)
If demand curve is linear, and
touching both the axes, elasticity at
the central point on the curve shall
be—————(>1/<1/unity)
(4)
Cross Elasticity of demand for totally
unrelated goods is——————
.(one/zero)
(5)
Measurement of elasticity by total
outlay method was introduced by—
———————— (Smith/ Flux/
Marshall)
Y
D
Price (Rs.)
A
B
e
f
D
0
A1
B1
X
Total Outlay
Figure 5.8 : Point elasticity on a non-linear
Demand curve
In figure 5.8, DD is a non-linear (curvy)
demand curve. On this curve are the two points,
‘e’ and ‘f’ in which we are interested in finding
the elasticity. If we draw a line AA’, which is
tangent to demand curve at point ‘c’ touching
both the axis, we get a part of the tangent as
‘A’c’ and another part as ‘cA’, we can measure
elasticity at point ‘c’ by using following formula:
EP ‘e’ =
Distance from Tangent ' e' to X - axis
Distance from Tangent ' c' to Y - axis
(B) From the following data, find price
elasticity of demand using ratio
method.
Price of X Quantity
Particulars
(Rs.)
demanded
(units)
Original position
20
8,000
Change in position
25
6,000
Managerial Economics : Nature and Concepts : 108
(3)
State whether the following
ü)
statements are true or false. Put (ü
û ) in brackets.
or (û
how perfect the substitute is. In case of perfect
substitutes, elasticity is likely to be higher than
those with near substitutes.
(1)
In Ratio Method of measuring price
elasticity of demand, we work out
the ratio of change in quantity
demanded to change in price. ( )
(2)
We can judge the elasticity of
demand by the slope of demand
curve. ( )
(3)
A seller is required to study elasticity
of consumers’ demand. ( )
(4) Complementary Goods : Demand
for complementary goods is relatively inelastic.
One cannot use a car without petrol. One, who
has a car, must buy petrol, regardless of its price.
Similarly, demand for petrol may not increase
simply because petrol is now cheaper. Unless
cars become affordable to more people, mere
fall in petrol price would not lead to increase in
demand.
5.2.4 Factors Determining
Elasticity of Demand
Elasticity of demand changes according
to situation. Elasticity of demand for different
commodities is different. Not only this, elasticity
of demand for the same product differs from
individual to individual. Which factors affect
elasticity of demand is a question and we need
to seek an answer to it. Elasticity depends on
the type of the product, its utility, testes and
preferences of the consumers, their habits,
income, prices of substitute and complementary
goods etc. Let us now go into details of each
factor.
(1) Essential Commodities : Demand
for essential commodities is generally inelastic
or less elastic. Food grains, salt, edible oil and
medicine are a few examples of such
commodities. Regardless of any changes in price,
demand for these commodities remains
unaffected.
(5) Consumers’ Habitual Goods :
People are used to consume certain commodity
simply because they develop such habits. Tea,
coffee, wine, tobacco, cigarettes etc. are such
commodities of habitual consumption and these
have less elasticity of demand.
(6) Consumer Durables : Auto vehicles,
furniture, refrigerator, TV, air coolers and air
conditioners are durable goods. These can be
used for years once purchased. However,
purchases of such goods can be postponed if
current prices are high. As such, demand for
consumer durables is highly elastic.
(7) Multipurpose Commodities :
Goods that can be used for a variety of purposes
have greater elasticity of demand. Electricity,
gas, iron and steel are examples of multipurpose
goods. A slight fall in price of such goods leads
to large increase in their demand. Demand for
such goods is highly elastic.
(2) Comforts and Luxuries :
Ornaments, high quality clothes, food in a five
star hotel are examples of goods offering luxury
to the consumer. Demand for such goods is
highly elastic. A slight fall in price of these goods
leads to a large increase in quantity demanded.
Similarly, milk, eggs, fish, meat, a reasonably
good house offer comforts to the user. Demand
for comforts is more elastic than essential
commodities but less elastic as compared to
luxuries.
(8) Level of Price of the Commodity :
Price elasticity of demand for a single
commodity would be less at a very high or very
low price. If price of a commodity is very high,
a small group of rich persons only could buy.
Reponses of demand to a price change are poor.
Similarly, if the price of a commodity is very
low, it will be within reach of every body that
would buy sufficient quantities at existing price.
Any further cut in the price would not increase
demand. Hence, price elasticity of demand is
very less if the initial al prices of goods is either
too high or too low.
(3) Substitutes : Demand for goods
having substitutes is more elastic because if
substitutes are relatively cheaper, consumers can
switch over to substitutes satisfying the same
want. However, degree of elasticity depends on
(9) Consumers’ Income : It is an
important determinant of demand, independent
of changes in price. If the income effect is
positive to a commodity, demand increases at a
going price. An impact of increse in the price of
Managerial Economics : Nature and Concepts : 109
a commodity is nullified if there is a
corresponding increase in income. However,
between a rich and a poor person, rise in price
makes a difference. Rich person will not mind
paying higher price because of his high-income
level, but a poor person shall cut down his
purchases.
(10) Proportion of Spent on a
Commodity : How much part of his income a
consumer spends on a particular commodity has
much influence on price elasticity of demand. If
a very small, negligible part of consumer’s total
income is being spent on a single commodity,
elasticity shall be very less. Salt, postage, city
bus service etc. are such examples of inelastic
demand. On the other hand, if a major portion
of total income is spent on a single commodity,
say house rental, demand is likely to be elastic.
(11) Relativity to Person, Place and
Time : Elasticity is a relative term. It differs
from person to person, place to place and from
time to time. Farmer and factory owner, both
use electricity but its elasticity is different for
the two classes. From amongst the farmers,
elasticity of demand for electricity differs from
one state to another. Elasticity of demand for
the same product changes over time due to
changes in the testes of the people. Some
commodities most popular at one time go out of
fashion. Such changes over time lead to change
in demand elasticity of the same product.
(12) Government Regulations : in
socialist economies, the government controls
entire economic activity. People are not free to
make their own choices of production,
distribution and consumption. Prices are
artificially managed. Unless the people have
liberty to produce and consume, the concept of
price elasticity is meaningless. It has meaning
in ‘free market economies’, where state
intervention is minimum. Government controls
and regulations limit the operation of elasticity
of demand.
Questions for Self Study - 4
(A) State whether the following
ü)
statements are true or false. Put (ü
û ) in brackets.
or (û
(1)
Demand for essential commodities is
inelastic. ( )
(2)
Demand for luxuries is elastic. ( )
(3)
Demand for complementary goods is
elastic. ( )
(4)
Initially, if the price of commodity is too
low, a change in the price of the commodity
has little influence over demand. ( )
(5)
Demand for perishable goods is inelastic.
( )
(6)
If a small part of consumer’s income is
spent on a single commodity, its elasticity
of demand shall be less. ( )
(7)
Government control such as price controls
and public distribution system dose affect
elasticity of demand. ( )
5.2.5 Managerial Uses of
Elasticity of Demand
The concept of elasticity has importance
in theory and practice. Different classes in the
society have to think over elasticity in framing
their policies. Elasticity concept is applied in
consumption, production, exchange and
international trade sectors. In a liassez- faire
or free market economies, elasticity has a
special significance as consumer is supposed to
be sovereign. Under the circumstances, direction,
structure and size of production depend on
elasticity of demand.
To manager of a firm and government, the
concept of elasticity is of great use. Firm’s
decision on production and pricing depend on
the elasticity of the product concerned. Elasticity
principle guides the Sales Manager in pricing
his product. Effects of a change in price of the
product can be judged by the study of elasticity
concept. A production Manager executes his
production plan on the basis of elasticity of
demand for the product. A decision on
promotional expenses for boosting of sales,
without thinking of demand elasticity would be
a sheer waste. Top management has to plan for
future production and distribution. Demand
forecasting for future is a must. While doing so,
the concepts of price elasticity and income
elasticity are of foremost importance. In case a
firm is a producer of a substitute product or a
product complementary to the products of other
firms, the decisions on production, pricing and
distribution cannot be taken without considering
cross elasticity of demand. In brief, the study of
Managerial Economics : Nature and Concepts : 110
elasticity concept is of great help to the managers
of the firms, sellers and top management of the
firm, who are policy makers.
In brief, to estimate a demand function,
Statistical Studies and Experimental Surveys
must be jointly used to make it more reliable.
5.2.6 Empirical Demand Estimates
Questions for Self Study - 5
Managers in various businesses have to
estimate demand for their products from the
consumers. Such estimates are based on
historical experiences in the past. However, the
managers must take probable changes in
consumer demand into account before arriving
at a rational decision. For controlling external
factors, empirical estimates and its substance,
both are important.
(A) State whether the following
ü)
statements are true or false. Put (ü
û ) in brackets.
or (û
(1)
Elasticity concept is not only theoretically
important but also in practice. ( )
(2)
Since consumer is a sovereign, the concept
of elasticity is not important. ( )
(3)
Empirical demand studies can broadly be
classified into three categories; namely, (1)
Consumer Survey, (2) Statistical Studies and (3)
Experimental Surveys.
A manager can know the impact of an
increase in the price on demand for his
product by knowing the elasticity of
demand. ( )
(4)
Demand forecasting is possible through
consumer survey. ( )
(1) Consumer Survey
(5)
This type of survey is concerned with
consumers’ objectives. Data collected in
surveys can be used in preparation of sales
forecasts, but not of much use in framing pricing
policy. Sales forecasts may deviate from actual
sales.
Experimental surveys enable to measure
the impact of factors affecting
demand. ( )
5.3 Words and their Meanings
(2) Statistical Studies
Elasticity : Responsiveness
Statistics studies the trends in behaviour.
An independent variable is studied with
reference to a time period. Generally, these
studies do not cover the factors affecting
demand. It is the management that controls these
factors. In statistical analysis, a new technique,
multiple correlations and regression is used.
Statistical techniques are mostly used to find
relationship between two variables by separating
the impact of other variables that are probably
not quantifiable.
Price Elasticity : Responsiveness of demand
to a change in price.
(3) Experimental Surveys
Elastic Demand : Great change in quantity
demanded in response to a small change
in price.
Experimental surveys are also called
‘Controlled Surveys’. These types of surveys
are used to help management in controlling
external factors affecting demand. Impact of
such factors is measurable. Certain things can
be predicted. Impact of certain less important
factors affecting demand can be minimized if
due care is taken. At times, incentive based
experiments are also undertaken.
Income Elasticity : Responsiveness of demand
to a change in consumer income.
Cross Elasticity : Responsiveness of demand
for a commodity to changes in the prices
of ‘other goods’, either a substitute or a
complementary.
Advertisement Elasticity : Ratio of change
in the demand for product to a change in
advertising expenditure
Inelastic Demand : A small change in quantity
demanded in response to a great change
in price
Unitary Elastic Demand : Proportionate
change in quantity demanded in response
to a proportionate change in price.
Managerial Economics : Nature and Concepts : 111
Completely Inelastic Demand : Quantity
demanded remains unchanged regardless
of changes in price
(C) (1)
Perfectly Elastic Demand : A small decrease
in price leads to infinite increase in demand.
Questions for Self Study - 2
Point elasticity : Elasticity of demand on a
particular point along the given demand
curve.
5. 4 Answers to Questions
for Self Study
(2)
(A) (1)
(2)
(2)
(3)
(4)
Inverse
=1
Parallel
(4)
Constant (3) Substitute
Negative (4) Equal
(B) (1)
(û) (3)
(û)
(2)
(û) (4)
(ü)
Questions for Self Study - 3
(A) (1)
Questions for Self Study - 1
(A) (1)
< 1 (3)
1
(4) Zero
(2)
Different (5) Marshall
(3)
1
Elasticity of demand is the ratio of
change in quantity demanded and
change in price
(B) E=1
Ratio of change in the quantity
demanded and change in price is
called price elasticity of demand.
Ratio of change in quantity demanded
and the change in income of
consumer is the income elasticity of
demand. Ratio of change in the
quantity of X demanded and the
change in price of Y is cross
elasticity.
Questions for Self Study - 4
When percentage change in the
quantity demanded is greater than
percentage change in price, demand
is said to be elastic, E>1
When percentage change in quantity
demanded is smaller than the
percentage change in price, demand
is said to be less elastic, E<1.
(5)
When a proportionate change price
leads to proportionate change in
demand, elasticity is unitary, E=1.
(6)
When any change in price does not
change the demand at all, elasticity
is zero. E=0
(7)
When a small change in demand
leads to infinite change in the quantity
demanded, elasticity is equal to
infinity. E=µ.
(B) (1) (û), (2) (û), (3) (û),
(4) (ü), (5) (û)
(C)
(1) (û), (2) (ü), (3) (ü)
(1)
(ü) (5)
(ü)
(2)
(ü) (6)
(ü)
(3)
(û) (7)
(ü)
(4)
(ü)
Questions for Self Study - 5
(1)
(ü) (4)
(ü)
(2)
(û) (5)
(ü)
(3)
(ü)
5.4 Summary
Ratio of change in the quantity demanded
to a change in price is elasticity of demand.
Apart from the price of a commodity, income of
the consumer and prices of substitute and
complementary goods also influence demand for
a commodity. Thus there are different types of
elasticity. The types referred in this paragraph
are price elasticity, income elasticity and cross
elasticity of demand.
One more classification of elasticity is by
an impact of price on demand. These are E=µ,
E=0 and E=1.
Managerial Economics : Nature and Concepts : 112
E=µ, means elasticity of demand is infinity;
a small decline in price would increase demand
up to infinite units. E=0 means demand is totally
inelastic, whatever may be the changes in price,
demand for a commodity shall remain
unchanged. E=1 means elasticity of demand is
unitary; a proportionate change in price would
bring about change in demand in the same
proportion. However, all the three types of
elasticity are theoretical limiting cases, we would
rarely come across.
In real world, E>1 and E<1 are the only
types of elasticity, we call elastic and inelastic
demand. We can use a uniform equation or
formula for finding different types of elasticity.
In case there are close substitutes to a
commodity, its demand depends on prices of
substitutes as well. Demand for such goods is
sensitive to changes in the prices of substitutes
and their demand is elastic. Opposite is the case
with complementary goods. Mostly such goods
are in joint demand with complementary goods
with lesser elasticity of demand.
Total outlay method and geometric method
of measuring elasticity at a point on the given
demand curve, linear and non-linear, are some
other methods of estimating elasticity. The
formula is-
Ep =
Ep =
Change in Quantity Demanded of X
Change in Price of X
Above formula is used to find price
elasticity of demand. Here, Ep means price
elasticity. Income elasticity formula is given
below
Ey =
% Change in Quantity Demanded of X
% Change in the Income of the Consumer
In the above formula Ey denotes income
elasticity.
Cross elasticity of demand means demand
for commodity X in not dependent upon the price
of X only. At times, demand for x changes on
account of changes in the prices of substitute or
complementary goods though price of X is
constant. We use following formula to find cross
elasticity.
Ec =
% Change in Quantity Demanded of tea
% Change in the Price of Sugar
We should remember certain qualities of
elasticity of demand, such as price elasticity
should have negative value because of the
negative relationship between price and demand.
This is in perfect tune with the law of demand.
Income elasticity, on the other hand, shows
positive value. It is logical because income and
quantity demanded go hand in hand. Both change
in the same direction that makes elasticity
positive.
Distance from Tangent ' e' to X - axis
Distance from Tangent ' e' to Y - axis
Elasticity of demand depends on a number
of variables we have discussed in the text of
this unit.
The concept of elasticity has great
significance not only in theory but also in
application to practical problems of business.
There are a number of uses of this concept in
managerial decision- making. Even the
government applies this concept in commodity
taxation. Managers are expected to forecast
consumer demand for future. Consumer survey,
statistical studies and experimental surveys are
useful in preparing such forecasts.
5.6 Exercises
(1)
Explain the concepts of price elasticity,
income elasticity and cross elasticity with
suitable examples.
(2)
Explain the types of elasticity of demand
with figures.
(3)
Draw a non-linear demand curve. Choose
any two points on the curve and measure
elasticity of those points.
(4)
Explain the factors determining elasticity
of demand.
(5)
Explain the importance of the concept of
elasticity from the point of view of
managers, government and the planners.
Managerial Economics : Nature and Concepts : 113
(3)
Make a list of substitute gods you
observed.
(4)
Make a list of complementary goods you
know.
5.7 Field Work
(1)
(2)
Prepare a list of 20 articles you usually
purchase for your household use. Collect
prices of the same items last year and take
a note of tendency of price change during
the year. Also note the change in your
household purchases. Find the estimated
value of your own price elasticity of
demand.
Go to a grocer on the corner and obtain
data on price of any major commodity and
average demand this year and last year.
Estimate the price elasticity of that
commodity on the basis of data you
collected.
5.8 Books for Further Reading
(1)
Freeman A.M., Introduction
Microeconomic Analysis.
(2)
Adhikari M., Managerial Economics.
(3)
Gupta G.S. Managerial Economics.
(4)
Chopra O.P., Managerial Economics.
(5)
Stationer and Hague, A Text Book of
Economic Theory.
Managerial Economics : Nature and Concepts : 114
to
Unit 6 : Demand Forecasting
« Explain for the correctness of Demand
Forecasting.
Index
6.0 Objectives
6.1 Introduction
6.2 Subject Description
6.2.1 Concept of Demand Forecasting
6.2.2 Need for Demand Forecasting
6.2.3 Types of Demand Forecasting
6.2.4 Stages in Demand Forecasting
6.2.5 Factors in Demand Forecasting
6.2.6 Methods of Demand Forecasting.
6.2.7 Accuracy of Demand Forecasting
6.3 Words and their Meanings
6.4 Answers to Questions for Self Study
6.5 Summary
6.6 Exercises
6.7 Field Work
6.8 Books for Further Reading
6.0 Objectives
After studying this unit, you will be able
to :
« Explain the concept of Demand
Forecasting
« Explain the need for Demand
Forecasting.
« Explain various types of Demand
Forecasting.
« Explain the stages involved in Demand
Forecasting
« Explain the factors in Demand
Forecasting.
« Explain the methods of Demand
Forecasting.
6.1 Introduction
Each firm studies the happenings in
market minutely. Manager of a firm must think
over the demand for firm’s product in the market
on which sales, revenue and profit of the firm
depends. Manager forecasts future demand for
firm’s product and accordingly, decides on the
level of production. For a firm, consumer demand
is an unknown factor, whether there may be
competition or monopoly in the market. Demand
depends on consumer behaviour. Market
situation frequently changes such as change in
consumer test, change in income, utility of the
product, nature of the product such as substitute
and complementary goods etc. Such changes
cannot be predicted and therefore, forecasting
demand is not as easy task.
Markets are generally competitive. Every
manager tries to increase output to maximize
profit. Modern techniques are used to improve
quality of product and to cut down cost. Product
is widely advertised to boost sales. Supply is
adjusted to demand for the product. To do this,
it is necessary to forecast future demand.
Demand forecasting is an important stage in a
firm’s planning. It is also necessary to consider
the market share of other firms in the product,
their prices and market strategies. Demand
forecasting has to be done by taking all the above
factors into account. Then only a firm can design
its policy frame.
In this unit, we shall study the concept,
types, factors and methods of demand
forecasting.
Managerial Economics : Nature and Concepts : 115
6.2 Subject Description
6.2.3 Types of Demand
Forecasting
6.2.1 Concept of Demand
Forecasting
Demand forecasting is a special type of
economic forecasting. There are a number of
types of demand forecasting. Some major types
are discussed below:
Current age is known for production in
advance of demand. Manager forecasts demand
and carries on his production plan. Production
is essentially for sale that depends on consumer
demand. Many factors, economic and noneconomic influence consumer demands. It
makes demand forecasting difficult. Manager
attempts to increase sales through promotional
efforts. Production process in modern times is
much complicated and time consuming leading
to increase in uncertainty, especially because of
changes in consumer tests and preferences.
Under the circumstances, estimating demand for
the near future and for longer period in future
means demand forecasting.
Demand forecasting is a scientific study
of future demand for a product or products
of a firm under expected market situation
that is undertaken in advance of production
planning.
(1) Economic and Non-economic
Forecasting
Economic forecasts, as the name suggests
relate to economic factors such as demand,
supply, price, profit etc. Social scientists consider
socio-cultural and political factors such as
forecasts on social change, election results and
the like.
(2) Micro and Macro Forecasts
Economic forecasting is done at various
levels. When it is done in case of an individual
firm, production, demand and supply of a single
commodity, an individual consumer, such a
forecast is called Micro Forecast. As against
this, forecasting for the economy as a whole,
such as national income and output, general price
level, direction and composition of foreign trade
of a country etc. in future are examples of
Macro Forecasting. Such forecasting helps in
economic planning, framing income and
employment policies for future.
6.2.2 Need for Demand
Forecasting
(3) Active and Passive Forecasts
A manager is expected to take decisions
on future demand, supply, price, cost investment
etc. In such cases, demand forecasting has a
special significance. Demand fluctuates in future
that may have implications for the firm. Suppose,
a manager produces large output based on his
demand forecast but his expectations could not
realize because actual demand is far less than
his forecast. Inventories may pile up for want
of adequate demand and the firm may face a
crisis. Conversely, if actual demand exceeds
forecast, firm shall lose larger market share to
the competitors. In brief, success or failure of a
business depends on the accuracy of demand
forecasting. In brief, a manager must be capable
of taking correct decisions about demand
forecasting to bring success to the firm.
Demand forecasts are classified as active
forecasts and inactive forecasts. In active
forecast, sellers are active to execute sales plan
according to forecast. Activities they undertake
in this direction are to improve the quality of the
product, differentiate the product from those of
competitors, incur promotional expenses etc.
Regression analysis is undertaken while
preparing demand forecast. However, reliable
and adequate data on factors influencing demand
has to be available for the purpose. Under
competitive conditions, a firm has to study the
products, prices, sales and marketing strategies,
advertising expenditure and stock with the
competitive firms. Then and then only, a manager
can take decisions about his own firm.
Managerial Economics : Nature and Concepts : 116
In case of passive demand forecast,
nothing is required to be done like active
forecast. Forecasts are based on empirical data
on past demand. If there is no competition in
the market, passive forecasts are useful.
In brief, active forecasting is useful and
a must in a competitive market. Inactive
forecasting, on the other hand, is useful only in
absence of competition in market.
(4) Conditional and Unconditional
Forecasts
In demand forecasting, independent and
dependent variables are taken into account.
Possible effect of independent variable on
dependent variable is traced out in conditional
forecast. On the contrary, unconditional forecast
predicts possible changes in the independent
variables. However, risks involved in making
unconditional demand forecasts have to be
accepted.
Questions for Self Study - 1
(A) Write brief answers to the following
questions.
(1)
What does ‘Demand Forecasting’
mean?
(2)
Why is it necessary to forecast
demand?
(3)
What is the difference between
Active Forecast and Passive
Forecast?
(B) State whether the following
ü)
statements are true or false. Put (ü
û ) in bracket.
or (û
(1)
All consumers jointly forecast
demand. ( )
(2)
Manager of a firm as special
significance of the concept of
‘Demand Forecasting’. ( )
(3)
Expansion on contraction of a firm
depends on demand forecasts. ( )
(4)
Short-run forecast is useful in
launching a new product, sales and
capturing markets. ( )
(5) Short-run and Long-run
Forecasts
If a forecast is required in respect of a
factor, we must consider the time period for
which the forecast is required. If a forecast is
made for a short period, it is called Short-term
Forecast’. If it is for long period, it will be called
long run Forecast. In fact, the terms short-run
and long run are relative one can modify
according to his convenience. A short-run
forecast can be taken as a period of one year or
less. In that case, short-run forecasts may help
only decision-making in routine works. If, on the
other hand, a new product is to be launched or
to be added to the existing range of products, it
will be a long-term decision. A number of
dynamic changes may take place during that
period such as changes in population, income,
tests and preferences of the consumers,
techniques of production etc. affecting future
demand for the product(s). A long run demand
forecast must consider all such uncertain factors
to assure accuracy of the forecast.
Thus, forecasting for short period is
relatively easy as it can be prepared on the basis
of empirical data. Long-term forecasts are
somewhat difficult to make.
(C) Fill in the blanks using appropriate
word from bracket.
(a)
Forecasts about election results are
called———————forecasts.
(economic/non-economic)
(b)
Accuracy of demand forecasting
depends on ——————— of the
manager.
(Decision-making
capacity/administrative ability)
(c)
To face completion in the market,—
————forecasting is useful.
(Active/Passive)
(d)
Forecasting future national income
is———— forecasting.
(Micro/
Macro)
6.2.4 Stages in Demand
Forecasting
Demand forecasting is also called sales
forecasting as the sum total of consumers’
demand equals total sales of the seller. Demand
forecasting is a scientific study and has to pass
a number of stages till it is finalized.
Developments during each of the stage have to
Managerial Economics : Nature and Concepts : 117
Product vanishes from market.
Use of the product decreases.
Demand starts falling sharply.
Product becomes old,
outdated.
D
Maturity stage, stability in
demand, but new competitors
start entry.
Forecasting needs adequate and reliable
database and knowledge of making appropriate
use of the data. Updated statistical information
is required to be used in future planning of a
firm. First stage in forecasting is to identify the
nature of forecast; whether it is a short-term or
long-term, active or passive, micro or macro etc.
Data requirement differs by type of forecast.
Acceptance of the product
by consumers. Increase
in demand.
(1) Nature of forecast
Y
Entry of a new product
in to market
We shall discuss these stages one by one.
New products replace old ones. Figure 6.1
portrays life cycle of a product.
Annual Demand
be watched carefully. Important stages in
demand forecasting are: (1) Nature of forecast
(2) Nature of product (3) Determinants of
demand (4) Analysis of factors determining
demand (5) Choice of technique and (6) Testing
of accuracy.
0
D
X
Time Period
Figure 6.1: Life cycle of a Product
(2) Nature of Product
Second stage is to identify nature of the
product, whether it is a consumer good or capital
good, durable or perishable good, final good or
intermediate product etc. Existing demand for
a product and its demand elasticity required to
be studied. We have already seen in unit 4 that
demand for some commodities is inelastic and
for some other commodities, it is highly elastic.
If market is competitive and demand for the
product of every firm is highly sensitive to
changes in price. A firm can slightly cut down
price and fetch larger market share by selling
substantially more quantity. Perishable goods
have inelastic demand and have to be sold once
brought to market even at miserably low prices.
Nature of the commodity is thus important in
forecasting demand.
Element of time is a very important factor
in demand forecasting. This element concerns
life cycle of a product. When a new product
enters market, consumers feel an attraction
about it. They demand it more and more as time
passes resulting in increasing sales. After few
years, ‘optimal supply ‘ of the product becomes
available to market. The product attains the
stage of maturity. This is the time when
competitive, substitute products take entry in the
market. Sale of original product starts falling and
continues to fall thereafter. A day comes when
old (original) product vanishes from market. This
is the way life cycle of a product completes.
In figure 6.1, time period is measured along
OX axis and annual demand (trend) along OY
axis. DD is demand curve that shows change in
demand of a product over time. Vetical lines
drawn from OX axis are the dividing lines
between various stages in the life cycle of the
product. Numbers 1 to 6 represent different
stages in the life cycle and table below the figure
describes the stages in the life cycle of the
product.
(4) Factors determining demand
To identify the factors determining demand
for a product is third stage in forecasting demand.
We have already studied these factors in unit 3.
We simply repeat those as tastes and
preferences of the consumers, fashions, price
of the product, income of the people, prices of
other goods (substitutes and complementary)
advertising and expectations about future prices.
All these factors must be taken in to account
while forecasting demand. In long-term
forecasting, size of population and its structure,
changes in the attitude of the people, changes in
the technology etc. shall be additional factors
that must be accounted for.
(5) Analysis of factors determining
demand
We have studied the factors determining
demand with reference to demand function and
Managerial Economics : Nature and Concepts : 118
beyond it. Statistical analysis of demand
considers following additional factors influencing
demand function.
ti is brought to market, it remains in
continuous demand. ( )
(3)
In demand forecasting, it is not necessary
to consider factors determining
demand. ( )
(4)
Trend Factors concern Long period. ( )
(5)
With reference to demand forecasting,
measurement of uncertain factors is
possible. ( )
(a) Trend Factors: These factors influence
long-term demand.
(b) Cyclical factors: These factors concern
time period and influence demand. Cyclical
factors repeatedly activated.
(c)
Seasonal Factors: Certain events repeat
seasonally but these are more definite than
cyclical factors.
(d) Random Factors: These are uncertain
and it is difficult to measure their impact.
In brief, we need to analyze all the factors
that influence demand while forecasting future
demand. If the forecast is for long period, we
must analyze trend factors but for short period
forecasting we could rely on cyclical or seasonal
factors.
(5) Choice of technique
This is the most important stage. There
are a number of techniques of demand
forecasting of which we need to choose the best
one. There should be accuracy in the forecast.
Different techniques of forecasting are suitable
for different goods and different time periods.
Accuracy of the forecast mostly depends on
choice of appropriate technique.
(6) Testing of accuracy
Testing of accuracy of the results is the
final stage in demand forecasting. Various
statistical methods are available for testing
accuracy, some are simple and without cost,
others are much complicated and costly. Any
mistake or deficiency in forecast must be
corrected in the testing to have an accurate
forecast.
Questions for Self Study - 2
(A) State whether the following
ü)
statements are true or false. Put (ü
û ) in bracket.
or (û
(1)
In forecasting demand, adequate and
reliable statistical data must be
available. ( )
(2)
According to life cycle of a product, once
6.2.5 Factors in Demand
Forecasting
Following factors must be considered
while forecasting demand for future.
(1) Forecast and time period
Time period has to be considered while
forecasting demand for future. How long or how
short is the period has much importance in
forecasts. If the period under consideration is
short, planning output level will not be a problem.
However, if it is for longer period, output will
have to be planned with care. Such forecasting
may go wrong. Longer the period of forecast,
more difficult would be the task of forecasting
and actual may deviate from forecast.
(2) Level of Forecast
Generally, forecasting is done on three
levels; (a) Micro level, (b) firm level, and (c)
Industry level.
(a) Micro Level : If a demand forecast
is made for a firm, or an individual industrial
unit, it is called ‘ micro level forecast’. As against
this, if a forecast is made about the economy as
a whole about variables like national income,
effective demand in an economy, level of
employment etc., it will be called ‘macro level
forecasting’.’ These types of forecasts are useful
in formulating government policies.
(b) Firm Level : When a manager
forecasts demand for the product of his
individual plant or firm to plan production, it will
be a ‘firm level forecast.
(c) Industry : Many firms operate in a
single industry. For example, Textile is one of
the many industries in India. Each textile mill in
the country is a ‘plant’ under the industry. Firms
Managerial Economics : Nature and Concepts : 119
operating under different parts of the own and
manage the textile plants under them. Industry
is a wider term that covers all the firms operating
in textile industry. When demand forecasting for
textile industry as a whole is made, it covers
demand for the product of all the firms engaged
in production and distribution of textiles. If
industry level demand forecast goes wrong, an
imbalance is created between demand and
supply. On the other hand, if the forecast is
accurate, there can be equilibrium in demand
for and supply of the product.
(3) General and Specific Forecast
To estimate how much auto vehicles
would be demanded in future shall be an example
of general forecasting of demand. However,
such goods are not uniform. Their customers
also belong to different income groups. Some
consumers would be satisfied with ‘Maruti 800’
an economy car, some others may prefer
relatively comfortable cars, such as ‘Zen’ and
a few others may prefer ‘Honda City”, a
luxurious car. Although all cars satisfy the same
want, the product is not homogeneous. Demand
forecasts shall have to be brand specific,
different forecasts for different types of cars
would be necessary. In this case ‘demand
forecast for Maruti-800 would be a specific
forecast and overall demand for all cars would
be a general forecast.
(4) Established Product and New
Product
The products that are bought and sold in
the market are called established product. In
contrast to an established product, if a totally
new product is brought to market for the first
time is called new product. In case of established
products, empirical data on sales/purchases is
available., that shows the trends in demand. On
the basis of the tendency in the past, demand
forecasts of established goods can be prepared.
Consumers’ reactions, strategies of the
competitors and the demand supply position of
the product are known. This doesn’t happen in
case of a new product. In India, we have a
number of established brands of cars. If a new
variety of car enters the market, people look at
it with doubt. Whether it will work with the same
efficiency as the other established cars? Will it
consume less or more petrol? What will be its
const of maintenance? Such doubts lead to
demand uncertainty and forecasting future
demand becomes difficult. Forecasting demand
for an established product is relatively easy.
(5) Type of the Product
Type of the product is an important factor
in demand forecasting. Whether the product is
a consumer good or capital good, a consumer
durable or a perishable good, a good in direct
demand or derived demand and so on. We use
a number of consumer goods in our daily life
from which we derive satisfaction. Capital goods
do not directly satisfy human wants but are
demanded because these help production of
those goods, which are in direct demand.
Demand for capital goods fluctuates widely as
compared to consumer goods. If a long-term
demand for consumer good increases by 10
percent, demand for capital goods may increase
by 50 percent. This type of correlation is called
principle of acceleration.
Demand for durable goods is more elastic
as compared to perishable goods. If gold price
falls by 5 percent, demand may increase by 10
percent or more. It has a high price elasticity If,
on the other hand, price of vegetables drops by
50 percent, increase in demand can be negligible
or far less than the price change.
In short, nature of the product need be
studied while working on demand forecasting.
(6) Market Structure
Demand forecasting also depends on the
structure of market in which the firm is working.
Whether the market is competitive or monopoly?
In real world, neither perfect competition nor
pure monopoly prevails. Markets are
monopolistically competitive. In such a market,
it is difficult to forecast demand. What marketing
strategies competitors would follow in marketing
their products?
What changes would take place in consumer
demand? Unless the manager has answers to
these questions, demand forecasting becomes
really a difficult task.
Managerial Economics : Nature and Concepts : 120
Questions for Self Study - 3
Simple Survey Method
(A) Write brief answers to the following
questions.
(1) On what levels, demand forecasting is
done?
(2) What is the impact of established products
on demand forecasting?
(3) What are the effects of competition on
demand forecasting?
This is a simple and strait method of
demand forecasting. This method has two
techniques. In the first technique, experts from
marketing management are called on to express
their opinion that may be accepted. In the second,
consumers’ survey is conducted or they are
interviewed.
(1) Experts’ Opinion Poll
6.2.6 Methods of Demand
Forecasting
Broadly, there are two methods of demand
forecasting. In the first method, experts’ opinion
is considered with regard to expected future
demand, or a consumer survey is conducted to
know their views. Demand forecasting is based
on either or both the measures. Second method
is to collect empirical data on demand in the
past as a basis for demand forecasting. Both
the methods are based on value judgment. If
judgment goes wrong, it doesn’t leave demand
forecasting unaffected. First method is useful
for short-term forecasts and the second, for longterm forecasting. There are various techniques
of demand forecasting but all these techniques
are used in both the methods.
Techniques: Following flow chart shows
various techniques of demand forecasting.
Demand Forecasting Techniques
Simple
Survey
Method
Experts’
Opinion
Census
Survey
Market
Experiment
Method
Statistical
Method
Consumer
Survey
Sample
Survey
Final use
Survey
Trend
Regression Lead Simultaneous
Analysis Analysis Indicator Equations
Those experts with pretty long experience
in production and marketing are called on to
express their opinion. Many individuals and
institutions are busy in the field of production
and sales such as imaginative entrepreneurs,
skilled technicians, promoters, efficient
managers, experience salesman etc. These
experts can comment on whether a product shall
have certain demand in future. There can be a
difference of opinion between two experts, but
a mid-way could be found. The techniques of
averages and weighted Index Numbers could
help to solve this problem. These Indices can
be used in working out demand forecasting.
However, this is a crude method because expert
opinions are based on their own experiences
from which, they can make only broad
statements.
This is a simple method involving little cost.
But if the opinion goes wrong, it may call for
distress. Expert opinions may be self-conscious.
Some times, market situation may be so uncertain
that an invaluable expert opinion proves
worthless.
(2) Consumer Surveys (Interviews)
In this method, consumers’ views are
called for through conducting interviews with
regard to their estimates about future demand.
Some times, instead of oral interviews, a detailed
questionnaire is prepared and consumers are
requested to fill in. Inferences about demand
forecast are drawn about on the basis of
information gathered through interviews or
written questionnaires. If the product is a final
consumer good, households are taken as a unit
of inquiry. If the product is an export commodity,
foreign customers, individuals and firms, are to
be contacted to collect required information. If
a survey relates to a specific product, where
the population of customers is small, a census
Managerial Economics : Nature and Concepts : 121
survey covering all the customers is conducted.
However, in case of a product for which the
number of customers is quite large, a
representative sample, (small fraction of total
population), is selected as ‘sample’ customers
for detailed investigation. On the basis of
information gathered from consumer surveys,
estimates of demand forecast can be prepared.
If a product is a semi-finished good, survey of
firms buying the product only is necessary.
Surveys can be general or representative.
survey of sample households is conducted.
Aggregating individual demand of the sample
households, demand forecast is derived.
Inferences can be drawn for the entire
population on the basis of data supplied by the
sample households as representatives of total
population. It is not possible for an individual
firm to conduct market surveys of this type.
Firms can hire services of professional research
institutes to perform this task. Many firms in
the industry for their own demand forecasting
can share results of such surveys.
(a) Census Method
It is a simple and low cost method involving
less time and less labour. Sample survey is
suitable only when the number of customers is
very large. Care has to be taken to see that
sample selected represents total population.
Surveyor must be free and just so that his sample
selection would be unbiased. Customers should
extend full cooperation to the surveyor by
providing true and reliable information. Success
of any survey depends on the factors mentioned
above.
This type of survey covers entire
population of customers. This method requires
collecting information from every customer
regarding his or her future demand. Suppose, in
a specific market, product X is sold. Total number
of customers for the product is ‘n’. Let us
assume that the demand for X from various
customers would be X1, X2, X3, X4 ———Xn.
Estimate for total demand for product X would
be
Xd = X1+ X2+ X3+ X4 +———+Xn.
Aggregate estimated future demand for
the market would be equal to Xd and it is demand
forecast for product X. Main merit of census
survey is that it covers entire population of
customers and therefore, the results are likely
to be more reliable. The surveyors are required
to collect data with accuracy, reliability and free
from their own bias. This is possible only when
the customers provide accurate and reliable
information. However, this method has certain
limitations. It is time consuming and involves
huge cost of collecting information from a large
number scattered at distances. Processing and
analysis of such data is also difficult.
(b) Sample Survey
If the number of customers is quite large
and area to be covered is vast, the surveyor
prefers sample survey to census survey.
Customers are distributed in different strata by
their categories and total area is distributed into
different clusters. Finally, sample customers, a
small fraction of total population, say, 10 percent
or 20 percent of total population are selected
from each of the cluster and strata in such a
way that the selected sample is representative
of total population of the customers. Detailed
(c) Final Use Survey
This method requires survey of ultimate
consumers (users) of a product. A product is
partly used as a final consumer good and partly
as an interim good to produce another final good.
A part of the product is exported, which is not
available to domestic market. A part is imported
that is not produced in our country but consumed
by our people. The process of demand
forecasting, therefore, becomes much
complicated. We shall see how is it done, through
a simple example.
Suppose we have to estimate future
demand for sugar. Sugar can be used as a final
consumer good as well as an intermediate
product for some industries. A part of sugar is
exported but some quantity is also imported.
Demand forecast must provide for all these
transactions. We can estimate total demand for
sugar using following equation
S = Sc + (Sx –Si) + Sf1+ Sf2 +——Sfn
Where,
S = Total demand for sugar
Sc = Consumption demand for sugar
Sx = Export demand for sugar
Managerial Economics : Nature and Concepts : 122
Sf2= Demand for sugar as input by firm 2
In spite of the above-mentioned limitations,
market experiment method is a useful tool in
estimating the impact of any single variable on
demand.
Sfn= Demand for sugar as input by all
other firms.
Statistical Method
Si = Demand for imported sugar
Sf1= Demand for sugar as input by firm 1
Assume that firm 1 uses sugar in making
sweets, firm 2, in fruit juices and other firms in
producing biscuits chocolates and a variety of
confectionary products. Product of the above
equation shall be equal to demand forecast for
sugar.
Note that sugar exported is not available
to domestic consumers and imported sugar will
reduce demand for domestic firms to that extent.
This method helps demand forecasting on
the basis of historical data of the past. Prices
and demand fluctuate over time. Averages of
increse and decrease are worked out to find the
trend in price/quantity changes over time. A
trend line drawn from the data gives us idea
whether demand would increase or decrease in
future. See figure 6.2.
Y
Market Experiment Method
However, marker experiment method has
following limitations:
(1)
Market situations may not be uniform all
over.
(2)
Successful experiment in one market will
take time to show results in another
markets.
(3)
If the experiment fails, it may have
adverse effects. Price reduced once in a
market could not be raised because of
consumer resistance.
(4)
Price discrimination between two markets
will dissatisfy the consumers in dearer
(costlier) markets.
K
b
Sugar Demand (Lakh Tone)
We have already seen that a number of
factors influence demand for a commodity. To
find out impact of a single factor, we assume
for simplicity that other factors remain
unchanged. An experiment can be conducted
to judge the impact of price change on demand
for a commodity. Price is deliberately reduced
in one market only by keeping the same
unchanged in all other markets. Results of
change in demand on account of change in price
are noted. If demand increases substantially, an
estimate of change in demand in the rest of the
markets is worked out. Results of experiment
in one market are applied to other markets to
forecast total demand for the product. It is
assumed that consumer behaviour with regard
to tests, income, substitute and complementary
goods is uniform.
N
60
E
50
40
30
20
a
10
A
1970
X
1974
1978 1982 1986 1990 1994
Time Period
Figure 6.2 : Demand Trend
In figure 6.2, quantity of sugar demanded
over time is measured along OY axis. Time
period is given along OX axis. Demand curve
for sugar is shown by zigzag curve that shows
wide fluctuations in demand over time. Strait
upward rising line ‘a b’ is the trend in demand
over time. It is an average of time-to-time
fluctuations in demand. It shows a long-term
trend of rising demand. Trend line is based on
actual data up to 2005. If we have to estimate
demand for future, estimates may differ
depending upon expectations of the estimators
about future. One who is optimistic would feel
a sharply rising trend and a pessimistic would
find rather gloomy picture. A realistic estimator
shall find a midway between the two. Arrows
show these three positions for a period beyond
2005.
This method is also simple, easy to operate
and less costly. If past data of a given period is
Managerial Economics : Nature and Concepts : 123
available, demand forecast for future can easily
be worked out using statistical technique of trend
analysis. Trend analysis is most popular in recent
times. Our basic assumption in using this
technique is that past trend would continue in
future. In reality, this cannot be the case. This is
the main drawback of this technique.
Leading time series is the statistical data
about the variable that starts rising or falling
before other variables. Coincident time series
change in the same direction simultaneously in
which any other time series change. Lagging
series, however, change only after some other
series change. These series can be explained
with the help of a simple example of ‘Bank Rate’.
(a) Regression Method
The rate of interest at which Central Bank
of a country advances short-term loans to other
banks or the rate of discount on rediscounting
of bills by the banks with the Central Bank is
called Bank Rate. Bank rate is thus a leading
interest rate in the country. When Bank Rate
changes, other banks also change the rate of
interest on deposits, loans and advances. Interest
rate received by other banks is ‘coincident’
interest rate. Private moneylenders borrow from
banks and lend it to their customers at a higher
rate of interest than incident interest rate. The
interest rate charged by moneylenders to their
customers becomes ‘lagging’ interest rate.
For forecasting demand or any other
economic variable, economic theory and
statistical techniques are jointly used.
Information about factors influencing demand
must be available for using regression method.
Following are the essential prerequisites
of regression method.
(1)
To identify the factors influencing demand.
(2)
To collect statistical data on these
variables’
(3)
To find out independent variable of
demand function and to measure it.
(4)
To identify independent variables in a
demand function and to forecast it.
(5)
To forecast the dependent variable by
Regression method.
Regression method is useful in demand
forecasting. Relationship of demand with other
factors becomes clear in regression analysis.
Regression equations can be set for each of the
variable affecting demand such as income, prices
of substitutes etc. Demand forecasting can be
based on the possibility of changes in various
variables at one and the same time. However,
in practice, changes in the variables may be
different from those assumed in regression
analysis. This may lead to error in demand
forecasting.
Future demand can be forecasted by
leading indicator method. It is a simple and easy
to work method. How to find the value of
independent variable is a problem in regression
analysis. In leading indicators, it is not a problem.
Only problem in this method is that the leading
indicator of the dependent variable, about which
we have to forecast, is difficult to trace.
Relationship between the leading indicator,
coincident variable and lagging variable is
determined by the statistical data of the past
period. It is convenient to assume that in future,
same relationship would continue. If, however,
this relationship changes in future, forecasts
would go wrong. Furthermore, adequate and
reliable information about the indicator and the
variables is not always available. This method
is useful for short-term forecasts.
(b) Leading Indicators Method
There are three prerequisites of using this
method: (1) To determine leading indicator of
the variable (say, demand) of which, forecast is
to be worked out. (2) To determine the
relationship between the variable and leading
indicator and (3) To prove the forecast.
Three types of time series are used in
determining leading indicator: (1) Leading series,
(2) Coincident series and (3) Lagging series.
(c) Simultaneous Equation Method
This is a most advanced statistical method
with a complete system approach to demand
forecasting. Generally, simultaneous equation
method is used in micro level forecasting. An
econometric model is developed for working out
demand forecasts.
This method develops such a model that
explains tendencies among the entire variables
Managerial Economics : Nature and Concepts : 124
Let us assume that we are considering the
variables influencing demand for cars. Demand
for cars depends on price of car and advertising
expenditure. These variables are within the
control of firm and hence are independent
variables. In addition, demand for cars also
depend on certain variables beyond the control
of firm such as price of fuel, income of the
people, their tests etc., but firm has no control
over these variables.
In simultaneous equation, value of each
variable is worked out with reference to
exogenous variable and endogenous variable.
Values of endogenous variables are already
known but values of exogenous variables have
to be assumed. Simultaneous equations can be
developed to find estimated value of a variable
by including the values of endogenous and
exogenous variables into simultaneous equations.
Economic theory, mathematical and statistical
techniques are used in this method.
Simultaneous equation method is supposed
to be superior to regression method and is
convenient. The surveyor is required to find
expected value of exogenous variable. In
regression method, values of both, exogenous
and endogenous variables are required to be
found.
Simultaneous equations method too has
some limitations. Relationship between
economic variables in the past is assumed to
remain unchanged in future. It is a quantitative
method, not so easy to grasp. Empirical data
about all factors concerning decision-making
process has to be available, which may not
happen. It is a complex, complicated and costly
method. Theoretically, it may be a great method
but there are a number of practical difficulties
involved. As a result, simultaneous equation
method could not be popular. Use of computers
in computation has proved to be a boon to industry
and business. Computerisation has solved the
problem of complexity in computing values.
Accuracy is assured in solving mathematical and
statistical problems. If correct data is fed,
computers give accurate results.
After computerization of office work,
demand forecasting has been a relatively easy
task. Solving simultaneous equations has eased
the process of demand forecasting. It is now
the best and most convenient method of demand
forecasting.
6.2.7 Accuracy of Demand
Forecasting
None of the forecasts prove to be
completely correct. The forecaster must test the
accuracy of his results. If estimated value of
demand for the future and the actual value of
demand after the period is over are nearly equal,
we can say that the forecast is accurate. But it
is a rare possibility. There can be a deviation in
estimates and actual. If there is an error in the
forecast, it must be corrected during next period.
A test finding the gap between the forecast and
actual has to be applied.
Equality or inequality between demand
forecast and actual demand can be explained
with the help of a figure. See figure 6.3
Y
Value According to Demand Forecast
under control of a decision-making unit, a firm
or plant. Number of equations is equal to the
number of dependent variables in the model.
Simultaneous equations consider both
exogenous and endogenous variables.
F
N4
B
P
G
A
N2
H
45
0
X
0
Value of Actual Demand
Figure 6.3 : Value of Forecasted and Actual
Demand
In figure 6.3 , value of demand forecast is
measured along OY axis and on OX axis is
measured the value of actual demand. ‘O F’
line makes 45° angles at point of origin O, a
dividing line of rectangle YOX. Line ‘O F’
represents value of demand forecast. If the
actual value of demand is also along the line
’OF’, then there is no deviation in demand
forecast and actual demand. Demand forecast
is accurate. However, this is a rare possibility.
Managerial Economics : Nature and Concepts : 125
In fact, actual value of demand is as shown by
line ‘AB’ Vertical distance between the lines
‘OF’ and ‘AB’ shows error in forecast. Thus
the vertical distance HG shows that actual value
of demand is greater than forecasted value of
demand. But the vertical distance in the lines
PF shows deficiency in actual demand value as
compared to forecasted value. Such mistakes
in demand forecasting are not desirable. If at all
there is any error, it should be at its minimum.
Maximum accuracy is desirable in demand
forecasts.
6.4 Answers to Questions for
Self Study
Questions for Self Study -1
(A) (1) Demand forecasting means a scientific
study of future expected demand under
expected market situations, before planning
production by a firm.
(2)
Demand forecasting is necessary before
planning production, sales, price policy,
inventory management, profit etc.
(3)
When a deliberate action is taken to
materialize demand forecast, it is called
‘active forecast’. When nothing is done to
materialize forecast is called ’passive
forecast’
Questions for Self Study - 4
(A) Write brief answers to following
questions.
(1)
Which are the two methods of
demand forecasting?
(2)
Explain the difference between
Census Survey and Sample Survey.
(B) (1)
(ü) (3)
(ü)
(3)
What does ‘Regression Method’
mean?
(2)
(ü) (4)
(û)
(4)
What are Leading series, Coincident
Series and Lagging Series?
(5)
What is Simultaneous Equation
Method?
(C) (1) Non-economic (2) Decision-making
capacity (3) Active (4) Micro
Questions for Self Study - 2
(B) State whether the following
ü)
statements are true or false. Put (ü
û ) in bracket.
or (û
(1)
Demand forecasting may not be
always true. ( )
(2)
If there is a deviation in future
expected value and actual value after
the period, it can be said that the
forecast is accurate. ( )
(3)
There should be maximum possible
accuracy in demand forecasting. ( )
(ü) (4)
(ü)
(2)
(û) (5)
(û)
(3)
(û)
Questions for Self Study - 3
(1)
Demand forecasting is studied at three
levels. (1) Macro level (2) Industry Level
and (3) Firm Level.
(2)
Established products are those which are
bought and sold in the market for years.
Consumers are well accustomed to
consumption of those goods. Demand
forecasting of these goods is relatively
easy. New product means a totally
unknown product for consumers brought
to market for the first time. Consumers
doubt its utility. Demand forecasting is
relatively difficult.
(3)
In real world, there is neither perfect
completion nor pure monopoly, but
Monopolistic competition with all its
characteristics. In such a market, manager
6.3 Words and their Meanings
Forecast : Estimates for future period.
Price War : Cutthroat competition among seller
in cutting the product price.
Advertising War : Cutthroat competition
among seller in advertising the product to
boost sales..
(1)
Managerial Economics : Nature and Concepts : 126
finds it difficult to forecast demand for his
firm’s product.
Questions for Self Study - 4
(A) (1)
(2)
(3)
(4)
(5)
Expert Opinion Poll, Interviews/
Survey of consumers, and collection
of empirical statistical data are the
methods used in forecasting
demand.
In census survey, entire population
of consumers is covered in collecting
data regarding their individual
demand and demand forecasts are
prepared. In Sample survey, a small
fraction of population is selected as
‘representative sample’ for detailed
inquiry. Results obtained are applied
to entire population and demand
forecast is prepared.
In regression analysis, economic
theory and statistical tools are jointly
used to prepare demand forecasts.
Relationship between independent
and
dependent
variables,
interrelationship of variables
influencing demand are considered
while forecasting demand for a
product. This method clears the
relationship between demand and the
factors influencing it.
Leading indicator time series,
Coincident time series and Lagging
time series are three time series.
Leading indicator series is the one
that introduces changes in other
variable first. Coincident series are
those, which change simultaneously
with other series and the lagging
series are those lagging behind the
changes in other series.
In simultaneous equations method, an
econometric model is prepared to
solve the problems in demand
forecasting. Each variable is
presented in the form of equation,
number of equations equal the
number of variables. Both,
exogenous and endogenous variables
are considered. Values of
endogenous variables are assumed
to be constant, only values of
exogenous variables are worked out.
Simultaneous equations can be
presented by including related values
of variables. It is the most
sophisticated statistical method of
demand forecasting.
(B) (1) (ü), (2) (û), (3) (ü)
6.5 Summary
A producer is interested in knowing how
much quantity of his product would be sold in
market. Before he actually starts production, he
tries to understand existing market situation and
predicts about future conditions. Demand
forecast means an estimate of likely demand
for a product in future, given the market
conditions. It helps the producer to produce
approximately the same quantity as that of
expected demand in future. It saves stock pilling
or a situation of inadequate supply as compared
to actual demand in future.
Forecasts can be made at different levels,
Macro level for economy as a whole, Industry
level, for a specific industry in the country
covering all the firms and plants there under and
involved in production or distribution of a single
product, and Micro Level such as a plant, a firm
etc.
Forecasts are ‘active’ and ‘.passive’,
‘controlled’ and ‘uncontrolled’
Various stages in demand forecasting are
(1) determine the period of forecast, (2) Identify
the type of product, (3) to consider the life cycle
of a product, (4) consider the factors determining
demand, (5) to analyze the factors affecting
demand, (6) to choose right technique for
demand forecasting and finally (7) to test
accuracy of the results.
Factors in forecasting are mainly; (1) time
period of the forecast, (2) Macro or Micro, (3)
established or a new product and (4) market
structure etc.
Various methods of demand forecasting
are: (1) Consumer survey/ interviews, (2)
Opinion poll of experts. Both the methods
have some merits and limitations. Sample survey
in place of census survey can be adopted in the
Managerial Economics : Nature and Concepts : 127
number of respondents (consumers) is quite
large.
Methods of demand forecasting differ by
the type of product, nature of demand elasticity
of demand etc. We have some methods, which
are based on logic in economic theory, some
are based on purely empirical statistical data .
More sophisticated methods combine economic
theory, quantitative and statistical techniques in
forecasting demand. Each of these methods also
has its own merits and drawbacks.
None of the forecasts can be always true.
Demand forecast is no exception to this
experience. When the value of demand forecast
and the value of actual demand after the period
of forecast is over exactly match, forecast is
said to be accurate. However, this is a rare
possibility. In real life situation, forecast and
actual deviate. The best demand forecast is one,
which shows minimum gap between the forecast
and actual. Rationality demands a high degree
of accuracy in demand forecasts.
(6)
If you are asked to forecast demand for
wheat for your village for the next year.
Which method would you use? Why?
Write in detail.
(7)
Explain with figure, the concept of life
cycle of a product.
6.7 Field Work
(1)
Visit a factory close to your area. Obtain
information of the product it makes. Get
detailed information from the factory
owner as to how does he forecast demand
for factory product. What was his
experience during this task?
(2)
Write with figure, life cycle of readymade
garments.
6.8 Books for Further
Reading
6.6 Exercises
(1)
What does ‘Demand Forecasting’ mean?
Explain the need for demand forecasting.
(2)
Explain the types of demand forecasting.
(3)
Explain in detail, various stages in demand
forecasting.
(4)
Explain the factors of demand forecasting.
(5)
Explain in detail, the methods of demand
forecasting. Does the forecast always
proves true?
(1)
Chopra O. P. Managerial Economics,
TATA McGraw Hill, 1984
(2)
Dean, Joel Managerial Economics, New
Delhi, Prentice Hall of India, 1976 Ch. IV
(3)
Adhikari M. Managerial Economics,
New Delhi, Khosla Publishing House, 1987
Ch. VIII
(4)
Kopardekar, Kulkarni, Commercial
Economic (Part - 1) (Marathi)
Managerial Economics : Nature and Concepts : 128
Yashwantrao
Chavan
Maharashtra
Open University
MGM 224
Managerial Economics
Book Two
Markets and Price Determination
Writers
: Prof. S. R. Karandikar, Prof. V. G. Godbole
Unit 7
: Cost of Production : Concept, Types and Curves
Unit 8
: Production Function
39
Unit 9
: Break-even Point of Production
63
1
Unit 10 : Supply
74
Unit 11 : Market Conditions and Price-Output Decisions
85
Unit 12 : Market Structure Analysis (1)
100
Unit 13 : Market Structure Analysis (2)
125
Unit 14 : Price Determination Techniques
147
Managerial Economics (MGM 224)
Syllabus
Book 1 : Managerial Economics : Nature and Concepts
Unit 1 (A) : Managerial Economics : Nature, Objectives and Scope
Unit 1 (B) : Economic Analysis
Unit 1 (C) : Methods of Economic Analysis
Unit 1 (D) : Basic Concepts
Unit 2 (A) : Nature of Managerial Decisions
Unit 2 (B) : Methods of Studying Managerial Economics
Unit 2 (C) : Some Basic Concepts : Plant, Firm, and Industry
Unit 2 (D) : Size of the firm
Unit 2 (E) : Business Decisions
Unit 3
: Concept of Demand
Unit 4
: Demand Analysis
Unit 5
: Elasticity of Demand
Unit 6
: Demand Forecasting
Book 2 : Markets and Price Determination
Unit 7
: Cost of Production : Concept, Types and Curves
Unit 8
: Production Function
Unit 9
: Break-even Point of Production
Unit 10
: Supply
Unit 11
: Market Conditions and Price-Output Decisions
Unit 12
: Market Structure Analysis – 1
Unit 13
: Market Structure Analysis – 2
Unit 14
: Price Determination Techniques
Book 3 : Principles of Business Firms and Investment Analysis
Unit 15
: Firm : The Basic Concept
Unit 16
: Behavioural Theory of Firm
Unit 17
: Business Behaviour of firm
Unit 18
: Profit - Concept and Analysis
Unit 19
: Capital Budgeting
Unit 20
: Risks, Certainty and Uncertainty
Unit 21
: Decisions of public Investments
Unit 7 : Cost of Production : Concept, Types and
Curves
Index
7.0 Objectives
7.1 Introduction
7.2 Subject Description
7.2.1 Cost of Production Concept
7.2.2 Concept of Cost and Managerial
Decisions
7.2.3 The Principal Costs of Firms and
Managerial Decision : A Relation
7.2.4 Types of Costs
Differences

Explain different types of cost of
production.

Explain the cost curves.

Explain the economies of large scale
production.

Explain the limitations on achieving
optimum level of production.

Explain the applicability of concept of
costs.
and their
7.2.5 Cost Curves
7.2.6 Economies of Scale
7.2.7 Firms and Optimum Level of
Production
7.2.8 Applicability of the theory of
production
7.3 Words and their Meanings
7.4 Answers to Questions for Self Study
7.5 Summary
7.6 Exercises
7.7 Field Work
7.8 Books for Further Reading
7.0 Objectives
After studying this unit, you will be able to:

Explain the concept of cost of production

Explain the importance of cost for
managerial decision making.

Explain the relation between historical
costs of firms and managerial decisions.
7.1 Introduction
Cost is the most important aspect in the
process of production. An entrepreneur has to
spend on a large scale on plant and equipment,
machines, raw material etc. The decisions
regarding how much to produce depends on
costs of production. In the initial stages of
production, the production costs are high but as
production increases production costs start
falling. There are various types of costs. e.g,
fixed cost, variable costs, direct and indirect
costs etc. A firm has to take into consideration
all these types of costs. The producer then takes
into consideration the total cost, on the basis of
which price of product is determined. While
determining the price of the product, producer
needs to also consider the competition, he has
to face in the market and then accordingly incur
expenses on advertisement etc. So that there is
planned increase in the sales of his output.
In this topic, we shall study in detail, the
concept of cost, importance of cost from the
point of view of managerial decision making,
Economies of a large scale, and applicability of
cost analysis.
Markets and Price Determination : 1
7.2 Subject Description
The total cost of production is the sum of
the Direct and Indirect cost. In shortTotal cost = Direct cost + Indirect cost
7.2.1 Cost of Production
Concept
The total sum of money incurred
directly or indirectly, for producing one unit
or total units of output is called the cost of
production.
Cost of production involves both direct and
indirect cost. Let us discuss these.
(a) Direct Cost and Indirect Cost
Production means transformation of raw
material into a final product through a process.
In the process of production land, labour, capital
and entrepreneurs, these four basic factors of
production are used in varying quantities. These
factors of production are less in number
compared to the demand for them and hence
they are not available until they are paid a reward
for using their services. There are measures to
determine the reward payable to each factor of
production. Every factor of production can be
put to alternative use while transferring a factor
of production into an alternative use that factor
must be paid at least that amount which he was
actually drawing, e.g. an entrepreneur needs half
a hector land to set up his factory. On the same
piece of farm, he could produce food grains also.
If that farm earns Rs 25,000/- when food grains
are taken on that then the entrepreneur planning
to set up his factory on the same piece of farm
must pay at least Rs 25,000/- to that land owner.
This is an actual expenditure incurred by the
firm. This is called direct cost.
But if such a piece of farm belonged to
the entrepreneur himself, he could have set up
his factory without incurring expenses on land.
This cost is called the indirect cost of production.
To find out the total cost of production, indirect
cost has to be considered. This idea is applicable
to all the factors of production; just as it is to
land. Costs incurred directly on the factors of
production are called direct costs, whereas the
use of factors of production without incurring
any cost is called the indirect cost.
(b) Total Cost and Average Cost
Production cost is measured in two ways.
In the first method the total cost of production is
taken in to consideration.
For example : Rs 15 lakh have been
incurred on the production of 100 television sets.
Rs 15 lakh is its total cost .To find if the firm
has made profit or less the concept of total
cost is useful. By selling these 100 television
sets, if the concerned firm earns Rs 18 lakhs,
then in this example the total profit on sale of
100 T.V. sets is Rs 3 lakh worth.
Total Profit = Total Revenue - Total Cost
Another method takes the Average cost
of production into consideration. Average cost
is the per unit cost of production. In the above
example the Average cost of producing a single
T.V. set is Rs 15,000/-. This is according to
(15,00,000 ÷ 100).
Average Cost = Total cost ÷ Total output
Questions for Self Study - 1
(A) State whether the following
statements are true or false. Put ()
or () in the bracket.
(1)
Transformation of raw material into a final
product is called production. ( )
(2)
To retain a factor of production in a
particular job minimum remuneration paid
is that factor should be equal to what it
would get in any alternative job
option.( )
(3)
The concept of cost considers only direct
cost of production. ( )
(4)
If the producer uses his own factors (e.g.
Land ) in the process of production
expenditure incurred on such factors is not
included. ( )
(5)
Total profit = Total revenue - Total cost
( )
Markets and Price Determination : 2
(6)
Average cost = Total cost ÷ Total output
( )
7.2.2 Concept of Cost and
Managerial Decisions
The classification of cost could be done
from various points of view. Let us discuss those
types of costs which are mainly related to
managerial decisions. These types are as
follows:
(1) Future Cost
Majority of managerial decisions are taken
for future. The principal costs may help to
determine the costs in future or one can predict
future cost on the basis of the costs incurred in
the past. But the future conditions are
unpredictable and uncertain. Hence, principal
costs (or costs incurred in the past) can not be
taken as basis for taking future business
decisions. The changing monetary, fiscal and
import - export policies have a great impact on
the future managerial decisions. All expenses
incurred keeping in mind these policies, are
classified as future cost.
(2) Transfer or Alternative Cost
The concept of opportunity cost has
emerged due to the fact that resources are
scarce and they can be alternatively used. While
selecting any option of production, its next best
alternative is needed to be sacrificed; as both
the options of production may not be accepted.
The alternative sacrificed is important from the
view point of managerial decision making. How
much is the sacrifice and is the same appropriate
is concerned with ‘Right Decision’.
For example : An entrepreneur buys an
equipment worth Rs. 1 lakh. He could have
invested the same one lakh in a bank to earn
interest on. By buying this equipments he has
sacrificed the interest. While considering his
income from use of the machine, we need to
consider this interest on deposit sacrificed. It is
only after comparing income from these two
options, can one take investment decisions i.e.
whether to buy a machine or keep the money
invested in the bank. On the basis of the same
we can conclude whether investment in machine
is right or wrong. This is related to managerial
decision making.
It is out of alternative or opportunity cost
originates the concept of implicit or imputed cost.
Some costs are not recorded in the books of
accounts. e.g. rent on an unused land, rent from
owned properly, interest on owned funds. Since
these expenses are not incurred because the
resources were owned, the same would not be
recorded in the books of accounts. But while
taking some fundamental cost decisions the
above expenses may be considered. The concept
of implicit or imputed cost is useful in such
cases.
(3) Incremental Cost
When a new decision pertaining to
business is taken that adds to total costs and
such an additional cost incurred is called
incremental cost. Rise in production causes rise
in the cost of raw material, labour cost (wages)
etc. But all expenses do not rise.
For example : A Rickshaw driver, if drives
a rickshaw for 8 hours instead of 6 hours then
he may incur an additional cost in the form of
depreciation, fuel and repairs for the additional
two hours. But this would not add to the capital
investment of the Rickshaw driver. Those costs
that do not change after a particular decision
are called the sunk costs. These costs do not
affect the decisions, hence are not important
from view point of new decision.
(4) Common Cost
In modern times some firms produce
numerous products simultaneously. While
producing its main product, it also produces
serval by products, joint product and co products.
For example : While producing superior
quality wood for furniture purposes, an inferior
quality wood for the purpose generating energy
is also produced. Similarly, while producing
edible oil - fodder for cattle is also produced.
These products are called by products. In some
cases production of both the goods is essential.
e.g. in the field of dairy production of milk is as
important as is the production of curd, milk
powder, cream, etc. These are called joint
product. While, producing cycles in big industries
a classified production of cycles for kids, gents
and ladies cycles are made after making minor
changes in production process. Such products
are called co products.
Markets and Price Determination : 3
While determining the cost of the products
mentioned above, some costs incurred are
common while some other differentiated.
Different products carry different prices and
while determining these different prices of
different products, the managerial decisions
become important in dividing these costs among
different goods produced. In this regard up to a
level of production some costs are considered
(assumed) as common and beyond that level,
the costs are classified as per the differentiated
process of production.
We have studied the managerial decisions
pertaining to various costs of production. We
shall further discuss the various types of costs
and their differences in the next section.
Questions for Self Study - 2
(A) Answer in short.
(1)
What do you mean by future costs ?
(2)
Explain the importance of opportunity
cost.
(3)
What do you mean by incremental cost?
7.2.3 The Principal Costs of
Firms and Managerial
Decision : A Relation
Many managerial decisions are related to
future. The expenses incurred in past. i.e. the
historical costs, since already incurred can be
useful in taking future cost decisions. We need
to see to what extent are the historical costs
useful in taking future decisions. Are historical
costs useful in taking future decisions ? By and
large the answer is negative. The reasons are
as follows :
(2) Accounts Note
Some costs entered in the books of
accounts by the accountants regarding
depreciation are based on past experiences, but
they are not actual costs. the actual depreciation
of machines, buildings is different. The said
costs are entered from the view point of
accurate business control as also simplifying
planning pertaining to taxation. For future
planning such figures are not trustworthy.
(3) Changing Technology
Technology used in business undergoes a
change with time. Due to this the cost figures
regarding technology used in the past, because
inaccurate and insufficient. Based on past
experience the raw material composition for
producing goods may be ascertained even in
future, but due to changes in costs of raw
material, even if the composition of raw material
remains the same the old (historical) cost figures
(estimated) become redundant.
In a nutshell the costs incurred in the past
do not really serve as guidelines for future
decision making regarding production, sales,
stock, etc. In other words the historical cost
estimates neither prove to be trustworthy nor
guiding in case of managerial decision making
in future.
Questions for Self Study - 3
(A) State whether the following
statements are true or false. Put ()
or () in the bracket.
(1)
Managerial decision are by and large
related to the future events. ( )
(2)
Historical costs means the costs incurred
in the past during the process of production.
( )
(3)
Historical costs are useful in taking future
decisions. ( )
(4)
Due to dynamic nature of economy and
changing technology, the historical
information regarding cost of production
does not prove trustworthy. ( )
(1) Dynamic Economic System
The historical expenses incurred pertain
to the decision about production levels prevailing
then as well as the decision regarding stock and
sales. In a dynamic economy the future polices
change continuously. Hence, old and historical
data relating to cost is not a sufficient guide for
decisions about future.
Markets and Price Determination : 4
7.2.4 Types of Costs and their
Differences
There are different types of costs. Let us
understand those and differences in them. Some
of the types are useful from the view point of
accountancy, while some other are useful from
the point of view of economics. They are useful
mainly from the context of managerial decision
making. We shall first discuss the various types
of cost and we shall also examine which of these
costs are useful from the view point of both
economics and managerial decision making. We
shall later discuss costs related to short run and
log run and also the average and marginal costs.
The variable costs change as production
increases. If production is reduced the variable
cost falls. If level of production is zero, the
variable cost is also zero. So the costs that
change in conformity with the output are called
the variable costs. e.g. the wages paid to
workers, purchase of raw material, running
expenses on electricity, water, fuel, etc. and
excise duty.
Supplementary and Prime Costs
We learnt the fixed and the variable costs,
these were labelled differently by Dr. Alfred
Marshall. These new names to fixed and variable
costs are given below :
(1) Fixed and Variable Costs
The total costs of firm are classified into
two groups viz fixed costs and variable cost. In
an equation form they are :
TC =
Fixed cost = Supplementary / overhead cost
Variable cost = Prime cost
TFC + TVC
Fixed Cost
While expressing the concept of fixed cost,
we principally talk about the total fixed cost.
Total of fixed expenses are considered while
arriving at total fixed cost.
Fixed cost can be defined as follows :
Total fixed costs are those which
remain the same irrespective of the firm’s
decision to either reduce or expand output.
Some of the examples of fixed costs are
as follows :
The costs incurred by the firm in hiring of
factory premises, building etc. the costs of
equipments, depreciation of machines, interest
paid on capital, salaries of the administrative
staff, insurance premium, property tax, etc.
These expenses are constant irrespective of
whether production is carried out or not.
Variable Cost
The variable cost is defined as follows :
The costs that change according to the
changes in output produced are the
variable costs.
Marshall calls fixed costs as
supplementary or overhead cost, as this is the
expenditure which is neither recovered nor is it
expected to be recovered in the initial stages of
production. The supplementary costs are
recovered in installments. This cost is spread
over total production and is not restricted to a
particular number of units of production.
Dr. Marshall has labelled variable costs
as prime cost. This is because the expenditure
is incurred on a day-to-day basis. It is expected
of a firm to recover at least this cost from the
realized price of the product. While considering
total cost of production variable cost is given
priority. This is the reason why Marshall called
it prime cost. Once variable cost is recovered
firms aim at recovering the fixed costs hence
according to Marshall, fixed costs are also called
the supplementary cost.
Questions for Self Study - 4
(A) State whether the following
statements are true or false. Put ()
or () in the bracket.
(1)
Total cost of a firm includes fixed and
variable cost ( )
(2)
Changes in production do not affect the
fixed cost ( )
Markets and Price Determination : 5
(3)
Rent paid for premises and expenditure
on equipments are examples of fixed cost.
( )
(4)
Costs that change with the changes in
output are called variable costs. ( )
(5)
Fixed or supplementary cost must be
recovered in the initial stages of
production. ( )
(6)
Fixed cost is incurred on only production
of a fixed unit of output and not on the
entire range of production. ( )
(7)
Variable costs must be recovered from the
sale of goods produced. ( )
(8)
Expenses on raw material, fuel, wages to
labourers are examples of variables costs.
( )
(9)
Marshall has named fixed costs as
supplementary or overhead costs and
variable costs as prime costs. ( )
(B) The following is the table expressing
costs of a firm.
Sr.No. Particulars
Rs.
1.
Purchase of land
1,00,000
2.
Machines and equipments
2,00,000
3.
Wages to labourers
25,000
4.
Light and water Bill
10,000
5.
Central excise
6.
Purchase of raw material
7.
Transport expenses
8.
Building expenses
Total Variable Cost = Rs ——— + Rs.
——— + Rs. ——— + Rs. ——— =
Rs. ———
(2) Actual and Opportunity or Transfer
Costs
From the view point of accounting and
economic presentation of costs of production,
two important classification of costs are
identified. They are actual costs and opportunity
(or transfer) costs.
The actual costs are those which are
directly and explicitly incurred by the firms
during the process of production. These
are entered in the books of accounts of
the firm. e.g. purchase of raw material,
wages paid, interest on borrowed capital
and rent paid to land or building.
Opportunity or transfer cost has a broader
sense and scope. The concept is used in the
economic analysis and while finding the profit.
When a resource is used in one process
of production the same can not be put to
any other use. So it involves a sacrifice of
the nearest alternative use of the resource.
The cost of producing a particular product
is the value of other products that could
have been produced if the resources had
been allocated differently. This is called
the opportunity cost of production.
5,000
1,00,000
15,000
3,00,000
Using the data from the table answer the
following questions.
(1) What are the variable costs and fixed
costs?
(a) Fixed costs (write only the Sr.
Nos) ———————(b) Variable costs (write only the Sr.
Nos) ————————
(2)
(c)
Total Fixed Costs = ——— + ——— +
——— + ——— = Rs. ——————
Opportunity cost is alternative method of
estimating cost in economics. Let us understand
the concept of opportunity cost.
Resources can be put to different uses,
i.e. they have alternative uses. Land can be used
for agriculture purposes, for construction of
building, and construction of roads. But the
resources can be put in only a single use at a
point of time. If they are used for one alternative
they can not the used for the other alternatives.
e.g. if land is used for agricultural purposes the
same land can not be used for construction of a
building. This means the use of land for
agriculture purpose would involve sacrifice of
constructing building on the same land. The
sacrifice of constructing building or using land
for farming is the inability to construct a building
on the same.
Markets and Price Determination : 6
Let us express the same in a sample way.
A farmer has 2 hectares of land in which he
can take best sugarcane and rice. But in practice
he can take one crop at a time. If he takes
sugarcane, he earns a net per year of Rs. 30,000
from rice. He can earn a net per year of Rs.
20,000. Obviously, he would take sugarcane as
it yields him higher income per year. He would
not be able to take rice as a result of this. Hence
the foregone opportunity of growing rice is the
opportunity cost of producing sugarcane. To
express in monetary terms, the farmers loses
an opportunity to earn Rs. 20,000, in the process
of earning Rs. 30,000. Producing rice is the
nearest option to production of sugarcane. The
farmer had to sacrifice this nearest option.
Hence, the opportunity cost is Rs. 20,000. The
opportunity cost is presented in table form also.
studying. If cricket match was seen no study
was possible. So he needs to sacrifice studies
for seeing a match. Hence the opportunity cost
of a cricket match is the loss of three hours of
study.
T ime
available
3 hours
Alternative
uses
Watching Studying Playing Watching Reading
cricket
a movie

Chosen
Close
Option Substitutes
Options
Overlooked
2 hectare land
Alternative
Uses
Production
of Rice,
Net Yearly
Rs. 20,000/-
 Option
Sacrificed
Production
of Sugarcane,
Net Yearly
Rs. 30,000/-

Sacrificed
Opportunity
Cost of
watching
Cricket
 Option
Preferred
The opportunity cost is the cost of next
best alternative sacrificed in the process
of production.
Opportunity Cost
of Sugarcane
Opportunity cost of all production
resources can not be expressed in rupee terms.
Let us take an example of time. Suppose, one
has a spare time of three hours, he has several
options such as watching a movie, going for a
movie, reading, studying or playing. He can put
these three hours to any of the above mentioned
option, but only one of the option can be selected
at a time. Let us arrange these options according
to their degree of importance. Suppose the scale
of preference or importance is as follows :
Watching a cricket match, studying,
playing, watching a movie and reading a books.
But if he does not see the cricket match then
he can use these three hours for studying. So
the next best alternative for watching cricket is
Some of the factors of production are owned
by the entrepreneur himself; pricing such factors
of production becomes difficult. The concept
of opportunity cost turns of immense help here.
If the producer had to buy such resource from
the market, how much money would he have
been required to spend, the same can be taken
into consideration while arriving at the cost of
owned factors of production. For example,
suppose the producer himself worked as a
manager elsewhere and if he was paid Rs 3000/
-for the same work, then as a producer he would
have to lose this income as he would not be able
work elsewhere being a producer himself. This
is an opportunity cost of being a producer
himself and working as a manager is his own
firm than somewhere else.
Markets and Price Determination : 7
Opportunity Cost; Uses and Importance
(1)
Opportunity cost can be identified by
ascertaining what a factor of production
could have earnt if the same was used in
some alternative option. This can help us
find the implicit cost of production.
(2)
While determining profit implicit cost must
be considered. So one can say that in
determination of profit, concept of
opportunity cost is of great help.
(3)
Both Govt. and the private sector are
assisted by the concept of opportunity cost
in taking managerial decision.
For example, For implementing a
programme of water supply, a proposal of
constricting a dam on a river can bring some
villages and farms in food prone areas. In such
villages/farms, people would be required to leave
their productive activity. These people tend to
migrate and are needed to be rehabilitated. So a
making of single dam involves a number of
decision to be taken and after considering all
the cost and benefits alone, one can take a final
decisions with respect to construction of the
dam.The same is applicable even to the private
sector. If an industrialist once decides for a
particular industry, then he has to sacrifice all
other options he has. Here he focuses on the
best possible use of the available resource for
most essential products.
What is true of production is equally true
of consumption, distribution, trade and Govt.
transactions. In short, the concept of explicit cost
is convenient to arrive at and calculate. But in
economic decision making and when implicit
costs are to be determined, at that time concept
of opportunity costs turn out to be of immense
importance.
(3) Explicit and Implicit Cost
One classification of total cost divides
costs as fixed and variable, while the other
classification divides the total cost as
Total cost = Explicit cost + Implicit cost
Let us examine both :
Explicit Cost
Purchase of raw material by firms from
the markets at the prevailing market price
constitutes the explicit cost.
There are some factors of production that
an entrepreneur is required to purchase from
the market. The cost incurred on such factors
of production is called the explicit cost. These
expenses are incurred at market rates. Such
expenses include purchase of land, rent on
leased property, expenses on purchase of raw
material, electricity, water supply, advertisement,
transport costs, various taxes paid to the Govt.
etc. Such expenses are shown explicitly in the
books of accounts. These are important from
the view point of accountants.
Implicit or Imputed Cost
We can say that, implicit cost is a sub type
of opportunity cost.
Implicit costs are the costs of resources
owned and used by the firms owner, for
which the owner does not have to incure
any direct expenses. The market price of
all such factors of production is the implicit
cost.
The costs that are actually incurred alone
are considered while accounting the expenses.
All such activities that do not involve any direct
expenses are not recorded in the books of
accounts and are hence also called internal or
imputed costs. These costs are not fixed with
any express agreement. For example, an
industrialist erects a factory on his owned plot
of land and if the market price of that piece of
land is Rs. 1,00,000/- then the industrialist is not
require to spend Rs. 1,00,000/-. He is not
required to incure any direct expenditure on land.
Let us assume the industrialist has invested his
own capital of Rs. 1,00,000/- and the market
rate of interest is 15% per annum then he would
not be required shell out Rs. 15,000/- towards
payment of interest. Similarly, if he employees
his own family members in the process of
production, then they may not be paid any wages
or salary being the family members. Then both
Markets and Price Determination : 8
the expenses mentioned above are saved and
are indirect and hence are not accounted for.
But these costs are included in the concept of
economists’ costs. The economists costs
consider these expenses also which an
industrialist does not incure due to the ownership
of the same, so what amount would he have
spent had he not owned those. So they are
weighed at current market prices and are used
while calculating total cost of the economic
profits.
Let us also consider depreciation and
normal profit. Both these terms are used in
economics while calculating the implicit costs.
Depreciation
The Implicit and Explicit Costs and
Firms Profits
Profit is total revenueless total cost. There
are two views towards total costs. Approach of
the businessmen and that of the economists.
Businessmen include provisions for explicit cost
and depreciation in total cost. While the
economists include explicit costs, imputed costs,
depreciation and also the normal profit in the
computation of total costs. Hence, we get two
different approaches of calculating profit.
(1) Accounting =
Total
Profit
Revenue
The capital goods wear out as they are
used in production. To cover the worn out value
of capital goods a financial provision is made
and that is termed as depreciation.
In accounting sense depreciation is
associated with capital investment. e.g. a
machine cost is Rs. 10 lakhs and has a life of 10
years. 10 years later new machine replacing
this old would be required to be purchased.
Hence for the purchase of a new machine 10
years hence a monitory provision from the very
first year is needed to be made. This amount is
the amount of depreciation which an
entrepreneur keeps aside every year. The
amount of depreciation kept aside is considered
as direct cost in cost accounting. This is because
until the business activity is running the amount
of depreciation might not be spent but is kept
aside towards depreciation expenditure.
- Accounting
Costs of
Production
=
Total
Revenue
-
Explicit
Cost
+
Depreciation
(2) Economic =
Total
Profit
Revenue
=
Total
Revenue
-
Total
Cost
-
Explicit
Cost
+
Depreciation
Implicit
Cost
Normal Profit
+
Normal
Normal Profit is that minimum return
from business which is essential to retain
a producer in business. This amount is
included in imputed or internal costs.
We have so far understood the explicit and
implicit costs. This classification differentiates
two concepts viz the accounting profit and
economists’ profit.
Profit
The concept of accounting and economic
profit () would be clear from the following
example.
Markets and Price Determination : 9
Accounting Costs and Accounting Profit
Particulars
Rs.
1. Sales (Total revenue)
5,00,000
2. Less (Explicit cost of production)
(a) Raw material,
interest, fuel,
taxes, etc.
3,00,000
(b) Salaries
50,000
3,65,000 3,65,000
1,35,000
Economic Costs and Economic Profit
Particulars
Rs.
1. Sales (Total Revenues)
5,00,000
2. Less : Explicit cost of production
(a) Raw material, interest,
fuel, taxes, etc.
(b) Salaries
For example, A factory runs in a single
shift. If the entrepreneur decides to run this
factory in two shifts then the direct costs in doing
so are the cost of raw material, wages paid to
newly recruited workers. But expenses on land,
machines is of common nature. These are
indirect costs. In nut shell direct costs are variable
in nature while the nature of indirect costs could
be fixed or partially or fully variable. A firm
producing multiple products would find the
concept of direct and indirect costs important.
Questions for Self Study - 5
3,00,000
50,000
(A) Answers the following questions in
short.
(c) Capital depreciation 15,000
3,65,000 3,65,000
3. Less : Implicit Coast
(4) Direct and Indirect Costs
Production costs that can be spread
over output produced are direct costs and
those costs that are incurred indirectly are
called indirect costs. The indirect costs are
the commonly shared costs.
(c) Capital depreciation 15,000
Accounting Profit
It is because the economists costs include
the implicit costs. The economic profit is less
than the accounting profit by Rs. 1,20,000/-
1,35,000
(1)
What is actual cost ?
(2)
What is opportunity cost ?
(3)
What is the importance of
opportunity cost?
(4)
What is explicit cost ?
(5)
What is implicit cost ?
(6)
What do you mean by depreciation?
(7)
What is normal profit ?
(8)
What is the reason behind difference
in the (accounting) business and
economic profit ?
(9)
What do you mean by direct and
indirect cost ?
(a) Rent of self
owned land
10,000
(b) Interest on own capital
(Capital 1,00,000
@ 15%)
15,000
(c) Rewards of family
members employed 20,000
(d) Reward to owned
entrepreneur skills
(e) Normal Profit
50,000
25,000
Total implicit cost 1,20,000 1,20,000
Economic Profit = (1-2-3) =
15,000
From the example above the accounting
profit is Rs. 1,35,000 but the economic profit is
only Rs. 15,000/-
(B) State whether the following
statements are true or false and put
() or () in the bracket.
(1)
The explicit cost may not be shown
in accounts. ( )
(2)
While considering the economic
profit of business firms implicit costs
are considered. ( )
Markets and Price Determination : 10
(3)
(4)
(5)
(6)
(7)
The concept of accounting profits and
economic profit is the same. ( )
Accounting profit is greater than
economic profit. ( )
The concept of opportunity cost is
important from the point of view of
an accountant. ( )
The concept of opportunity cost is
useful while determining the
economic costs. ( )
The concept of opportunity cost is
important in case of those factors of
production that are scarce and also
have alternative uses. ( )
(C) Fill in the blanks.
(1) Husband is assisted by his wife in
his business while calculating ——
— profit. Wife’s income must be
considered.
(2) An owner of a firm has invested his
own capital of Rs. 1,00,000/- in his
business. An interest on this amount
is not considered in explicit cost while
calculating — - profit.
(3) Opportunity or transfer cost means
————
(4) An engineer earns Rs. 5,000/- per
month. If he was to be employed in
some other firm for the same kind of
a work there he must be paid on
income ————.
(D) Find out it the following costs fall in
the category of explicit or implicit
costs.
(1) Interest paid on money borrowed
from a bank.
(2) Interest paid on money borrowed
from a friend.
(3) Rent for the owned premises of a
building used as a factory premises.
(4) Excise duty paid on goods produced.
(5) The normal profit of a firm.
similarly taxes payable to the Govt. etc. But there
are some expenses that are incurred by the entire
society.
For example, Chemical companies,
companies producing pharmaceutical or
antibiotics, the leather factories release a lot of
industrial waste that is released either in air or
water, that polluted water and air. This water
and air pollution is injurious from the view point
of the entire society. The entire society has to
bear this cost. If the industries are densely
populated in a particular locality then such areas
suffer a lot due to such a concentration.
For example, increased slums, increasing
burden or existing roads, traffic, water supply
etc. The Govt. has to spend money to tackle
such problems. This means indirectly this cost
falls on the society. While discussing costs in
economist both private and social costs are
considered.
(6) Controllable and Non Controllable
Costs
Improving and maintaining productive
efficiency of a firm is the basic function of
management. An appropriate control over costs
can enhance the efficiency and thereby the
profitability of the firm. It is from this point of
view controlling some of the cost becomes a
managerial duty. Various departments in a firm
are given a pre sanctioned expenditure limits. A
check on the same can be made by companing
the pre-sanctioned limits and the actually incurred
expenses so the expenses that fall in the ambit
of the managerial control are called the
controllable costs. The variable costs of
production are largely controllable ones. But
some other express are beyond the controllable
limits of the manager. For example, costs
incurred on account of depreciation, central
excise, corporation tax, central sales tax and
import-export duties. These expenses change
almost every year. The other example could be
the salaries, honorarium and other expenses
incurred on the managing directors of firms.
These are called non controllable expenses.
(5) Private and Social Costs
The costs that the firm incures in the
process of production is the private cost. For
example, the remuneration paid to the factors
of production, e.g. rent, wages, interest, profit,
(7) Incremental and Sunk Cost
The production costs change due to
changes in levels of production, producing more
Markets and Price Determination : 11
than one product of different type, changes in
technique of production or increased production
using new techniques of production. These
expenses (costs) that are related to short run
managerial decision-making are called
incremental costs. These costs emerge only due
to changed decisions about production.
If such decisions are not taken these costs
would not erupt. Hence these costs are
avoidable.
These costs that are not related to
increasing production but have already been
incurred are called Sunk costs. These sunk costs
are also known as the non avoidable or non
escapable costs.
Variable costs are incremental in nature.
But all incremental costs are not variable. This
is because some of the incremental costs also
include the fixed costs. For example, An
entrepreneur buys a machine with an installed
capacity to produce 100 toys a day but actually
only 50 are produced. If the entrepreneur
decides to produce additional 50 toys, he would
have to incur an additional expenditure only on
raw material and workers. This expenditure
would constitute incremental cost but
expenditure on the purchase of machine has
already been incurred in the past and hence this
cost and depreciation there on is termed as the
sunk cost.
The classification of costs as incremental
and sunk is not watertight. In a particular
example a specific cost may be incremental
while in other example the same sunk cost.
(8) Marketing Cost
We have so far considered costs incurred
in the process of production. Production
completes one process of a product cycle. The
process next to this is the process of sale. The
goods are needed to be brought to the market
place from the place of production to sell those
to the customers. The transportation of a product
from the place of its origin till the place of sell
involves a big chain. The expenses incurred in
this process are called marketing cost. Marketing
cost involve expenses on the following items.
(a) Storage
The produce until it reaches the final
consumer should not lose its utility. Hence the
goods are required to be stored, for which a
good deal of facility is required in the from of
cooling station, storages, warehouses etc. These
facilities ensure that some of the products like
medicines, milk, meat, and fruit do not perish.
Expenses incurred on preserving the quality and
utility of the product are called storage cost.
(b) Packing
Some goods are properly packed so that
they reach the market in proper condition. Now
a days we can see packed grapes, bread and
milk sold in the market. Attractive packing is a
part and parcel of salesmanship. Customers get
attracted towards attractively packaged
products easily. The expenditure incurred on
packaging of products is included in marketing
costs.
(c) Transport
The goods produced are needed to be
transported to the market place. They are
transported by railway, road or airways. The
expenditure incurred on this part of marketing
is called the transport cost. Of the total turnover
in agriculture around 70 to 80% of the
dependence is on the transport. The prices of
products increased due to transports cost. The
price in the local markets and the prices in
markets away differ substantially due to
transport cost. Some products have local
demand while some other products have
national as well as international demand e.g.
grapes, mango etc. In a nutshell the cost involved
in transporting the goods from its place of
production to the market is called transport
cost.
(d) Insurance
The goods should be well protected during
their transit from the place of production to
godown and from godown to market. The same
should be hence insured against the risk of theft,
accident and fire. The insurance premium paid
for protection of goods is a cost and is recorded
under marketing expenses.
Markets and Price Determination : 12
(e) Sales Arrangement
Questions for Self Study - 6
(1) Advertisement : Advertisement is an
inseparable part of sales today. In advanced
nations advertisements constitutes 30% to 50%
of the price of certain commodities. A number
of advertisements flash through various
advertisement media, now a day. Commodities
such as Television sets, cosmetics, cold drink,
electrical and electronic equipments, clothes
etc…are advertised on a large scale that too on
regular (daily) basis. The advertisement are not
only through the electronic and print media but
also through various hoarding on roads, wall
papers, and through the government vehicles.
Due to advertisement, a market for product is
created and its demand is even expanded. The
prime objective behind advertisement is to
ensure rise in sales, hence such expenditure is
termed as marketing expenditure.
(A) Answers in short.
(2) Hawkers : Some of the firms even
appoint selling agents who roam around across
cities to sell their products. Once a good is
produced, identifying where, whom and how to
sell the product requires a very disciplined
arrangement. To ensure this a systems of sales
agent or hawkers is made. The selling agents
enable the firms to reach the retailer in the
market and through the retailers buyers directly.
This enables the firms to get a feedback from
the buyers with reference to the size, colour,
taste and grade of the product. The expenditure
incurred on this selling link is included in
marketing expenditure.
(3) Gifts and Discounts : In order to
maintain healthy and long lasting relation with
the buyers, sellers offers various gifts and even
schemes of discounts. These schemes attract
customers to such firms. Complimentary goods
like soap, comb, diary, pencil, ball pens,
handkerchiefs, calendars, toothbrush, etc; are
given to buyers to attract them. Some goods
even carry heavy discounts. The buyers are
happy due to this. Expenditure incurred on this
is also treated as marketing expenditure.
(4) Local Taxes, Octroi and Sales Tax:
While selling goods in the vicinity of corporations
the sellers have to pay octroi and sales tax. Some
goods are charged at different rates of sales
tax. All the points mentioned above are expenses
not related to production but are related to
expenses on sales and are marketing costs.
(1)
What is private cost and social cost?
(2)
Distinguish between cash and Book
costs.
(3)
What do you mean by controllable
and non controllable cost ?
(4)
Explain incremental and sunk costs.
(B) Fill in the blanks.
(1)
Expenditure of _____increases due
is social costs.
(2)
Those expenses not incurred directly
but are recorded in the books are
called _______.
(3)
The costs that are beyond the
managerial controls are called____.
(4)
_______costs increase due to a
decision to increase production.
(5)
Marketing costs include expense
ranging from______.
(C) State whether the following
statements are true or false and put
() or () in the bracket.
(1) Some factories cause air, water and
river pollution, due to which their
private expenditure increases. ( )
(2) All those costs that are current in
nature and are incurred in cash are
called accounting costs. ( )
(3) Variable costs are controllable. ( )
(4) Sunk costs are those taken in the past,
having no relation with decisions of
increasing production. ( )
(5) In a competitive market expenditure
incurred on advertisements can be
avoided. ( )
(6) From the final stage of production
till the good reaches the consumer
transport cost is incurred. This
transport cost is a part of cost of
production. ( )
(7) Expenditure on advertisement is
recovered from the consumers. ( )
(8) Expenditure on advertisement is a
kind of liability on a society. ( )
Markets and Price Determination : 13
7.2.5 Cost Curves
Table 7.1 : Fixed Cost of Business Firm
Output
(1) Total, Average and Marginal Cost
Curves
TFC
+
TVC
We have studied this. Let us now see how
there cures are derived. The above equation is
known to us. Let us now find out how total and
average cost curves can be derived for individual
factors of productions.
Cost (Rs.)
Cost (Rs.)
0
100
00
1
100
100
2
100
50
3
100
33.3
4
100
25
5
100
20
6
100
16.7
7
100
14.3
8
100
12.5
The same table could be expressed in a
graphical form.
Y
Cost
=
Average Fixed
(Pieces)
So far we have understood the various
types of costs of production and the differences
therein. We have also examined the fixed and
variable costs. Let us now find out the total,
average and marginal cost curves on the basis
of our available information. While finding the
equilibrium of firms and industry and while
determining the prices in various markets the
cost curves play an important role. At the same
time these cost curves are used for identifying
the ratio of profit and loss.
Total cost
Total Fixed
100
P
F
TFC
Fixed Cost
(a) Total Fixed Cost
The concept of fixed cost can be explained
using a cost schedule and a cost curve, derived
using the data from the cost schedule.
(See Table 7.1) The table shows that the
total fixed cost (TFC) is Rs 100/-. This is a
hypothetical example for a hypothetical firm. If
a firm were to produce even one unit of output,
it would have to install a plant. In a nutshell, it
means irrespective of the level of output, the
firm would have to spend Rs 100/- as a fixed
cost. The firm would not have to incure any
additional fixed cost if it were to produce any
additional output. Hence fixed cost over a range
of production (level of output) remains constant.
In our example it is Rs 100/-. We have to show
it as Rs 100/- even at zero level of output.
X
0
1
2
3
4
5
6
Out Put
Fig. 7.1 : The TFC Curve
At any level of output TFC remain
constant
In our diagram we measure output on the
X (horizontal) axis and the fixed cost on the Y
(vertical) axis. Using the data given in Table 7.1
we plot the cost at various levels of output, to
find that at various levels of output total fixed
cost is at a constant level. The various points
representing cost at various levels of output
when are joined together we get a straight line
parallel to X axis called the total fixed cost curve.
This is denoted by “PF”.
Markets and Price Determination : 14
(b) Average Fixed Cost
Variable Cost
Let us consider the fixed cost from the
point of view of the average cost. We have
shown average fixed cost in the last column of
Table 7.1. The formula for calculating AFC is
given below:
AFC 
(a) Total Variable Cost
The variable cost for a firm is shown in
table 7.2.
Table 7.2 : The AFC curve
Output (Pices)
TFC
Total Output
From the table we can find that as
production increases the average fixed cost goes
on falling. This is because the total fixed cost by
name and its nature is fixed and it gets shared
as more and more output is produced. The fixed
cost for one unit of output is Rs. 100/- so is the
average fixed cost. For the second unit produced
though the fixed cost remains same, average
fixed cost falls to Rs. 50, while it is Rs 16.70 for
the sixth unit produced. The AFC has been
plotted for you.
AFC
Y
AFC
X
0
Out Put
Fig. 7.2 : Average fixed cost curves
The average fixed cost goes on falling with
rising output. The speed of fall in AFC in
the initial stages of production is high. Later
it slows down.
0
1
2
3
4
5
6
7
8
TVC (Rs.)
AVC (Rs.)
0
60
110
150
180
200
240
300
400
0
60
55
50
45
40
40
42.9
50
The table indicates that the variable cost
is zero when the level of output is zero. The
variable cost increases with the level of output.
But the proportionate rise in TVC does not match
with the level of output over the range of
production. The proportionate rise in variable
cost is greater than the proportionate rise in
output in the initial stage of production. In the
second stage (mid-stage) production, the
proportionate rise in variable cost gets stabilized
and finally it starts rising again. There are reasons
behind such a pattern of variable cost. The reason
being the various levels of output produced and
the optimal utilization of the variable factors of
production. Firms may have some factors that
are condusive in reducing variable costs beyond
a level of production. For instance when a firm
buys raw material on a large scale it gets an
advantage of discounts, which would not have
been possible if the raw material purchases were
less in quantity. Large purchases of raw material
is invariably associated with high levels of output.
The same condusive conditions may prevail when
demand for labour and capital is on a large scale.
These favourable conditions are also termed as
economies of scale. In our table the rise in
variable cost seems to have been slowed down.
Just as there are favourable conditions for cost
reduction up to a certain level of output, there
are unfavourable conditions also beyond a
particular level of output. Scarcity of raw
material, the scarcity of labour force or their
Markets and Price Determination : 15
unavailability in time, scarce and irregular supply
of fuel, difficulties in organisation and allied
entrepreneurial problems may cause, the variable
cost to rise fast. In our table the variable cost
beyond unit six, rises at a rate faster than before.
Y
AVC
The variable cost can be studied from
average point of view also. In table 7.2 the last
column represents the AVC. The AVC is
calculated as:
AVC 
Cost
(b) Average Variable Cost
TVC
Total Output
X
0
Units of Output
Table 7.2 shows that the average variable
cost until sixth unit of output goes on falling. It
is the least at the sixth unit of output while it
goes on rising continuously from the seventh unit
of output.
We have understood the total and the
average variable cost from the preceding
discussion. We now see their graphical
presentation. The TVC and AVC are shown in
diagram 7.3 and 7.4 respectively.
Fig 7.4 : The AVC Curve
AVC
* AVC in the initial stages of production
falls and beyond a point it goes on rising.
* AVC in a U shaped curve.
(a) Total Cost
As mentioned before TC is a sum total of
TFC and TVC.
TC
=
TFC
+
TVC
Y
TVC
TVC
The tendencies of total fixed and variable
cost can be seen in total cost. We shall study
the same through a cost schedule and diagram.
Table 7.3 : TFC, TVC and TC
0
X
Units of Output
Fig 7.3 : The TVC Curve
TVC
*
*
TVC rises with rising level of output.
It is zero when output is zero, over a
range of output it rises at a decreasing
rate and then at an increasing rate.
Output
(pieces)
TFC
(Rs.)
TVC
(Rs.)
TC
(Rs.)
0
100
0
100
1
100
60
160
2
100
110
210
3
100
150
250
4
100
180
280
5
100
200
300
6
100
240
340
7
100
300
400
8
100
400
500
Markets and Price Determination : 16
As shown in table 7.3 the total cost has
been rising until 5th unit of output, but the rate of
rise in the same has been falling. The
proportionate rise in the total cost speeds up
beyond the 5th unit of output. The fixed cost for
a firm in the short run, as the name suggests
remains fixed. The only cost that changes in the
short run is the variable cost and hence the
variable cost determines the tendencies
(movement in) of the total cost curve. It is shown
in the diagram. 7.5
Both the formula above, give us the same
answer. We can find the average cost from the
data given in table 7.3 by using the TC figure
from the same.
Table 7.4 shows that as production rises
the Ac goes on falling until the 6th unit. It is
minimum at a particular level of output ( in our
example it is the 6th unit) Beyond a particular
level of output (beyond 7th in our example) AC
goes on rising. The movement in (shape of)
average cost curve are shown in Fig 7.6.
Table 7.4 : Average Total Cost
Y
TC
Output
TFC
TVC
(pieces)
(Rs.)
(Rs.)
0
100
0
1
160
160
2
210
105
3
250
83.3
4
280
70
5
300
60
6
340
56.7
7
400
57.2
8
500
62.5
Cost
TVC
TFC
0
X
Units of Output
Fig. 7.5 : TFC, TVC and TC
Y
TFC, TVC, TC
* With the rise in output the TC rises in
proportion with TVC hence their shapes
are the same and they are parallel to each
other.
(b) Average Total Cost (ATC or AC)
ATC is also known as the AC. We can
derive AC from the TC. There are two ways of
arriving at AC. They are
TC
(i) AC 
Total Output
(ii) AC = AFC + AVC
AC
AVC
* TC rises with the level of output. The
TC and TFC are equal at zero level of
output. Hence the Y intercept of TC
and TFC curves is the same.
X
0
Units of Output
Fig. 7.6 : Average Total Cost Curve
ATC
* AC initially falls, with rise in the level of
output reaches the minimum and rises
thereafter.
* It is a U shaped cure.
Markets and Price Determination : 17
Marginal Cost
Y
The net rise in the cost due to a unit change
in output is called Marginal Cost.
MC
MC
Marginal cost is an important concept in
economics. What should be the optimum level
of output for a firm, can be determined using
the concept of marginal cost. The marginal cost
is measured using total cost. Let us first
understand what marginal cost is :
Table 7.5 : TC and MC
Output
(pieces)
TC
(Rs.)
MC
(Rs.)
0
100
100
1
160
60
2
210
50
3
250
40
4
280
30
5
300
20
6
340
40
7
400
60
8
500
100
The last column in table 7.5 shows the
marginal cost of production. Total cost of
production is Rs 100/- when production is zero.
Total cost moves up to Rs 160/-, when output is
one unit. This means when there is a unit change
in output Total cost rises by Rs 60/-. This rise in
total cost is called marginal cost. Marginal cost
is calculated this way. The table shows that
marginal cost initially falls (in our example until
5th unit of output) At a certain level of output it
reaches its minimum (5th unit of output) and it
starts rising (i.e. after the sixth unit in our
example) thereafter.
MC
*
MC in the initial stage of production falls
and rises thereafter.
*
The shape of the TVC influences the
shape of the MC curve.
*
MC is U shaped.
Table 7.3 and 7.5, when put together show
that since the total fixed cost is stable the
marginal cost has risen by an amount equal to
the change in variable cost due to the change in
the level of output. The MC cure is shown in
Fig. 7.7.
X
0
Units of Output
Fig. 7.7 : MC Curve
Putting Fixed and Variable Cost together
We can now bring the table and diagrams
drawn until now together. On the basis of this
we can arrive at a total picture about the cost of
a firm. We must known that when a firm
considers costs interns of the total costs it helps
the firm to arrive at its profit. The average costs,
on the other hand, help the firms to determine
the optimal level of output it should produce.
We examined this while studying the concept of
cost of production. While putting the costs
together we would consider only the average
costs. The firms in perfect competition,
monopoly etc. use the average cost tools while
determining the levels of output in these markets.
We shall study this in the topics to follow :
Let us put the Average and marginal cost
together. We shall consider figure from table
7.1, 7.2, 7.4, 7.5, to prepare table 7.6. The same
is shown below :
Table7.6 : Short Run Costs of Firms
Output
(Pieces)
AFC
(Rs.)
AVC
(Rs.)
AC
(Rs.)
MC
(Rs.)
1
2
3
4
5
6
7
8
100
50
33.3
25
20
16.7
14.3
12.5
60
55
50
45
40
40
42.9
50
160
105
83.3
70
60
56.7
57.2
62.5
60
50
40
30
20
40
60
100
Markets and Price Determination : 18
We can put the table in a graphic form to
see AC, AFC, AVC and MC together. Their
tendencies can be seen from their shapes in
relation to the corresponding level of output.
(4) AFC declines continuously with rising
levels of output.
(5) Average variable cost (AVC) goes on
declining until a certain level of output
increases thereafter.
Y
MC
(6) ATC goes on declining until a certain
level of output and thereafter rises.
AC
AVC
Cost
(7) MC follows the behaviour of the ATC
and the AVC i.e. goes on decreasing
with rising level of output and rises
beyond a particular level of output.
(8) AVC, ATC, and MC are U shaped
curves.
AFC
X
Output
Fig. 7.8 : Short Run Cost Curves of Firms
* MC curve cuts the AC curve and the
AVC curve at their minimum.
* The minimum of the ATC curve lies to
the right of the minimum of the AVC
curve.
* The distance between the AVC and
ATC goes on decreasing continuously.
So far we discussed the fixed, variable
and the managerial cost and we also how, their
curves are. The entire discussion pertains to their
short run behaviour. This must be borne in mind.
The costs of production is given a different
treatment (different angle) in the long run. We
shall discuss the same in the next section. The
features of short run tendencies of costs of
production can be examined by looking through
table 7.1 to 7.6 and diagrams 7.1 to 7.8. The
features can be mentioned in a nutshell.
(1) Total fixed cost (TFC) remains fixed
at any level of output.
(2) Total variable cost ( TVC) increases
with the level of output.
(3) Total cost (TC) also rise with rising
output.
(9) MC curve cuts the AC and AVC curves
at their minimum point.
(2) Fixed and Variable Costs : Short
Run Differences
In the preceding section we saw that the
total cost is the sum total of fixed and the variable
cost. The equation is :
TC = TFC + TVC
The TC can be classified in this way only
in the short run. Such a classification (or division)
is not possible in the long run. This is because
all the costs are classified as variable costs in
the long run. We need to consider the difference
between the short run and the long run from the
point of view of Economics. We can then
determine that fixed and variable can not be
distinguished from each other in the long run.
Short and Long run can be classified on
the basis of the time available for the supply of
goods. Demand for a commodity can change, it
can either increase or decrease.
For example, Demand for milk was 2000
liters the other day. The same could change to
5000 or ever 1000 liters today. But it is not true
of supply. Supply of any product can not be
changed instantaneously. It can neither be
increased nor decreased all of a sudden. In this
context the principle classification of supply of
goods could be made as short run and long run.
Using the given raw material and level
of technological when output can be
marginally changed, such period is called
the short run.
Markets and Price Determination : 19
Let us consider the above definition in the
light of the previous example.
Consider that the milk producers have to
increase the supply of milk. They are required
to bring the maximum quantity of milk, in the
market on 2nd and the 3rd day. What immediate
action (can) would they take? Their first attempt
would he to extract more milk from the given
stock of animals. They would feed the animals
more fodder and better fodder. This would
enable buffaloes to deliver 4 liters of milk in place
of original 3 liters. This would enable them to
increase the supply of milk with the given stock
of animals. This would involve nothing but
increasing the productivity of the same animals.
This way they may be successful increasing the
supply of milk from 2000 liters to 2,500 liters.
This increase in supply of milk by 500 liters is a
marginal rise in supply of milk without increasing
the number of animals.
Let us assume that the large number of
people decide to drink milk, for the purpose of
maintaining their health. Demand for milk rises
on account of this. The producers of milk, would
resort to long term measure when they are such
of the sustaining of this demand for long term.
They would purchase new animals. The Govt.
would resort to programme of breeding
additional milch animals. Long run measures
would the resorted to. This would involve some
time. In other words Time span over which changes in new
material and level of technology can be
brought about is called the long term / run.
In the long run supply can be totally
adjusted and matched with the demand for
product. This alone can be termed as the total
change.
While using the terms, short run and long
run their exact term cannot be determined. It
depends on the method of producing goods and
the conditions prevailing at the time of
production. In general sense short run involves
a span of some months while long run involves
span of some years.
Let us now turn to the core issue. Why
are all costs variable in the long run. If the
demand for goods is expected to increase and
remain at that level in the long run, the
entrepreneurs are required to change the scale
of production. They may be required to construct
new buildings or renovate the old ones.
Purchases of new tools, machines and
equipments would be required.
On the managerial level, new and
experienced managers will have to be appointed.
Specialization in the field of production and sales
will have to be introduced by appointing specialist
(experts) from the respective fields. The
responsibility of sales department will rest on
an expert from the sales department. In short,
the expenses, which are termed as fixed in the
short run, become variable in the long run. Hence
in the long run we call them variable costs. The
nature of long run costs can be put across as
follows :
Short
Run
Total
Cost
=
Fixed
Cost
+ Variable
Cost
Long
Run
Total
Cost
= Variable + Variable
Cost
Cost
Total
Cost
=
Variable
Cost
(3) Average Cost : Long Run Tendency
In the long run all costs are variable as
the fixed costs becomes variable and hence there
is no separate place left for classifying total cost
as between fixed and variable. So in the long
run we have total cost and marginal cost. Since
total cost is nothing but TVC, in the long run, it
rises with the rising level of production. We can
arrive at LAC from the LTC using the following
formula.
Markets and Price Determination : 20
Long run Avg. Cost 
Total Cost
Units of Output
Y
LMC LAC
Table 7.7 : Long Run Costs of a Firm
Output
TC
AC
MC
(Pieces)
(Rs.)
(Rs.)
(Rs.)
0
0
0
-
1
5
5
5
2
9
4.5
4
3
12
4
3
4
14
3.5
2
5
18
3.6
4
6
23
3.8
5
7
29
4.1
6
8
36
4.5
7
0
X
Units of Output
Fig. 7.10 : Long Run Marginal and Average Cost
Curves
* Both LAC and LMC are U shaped in
the long run but are flatter than the short
run curves.
* The LMC cuts the LAC at the
minimum of LAC.
Questions for Self Study - 7
(A) Answer the following questions in
short.
(1) What is fixed cost ?
(2) What is average fixed cost ? Why does it
go on decreasing ?
(3) What is variable cost ?
(4) Why does variable cost decrease up to a
certain level of output ?
(5) Why do we find classification of costs as
fixed and variables only in the short run ?
Y
Cost
LTC
0
Cost
The LMC is the rise in the LTC as a result
of rise in output. Let us examine the LTC, LAC
and LMC from the following table and diagrams.
X
Units of Output
Fig. 7.9 : Long Run Total Cost Curve
* In the long run since all the costs are
variable TC = TVC
* In the long run when the level of output
is zero long run TC is zero. It rises with
the output.
(B) State whether the following
statements are true or false and put
() or () in the bracket.
(1) In the long classification of costs in to
variable, fixed cost is not applicable ( )
(2) Long run Total Cost = TFC + TVC
( )
(3) In the long run fixed cost remains fixed
and only variable cost changes ( )
(4) Total cost in the long run changes with total
variable cost ( )
(5) The net increase in total cost due to a unit
change in output is called total variable cost
( )
(6) TFC is U shaped ( )
Markets and Price Determination : 21
(7)
AVC is U shaped. (
)
Y
(C) Choose the correct option.
(1) LAC and LMC are ——— Shaped.
(Parallel to X axis, ‘U’)
(3)
(4)
Total Cost
 Average Cost . (unit of

output, MC)
In the long run, all the cost are ——— .
(variable, fixed)
Only ——— costs affect the long run
average cost curve. (fixed, variable)
SAC2
M1
SAC3
0
Output
TFC
TVC
TC
MC
(Pieces)
(Rs.)
(Rs.)
(Rs.)
(Rs.)
1
2
3
4
5
55
55
55
55
55
30
55
75
105
155
(1)
If the producer produces AX1 level of
output he would produce it on SAC1.
(2)
If the demand rises from AX1 to AX2 the
producer would move to medium scale
plant and would operates on SAC2. This
is because if he operates on SAC 1, for
producing AX 2 output he would be
incurring a higher cost than what he would
on SAC2. This is indicated by a distance
M1 M2 in the diagram. Since X2M2<X2M1
producer would like to shift to AC2.
M2
D
X1
X2
X3
Units of Output
X
Fig. 7.11 : Planning Curve
(3)
On the same lines if the demand increases
further to AX3, the producer would have
to decide whether to continue with the
medium scale plant or move towards a
plant of higher capacity i.e. the large scale
plant. If he continues with the medium
scale plant the average cost he incurs is
X3 M2 which is higher than X3 M3. The
producer would be producing at falling
costs, if he produces on SAC3 but if he
produces the same level of output on SAC2
he would be producing on rising costs.
Hence it would be beneficial for him to
produce on SAC3.
(4)
If we join the path of production putting
these 3 cost curves together it gives us 4
points A, B, C, D. These points when are
plotted together on a separate X, Y plane
we get LRAC. This curve envelops all the
short run cost curves. In the example
discussed above we have talked about only
3 levels of production. But in reality, the
short run cost curves are very close to each
other and a long run cost curve is one which
touches all these short run cost curves.
This is shown in Fig. 7.12. This is the
reason why the long run cost curve is called
the planning or envelope curve.
Long Run Average Cost (LRAC)
Curves : Planning Curve or
Envelope Curve
The LRAC is also known as the planning
curve because the costs of production can be
planned in the long run. The costs can be planned
on the basis of the shape of the curve. Every
point on the long run average cost curve
corresponds with a point on series of short run
average cost curves. In this sense the long run
cost curve envelops all the short run cost curves.
This is why the LRAC is also called an envelope
curve. Fig. 7.11 SAC 1 + SAC2 and SAC3
indicate small, medium and large scales of
production respectively, we can derive a long
run AC curve using these 3 short run cost
curves. Let us see how it is derived.
C
M3
(D) Fill in the blanks.
(4)
B M1
M2
Cost
(2)
SAC1
A
Fig. 7.12 shows the LRAC curve which
is U shaped. But it is slightly flatter than short
run average cost curves. In the traditional theory
of cost the cost curves are U shaped and are
based on laws of production. As per the laws of
Markets and Price Determination : 22
returns to scale, as the size of the firm expands,
the average cost of production falls. The firm in
the initial stages of production enjoys the
advantages of scale of production. This is
possible upto a certain level of output where the
cost gets shared between the rising levels of
output. A point is attained where the average
cost becomes the least and that is the point of
optimum production. The minimum point of the
cost curve indicates the optimum level of output
produced by the firm and the firm is of optimum
size, in Fig. 7.12 for AN used of output MN is
the least cost of production. MN is the least
cost of production. Hence, AN is the optimum
level of output.
Y
*
The various points of LRAC curve
correspond to some SRAC or the other.
Hence, LRAC curve is a locus of several
SRACs. The LRAC curve is hence
called an envelope curve, the planning
about future cost of production can be
made on the basis of the LRAC curve
curve and hence it is also called the
planning curve.
*
Both the short and the long run cost
curves are U shaped. The long run
average cost curve has a much flatter U
shape than the short run average cost
curve.
*
The minimum of log run average cost
curve shows that the costs at that level
of output are minimum. Hence that point
of minimum costs shows optimum level
of output and the firm producing that
level of output is called an optimum firm.
LAC
M
A
N
Units of Output
X
Fig. 7. 12 : Average Cost
If output is expanded beyond AN the
advantages or economies of production (scale)
are reduced. Managerial controls and exercising
coordination in various activities of the firm
becomes difficult. Decision making not only
becomes difficult but also involves long time.
The entire process becomes technical and the
long run average cost goes on rising.
The discussion can be summed up in points :
*
For any scale of production the long run
average cost is below the short run
average cost. Hence the short run
average cost curves lie above the long
run average cost curves. The LRAC
curve is tangent to every SRAC curve.
We saw that the long run average cost is
U shaped but is flat in nature. But according to
some economists the LRAC curve is not U but
L shaped. George Stigler opined in 1939 that
the short run average variables cost curve is
straight line (constant) over a certain ranges of
production. The reason behind this is that every
firm maintains a reserve capacity so as to
increase production whenever it is required to
do so on a short notice.
Y
SAVC
Cost
Cost
L Shaped LRAC Curve : Modern View
Reserve
Production
Capacity
A
N1
N2
Units of Output
X
Fig. 7.13 : Short Run Variable Cost : Actual
Shape
Markets and Price Determination : 23
Accounting to modern approach there are
two types of costs in long run, they are production
costs and entrepreneurial costs. the production
costs go on declining while the entrepreneurial
costs go on increasing with the level of output.
The fall in the cost of production is greater than
the rise in entrepreneurial costs hence the long
run average costs curve is a continuously falling
curve. It is straight over a ranges of excess
productive capacity.
All costs become variable in the long urn.
The costs of production go on falling till the long
run reached. In the initial stages of production
due to economies of techniques the costs of
production falls sharply. But over time these
economies reduce. At a certain level of
production, since all the economies have been
reaped, an optimum level of production is
attained. Beyond this point LAC remains fixed.
The LMC is below the LAC till this point of
optimum level of output is attained. LMC meets
LAC at that minimum of LAC and thereafter
merges with LAC. This condition prevails over
a long range of production and hence LAC and
LMC are seen in a single line (on the same line)
and hence are ‘L’ shaped.
The features of the long run marginal and
average costs, as identified by modern economist
can be expressed in form of a graph.
Y
SAC1
Cost
SAC2
2/3
SAC3
2/3
2/3
LAC
X
A
Units of Output
Fig. 7.14 : Falling LAC Output Cutting the SACs
(1)
SAC1, SAC2 , SAC3 shows 3 different
scales of production.
(2)
It is assumed that every scales of
production uses only 2/3rd of its capacity.
(3)
The LRAC curve is a falling and not a
rising curve.
(4)
The LRAC curve is not an envelope curve
but in fact it cuts the 3SRACs at their load
factor level.
Y
LAC
LMC
Cost
In Fig. 7.13 N1N2 range of production is
the firms reserve productive capacity. If the
demand for the firms product rises then such a
short run spurt in demand could be met with
using the reserve capacity. Production can be
increased from AN1 to AN2. Normally a firm
produces 2/3rd to 3/4th of its productive capacity.
The scale of production is more inclined towards
N 2 than towards N 1 . The firms make
investments equal to that level of productive
capacity which is more than demand for that
product. This concept is also termed as load
factor. The reason for maintaining excess or
reserve capacity are obvious. The seasonal or
cyclical fluctuations in demand require the firms
to maintain the equal reserve capacity. This
reserve capacity would be sufficient enough to
cope with such fluctuations. If demand increases
supply can be matched with it by altering the
variable cost curve. By and large the experience
of the entrepreneur shows that demand for any
product keeps rising over time. The entrepreneur
also needs to bear in mind that he can not afford
to let his customers go to his competitors due to
disturbances in supply of his product. Hence,
building reserve capacity can be beneficial for
him.
X
A
Units of Output
Fig. 7.15 : LAC and LMC
Markets and Price Determination : 24
The LRAC curve goes on falling
continuously and the LRMC curve lies below it.
(1)
Long run average cost curve is also
known as the planning curve. ( )
(2)
Change in scale of production has
no impact on the shape of the cost
curves of firms. ( )
(3)
Long run average cost curve
envelops all at short run cost curves.
( )
(4)
Firm attains an optimum size at that
level of output where the average
cost curve is at its minimum. ( )
(5)
The long run average cost is less than
the short run average cost at any level
of output. ( )
(6)
The lowest point on the long run
average cost curve shows the
optimum level of output. ( )
(7)
The modern view depicts long run
average cost to be L shaped. ( )
Y
LAC
Cost
LMC
LAC = LMC
X
A
M
Units of Output
Fig. 7.16 : LAC and LMC - Complete Picture
(1)
(2)
In the long run LRAC curve lies above
LRMC curve until the scale of minimum
optimum production is attained. In our
example it is AM.
The LARC beyond the minimum optimum
scale of production becomes a straight line
and merges with LRMC curve.
The observations made by many
economist about the costs entail that the SRVCs
are with flat bottoms and long run average costs
curves are L shaped.
Although the above expressions about
costs may seem realistic the economic literature
discuses the U shaped cost curves in great detail.
The traditional theory of cost curves is used in
the determination of equilibrium prices in various
markets.
Questions for Self Study - 8
(A) State whether the following
statements are true or false and put
() or () in the bracket.
7.2.6 Economies of Scale
As a firm grows, its output, the size of the
firm also increases. The rising scales of
production help the firms to reduce their costs.
The large scale production by firms helps them
enjoy economies of a large scale. While enjoying
the economies of a large scale, firms experience
falling average costs. But when the firms
produce beyond a certain level of production
(beyond a certain production capacity) they
even experience diseconomies of scale. The
average costs over this ranges of production are
rising.
The firms avail of economies of scales in
two ways. When the firms enjoy benefits of
economies of scale, they are termed as internal
economies. The internal economies could be real
or pecuniary. They are real when the reduction
in costs is realized indirectly while they are
pecuniary when costs cuts are realized directly.
The economies of scale can turn beneficial
also to those firms associated with the original
Markets and Price Determination : 25
firm. Some of these benefits are shared or are
common for example if the industries like textile,
iron and steel are centralized in a particular
locality, they cause the social overhead capital
to grow in that area. The infrastructural
development in the form of water, electricity,
network of railways and radio and the
institutional development in the form of banks,
schools and colleges automatically help the other
industries in that area. These are called external
economies. The classification of economies of
scale is given in a tabular form.
Table 7.8 : Classification of Economies of Scale
Economies of Scale
Internal
External
Due to concentration or growth in
industrial activities, all the firms enjoy
some common benefits
A single firm grows such a level
which enables it to reap economies of
various nature.
(a) Real economies
(b) Pecuniary Economies
• About localization
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About
About
production
management marketing
technique
About
transport
& storage
About
risk
bearing
• About finance
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• Specialization
• Specialization
• Advertisement
• Large size and • Modern
• After sales
indivisibility
service
management
skills
• Processes put
• Innovation and
together
changes in
• Modernization
product
• Control over
raw material
and production
of by products
• Stock of goods
and reserve
capacity
Markets and Price Determination : 26
Internal Economies
(A) Real Economies
(1) Related to production (Technical in
nature)
Following are the five indirect benefits
arising out of economies of scale.
(a) Specialization : Division of labour
principle can be used very effectively while
producing on a large scale. Different machines
are used for different purposes and their use is
also optimal. The productive capacity of such
machines is also large. Efficient labour force
can be employed to use such machines.
(b) Big size and indivisibility : For large
scale production use of big machines is also
essential. The machines can be used up to their
optimal capacity when the scale of production
is large. Machines are undivisible. Since these
machines are used to their optimal capacity the
costs also falls. These are benefits purely arising
out of technical improvements or techno
efficiency and hence are technical in nature.
Some benefits arise only out of the size,
e.g. a water tank measuring 4’ x 4’ x 4’ would
carry a capacity of storing 64 cubic feet water
in it. But if we double the size of this tank (i.e.
8’ x 8’ x 8’) it would store 512 cubic feet water.
If we assume that tank of double the size, costs
double the price. But in terms of capacity it
would store 8 times more water than the tank
of a smaller size. A double decker bus would
definitely not cost double the price of single bus,
but would carry double passengers and would
be run by a single driver.
(c) Process assimilation : In carrying
out large scale production various process can
be brought together. In case of a publishing
company or a newspaper publishing company
various department such as editorial,
advertisement, circulation would be functioning
in the same building or in the same premises,
which would help economise on the time required
and even costs. This would be possible due to
specialization and assimilation of process.
(d) Control over raw material and
production of by products : The small scale
industries have to depend on others for the want
of raw materials. The supply of raw material is
prone is interruptions. These small industries can
not even produce by products that could be
produced using the remainder in the process of
production. This is possible for the large scale
industries. For example, Coal required by the
iron and steel industry may be availed by
purchases of coal mines. This would ensure that
there is no disturbance in supply of coal. The
same is the experience in case of by products.
The sugar factories can produce liquor and paper
from the remains in the process of production
of sugar. Big industries can own trucks, tractors
and trailers. They can even go to the extent of
producing electricity just enough to satisfy their
needs. Maintenance of their own instruments
through their own maintenance departments can
also be done by the large scale industries.
(e) Stock of Goods and Reserve
Capacity : The large scale industries can
maintain stock of raw material and other goods.
The lags in supply of raw material do not pose
the threat of closure of such industries. The
reserve capacity increases as human resource
and machines are used on a large scale. Meeting
unforseen contingencies hence, becomes
possible.
Due to these economies of scale that are
technical in nature indirectly cost also falls.
(2) Managerial Economies
Management is basically related to the
production and sales of goods. Hence,
managerial economies are useful from the point
of view of production and sale of goods. These
economies includes :
(a) Specialization : Specialization in work
can be attained when production is on a large
scale, specialized human resource can be
appointed in the field of sales, accounts, cost
analysis, raising of capital, etc. The use of
educated and qualified personnels from their
respected fields helps the organisation and this
helps these people also as they specialize in their
field. The decision making becomes department
specific and is decentralised. For example,
Decisions pertaining to production and sales
would be taken separately and the responsibility
of the same would rest with the concerned
specialist. This enables the firms to arrive at
scientifically tested and correct decisions in less
Markets and Price Determination : 27
time. The main organizer / promoter of the
business, due to this specialization could
concentrate on other business activities.
(b) Modern Entrepreneurial Skills and
Modernization : These has been a great
progress in the field of industry and commerce.
The entrepreneurial skills are imparted through
management institutes. Appointing a skilled
human resource through such management
institution is costly and can be possible only for
the large scale industries. The overhead
expenses in the form of modern tools and
equipments (e.g. Telephone, Telex, Computer,
Fax, etc.) is affordable only to large scale
producers. The decision making process turns
faster due to such advantages, money and time
is saved and the whole process leads to
reduction in total cost.
(3) Marketing
Economies pertaining to marketing are of
three types :
(a) Advertisement : Big industries can
spend on advertising. There may be no positive
corelation between expenditure on advertisement
and rise in production always. The advertisement
expenditure depends mainly on the firms
budgetary allocation for the same and the rival
firms expenditure on advertisement. Big
industries strike a balance in all these factors.
These industries may use newspapers and
magazines for their advertisements and can even
use, the television time for the same. The
average advertisement expenditure falls as the
production rises and the costs are reduced.
(b) After Sales Services : Sale of most
of the goods is followed by after sales services.
It involves supply of spare parts and even
maintenance services. e.g. the manufactures of
fast moving consumer goods, such as motor,
scooter, fridge, television sets etc., appoints
authorized dealers in the market to facilitate sale
of their goods. Customers due to such a network
get attracted towords such products.
(c) Product Innovations : The
continuous change in the nature of the products
has become essentials due to ever rising
competition in the market. The producers are
required to produce keeping in mind the
requirements of the buyers. The products need
to innovated and differentiated on the basis of
their colour, shape, packing, size, etc. The
research and development departments are
essentially built and required for the same. It is
not possible for small entrepreneurs. They can
neither have separate departments for research
and development nor can they bring constant
changes in the quality and nature of their
products. For large scale industries it is essential,
possible and affordable to have separate
research and development departments. The
entire expenditure incurred is spread over the
range of production.
(4) Economies pertaining to transport
and storage
The economies pertain to the production
of goods and its distribution. If we consider only
the transport cost, then in case of large scale
industries assuming that sources of transport are
self owned, the long run average transport cost
curve would be L shaped instead of being U
shaped. The transport cost goes on deeting until
the transport equipments are used to the optimal
and lates it remains, stable over a long range of
production. If the source of transport is not
owned and is through the Govt. then the
transport cost rises beyond a certain level of
production. But most of the large scale
production houses prefer to use their own modes
of transport. The purchase of such heavy
transport vehicles is possible for them due to
their voluminous production and sales.
The big industrial undertaking also need a
good back up of big godowns and storages to
ensure that the excess produce is properly
stored. The cost incurred in installing such big
godown and their capacity to store goods if are
compared, then the average cost incurred is less.
(5) Economies of Risk Bearing
All business whether small or big carry
risks. Lags in supply of raw materials, govt.
policy regarding taxation, the demand for goods
by consumer, the changing fashions, substitutes
produced by the rival firms, the changing exportimport policies of the Govt.; these and many
other causes may lead to fall in production or
fall in demand for production. These types of
risks can erupt in any business. Small industries
may not be able to plan against such risks due
to financial reasons. Big industries on the other
hand produce several products, e.g. company
Markets and Price Determination : 28
like TATA is in the production of lighter products
like soaps, watches and even in the production
of motor cars and heavy tools and equipments.
Since their productive activities are diversified
even if they incure loss on any one productive
activity, the same could be compensated by profit
in another. A range of products and
decentralized sales arrangement enables these
firms to reduce risks and firm due to this enjoy
stability. The long run average costs gets
stabilized or it falls.
The economies of scale mentioned, so far
indirectly helps in (assist in) reducing the costs
of production. The economic condition
favourable in reducing the cost of products would
be discussed now.
(B) Pecuniary Economies
The costs are directly reduces due to
favourable economic conditions. Economic
profits (s) emerge as a result of such economic
conditions. There’s direct reduction in costs.
These economies are experienced in case of
the following cases :
(1) Financial Economies
Big industries can easily raise capital by
way of sale of debenture and shares. They even
sale shares at a price higher than its face values
i.e. at a premium, raising capital or loan from
banks is also not difficult for such big business
houses. They even get loan at concessional rate.
(2) Purchase - Sales
The big industries avail of large discounts
in case of purchase of raw material, since their
purchases are in large scale. Their raw material
suppliers supply the same at a very concessional
rates of interest. They avail of such concession
even in case of water supply, supply of electricity
and transport facilities. These undertakings not
only get such raw material and inputs at
concessional rates but are also assured of a
good quality statndard inputs. In case of sales,
these industries set their sales offices throughout
the nation. They appoint experienced sales
persons. Tata, Birla, Reliance, Fertilizer
company, ACC, Brook Brond, Philips, Warna
and many such other companies are living
examples. All these economies pertaining to sales
and purchases are not available for the small
industries.
(3) Advertisement Economies
The advertisements of big industrial houses
are sold at very subsidised rates than advertising
agencies, newspapers and other sources of
media.
(4) Economies Pertaining to Employment
of Workers
The big industries need skilled workers and
trained officers. These industries do not face
the problem of recruiting such employees; this
is because everyone wishes to be with big
industries. The workers wish to work with big
industries even at lower wages due to the name
(goodwill) of the company, status in being
employed in such a company and stability of
employment. These advantages are not available
to the small firm.
External Economies
All industries established in already
industrially developed area or regions enjoy the
external economies. There economies includes:
(1) Economies of Centralization
If industries develop in a particular region
then the infrastructural facilities are automatically
made available there. The responsibility of
providing such infrastructural facility rests on
the state, central or the concerned local govt.
These areas attract the flow of labourers.
Development has a multiplying effect and
schools, colleges, rest houses and regulated risks
are established in such area. The facilities that
any firm requires are made available.
(2) Economies of Decentralization
Just as concentration of industries has
benefits similarly there are some common
benefits of decentralisation as well. Many a times
big industries leave the responsibility of supplying
small spare parts or even some processes on
small business concern operational in areas
nearby. This enables many small industries to
grow in their local area. If production is carried
out on a small scale then such benefits of
decentralisation are not possible.
Markets and Price Determination : 29
(3) Compilation of Information and its
Presentation
Due to localisation of industries information
regarding business is compiled. This business
related information is published (presented)
through newspapers and magazines keeping in
view the need of the big industries. The daily
prices of commodities, share prices, weather
forecast are made available through various
sources of media to big industries. In the
advanced nations such information is complied
and published by private entities but in a
developing nation like India this responsibility lies
with the Govt. agencies but he beneficieries are
all. All industries benefit from this.
In a nutshell, the internal and external
economies of sales can be availed by the large
business houses only upto a certain level of
production. As these economies are exhausted
the average cost of production goes on
increasing.
Questions for Self Study - 9
(A) Answer the following questions in short.
(1)
What do you mean by internal economies
of sale ?
(2)
What are external economies of scale?
(3)
The firms enjoy increasing returns to scale
and reduced average costs of production due to
the internal and external economies mentioned
so far.
What are economies pertaining to
specialization ?
(4)
What are managerial economies to scale?
(5)
What are economies of risk bearing ?
Diseconomies of Scale
(B) State whether the following
statements are true or false. Put ()
or () in brackets.
It is not true that large scale production
would necessarily offer economies of scale. The
economies of large scale can be availed upto a
certain level of production of our produces
beyond that point costs in fact start rising than
falling. If a firm grows beyond the controllable
limits losses are incurred. This may lead to
organizational, entrepreneurial and manageiral
problems. There may be tug of war between
the officers. This would result in unimpressive
managerial control. The coordination between
the production and sales department may be lost
and this may lead to a very lengthy decision
making process. Large increase in number of
workers may lead to forming of big trade unions,
which may in turn bargain with their own
interest. This may require the management to
incure expenses of permanent character.
The process of supply may be stressed.
This could be because of variety of resons like
inability to access the remote markets, strikes
called by the transportors, delaying such supply
etc. The every growing competition may require
the firm to incure heavy advertisement expenses.
These external economies also stop operating.
The concentration of industries in one area leads
to problem of pollution, garbage, inadequate
water supply, ill use of infrastructural facilities.
This pulls back the development of the exiting
industries.
(1)
The economies of scale are availed when
firms increase their level of production.( )
(2)
The internal economies of scale are
reaped by the firms on a regular basis. ( )
(3)
The scope for division of labour is high
when the production is on large scale. ( )
(4)
External economies of scale are enjoyed
by all the firms operating in a particular
industrial area. ( )
(5)
Beyond a particular level of output, the
economies of scale fall. ( )
7.2.7 Firms and Optimum Level
of Production
The output corresponding to the minimum
of the average cost curve in the long run is taken
as the optimal output of the firm. The U shaped
average cost curve would explain that either to
the left or to the right or the minimum of AC
curve, the costs are rising. Hence, in the long
run the firms would try to produce at the least
cost of production. This may not be witnessed
in practice, as the firms may not be producing
exactly at that level of output. The reasons why
the firms may not be able to operate at the lowest
level of costs are as follows :
Markets and Price Determination : 30
(1) Demand Constraints
How much to produce? This decision of
the firm completely rests on what is the demand
for products. If quantity demand is limited then
optimality in production can not be attained, on
the contrary if the demand is very large then it
may be required to produce output beyond the
optimal level. In both the cases firm may not be
able to produce at the lowest level of cost.
(2) Absense of Perfect Competition
It is assumed that firm operate in perfectly
competitive market to be able to produce at the
minimum of LAC. But infact, we either have
monopoly or monopolistic competition in practice.
In an imperfect market the firm may not produce
at the optimal level as it may charge a price
higher than the price in perfect competition
market to earn exortbitant profits.
(3) Government Control
Consumption of certain goods is regulated
(controlled) by the Government. Reducing the
level of production, in such cases, becomes
mandatory on the part of producer. The results
is but obvious that the firms would not be able
to attain the optimum level of production.
(3)
Optimum level of production depends on
demand for that product. ( )
(4)
In practice we come across either
monopoly or monopolistic competition.
( )
(5)
The optimum level of production changes
with changing conditions. ( )
7.2.8 Applicability of the Theory
of Production
We have so far studied the concept of
cost of production, the types of costs difference
in the types of costs, economies of large scale ,
cost curves, concept of optimum production. It
is essential to analyse the costs as the same are
important from the view point of firms. Let us
consider the importance of the applicability of
cost analysis. The importance of cost analysis
are as follows :
(1) Price and Output Determination
The tendencies of short run cost are useful
in determining equilibrium prices and output. In
the long run the cost analysis is useful from the
view point of future growth and the investment
decision in future.
(4) Changing Marketing Condition
The technology, market condition and
prices of factor inputs are prone to continuous
changes. If these conditions changes, then the
minimum of the AC curve i.e. cost conditions
would also change. Even if the costs are adjusted
with the changing condition and the minimum of
costs is attained, the conditions may still change
to disturb the cost structure.
Keeping the points mentioned above it
becomes difficult (hard) to believe if the firms
would really be able to attain the objective of
least costs.
Questions for Self Study - 10
State whether the following statements are
true or false. Put () or () in brackets.
(1)
The optimum output is one where the long
run average cost is the least. ( )
(2)
Every firm can attain optimum level of
output. ( )
(2) Profit Maximization
Firms have to fulfill the MC=MR condition
to maximize its profits. In the discussion of cost
of production, the concept MC holds a great
importance. The discussion on costs makes us
understand what MC is and thereby we are able
to know and understand the conditions for
attaining maximum profit.
(3) Nature of the Market
The number of firms in particular business
would remain constant in the long run if (a) the
product has a definite demand, (b) economies
of large scale can be attained. The market for
such product, shares oligopoly featuring in the
long run. The number of firms in the market
would be large, if the economies of scale are
not existing on a large scale.
(4) Optimum Level of Production
The lowest point of cost curve is called
the point. Corresponding to the optimal level of
Markets and Price Determination : 31
output. The MC cuts the AVC and AC at their
minimum. The cost curve enable us to
understood the point, where the optimum level
of production could be attained.
It is from the point of view of the above
mentioned reasons, cost analysis becomes
important.
(5) Dermination of Break Even
Questions for Self Study - 11
The level of production when break-even
can be attained that level of production should
be known to firm. The break-even is a point
where total profit is equal to TC. The concept
of costs (Total Cost) is useful while determing
the break-even.
State whether the following statements are
true or false. Put () or () in bracket.
(1) The analysis of cost of production is
important to a firm from the viewpoint of
determining its production policies. ( )
(2) Profit maximising condition for a firm is
MC = MR. ( )
(3) Many firms would enter the business
where optimum level of production would
attained at low level of output. ( )
(4) The firms tend to come together to attain
the optimum level of production in case of
those products where economies of scale
are important. ( )
(6) The Entry of Firm
Any productive activity may have new
firms entering. The entry of such firms would
depend on the level of costs. If the small scale
operations attain the optimum level of production,
the no of firm entering into business world be
large but if the optimal level of production
requires large scale operation then the number
of new entrants would be restructed to a few.
7.3 Words and their Meanings
(7) Direction of Growth
The direction of growth of any firm
depends on the shape of the cost curve. If the
long run cost curves are U shaped and if the
firms are operating at the minimum of the U
shaped cost curve having attained the economies
of scale, then production beyond this optinal
point is unthinkable. The firms would try to start
a new plant of its a fresh, if it expects the demand
to grow further; but if it does not expect any
further rise in the demand for product; then it
would involve itself in product diversification.
So cost curves and cost analysis would give
one an idea about direction of growth.
(8) Policies Pertaining to Control
The cost analysis turns important when
the government controls over business are
expected. If the government policies are
towards restricting the monopoly practices then
there would be growth in the number of firms
so as to breed competition. On the other hand if
the government feels that economies of scale
are essential in a particular business in such a
case government may go in for consolidation
and unification of large number of firms into a
single large unit. This consolidate may continue
until the optimal level of output at least cost is
attained.
Historical cost : Cost incurred in the past,
costs that do not affect future decisions.
Future cost : Costs that change due to changes
in future economics conditions and
government policies.
Fixed cost : Costs that do not change with the
level of output are fixed costs.
Variable cost : Costs that changes with the
changing level of output are variable costs.
Opportunity cost : If the cost of the next least
alternative sacrificed in the process of
production.
Explicit cost : The direct cost incurred on
production is explicit cost. eg. Expenditure
on raw material, wages, rent, interest etc.
Implicit cost : Expenditure that is not incurred
directly on raw material due to their
ownership is called implicit cost.
Direct cost : These costs which can be divided
over different stages of production e.g.
expenses on raw material, salaries, etc.
Indirect cost : These are costs that are incurred
indirectly and as such can not be divided
Markets and Price Determination : 32
over different units of output or over range
of production. e.g. expenses incurred on
electricity, water, provision for
depreciation, etc.
Cash cost : These are expenses that are
incurred by the firms in cash, e.g. expenses
on raw material, wages paid to workers,
rent of land and building, etc.
Incremental cost : Refer to the additional to
total cost due to implementation of a
managerial decisions. This could involve
changes product line, change in methods
of distribution, etc.
Sunk cost : These expenses are incurred in
the past, but are not affected due to new
or future decisions. These must be paid in
future as a part of previous decisions.
Marketing cost : The expenditure is incurred
during the phase of production to sale of a
commodity, e. g. storage transport, sales ,
gifts, etc.
AFC 
TFC
X
AVC 
TVC
X
AC 
Questions for Self Study - 2
(1)
(2)
(3)
TC
X
MC= Rise in total cost due to a unit change
in output.
Multiproduct firm : A firm that produces by
products, joint products or co-products in
the process of producing its main product
is called multi product firms.
Economies of scale : The benefits of large
size enabling the firm to reduce its cost of
production.
Optimum level : Level of output where the
AC is the least.
Future costs are those that are likely to be
incurred in future. These costs depends
on the managerial decisions in future, but
if the future is uncertain there could be
changes in the same. The future costs can
not be absolutely correctly figures. The
government’s decisions relating to money
and fiscal policy, import and export policy
can affect the future decisions of
managers. The expenses fixed in terms of
such future decisions are called future
costs.
The factors of production are available in
scarce number but they can be used
alternatively. While using factor, input in
production of particular product, its
alternative use will have to be sacrificed.
As the same factor input can not be used
simultaneously in several production
process.
While calculating the cost of production
an entrepreneur can take into consideration
the opportunity cost of a factor input. This
enables the firm to decide whether or not
to make investment.
Incremental costs refer to the addition to
the total cost due to implementation of a
new managerial decisions. This may
involve a change in or adding a machine,
changing the level of output etc.
Questions for Self Study - 3
(1) (), (2) (), (3) (), (4) ()
Questions for Self Study - 4
(A) (1) ( ), (2) ( ), (3) ( ), (4) ( ),
(5) (), (6) (), (7) (), (8) (), (9) ()
(B) (1) Fixed Costs - (No. 1, 2, 8)
(2) Variable Costs - (No. 3, 4, 5, 6 and 7)
7.4 Answers to Questions
for Self Study
Questions for Self Study - 1
(1)
(), (2) (), (3) (), (4) (), (5) (),
(6) ()
TFC= 1,00,000 + 2,00,000
+ 3,00,000
= 6,00,000.
TVC = 25,000 + 10,000+ 5,000
+ 1,00,000 + 15,000
= 1,55,000.
Markets and Price Determination : 33
Questions for Self Study - 5
various stages of production e.g. the use
of extra raw material and labour would
increase the direct cost. There are some
indirect costs which can not be classified
accurately and separated exactly in terms
of individual units of output produced.
These are calculated on arbitrary basis.
e.g. expenditure incurred on machines, land
etc. these expenses are common for a
range of output produced.
(A)
(1) The actual costs are the cost that are
incurred by the firm while producing a good
or service like raw material, labour, land,
etc.
(2)
(3)
Opportunity cost is the next best alternative
sacrificed by a firm in the process of
production. It is the value of any resource
in its next best use, e.g. a piece of farm
can either be used for agriculture purpose
or for construction of building. If we till
the farm we can not construct a building.
The concept of opportunity cost enables
a produces to arrive at the sacrifice
involved in using a factor input in a
particular production process. It is useful
in arriving at the economic profit of a firm.
In building a dam in a particular area one
must consider the expenses to be incurred
on rehabilitating the people displaced due
to construction of a dam and also the loss
of farming action.
(4)
Explicit cost are those that can be
expressed clearly and involve on actual out
lay of money. These are the actual
payments made to other parties.
(5)
Implicit cost - involve no actual cash
payment. These costs could be ignored
as they are not so obvious e.g. a firm owner
using his own piece of land for constructing
his factory building.
(6)
Capital goods, tools and equipments
depreciate is their value terms due to their
use. Their continuous use involves a wear
and tear. To compensate the wear and tear
a financial provision made is called
depreciation.
(7)
Normal profit is the amount of minimum
return that a firm must get to be in business.
(8)
For the accounting or business point of
view profit involves only explicit costs and
depreciation while economists include
explicit cost, implicit cost, depreciation and
normal profit. Economic profit is lower
than the accounting profit as the former
includes opportunity cost in it.
(i)
Direct costs are those which are incurred
directly on the production of a given
product. These costs are classified in
(B)
(1) (),
(5) (),
(2) (),
(6) (),
(3) ( ), (4) ( ),
(7) ()
(C)
(1) Economic, (2) Accounting, (3) Next
best alternatives sacrificed, (4) over
Rs. 5,000/(D)
(1) Explicit (2) Explicit (3) opportunity
(4) Explicit (5) Explicit
Questions for Self Study - 6
(A)
(1)
Private costs are the costs that are
incurred directly by the individuals or the
firms involved in a productive activity. The
wages paid to worker, purchases of raw
material etc. are private costs while social
costs are those which are borne by those
people also who are not linked directly with
the productive activity. They are passed
on to persons not involved in the activity
directly. e.g. the air and water pollution by
the factories, the people in the areas nearby
have to bear the cost of such pollution.
(2)
Cash costs are also known as the out of
pocket cost that are incurred in the process
of production, e.g. the expenses on wages
and salaries of the administrative staff. The
payment made to the factors of production
is generally treated as cash cost.
Book costs on the other hand involve no
cash payments and are mere entries in the
books of accounts.
(3)
Controllable costs are those which can be
controlled by the entrepreneurs and their
decisions. They are capable of being
controlled. The continuous supervision over
the directions of costs can keep such costs
under control. Prepare regular and
supervision can control these costs, hence
Markets and Price Determination : 34
are called controllable cost. The non
controllable cost are beyond the
administrative supervision and control
speciation and a particular commodity or
asset is bound whether used or not and
hence becomes an unavoidable and
controllable cost.
(4)
Incremental cost are those that add to the
total cost of production. This may be
caused due to implementation of a new
managerial decision, involving a change in
product lines, change in methods of
distribution etc.
(3)
Variable cost is that cost that goes on
varying as more and more variable factors
are used in process of production. It is a
function of output and varies with the level
of output.
(4)
Variable costs decrease upto a certain level
of output as the firm enjoys over that range
the economies of large scale. This is in
terms of cheap raw material, capital at low
rate of interest, etc. This reduces the
variable cost.
(5)
The theory of costs is derived using the
theory of production. There is a short run
law of production and a long run law of
production. In the short run there are some
factors variables and some fixed. The
costs incurred on fixed factors is called
the fixed costs while the variable cost is
incurred on variable factors of production.
All these factors of production turns
variable in the long run. Supply of all such
factors of production can be increased in
the long run and hence are variable. So
there are no fixed costs in the long run.
Since there are no fixed factors in the long
run, there are no fixed costs also.
Sunk cost on the other hand are expenses
incurred in the past, but are not affected
due to new or future decisions. These are
the costs that can not be recovered and
must be paid as a part of the decisions
taken in the past.
(5)
(B)
(1)
(2)
(3)
(4)
(5)
In the marketing costs following costs are
included : (1) Storage expenses, (2)
Packing and Transport expenses, (3)
Insurance (4) Sales Systems (5) Discounts,
etc.
Government,
Book costs
Non controllable
incremental
the point of goods produced till it is sold.
(C)
The classification of fixed and variable
costs can be hence seen only in the short
and not in the long run.
(B)
(1) ( ), (2) ( ), (3) ( ), (4) ( ),
(5) (), (6) (), (7) (), (8) (), (9) ()
(1) ( ), (2) ( ), (3) ( ), (4) ( ),
(5) (), (6) (), (7) ().
(C)
(1) ‘U’ Shaped, (2) Units of output
(3) Variable, (4) Variable
Questions for Self Study - 7
(A)
(1)
(2)
(D)
Fixed costs are those which remain fixed
over any range of output. They are fixed
in nature, irrespective of the level of output
produced. These costs include the salaries
of the administrative staff, depreciation,
purchases of land and building etc.
Average means per unit. Average fixed
cost means the per unit fixed cost incurred
by a firm. Since in the process of
production output goes on increasing while
total fixed cost remaining the same, the
per unit fixed cost gets shared over that
range of output and hence AFC falls.
Output
1
2
3
4
5
TC
MC
85
110
130
160
210
25
20
30
50
Questions for Self Study - 8
(A)
(1) (), (2) (), (3) (), (4) (), (5) (),
(6) (), (7) ().
Markets and Price Determination : 35
Questions for Self Study - 9
(1)
Economies of scale, in simple terms,
correspond the reduction in long run
average costs. The reduction in the long
run average costs is attributed to increase
in the scale of operations i.e. the size of
the plant. These economies of scale are
also called the internal economies of scale.
(2)
The growth of industry in particular locality
leads to improvement in transport,
communication and other infrastructure
facilities in that area. These are some of
the common benefits reaped by various
industries in that area. These are called
the external economies.
(3)
The economies of specialization pertain to
use of specialized techniques of production,
employment of special and skilled workers
for a specific job / work. Specialization
involves division of labour. Due to
specialization accountability about ones
own work increases.
(4)
Managerial economies pertain to various
aspects of managerial decision making,
such production, raising of capital, market
research, recruiting experts in the process
of production, use of modern technique of
production, etc.
(5)
All business whether small or big bear
risks. These risks erupt in the form of
changes in Govt. policy relating to taxes
and import and export, demand for
production, competition, etc. Small
industries may not be able to withstand
such fluctuation and risks but big firms
producing a large variety of products can
bear these risks. They can offset their loss
incurred on one product by the profit gained
on the other.
(B)
(1) (), (2) (), (3) (), (4) (), (5) ().
Questions for Self Study - 10
(1) (), (2) (), (3) (), (4) (), (5) ().
Questions for Self Study - 11
(1) (), (2) (), (3) (), (4) ().
7.5 Summary
Production involves the conversion of raw
material into a final product through a process
of manufacture. The productive process involves
use of several factor inputs. Such as land, labour,
capital and entrepreneur. To retain a particular
factor input in a particular process that factor
must be paid an amount which the factor would
get in some different process of production. The
expenses incurred on the production of goods is
its cost. The cost incurred in production process
would involve both the implicit and explicit costs.
The study of costs becomes of great importance
from view point of managerial decision making.
There are a wide variety of costs. They include,
direct and indirect, explicit and implicit, sunk and
incremental, short run and long run, fixed and
variable, etc. The fixed costs are the ones those
do not change with the level of output. The
variable costs on the other hand keep varying
with the level of output used. The sum total of
fixed and variable costs is the total cost. We
can find the classification of fixed and variable
costs only in the short and not in the long run as
variable costs alone exist in the long run. The
total costs takes the total fixed and the total
variable cost into consideration. The average
fixed cost can be calculated by dividing the total
fixed cost by the correcting level of output. So
TFC divided by output would given an average
fixed costs. The same way AVC is calculated.
The division of TVC by the corresponding level
of output gives AVC. So we can have the total
cost classified in to total fixed and variable cost.
Similarly the sum total of the average variable
and average fixed cost would give the average
cost. Average cost is the per unit cost. We hence
derive TC, TVC, TFC, AC, AVC and AFC. The
addition to total cost is called the marginal cost.
It is calculated by dividing the change in total
cost by the corresponding change in the level of
output. The AVC, AC and the MC are the ‘U’
shaped curves indicating the laws of production.
The long run shape of these cost curves
is also U shaped but it is flatter than the short
run.
As the firms expand they start getting the
economies of scale of large scale production.
The economies of scale are reaped in the form
of reduced long run costs. The economies of
Markets and Price Determination : 36
scale are both confined to business and are
external to the business also. The growth of
business of one firm helps other firms also. On
this basis, we call it internal and external
economies of scale. The internal economies of
scale help the firms to reduce their long run costs.
While the external economies of scale help the
other firm to gain the benefits of improved
facilities of infrastructure, transport and
communication. The external economies of
scale are in the form of improved banking
facilities, decentralization of production process,
transport facilities, supply of water and electricity
etc.
The optimum level of production is
represented by the minimum of average cost
curve. When the average cost of the firm is
minimum, we say that the level of production is
maximum. Attaining this optimum level of
production is essential from the point of view of
decision making by firms, as they optimum level
of production, corresponds to the least average
cost and it is rising when this optimum output is
not attained. It may not be essential that a firm
would necessarily attain optimum level of output.
The use of cost analysis is essential for a
business firm as it helps firms to decide output
price, level of profit and attain maximum profit,
determine the break-even, etc.
(8)
Differentiate between explicit and implicit
cost.
(9)
Write in five sentences about the
opportunity cost.
(10) What is the importance of opportunity
cost?
(11) Write a note of 20 lines on marketing
costs.
(12) What is the importance of marketing cost?
Can they be avoided ?
(13) What is the use of opportunity, incremental
and marginal in decision making ?
(14) Differentiate between economic and
accounting profits ?
(15) What is the shape of the planning curve ?
Show it with the help of a diagram.
(16) Explain the point of view of the modern
economists, who argued that the long run
average cost curves are ‘L’ shaped and
not ‘U’ shaped.
(17) What are the economies of large scale ?
Explain using examples.
(18) What are the benefits arising out of internal
economies of scale? Explain using
examples.
(19) What are features of optimum production?
Explain using diagram. What obstacles
does a firm face in attaining optimum level
of production ?
7.6 Exercises
(1)
Using an example, differentiate between
fixed and variable cost.
(2)
Explain that, all costs are variable in the
long run.
(3)
Draw TFC and TVC curves and explain
their features.
(4)
Explain the relationship between the MC
and TVC.
(5)
Explain AFC, AVC, AC and MC.
(6)
Using cost schedule and curves explain
AFC, AVC, AC and MC.
(7)
Draw long run AC curve and MC curve.
How are they different from the short run
AC and MC curves ?
(20) What is the importance of the cost analysis
in the context of production and supply ?
7.7 Field Work
(1)
Collect information about the fixed and
variable cost of the diary, laundry, tailoring
firm or restaurant in your area.
(2)
Understand from the seller nearby his cost
of marketing soap, toothpest, ready made
garments, tea and food products.
(3)
Understand in practice the actual concept
of accounting and economic profit from
an auditor familiar to you.
Markets and Price Determination : 37
(4)
From a nearby medical shop find out the
marketing expenses incurred on sale of any
four medicines. Also try to explain the
proportion price that seller spends on
marketing.
(5)
Meet on entrepreneur in your area and
find from him if his firm is producing on
optimal level of output. Also get from him
his opinion about optimum level of output.
(6)
Visit a factory and find the reserve
capacity of that firm.
7.8 Books for Further
Reading
(1)
S. M. Desai and S. S. Joshi, Economic
Analysis (Part-II), Pune, Nirali Publishers,
Second Edition, 1985, Chapter 8, Appendix
1 and 2, Chapter 10, pages 229 to 249.
(2)
(3)
(4)
(5)
(6)
(7)
(8)
Varma J. C., Managerial Economics,
New Delhi, Deep and Deep Publications,
1988, Chapter 4.
Samuelson Paul, Economics, McGrawHill, 1976, Tenth Edn., Chapter 24, PP. 46582.
H. Craig Peterson and W. Cris Lewis,
Managerial Economics, Mac Millan
Publishing Co., 1986, Chapter 8, PP. 26087. and Chapter PP 292-217.
Anderson, Pultallaz, Sheepherd,
Econnomics, Prentice Hall, Inc.
Englewood Cliffs, 1986, Chapter 8, PP.
147-76
Larry C. Peppers, Dale G. Bails,
Managerial Economics, Prentice-Hall,
International Edition, 1987, Chapter 9.
Spencer, Milton H., Contemporary
Economics, Worth Publisher, Inc., 1983,
Fifth Edition, Chapter 20, PP.432-52.
Koutsoyiannis A., Modern Micro
Economics, ELBS, Second Edn., 1979,
Chapter 4, PP. 105-22.
Markets and Price Determination : 38
Unit 8 : Production Function
Index
8.1 Introduction
8.0
Objectives
8.1
Introduction
8.2
Subject Description
8.2.1 Production Function : Concept
8.2.2 Production Function : Types
8.2.3 Short Run and Long Run
Production Function
8.2.4 Production Function with One
Variable Factor
8.2.5 Law of Variable Proportions
8.2.6 Production Function with Two
Variable Inputs
8.2.7 Least Cost Combination of Input
8.2.8 Production Function with All
Variable Factors
8.3
Words and their Meanings
8.4
Answers to Questions for Self Study
8.5
Summary
8.6
Exercises
8.7
Books for Further Reading
8.0 Objectives
After studying this unit, you will be able to
understand and explain the following :

Concept of production function.

Types of production function.

Short run and long run production function

Law of variable proportion.

Production function in terms of two
variable factors inputs.

Meaning of Iso-quant.

The importance of least cost combination
of inputs.

Production function in terms of all variable
factors.
Some basic factors of production are
essential for producing goods. The rise in demand
for goods also increases the demand for factors
of production. The firms aim at maximum
production with least possible cost so as to
maximise their profit. The input output
relationship in the process of production is called
Production function. On the basis of production
function, what quantity of input is essential to
get a desired level of output can be determined.
The rise in total (product) output can be found
out form for the rise in marginal product.
Increasing returns, constant returns, and
decreasing returns these 3 tendencies are
associated with production function. It can be
explained on the basis of law of variable
proportions. What level of output to produce or
what should be the expenditure incurred on the
inputs in the short run to minimize the costs of
production, is the decision the firm has to take
and there by maximising their profit levels. In
the long run all the factors of production become
variable. Due to the variability of factors of
production in the long run productivity also
increases. The long run law relating to production
is called the law of returns to scale. We
experience increasing constant and decreasing
returns to scale in long run. There are specific
reasons behind this.
In this unit we shall study in detail the
concept of production function, its types law of
variable proportions to scale, reasons behind
increasing constant and decreasing returns, Isoquants and production function with two or all
variable factors.
Markets and Price Determination : 39
8.2 Subject Description
8.2.1 Production Function :
Concept
Production of goods and services require
some basic factors of production. They are called
factor inputs. The basic factors of production
are 4. They are labour, capital, entrepreneur and
land. Production of any good, initially is on small
scale. Level of production rises as the demand
for that product rises. The rise in level of
production causes rise in demand for factors of
production also. The supply of factors inputs is
also required to increase due to the rise in
demand. As the demand for factor input
increases it is not essential that its supply would
also increase to that extent. Some factors of
production available in abundance while some
are scarce. The production is increased
depending on its importance and availability of
factor inputs.
Objective of any firm is to maximize its
profit. For attaining this objective the firms try
to minimise their cost of production. The firms
have to increase production keeping in view the
rising demand for goods. To increase production
the factors inputs are either increased
proportionately or in more or less proportion.
The increases, decreases in factors inputs could
depent on the level of techniques prevalent in
the business. The law slating the relationship
between the impact of rising proportion of factor
inputs on the level of output is called the law of
returns to scale. It basically spells out input
output relationship. Production function and laws
relating to production basically talk about the
input output relationship. Let us 1st understand
what is input output relationship.
Let us understand the concept of
production function using an example. For
example, A farmer has 2 hectors of farm. He
has to produce wheat in that. He would require
seeds, fertilizers, pesticides, labour, water and
the efforts of even bullocks in ploughing the farm.
This is in addition to the basic factors of
production land (farm). Wheat could be produced
only when all these there factors of production
are put together. All the factors mentioned so
far are called the inputs and product of wheat
means the outputs. One can represent the input
output relationship in the following manner.
Output
Input (units)
20
2
20
2
20
10
Rain
Qtls. = hect. + Kg. + Worker + Lorries + ltrs.of + fall
of
farm
Seeds
of
PestiWheat
Fertilizer cides
From the diagram mentioned above, one
can understand that a combination of various
inputs produces 20 kgs of wheat. This is input
output relation. In economics it is called
production function.
The input-output relation in the process of
production is called the Production
Function.
The production function tells us how many
units of input are required to produce a certain
level of output. One must understand that
relationship between factor inputs for a certain
level of output may not be a permanent and a
certain one. Let us take an example of tea. To
prepare a cup of tea water, milk, tea powder
and sugar these four factors are brought
together. These four factors are input and a cup
of tea is output. Have we fixed the proportion
of these four factors in preparing tea? The
proportions are unknown. But while making a
cup of tea various individuals may use various
proportions of these factors inputs as per their
choices. The production function of tea changes
from person to person. Just as production
function is not same for various cups of tea,
similarly it is different for different products.
Hence, we can conclude that production
functions are not permanent in nature for any
particular product. Let us discuss the example
of farmer once again. To produce 20 quintals of
wheat he would bring the factors input, as shown
in the diagram, together. This production of 20
quintals of wheat can be taken in a different
manner as well. Suppose he has 1.5 hectare of
farm in place of 2 hectares. To compensate the
production cost on the ½ hector of land he may
increase the amount of seeds used, the chemicals
Markets and Price Determination : 40
fertilizers used and may use some other fertilizers
improving the productivity. He may maintain the
level of output at 20 quintals by changing the
production function. So every producer (in our
case farmer) besides the production function
keeping in view the availability of resources.
No business process has a permanent
production function but there are
alternatives available. Any business firm
picks up economically the most efficient
production function.
Mathematically
Output
Y
= f
Input
(X1 + X2 + X3 + ……. + Xn)
8.2.2 Production Function :
Types
The input output relationship in the process
of production is called production function.
Production function is not permanent in nature.
A given level of output could be produced using
various production function. There could be more
than one technically efficient methods of
production. But there would exists only one
methods of production which would be efficient
both technically and economically. The firms
attempt to select such a method of production.
The output increases if the amount of any
one of the factors of production is increased.
The marginal productivity of a factor input
explains the level of increase in total productivity.
There are 3 tendencies reflected in the rise of
marginal productivity.
They are : (1) Increasing returns,
(2) Constant returns,
It means Y is a function of X1 to Xn, where
every X represent an input level. F denotes a
functional relationship between Y and X.
Let us in the next section understand the
types of production function.
(3) Decreasing returns
Let us discuss them in details.
(1) Increasing Returns
Table 8.1 : Increasing Returns
Fixed
Variable
factor
factor
(land)
(labour)
(Quintal)
(Quintal)
2
1
4
4
2
2
10
6
(B) State whether the following
statements are true or false. Put ()
or () in bracket.
2
3
18
8
(1)
Initially, any commodity is produced on a
small scale. ( )
2
4
18
10
(2)
Supply of all the factors of production to
the produces is as per their demand for
the same. ( )
(3)
Every firm tries to produce maximum
output at the least cost. ( )
(4)
In any production process, we get the
same level of output. ( )
Questions for Self Study - 1
(A) Answers the following questions in
short.
(1)
What are the basic factors of production?
(2)
What do you mean by returns to scale ?
(3)
What is production function ?
Total
More
Production Product
The example states that the total availability
of land is fixed that is 2 hectares. To produce
more the supply of labour is alone increasing
with every rise in labour input the total
productivity is increasing. The rate of increase
in total productivity can be understood from the
level of marginal productivity with every unit
rise in labour input, marginal productivity is
increasing by 4, 6, 8 and 10 quintals.
Markets and Price Determination : 41
This means the rate of rise in marginal
productivity is rapid and it is increasing at an
increasing rate. Initially, when one unit of labour
was applied the productivity was 4 while it
increased to 10, when 2 nd worker was
employed.
This means the productivity of 1st worker
was 4 quintals, while that of the 2nd worker was
6 quintals (10-4=6). As more and more workers
are employed the additional productivity from
an additional worker is increasing. These are
called increasing returns to scale.
If the output increases at an increasing rate
due to increase in the variable factor inputs,
the returns are said to be increasing.
Table 8.2 : Constant Returns
Fixed
Variable
factor
(land)
Total
Marginal
factor Production Productivity
(labour) (Quintal)
2
2
2
2
1
2
3
4
(Quintal)
4
8
12
16
4
4
4
4
From Table 8.2, it can be seen that an unit
change in labour, increases total productivity by
only 4 quintals over the entire ranges of
production. This means the rise in production is
at a steady rate. Since the output is increasing
at a constant rate, these changes in production
are called the constant returns.
Y
Y
24
20
P
16
+4
12
+4
8
+4
28
4
P
Total Production
28
Total Production
If you see the diagram 8.1 the triangles
created using points on the curve corresponding
to a particular level of output show that every
successive triangle is bigger in size.
24
X
A
20
1
2
+10
4
No. of Workers
16
Fig. 8.2 : Constant Returns
+8
12
8
3
The diagram shows that every triangle
created the production curve shows a constant
size.
+6
4
A
X
1
2
3
4
No. of Workers
Fig. 8.1 : Increasing Returns
(3) Decreasing Returns
If the rise in variable factor leads to
increase in production at a decreasing rate, it is
termed as decreasing returns to scale.
Table 8.3 : Decreasing Returns
(2) Constant Returns
The rise in factor inputs, when increase
the total productivity in constant proportion,
the returns are said to be increasing at a constant
rate. We can see the same using a table
below :
Fixed
factor
(land)
Variable
Total
Marginal
factor Production Productivity
(labour) (Quintal) (Quintal)
2
1
4
4
2
2
7
3
2
3
9
2
2
4
10
1
Markets and Price Determination : 42
Table 8.3 shows that the total productivity
has moved from 4 to 7 and 7 to 9 on employing
the 1st , 2nd and the 3rd worker respectively.
This in simple terms means that the productivity
of 1st worker is 4 units, 2nd worker 3 units (i.e.
7-4) and that of the 3rd worker 2 units (i.e. 9-7).
The productivity of the 4th worker is only one
unit all these worker are contributing positively
to the total productivity but their individual
productivity is falling. This means as more of
the variable factors are employed the
productivity of variables factor is increasing at
a decreasing rate. Hence, these tendencies in
production are recorded as decreasing returns
to scale.
Y
Total Production
28
24
20
P
16
+1
+2
12
8
X
1
2
3
4
No. of Workers
Fig. 8.3 : Decreasing Returns
This is shown in Fig. 8.3. The size of every
successive triangle, created by jotting the points
corresponding to levels of output, on the curve
is becoming smaller and smaller.
Questions for Self Study - 2
(A) Answers the following questions in
short.
(1) What do you mean by increasing returns?
(2) What do you mean by constant returns?
(3) What do you mean by decreasing returns?
(B) State whether the following
statements are true or false. Put ()
or () in bracket.
(1)
(2)
(4)
Rise in marginal productivity can tell us
about the rise in total productivity ( )
8.2.3 Short Run and Long Run
Production Function
In the process of production 3 tendencies
of production are identified. They are increasing,
decreasing and constant productin function.
These are identified in various stages of
production. A firm experiences increasing
returns in the initial stages of production, as
production expands further, the firms experience
constant returns and beyond that they
experience decreasing returns. It is in this
sequence the production function tendencies can
be noted.
Both these tendencies can be seen in short
and long run. Economist have extended laws
related to production. The law relating to short
run production function is called the law of
proportions, whereas the long run law of
production is called the law of returns to scale.
+3
4
A
(3) Firm experiences only increasing
returns. ( )
Production function is not permanent or
certain. ( )
A firm has to choose from amongst various
production functions, the most profitable
and economic production function. ( )
8.2.4 Production Function with
One Variable Factor
The traditional view in economics terms
all those resources used in the process of
production as factor of production. The modern
view treats the factors of production as inputs.
This means the services of the factors of
production used in the process of production are
inputs. Production is carried out with the use of
inputs available and the existing technology
together. In the short run technology remains
constant. In the long run it can change. In the
short run some factors are variable while others
are constant.
The law of variable proportion studies the
input-output relationship keeping one factor of
production variable and other fixed. What
happens to production function, when one factor
input is variable and others constant. Let us see
the law of variable proportions.
It can be studied for 2 variable factors
also. We shall study both these methods
separately. In the long run all the factors of
production become variable and the entire scale
of production can change. This enables us to
Markets and Price Determination : 43
Production Function
Short Run
Long Run
Law of Variable Proportions
Law of Returns to Scale
How to produce optimum output ?
With One Variable Input
With Two Variable Inputs
(What stage of production to
produce in ?)
How to produce optimum output?
(How to choose the best
combination of factor inputs?)
Three stages of
production
• Increasing
• Decreasing
• Negative
All factors variable
• Increasing Returns
• Decreasing Returns
• Constant Returns
see various returns to scale. The long run law
of production is called returns to scale.
Questions for Self Study - 3
(A) State whether the following
statements are true or false. Put ()
or () in bracket.
(1)
In the process of production all the 3
tendencies of production function can be
taken. ( )
(2)
According to the modern approach, the
services used in the process of production
are called factor inputs. ( )
(3)
Technology changes in the short run. ( )
(4)
In the long run we experience all types of
returns to scale as the proportion of all the
factor inputs changes. ( )
(5)
To express the long run tendencies in
production, law of returns to scale is used.
( )
8.2.5 Law of Variable Proportions
Meaning : We shall study the three levels
of productions, using the law of variable
proportions. The traditional theory of production
believes that all the factors of production can
be variable in the short run. Some factors of
production can increase while other remain
stable. Production can increase using more of a
variable factor say, labour, other factors such
as land, techniques of production remaining
stable. Due to the changes in the combination
of factor inputs, production passes through
various phases. This changing input-output
relationship, keeping one factor variable and
others constant is noted in the law of variable
proportions.
“As the proportion of one factor in a
combination of factors is increased, after
a point, first the marginal and then the
average production of that factor will
diminsh”.
- F. Benham
Markets and Price Determination : 44
Mathematically, it is
(1)
Total Production : Total production has
been rising until the seventh labour input.
The TP becomes stable with the 8th labour
input while it falls beyond that.
(2)
AP : AP has been rising until the fifth
workers but it starts falling from thereafter.
(3)
MP : The MP is rising until the 4th labour
input and starts falling beyond that. It is
zero when 8th labour input is employed and
from the ninth unit on it becomes negative.
Y = f ( X1 + ( X2 + X3 + X4 +…. + Xn) )
Rise in
output
Increasing
amount of
factor input
Constant
amount of
factor input
The process of rise in production is not a
constant one. Three different situations can be
witnessed while the production rises. The
reasons for occurances of such situations will
be studied by us.
It has been shown in figure 8.4.
Y
PP1 Total Productivity Curve
PP2 AP Curve
PP3 MP Curve
Assumptions of the Law
Table 8.4 : TP/AP/MP from the Farm
Fixed Variable TP
AP
MP
Input Inputs (Qtls) (Qtls) (Qtls)
Land (Labour)
Stages
of
Prod.
1st Stage
Increasing
Returns
2
2
2
2
2
1
2
3
4
5
5
15
30
52
65
5
7.5
10
13
13
05
10
15
22
13
2
2
2
6
7
8
75
80
80
12.5
11.4
10
10 2nd Stage
05 Decreasing
00
Returns
2
2
9
10
75
65
8.3
6.5
-5 3rd Stage
-10 -ve Returns
II nd
Stage
AP, MP, TP
(1) Short Run Law
(2) The efficiency (productivity) of each
variable factor input is the same.
(3) The technology is assumed to remain stable.
(4) The amount of one factor input is increased,
while all other factors are held constant.
(5) Production is counted in terms of the units
of output.
Suppose, a farmer wants to produces food
grains. He uses land and labour in the process
of production. Land is assumed to remain fixed
at 2 hectare. The farmer increase the labour
force to increase production. Let us see the
nature of rise in production, when quantity of
labour input alone is increased. Table 8.4 shows
the same. The table shows that the quantity of
land remaining the same as the supply of labour
inputs is increased the quantity of food grains
produced increases up to a certain level and later
it goes on decreasing. The changes in TP, AP
and MP are listed in the table. The same could
be used to explain their interrelationship and
changes their in.
Ist
Stage
P1
P2
A P
-5
-10
-20
III rd
Stage
X
1 2 3 4 5 6 7 8 9 10
P3
No. of Workers
Fig. 8.4 : Law of variable Proportions
Three stages of production function Let us see table and figure 8.4 to get to
know about stages of production.
(a) First Stage - Increasing Returns
The findings in this stage are :
(1)
TP is rising
(2)
AP goes on increasing and reaches its
peak.
(3)
MP initially increases, reaches its peak and
then starts falling.
In the initial stages of production since
the MP is rising over a large range of production,
increasing returns are experienced. Towards the
end of this stage of production the MP starts
falling. The first phase is between the 1 and 5th
worker.
(b) 2nd Stage - Decreasing Returns
The findings are :
(1) TP is rising
Markets and Price Determination : 45
(2)
(3)
AP is falling
MP is falling but its positive.
The second stage ends with the 8th labour
input. The MP of the variable factor is zero.
The 2nd stage is between the 6th and 8th worker.
In this stage MP is falling. Hence it is a phase
of decreasing returns.
(c) 3rd Stage - Negative Returns
The findings are :
(1) TP starts falling
(2) AP is falling
(3) MP is falling and is negative.
The stage starts with the 9th labour input.
In this stage MP is negative. Hence, this stage
in termed as one with negative returns. Due to
this TP continues to fall.
The reasons behind increasing, decreasing
and negative returns. Let us discuss causes
behind these tendencies of production function.
(1) Reasons behind Increasing Returns
The returns are increasing in the initial
stages of production. The reasons are as follows:
(a) Complete and Intensive use of the
Fixed Factor Input : In the initial stage of
production the availability (supply) of fixed factor
is greater than the availability of variable factor
input. Over a range of production the productive
capacity of the fixed factor is used and as a unit
of variable factor input is increased the total
productivity shows a rising trend. As more and
more variable factor input is used the fixed factor
is intensively used. This enables productivity to
increase. In our example the total productivity
seems to be increasing at an increasing rate until
the fourth labour input was employed. The MPL
at that unit of labour is the maximum.
(b) Indivisibility : Some factors of
production are technically indivisible. A certain
proportion of factor inputs must be used, e.g. a
farmer buys a tractor, to use the capacity of the
tractor, he must possess that amount of farm
also. But if farmer has only 10 hectares of land
then the optimal capacity (indivisible capacity)
of the tractor can not be used until at least 50
hectare of land is tilled. Hence, the total capacity
of the tractor would be put to use continually, so
long as the variable factors are employed. So
until its productive capacity is put to optimal use
the total productivity would use at an increasing
rate.
(c) Internal Economies : As the
business expands the economies of large scale
are experienced. They are called internal
economies. Division of labour, specialization and
technical specialization and other such benefits
are reaped by firms. The productivity of not only
the fixed but variable factors also increase. This
results in increasing returns resulting further in
reduced average costs.
(2) Decreasing Returns : Reasons
The second phase of production reveals
decreasing returns. The reasons of decreasing
returns are :
(a) Imbalance : The balance between the
fixed and the variable factor inputs struck during
the 1st phase of production tends to collapse as
production increases. In our example the quantity
of land is fixed and that of labour is increasing.
Beyond 4th labour input if the labour force is
increased, then the proportion of farm input to
labour input imbalances. The labour input
becomes more than that required by land for
the purpose of farming. This has as adverse
impact on productivity and the rate of production
falls slowly. The number of workers working
on the farm since are more than required, hence
decreasing returns are expensed.
(b) Diseconomies or Losses : With the
growing size of the firms they enjoy the internal
economies of scale but this could result in
diseconomies of scale if the level of production
goes beyond a particular level e.g. the
management is overburden, the machines are
used beyond capacity, wastage of raw material
is seen. In a nutshell the rise in production is
accompained by rising average costs.
(c) Imperfect Substitutability : Ms. Joan
Robinson has expressed a different opinion in
this regard. According to her as the production
increases the substitutability between factor of
production is reduced. For e.g. the combination
of land and labour for a certain level of
production (up to a certain level of production)
can be altered to any combination of labour and
land. This means a little more of land and little
less of labour or vice-versa is possible only up
to certain level of production. But this
substitutability has a limit, e.g. 2 hectares of land
Markets and Price Determination : 46
can produce 80 quintals of rice with 7 workers.
In under developed nations the availability of
land is less and there is abundance of labour. In
such a case even if the proportion of labour to
land is increased the productivity would
increases only up to a certain level and that is
up to productivity of fixed factor called land.
This proportion means that there is an implicit
productivity of fixed factors. That productivity
is attained as we employ more and more variable
factor. If a piece of farm can produce only 80
quintals, increasing the labour force on the farm
would not increase productivity beyond 80
quintals. So 80 quintals is the productive capacity
of the farm. It is its implicit productive capacity
which can not be increased by increasing the
labour force. This is imperfect substitutability
of factors of production. The imperfections lead
reduction in M.P. of fixed or variable Factor of
Production.
(d) Negative Returns : In the 3rd stage
of production negative returns to scale are
registered. Table and diagram 8.4 show that there
are negative returns beyond 8 labour input. The
major reason behind this is that land as an input
remains fixed and only labour input increases.
The excessive rise in labour inputs leaves an
adverse impact on the productivity of land
leading to fall in even total productivity. The
marginal productivity is in fact negative. We
know that if a fixed factor is put to use beyond
its capacity with a want of increase in production
its productivity in fact falls. For example,
excessive use of fertilizers on a given piece of
farm leads to fall in farm production.
Which stage of production to operate in?
The analysis above requires every one to
find a level of production (stage of production)
a producer should operate in :
In the 1st Stage of production i.e. up to 5
workers, the total and the average production
is increasing continuously. The MP is also
increasing over a that range. But the feature of
this stage is that input of land is fixed while that
of labour is variable. This would enable a
producer to increase the labour inputs and
increase the production further. This gives us a
hint that the productivity of the fixed factors
(land) is unexplored. The same can be explored
further by employing more workers. This would
ensure optimal use of the fixed factor. Hence
production can not be stopped in the 1st stage.
On the other hand the 3rd stage of produce
i.e. beyond 9th unit of labour marginal productivity
turns negative. The reduction in variable factor
input would infact lead to positive marginal
productivity. This means reduction in variable
factors beyond a point would lead to rise in
productivity as a firm would be moving from
negative M.P. to positive M.P. e.g. if labour input
is reduced from 10 to 9 total productivity moves
up from 65 to 75. If it is further reduced to 8 the
total productivity rises to 80 quintals.
The observation show that any rational
producer would produce only in the 2nd stage of
production whete T.P is rising though at a
decreasing rate.This means in this stage of
production M.P is falling but is still positive. In
our example a producer would want to produce
with a minimum of 5 workers upto a maximum
of 8 workers. Between 5 and 8 workers how
many would he employ depends on market
demand for his product. The market price of
factor of production and the market price of
product. The increasing T.P passes through
increasing or decreasing returns.
Turgo, Marshall and Ricardo have given
a detailed explanation of diminishing returns.
According to Marshall when there is natural
tendency of 1 factor being fixed, there is a strong
possibility of decreasing returns. Decreasing
returns are experienced in fishery, agriculture,
mining, forestry etc. The production associated
with these activities depends on their natural
availability. In fact the increased production
would lead to their scarcity. In these fields
division of labour is not possible, as it is in case
of industrial sector. There is no great scope of
mechanisation as well. There is no control over
production. Hence these fileds of production
experiences decreasing returns.
Marshall has opined that the decreasing
returns are associated with any field of
production if the availability of a fixed factor
reduces continuous in the process of production.
According to Marshall, generally, the industrial
activity experience increasing returns as the
proportion of both labour and machines can be
increased in the long run. Both small and big
machines, slow and advanced techniques of
production can be used in industries. Industries
can even adopt the principle of division of labour
effectively. All the benefits of specialization can
Markets and Price Determination : 47
be reaped. Some of the techniques of production
could be fully automated. The industrial sector
enjoys the advantage of effective control over
production process compared to agriculture
sector.
The modern economist however have
opined that the decreasing returns is a
phenomenon associated with both agriculture
and industry. The modern equipments and
techniques can prolong the tendency of
decreasing returns in agricultural sector. The
increasing and dereasing returns are
experienced in different stages of production.
In all the productive activities increasing returns
are experienced and are latter followed by
decreasing returns forever. In agriculture the
increasing returns are seen for some initial period
and are followed by prolonged decreasing
returns whereas in the industrial sector
increasing returns are experiened for a long
term and while production reaches a large scale
beyond that point decreasing returns are
witneed. Diagram 8.5. makes it clear.
Y
KR is the MP curve for industrial sector,
this shows that the industrial sector is using more
factor inputs than does the agricultural sector.
The use of more factor input in one sector
compared to the other gives us 2 different points
of maximum M.P. In industrial sector the use of
factor inputs beyond AU also shows rising MP.
This shows that M.P for industrial sector is rising
over a long range than for the agriculture sector.
Production Function and Production Cost
There is a definite relationship between
the production function and production cost. The
A.C is falling when increasing returns are
experienced. This is because rise in production
leads to internal economies of scale. Once the
firms attains the optimal level of production the
economies of scale disappear and the factors
of production are strained. This means as
production goes beyond optimum level of
production falls and the production cost rise. In
a nutshell it means cost are falling when returns
are increasing stable when production is stable,
and rising when returns are decreasing.
Returns
Average Cost
Increasing
Constant
Decreasing
Falling
Constant
Rising
MP
U
R1
Industry
T
Agriculture
S
K
0
A
B
Factor Inputs
X
Fig. 8.5 : Marginal Productivity Curve
(Agriculture and Industry)
The diagram shows the M.P in agriculture
and the M.P in industrial sector also. They are
shown by two different curves. The M.P of
agriculture is shown by ST and that of industry
by KR. The MP curve shows the tendency of
rise in TP. If you see ST it shows that the MP is
rising till AU level of input which means the TP
is increasing at an increasing rate for the
agricultural sector. Beyond AU agriculture
sector experiences decreasing returns and hence
the MP curve beyond AU starts falling.
Questions for Self Study - 4
(A) Answers in brief.
(1) What does the law of variable proportions
explain?
(2) What do you observe in the first stage of
production?
(3) What do we observe in the 2nd stage of
production?
(4) What do we observe in the 3rd stage of
production?
(5) What are the reasons behind increasing
returns?
(6) What are the reasons behind decreasing
returns?
(B) State whether the following
statements are true or false. Put ()
or () in brackets.
(1) The law of variable proportions tells us
how output changes, as proportion of one
factor input is increased while that of all
others remaining constant. ( )
Markets and Price Determination : 48
(2)
The law of variable proportions tells us
the rise in output as a result of rise in
proportion of all factor inputs in the process
of production. ( )
(3)
In the short run, various economic theories
explain all three tendencies of increasing,
decreasing and negative returns. ( )
(4)
If the proportion of any one factor input
from a group of inputs in increased
continuously, first the marginal and later
the average productivity of this variable
factor input decreases beyond a certain
level of output. ( )
(5)
The first stage of law of variable
proportions is of decreasing returns. ( )
(C) Match the following.
(1) MP rises
(a) TP is maximum
(2) When MP is zero
(b) TP rises at an
increasing rate
(3) First stage of
(c) Stage of negative
production is called
returns
(4) Since production (d) Decreasing AC is
declines continuously, experienced
in 3rd stage it is called
(5) In case of
(e) Stage of
increasing returns
increasing returns
(D) A farmers has 3 hectares of land on which
he takes wheat. He increases the labour
inputs. The production realized by him is
shown in the table. Find the AP and MP
from the information provided in the table.
Show three stages of production
tendencies. Comment on the minimum and
maximum number of worker a farmer
should employ.
Production of Wheat (in Quintals)
Land
3
3
3
3
3
3
3
3
hec.
hec.
hec.
hec.
hec.
hec.
hec.
hec.
Labour
TP
1
2
3
4
5
6
7
8
8
20
36
48
55
60
66
56
AP MP Stage Tendency
(1)
Fill in the columns of AP and MP.
(2)
Write three stages of production and
tendencies therein.
(3)
Comment on the minimum and maximum
number of workers a farmer should
employ.
8.2.6 Production Function with
Two Variable Inputs
In the short and long run production
function shows three tendencies. Production
could be in any stage, it could be when the returns
are increasing, decreasing, constant. Production
depend on level of demand and the nature of
demand. At any given point of time firms would
aim at attaining an equilibrium. To attain
equilibrium, firms have to consider the cost of
inputs and output from such inputs. So as to
determine an optimum level of output while
determining optimum level of output availability
of inputs, their scarcity or abundances, prices
and productivity will have to be considered.
In the process of production of two factor
inputs are variable, finding the optimum
combination of these inputs becomes a question
for the firm. The factor inputs are essential to
be used efficiently. By and large firms are
required to take 3 types of decisions.
(i)
The combination of labour and capital, to
maximise production, when the cost to be
incurred on inputs is fixed.
(ii)
The combination of labour and capital, to
maximise production, when the level of
output is determined.
(iii) That level of output which maximise
production
1st two types point at the problem of
constrained optimization. The 3rd type does not
pose any constraint either in the form of cost or
in the form of output.
The questions above are practical in nature.
In managerial economics some tools are used
to solve the above problems. If production is
dependent on two variable factors then concepts
of iso quants, iso cost curves and other related
terms are used to solve the 1st two problems.
Let us see what these terms are :
Markets and Price Determination : 49
Iso-quants : Iso-quant means an equal
quantity curve. Any point on this curve shows
the same level of output but with various
combination of factor inputs X and Y. Let us
understand this concept using an example. We
denote labour on X axis and capital on y axis.
Various combinations of X and Y would produce
a particular level of output. These various
combinations of X and Y can be shown by points
on the curve, Table 8.5 and diagram 8.6 show
the isoquant. Let us analyse the same.
Table 8.5 :Iso-quants
Factor Inputs (in Units) MRTS
Combination Production
Capital between
of X & Y
(Units)
Labour (X)
L &C
(Y)
A
B
C
D
E
50
50
50
50
50
1
2
3
4
5
13
9
6
4
3
4:1
3:1
2:1
1:1
Y
Units of Capital
28
24
A
20
B
16
12
8
4
Y 4
1
X
C
Y 3 1
D
X
2
Y
1 E
1
1
X
Y X
F
IQ=50
X
A
Units of Labour
Fig. 8.6 : Iso-quant
See table 8.5 the firm has to produce 50
units of a product it can bring various combination
of labour and capital together. See method A of
production. It uses 1 unit of labour and 13 units
of capital to produce 50 units of output. So
(X+13Y = 50 units). A substitute method of
production of A would be B which is increases
the labour inputs but only after sacrificing some
units of capital. So combination B uses 2 units
of labour but only 9 units of capital to produce
50 units of output (2x + 9y = 50 units). Any
combination of X and Y would produce only 50
units of output. This is a concept of isoquant. In
brief,
An isoquant schedule shows various
combination of factor inputs producing a
constant level of output.
Table 8.5 is an isoquant schedule using the
data in isoquant schedule one can draw an
isoquant. Fig. 8.6 shows the isoquant. We 1st jot
down the points representing different
combinations of X and Y. These points when
are joined together we derive a graph that is an
isoquant. In our example it is denoted as IC
curve. The most important point is that it denotes
50 units of output. The curve shows various
combinations of X and Y which could be used
for producing 50 units. Since any combination
on this curve produces only 50 units of output it
is called isoquant. This curve is negatively sloped
from left to right and is convex to origin.
In book 1 which studying the analysis of
demand we saw the indifference curve showing
the consumer satisfaction level. The isoquant is
similar to the indifference curve. The
indifference curve is the equal satisfaction curve,
while the isoquant is the equal output curve. But
there is a difference between the two while the
concept of satisfaction is objective and can not
be compressed in terms of units of satisfaction
derived. The levels of production can be
expressed in terms of numbers. We can say that
isoquant shows 50 units of output produced and
hence it can say production (output) is
quantifiable. Putting various isoquants together
we can arrive at an isoquant map.
Fig. 8.7 shows various levels of output
corresponding to various isoquants. Every next
isoquant (further away from origin) shows
higher level of output. This is how we get on
isoquant map.
Markets and Price Determination : 50
Mathematically,
Y
Units of Capital
Slope of isoquant 
ΔY
ΔX
Using this equation we can find the slope
of isoquant at point B. We use figures from table
8.5.
Slope of isoquant at B = 
IQ4=120
IQ3=100
IQ2=80
IQ1=50
ΔY 4
 4
ΔX 1
Similarly,
Slope of isoquant at D = 
X
0
Units of Labour
ΔY 1
 1
ΔX 1
Where,
Fig. 8.7 : Iso-quant Map
Marginal Rate of Technical
Substitution (MRTS) : The concept of MRTS
is at the base of the isoquants. Let us understand
the same.
While studying demand analysis, we
understand the concept of MRS. The concept
of MRTS is a like. Table 8.5 shows that at a
certain level of output if one unit of X is increased
some units of Y are required to be scarificed.
The sacrifice of one unit of factor input to gain
another is technically termed as MRTS between
X and Y. To increase one unit of labour some
units of capital is sacrificed. How many units of
capital are sacrifieced determines the marginal
rates of technical substitute of labour. When we
move from A to B labour inputs increase from
1 to 2 but capital inputs fall from 13 to 9. It
means for an additional unit of labour 4 units of
capital is sacrificed. Hence, the MRTS is 4:1
the same logic is used for the next combination.
The rate of technical substitution goes on
declining continuously MRTS can be shown in
the diagram also we can see it in diagram 8.6. It
shows us the slope of isoquant. Let us know
how to calculate. Let us 1st understand the units
of capital sacrifised for additional units of labour.
This change in capital is denoted by Y
correspondingly how many units of labour are
increased can be denoted as X. Fig. 8.6 shows
these changes using horizontal and vertical lines
corresponding to the original and changed levels
of X and Y. This will tell us the slope of isoquant.
Y = Fall in factor input Y
X = Rise in factor input X
and  = Change
Properties of Isoquant
Following are the properties of isoquant
(the properties of isoquant are same as the
properties of the indifference curves)
(1)
The isoquants are negatively sloped. In that
sense isoquants slope down ward from Y
axis to X axis. This means as a person
uses more of X, he is required to sacrifice
some units of Y.
(2)
The higher the isoquants are, higher the
level of output they reveal.
(3)
Two isoquants do not intersect each other.
(4)
They are convex to origin. The marginal
rate of technical substitution is diminishing.
This can be seen from diagram 8.6 with
every successive triangle on the curve
becoming smaller and smaller.
Isocost Curve
The producer is faced with a challenge of
obtaining maximum output at the least cost. This
can not be explained merely with the help of an
isoquant. It requires information about prices of
the raw material and the amount available with
the firms.
The market prices of the raw material
provide guidance about what to produce and
what not to. The actual market prices must be
known to select an optimal set or combination
of raw materials. It pays to the firm to use
Markets and Price Determination : 51
The shifts in the Isocost curve can also
be seen if the prices of raw material change.
Let us understand the same using different
example. (see figure 8.9).
The price of labour and capital is rupees
50 and 100 respectively. If the amount to be
spent is rupees 400 then the original Isocost
curve would have Y-intercept as 4 and Xintercept as 8. The Isocost curve would join
these two intercepts. This is shown by a line
PR.
Let us now change either the price of
inputs or the total expenditure. We will see how
the original PR changes. This can be seen using
diagram 8.9.
Y
6
Units of Capital
cheaper instead of dearer raw material. The
average cost of production can fall due to this.
We need to know the isocost curve also. For
constructing our isocost curve, we need to know
two things (1) the process of raw material, (2)
the amount to be spent on raw material.
Let us understand using an example. A
producer requires labour and capital. Labour is
shown on X axis and capital on Y axis. The
price of labour is Rs.100 and that of capital
Rs.200. The total expenditure on raw material
would be Rs.1,000. If we spend the entire amount
on labour, we can have maximum 10 units of
labour (1000/100 per worker = 10 units of labour)
If the same amount is spent on capital alone, 5
units of capital can be purchased (1000/200=5
units). So 5 and 10 are the maximum limits of
capital and labour respectively. This has been
explained using a diagram. The line that joins
these two extremes is called an isocost curve.
Any point on isocost curve would give you
a combination of X and Y that would exhaust
the entire budget of Rs.1000. In the analysis of
consurner equilibrium we studied the budget line,
the isocost line resembles the budget line.
5
4
P1
P
3
2
1
Y
R
Units of Capital
6
5
A
2
3 4
6
7
R1
X
8 9 10 11 12
Fig. 8.9 : Changes in Isocost Curve
M1
(1)
If the per unit price of labour changes from
Rs. 50/- per unit to Rs.40/- per unit, then
in total budget of Rs.400/- the producer
can buy maximum 10 units of labour in
place of the earlier 8 units. The change in
X intercept would the Isocost curve.
(2)
If the price of capital alone changes from
Rs.100/- per unit to Rs.80/- per unit, then
the producer is able to purchase 5 units of
capital in place of 4 units. The Y intercept
changes holding the X intercept constant.
The Isocost curve rotates and the new
Isocost curve in P1R.
(3)
Now if prices of both labour and capital
simultaneously change as Rs. 40 and Rs.
80 respectively, then more units of both
the inputs can be employed and the Isocost
curve would shift to the right from its
original position.
3
2
M2
1
R
1
5
Units of Labour
P
4
A
1
2
3 4
5
6
X
7 8 9 10 11 12
Units of Labour
Fig. 8.8 : Isocost Curve
Shift in the Isocost Curve
If the produces spend more money on
inputs the isocost curve shifts to the right. If
they reduces their expenditure, it would shift
inside that is to the left of the original Isocost
curve.
Markets and Price Determination : 52
If the expenditure to be incurred on inputs
changes or the inputs prices change then
the original Isocost curve changes. The
slope of the Isocost curve shows the
relative change in prices of the inputs.
The Isocost curve is the locus of all the
points where the entire budget of the producer
is exhausted.
The Isocost curve is the total amount of
money to be spent on the factor inputs. Hence
a producer cannot go beyond the ISC to select
any combination of factor inputs.
Questions for Self Study - 5
(A) Answers in short.
(1)
What three decisions does a firm by and
large need to take ?
(2)
What is an isoquant ?
(3)
What is marginal rate of technical
substitution ?
(4)
Why does isoquant slope down from the
left to right ?
(5)
Why is the isoquant convex to origin ?
8.2.7 Least Cost Combination of
Inputs
Any firm pursues an objective of
minimization of cost. This is an important test of
a firm in the process of production. The firm
has to face a number of questions while proving
its efficiency in the process of production. Two
of these important questions are (1) attaining a
certain level of production in minimum cost (2)
attaining the maximum output in given costs. The
same can be explained using the isocost curves
and isoquants.
(1) Attaining a certain level of
production in minimum cost
Let us say that K and L are variable inputs
and are continuously substitutable in a given
range of production. Let us assume that a firm
has to produce hundred units of output. We need
to select such a combination of inputs, which
incurs the least cost. This can be explained by
using a diagram. Fig. 8.10 shows an isoquant
IC1, showing 100 units of output. Any point on
IC1, shows the same level of output, whether it
is T, R or S.
(B) State whether the following
statements are true or false. Put ()
or () in brackets.
(2)
(3)
IC2=(150) IC3=(200)
Various points on the same isoquant depict
various levels of output ( )
Marginal rate of technical substiution is
the slope of the isoquant on any point on
the isoquant ( )
Any point above the iso cost curve shows
higher level of costs than a point below an
isocost curve ( )
IC1=(100)
P1
Units of Capital
(1)
Y
D
P
R
S
(C) Fill in the Blanks.
(1)
T
Rs. 2000
Any point on the isoquant shows the —
—— level of output.
(2)
On an isoquant as units of X are increase
that of Y are decreased, this relationship
is termed as —————— .
(3)
The isocost curve ———— as the
expenditure of factor inputs changes.
(4)
The slope of the isocost curve depicts —
—— relation between two factor inputs.
(5)
Isoquants are ————— to origin.
0
Rs. 3000
R
R1
X
Units of Labour
Fig. 8.10 : Isocost and Isoquant Curves put
together
IC2 : is an isoquant above IC1 showing higher
level of output that is 150 units.
PR : is an isocost curve showing a total budget
of Rs.2000/-. Any combination of labour
and capital on this curve would show a
same level of expenditure i.e. Rs. 2000/-
Markets and Price Determination : 53
P1 R1 : is an isocost curve above PR which
shows an expenditure of Rs. 3000/A firm has to produce 1000 units with the
least cost. Let us see how this happens IC1 gives
3 points viz. R, S and T, all these show output
equal to 100 units. Point R among these three is
the point of least cost. This is clear from the
diagram. This is because R lies on an isocost
PR which is lower than P1R1 on which S and T
lie, indicating that producing R requires the firm
to spend Rs.2000/- to produce 100 units while S
and T require the firm to spend Rs.3000/- This
enables the firm to select R and thereby minimize
and restrict cost of production to Rs.2000/-. The
above discussion clears the criterion used by
the firm in selecting a particular L and K
combination.
The point at which the isoquant is tangent
to the isocost is a point corresponding to
that level of output produced at the
minimum cost.
In the example above, the output is 100
units and the corresponding isoquant is IC1. PR
is the isocost line showing the minimum cost of
Rs.2000/-. This isocost line touches the isoquant
IC1 at R. Hence, this is the point of equilibrium
for the firm. Point S and T represent 100 units
of output each but incurs an expenditure of
Rs.3000/- each. Hence, these two points cannot
be thought of as they incur an additional
expenditure of Rs. 1000/- over R.
(2) Attaining the Maximum Output in a
given Cost
Let us new turn to the second question.
The second question is about attaining the
maximum level of output in a given cost
constraint. How does the firm attain this, is
explained in figure 8.10.
T, D, S are on the same isocost line i.e.
P1R1. They are in the cost constraint of Rs.3000/
-. The expenditure incurred on any of the above
combinations is equal that is Rs.3000/- But we
need to see the point that gives the maximum
output.
Fig. 8.10 shows that IC2 which shows an
output level of 150 units is the only optimum
level of output that can be attained in the budget
constraint of Rs. 3000/- The P1R1 is tangent to
IC2 at D and hence D is the only optimum point
of output. IC3 shows a higher level of output but
none of the points on IC3 correspond to P1R1,
hence, IC3 is beyond the budget of Rs.3000/-.
On the basis of the above discussion we can
take the following conclusion.
Given the isocost line (cost constraint) the
point of its tangency with the isoquants
offers us a maximum output corresponding
to the given level of costs.
At point D, P1R1 touches the IC2. it is at
point D firm is in equilibrium as it produces the
maximum level of output i.e. 150 units at a cost
of Rs.3000/- This is optimum production.
While solving both the questions mentioned
above the criterion to be remembered is that
while determining the combination of labour and
K the firm must equate the MRTS with their
price ratios. The criterion is explained in an
equation form below:
MRTS =

PL
PK
Y
wage rate

X interest rate
In a nutshell, if the above criterion is
followed the chosen combination of inputs would
be one with least cost and maximum output.
This is one important test of production
efficiency of the firm.
The Expansion Path
If we keep the price of L and K constant
and go on increasing the firms total cost for
increasing production then we tend to get new
points of equilibrium. These points of equilibrium
are on higher level. If we plot these points of
equilibrium we get a line called the expansion
path. Fig. 8.11 would explain us the EP.
Markets and Price Determination : 54
Y
Y
P3
P2
S
R
P1
IC3
Q
P
0
IC 4
IC2
IC2
IC1
P
P4
Units of Captial
Factor Inputs (Capital)
IC 1, IC 2, IC 3, IC4,= Isoquants
PR, P 1R 1, P2R 2, P3R3, P 4R4,= Iso cost Curves
PQRS = Expansion Path
S1
R1
Q1
P
Q
R
S
IC1
R1
R2
R3
R4
X
0
R
R1
X
Factor Inputs (Labour)
Factor Inputs (Labour)
Fig. 8.11 : Straight Line Expansion Path
Fig. 8.12 : Curvatured Expansion Path
The prices of L and K are constant. Due
to these assumption every subsequent isocst lines
are parallel to each other. The rise in expenditure
on inputs (rise in budget of a firm) would increase
the L and K inputs. This enables us to get isocost
lines that are to the right of each other (e.g.
P1R1, P2R2, P3R3, P4R4). The increased level
of L and K give us a new combination of L and
K. The Higher levels of L and K would give
higher levels of output also. This means every
subsequent isocost line would be touching an
isoquant of a level higher than the previous, for
example, IC1, IC2, IC3, IC4.
If the price of labour compared to that of
capital falls, then more labour input could be used
over capital and the isocost line would PR1 in
place of PR. The production will shift to Q from
P. The expansion path denoted by PQRS is
below to the right.
The new isocost lines and new isoquants
are tangent at points like P,Q,R,S. These are
the points showing equilibrium
All the above points are the points of
optimum output and least cost as well.
If the capital becomes cheaper than labour
then more of K wold be used and the expansion
path would be PQ1, R1, S1
In short, the line of expansion path could
be straight or curved. The shape of the
expansion path would depend on the price of
inputs and on the shape of the isoquant.
Questions for Self Study - 6
(A) State whether the following
statements are true or false. Put ()
or () in brackets.
(1)
The slope of the isoquant and the isocost
line is the same (equal) when the isoquant
is targent to the isocost line. ( )
(2)
The expansion path is always a straight
line. ( )
The shape of the expansion path could be
indeterminate. If the combination of factor inputs
for higher levels of output is constant and so is
the cost of factor inputs then the expansion path
would be a straight line as shown in Fig. 8.11.
(3)
At the point of equilibrium, the isocost
curve touches the isoquant. ( )
(4)
At the point of equilibrium, the isocost
curve intersects the isoquant. ( )
The shape of the expansion path can
change as shown in Fig. 8.12.
(1)
These points are joined together from
origin to get a line ‘OPQRS’. This is a line
showing expansion in output.
(B) Fill in the blanks.
The output corresponding to the optimum
combination of inputs in attained at ——
cost. (minimum, maximum)
Markets and Price Determination : 55
(2)
At an optimum combination of inputs the
cost incurred corresponds to —— level
of output. (minimum, maximum)
(3)
The least cost combination of inputs would
correspond to ——— group of inputs
(inputs with less cost and maximum
production, inputs with less cost and
maximum profit)
(4)
A curve drawn joining various points
corresponding to least cost combination of
inputs in called ———. (isoquant, isocost
curve, expansion path)
Increasing, Constant and Decreasing
Returns to Scale
The rise in output in the long run due to a
proportionate increase in all factor inputs could
show following tendencies :
(i) Increasing returns to scale
(ii) Constant returns to scale
(iii) Decreasing returns to scale
The tendencies mentioned above are
shown diagrammatically below :
Tendencies in Returns to Scale
8.2.8 Production Function with
All Variable Factors
We have seen the decision of short run
production function and the variations in scale
of production in short run. Let us see the long
run production now. The long run law of
production is called the Law of Returns to Scale.
Let us study that.
Law of Returns to Scale
If the demand for a product is going to
rise in future, it pays the firm by producing more.
The higher level of output could be produced in
the long run because all the factors of productions
are variable in the long run. There is no standard
relationship between the additional units of factor
inputs used and the additional output realised.
In the long run, the output realized shows 3
tendencies.
(1)
Increasing
(2)
Decreasing
(3)
Constant
Increasing
Returns
to Scale
In the long run as the proportion of all inputs
is increased the corresponding rise in
output is registered by the law of returns
to scale.
Decreasing
Returns
to Scale
Let us first understand these tendencies
mathematically and the same could be later
studied with a separate example.
The equation of production function is
y = f(X1, X2, …….. Xn). This equation means
that farmers produces a certain level of output
using certain level of factor inputs. If X1 = Land
(2 hectare), X2 = Labour (5) y = Total production
of food grains (40 quintals) then we can say
that 40 quintals of food grains can be produced
by using 2 hectares of land and 5 labourers. If
the farmer decides to increase production
keeping in mind the rising demand for food grains
in future, he would increase the combination of
all factor inputs to increase the output.
Y
In a nutshell, in the long run due to
increase in all the factor inputs the total size of
the firm itself increases and the scale of
production also increases. Hence, it is referred
to as returns to scale.
Constant
Returns
to Scale
= f ( ( X1, +X2 + X3 +…….. +Xn ) )
Rise in production
All inputs increased in
same proportion
In the production process, if these is a rise
in input, by a certain proportion, output may not
change in the same proportion. There are
tendencies about rising output. They are summed
up in Table 8.6
Markets and Price Determination : 56
Table 8.6 : Tendencies about Rising Output
1
2
3
The proportionate
rise in output is
greater than rise in
inputs
Rise in output
proportionate to rise
in input.
The rise in
production is less
cost proportionate
to rise in factor
inputs.
Tendency of
Increasing
Returns to
scale
Constant
Returns to
scale
Decreasing
Returns To
scale.
6 hectare +15 workers), the foodgrain production
rise by more than 3 times the amount, that is it
moves to 180 quintals in place of 120 quintals.
The marginal productivity is increasing at an
increasing rate that is by 40, 60, 80 etc. This is
an increasing return to scale.
(2) Constant Returns to Scale
When the rise in output increase
proportionately with the rise in factor inputs, it
is referred to as constant returns to scale. In
constant returns to scale doubling the factor
input results in doubling of output.
Table 8.8 : Constant Returns to Scale
(1) Law of Increasing Returns to scale
When the rise in all factors inputs leads to
more than proportionate rise in output the
resulting tendency is of Increasing Returns to
scale.
Let us take an example of a farmer. He
produce 40 quintals of foodgrains using 2
hectares of land and 5 laboureres. He increases
the land and labour use as the demand for
foodgrains increases. The total and the marginal
productivity changes due to changes in the use
of factor inputs. The table showing total and
marginal productivity is given.
Table 8.7 : Increasing Returns to Scale
S e t o f N o o f in p u ts u s e d
fa c to r
Land
Labour
in p u ts (h e c ta r e )
TP
MP
R is e in
In p u t
R is e in
P r o d u c tio n
40
40
-
M ore
th a n
d o u b le
M ore
th a n
T r ip le
1
2
5
2
4
10
1 0 0 6 0 D o u b le
3
6
15
180 80
T r ip le
From table 8.7 it can be seen that 5 units
of labour and 2 hectares of land produce 40
quintals of foodgrains. But when the farmer
doubles the use of factor inputs, that is he
increases labour from 5 to 10 and capital from
2to 4, the production increases by more than
double the amount. This means output in the
earlier case was 40 quintals of foodgrains which
moves upto 100 quintals ( by doubling the factor
inputs it should have ideally doubled to 80
quintals, but it rise to 100 quintals). If the factor
inputs are increased by 3 times the amount (land
Set of No of inputs used
factor
Land
Labour
inputs (hectare)
1
2
3
2
4
6
5
10
15
TP
MP
Rise in
Input
Rise in
Total
Output
40 40
80 40 Double Double
120 40 Triple Triple
In table 8.8 we can see that as the factor
inputs were doubled the rise in production also
doubles and in the third instance when they were
increased by 3 times the output also increased
by 3 times. The rise in MP is constant at 40
quintals and hence this is called the law of
constant returns.
(3) Decreasing Returns to Scale
When we increase all the factor inputs
during the process of production, if the
resulting rise in output is proportionately
less than the rise in factor inputs the
corresponding rule is known as decreasing
returns to scale.
Table 8.9 : Decreasing Returns to Scale
Set of No of inputs used
factor
Land
Labour
inputs (hectare)
1
2
5
2
4
10
3
6
15
TP
MP
40 40
Rise in
Input
Rise in
Total
Output
-
Less
70 30 Double than
Double
Less
90 20 Triple
than
Triple
Table 8.9 shows that when the factor
inputs were double the rise in production was
less than double and in the third set of inputs
Markets and Price Determination : 57
when the factor inputs were increased by 3
times, the output increased by less than 3 times.
The diagrams for there 3 tendencies are shown
in figure 8.13. They are shown as A,B,C.
Marginal Product
Y
g
in
as
R
et
ns
ur
e
cr
In
)
(a (b) Constant Returns
( c)
De
cre
asi
ng
Re
tur
ns
X
A
Factor Inputs
Fig. 8.13 : (a) Increasing (b) Constant (c)
Decreasing Returns
Returns to Scale and Long Run Average
Cost
The relationship between the returns to
scale and long run average cost curve can be
established. Incase of increasing returns to scale
since the rise in factor inputs is less than the
rise in output the total cost is spread over the
total output produced and hence the long run
average cost continues to fall. The LAC
remains stable when the returns to scale are
constant. In case of decreasing returns to scale
since the rise in output is proportionately less
than rise in factor inputs, the TC is spread over
smaller output produced and hence the LAC is
rising.
Returns to Sale
Long Run Average Cost
Increasing
Decreasing
Constant
Constant
Decreasing
Increasing
The Reasoning behind Returns to Scale
The long run supply of goods changes
according to the demand for these goods. The
firms increase their productive capacity, in fact
the size of the firm changes. When the size of
the firm increases the proportion of all factor
inputs in increased. In such a case the firms
experience either increasing, constant or
decreasing returns to scale. In the long run the
firms obviously produce in a particular phase of
production from out of the 3 mentioned above.
Hence, they experience only one of these
returns to scale.
The reason behind increasing returns to
scale is the indivisibility of factors of production.
This indivisibility can be seen in case of
machines, capital, entrepreneurship, etc. These
factors have to be used in a certain proportion
when production is carried on a large scale.
Using their entire productive capacity in the
process of production becomes important as
they are indivisible. This enables production to
rise. Along with this division of labour or
specialization can be resorted to produce on a
large scale. Internal economies of scale are also
associated with large scale production. Large
scale production may involve use of big and
modern machines, purchase of factor inputs on
large scale, the sale of output so produced with
ease, use of expert entrepreneurs and their
entrepreneurial proficiency etc. This would all
be done in the most cost effective manner. This
in a nutshell means that with large scale
production are associated economies pertaining
to production, investment, entrepreneurship and
purchase and scale. This would enable the output
to rise in a proportion greater than the rise in
inputs. Apart from this if the production is
focused in a particular locality this would cause
development in the field of transport and
communication, availability of skilled human
resource, availability of magazines and
newspapers pertaining to business etc. These
developments would help the other dependent
businesses also. These benefits are called
External Economies of Scale. The internal and
external economies of scale cause the long run
average cost curve to fall.
When constant returns to scale are
experienced both the internal and external
economies as well as diseconomies balance.
When the production increases beyond a
certain proportion, the size of the firm also
increases beyond proportion. This raises
problems pertaining to control and organization
of the firm. The external and internal
diseconomies to scale are experienced. The
firms also experience falling productivity of some
of the factor inputs whose prices either remain
stable or are rising. The excessive spread of
Markets and Price Determination : 58
industries also creates scarcity of efficient labour
face. The transport and communication is
strained. Due to all these factors the LAC goes
on rising. The Law of Variable Proportions and
Diminishing Returns to Scale are experienced
in almost all fields of productive activity.
Questions for Self Study - 7
(A)
(1)
(2)
(3)
Answers in Short.
What are increasing returns to scale?
What are decreasing returns to scale?
What are constant returns to scale?
(B) State whether the following
statements are true or false. Put ()
or () in bracket.
(1)
In the long run all factors of production
are increased in uniform quantities. ( )
(2)
When the proportionate rise in output is
equal to the proportionate rise in inputs the
long returns are increasing. ( )
(3)
When firms experienced increasing
returns to scale, the long run average cost
is increasing. ( )
(4)
When firms experience constant returns
to scale the long run average cost curve is
parallel to X-axis. ( )
(C) Fill in the blanks.
(1)
A 20% rise in inputs, when leads 15% rise
in output, it corresponds to —— returns
to scale. (increasing, constant, decreasing)
(2)
Internal economies of scale arising out of
large scale production lead to ———
average cost. (falling, rising)
(3)
Decreasing returns to scale is associated
with ——fields of production. (all, specific)
(4)
In the long run to increase production
proportion of all factor inputs is increased
and hence all these inputs are called ——
— factor inputs. (variable, fixed)
Law of variable proportions : If the proportion
of one factor in process of production is
increased continuously, proportion of other
factor remaining stable, the marginal
productivity of that variable factor
diminishes first and later the average
productivity, beyond a certain level of
output.
Increasing Returns to Scale : Rise is output
is greater than the proportionate rise in
inputs.
Constant Returns to scale : The proportionate
rise in inputs and output is constant, it is
same.
Decreasing Returns: The proportionate rise
in output is less than the proportionate rise
in factor inputs.
Isoquant: It is an equal quantity curve. Any
combination of factor inputs on this curve
gives the same level of output.
Isocost Curve: It is a line joining various
combinations of factors a firm can
purchase with a given budget.
Marginal Rate of Technical Substitution:
Marginal rate of technical substitution
measure the degree of substitutability
between two factor inputs. It tells us the
number of a particular factor needed to
be sacrificed to gain additional (number)
units of other factor input.
Least Cost Combination of Inputs: Given
expenses to be incurred of two factor
inputs and given their prices, it is that
combination of those and two factor inputs
that produces the maximum output with
least average cost.
8.4 Answers to Questions
for Self Study
Questions for Self Study- 1
8.3 Words and their
Meanings
Production Function : The functional
relationship between input and output is
called production function.
(A)
(1)
Land, Labour, Capital and Entrepreneur
are four main factors of production.
(2)
The theory stating the relationship between
the rise in factor inputs and its
corresponding effect on output is the theory
of returns.
Markets and Price Determination : 59
(3)
The input output relationship is expressed
in terms of production function.
(5)
(B) (1) (), (2) (), (3) (), (4) ().
Questions for Self Study - 2
(A)
(1)
In production process when rise in variable
factor inputs leads to an increase in
production at an increasing rate, it is termed
as increasing returns to scale.
(2)
When rise in variable factor input leads to
a proportionate increase in the output, it is
termed as constant returns.
(3)
When rise in variable factor input leade to
a less than proportionate increase in the
output it is termed as decreasing returns.
(B) (1) (), (2) (), (3) (), (4) ().
Questions for Self Study - 3
(1) (), (2) (), (3) (), (4) (), (5) ().
Questions for Self Study - 4
(A)
(1)
(2)
(3)
(4)
The law of variable proportions states that
as the number of units variable factor
inputs is increased, the other factors being
constant, beyond a certain point the
marginal and average productivity of the
variable factor input declines.
Economists have classified production in
to three stages. This is on the basis of how
the average product and marginal product
change. In the first stage of production
marginal product is greater than average
product MP is also greater than zero. The
average product is maximum in this stage.
In the second stage of production total
product is rising but at a decreasing rate.
This is shown through a falling MP curve.
This means MP is also falling in the second
stage, so is the AP.
In the third stage of production all AP, TP
and MP are falling in fact MP less than
zero. (MP<0)
In the initial stage of production the
proportion (availability) of fixed factor is
more. This in itself means that the
productive capacity of the fixed factor,
initially, is more and is unutilized. It is used
as more and more variable factor inputs
are employed on term. The additional use
of variable factors increases the total
productivity via rise in use of productive
capacity of fixed factor.
Some factors of production are indivisible
and their optimal use is essential from the
point of recovering investment made in
them. As the variable factors are employed
an greater scale, the productive capacity
of both the fixed and the variable factors
are utilized giving increasing returns to
scale.
(6)
The production process goes on as
demand for such a product is rising. In this
process the proportion of variable factors
employed in association with the fixed
factors, may turn in favor of the variable
factors. The variable factors in proportion
to the fixed factors become larger in
number. The productive capacity of the
fixed factor remains fixed and can not be
increased even if more and more variable
factors are employed. So when the
proportion of variable factors rises beyond
the required, the diminishing returns set in.
Beyond, certain point the factor inputs,
machines and even management is
straianed. This leads to setting in of
diseconomies of scale. This cause
decreasing returns.
(B) (1) (), (2) (), (3) (), (4) (), (5) ().
(C) (1) - (b), (2) - (a), (3) - (e), (4) - (c),
(5) - (d)
(D) (1) and (2)
Labour
1
2
3
4
5
6
7
AP
8
10
12
12
11
10
8.6
MP
8
12
16
12
07
05
00
8
07
04
Markets and Price Determination : 60
Stage Tendency
1st
Increasing
returns
2nd
Decreasing
Returns
3rd
Negative
Returns
(3)
Minmum - 04 workers and Maximum - 07
workers.
Questions for Self Study - 5
(A)
(1)
The firms need to decide the combination
of inputs that would incur the least cost if
the input expenditure is determined. If the
units of output to be produced is determined
then using then that combination of factor
inputs that would cost the least and
attaining the level of output that yields
maximum profit. These three decisions are
taken by firms.
(2)
An isoquant is an equal quantity curve. It
represent a certain (fixed) level of output
produced using various combinations of
factor inputs.
(3)
Marginal rate of technical substitution
measures the degree of substitutability
between two factor inputs. It is the number
of one factor input sacrificed for attaining
some number of the other factor input.
(4)
The isoquants slope downward due to
diminishing marginal rate of technical
substitution. As quantity of one factor input
in production process is increased the
quantity used of the other is needed to be
reduced and hence isoquant slope
downward.
(5)
Since, the marginal rate of technical
substitution between two factor inputs is
decreasing the isoquants are convex to
origin.
(B) (1) (), (2) (), (3) (),
(C) (1) same, (2) Marginal rate of technical
substitution, (3) changes, (4) relative,
(5) convex.
Questions for Self Study - 6
(A) (1) (), (2) (), (3) (), (4) ().
(B) (1) minimum, (2) maximum, (3) input with
less cost and maximum production,
(4) expansion path.
Questions for Self Study - 7
(A)
(1) In the long run all factors of production
are variable. The rise in factor inputs when
increases production by a greater
proportion, the returns are increasing.
(2) If rise in output is less than the rise in
proportion of factor inputs, it is a case of
decreasing returns to scale.
(3) When the proportionate rise in factor
inputs brings exactly the same rise in output,
we say it is constant returns to scale.
(B) (1) (), (2) (), (3) (), (4) ().
(C) (1) Decreasing, (2) falling, (3) all,
(4) variable
8.5 Summary
Supply of any good depends basically on
the demand for that commodity. The rising
demand for a product requires more production.
The possibility of additional production is
dependent on the availability of raw material.
The availability of factor inputs determine the
possibility of producing the required level of
output. This relation between input and output
is known as production function. In a productive
process a variety of production function can be
witnessed. They do not remain the same in every
business.
The level of production depends on the
availability of factor inputs. The availability
would mean the time required to get those. The
laws of production have been classified on the
basis of time. They include the short and the
long run laws of production. The short run law
of production is known as the law of variable
proportions, while the long run law is known is
the returns to scale.
In the short run all factor inputs may not
be made available in that number as desired.
The supply of some factor inputs may remain
fixed while of some of them may be increased.
With a factor fixed and a factor variable as more
of variable factor inputs are used on the fixed
factor the productivity of the variable factor
initially increases, then diminishes and finally
turns negative. This phenomenon is known as
the law of variable proportions.
Markets and Price Determination : 61
The same analysis is extended to two
variable factor inputs and remaining being fixed.
This relationship is explained using an isocost
curve and isoquants. The isocost curve is the
equal cost curve while isoquant is the equal
quantity curve. Isocost curves shift rightward
or leftward depending upon the expenditure
fixed on the factor inputs. The tangencies of
successive isoquants with successive isocost
curves can be plotted to draw as expansion path
of production.
Production can be increased in the long
run using more units of all the factor inputs. The
long run relation between input and output is
termed as returns to scale. The types of such
long run relations are increasing, constant and
decreasing returns.
8.6 Exercises
(1)
(2)
(3)
(4)
(5)
(6)
What is production function and what are
its types?
Explain the law of variable proportions,
using examples and diagram.
Explain the concepts of isoquant and
isocost curves.
Explain, how least cost combination of
inputs is attained using isoquants and
isocost curves?
In the long run production, how is
increasing and decreasing return to scale
experienced?
Distinguish between
(a) Law of variable proportion and
returns to scale.
(b) Marginal productivity curve in
agriculture and industry.
Diminishing Returns : A Common
Experience
In short run the law of variable proportions
reveals that in the same productive process one
can experience an increasing, diminishing and
negative returns. The classical economists
believed that the diminishing returns are
experienced for longer duration hence the
classicists termed it as law of diminishing returns.
8.7 Books for Further
Reading
(1)
Desai S. M. and Joshi S. S., Economic
Analaysis (Part-I), Pune, Nirali
Publishers, 1985, 2nd Edition, Topic - 8,
(with appendix -1), Pages - 172 to 209.
On the other hand all the factor inputs are
variable in the long run. If all these factor inputs
are increased in certain proportion the firm
increases in size. The long run tendencies are
mentioned earlier also. They are increasing,
constant and decreasing returns to scale.
(2)
Samuelson, Paul, Economics, McGraw
Hill, Kogakusha Ltd., 1976, 10 th Edn,
Chapter 24 and 27, PP 464-82 and 535-58
(3)
Spencer, Milton, Contemporary
Economics, Worth Publishers, Inc, 1983,
Fifth Edn., Chat. 20, PP 432-51.
There is a relationship between cost of
production and returns to scale. The law of
variable proportions gives explanation to the short
run average cost curves while returns to scale
about the long run average cost curves.
(4)
Seth M. L., Micro-Economics, Agra,
Laxmi Narain Agarwal, 1980, Chapter 14
and 15, PP, 275-346.
(5)
Jhingan, M. L., Advanced Economics
Theory, Konark Publishers Pvt. Ltd.,
1990, Chapters 14 and 14, PP 255-288.
Markets and Price Determination : 62
Unit 9 : Break-even Point of Production
Index
9.0
Objectives
9.1
Introduction
9.2
Subject Description
9.1 Introduction
9.2.1 Meaning of Break-even Point
9.2.2 Break-even Point : Explanation
9.2.3 Break-even Point : Importance
9.3
Words and their Meanings
9.4
Answers to Questions for Self Study
9.5
Summary
9.6
Exercises
9.7
Field Work
9.8
Books for Further Reading
9.0 Objectives
After studying this unit, you will be able to:
Objective of any firm is to earn maximum
profit. Profit depends on a number of factors.
The main determinants of profit include price of
the product, its cost of production, the quantity
of that commodity sold. The 3 determinant
mentioned above are related to each other. In
the initial stage when the production and sale of
a firms is less, firm incurs losses. At a certain
level of output firms total revenue and total cost
become equal and this is the point where the
firm neither earns profit nor does it incur any
loss. This is level of output is called a level of
output corresponding to no profit no loss. Beyond
a particular point of production, as the firm
increases its output and sales, its profit go on
increasing. The break-even or a point of no profit
or no loss can be explained using a graph. It
portrays the financial position of any firm. Every
enterpreneur is interested in knowing the impact
of changes in production and sales on total
revenue, total cost and eventually total profit.
Every efficient entrepreneur likes to operate
beyond the point of no profit no loss where he
not only produces more but earns a handsome
profit. It becomes essential for an entrepreneur
to know what break-even means. We will
examine in this topic the Break-even Analysis.

Explain the meaning of break-even point.

Understand the method of explaining
break-even point.

Familiarize yourself with the concept of
break-even point.

Understand why it is apt for a firm to
produce and sell beyond the point of breakeven.

Know how to prepare the table indicating
break-even point.

Develop some insight into the terms like
no profit, no loss and contribution.
9.2.1 Meaning of Break-even
Point

Understand the importance of break-even
while taking decisions pertaining to the
level of production total sales, price of
commodity, etc.
We have studied organization, production
stages in earlier chapter. Although an
organization has many goals, its prime and final
aim is to earn maximum profit (or to have
minimum loss). If this goal is achieved, then
9.2 Subject Description
Markets and Price Determination : 63
organization is considered as financially strong
(successful).
But to reach this final goal, the organization
has to undergo an important task. This task is to
earn or generate revenue which is at least equal
to the cost of production. This task is called the
task of attaining a break even. This break-even,
or no Profit, no Loss principle could be
considered as final goal / aim for a service
organization. For example, Grocery, firecrackers, school books, etc. are sold by some
organizations on no profit on loss basis or some
other organizations which we read in the
newspapers. But from a business point of view,
break-even is just an important stage towards
the final goal and the organization which has
crossed this stage is said to be a successful
organization.
The term no profit, no loss is useful for
people working in private sector, investment
officers, union leaders or government officers.
This is because this term is associated with
costing, net gains, profits, production. This is just
like a mirror for the organization or business.
From this information any organizations financial
strength and weakness could be judged. Its
capacity to expand can be judged. How much
production is essential to earn determined profits,
can also be judged. In a nutshell, this term does
not just take into consideration the profit or loss
for a particular year, but also guides to decide
the profits, cost control and to decides the price
for the product. We are going to study this simple,
compact and useful tool which is available in
the hands of the organization.
What is Break-even Point ?
When an organizations costs and total
earnings are equal, the situation of break-even
point is said to be achieved. At this point, the
production level is at break-even point. The
contribution which is generated by selling this
production level of covers the total variable as
well as fixed costs. This means when production
is done at break-even point level the
organizations total profit is zero.
(1)
(2)
If the production is above BEP, the
organization has profit.
Low
BEP level
More
production
production
production
Loss
Zero profit
Profit
Any organization is interested in sales after
the BEP level because with that sales, the profits
are also increased.
Break-even Point concept can be
explained in different manner with the help of a
diagram. It depends on how are we going to
consider the revenues functions and cost
function. Geomatrically, it is shown by linear and
non-linear methods.
Linear Revenue Function : Revenue
function is dependent on price. If the price is
constant upto a level of production, then it is
represented by a straight line.
Linear Cost Function : Total cost =
variable cost + fixed cost, is known to us. Fixed
cost is fixed in short run. Variable cost varies
with a level of production. It is a straight line in
certain cases.
Non-Linear Revenue and Cost
Function : When price decreases and demand
expands, demand curve slopes downwards to
the right. This means demand curve has negative
slope that’s why it is called as non Linear
revenue function. The same is the case of cost
function. If average variable cost changes
according to the production then it is shown as
non-linear cost function.
We can draw BEP with the help of both
linear and non-linear lines, as follows :
In diagram 9.1
•
Revenue and cost function are linear
•
‘P’ is the BEP
From this we can conclude :
•
‘AM’ is BEP level of production
If the production is below BEP, then the
organization has losses.
•
Production below AM - Loss
•
Production above AM - Profit
Markets and Price Determination : 64
(4)
Y
Non-linear revenue function and linear cost
function gives one BEP. ( )
Cost Revenue, Profit, Loss
(B) Fill in the blanks.
ve
Re
l
ta
To
Profit
e
nu
al
Tot
P
In linear revenue and cost function area
before BEP is ——— (profit/Loss)
(2)
With an increases in production, total cost
and total revenue ——— (increase /
decrease)
(3)
If total variable cost is deducted from sales
price, then the remainder is called ———
(4)
If price is constant, then total revenue
function is ———— (linear / non-linear)
t
Cos
Loss
0
(1)
X
M
Production
9.2.2 Break-even Point :
Explanation
Fig. 9.1 : BEP : Linear Function
BEP can be explained using two methods.
Y
Cost Revenue, Profit, Loss
BEP
Physical Units
Value of Sales
Total Cost
P2
P1
Total Revenue
0
M
N
X
When an organization produces and sales
just one product, then showing BEP through
physical units is easy. As more products are
produced in multiproduct organization it becomes
difficult to show BEP through physical units. In
such a case it is easier to show it through the
second method of value of sales.
We will understand the above two
methods with the help of examples.
Production
Fig. 9.2 : BEP : Non-Linear Function
• Cost and revenue function are non-linear
•
P1 and P2 are two BEPs
•
Left of P1 and right of P2 is loss and P1
to P2 is profit
(a) Physical Units
Production level, selling of which gives an
earning equal to total, fixed and total variable
costs is BEP level of production.
These physical units (production) can be
explained with the help of the following formula:
Questions for Self Study - 1
BEP Production (Physical Units)
(A) State whether the following
statements are true or false. Put ( )
or () in brackets.
BEP 
(1)
At BEP, total cost and total revenue are
equal. ( )
(2)
Every organization final aim is to attain
BEP. ( )
(3)
Non-Linear cost and revenue function
gives two BEP. ( )
Total Fixed Costs
Pr ice  Average Variable Costs
For example
Let us consider that an organization
produces only one product and its fixed and
variable costs are :
Markets and Price Determination : 65
Total fixed cost Rs. 40,000/-
 Selling price would be
Average variable cost Rs. 10/BEP selling price 
Price Rs.20/In this situation, with the help of the above
formula, the BEP production (physical unit)
would be :
BEP 
Total Fixed Costs
Pr ice  Average Variable Costs
40,000
1
2
= 80,000
This means organization gets Rs.80,000
after selling its BEP production. At this time, its
total cost is also equal to Rs.80,000. That is why
Rs.80,000 is BEP selling price.
From the above explanation, we have
understand how BEP is calculated by using two
different methods.
40,000
BEP 
20  10
BEP 

40,000
10
1
20
40,000
10
= 4,000 units
Y
At this level of production, the organization has
zero profits. This can be proved as follows :
Total revenue = Total Cost
 Total units x price = Total fixed cost
+ Total Variable Cost
Total
80,000
Revenue
BEP
ue
en
ev
R
t al
To fit ost
P P ro l C
ta
To
Variable
Cost
60,000
 4,000 x 20= (Rs.40,000) + (4,000 x 10)
Total
Cost
40,000
 Rs. 80,000 = Rs.80,000
 Total Profit = 0
30,000
In brief :
Fixed
Cost
Loss
20,000
BEP (physical units) production = Total
Cost. This is the situation and at this point,
organization profit is zero.
0
1000
2000
3000
Production
4000
X
Fig. BEP Production Level
(b) Value of Sales
• Price = Rs.20.
To decide BEP for multi-product
organizations, this second method is used rather
than the first one. According to this method, the
formula to calculated BEP is as follows :
Total Fixed Costs
BEP (Selling Price) 
Average Variable Costs
1
Pr ice
Now, we will see what is the BEP by
taking the same figures from the previous
example. We will first arrange the cost and price
structure.
Total fixed cost = Rs. 40,000
Average variable cost = Rs.10
Price = Rs.20
• Total fixed cost = Rs.40,000.
• Average variable cost = Rs.10.
• ‘P’ is BEP, at this point
• A - production
= 4,000 units
• B = Selling price
= 4,000 x 20
= Rs. 80,000
• Left to ‘P’ is loss, while right to ‘P’ is
profit.
Contribution
While studying BEP concept, we come
across the term contribution very offen. One
needs to understand the concept of contribution
to determine how would fixed and variable costs
Markets and Price Determination : 66
The amount which remains after
deducting variable costs from value of sales
is called contribution. It is the ratio between
total sales and balance amount after
deducting total revenue from total variable
cost.
After deducting fixed costs from
contribution profit stats to occur. That’s why the
concept of contribution is important in decision
making. In short,
Y
Total Cost Revenue
be recovered and when would the firms start
earning profit.
ta l
To
Profit
BEP
80,000
Contri
40,000
Loss
Similarly,
Contribution Ratio

Total Revenue  Total Variable Cost
Total Sales
Contribution Ratio (per unit)

Price  Average Variable Cost
Price
Diagrammatic Explanation of Contribution
In short run, it is important to get the
information of the balance amount of per unit
after deducting average variable cost from price
per unit.
It means, how much is the per unit
contribution (in the previous example, Rs.20-10
=Rs.10 is per unit contribution, this contribution
is ½ of the price).
When would this contribution cover the
fixed costs ?
(In the previous e.g. Rs.40,000 / 10 = 4,000,
so after sale of 4,000 units.)
After covering variable and fixed costs,
when is profit is generated ? In the previous
e.g. total cost is Rs.80,000 and this is all
recovered after the sale of 4,000 units. (4,000
units x Rs.20 = Rs.80,000). From the concept
of contribution many important business
questions are easily answered. How these
question are answered is explained in Fig. 9.4.
al C
Tot
ue
ost
Fixed Cost
co
ble
a ri a
V
l
Tota
Variable
Cost
40,000
A
st
X
Production
Contribution = Total revenue - Total
variable cost
Contribution (per unit) = Price - Average
variable cost
M
n
ve
Re
Fig. 9.4 : Contribution
There would be one difference in Fig. 9.1
and the above diagram. In this fig. TVC is shown
from origin and the straight line. Above that is
total cost. Total cost curve consists of both fixed
cost and variable cost.
With an increase in units, contribution also
increases. First, variable costs are covered, then
fixed costs are covered and finally, BEP is
reached. In Fig. 9.4, by selling 4,000 units
Rs.80,000 is received from that total cost of
Rs.80,000 (fixed cost 40,000 and variable cost
40,000) is covered. M is the BEP. After point
‘M’, profit is generated. Hence, in fig. 9.4 the
concept of contribution is easily explained.
If an organization wants to receive some
particular percentage of profit, then how many
units have to be sold can be determined with
the help of contribution. This can be explained
with the help of an example.
Example
We will assume that fixed cost of a
particular production process is Rs.40,000, AVC
Rs. 10 and price Rs.20. In this example
contribution per unit is Rs. 10 and it is ½ the
price, which we have already seen earlier.
Similarly, we have also seen that BEP is achieved
after selling 4,000 units and at that time revenue
is 80,000
Now, if this organization has to get at least
25% profit, then how many units have to be sold,
will be explained through the concept of
contribution.
Markets and Price Determination : 67
X = unit sold to get expected profit.
Fixed Cost  Expected Profit
Per Unit Contributi on
Now, X =


(B) The price of a product is Rs.14,
variable cost is Rs.4/- unit and fixed
cost is Rs.80,000.
X
X
=
4 0 , 000  0.25 (20 X)
10
=
4 0 , 000  5X
10
 10X = 40,000 + 5X
 5X = 40,000

X = 8,000 units
From this, the organization which wants
25% profits has to sale 8,000 units. Its explanation
is given below :
Particulars
Rs. Units
%
Total
revenue
Less TVC
1,60,000 8000 x 20
(price)
- 80,000 8000 x 10
100
- 50
(AVC)
Contribution
Less FC
Net Profit
80,000
50
- 40,000
25
40,000
25
Questions for Self Study - 2
(A) Fill in the Blank.
(1) BEP (Units) 
Total F.C.
- - - - - - AVC
(total revenue, price)
(2) BEP (Units) 
Total F.C.
AVC
----- Price
(1, total revenue)
(3)
Contribution = Total value of sale …………. (TFC, TVC)
(4)
Contribution ratio = Proportion of x
Contribution to ——— (Total sales, TC)
(5)
If fixed and variable costs increase then
contribution ratio ———— (rises, falls)
(6)
If sales volumes increase then BEP ——
(is affected / remains unaffected)
(1)
BEP production ?
(2)
How much will be the profit if 80,000 units
are sold?
(3)
How many unit should be sold to get
Rs.80,000 profit?
(C) Following are the detailes of a firm
producing toys :
Fixed cost Rs. 40,000
AVC Rs.1
Price Rs. 2
(1) BEP production ?
(2) If price is Rs.1.50, then what would be
BEP production?
(3) If price is Rs.3, then what would be BEP
production?
(4) To get Rs. 10,000 profit, how many units
will have to be sold?
9.2.3 Break-even Point :
Importance
BEP has an important position in decision
making process of any organization. Now we
will analyse how it is used in day to day business,
expansion, sales and profit maximization or any
other decision making process in an organization.
(1) Important Position in Organization
Decision Making Process
Upto what extent the increase or decrease
in production and sales is to be done could be
decided through BEP.
After deciding the BEP production, upto
what extent the sales are to be brought down
could be judged. What is the proportion of profit
to production? and sales can also be judged
through this concept. Margin of safety can be
explained using the following formula.
Margin of Safety
Actual Production - BEP Production

 100
Actual Production
For example
If Actual production = 6000 units
BEP production = 4,000 units
Then, according to the above formula
Markets and Price Determination : 68
6000 - 4000
100
Margin of Safety =
6000
=
2000
 100
6000
= 33.33 %
This means, in future even if the sales get
reduced to 33.33 % of the present sales, there
would be no loss. If the above answer is
negative, then the organization will have to
increase the sales. Then only loss will be
recovered. How much should the sale be
increased is also answered by BEP.
(2) Components of Product
Many a times, through BEP, an
organization can take decisions on whether to
produce the components used for the product
or to buy then from outside.
For example, a medicine company has to
buy bottles worth Re.1. If that company has to
produce the bottles, given that its fixed cost
would be Rs.30,000 and variable cost (per units)
Re.0.50, then the company will have to determine
the BEP production first. According to the
formula, BEP production would be :
BEP Production =
=
intensive technology. Technology involving
greater fixed cost and less variable cost is capital
intensive technology. In labour intensive
technology the BEP can be attained at lower
levels of output while in the capital intensive
techniques it would be at higher levels of output.
In capital intensive technique the level of profit
recorded is high beyond a certain level of output.
When demand for product is less labour intensive
technology is suitable, but when demand for a
product is high, it is the capital intensive
technology that proves to be profitable. This can
be explained using an example.
Price of a
Good
TFC (Rs.)
AVC (Rs.)
Capital
Intensive
Technology
(B)
10
10,000
5
10
40,000
2
TFC
TFC
Price - AVC Price - AVC
Break Even
(Output)
Profit (per
10,000)
Fixed Costs
Pr ice  AVC
30,000
1  0.50
Labour
Intensive
Technology
(A)
10,000
10 - 5
40,000
10 - 2
= 2000 units
TR – TC
1,00,000
- 60,000
= 40,000/-
= 5000 units
TR – TC
1,00,000
- 60,000
= 40,000/-
Conclusions
(a)
Labour intensive technique pays more
profit if production is between 2,000 and
10,000 units.
(b)
At 10,000 units of output both the
techniques yield the same profit.
(c)
Beyond 10,000 units of output the capital
intensive technique start yielding larger
profit. So if the demand for a product is up
to 10,000 units labour intensive technique
is suitable and beyond 10,000 units the
capital intensive technique.
= 15,000 units
If the company’s requirement is less than
15,000 units then producing the bottle in a house
would not be profitable, as there would be loss
if production is below 15,000. If the requirement
is more than 15,000 then being profitable it would
be beneficial to produce.
(3) Choice of Technology
When a product can be made with the help
of two technologies, then it has to be decided
which technology to use. Where there is less
fixed cost and more variable cost, then it is labour
(4) Place of the Product
There are firms that produce a variety of
products. They have their main product and their
other products are sub products. The break-
Markets and Price Determination : 69
even analysis enables the firms to determine the
proportion of the main and its sub products in
total production of the firm. To attain a certain
level of profit, the level of their output to be
produced and the price to be fixed, can also be
determined.
(5) Sales Cost
Firms can increase their sales by spending
some money on advertisement. The analysis of
break-even can enable us to understand the
correlation between amount of money spent on
advertisement and the proportionate rise in sales
of that product. We can arrive at an answer by
considering advertisement expenditure as fixed
expenditure. eg. A toothpaste is for Rs 10/-.
The fixed cost for its production is Rs 1,00,000/
-. The Average cost is Rs 2/-. The break-even
would be 12,500 units of toothpaste. Let us solve
it,
Break Even =
TFC
1,00,000

 12,500 units
Pr ice  AC
10  2
If the firm increase the advertisement
expenditure to Rs 20,000/- then the new
breakeven would be 15,000 units.
(7) Standard and Price of the Products
The expected sales of a product would be
considered by a firm while determining the price
and quality of the product. The use of breakeven can be made better by either raising the
price of that product or by reducing its variable
cost. The firms may pay less to the workers or
even use raw material of low quality in the
bargain to reduce its loss.
The use of break-even can be made in
other areas also. The impact of changes in sales
on profit can be determined using this. The
impact of different levels of output on profit can
also be gauaged. To earn a certain level of profit
or to earn a specific return on investment, what
should be a corresponding level of output and
sales this can be determined. The forecast
pertaining to optimum sales volume can be
made. The impact of depressed market
conditions on sales can be studied and
understood. One can experience the impact of
changes in fixed and variable cost on levels of
profit. The use of optimum level of production
and its relationship with profit can be judged.
The break-even analysis, in a nutshell, is useful
from various point of view.
Questions for Self Study - 3
Break Even =
1,00,000 20,000 1,20,000

 15,000 units
10 - 2
8
The conclusion is if a firm could sale more
than 2,500 units of toothpaste, the firm can
recover its advertisement cost and would hence
be supported.
(A) State whether the following
statements are true or false. Put ()
or () in brackets.
(1)
On determining the level of production,
break-even can help one to understand
the level to which sales may be brought
down.( )
(2)
Every firm benefits by producing the
required spare parts on its own.( )
(3)
In labour intensive method the break-even
is attained at low level of output while
in capital intensive at high levels of
output. ( )
(4)
Break even analysis is not useful for multiproduct firms. ( )
(5)
Since the demand for a product is always
stable the firms may not have to decide
price of the product and its quality. ( )
(6) Planning of Production
The use of break-even is essential from
the view point of determining what to produce
and how much. If a single production process
can produce three to four different products,
then finding the price and average cost of each
of these products can be found out and so could
the break-even be. On the basis of the same
demand for a product and its profits can enable
one to decide upon which among this group of
three or four products should be produced on
priority.
Markets and Price Determination : 70
(B)
9.3 Words and their
Meanings
(1)
Break-even Production
=
TFC
Price - AVC
=
80,000 80,000

 8,000
14  4
10
Total Revenue : Price X Quantity sold.
Total Cost : Average cost X Output produced.
Total Revenue Function : A relationship
between TR and the change in number of
units sold.
Total Cost Function : Relationship between
TC and the change in number of goods
produced.
Profit Loss : Profit = TR-TC (where TR>
TC)
(2)
= (80,000 X 14)- 80,000-(80,000 X 4)
= (11 20,000) - 80,000 - 3,20,000
= 7,20,000.
(3)
=
80,000  80,000
14  4
=
1,60,000
10
= 16,000 units
(C)
(1) No Profit no loss (Break-even) Production
Contribution is defined as the difference
between the sales price and the
variable cost : The fixed cost is
recovered, from this contribution and once
the fixed cost is recovered, firms start
getting profits.
Linear and Non-Linear Function: A straight
line relationship is linear while the one
expressed through a curve is non-linear.
Expected Sales =
Fixed Cost  Expected Profit
Contribution
Loss : TR-TC (where TR <TC).
No Profit No Loss or Break-Even Point:
It’s a point where the total cost incurred
on producing a certain level of output is
exactly equivalent to the total income
earned by sale of that output produced.
The corresponding level of output where
TR=TC is called the break-even output.
At this level of output the net income of
the firm is zero.
Profit = TR - TFC - TVC
(2)
=
Fixed Cost
Pr ice  AVC
=
40,000
Rs.2  Rs.1 = 40,000 units
If price is Rs 1.50/- the break-even
production would be
40,000
40,000

1.5  1 0.50 paise = 80,000 units
9.4 Answers to Questions
for Self Study
(3)
40,000 40,000

= 20,000 units
31
2
Questions for Self Study - 1
(A) (1) (), (2) (), (3) (), (4) ().
(B) (1) Loss, (2) increase, (3) contribution,
(4) Linear.
If price is 3- break-even production would
be.
(4)
Expected sales
=
Fixed Cost  Expected Pr ofit
Contributi on
=
40,000 50,000

2 1
1
Questions for Self Study - 2
(A) (1) Price, (2) One, (3) TVC, (4) total sales,
(5) falls, (6) Remains unaffected.
= 50,000 units
Markets and Price Determination : 71
Questions for Self Study - 3
 Pr oportionation of Contribution 


  Total Value of Sales  TVC 


Total Value of Sales


(A) (1) (), (2) (), (3) (), (4) (), (5) ().
9.5 Summary
There are various objections that the firms
may cherish but the most important and final
objective is making profit. Before the firms attain
this objective they have to cross the basic step
of break-even point. Once the firms overcome
this step they can increase their sales and
production to maximise their profit in the long
run. A point of no profit no loss corresponds to
that level of output where the total revenue
equals to the total cost for the concerned firm.
No profit no loss analysis is dependent on
many assumptions. The most suitable analysis
is one which consider the price and the average
cost to be constant. The total cost and revenue
function with such an assumption is linear and
hence we obtain a single break-even point. If
any of these two functions is non-linear we get
two points of break-even. Profit in this case
ranges between these two points and beyond
the second point loss is incurred.
Concept of Contribution is important in
the break-even analysis. Contribution is the
difference between the sales prices and the
variable cost. The production of this contribution
to total sales is called the proportion of
contribution. Once the firms recover the variable
cost first and later the fixed cost from
contribution, they start realising profit.
The use of break-even analysis in decision
making is enormous. This analysis enables:
(1)
To identify safe level of production. It also
help to find the level of possible fall in sales
without the firm having to incur losses.
(2)
To survey of the firm should itself produce
the spares or other small inputs required
in the process of production.
(3)
To choose the best technique of production.
(4)
Firms producing multiple products,
determine production levels of main and
sub products as a percentage of total
output (production) of the firm.
(5)
To identify, if the rise in profits be attained
by increasing advertisement and other
sales costs.
(6)
To find what output to be produced the
most from out of the group of products, if
the machine can produce more than one
product.
(7)
Determine the changes in price of the
product, changes in quality of the product,
as to increase and materialize the expected
sales.
Break-even analysis can be explained via
2 methods:
(a)
(b)
By way of quantity of output needed to
be sold:
By value of sales method. There are 2
formula evolved. They are
TFC
(a) Break-even output =
Pr ice  AVC
OR
=
TFC
Per Unit Contribution
TFC
(b) Break Even Sales 
AVC
1
Pr ice
OR
=
AFC
Pr oportionation of Contribution
The Break even analysis is subject to
limitations as it is based on certain assumptions.
But still the analysis is useful to many .The
graphs explaining the break-even analysis are
not only useful in understanding levels of profit
or loss, but they enable profit planning as well.
This is a very handy and useful tool of decision
making for individuals and firms.
Markets and Price Determination : 72
9.6 Exercises
(1)
(2)
(3)
(4)
(5)
What is Break-even ? Explain BEP using
formula.
What is contribution explain using
examples.
Explain the practical relevance of breakeven using examples.
Price of a good produced in a factory is
Rs. 120/- AVC is Rs 30 and the fixed cost
is Rs. 54,000. Using production and value
of sales method explain the break Even
point.
In the Example above of
(i) Price changes to Rs. 150/(ii) Fixed cost reduces to Rs. 48,000/(iii) AVC falls to Rs.24, then what
changes do you expect in answer to
question 4.
calculate the BEP find out what output is the
break-even output and find out its sales price.
Find out the actual production and actual price
to arrive at the profit of those producers.
Graphically plot the information collected
separately from the three people mentioned
above.
The conclusions drawn by you may be
shown to the concerned and their opinion can
be obtained.
9.8 Books for Further
Reading
(1)
Dean Joel, Managerial Economics, New
Delhi, Prentice hall of India Pvt.Ltd.
(1987)PP-326-41.
(2)
Verma J. C., Managerial Economics,
New Delhi, Deep and Deep Publications,
(1988) Break-even Analysis, PP-128-37.
(3)
Dufty, Norman F. Managerial
Economics, Asia Publishing House, (1966)
Break-even Analysis, 83-103.
9.7 Field Work
From your familiar farmer, industrialists
and trader find out the information about their
business and the other information required to
Markets and Price Determination : 73
Unit 10 : Supply
Index
10.0 Objectives
10.1 Introduction
10.2 Subject Description
10.2.1 Meaning and Law of Supply
10.2.2 Elasticity of Supply
10.2.3 Factors Determining the Elasticity
of Supply
10.2.4 Elasticity of Supply : Practical
Significance
10.3 Words and their Meanings
10.4 Answers to Questions for Self Study
10.5 Summary
10.6 Exercises
10.7 Field Work
10.8 Books for Further Reading
10.0 Objectives
After studying this unit, you will be able to :

Explain the concept of supply.

Understand and explain the law of supply.

Explain the concept of elasticity of supply.

Illustrate the types of elasticity of supply.

Express the factors determining elasticity
of supply.

Prove the importance of elasticity of
supply in practical life.
10.1 Introduction
Price of a product is decided by its demand
and supply. There is an inverse relationship
between price of a product and its demand. But
the price of a product and its supply has direct
relation. Because ensuring maximum profit is
any producers main aim. That’s why as soon as
there is increase in demand, producers try to
increase the supply. But it is not necessary that
supply can always be increased with increase
in demand. To increase supply, all the
components of production need to be assembled.
Production process needs to be completed and
only after that the production and supply from it
can be increased. It does not mean that if a
product is produced then there is a supply. A
producer does not offer all of the production for
supply in the market. Some portion is stocked
and hence there is difference observed in stock
and supply. Time factor has an impact over the
supply. In short run, supply can’t be increased
or decreased according to the demand whereas
in long run, supply is observed to be elastic.
Apart from this, elasticity of supply is also
dependent upon the business, capital employed,
parallel market, etc. The concept of elasticity
of supply is very important in making decision
with regards to fixation of price, production, tax,
capital support, etc.
In this chapter, we are going to study
supply, rules of supply, concept of elasticity of
supply and the factors on which it depends and
its importance in business.
10.2 Subject Description
We shall study in this topic the supply
schedule, supply curve, expansion and
contraction in supply, etc. The extent of
relationship between price and supply can be
explained using concept of elasticity. The same
is discussed in this topic. The elasticity of supply,
factor affecting the elasticity of supply and short
and long run relevance of elasticity would be
studied in this topic.
Markets and Price Determination : 74
10.2.1 Meaning and Law of Supply
Y
The amount or units of goods a seller is
willing to sell at a given price per unit of
time is called the supply.
In the above definition two things are
important (i) particular time and (ii) particular
price. These two references are important to
understand the concept of supply. If any of these
is not there then in economics, there is no
meaning to the concept of supply. For example,
in vegetable market, if we say that there’s 10
quintal supply of potatoes, then this sentence is
incomplete. Instead on Monday 10 quintal
potatoes are supplied at Rs.4 Kg. is a complete
sentence. Here, time is specified and the price
is also clear.
There are two more important points in
the above sentence. In common parlance, stock
of a particular product or its production per unit
of time is treated as it supply. But a producer
will always bring the whole of the production or
stock in the market, is not necessary. All of the
production and stock will be supplied in the
market, when price suddenly increases. For
example, a farmer has a produced 30 kg of
potatoes of which seller have purchased 20 Kg.
to sell, then stock of potatoes is 20 Kg. If it is
profitable for the sellers to sell only 10 Kg.
potatoes at Rs. 4 per Kg. then they would sell
only 10 kg in the market, hence, in this example
production of potatoes is 30 kg, stock 20 Kg.
and supply is 10 Kg. at Rs. 4 per Kg. In short,
at a particular time, for a price the number of
units brought for sale in the market for selling is
known as supply.
Price (Rs./Kg.)
In economic supply is defined as :
P1
8
6
4
2
A
P
X
5
10
15
20
25
Supply of Jawar (Quintal)
Fig. 10.1 : Supply Curve
Law of Supply
Law of supply explains how the suppliers
change the supply according to the changes in
price. Other things remaining the same, when
price of a product increases, its supply also
increases and vice-versa.
The above statement states the relationship
between price and supply. It is already clear
why this kind of relationship is exists. It is because
of price. That’s why the supplier is encouraged
to supply more. On the contrary, if price
decreases, then profit also decreases or at times,
loss also ocurrs. That’s why supplier reduces
supply when its price falls. Other than price,
there are some other factors which impact
supply. The other things afecting supply are
natural conditions, cost of production, technology
used, govt. policies, law and order situations,
customers income, customers preferences, etc.
If these things are constant, then if price
increases, supply also rises and price decreases
supply falls.
Table 10.1 : Supply
Jawar Price
Total Supply
Rs. / Kg.
(Qtil.)
2
05
4
10
6
15
8
20
Expansion and Contraction - Increase
and Decrease in Supply
Other thing remaining the same, price
increase and supply also rises. This is called as
expansion supply. If supply falls because of
decrease in price, then it is contraction of supply.
Both these changes are shown on the same
supply curve as a movement along the curve.
If other things change, then supply can also
change price remaining constant. If supply
Markets and Price Determination : 75
increases due to other things other than price, it
is “increase” in supply. And if supply decreases
due to other things other than price, it is called
“decrease in supply”. For example, technological
advancement or fall in cost of production cause
supply to increase and vice-versa. Because of
these two changes, there is a shift in the supply
curve. If supply is decreased, then the curve
shifts to the left hand side from its original
position. SS to S2S2 and if it is increased then
the curve shifts to the right hand side of the
original supply curve (SS to S1S1).
The following figure shows the increase
and decrease and expansion contraction.
an
s
io
n
Y
Ex
p
S
ns
io
n
Price
K1
K
a
ntr
Co
K2
on
cti
pa
Ex
S
experienced. For example, In case of perishable
goods, even if their prices fall, they have to be
sold because after some time span their
usefulness is destroyed. Even though there is
rise in prices of agricultural products, supply of
it may not be increased. Because production of
agricultural products totally depends on nature
(i.e. rain, weather, etc.) In short, even though
price rises, it is not possible to supply the product.
If there are chances of shortage of supply of
goods in near future, then sellers will provide
less goods at current prices. Because it will give
them more profit, by selling same goods at higher
prices. Supply of goods which are artistic ancient
and antique cannot be increased even though
prices are rising. Similarly an exceptional
experience is faced in case of labour supply.
Increase in wage rates of labour sould lead to
more supply of labour. Contradictory situations
are seen in under developed nations where
laboures are happy even with low wage rates
and hence prefer less work when wages are
high. They do not wish to earn more money and
to live in better conditions.
Questions for Self Study - 1
X
A
N2
(A) State whether the following
statements are true or false. Put ()
or () in bracket.
N1
N
Supply
Fig. 10.2 (a) : Expansion and Contraction in
Supply
(1)
At particular time for a particular price
the quantity which is ready for sale is called
supply. ( )
(2)
At particular time, the stock of a product
indicates its supply. ( )
(3)
Price increases supply increases and viceversa. ( )
(4)
Changes in supply of commodity is only
because of changes in price. ( )
(5)
Supply curve slopes from left to right. ( )
(6)
Increase and decrease in supply is shown
on the same supply curve. ( )
(7)
If, because of other things and price
remaining constant, supply increases it is
called increase in supply. ( )
(8)
There are some exceptions to increase in
supply because of increase in price and
vice-versa. ( )
S1
In
cr
ea
s
e
S
Price
De
c
re
as
S2
e
Y
S2
S
A
S1
N
N2
Supply
N1
X
Fig. 10.2 (b) : Increase and Decrease in Supply
Obviously, some times price and supply’s
rule has exception. In some exceptional cases,
this relation between price and supply is not
Markets and Price Determination : 76
10.2.2 Elasticity of Supply
Measurement of Elasticity of Supply
Elasticity of supply (EOS) is studied as is
elasticity of demand. The elasticity of supply
explains the magnitude of relationship between
price of commodity and quantity supplied of that
commodity. What is the change in quantity
supplied of a commodity due to change in price
of that commodity is what elasticity of supply
studies. The fall in price of a product does not
bring a proportionate fall in the quantity supplied
of that commodity and hence knowing how
much do changes in price of a commodity affect
the quantity supplied of that commodity becomes
important.
The equation of elasticity of supply is the
same as the equation of elasticity of demand.
In economic analysis two main types of
elasticity of supply can be seen. They are :
(1)
(2)
Perfectly Elastic Supply : When a small
change in price brings with it a large
(infinite) change in quantity supplied of a
commodity, we say that the supply is
infinitety elastic or perfectly elastic. The
supply curve in this case is a straight line
parallel to X axis.
Perfectly Inelastic Supply : When any
change in price of a commodity leaves no
impact on the supply of that commodity,
supply is perfectly inelastic. It is said that
elasticity is equal to zero in this case and
the supply curve is parallel to Y axis.
Between these two extremes there are
other responses given by QSx to changes in Px.
They could be either elastic or inelastic. These
charges in QSx could be either more or less in
terms of the changes in price of X. The concept
of supply elasticity is not as important as is the
concept of demand elasticity; this is because
the elasticity of demand is related to total
earnings of the firm. The unit elasticity of
demand leaves the consumption expenditure of
a buyer on that commodity unchanged. In case
of elasticity of supply unit elasticity does not carry
any significance economics.
%  in Qs x
%  in Px
Let us understand the same using an
example.
Px
Qs x
10
10,000
12
15,000
The rise in Px by Rs. 2/- leads to a rise in
Qsx by 5,000/- units, from 10,000 to 15,000. the
same can be put in an equation to arrive at the
EOS.
EOS =
%  in Qs x 50 %

 2.5%
%  in Px
20 %
The EOS in this example is 2.5%. The
equation would give us answers of EOS
fluctuating in various ranges. On the basis of
the same we can arrive at as many as five types
of elasticity.
Y
Price
Types of Elasticity of Supply (Extreme
cases)
EOS =
P
S
X
0
Supply
Fig. 10.3 : Perfectly elastic supply (E = )
Markets and Price Determination : 77
Perfectly elastic supply (E = )
Infinite units of X are supplied at the
current market price.
Y
S
Y
Price
P2
P1
Price
P2
X
0
P1
Q1
Q2
Supply
Fig. 10.6 : Relatively Inelastic Supply (E < 1)
X
0
Q1
Q2
Supply
Relatively Inelastic Supply : (E < 1)
Fig. 10.4 : Relative Elasticity of supply ( E > 1)
Relatively elastic supply : ( E > 1)
The proportionate change in price is less
than the proportionate change in Qsx.
Y
The percentage change in P x is greater
than percentage change in Qsx. E<1
Figures from 10.3 to 10.7 shows a linear
supply curve but in 10.8 one can see a nonlinear supply curve. Elasticity of non-linear
supply curve can be obtained by drawing a line
from origin on the supply curve. At the point of
tangency the elasticity of supply can be found
using the same formula.
Y
S
P2
P2
Price
Price
S
P1
P1
0
X
Q1
Q2
Supply
X
0
Fig. 10.5 : Unit Elastic Supply (E=1)
Q1
Supply
Fig. 10.7 : Perfectly Inelastic Supply (E = 0)
Unit Elastic Supply : (E = 1)
The proportionate change in Px is exactly
equal to proportionate change in Qsx.
Perfectly Inelastic Supply : (E = 0)
The change in price of X leaves no impact
on supply. E = 0
Markets and Price Determination : 78
Y
S
K
10.2.3 Factors Determining
the Elasticity of Supply
G
Factors determining the elasticity of supply
are as follows :
C
L
(1) Time
Price
R
S
Time plays an important role in determining
the quantity supplied of any commodity. Let us
see how elasticity changes with time.
Y
B
(a)
0
X
Q
Supply
Short run is classified into very short run
and short run.
(i)
Very Short Run : (Perfectly inelastic
supply) This is a span where quantity
supplied of any commodity can not be
increased to meet the demand. The
inability to increase production is the
feature of this period. Hence, supply
remains stable. For example, A farmer sells
10 quintals of Jawar in the market. If the
market experiences a rise in price of Jawar
and the farmer earns exorbitant profits yet
he can not earn profit beyond that by
producing more of Jawar as the production
of Jawar requires some time. This is an
example of supply being inelastic in the
very short run. The supply of Jawar
remains stable even if the price of Jawar
is rising in the market. There could be a
rise in supply of Jawar only in the next
season. In case of perishable goods. (e.g.
fruits, vegetables, etc.) the seller has to
sell these goods even at low pries. The
supply price or supply does not depend on
the cost of production of such commodities.
Since the goods are perishable, they are
required to be sold only in the short run.
Hence, supply is perfectly inelastic in the
very short run.
(ii)
Short Run : Inelastic supply : Short run
is a period which offers a reasonably, more
time for production. During short run no
change in cost of production, especially
with reference to the fixed factors, can be
made. But as variable factor changes, it is
possible to make change in variable costs.
There could be a rise in Jawar production
where a farmer may employ more labour
and improved seeds as an effort towards
the same. The short run does not enable
Fig. 10.8 : Elasticity of Supply
In figure 10.8 ‘SS’ is the Supply Curve
with three points ‘Y’, ‘R’ and ‘L’ on it. Three
tangents have been drawn on these three points.
These tangents are shown as QK and OG. The
line tangent to the points mentioned on the supply
curve when meets the ‘X’ axis at the
corresponding point of tangency the elasticity
of supply is less than one (e.g. QK line for point
L on the supply curve). While elasticity of supply
is equal to one at the point when the line of
tangency starts from the origin and tangent to a
point of the supply curve. (e.g. point R on the
supply curve and the line of tangency being OG).
When the line of tangency meets ‘Y’ axis the
point to which it is tangent at that point the
elasticity greater than one. On the basis of this,
we can conclude that the elasticity of supply to
the right of R is less than one and to the left of
R it is greater than one.
Questions for Self Study - 2
Answers in short.
(1)
What do you mean by perfectly elastic
supply?
(2)
What do you mean by elasticity of supply
being zero?
(3)
What is the meaning of elasticity of supply
greater than one?
(4)
What is unit elasticity of supply?
(5)
What do you mean by inelastic supply of
a commodity?
(6)
What do your mean by perfectly inelastic
supply?
Short Run Elasticity
Markets and Price Determination : 79
the farmer to increase the supply of the
product much, hence the supply in the short
run is reasonably inelastic. In such a case
the change in price of a product is grater
than the change in supply of that product.
(b) Long Run : Elastic Supply
There could be a rise in production as
supply of both fixed and variable factor inputs
can be increased in the long run. If the farmers
realize a long run sustainable rise in price of
Jawar then the farmers would produce more of
Jawar by brining more land under Jawar. The
production would be increased by using more
factor inputs in the form of labour, fertilizers,
etc. This makes the supply curve elastic in the
long run.
Let us see how elasticity changes with
time. This is illustrated in Fig. 10.9.
Y
S3
S1
S2
(2) Size of Business
Elasticity of supply also depends on the
size of business. For example, in case of small
scale production the raw material used is less
and is available readily. Hence, the supply of
product by small scale industry is elastic in
nature. In case of large scale business,
increasing the proportion of factor inputs is
difficult and their prices increase substantially,
if their supply is not readily available. This is the
reason why the elasticity of supply of goods
produced by large scale firms is less.
(3) Proportion of Investment
In case of heavy and basic industries the
investment required is large and hence in the
short run these supply can not be increased. The
supply of these goods can be increased in the
long run that too marginally. On the contrary if
the firms use less investment can increase the
supply of goods produced by them much easily
and hence supply of these goods is elastic.
(4) Scarcity of Factor Input
Price
P1
Some of the factor inputs are scare; at
times these factor inputs even do not have
substitutes and to obtain such factor inputs high
price is needed to be paid. The goods produced
from out of such a process of production have
inelastic demand.
P
0
Q
Q1
Q2
X
Supply
Fig. 10.9 : Long Run Elastic Supply

Very short Run : Supply curve S 1
shows that quantity supplied of X remains
OQ at price OP and even OP 1 . This
makes the supply curve parallel to Y axis
and hence called perfectly inelastic.

Short Run : Supply curve S2 reveals that
at a proportionately higher changes in
prices, the quantity supplied changes less
proportionately. This is an inelastic supply
curve.

Long Run : Supply curve S3 shows that
the change in price is less than change in
quantity supplied of X. It is elastic supply
curve
(5) Availability of Multiple Markets
and Variety of Products
When a product commands more than a
market, it can be sold in a dearer market if it is
sold at a less price in any other market. If the
supply of the product can be immediately
adjusted according to the changes in demand
for than commodity, then supply is relatively
elastic. Fashionable and goods having artistic
effects can be produced quickly and supply of
such goods can be increased, as the production
of these good would involve use of limited
investment and techniques. The use of labour
and their skills is more in case of production of
such goods.
(6) Possibility of Change in Techniques
of Production
A business activity that can be shut and
restarted easily, means the factor inputs required
Markets and Price Determination : 80
for such a productive activity are available easily.
In technical terms the labour capital
substitutability is possible and is easy. The supply
of such goods is elastic.
Questions for Self Study - 3
State whether the following statements are
true or false. Put () or () in bracket.
(1)
In very short run supply of products can
not be increased even if its demand and
price are rising. ( )
(2)
In short run ability to increase the quantity
of variable factor inputs enables producers
to produce more. ( )
(3)
Supply of goods in the long run is elastic
as the proportion of variable factors to
fixed factors can be changed in the long
run. ( )
(4)
In case of large scale industry since the
use of factor inputs is on large scale
production can be increased immediately
as demand increases. ( )
(5)
Supply of any product would be elastic if
it has ready substitutes in the market. ( )
(6)
In very short run supply curve is parallel
to Y axis. ( )
10.2.4 Elasticity of Supply :
Practical Significance
The concept of elasticity of supply is useful
in various fields of economic activity. It is useful
in case of the following :
(b) Rise in the Level of Production
The agricultural and other allied products
see fluctuations in its production. The agricultural
production rises or falls depending upon the
rainfall and the available climatic conditions. The
supply of such products is comparatively
inelastic. Hence, even if there is a rise in demand
it is not essential that it would be met with
necessarily. The supply of industrial goods can
be adjusted as per the demand for those
products, which is not true in case of the
agricultural products.
For example, Supply of Food grains,
cotton, sugarcane, etc. can not be as easily
increased as could a supply of radio, television
sets, medicines, chemicals, etc. The supply of
industrial goods can be increased and hence is
elastic.
(c) Imposition of Taxes
Elasticity of demand and supply both play
an important role in determination of imposition
of taxes. If supply for a product is inelastic
increased levy of taxes on such commodities
would not have an adverse effect on their
production.
For example, production of food grains,
fruits, milk, vegetables can not be reduced in
the short run even if higher levels of taxes are
imposed on them. This is because production is
constant in nature which means supply is also
fixed means fixed in nature. The rise in tax rates
on such products would lead to rise in price of
such products leading to a corresponding falls
in demand for such products resulting in a fall in
production and thereby supply of such products
in the long run.
(a) Price of a Commodity
Price of a commodity is determined not
only by its demand and supply but also by the
elasticity of demand and supply. In short run
supply is less and is inelastic. The rise in demand
hence leads to rise in price. This leads to a rise
in profit levels of people, requiring producers to
produce more of that product. The rise in
production leads to an increased supply and a
corresponding fall in price. The scarcity of some
of the factors of production does not enable
supply of some of the products to increase even
in the long run. In such a case price instead of
falling in the long run in fact rises.
(d) Tax Burden
Like tax levying, the sharing of tax burden
is also linked with elasticity of demand and
supply. By and large the burden of indirect taxes
on goods is shared by consumers and sellers.
How much tax burden would a buyer share
depends upon the elasticity of demand for the
product. If demand is inelastic the tax burden
borne by the buyer is large. It would be less if
demand is elastic. Like demand elasticity, supply
elasticity is also important in determining the tax
sharing between buyers and sellers. In case of
commodities whose supply is inelastic (that can
Markets and Price Determination : 81
not be changed in the short run), the excess
burden of taxes has to be borne by the sellers.
Especially in case of the perishable goods the
sellers have to be ready to bear the entire burden
of taxes. This is because taxes if are transferred
to the buyers, it leads to rise in their prices which
leads to a fall in demand for these (perishable)
products and hence the suppliers have to be
ready to bear the entire burden of taxes. But in
the long run the elasticity of supply is high and
hence the suppliers can push (transfer) some
burden on to the buyers.
(2)
(e) Financial Assistance
(6)
The Govt. offers financial assistance to
both business class and general public so that
they get these commodities at a reasonable price.
It is called subsidy. Subsidy is made available
for a particular good or for a group of particular
good. The financial assistance makes these
goods available to consumers at a reasonable
rate. This increases the demand for these
products, enabling the rise in products and
employment. The Govt. usually helps the primary
sector of the economy for purchase of
equipments to and other raw material. In the
long run the present supply of primary products
becomes elastic. In a nutshell, commodities
whose supply is elastic, if such products are
given subsidy to , then such a financial assistance
leads to a fall in their price leading to a rise in
demand. The rise in demand along with elastic
supply leads to rise in production.
(f) International Trade
A nation can earn foreign exchange via
international trade. Controlling imports and
export promotion is always a policy of a nation.
Commodities that have demand from abroad and
the commodities whose internal supply is elastic,
such commodities can be exported by providing
export incentives. This will help nation to attain
equilibrium in Balance of Payments.
Questions for Self Study - 4
(3)
(4)
(5)
10.3 Words and their
Meanings
Supply : The units or goods made available for
sale by the suppliers per unit of time is
supply.
Law of Supply : Other things remaining the
same, rise in price of a commodity leads
to a rise in supply of that producer and fall
in price leads to fall in quantity supplied of
that product.
10.4 Answers to Questions
for Self Study
Questions for Self Study - 1
(1) (), (2) (),(3) (),(4) (),(5) (),(6) (),
(7) (), (8) ()
Questions for Self Study - 2
(1)
When a small change in price brings a
very large or infinite change in quantity
supplied, we say it is perfectly elastic
supply. The supply curve in such a case in
parallel to X axis.
(2)
When any change in price whether rise
or fall does not bring with it any change in
quantity supplied of a commodity. We say
State whether the following statements are
true or false. Put () or () in bracket.
(1)
Price of a commodity is determined by
demand for and supply of a product and
also by the demand and supply elasticity
of these products. ( )
Commodities whose supply is inelastic,
such commodities would not experience a
fall in production even if taxes are imposed
on them. ( )
Commodities whose supply is elastic
would experience a rise in price on
imposition of taxes on them. ( )
The consumers bear a large tax burden if
an indirect tax is imposed and demand for
such commodities is inelastic. ( )
Commodities whose supply is inelastic in
such case the suppliers have to share a
large tax burden. ( )
Subsidies enable the producer to make
commodities available at a less price. ( )
Markets and Price Determination : 82
it is perfectly inelastic supply. Supply curve
in this case in parallel to Y axis.
(3)
When the proportionate change in quantity
supplied is greater than the proportionate
change in price of that commodity, the
supply is relationally elastic. This is shown
as es>1. Supply elasticity in this case is
greater than one.
(4)
When the proportionate change in quantity
supplied is exactly equal to the changes in
price of that commodity, the supply
elasticity is unitary. It is represented as
es=1.
(5)
When the proportionate change in quantity
supplied of a commodity is less than the
proportionate change in price of that
commodity, the supply is relatively inelastic.
This is shown as es<1.
(6)
When price changes leave no impact on
quantity supplied of commodity, we say
supply is perfectly inelastic. The elasticity
of supply is zero in this case.
Questions for Self Study- 3
(1) (), (2) (), (3) (), (4) (), (5) (), (6) ()
Questions for Self Study - 4
(1) (), (2) (),(3) (),(4) (),(5) (), (6) ()
10.5 Summary
We have studied supply, theory of supply
and elasticity of supply in this unit. the units of
commodity and suppliers are willing to supply in
the market at a given price, per unit of time is
called supply. Stock at a given point of time and
total production does not mean supply.
The law of supply states that other things
being constant as the price of any commodity
rises its supply also rise and falls when price
falls. Leaving few exceptions the supply curve
is an upward sloping curve. When changes in
quantity supplied of a commodity occur only as
a result of change in price of that commodity
such changes are called expansion and
contraction in supply, but when changes in
quantity supplied of a commodity occur not due
to changes in its price but due to changes in
other factors determining supply, the
corresponding rise or fall in supply is called
increase and decrease in supply.
The proportionate changes occurring in
quantity supplied of a commodity due to changes
in their prices are recorded under the concept
of elasticity of supply. While law of supply tells
us the direction of relationship between Qsx and
Px, the elasticity of supply tells as the extent
(degree) of relationship between the two. The
percentage change in price of a commodity
would tells us the percentage change in quantity
supplied of that commodity.
In elasticity of supply could be infinite,
zero, one or between zero and infinity. In reality
we find elasticity of supply ranging between
greater than and less than one.
In short run the elasticity of supply is less.
But in the long run use of appropriate technology,
changed techniques of production would help
one to increase supply. Hence the elasticity of
supply is high in the long run. Considering the
elasticity in these two different periods in useful.
Like period, size of business also
determines the elasticity of supply. The size of
business, capital invested, use of scarce raw
material, availability of alternative markets,
variety in production, possibility of changing
techniques of production all these factors affect
the elasticity of supply.
The entrepreneur while taking their
business decisions and Govt. while determining
their economic policies have to take elasticity
of supply into consideration. Price of commodity,
levying of taxes, distribution of tax burden,
policies relating to economic assistance and
policies regarding international business, etc. in
determining these concept of elasticity times
useful.
10.6 Exercises
(1)
Total production, stock and supply distinguish between these three.
(2)
Explain the law of supply.
(3)
How is the elasticity of supply measured?
Explain in details.
Markets and Price Determination : 83
(4)
Explain various types of elasticity using
diagram.
(5)
Explain the factors determining the
elasticity of supply.
(6)
What is short and long run elasticity of
supply?
(7)
In case of the following commodities,
would the supply be elastic or inelastic;
explain with reasons.
(a) Milk, (2) Vegetables, (3) Eggs, (4) Rice,
Wheat, (5) Plastic toys, (6) Services of
efficient doctors, (7) Books and note
books, (8) Excellent singer, artist or
instrumentalist, (9) Currency notes.
(8)
Explain the elasticity of supply
Price (Rs.)
Supply (quantity)
3
32,000
4
40,000
supply of these commodities. Obtain figures from
the shop keeper pertaining to individual
commodities. See if the law of supply is proved
from such obtained data. If no, then find out the
reasons why is it not the case. Calculate the
elasticity of supply.
10.8 Books for Further
Reading
(1)
Desai, Joshi, Economic Analysis (PartI, Micro), Pune, Nirali Publication (1985),
Topic 7, Pages-169-171.
(2)
Samuelson, P. A., Economics, McGraw
Hill, (10th Edn.), Chapter 20 A, PP 38188.
(3)
Anderson,
Putallaz,
Shepherd,
Economics, Prentice Hall, (1983), Chapter
4, PP 75-78.
(4)
McConnel & Gupta, Economics, TataMcGraw Hill, 1977 (Reprinted), Chapter
8, PP. 142-48.
(5)
Stilwell, J. A. and Lipsey R. G. Work
Book, Second Edn. 1971, ELBS, Chapters
8 and 10, PP. 25-30 and 36-43.
Assume original price as Rs. 3 and supply
as 32,000 units.
10.7 Field Work
Go to the nearest shop and find, how
changes in prices of the commodities affect the
Markets and Price Determination : 84
Unit 11 : Market Conditions and Price-Output
Decisions
Index
11.0 Objectives
11.1 Introduction
11.2 Subject Description
11.3
11.4
11.5
11.6
11.7
11.8
11.2.1 Factors Affecting Prices of Goods
11.2.2 Objectives of Firms
11.2.3 Classification of the Market
Structure
11.2.4 Factors Determining the Nature of
Competition in the Market
11.2.5 Entrance of the Firms in the Market
: Obstacles
11.2.6 Importance of Government Policy
in Industrial Development
Words and their Meanings
Answers to Questions for Self Study
Summary
Exercises
Field Work
Books for Further Reading
11.0 Objectives
After studying this unit, you will be able to
explain the :
 Factors affecting price of goods.
 Objectives of the firms.
 Obstacles in the way of entry of firms into
the market.
 Importance of government policy in
industrial development.
11.1 Introduction
Producer not only has to decide what to
produce but he also need to decide the price of
these goods. The objective of the producer in
fixing prices is to recover the cost of production
with a reasonable profit. The producer also
needs to take into consideration the number of
competing firms, their level of production, their
price policies etc. Determining the price of ones
output cannot be an independent decision of the
producer. The government policies also affect
the determination of prices of goods.
Earning profit is the objective of every
firm: but that is not the only objective. The firms
operate with many other objectives to attain.
The other objectives of the firm include sales
maximization, market leadership, creating
credibility in the market etc. The nature and
process of the decisions of the entrepreneurs is
in accordance with the objectives of the firm.
The market structure plays a very
important role in determination of output and
prices. In perfectly competitive market since the
number of buyer and sellers is very large, the
firms have to be price takers. In monopoly
producer can determine prices of his products
independently. In practice we see imperfect
competition. A producer enjoys monopoly for
his products confined to only a certain group of
his customers but at the same time he has to
compete with the other producing substitutes to
his products. There are numerous factors
affecting competition in the market. e.g. The
number of buyers, the nature of production or
product, the nature of production process etc. A
Firm may not be able to enter the market simply
because its objective is to make maximum profit
and the actual profit levels in the market are
also high. There are some internal obstacles in
the market. The government policies of any
nation affect the industrial development of the
concerned nation.
In the unit we shall be studying the factors
affecting process of goods, objectives of firms,
market structures, obstacles faced by the firms
while entering the markets and the importance
of the government policies in industrial
development.
Markets and Price Determination : 85
11.2 Subject Description
11.2.1 Factors Affecting Prices of
Goods
The most important thing in managerial
economics is taking appropriate decision
regarding price and output. Once what to
produce is decided the decisions regarding
howand where to sell that output , what should
be the price of the output, what should be the
commission to sellers and discount to buyers etc
are needed to be taken by the managers.
What factors would a manager consider
while deciding what to produce? The traditional
economic analysis offers a very simple answer
to this. A firm should produce that good which
has a market demand. Price of any product is
determined by the equilibrium between demand
and supply in the market. Market face scarcity
of a particular good if supply of that good does
not increase with increase in demand. This
increase the price of the product. The profit of
the producer producing this good would
increase. It is obvious that the producers would
produce that commodity which yields him the
maximum profit.
The producer need not take a decision
pertaining to prices as price depends on the
overall market for i.e. demand for and supply of
a particular commodity. The equiliburium
between demand for supply of commodity
determine prices in the market. The producers
should produce the goods and operate in the
market if the prevailing market price is
acceptable to them. If the existing market prices
are incapable to cover the producers cost of
production, the producer should quit the market.
This explanation is on the assumption that
there are large number of firms producing
homogeneous goods with the objective of
making profits in a perfectly competitive market.
The nature of competition in the real world
is different. The firms have expanded
themselves their ownership is with the equity
shareholders and the management with the
managers. A single firm is producing various
products and is into various businesses. By and
large the markets are controlled by sellers and
producers. The objective of profit has reduced
in importance and the objectives of the firms
have also changed. Hence today’s firms are not
price takers, they can determine their own
prices. But while determining these prices the
firms need to determine the quality of the
product, its cost, number of compecting firms,
nature of production, possibility of new entrants,
government policy etc. Let us discuss some of
them now.
(a) Scale of Production and Cost of
Production
As the firms expand they experience
increasing marginal productivity which results
in fall in average cost of production. To establish
itself in the market or due to the reducing average
cost the firms reduce prices thereby trying to
generate a greater consumer base.
But reducing price is not beneficial from
the viewpoint of a firm as the buyers feel low
priced products are low in quality as well.
Similarly the buyers may postpone their
consumption on the assumption that the prices
would fall further in future. The production
receives a set back in the sense that there is no
adequate demand for the same. To avoid this
risk the producer pays more commission to the
sellers and increase sales thereby. The producer
inplace of giving price concessions, offers free
goods on the sale of his product and reduces
price indirectly. The average revenue to the
producer due to concessions, discounts, free
gifts, falls. The producer does not have to incure
losses as the AC (Avg. Cost) falls with a rise in
production. So even if AR (Avg. Revenue) is
falling, falling AC would not affect the producers
interest.
The same is experienced in practice. The
producers in the initial stages of their presence
in the market sell the consumer durables on a
large scale by offering huge commissions to the
sellers. They offer incentives to consumers,
distribute free samples to popularize their product
in the market. One their products are established
they withdraw all such incentives.
(b) Market Competition
The producer needs to take into
consideration the number of competitors for his
product. The competitors in the field of computer
technology, machines and equipments are less
while they are very high in the field of consumer
Markets and Price Determination : 86
goods. Let us consider an example of the
detergent sectors. The main producers
producing detergent are Tata, Hindustan Lever,
Procter and Gamble, Nirma etc. There are
numerous small companies producing detergents
on a small scale.
Let us assume that we are lauching a
detergent powder ‘Dhaval’ in the market as a
small firm. We are required to take a decision
regarding its price. The most important to be
considered in the process of production is the
TC (Total Cost). On the basic of this TC we
would derive per Kg. AC (Average Cost). The
per Kg. price can be determined only on finding
tax, transport cost, cost of advertisement,
commission to be paid to the sellers and expected
profit etc.
Can the firm charge that price which it
determined taking the above factors into
consideration? The answer to this question may
not necessarily be positive. This is because we
will have to consider the per Kg. price fixed by
our competitors. If the price of our product is
less than the cost of production of our
competitors in that event some buyers of our
competitors products can be turned in favour of
our product. But if the price of our product is
high, we would be compelled to keep the price
at par with the competitiors prices inspite of
occurrence of loss at such a price. Our product
may have to be sold at a price lower than the
market price to attract customers.
SASA
Price
NIRMA
Price
DH
A
P r VA
i ce L
RIN
Price
SURF
Price
WHEEL
Price
ARIAL
Price
What is the price policy of other firms?
Should we reduce the price if our competitors
do? should we charge the market price and
realise fall in demand for our product? Should
we charge a high price and serve limited
customers or should we change a low price and
maximise sales? Will we have long term profit
if we have short term losses? These and many
other questions are considered while determining
the price for a product.
(c) Government Policy
The firms need to consider government
decisions also as the government by and large
controls the firms. The firms have to obtain a
license, abide by government rules and
regulations, pay government taxes regularly and
follow the goernment policies.
The government policies change according
to circumstances. Firms may be permitted to
produce more by the present government, but
the governments in future may put prohibitive
restrictions on such rise in production. The
efforts of the firms in expansion of their business
and raising investments go waste because of
such change in government policies. If the
government imposes taxes, how to share this
tax burden with the buyers of the product
depends on the elasticity of demand for the
product. The cost of the product to a very large
extent depends on the raw material i.e.
specifially supplied by the government for eg.
Oil and petrol, electricity, water etc. The firms
have to device their policies in tune with
government budgetary stance. The central banks
monetary policy, interest of banks. Export- Import
policy and rules of nations, the legislations
regarding wages of the workers and many such
other things determine and affect the costs of
production and the firms have to decide prices
keeping in view these costs. In our previous
example if the government imposes excise on
detergent powders the price of all detergent
powders would increase. If the price of
petroleum products and other raw materials is
reduced then the overall prices would fall. If
the exports of detergents is permitted and exports
rise the prices of detergents would rise. If the
regulation regarding production are reduced all
the producers would increase production due to
which there would be rise in supply and fall in
prices. Rise in interest rates would increase the
cost of capital leading to rise in cost of production
and the prices would rise thereby. This is how
Markets and Price Determination : 87
government policy becomes an important part
of managerial decision making.
(d) Substitutes and Complements
While determining price of its product in
the market the firm has to take the prices of its
substitutes and complements into consideration.
When the buyer selects one commodity from
out of the available options all these options he
has are substitutes. Detergent soap is a substitute
to detergent powder.
Substitutes are those commodities which
can be consumed in place of one another as
alternatives to one another. Their joint
consumption is not needed and their consumption
is not interdependent.
Detergent
Powder
+
Substitute
Product
Indigo
Complimentary
Product
Soap
Like the substitutes there are complements.
Complements are those commodities whose joint
consept is inevitable eg. Petrol and vehicle. A
detergent cake could be substitute to detergent
powder but it nees a complement in the form of
a bleaching powder (indigo) for extra whiteness
of clothes. A firm will have to consider the
pricesof substitutes and complements while
determining the price of its own products.
A firm would reduce usage of those
equipments which involve consumption of
electricity especially when the per unit price of
electricity rises. This reduces demand for such
products. To enhance demand for such products
the producers have to reduce its prices. In case
of a fall in per unit price of electricity producers
of electronics equipments produce more of such
equipments keeping the probable rise in demand
for such equipments. When the petrol prices rise
the producers of cars find it impossible to
increase car prices. Infact petrol being a
complement to cars, the demand for cars falls.
This requires the producers of cars to reduce
production. This is how the producers need to
take into considertation the impact of the changes
in prices of those goods which are
complementary to their product.
Producers have to be cautious all the more
incase of substitutes. If the producer increases
the price of his product, his rivals would gain as
the buyers would prefer a loss priced commodity,
so the producer who increases the price of his
commodity would experience a fall in his
customer base. To what extent would the
producer bear this depends on the degree of
substitutability between products. Incase of soft
drinks Thums-up is a close substitute to Pepsi.
This requires the producers of these products
to keep their price in a particular range. The
rise in price by Pepsi would reduce the Pepsi
subscribers and they would be captured by
Thums-up.
If watching movies at the theatre becomes
costly, people subscribe to home thratres. This
leads to rise in number of subscribers to video
libraries. If the VCD players turn costly people
subscribe to cable television. Not only this, but
people even substitute refrigerator or washing
machines for a television set, when television
sets become costly. In a nutshell in case of
comforts all become substitutes to each other.
Commodities such as refrigerators, TV
sets, steel cupboards and furniture require a one
time investment and have a very long life as in
they do not wear out as fast as the commodities
like soap, clothes, and eatables do. A buyer is
more sensitive incase of substitutes among the
non durables than among the durables. The
producers have to be careful while determining
prices of non durables than durables. This may
cost the producers his customers.
In brief the factor affecting prices of
products are.
Markets and Price Determination : 88
 Scale and cost of production
 Competition in the market

Government policy
 Availability of substitutes and
complements
Questions for Self Study - 1
(A) State whether the following
statements are true or false. Put ()
or () in bracket.
(1)
The most important thing in managerial
economics involves taking a correct
decisions regarding production and pricing.
( )
(2)
In perfect competition there are large
number of firms producing homogenous
products. ( )
(3)
While taking decisions pertaining to pricing
its products the firm also needs to take
prices set by competitors, Govt. policy,
possibility of entry of new firms, etc. into
consideration. ( )
(4)
As the firms expand they experience
rising marginal productivity. ( )
(5)
To attract
towards its
firms to
products. (
(6)
The firms can change that price which is
the actual price (cost) of producing the
good. ( )
(7)
more and more customers
products, it is beneficial for
reduce prices of their
)
The Govt. policies do not affect the growth
and development of firms at all. ( )
11.2.2 Objectives of Firms
The basic objective of any firm is to earn
profit. But this is only one of the many objective
of a firm. Firms also have to increase its turnover
in the market, it has to earn goodwill in the
market. It has to compete with and eliminate its
competitors from the market. It also has to
spread or venture itself into many other diverse
fields. These and many other objectives are
cherished by firms. Let us express some of these
objectives.
(a) Profit Maximization
In the traditional analysis profit
Maximization has been taken as the only and
basic objective of the firm. In the private sector
any business emerges with the lone objective of
profit maximization.
Profit= Revenue-Cost
Firms try to maximise their profit by either
reducing the cost or by producing the cost or by
increasing the revenue. The revenue can be
increased either by reducing price or increasing
the sales. The firms can even reduce cost by
enhancing their efficiency.
In economic analysis we have studied
firms keeping this objective of firms in mind. In
a perfectly competitive market firms cannot
determine the price. This requires these firms
to operate and produce at that level where the
Avg. Cost (AC) is the minimum. This is how
the firm in Perfectly Competitive Market (PCM)
can maximise its profits. On the other hand a
monopoly firm would reduce the supply of its
products and create artificial shortages so as to
realise a rise in price. It would increase the Total
Revenue (TR) for the firm and thereby the total
profits. In fact a monopolist would fix that price
where the difference between TR and TC is
the maximum. While analyzing the equilibrium
of the firms we consider the profit levels that
are maximum. But do we experience this
phenomenon in real life?
According to Arthur Thomson since there
are many objectives in front of the firms, the
objective of maximum profit is replaced by the
objective of normal profit.
According to Samuelson the firms may
just concentrate on their existence more than
concentrating on their revenue and cost.
What do we experience in case of India?
Why are the firms with perpetual losses not shut
down? Why is there an emphasis on govt. taking
over and running sick industries? Are the
economic factors not important here?
In the second half of the twentieth century
economists like Baumol, Simon, Marries showed
the irrelevance of profit maximization as the
objective of firms. According to Simon attaining
levels of maximum profit on a continuous basis
Markets and Price Determination : 89
in fact beyond, the capabilities of human brain.
Profit maximization is one of the objectives of
firms and not the only objective.
(b) Maximization of Sales Turnover
In modern days firms aim at attaining
number one position in the market. The rise in
sales turnover is identified as the symbol of their
success. As the firm gain fame the relative
importance of these firms also increases. The
firms selling costly products may gain high profits,
this would be at the cost of low base of
customers. While the firms accepting lower
profits may gain more and more customers as
their sales increase due to personal (mouth)
publicity. The rise in sales enable these firms to
maximise their profits at low prices but higher
levels of sales. The rise in sales turnover would
enable the firms to lead the market.
Some firms whose names could come to
the forefront in their respective fields are Asian
Paints (paints), Bajaj (scooters) and Telco (Now
Tata Motors in the field of heavy motor vehicles).
These firms fix their profit margin at a level of
15% to 20% of their production costs, increase
sales thereby and ensure that they are ranked
first in the market.
(c) Other Objectives
Apart from profit maximization and sales
maximization firms also cherish some other
objectives. The firms try their luck by expanding
their business in hitherto unexplored areas. This
is ones they are successful in their area of
business. The firms expand due to this, firms
try to grow in the areas like their capitals,
turnover and market position (leadership).
Economic growth is their objective. Firms try to
claim, distinction in the market. Some firms also,
show their keen interest in keeping their
shareholders, workers (employees) and
customers happy. The firm chalk out their plans
with the objectives of controlling its competitors
or eradicating its rival (competitors) from the
market. There are some firms, who concentrate
on research and technical programme.
The points above can be illustrated using
some real life examples. The Tatas are into a
numerous business activities apart from the
production of iron and steel. Taxas are into
production of many consumer durables also. So
they are not only into basic and heavy industries
but also into the production of consumer durable
goods. Tatas produce Tea, Soap, Computer,
Trucks, Medicines, Cement, Salt, etc. They have
even entered into hotel business, banking,
insurance, transport, advertisement and
distribution.
TATA
SALT
TATA
TEA
TELCO
Tatas are famous in the field of business
and industry. Companies like Colgate, Palmolive,
from this group, have been paying to their equity
holders a dividend that is more than the face
value of shares. The companies have been
concentrating on paying their employees more
and keeping them happy, then paying heavy taxes
to the govt. In the field of consumer durables
companies like Hindustan Lever, Bata, etc. have
proved their small time competitors
unimpressive.
According to Williamson, the role of
technical experts, entrepreneurs and professional
experts has become more important than that
of the capitalists in modern times. In a joint stock
company there are a number of equity holders.
The role of salaried entrepreneurs and managers,
the group of technical experts becomes more
important who work under the guidance and
leadership of the directors especially the
managing directors. These experts come
foreword with a policy of progress of the firm
using their knowledge, skill and experience.
Hence the objectives of the firm are also the
objectives of managers. These objectives are
as follows.
(1) The managers seek to maximise their
income and facilities. This is possible when
firms are growing and are making huge
profits. Hence they allocate more
Markets and Price Determination : 90
importance to the growth of firms.
(2)
(3)
Second objectives of the managers is their
promotion. Promotions, helps them to bring
more and more employees, workers and
officers of lower cadre under their
command and control. This enhances their
importance in the firm which is possible
only if the firms progress.
Like promotions, the managers also seek
the possibility of bringing as many financial
controls as possible under their control.
Their importance in the firm and also in
the society increases as their consent is
needed in taking decisions pertaining to
purchase of raw material and capital
investments.
This does not mean that objectives of profit
maximization is overlooked. If firms earn profit
then alone can the firms yield a good fame for
themselves? The firms using this goodwill and
fame can raise more capital. It can even use
this profit for building big reserve fund can be
used in future, when firms are in financial crisis.
The high levels of profit are also important from
the point of view of distributing dividends to the
share holders. The firms can spend enough on
research and development. This means profit
maximization is not a secondary objectives of
the firm but the entire preceding explanation aims
at clearing the fact that profit maximization can
not be the only objective of firms.
Important objectives of firms
•
Maximization of profits
•
Market leadership
•
Economic progress
•
Elimination of rival firms
Questions for Self Study - 2
(A) Fill in the blanks.
(1) Profit = (—————) - (————)
(2) Now-a-days the objective of firms of profit
maximistion has become ——.
(3) Firms can —— the market once it
becomes popular due to their increased
sales turnover.
(4) A firm producing variety of products or
performing various business is termed as
———.
(5)
Today the importance of investors in
business has —— while that of technical
experts and Enterpreneurs has ———.
11.2.3 Classification of the
Market Structure
We know the meaning of market in
economic literature, market does mean a
particular place, but it is related to exchange.
Market relates to the establishing of exchange
relationship between buyers and sellers. Market
can be established through shops, telephones,
letters and internet.
Competition is the soul of the market
system. The higher is the competition higher
would be the protection of interest of the
customers. Competition brings with it quality
products for customers, the efficiency of the
firms increases, the cost of production falls and
an ideal standard of Economic affairs is attained.
In practice when we talk of markets we
actually talk of market structure. The markets
are classified on the basis of the no of buyers
and sellers, nature of product, freedom of entry
and exit to the producers, etc. The major markets
identified on the basis of the criteria mentioned
above are perfect competition, monopoly,
monopolistic competition.
(a) Perfect Competition
It is a market characterised by the
existence of large no of buyers and sellers selling
homogenous goods. The equilibrium between
total demand and supply in the market determine
the price, which has to be accepted by both
buyers and sellers. Another feature of this
market is the free entry and exit. This enables
the buyers and sellers to entry and exits the
market freely. The long run price in the perfectly
competitive market depends on the long run
production cost. The normal profit of the firm is
included in the production cost.
Perfect competition is an ideal form of the
market structure. This is a model as this types
of markets do not exist in real life. There are
some close examples of perfect competition
market such as market for gold or silver,
agricultural produce, etc. These markets share
many features of the perfect competition market.
Markets and Price Determination : 91
(b) Monopoly
Like perfect competition market,
monopoly is another extreme form of the
market. Market for monopoly has a single sellers
but large no of buyers. The product produced
by a monopolist has no substitute and the prices
are determined by the seller. The seller is in
complete control of the market price. He would
fix such a price that would bring him the
maximum profit. In monopoly there is no
difference between a firm and an industry. A
monopolist earns an additional profit in the long
run unlike a firm in a perfect competition market.
In practice complete monopoly is absent.
e.g. In case of market for electric bulbs there
may be a single producer who may charge a
very high price that may require the customers
to resort to alternatives, to electric bulbs, such
as candles, lanters etc. The extent and power
of monopoly depends on how close a substitute
exists for a product in a market. A single seller
may control a substantial portion of the market
and establish his power in the market, among a
large group of sellers. In such a case also
monopoly may be established among many.
For example, In case of toothpastes
Colgate reigns the market.
(c) Monopolistic Competition
After 1925 Piero Sraffa, Mrs. Joan
Robinson Chamberlin and others pointed out that
there exists no pure competition or pure
monopoly. The limitations of traditional economic
analysis were made clear. Chamberlin introduced
the concept of ‘Monopolistic competition’ while
Joan Robinson introduced ‘Imperfect
Competition’ which are more of realistic
markets according to them. Absence of any of
the assumptions from out of those of the pure
competition would introduce us to, what is
known as imperfect competition? The number
of buyers or sellers is less / restricted. The
reasons creating imperfect competition are bias
of the buyers about products, entry barriers,
imperfect information, etc.
Product differentiation enables the
producers to establish their product in the
market. The producers create a customers base
of their own by advertising their products on the
basis of the features of their products. They try
to prove, how their product is better than that of
their competitors. This enables them to create
their monopoly. The entire process of attracting
the customers of other firms involves competition
also. Each and every producers tries to gain a
reasonable portion of the market. So a condition
of monopoly and competition is established
simultaneously. This is called as a state of
monopolistic competition.
Let us summarise the same using an
example. There are numerous companies
producing washing powders. Nirma, Surf, Arial,
Wheel, Sasa etc. are known products to you.
Every producer from the names mentioned
above is interested in differentiating his product
from that of the others. Each producer is
interested in proving the superiority of his product
over his rivals. The advertisement comes in
effect due to this. A large amount is spent on
advertisement. The use based groups evolve out
of this. Such as a group of Surf users, Nirma
users etc. Every such group is dominated by a
particular producer or a producer creates a
monopoly within such groups. The producers
try to attract as many customers as possible by
way of advertisement. There emerges a
competition among the producers, who try to
capture customers of each other. This is how
both competition and monopoly is seen among
the producers. This is how there exists
monopolist competition in the market.
In market structure there exists features
of both monopoly and competition. The sellers
do control prices but only in the short run as
their controls over prices vanish in the long run.
This is only due do competition among the
producers that they have to keep their prices
under control in the long run. The commodities
may not the a perfect substitute to each other
but are very close substitutes. At the same time
there are neither entry nor exit barriers. But with
this the every sellers think to establish a group
of his own customers.
(d) Oligopoly Market
There is an oligopoly established for the
sellers when there are large number of buyers
but very few sellers. For example, in the motor
car sector we have in India only a few players
such as Maruti Udyog, Premier Automobiles
and Hindustan Motors. In case of iron and steel
there are as many as six producers while in case
of shaving blades there are only two producers
viz. the Malhotras and India shaving company.
Markets and Price Determination : 92
In such a market there could either
emerge monopoly or competition. If the
producers come together and thereby form a
cartel this will enable them to fix their own price.
In this case these producers may divide the
market among the group and accept one among
them as their leader whose decision would be
accepted by all. So there would be monopoly
with existence of many producers. On the
contrary if they try to attract their competitors
client (customers) and eliminate the competitors
this would create a situation of competition.
One fact remains that the existing group of firms
(players) ensures that there are no new entrants
in the market.
In Indian industrial sector one many find
various forms of markets. In the post and
railways monopoly of the Govt. may be seen.
In the private sector supply of food grains,
vegetables, etc. portray an example of
competition. In case of production of consumer
durable, comforts and luxuries we find
monopolistic competition, while motor, chemical
and engineering goods industries reveals that
there is oligopoly.
There may be a case where there could
be large number of sellers but a single buyer.
This establishes a buyer’s monopoly called
Monopsony. If there is a single buyer and a
single seller we call it bilateral monopoly. If there
are many buyer but only two sellers, it is termed
as duopoly.
Sr.
No.
1
Market
Type
Perfect
No. of No. of
Buyers sellers
Nature of
product
Leadership
over the
market
Large
Large Homogenous
No one
Large
Single Differentiated
Sellers
3 Monopsony Single
Large Homogenous
Buyers
4 Duopoly
Two Homogenous
Sellers
competition
2 Monopoly
Large
Homogenous
5 Oligopoly
Large
Few
/
Sellers
differentiated
6 Oligopsony
7
Bilateral
Monopoly
Few
Large Homogenous
Buyers
Equal
One
One Homogenous stronger of
the two
Monopolisti
8 c
competition
Large
Large Differentiated
Sellers
Questions for Self Study - 3
(A) Answers the following questions in
short.
(1)
What do you mean by a perfectly
competitive market?
(2)
What do you mean by monopoly?
(3)
What do you mean by monopolistic
competition?
(4)
What do you mean by oligopoly?
(B) Match the following
(1) Perfect competition (a) Chamberlin
(2) Monopoly
(b) Single buyer and
single seller
(3) Monopolistic
(c) Few buyers
competition
and large sellers
(4) Duopoly
(d) No difference
between firm and
industry
(5) Bilateral Monopoly (e) Free entry
(f) Large number of
seller and single
buyer
(g) Two seller and
large number of
buyers.
(C) Chose correct option.
(1) There is free entry to buyers and sellers
in a perfectly competitive market. (True /
False)
(2) In a monopoly, a firm earns normal /
abnormal profits.
(3) Price discrimination is a feature of
monopoly. ( Yes / No )
(4) There are few / large sellers in oligopoly.
11.2.4 Factors Determining the
Nature of Competition in
the Market
In the fore going analysis we found that
the nature of commodity and the number of
sellers in the market determine, the extent of
competition in the market. Various types of
markets are determined on the basis of number
of sellers in the market as the number of buyers
is by and large, large. At the same time excluding
Markets and Price Determination : 93
monopoly and oligopoly markets by and large
producing homogenous products.
We need to now see how the other factors
and conditions prevailing in the market from time
to time determine competition. What happens
when there are less buyers but large number of
sellers ? What would be the impact of the size
of the firm producing identical products in
determining price of that product? Is the degree
of competition dependent on the nature of
product? Let us sum up the same.
(a) Number of Buyers
Many a times there are quite a few sellers
but a lone buyer. There are as many as six
factories in India producing rail bogies and
wagons but all of them have to sell their produce
only to Indian railways. The farmers producing
sugarcane have to sell their crop to a sugar
factory of whose they are member. This creates
a situation of single buyer many producers and
the market is called monopsony.
On the similar lines we may also have
oligopsony where the number of sellers is large
but buyers are few. The producers of raw
material to dynamite are large in number, but
their buyers are very few such as The Coal India
Ltd., the Public Works Department of the state
etc.
The mechanism of demand and supply in
determination of prices does not work in these
markets but the prices are negotiated between
the buyers and sellers. The buyers and seller in
such type of markets determine prices via
negotiations. The prices are reconsidered and
renegotiated from time to time.
(b) Features of Process of Production
There operate a variety of firms in the
market, some of which are large while some
small. The local conditions where they operate
are different. The raw material they receive,
the human resources they get differ. Some firms
go in for labour intensive while some other
prefect capital-intensive techniques. This
changes the cost of production from firm to firm.
Due to some technical reasons a
production process many require the size of the
firm to be inevitably large. This causes existence
of few firms in a particular field of production.
In any nation the number of firms producing iron
and steel is less. Obviously, in such markets the
dominance of sellers is natural. On the contrary
textile, leather goods, soaps, etc. producing firms
would be large in number. The extent of
competition there would be stiff.
Just as the large firms are successful in
markets by producing at that level which is
economical optimal and economical, similarly
that small firms could also successive by
introducing right technique, by introducing
innovations in the techniques and so on. This
would enable them to generate profit and face
competition of the large firms. The local shoe
producer can compete with Bata, which
produces lakhs of shoes every year. The local
producers can even get a good local customer
base.
(c) Features of Goods Produced
Some goods have very good substitutes.
Many produce the washing powders. They are
produced as close substitutes to each other. The
washing powder can also be replaced by washing
soap (cakes) or crush of washing soap.
Obviously in such markets competition is
intense. On the contrary for a colour television,
black and white T.V. set is a remote substitute
and hence price differential between the two is
large. The customers who find purchase of
colour television unaffordable would purchases
atleast black and white television set. This means
the degree of competition is less in this market.
In case of perishable goods produce
would be sold in the nearest market. This means
the perishable goods would have a local market
with local competitors. On the other hand durable
goods would have wider market as they can be
transported to nearby markets if the transport
cost are less. The competition would be between
the local and the other nearby competitors. This
means the durable goods would have a bigger
market, better competition and stiff competition.
Factors determining the nature of
competition
•
Number of buyers
•
Features of production process
•
Features of goods produced
Markets and Price Determination : 94
Questions for Self Study - 4
(A) State whether the following
statements are true or false. Put ()
or () in bracket.
(1)
In oligopoly and monophony market
price is not determined by interaction
between forces of demand and supply but
by natural agreements between buyers and
sellers. ( )
(2)
The size of all the firms is equal in the
market. ( )
(3)
The small firms would also compete with
the large firms if they introduce right
techniques, innovations and right
polices. ( )
(B) Fill in the blanks with correct option.
(1)
———— market is evolved when there
are large number of sellers but few buyers.
(Oligopsony / bilateral monopoly /
monopsony)
(2)
From technical point of view if large scale
operations are inevitable then the number
of firms in such activity would be ———
——— (very less / less / large / very large)
11.2.5 Entrance of the Firms
in the Market : Obstacles
Until now we focused on the firms present
in the market. There are new entrance in the
market as well and there are no restrictions either
on their entry or exit.
J. S. Bain in his book “Barriers of New
Competition” has expressed the possibilities of
new entrance in the market. In the context of
competition we need to consider not only the
existing firms but also the possible new entrance.
When the market demand for a particular
product increases and its scarcity is felt, the
producers can increases the prices and maximise
their profits. This can even require the existing
firms to increase their production and even
require the new entrance to come in the market.
The large scale production makes the
competition intense.
In oligopoly, the number of firms is very
less and they can restrict the entry of the firms.
These firms even resort to bringing the rival firms
under their control or even eliminate them by
cut throat competition. The existing firms are
successful in maintaining their customers but
they also have to bear in mind threat of new
entrants in mind and design the policies and
strategies accordingly. These firms do not charge
high prices and if they maintain lower margins
of profit, rivals have no incentive to enter.
Apart from this there are some more
reasons why entry of new firms is not possible.
(a) Proportion of Investment
In some business the initial investment
required is large. Some of these projects also
have huge gestation periods. To realise initial
profits, they hae to wait for long. In fields of
production such as iron and steel, fertilizers, petro
chemicals, ship building, heavy machines and
equipments, huge investment is required. In such
business entry of new firms is not easy. The
entry of new firms is possible in those business
where investment required is low and returns
are quick.
(b) Economies of Sale (Benefits of
Large Size)
Big firms have benefits of large size. The
new firms do not get profits in their initial stage
of production. Their production cost are higher
than the market price of such products and hence
they have to sustain looses initially. They are
unable to sustain such looses for long.
The efficiency of large firms is high in case
of transport, distribution and advertisement. For
example, Hindustan Lever has spread its network
in even small villages. Such companies distribute
their products in remote villages, the moment
their product is advertised through news paper,
radio and television. Their sales expands due to
this. A small producer cannot do this.
(c) Advanced Technology, Research and
Patents
In some fields advanced technology is a
must. The new entrants may find it difficult to
resort to the same. On the other hand the big
business houses introduce their products in the
market after enough research and experiment.
The imitation of such products is not easily
possible.
Markets and Price Determination : 95
The patents pertaining to specialized
research, process, specific products and trade
marks is legally obtained by specific firms and
individuals. Use of patented products and even
processes is possible only on payment of defined
royalty otherwise using it is illegal. Hence, entry
of new firms in such areas of business is difficult.
In fact patents acts as barriers to entry.
the nation the concern government imposes
taxes on industrial production. In certain cases,
where the ownership lies with the government,
goods and services are produced by government
itself. Government also buyes goods and service
in large quantities. This makes the government
a big buyer also. In many occasions government
even enters the field of trade.
(d) Exorbitant Cost
Government not only participates in
industrial field but also puts directs and indirect
restriction on business. In certain cases
government licenses to start a new business are
essential. In some other cases government
permission is essential even in case of expansion
of production and over all expansion. A number
of times government even regulates prices.
Government may also require the private
producers to sell a portion of their produce
mandatorily to the government. This is called a
levy charge. The firms have to meticulously
follow the government rules pertaining to their
location, size and process (techniques) of
production. The government imposes restrictions
regarding imports and exports also.
In some fields of productions involve
heavy costs and this could be borne by only the
existing firms. For example, for construction of
roads requires use of machines such as crushers,
cranes and dumpers. Use of such machines is
immensely costly and new firms cannot bear it
at all. As a result, new firms are unable to enter
such filed.
In this way longer is the number of
obstacles to entry of new firms, lesser is the
competition in the market. New firms can easily
enter those market where barriers to entry are
less and no single seller or group of sellers can
establish their dominance.
Questions for Self Study - 5
(A) State whether the following
statements are true or false. Put ()
or () in brackets.
(1)
Entry to new firms is easy in a competitive
market. ( )
(2)
In oligopoly existing firms can create
barriers to entry through cut throat
competition. ( )
(3)
In an industrial activity requiring huge
investment entry to new firms is easy. ( )
(4)
The cost of production for large scale firms
is less as they reap the benefit of
economies of large scale. ( )
11.2.6 Importance of
Government Policy in
Industrial Development
Industrial development of any nation is
dependent on the policy of the government
relating to developing of industries. In almost all
In such cases firms are left with restrictive
freedom. They have to peg their prices as per
their restriction laid down by the government.
They have to maintain a certain level of
production. In many cases almost all the
decisions are determined by the committees
appointed by the government.
The government attains its pre determined
level of output and industrial progress by offering
incentives and discounts to the industrial sector.
The government encourages productive activity
in industrially backward areas by offering
discounts, subsidized loans and grants to such
industries starting their business in back ward
areas. Now a days incentives have turned more
effective than direct controls. The government
imposes restrictions to avoid mal practices in
industrial sector. But restrictions in certain cases
bring wrong results. Hence in some nations
industrial restrictions and controls have been
liberalised. In almost all the nations market
oriented economies are evolving. In such
circumstances the firms would ones again be
able to determine their prices and the level of
production.
Markets and Price Determination : 96
Questions for Self Study - 6
(A) State whether the following
statements are true or false. Put ()
or () in bracket.
Questions for Self Study - 2
(1)
Revenue, Cost
(2)
Secondary
The role of government is important in
industrial development of a nation. ( )
(3)
Lead
(4)
Diversification
Industrial policies by firms can not be
determined independently in those nations
in which there are lot many restrictions
and controls over the industrial sector. ( )
(5)
Reduced, increased
(3)
Now-a-days industrial growth is sought
mainly by imposing restrictions on the
industrial concerns instead through
industrial liberalisation.( )
(1)
(4)
To set up industries in industrially
backward areas scheme of incentives and
facilities has been offered by the
government in such areas. ( )
A perfectly competitive market is one
which has a large number of buyers and
sellers producing homogenous products.
These are core features of perfectly
competitive market. The other important
feature of this market is that there is free
entry and exit possible in this market and
from out of this market.
(2)
Monopoly means a market characterised
by existence of a single seller producing a
product which has no close substitute. The
monopolist is a price maker and can set a
price of his own choice.
(3)
Monopolistic competition is a market
structure characterised by the existence
of large number of buyers and sellers
producing differentiated products. This
type of a market involves a combination
of features of both competition and
monopoly.
(4)
Oligopoly is a market with existence of a
few sellers. These few sellers may
produce homogenous or differentiated
products. The limiting case of oligopoly is
duopoly.
(1)
(2)
11.3 Words and their
Meanings
Questions for Self Study - 3
(A)
Diversification : Where a single firm is
producing varied products and is into
varied businesses.
Price Discrimination : A policy of a monopolist
wherein he charges different prices from
different buyers for a homogenous
products.
Product Differentiation : Differences in the
nature of product either created by the
producer by illusion to sell his product
among large number of buyers or such
differences could even be real.
(B) (1) - (e), (2) - (d), (3) - (a), (4) - (g),
(5) - (b)
(C) (1) True, (2) abnormal, (3) yes, (4) few.
11.4 Answers to Questions
for Self Study
Questions for Self Study - 4
(A) (1) ()
(2) ()
(3) ()
Questions for Self Study - 1
(B) (1) Oligopoly, (2) very less
(1) () (2) () (3) () (4) () (5) () (6) ()
(7) ()
Questions for Self Study - 5
(A) (1) (), (2) (), (3) (), (4) ()
Markets and Price Determination : 97
Questions for Self Study - 6
(A) (1) (), (2) (), (3) (), (4) ()
11.5 Summary
The decisions pertaining to prices and
production are of core importance in managerial
economics. The decision about what to produce
is immediately followed by decisions regarding
sale, prices, discounts and commissions etc.
These decisions are required to be taken from
time to time. As the firms produces more and
more and their scale of production enlarges they
start reaping the benefits of economies of scale
and their average costs fall. This enables the
firms to sell more at reasonably low price and
attract more customers. But some feel that
lowering prices in this way is not possible as
consumers psychological bias plays an
important role while buying goods. Consumers
may associate the low price of the product with
low quality. At the same time the concerned
firm may also consider the pricing tactics of the
other competitor firms. The said firm can not
keep its prices higher than that of its competitors.
Pricing decisions of firms are also affected due
to the governments decisions and policies
pertaining to the industries. Firms have to hence
follow government policies carefully.
Maximizing profit is not the only objective of
the firms but increasing its sales turnover, and
leading the market and gaining goodwill in the
market are some of the objectives of the firms.
The market structure determines the
efficiency of firm and production levels. In a
perfectly competitive market there are large
number of buyers and sellers, and they produce
homogenous goods. There is free entry and exit
possible in the market and in the long run the
prices are determined by the long run costs.
In monopoly there is a single seller, selling
goods that have no close substitutes. This
enables the sellers to exercise control over price
of his products. In monopolistic competition
there are large number of buyers and sellers.
These sellers try to create their monopoly among
the available number of buyers. The sellers sell
differentiated products but these goods are close
substitutes to each other. This creates
competition among the sellers requiring them to
advertise their products, offer various schemes
and discounts to attract as many buyer to their
product as possible.
In oligopoly there are few seller who if
come together can create a monopoly but it opt
to operate individually are required to compete
among themselves. The entry to new firms is
difficult in oligopoly. The nature of market
competition depends on the number of buyers
and sellers in the market, the production
techniques and features of goods produced. If
the process of production is technical involving
huge investment then the number of producers
would be restricted to very few. If the process
of production is simple and t he product has
number of substitutes, then the number of firms
operating in such market would be large. The
number of new firms in the market would
increase it the profit margin associated with the
product are large. The entry of new firms may
not necessarily be possible or successful. The
economies of large scale, huge investments,
patents, gestation periods and research along
with up date and modern techniques may not
enable the new firms to enter the market even
if the profit level are abnormal.
In the industrial development of a nation
the industrial policy of that nation plays a vital
role. The polices of the government pertaining
to taxes, the legal restrictions imposed by the
government on industries, etc would determine
the atmosphere for industrial growth. The higher
the restrictions on industries higher would be its
adverse impact on industrial development. In
recent times many nations have resorted to
liberal industrial policy.
11.6 Exercises
(1)
State the factors affecting the decisions
of the producers pertaining to pricing of
his product.
(2)
How do producers use the information
about prices of substitutes and
complements while determining prices of
their own product?
(3)
Explain the objectives of profit
maximization. How would the firms in
Markets and Price Determination : 98
competition and monopoly behave with
profit maximization as their objective?
(1)
The initial conditions at the time of
inception of the firm.
(4)
Explain various objectives of firms. What
would be the role of the manager in
attaining these objectives?
(2)
The hurdles faced by him in starting and
running his business.
(3)
How did he overcome these hurdles?
(5)
Why can not come across examples of
perfect competition and monopoly in real
life ?
(4)
How did he progress? How did his
business progress?
(6)
State the market structures that are
witnessed is the real world with special
reference to India.
(7)
Explain the factors that determine the
extent of competition.
(8)
What are the possible obstacles in the way
to entry to new firms?
(9)
Explain how govt. policy affects the
decisions taken by firms.
11.8 Books for Further
Reading
(1)
Mahajan, Barve, Pawar, Business
Economics (Part-I), Orient Longman,
Mumbai.
(2)
Dastase, Godbole, Geet, Business
Economics (Part-II), Seth Publishers Pvt.
Ltd., Mumbai.
11.7 Field Work
(3)
Collect the following information from the
manager of the firm from your area.
Savage and Small, Introduction to
Managerial Economics, Hutchinson of
London.
(4)
Dean Joel, Managerial Economics,
Prentice Hall of India, Delhi.
Markets and Price Determination : 99
Unit 12 : Market Structure Analysis (1)
Index
12.0 Objectives
12.1 Introduction
12.2 Subject Description
12.2.1 Perfect Competition :
Definition and Features
12.2.2 Perfect competition: Price
Determination and Equilibrium
12.2.3 Taxations and Spatial Distributions
12.2.4 Effects of Control on Price and
Production
12.2.5 Monopolistic Competition :
Definition and Features
12.2.6 Advertisements and Product
Differentiation
12.2.7 Monopolistic Competition :
Price Determination and
Equilibrium
12.2.8 Situation in India
12.3 Words and their Meanings
12.4 Answers to Questions for Self Study
12.5 Summary
12.6 Exercises
12.7 Field Work
12.8 Books for Further Reading
12.0 Objectives
After studying this unit, you will be able to
explain :
 The meaning of perfect competition
 Features of perfect competition
 How is the price determined in perfect
competition
 How is short run and long run equilibrium
of a firm and industry attained
 Effects of taxation on the price of a
commodity
 Effects of transportation costs on the price
of a commodity
 The meaning of monopolistic competition


Features of monopolistic competition
Price determination and equilibrium
attainment of a firm in monopolistic
competition
12.1 Introduction
Competition plays a vital role in price
determination of any commodity. Thus whether
a market structure is perfectly competitive or a
monopoly, becomes a factor of great
importance. In perfect competition or perfectly
competitive market there is a large number of
buyers and a large number of sellers selling
homogenous goods. No single buyers or seller
is in such a condition so as to affect the price of
the commodity by altering the volume of
purchase or sale. On the other hand, in monopoly,
the monopolist enjoys complete control over the
price of the commodity through its supply.
Perfect competition and monopoly are rare
phenomena in the real world. What we come
across in real world is monopolistic competition.
In such a market, the commodities sold are very
similar to each other if not the same and are
considered to be substitutes of each other. The
entrepreneur in such a market has to convince
the consumers that his product is better than
the other substitutes available in the market. He
has to advertise for his goods. Thus,
advertisement costs constitute a large share of
total costs. Other costs which increase the total
costs in a monopolistic competition are taxes
and transportation costs. In perfect competition
transportation cost is assumed to be zero.
In this chapter we would look into the
meaning and features of perfect competition,
price determination and equilibrium in short run
and long run of a firm and industry and its
consequences, and capital distribution, in details.
We would also look into details, the
Markets and Price Determination : 100
meaning and features of monopolistic
competition, price determination and equilibrium
attainment and case study of some sectors of
India’s economy which fall under the category
of monopolistic competition market structure.
producer also is the ‘Price-Taker’ in perfect
competition. One example of this could be
farmers producing wheat. In India there are
innumerable wheat farmers. An increase or
decrease in supply by one farmer would not
affect the total market supply and therefore the
price.
12.2 Subject Description
(3) Homogenous Goods
12.2.1 Perfect Competition :
Definition and Features
Perfect competition is an imaginary, ideal
market structure.
A market structure where there are
innumerable buyers buying homogeneous goods
and innumerable sellers selling them while facing
tough competition is known as perfect
competition.
There are certain characteristic features
of perfect competition, which define it. They
are as follows.
(1) Innumerable Buyers/ Consumers
The number of consumers in this market
is innumerable. Thus demand by one single
consumer is a very -very small part of total
demand. Any alteration in demand by a single
buyer doesn’t affect market demand. So he
cannot affect the price. He has to adjust his
demand according to the price determined by
the market. Therefore consumer is a ‘Price Taker’.
An example could be a single consumer
in a wheat market. There are innumerate
consumers in a wheat market. An increase or
decrease in one consumer’s demand would not
affect the market demand and turns the prices.
(2) Innumerable Sellers
The number of sellers in a perfectly
competitive market is as large as innumerable.
Thus, the supply by one producer is a very small
part of total supply in the market. Any increase
or decrease in supply by a single producer
does’nt affect the total supply in the market and
therefore it does’nt affect the price. Every
producer has to adjust his supply according to
the price prevailing in the market. Thus a
In perfect competition, the goods produced
in an industry by various firm are homogenous
in nature. In other words, there is no difference
between two goods produced by two different
firms in an industry with respect to colours, size,
shape, smell, taste etc. For example, a certain
quality of wheat produced by any farmer would
be the same. Thus it would make no difference
whether a consumer buys it from farmer A or
farmer B or farmer C.
No producer can charge a price that is
higher than the market price. If the does so, the
consumers would buy the commodity from
another producer who is charging just the market
price. For the consumer, it would not be a
problem as commodities sold by both the
producers are homogenous or same.
Similarly no producer would charge a
price less than the market price when he can
sell the same amount of goods at market price.
(4) Free Entry in Market
In perfectly competitive market, any firm
is free to enter any industry. There is no
restriction regarding its entry. This is called ‘Free
Entry’. Similarly, if a firms wants to close down
its business for some reasons, it is free to do
that. This firm can shift from one industry to the
other without any restrictions. This is called
‘Free Exit’.
Free Entry and Exit keeps the number of
producers of any commodity very large.
For example, as there is free entry and
exit for wheat producers in the wheat production
industry and the producers lecing innumerable,
an entry or exit of few producers would not make
a difference to the number of producers in the
market or total market supply.
A market structure which has only these
four features of innumerable buyers and sellers,
homogenous goods and free entry and exit of
firms is known as ‘Pure Competition.’ Pure
Markets and Price Determination : 101
(5) Perfect Knowledge about the Market
In perfect competition buyers and sellers
have full and perfect knowledge about the
market. A seller knows at what price a buyer is
willing to buy goods. A buyer knows at what
price sellers is willing to sell his goods. This leads
to a situation where no buyers buys goods at a
price higher than market price and no seller sells
goods at a price lower than the market price.
The consequence is that there is a single price
established in the market for a particular good.
(6) Absence of Transportation Costs
Every time a good is brought from the
place of production to the place of sale, some
costs are incurred. These costs are called
transportation costs. These costs differ
alongwith the distance between place of
production and place of sale. If these costs were
to be included in the price of the commodity, the
prices would differ and not remain same. To
avoid this problem, we assume that
transportation costs in a competitive market are
zero.
(7) Perfect Mobility among Factors of
Production
Land, labour, capital, entrepreneur are the
four factors of production. These factors shift
from one firm to the other and one industry to
the other depending upon the returns they get in
each firm or industry. This capacity to shift from
one to another is called ‘mobility’. We assume
perfect mobility among factors of production in
perfect competition which results in same rate
of returns to various factors of production in the
form of wages, rent, interest and profit. This
keeps the price of commodity same everywhere.
(8) Perfectly Elastic Demand Curve
All the above mentioned features affect
the demand curve of the sellers. This demand
curve is perfectly elastic to the price prevailing
in the market. Fig 12.1 explains this .We have
seen that a producers in a perfect Competition
is just a price taker. He has to accept the price
prevailing in the market. According to the fig
12.1 is the price of commodity (Rs .10). As
producers share the total market, supply is very
less, all he can offer is demanded in the market.
He can thus, sell any number of the commodity,
say 100, 200 or 300. Thus the demand curve
PM is a straight line parallel to x axis. This is
called perfectly elastic demand curve.
Y
Price
competition is a constrained condition of perfect
competition.
MR = AR
P
10
0
M
X
100
200
300
Quantity
Fig. 12.1 : Demand Curve in Perfect Competition
From the discussion of above points we
can explain the following indications of perfect
compet?
Table 12.1 : Indications of Perfect Competition
Deciding Factor
Indications of
perfect Competition
(1) No. of Buyers
Many
(2) No. of Sellers
Many
(3) Nature of Product
Homogeneous
(4) Knowledge about
Perfect and
the market
complete
knowledge
(5) Entry in Market
Free Entry
(6) Demand Curve
Perfectly elastic
for Seller
to the price
prevailing in the
market
(7) Others
Markets and Price Determination : 102
(a) Absence of
transportation
(b) Perfect mobility
of factors of
production
A market structure that fulfills all these
conditions/features is known as a perfectly
competitive market. Perfect competition does
not exist in the real world. It is an ideal market
condition. It is used as a mode to explain various
economic principles. The example of wheat
production shows us that in agricultural sector
the market structure is nearly of perfect
competition, if not exactly.
Now, the question that would arise in your
mind is that if perfect competition is just an
imagenary situation, why study it in detail.
Perfect Competition is an ideal market
situation where welfare of both buyers and
sellers is attained. Producer can earn normal
profit only if he keeps his costs to the minimum.
This means that there has to be optimal use of
resources. Producer cannot earn super normal
profits and thus cannot exploit the consumers.
Only after a detailed study of this ideal market
structure, we realise that we are real far away
from this ideal market condition. The study of
this ideal structure gives us the reasons for many
questions like why are the resources so
extravagantly used by the producer, how are
consumers exploited in the market, why isn’t
there an optimal use of resources in the economy
etc. It also helps us to find out solutions to these
questions. A study of the ideal structure is
necessary to understand it s contrast.
There are some industries which are
nearly a perfectly competitive market. Milk,
vegetables, fruits, pulses are some commodities
which have innumerable buyers and sellers. In
share market, the price of share is determined
by demand and supply condition of these shares
which constantly keeps on changing . The result
is that the prices of shares change daily. Another
example could be of precious metals such as
gold and silver. As the market for these metals
is worldwide. Moreover, there are not many
types in gold and silver. A chip or brick of gold
and silver weights the same all over and is of
similar quality all over. Similar is the condition in
cotton market. Cotton bale is of same size,
weight and quality everywhere.
The study of perfect competition gives vital
insights into the basic question such as how does
a firm behave in order to earn maximum profits
or why does a firm try to increase its efficiency?
Questions for Self Study - 1
(A) State whether the following
statements are true or false. Put ()
or () in bracket.
(1)
A market structure where there are
innumerable buyers and sellers selling
homogenous goods and the market is
featured by price competition is known as
perfect competition ( )
(2)
No single buyer can affect the price by
increasing or decreasing his demand. ( )
(3)
No single seller can affect the price by
increasing or decreasing his supply. ( )
(4)
A good sold in perfectly competitive
market is exactly same as the other with
respect to colour, appearance, size, shape,
weight etc. ( )
(5)
The firms in perfect competitive market
are free to enter or exit any industry. ( )
(6)
The buyers and sellers have complete
knowledge about the market condition and
prices provailing in the market.
(7)
Every producer in perfect competitive
market tries to convince the consumer how
his product is superior to other similar
products available in the market. ( )
(8)
Perfect competition can be easily observed
in every sector in the real world. ( )
(9)
It is useless to study perfect competition
as it does not exist in the real world. ( )
12.2.2 Perfect Competition :
Price Determination
and Equilibrium
In the previous section, we have seen
what is perfect competition and what are its
features? Now, we would look into how the price
is determined and how does a firm and industry
attain freedom.
The process of determination of price is
also the process of attaining equilibrium. The
maximum output that a firm can produce is
determined by the point where marginal revenue
is equal to marginal cost. This is the basis on
which price and equilibrium level are established
and explained.
Markets and Price Determination : 103
We need to explain the following with
respect to the perfect competition.
(1)
Duration of production
(2)
Price determination in a firm and industry.
This can be explained by following flow chart
Price Determination
in Perfect Competition
To study how a firm attains equilibrium,
we need to bring together the short run marginal
cost curve and revenue curve under perfect
competition. The marginal cost cure also
explains the supply curve of the firm. This we
have studied earlier. In perfect competition the
revenue curve is also the demand curve. If both
these curves (marginal revenue curve and
marginal cost curve) are brought together, we
get the following figure.
Price in Long Run
Prices
Prices
Prices
Prices
of
of
of
of
Firm
Industry
Firm
Industry
Y
Price, Revenue, Costs
Price in Short Run
Equilibrium - Supernormal Profits
MC
Profit
AC
E
P
M
T
DD=MR=AR
F
AVC
Now, we would explain the process of
price determination in four phases.
AFC
X
0
(1) Price in Short-Run
N
Output
(a) Equilibrium of a Firm
Fig. 12.2 : Equilibrium - Supernormal Profits
Equilibrium Test
Every firm want to earn the maximum
profit it can. If the firm is facing losses
temporarily, it would try to atleast minimise it.
Now, what we would study is how does a firm
maximise its profits or minimise losses. In perfect
competition, a firm can not decides the price.
What it can decide is the level of output? It
chooses that level of output where it maximises
its profit. This level is the intersection point of
marginal costs and marginal profits. In short;
Production
Marginal Profit =
Profit
Level
Marginal Cost
Maximisation
Equilibrium of a Firm
Following steps should be followed to
arrive at the above diagram.
 Draw tow axis viz. X and Y Name then
as shown in the figure.
 Draw AFC, AC and MC for short run.
 Assume the price to be OP and draw
demand curve PT. Mention that it show
DD = AR = MR
 Name the point which shows the
intersection of MC and MR curves as E.
at this point E, MR=MC. Therefore, it is
an equilibrium point.
 To show what level of output is supplied
at equilibrium point E, draw a line from
Point E, perpendicular to X axis. We would
get a point N. ON is the level of output.
 The price at this level of output is OP.
However this price is not determined by
the firm, but the markets.
 Now, we would look into profits and losses.
The following formula should be kept in
mind
Markets and Price Determination : 104




–
Avg. Cost
To produce ON level of output, the firm
incurred some costs. To calculate these
costs locate the point where EN, cuts AC.
Name the point F. This shows that AC =
FN.
The price of the good is OP and the AC is
FN. We can now, conclude two things.
i)
Price is more that the average costs.
P > AC
ii) This results in a per unit profit of EF
to the firm
Profit per unit = price - average cost, EF
= OP – FN
The total profit to the firm can now be
calculated. To calculate this, draw a line
from F perpendicular to Y axis. Name the
line FM. PMFE is the rectangle which
shows the profit of the firm. This area has
been shaded in the figure. The formula to
calculate total profit of the firm.
Profit = No. of Units sold x Profit per Unit
PMFE = ON x EF
Rs. 20 = 10 units x Rs. 2
If the equilibrium is attained in the above
explained manner, the firms profit is called
excess profit or supernormal profit.
Equilibrium - Loss
The previous situation shows excess
profits to a firm in short run. But this does not
always happen. The firm may have to face a
loss. Fig. 12.3 shows a situation of loss in short
run.
Same steps should be followed to draw
the figure as explained in previous case. In this
case, we have to show a situation of loss. The
important thing is about the demand curve. The
price should be determined anywhere between
the AFC and AC. All the other phases can be
drawn according to the steps in previous case.
They can be expressed to in short as
follows :
Equilibrium E (MC = MR)
 Level of production = ON
 Equilibrium price = OP (=EN)
 AC = FN (to arrive at this, extend NE to
the point, where NE intersects AC curve.
Name this point as F.
 Price AC (EN<FN),
Thus, loss per unit = FE

Total Loss = PE x FM = PMEF
The shaded area or the rectangle shows
total loss.
Y
Price, Revenue, Costs

Price
DD=AR=MR
MC
AC
Loss
P
F
M
AVC
E
AFC
0
X
N
Output
Fig. 12.3 : Equilibrium - Loss
Equilibrium - Normal Profits
There is a third case which is possible
where the firm earns no profit and faces no loss.
The figure 12.4 shows this case. The steps to
draw the figure are same as explained earlier.
The only thing, which is different, is the demand
curve PE. We want to show a case, where there
is no profit and no loss. In such a condition AC
and price would be equal. Therefore, demand
curve should be drawn in such a way that it is
tangent to the AC curve. See Fig. 12.4
Y
Price, Revenue, Costs
Per Unit Profit =
DD=AR=MR
MC
AC
AVC
P
E
AFC
0
N
Output
Fig. 12.4 : Equilibrium - Normal Profits
Markets and Price Determination : 105
X
The steps are the same as explained
earlier. They can be expressed in short as
follows:
 Equilibrium point = E (MR = MC)
 Level of output = ON
 Equilibrium price = OP = EN
 Average Cost (AC) = EN
 Price = AC
 Thus, ‘no profit no loss’ per unit.
 In ‘no profit no loss’ condition, a firm earns
normal profits.
The summary of the there cases can be
expressed as :
Taking these points into consideration,
when equilibrium price = AC, we describe this
case as no profit no loss. In economics this
condition is referred to as ‘normal profit’.
Now, let’s see, what is meant by excess
profit?
In this case, a firm earns more profit than
what it expected. This part which is over and
above normal profit is called excess profit. In
this case price is more than AC. Let’s see how:
Price =
The equilibrium of a firm can be at any of
three conditions.
Total Avg.
Cost
+
Excess
Profit
(1) Price > AC Excess profit
(2) Price < AC Loss
Production + Normal +
Cost
Profit
(3) Price = AC Normal profit
(No profit, No Loss)
The difference between the two terms that
we mentioned with respect to profit should be
understood completely. First we would see what
is meant by normal profit.
Every firm requires a certain minimum
profit to remain in the business. This profit
is called normal profit.
If a firm is earning less than this expected
profit, it would switch over to some other
industry. That’s why expected profit is the
minimum profit. While deciding the price of any
product, this expected profit is added to the total
cost. In other words expected profit is considered
to be a part of total costs. The formula can be
given as :
Price
=
Cost of
+
Production
Rs. 10
=
Rs. 8
Rs. 13 =
Rs. 8
+
Excess
Profit
Rs. 2 + Rs. 3
(b) Equilibrium of Industry
An industry is a group of all the firms
involved in a particular production process. There
are more than hundred sugar producing firms in
Maharashtra. When all of them are taken
together, it is known as sugar production industry
in Maharashtra. How can the equilibrium for
such an endure. The test for it is a s follows :
The price at which market demand and
supply equal each other is known as
equilibrium price. At this price the industry
is in equilibrium.
Normal
Profit
+
Rs. 2
From this, two tings can be deduced.
(a)
The expected profit of the firm is same as
normal profit.
(b)
Normal profit is included in the total cost.
When any firms earns over and above
normal profit, it is known as excess or
super normal profit.

Equilibrium :
Price
Supply in = Demand
Market
in Market
How it is achieved can be seen from table
12.2.
Markets and Price Determination : 106
Table 12.2 : Equilibrium of Industry in Perfect
Competition
Market equilibrium can be shown as in the
figure 12.5
Price (Rs.)
Supply in
Demand in
(Rs.)
Market (Units) Market (Units)
4,000
8,000
5
5,000
7,000
6
6,000
6,000
7
7,000
5,000
8
8,000
4,000
S1
D
Price
4
Y
E
P
D1
S
The market supply in the table is noting
but total supply by all the firms. i.e. addition of
supply by all the firms. An increase in price
increases the supply and a reduction in price
reduces the supply.
0
6,000
X
Output
Fig. 12.5 : Market Equilibrium
The market demand, in the table, is nothing
but addition of demand by all the consumers in
the market. An increase in the price reduces
the demand and a decrease in price increases
the demand.
The figure is based on table 12.2, the
demand curve DD1 intersects the supply curve
SS1 at point E. At this point price is Rs.6 and
supply and demand are equal at 6,000 units and
hence both Rs. 6 is the equilibrium price.
Thus, the consumers and producers alter
their demand and supply respectively according
to the above given rules. This stimulates the
movement of price. Let’s see now :
Questions for Self Study - 2
(a) Demand > Supply
There is a competition among consumers.
Therefore, there is a tendency of price to
increase. In the Table 12.2 this condition occurs
when the price is Rs. 4 and Rs. 5. Thus
equilibrium does not happen at these prices.
(b) Supply > Demand
There is a competition among producers.
There is a tendency among producers to reduce
the prices. In Table 12.2, this condition occurs
when the price is Rs. 8 and Rs. 7. Thus,
equilibrium does not occur at these prices.
(c) Demand = Supply
There is a tendency of price to be stable
in this condition as the demand and supply are
equal and there is no competition among
consumers or producers.
In the table Rs. 6 is the equilibrium price
as at this price, both demand and supply are
equal.
(A) State whether the following
statements are true or false. Put ()
or () in bracket.
(1)
The level of output at which the firm
maximise profit or minimise loss, is the
equilibrium level of the firm. ( )
(2)
The firm earns maximum profit at the level
of output where marginal revenue is equal
to marginal cost. ( )
(3)
A firm always earns supernormal profit
at short run equilibrium point. ( )
(4)
When a firm is in ‘no profit no loss’
situation, it earns supernormal profit. ( )
(5)
The minimum profit that a firm requires
to remain in the business is known as
‘normal profit’. ( )
(6)
The price is determined after taking into
account, the expected profit. Therefore,
expected profit becomes a part of total cost.
( )
(7)
The profit that a firm gets over and above
normal profit is known as supernormal
profit. ( )
Markets and Price Determination : 107
(8)
When a firm is getting less than the
expected profit, then it shift to some other
industry. ( )
(9)
The group of firms producing the same
good is called an industry. ( )
(10) At equilibrium price, market demand and
market supply are equal. ( )
(2) Price in Long Run
Now, we would look into the equilibrium
condition in long run. In perfect competition
there is a free entry and exit of firms. New firms
come into the industry and existing firms go out
of business depending upon the market
conditions. This changes the total supply in the
market and thus the price. Given this situation,
let’s see how a firm and the industry attain
equilibrium in the long run.
(a) Equilibrium of a Firm
Both the conditions should be fulfilled at
the same time for the equilibrium to occur. The
level of output at which both the conditions are
fulfilled is the equilibrium level of output. Let’s
see, how. In Fig. 12.6, the original price of the
good is assumed to be OP and the demand curve
as MM. What would be the consequences if
the price changes, can be explained in following
steps.
(1) If the Price Increases
Suppose the original price was OP (Rs.
10) now it increases to OP1 (Rs. 13)

In perfect competition, the demand curve
is perfectly elastic to the price level.
Therefore, the new demand curve will be
at Rs. 13 is the price will shift upwards.
The new demand curve is M1M1.

Short run equilibrium : Excess profit to
each firm due to increase in prices. This
would result in more firms entering the
industry resulting into an increase in supply
of goods.

Demand remains constant but the supply
is increasing.

Result is that the price starts declining as
the supply of goods increases.

When would this decline in prices stop? It
stops where due to abundant supply price
get equal to the AC of the firm. No one
would earn excess profit in this situation.
There would not be any incentives for new
firms to enter the market. The number of
firms would stabilize here.

The price would come down to original
position of Rs. 10 and would stabilize there.
At this point.
We need two curves to show the
equilibrium condition of a firm in long run in a
perfectly competitive market.

Long run cost curve (supply curve)

Demand curve in perfect competition
(demand curve)
Fig. 12.6 Shows this condition.
Y
Cost / Price / Revenue
DR=AR=MR
MC
AC
P1
(13)
M1
P M
(10)
M1
E
M
M2
P2
M2
(7)
0
Price = Average Cost
Therefore, in this situation
X
N
Output
Price = AR = MR = AC
Fig. 12.6 : Equilibrium of a Firms
First, consider the essential condition of
equilibrium. Long urn equilibrium
conditions of a firms are :
 MC = MR
 AR = AC
(2) If the Price Decreases
Exactly the opposite happens when price
decrease let’s see how :

Price decreases from Rs.10 to Rs.7

New demand curve would be at the level
M2 M 2 .
Markets and Price Determination : 108
Short run equilibrium : Reduction in prices
would lead to a condition where price <
AC.

First, X and Y axis are drawn (draw the
diagram on a separate piece of paper
according to the following direction)
This would result in losses to firms.

Original equilibrium condition of the
industry : Draw demand and supply curves
as in the short run equilibrium figure. Both
the curves intersects at E and OP price is
determined.

As it would become impossible for the
firms to bear the losses for long, firms
would shift to other industries. Therefore,
the number of firms would reduce.

This would lead to decrease in supply and
the price would start rising.

Finally, the price where price = AC, the
prices would stop rising. The losses of the
firms and their tendency to go out of
market would stop. The number of firms
would stabilize at this point. The price will
stabilize at the original price of Rs. 10. At
this point.
Y
D1
S2
D
S
D2
Price = AC

S1
E1
P1
E
E4
E2
P
D1
E3
P2
E
D
S2
Price = AR = MR = AC
S
D2
S1
X
0
One thing gets very clear with these two
examples. The price stabilizes only where AR
= AC. Therefore, one condition of equilibrium
is attained. Thus, it can be said that price is
nothing but the average revenue.

Important thing to note is that the
equilibrium point MC curve cuts AC curve at
its minimum. This why at this very point MC =
MR
Now, assume that due to some reasons
(say, increase in consumers income) the
market demand increases. What would
happen now.

With the help of Fig. 12.6 equilibrium can
be explained as follows :
The demand curve would shift upward and
the new demand curve would be D1D1.

The supply has yet not responded to the
demand. Thus the intersection of D1 D1
and SS gives a new equilibrium point E1

Price increases from OP to OP1

This price is more than the total cost, which
would lead to excess profit to the firms.

Excess profit leads to entry of new firms
in the market and the supply would
increase causing the prices to fall. Thus
OP1 price would reduce.

An increase in demand equal to the total
supply would stabilize the price at OP.

Increase in supply is shown by new supply
curve S 1 S 1. S1 S 1 intersects new demand
curve D1D1 at E2. At this equilibrium point
price is again OP.

The route of attainment of equilibrium is
E -> E1 -> E2.

Long term equilibrium of firms is attained
at the lowest point of AC curve.

At equilibrium :
Price = AR = AC = MR = MC

Output level = ON

Price = OP

AC = EN
Price = AC
Quantity
Fig. 12.7 : Equilibrium of Industry
Therefore, the firm gets normal point.
(b) Equilibrium of Industry
We saw how the process of entry and exit
of firms leads to attainment of equilibrium of
firms. New, we would see the effect of these
activities on the industry. These effects also can
be explained with the help of figure 12.7.
Markets and Price Determination : 109

What if due to some reasons demand
decreases?

Demand curve would shift downward to
the left and the new demand curve would
be D2 D2 .

The supply is yet to change. So intersection
of D 2 D 2 and SS would give new
equilibrium at E3.
(7)
In perfect competition, the price in the
industry is equal to the Average Cost.
12.2.3 Taxation and Spatial
Distributions

Price will come down from OP to OP2
While studying the competitive markets,
we would now look into two important factors
namely.

Since price < average cost, firms will incur
loss.
(a)
(b)

Firms will thus go out of business
decreasing the supply and OP2 would start
rising.
(a) Taxation

When supply decreases to the level of
demand price stabilises at original price OP.
We now consider a hypothetical demand
and supply schedule.

Decrease in supply is shown by new
supply curve S 2 S 2 . S 2 S 2 . and D 2 D 2
intersects at a new equilibrium point E4
where demand is equal to supply and price
is stable at OP.
Table 12.4 : Market Demand and Supply
Taxation by the government.
Transportation cost due to geographical
distances.
Price
Qty.
Qty.
5
1
5
4
2
4
The route of equilibrium attainment is
E -> E3 -> E4
3
3
3
2
4
2
The explanations shows that the supply
adjusts to the changed demand through the
process of entry and exit of firms and the
equilibrium is attained at the same price level.
This price is equal to the average cost of the
firm. Therefore, the industry also earns only
normal profit.
1
5
1
*
Questions for Self Study - 3
(A) State whether the following
statements are true or false. Put ()
or () in bracket.
(1)
In perfect competition, new firms enter
and exit the industry in long run. ( )
(2)
In long run in perfect competition the entry
and exit of firms in the industry doesn’t
affect the supply or the price.( )
(3)
When price is equal to average revenue,
it is stable. ( )
(4)
The demand curve shifts upwards with an
increase in demand. ( )
(5)
The demand curve shifts downwards when
demand decreases. ( )
(6)
In long run in perfect competition, firms
earn execs profit. ( )
In this market, Rs 3 has been established
as the equilibrium price.
What would happen if the government tax
Re.1 as sales tax per unit of good.
(1)
The price of good will increase by Re.1
(Rs 3 + Re. 1) and the consumers will have
to buy it at Rs 4.
(2)
The demand is of 2 crore units when the
price is Rs 4. Thus now 1 crore consumers
would not be able to consume it now.
(3)
Total revenue to the producer would
decrease from Rs.9 crores (3x3 crores)
to 8 crores (4x2 crores). Out of this 2
cores will go to the government as tax and
producer’s net revenue will be 6 crores.
(4)
As the demand is less the level of
production would decrease by 1 crores
units making some factors of production
unemployed.
Therefore, Taxation would have an
adverse effect on all 3, producers, consumers
and the factors of production. Assume that all
Markets and Price Determination : 110
that the government needs is Rs.2 crores from
this firm. Let’s see if there is an alternative.
We assume that at Rs.3, the producer’s
profit is 33%. This means that out of the revenue
of Rs. 9 crore, Rs 6 crore is the cost and Rs 3
crore in the profit. Now what would happen if
the government levies 66% tax on this profit?
When we assume this, we also assume
that the government, would tax all the other
industries similarly so that profit after tax of all
the industries remains at a same level. In
absence of this, the firms would easily shift to
the industry where profit after tax is more.
Therefore taxation is carried out in such a way
that the equilibrium level of all the industries
remains the same. In such a situation, what will
be the effect of 66% tax on the industry?
(1)
There will be no change in the equal level
of the market.
There would remain a demand of 3 crore
units at Rs. 3 and 3 crore units will be
supplied.
(2)
Consumer’s will also get the good at the
same production as before.
(3)
The level of output has not decreased.
Therefore the employment level would
remains the same and no one would be
unemployed.
(4)
Producers profit, however, would reduced
from Rs. 3 crore to Rs 1 crore. The
government decides the taxation policy in
such a way that level of profit in all the
industries remains the same. Thus, no one
would think of shifting to another industry.
So it can be seen that taxation adversely
affects producers, consumers and factors of
production. But a tax on profit would adversely
affect only the producers. Consumers and
factors of production remain unaffected.
If minimum adverse effect is the test of
taxation, taxes on the profit is the most
suitable way of taxation because it doesn’t
disturb the equilibrium condition in the
market.
(b) Spatial Distribution
In an ideal situation as perfect competition
we do not think about transportation cost. In
reality, however, a firm does incur this cost.
There is a cost involved in transportation of raw
material to the firm and transportation of finished
goods to the market. In total cost, both production
and transportation cost are important.
Let’s look into this matter with the help of
an example. There are firms which produce
mango pulp in Ratnagiri and Vengurla
(Sindhudurg) Firms at both the places send their
final goods to Mumbai. Obviously, the firms have
to consider transportation cost along with the
production cost while deciding the price. Suppose
the production cost at both the places is Rs. 50
per Kg. but transportation cost from Rantnagiri
to Mumbai is Rs. 5 per Kg. Now, suppose the
price of mango pulp in Mumbai market is Rs.
50. In this case, the firms in Ratnagiri and
Sindhudurg will not be able to sell anything in
Mumbai. If price increases to Rs. 55, firms from
Ratnagiri will send their product to Mumbai
market and the firms from sindhudurg will do so
only if the price, increases to Rs. 60.
What will happen if firm from Ratnagiri
and Sindhudurg send their product to Mumbai
market resulting into supply becoming more than
demand. The market price will come down from
Rs. 60 per Kg. Assume that it becomes Rs 58
per Kg. In this case, the profit to Ratnagiri firms
will of Rs.3, but Sindhudurg firms will have to
face to a loss of Rs. 2. What will happen if this
condition remains for long. In this case, firms in
Sindhdurg will shift to Ratnagiri. New firms
would emerge in Ratnagiri and in long run, the
supply from Sindhudurg will complete stop and
all the supply will be from Ratnagiri.
The firms in Ratnagiri incur a total cost of
Rs.55 per Kg. i.e. they earn a profit of Rs3 when
the price is Rs. 58 per Kg. with all the firms
from Sindhudurg shifting to Ratnagiri, the
demand will rise once again and the price will
reduce and stabilize at Rs. 55 per Kg.
At this price demand and supply are equal.
However, if the price goes even below Rs. 55
per Kg., Ratnagiri firms will stop sending their
output t o Mumbai. The supply will reduce and
the price will once again get stabilised at Rs. 55
per Kg. This is the way the transportation cost
affects the decisions regarding production. On
the same basis, can the firms in Ratnagiri shift
to Mumbai? They would shift to places near
mumbai such as Chiplun or Mahad, but shifting
in Mumbai itself seems a bit difficult. This is
because the rent in Mumbai is very high. Wages
Markets and Price Determination : 111
will have to be higher. The raw material, mango
is abundant in places like Chiplun, Mahad,
Ratnagiri. A firm will have to transport the raw
material from these places to Mumbai which
will add to its transportation costs. There even
if the transportation cost for finished goods
reduces, the same cost for raw material
increases leading the total cost to increase even
more. Now, farmer and labour class at
Sindudhurg will be unemployed due to the sifting
of firms. Thus, many people will have to suffer
because if the shift of firms. Therefore it
becomes essential that the state government
takes its decisions considering the welfare of
all. This situation increases the value of concepts
like taxes and subsidize.
Suppose, if the government charge firm
Rs. 3 per Kg. as tax, when the price is Rs. 58
all the excess profit of Ratnagiri firms will be
wiped out and they will earn only normal profit.
This will not lead to any substantial decrease in
supply because this tax doesn’t wipe out the
normal profit as the firm still covers all its cost
including transportation cost at Rs. 55 per Kg.
From the tax amount, suppose the government
gives subsidy to the producers in Sindhudurg of
Rs. 2 per Kg. This would enable them to get
Rs. 60 per Kg. (Rs. 58 + Rs. 2) even if the
price is Rs. 58 per Kg. This would cover all
their costs including transportation cost. Now
the firm in Sindhudurg will not need to shift to
Ratnagiri and their interests will be secured.
Questions for Self Study - 4
(A) State whether the following
statements are true or false. Put ()
or () in bracket.
(1)
The transportation cost is assumed to be
non existing in perfect competition. ( )
(2)
Sales tax increases the price of the
commodity. ( )
(3)
If minimum adverse effects is the test of
taxation, then a tax on profit is better than
the sales tax. ( )
(4)
Firm incurs transportation cost along with
production cost in a business. ( )
(5)
Their emerges no difference between the
price of a commodity in two different
markets, even if the transportation cost is
incurred. ( )
12.2.4 Effects of Control on
Price and Production
In certain conditions, the govt. interferes
in the market to protect the interest of people. It
coercively takes some part of production from
different firms. It gives them a controlled fixed
price for it and allows the rest part of production
to be sold in the market at market determined
prices. The govt. sells the former part of
production to the public at prices less than the
market price through public distribution system.
Such products include Sugar, Cloth, Cereals, etc.
which are sold through ration shops at Govt.
approved prices. But one can not get these goods
as much as he wants. One gets only that amount
which is fixed by the govt. If one needs them
more, one has to get them from the open market
at market determined prices.
Let’s take an example of sugar which is
known to all. If all the sugar comes to the market,
let’s assume that its price will be Rs. 7.50 per
Kg. Now govt. purchases 40% of the sugar and
allows 60% to be sold in the market. The govt.
purchased it at say, Rs.4.50 per Kg. and sold it
at Rs.5 per Kg. But the constraint put is 2 per
Kg. per person. What would happen now? Those
who can not afford sugar at Rs. 7.50 per Kg.
will now consume it at Rs. 5 per Kg., be it just
2 kgs. 40% of the sugar will be sold in this
manner.
Now, the govt. has given the producers
just Rs. 4.50 per Kg. They have faced a loss if
we consider equilibrium price. Tenders will be
called to sell the rest 60%. so as to offset the
losses. Traders would submit tenders of different
rates depending upon the needs of the public,
festivals, etc. The one who would quote the
maximum price will be given the tender and all
the sugar will be sold to him. Suppose the one
who bought all the sugar, bought it for Rs. 11
per Kg. He will calculate all his cost and sell it
to the public for Rs. 12.50 or 13 per Kg.
Those, who need only 2 kgs. of sugar will
benefit as they shall get all they want at Rs. 5
per Kg. Suppose some people need 4 kgs. of
sugar. They will get 2 kgs. at Rs. 10 (at Rs. 5
per Kg.) and rest 2 kgs at Rs.26 (at Rs. 13 per
kg). Therefore they will have to spend Rs. 36
for 4 kgs of sugar i.e. they would get 4 kgs of
sugar at an average price of Rs. 9.
Markets and Price Determination : 112
Now, let’s think from the perspective of
the sugar producer. Suppose he produces 1 lakh
kgs of sugar a month. A sale in open market
would have earned him Rs. 7,50,000/- But out
of this 1 lakh kgs, he sold 40,000 kgs to the govt.
at Rs. 4.50 per Kg. and earned Rs.1,80,000.
The rest 60,000 was sold at Rs.11 per Kg. and
Rs. 6,60,000 was earned. His total revenue is,
now, Rs.8.40,000 which 90,000 more than the
revenue when one sold all the sugar at a single
price (Rs. 8,40,000 - Rs. 7,50,000)
However, there is no assurance of this
happening everytime. Suppose supply increases
and the tenders submitted are only of lower
prices then the producer will accept the tender
which quotes price more than govt. approved
price. He will sell the rest 60% at these prices.
The prices in the open market will now be a
slightly more than the price at ration shops (Rs.5
Per Kg.), say Rs. 6 or 7.
In this case, considering the producers
interests, the govt. will have to cut down its
purchase of sugar. The govt. will reduce its
purchases form 40% to say 25% and the
constraint put for consumers buying from ration
shops will be of 1 per Kg. As ration shops fail to
give enough sugar, consumers will buy it from
the open market. Thus, even if share of sugar
for sale in open market increases, demand will
also increase and interests of producers will be
protected.
Therefore, a dual price is established in
the market due to the price control and share
policy of the Govt. It becomes essential to think
of govt. share now along with the demand and
supply while determining the price of a
commodity.
Questions for Self Study - 5
(A) State whether the following
statements are true or false. Put ()
or () in bracket.
(1)
In dual price policy, govt. allows a certain
share of produce to be sold in the open
market and a certain share to be sold to
the govt. at the govt. approved prices. ( )
(2)
The share which the govt. buys from the
producer is sold at a price higher than the
market price through public distribution
system. ( )
(3)
The producer always stands to gain in dual
price policy as he earns more revenue than
what he would have earned, had he sold
the all produce at market price. ( )
(4)
In recent times, the govt. policies towards
producers are also considered alongwith
the demand and supply while determining
the price. ( )
12.2.5 Monopolistic Competition:
Definition and Features
Perfect competition and monopoly are
exactly opposite market structures. Both of them
do not exist in the real world. What exists in
reality is the monopolistic competition. Now, we
would study this realistic market structure. In
market we often see goods which are very close
substitutes of each other. These goods are
produced by different producer. Let’s take the
example of soaps. There are many producers
who produce soaps. There is a competition
between them to increase the sale and profit.
But we look at all the soaps available in the
market, we see that every soap is different than
the other. ‘Hamam’ has a different colour, odour
size and weight than ‘Lux’. Same is the condition
of toothpastes. ‘Close-up’ is different from
‘Colgate’ in colour, taste and packing. It can be
concluded from this that, through one good is
sold by many producers, the goods sold by them
are not homogenous. Every television set in the
market is different from the other in some
respect. What could be the reason behind this?
In every country, there are some certain
set of rules and regulations. Such as trademark,
patents, copyright, etc. These rules do not allow
a producer to produce a good, which is exactly
the same as the good produced, by another
producer. For example, only the producer of
‘Colgate’ can sell the product with this name,
with a certain chemical formula and packing.
This means that now the producer has monopoly
over this brand of toothpaste. In this context
‘monopoly’ does not mean that he is the only
producer. His monopoly is limited to his brand
of product. Any other producer can produce this
good with a different colour, taste, chemical
properties and brand name other than Colgate.
Therefore, every toothpaste is different from
the other. Thus, every producer is a monopolist
Markets and Price Determination : 113
of his own brand of product. There are many
more monopolists in such a market structure who
compete with each other. That’s why this
market structure is known as monopolistic
competition.
brand. But he never gets a full control over the
price. That’s why the proudcer also is a ‘pricetaker’ in this market.
This concept of monopolistic competition
was first put forth by H. Chamberlin. In this
market structure, we see a combination of
features of monopoly and perfect competition.
Let’s see how.
(3) Nature of Good
A market structure, with many producers
selling goods, which are close substitutes of each
other, but differentiated in nature is called
Monopolistic Competition. There is a competition
among the producers, mainly price competition.
Features of Monopolistic Competition
(1) Number of Consumers
In monopolistic competition there are
innumerable buyers. Therefore, no single buyer,
with the help of other buyers can change the
price by altering their demand. In other words,
the number of buyers is so large the demand of
one buyer is negligibly small than the market
demand. Thus, a change in his demand does not
affect total demand and inturn the price. The
buyer is the ‘price-taker’
(2) Number of Sellers
Though the number of sellers in this market
is many, it is not as large as was the case in
perfect competition. It is approximately 40, 50
or 60. Thus every seller has only a certain share
of total market supply. That’s why there is a
competition among sellers. No seller can have
complete control over the process. He has to
accept the price determined by demand and
supply in the market. But, it should be kept in
mind that every producer is a monopolist of his
own brand. As we have seen earlier, no producer
can produce exactly the same good due to
patents, trademarks and copyrights. Tata has
monopoly over Hamam and Hindustan Lever
has monopoly over Lux. The producer is, thus
monopolist in a limited sense and many such
monopolists compete with each other in the
market. That is why this competition is
monopolistic in nature. Because of this monopoly,
he can manage to the same consumers to his
The most important feature of monopolistic
competition is that every good that one seller
sells is different from the same good sold by
other producer. The differentiation can be with
respect to colour, size, shape, constitution,
packing, service after sale, etc. That’s why
different brands produced by different producers
can be close substitutes of each other. For
example, ‘Onida’ is a close substitute to ‘Crown’
television set. Philips radio is a close substitute
to ‘Bush’ radio. Every producer tries to convince
the consumer how different is his good from
the other goods. There are different tool used
by producers to do this for example, Lux is pink
in colour whereas ‘Humam’ is green, Colgate is
white, whereas Closeup is available in three
colour. The producers try to attract more and
more consumers towards its products also by
using things like discounts, gifts, advertisements,
etc. This is known as product differentiation. It
is important to note that producer compete with
each other using this tool of product
differentiation. Price is rarely used as a tool of
competition. That’s why monopolistic
competition is also called non-price competition.
This competition persists because goods are
close substitutes of each other.
Difference of production cost and selling
cost is one of the major features of this market
structure. Production cost includes all costs
starting from production to the finished goods.
Selling cost includes cost incurred in creating
new demand or increasing existing demand. In
perfect competition as goods are homogonous
the need of selling cost does not arise. In
monopoly, as there is a single seller, the need of
selling cost does not arise. Detailed explanation
of selling cost is as follows :
In monopolistic competition every seller
has to use selling and advertising skills. The need
of advertising arises due to product
differentiation and preferences of consumers to
a particular good. This need is not there in perfect
competition due to homogeneity of goods and in
monopoly due to existence of a single seller.
Markets and Price Determination : 114
As producers sells differentiated goods
with different brand names, there is a lack of
knowledge on part of the consumer about the
price of various goods. Moreover, use of selling
and advertising skills (home delivery, after sale
service, free maintenance, guarantee, etc.) also
affects the demand to a great extent. Because
of all these reasons even the producers do not
have the complete knowledge of preferences
of consumers or the prices at which they buy
goods.
(5) Entry of Firms in the Market
(a)
It is at the level of market price, because
every seller is a price-taker. This condition
is similar to that in perfect competition.
(b)
This curve is lightly elastic. It is downward
sloping form left to right. This conditions
is similar to that in monopoly.
Y
P D
Revenue
(4) Knowledge of the Market
In perfect competition, the entry and exit
of firms is unrestricted and easy. So is not the
condition in monopolistic competition. Though
the entry is free, every producer has to create a
brand and only then can it produce. This further
increases the competition with more and more
entering the market.
P=AR
P
MR
D1
X
0
Output (units)
Fig. 12. 8 : Demand Curve in Monopolistic
Competition
(6) Demand Curve as Perceived by the
Producer
As the producer is monopolist in a limited
sense and goods produced are close substitutes,
sellers demand curve is downward sloping to
the right and very elastic.
This means that a small change in price
demanded brings about a large change in
demand. In this market structure every producer
has a certain group of consumers. For example,
people buying ‘Lux’ are the consumer group of
this brand. What would happen if producer of
‘Lux’ decreases the price slightly? Consumers
of other soaps will shift to Lux. This would lead
to more than proportionate increase in demand
of Lux. Conversely, if ‘Lux’s price is increased
slightly, its many of its consumers will shift to
other brands. Only those consumers who have
a special preference towards ‘Lux’ will continue
to buy it at the increased price. Therefore, an
increase in price will not make the demand for
‘Lux’ zero. But, there will be a more than
proportionate decrease in demand with an
increased price. In short, the demand curve in
monopolistic competition is highly elastic to a
change in price (see fig. 12.8).
This demand curve is nothing but price line
and average revenue (AR) curve. As this curve
is downward sloping, MR curve is also
downward sloping and below AR curve. As
demand curve is highly elastic, it should be
drawn slightly flatter.
Questions for Self Study - 6
(A) Answers in short.
(1)
What is monopolistic competition?
(2)
What can you say about number of buyers
and sellers in a monopolistic competition?
(3)
How is monopolistic competition a
combination of monopoly and perfect
competition?
(4)
Why is there a need of selling cost in
monopolistic competition?
12.2.6 Advertisement and Product
Differentiation
Selling cost and product differentiation is
a very important feature of monopolistic
competition.
Markets and Price Determination : 115
Selling cost is incurred to bring about an
increase in demand. Selling cost does not lead
to any increase in level of output, but only sale.
AC
M
Costs
In the language of Economics, selling cost
leads to an upward shift in demand curve.
Second important thing is that the elasticity of
demand curve increases. A major part of selling
cost is spent on advertisements.
Y
Se l
l
C
in g
ost
APC
N
(a) Advertisements
We all are aware of increasing advertising
costs in recent times. Newspaper, TV, Radio
and other medium which frequently come across
people are mainly used for advertisements.
Advertisements have become as important as
the production itself. Otherwise the produce
might not be able to sell anything. Producer can
peat each other only with the help of
advertisements. Thus, one likes it or not,
advertisements has become a must.
In perfect competition there is no need for
the producer to advertise his product because
he can sell unlimited number of units at the given
price. In monopoly also advertisement is not
needed because there is no other option for
consumers rather than buying the good. In spite
of this situation why do some monopolist such
as railways, and other private monopolies
indulge into advertisements?
The reason is that these advertisements
add to the knowledge of consumers and make
them aware of the firms works. Advertisements
of public sector firms impart moral education
and promote national integrity, patriotism and
literacy.
However, advertisements are also
misleading many-a-times. They encourage
unnecessary consumption. Inspite all that they
are necessary in monopolistic competition. Today
the consumer has become such that under the
influence of advertisements he consumes a lot,
irrespective of whether he needs it or not.
The selling cost curve also, like production
cost curve, increase initially, becomes stable
after some time and later decrease. Thus, the
average cost curve of advertisement is also ‘U’
shaped exactly like the total cost curve.
X
0
Quantity
Fig. 12.9 : Different Cost Curves
The curve which is at the lower level is
Average Production Cost (APC) curve. Out of
total cost PM (average production cost + average
selling cost) PN is the average production cost.
This explains the importance of selling cost. As
both of them add to form average cost, the
shaded area shows us the selling cost.
Average selling cost curve is of U shaped.
This is because initially the advertisements
attract a large number of people towards the
product. The consumers of the competitors
product reduce. So these competitors also start
advertising. Thus producer has to constantly
increase its selling cost because the initial
response to the advertisements does not remain
constant all the time. After consuming the good
the consumer is no more curious about it and he
turns to new things. Therefore, the average
selling curve initially slopes downwards towards
right and then goes upwards toward right. That’s
why the figure shows AC at a level higher than
APC and is of U shape.
(b) Product Differentiation
It is one of the very important features of
monopolistic competition. First let’s see what is
product differentiation exactly?
The various ways and methods used by
firms in monopolistic competition to create
demand for their product is known as product
differentiation.
Markets and Price Determination : 116
Product = Commodity +
Product
Differentiation
CloseUp
CloseUp
Ballpen
+ Ballpen
Toothpaste
Free
Methods of Product Differentiation
Different ways are used to as product
differentiation. They can be shown with the help
of following chart.
Differentiate and
attractive appearances
Tools of Product Differeentation
With the help of product differentiation,
every producer tries to convince the customer
that his product is different and other than other
substitutes available in the markets. The
objective behind this is to increase the demand
for his product in the market. That’s why ways
used to increase the demand of the product are
collectively known as product differentiation.
Some deliberate steps are taken to achieve this.
The result is that there emerges a difference
between the commodity produced by the
producer and the commodity perceived by the
consumers because of the advertisement.
Following chart would explain the concept
clearly.
Convenience in purchase,
free gifts, discount, etc.
at the time of purchase of goods.
Excellent service to the
customer, quality of product,
guarantee, home delivery, etc.
Selling Skills
Advertisement
Toothpaste
Seller A
Seller B
All the above described tools can be
collectively brought under three major heads.
(1) Qualitative Change in the Good
Sells only
Cibaca
Toothpaste
Gives a ballpen
free with CloseUp
toothpaste
Commodity
Sold Only
Cibaca Toothpaste
Commodity Sold
CloseUp +
Ballpen
To achieve this the firms use superior raw
material, increases the work efficiency of the
commodity, discovers new uses of the
commodity. This would attract new consumers.
For example, the Mixer-Grinder of X firms can
work continuously for 45 minutes, mixers of other
firms can work continuously only for 20 minutes.
Obviously consumers will buy mixer of X brand.
(2) Apparent and Imaginary Differences
Demand
Decreases
Demand
Increases
The above chart clearly shows that the
attraction of a free pen makes people buy
Closeup rather than Cibaca leading to increase
in demand for Closeup. The competition is
through the medium of product differentiation.
That’s why it is also known as non price
competition.
Every producer tries to create a difference
in the appearance of his good. This may be of
colour, size shape, packaging, etc. For example
Closeup toothpaste is sold in three different
colours. Lux is sold in four different colours and
fragrances. Some producer gives a guarantee
of two years, some gives a guarantee of 5 years
for a purchase of black or red sealing fans.
A producer of garment claims to have 100
different shades of a suiting. Alongwith these
Markets and Price Determination : 117
some producers give good service to the
customer, give discounts or free gifts, give goods
on credit, home delivery, give preference. All
this is to gain new consumers. In monopolistic
market the selling skills of the seller are of
utmost importance.
Questions for Self Study - 7
(A) State whether the following
statements are true or false. Put ()
or () in bracket.
(1)
Selling cost is the cost incurred in
increasing the demand. ( )
(2)
There is no need of advertisement in
perfect competition because of
homogeneity of goods. ( )
(3)
In monopolistic competition as the goods
are close substitutes of each other and
differentiated in nature, advertisement
become essential. ( )
(4)
Selling cost does not have any effect on
the price. ( )
(5)
The ways and methods used by firms to
increase the demand for their goods is
known as product differentiation.
(6)
The competition through the medium of
product differentiation is price competition.
()
(7)
In non-price competition, price is
used as a major tool to increase the
demand. ( )
(8)
Product differentiation provides the
consumer with a wide variety of goods to
choose from. ( )
(9)
Producers bear all the cost incurred on
product differentiation. ( )
(3) Advertisement
The most frequently used tool of gaining
consumers is advertisement. Newspaper,
magazines, radio, TV, hoardings, theatres, etc.
are the media used for advertising. Today,
advertisement on television have become very
popular. The people used to promote goods are
generally film stars or sports persons. Babies
are used in advertisement recently.
Advertisement are mostly presented in such an
attractive way that the viewer falls pray to them
and buys the goods.
Consequences of Product Differentiation
Product differentiation has both positive
and negative effects on the society. Some
important points can be mentioned in this regard.
(1)
The consumer has to choose from a wide
range of varities as the same goods is
produced by a number of brands. This adds
to the satisfaction of the consumer.
(2)
A firm has to keep on searching for
innovations so as to attract the customers.
This leads to an improvement in quality of
the good.
(3)
However, there are chances that the
consumer might be cheated. Many a times
consumers buy certain goods before
rationally thinking over it. An example
would be of young girls falling prey to
advertisement of soaps showing some
films actresses using that soap. These
young girls just buy the soap without
actually knowing this product.
(4)
All the selling cost is initially borne by the
producer. But later he transfers these costs
to the consumers by increasing the price.
Most of us are usually unaware of this fact.
Moreover, it is argued that this cost is
justified as it provides the consumer with
a wide variety and takes care of his likes
and dislikes.
(10) In product differentiation, it is also tried to
increase the quality and efficiency of the
good. ( )
12.2.7 Monopolistic Competition :
Price Determination and
Equilibrium
We have already seen what monopolistic
competition means. Now, we would look into
how price is determined in this market. The
process of determination of price is also the
process of attaining equilibrium in this market
exactly the way it is in perfect competition and
monopoly. In given conditions a firm wants to
maximise its profit. We would explain this from
the view of a firm with respect to both short run
and long run. First we shall see how price in
short run is determined.
Markets and Price Determination : 118
(1) Price in the Short Run
E = Equilibrium Point (MR=MC)
ON = Unit of Goods
OP = MN = Price
QN = AC  Price > ACP
MQ = Profit Per Unit
PRQM Total Profit (MQ x RQ)
Excess Profit (Shaded region)
Similar to the case in perfect competition
and monopoly, every firm has to go through the
fallowing test for attaining equilibrium in
monopolistic competition also.
The level of output, where marginal
revenue is equal to the marginal cost, is
the equilibrium level of the firm.
In other words, MR = MC is the test which
should be looked for. When this test is followed
a firm is at its maximum possible profit and
minimum possible loss. Let’s see how this
happens.
Equilibrium - Excess Profit
We shall now explain this with the help of
the figure that we have studied many-a-times.
For this we need to bring together short run cost
curve of the firm and revenue curve of
monopolistic competition. When they are
brought together we will see the figure as Fig.
12.10
Equilibrium - Loss
At equilibrium point in short run, a firm
doesn’t earn profit every time. He may have to
face loss also. Fig. 12.11 shows this situation of
loss. The steps to draw the figure are same as
before. (That’s why draw them on a separate
sheet of paper)
The important thing is the demand curve
D1D1. We want to show a situation of loss. A
firm faces loss, when price < AC. Thus draw
demand curve D1D1 such that it is somewhere
between AC and AVC, see Fig. 12.11. All the
following things are drawn on the basis of steps
explained earlier. Go on drawing the figure and
label the following details alongwith.
Y
Price, Revenue, Costs
MC
D
AC
Profit
P=AC
M
P
D1
Q
R
AVC
E
Price, Revenue, Costs
Y
MC
R D1
P
Loss
Q
M
M
AC
AVC
D1
E
AFC
MR
MR
AFC
0
N
Quantity
X
0
X
N
Output
Fig. 12.11 : Equilibrium Loss
Fig. 12.10 : Equilibrium - Excess Profit
The important thing here is the demand
curve. We want to show the condition of excess
profit. This would happen when X price > AC.
Thus we will draw demand curve such that it
lies above the AC curve. Then MR curve should
be drawn anywhere to the left of demand curve
D1D1. (See Fig. 12.10).
E : Equilibrium MR=MC
ON : Quantity as output
OP = (MN) price
QN : AC (Price < AC)
PMQR = Total loss (PM x QM)
Sheded region shows the Loss
Equilibrium : Normal Profit
In short run equilibrium can take place at
Markets and Price Determination : 119
one more situation. This is ‘no profit no loss’
situation. This situation is explained with the help
of fig. 12.12.
Y
Test of Equilibrium
(Equilibrium Conditions)
In long run firms try to maximise their
profit. But following two conditions have to be
fulfilled at the same time.
MC
(1) AR = AC
(2) MR = MC
AC
R
D
Let’s see how these two conditions are
fulfilled.
AVC
M
P
D1
E
AFC
MR
0
X
N
Quantity
Fig. 12.12 : Equilibrium : Normal Profit
The steps to draw the figure are same as
earlier. (Draw the figure on a seperate sheet of
paper following the setps) The important thing
is again the demand curve DD1. What we intend
to show is a no profit no loss situation. This
situation emerges when price = AC. Therefore
draw DD1 such that it is tangent to the AC curve
and touches it at its minimum point. At this level
of output MR=MC at point E. To get this point
E, do not draw the MR curve immediately. First
draw a line from M perpendicular to X axis.
Now locate a point on this line where MC cuts
it name it E. Now draw MR such that it passes
through this point E. Now complete the figure
and then write the following details.
E = Eqilibrium Point MR=MC
ON : Quanitity of Output
OP = MN = Price
MN = AC  Price = AC
Equilibrium : Normal Profit
Before, explaining the process of
equilibrium, one thing should be kept in mind in
monopolistic competition there is a free entry to
the firms. Thus, in long run new firms can enter
the market. This affects the level of production
and final profit of existing firms. In perfect
competition also same situation is observed. To
explain this process in monopolistic competition
we will use following tools.
(a) Long run cost curves (Supply Condition)
(b) Revenue curves (Demand Curves)
When these curves are put together, we
get fig. 12.13 The steps of drawing this figure
are same as those explained while explaining
short run normal profit.
Y
Price, Revenue, Costs
Price, Revenue, Costs
(2) Price in Long Run
MC
D1
MAC
D
M
P
D2
D D=
AR
MR
0
D2
X
N
Quantity
Equilibrium can be attained for three situations.
(1) Price > Ac -> Excess Profit
D
E
No Profit, No Loss i.e. Normal Profit
D1
Fig. 12.13 : Long Run Equilibrium
(2) Price < AC -> Loss
(3) Price = AC -> Normal Profit
We shall now look into the process of
equilibrium.
Markets and Price Determination : 120
(a) When Demand for Good Increases

Original demand curve is DD. It shifts
upward and we get a new demand curve
D1D1 .

Demand curve is nothing but the price line.
Therefore, price will be more than AC.

Firms will earn excess profit.

This will encourage new firms to enter the
industry and supply will increase.

As supply increases the increased price
will start falling and so will the profit.

Therefore, due to new entry of firms and
thereby increase in supply, price will fall
upto a level price where Price = AC. At
this point entry of new firms will stop.
E = Equilibrium point
(AR = AC) and
(MR = MC)
ON = Quantity of Output and MR = MC
OP = MN = Price
MN = AC
 Price = AC
 No profit no loss i.e. normal profit
Therefore, in monopolistic competition
equilibrium in longrun is attained at the point
where Price = AC. All firms earn normal profit.
This situation is exactly like the one in perfect
competition.
Questions for Self Study - 8

The situation in this case is just the opposite
of the above explained situation.

The original curve DD will now come
down to D2D2.

Demand curve is nothing but the price line.
Therefore, price will become less than AC
(Price < AC)

Firms will face loss.

Therefore, the firms will start shifting to
other industries and the supply will
decrease.
(A) State whether the following
statements are true or false. Put ()
or () in bracket.
(1) In monopolistic competition the equilibrium
of the firms in short run is attained where
marginal revenue = Marginal cost. ( )
(2) A firm can earn normal profit, excess
profit or face loss in the short run. ( )
(3) Long run equilibrium condition of a firm in
monopolistic market is AR=AC and
MR=MC. ( )
(4) In long run in monopolistic competition
firms do not fear by the entry of new
firms. ( )
(5) When a firm is earning excess profit in
short run price is greater then AC. ( )
(6) When a firms is earning normal profit, the
price is equal to AC. ( )

With decreasing supply, price starts
increasing. Losses also start reducing.
12.2.8 Situation in India

This process continues till enough firms
have gone out of the industry and the Price
= AC. At this point exit of firms stops.

Therefore, the final price will stabilise
where Price = AC. No firms will get
excess profit.
(b) When Demand Decreases

Therefore the final price will be equal to
the average cost and no one will have to
bear losses.
This clearly implies that the equilibrium of
firms in long run is .only at the point where
Price=AC. In other words it is at the point where
price line touches the AC curve. In Fig. 12.13,
this point is M. On this basis, the price in the
market is decided. Every firm then decides it
level of output at this price on the basis of the
test where MR = MC. At this level the test that
AR = AC also holds true. The final picture of
equilibrium is as follows :
Does monopolistic competition as a
market structure exist in India? Let’s see.
When we observe the monopolistic
competition in many consumer goods sector in
many countries and compare this situation with
that in India, we see that In some selective sectors there is a strong
monopolistic competition. The textile mills in
India are very few in number considering the
number of consumers of course, there are
indigenous weavers but the sectors in which they
are working are different. Weavers mainly
produce khadi, dhotee (male garment), sarees.
Whereas companies like Raymonds, Digjam,
Modern, Grasim are in the production of suiting-
Markets and Price Determination : 121
shirtings, Mills like Vimal and Bombay Dying
produce sarees. Product differentiation and
advertisement are the features observed
frequently in textile industry.
12.3 Words and their
Meanings
In soap industry Tata, Hindustan Lever,
Godrej, Ahmedabad Chemicals dominate the
industry. A single firm brings in different brands
or varieties of soaps. Thus an increase in
competition favours only a few firms. Today
there are only two major companies in the soap
industry, thanks to takeovers and mergers. All
other firms seen are very small in comparison
to them. In toothpaste industry also only firms
like Hindustan Lever, Colgate, Pamolive, Cibaca
and Vicco are dominant. Therefore the
competition between them is also illusionary in
nature.
Homogeneous Goods : A good which is
exactly the same as other in every respect
of colour, size, shape weight, etc.
However, monopolistic competition is
prominent in local markets. Grocery and
Garment shops are very less in number as
compared to the number of consumers. Some
shop keepers give excellent service to attract
customers, some give the facility of home
delivery. Some give goods at credit, some give
goods at discounted prices. Product
differentiation and advertisement enable the
sellers to maintain their customers and attract
customers of some other sellers as well.
Dual Price : Two different prices of same good
at one point of time. One is the price
approved and controlled by Govt, the other
is the one determined by market.
Questions for Self Study - 9
(A) State whether the following
statements are true or false. Put ()
or () in bracket.
(1)
We see monopolistic competition in
consumer goods sector in India. ( )
(2)
Sellers try to fix a consumer group for
themselves by giving various facilities to
them. ( )
(3)
In many sectors in India the monopolistic
competition is imaginatory in nature. ( )
(4)
Monopolistic competition is prominent in
local markets in India. ( )
(5)
The lesser the firms in an industry, the more
the competition among them. ( )
Normal Profit : The minimum profit essential
to the keep the firm in the business. It is
included in cost.
Industry : A group of firms producing the same
good.
Spatial Distribution : The situation emerging
because of the distance between the firm
and the market. It gives rise to
transportation cost over and above
production cost.
Monopolistic Competition : A market
structure which is a combination of perfect
competition and monopoly.
Selling Cost : Cost incurred on methods aimed
at increasing the demand.
12.4 Answers to Questions
for Self Study
Questions for Self Study- 1
(1) (), (2) (), (3) (), (4) (), (5) (),
(6) (), (7) (), (8) (), (9) ().
Questions for Self Study- 2
(1) (), (2) (), (3) (), (4) (), (5) (),
(6) (), (7) (), (8) (), (9) (), (10) ().
Questions for Self Study- 3
(1) (), (2) (), (3) (), (4) (), (5) (),
(6) (), (7) ().
Markets and Price Determination : 122
Questions for Self Study- 4
(1) (), (2) (), (3) (), (4) (), (5) ().
Questions for Self Study- 5
(1) (), (2) (), (3) (), (4) ().
Questions for Self Study- 6
(1)
(2)
(3)
(4)
A market structure, with many producers
selling goods which are close substitutes
of each other, but differentiated in nature
is called monopolistic competition.
The number of consumers in monopolistic
competition is large. Therefore no single
buyer or a group of buyers can change
the price by altering their demand. The
number of sellers is also large, but not as
large as in the case of perfect competition.
The seller in monopolistic competition is a
monopolist only for his consumers and has
monopoly only over his brand of goods
because he has a certain group of
consumers demanding his goods. However,
he has to compete with other producers
producing similar goods. Therefore this
market has a combination of features of
monopoly and monopolistic competition.
Advertisement or selling cost is must in
order to create new demand and increase
the existing demand. In monopolistic
competition as there is a difference
between goods, each producer has to
convince the consumer that his product is
better. Advertisement, thus, becomes a
must.
Questions for Self Study- 7
(1) (), (2) (), (3) (), (4) (), (5) (),
(6) (), (7) (), (8) (), (9) (), (10) ().
Questions for Self Study- 8
(1) (), (2) (), (3) (), (4) (), (5) (),
(6) ().
Questions for Self Study- 9
(1) (), (2) (), (3) (), (4) (), (5) ().
12.5 Summary
On the basis of competition, market
structures can be divided into perfect
competition, monopoly, monopolistic competition
and oligopoly.
A market structure where there are
innumerable buyers and sellers buying and selling
homogeneous goods and there is a strong
competition, is called perfect competition. The
main features of this market are innumerable
buyers and sellers, homogeneity of goods, free
entry and exit of firms, perfect knowledge of
the market on the part of buyers and sellers and
absence of transportation cost. In perfect
competition we can distinguish between a firms
and an industry. Industry is a group of firm
producing homogeneous goods. There can be
three situations of equilibrium in the short run in
perfect competition viz. excess profit, loss and
normal profit. Loss occurs when Price < AC.
Excess profit occurs when Price > AC. Normal
profit occurs when Price = AC. In Long run
equilibrium is at the point where MR=MC and
AR=AC. The number of firms can reduce or
increasing in long run. In perfect competition
transportation costs are assumed to be absent.
There it does not affect price of the good. But
in reality transportation cost is incurred by the
firm and it affects the price. Taxation also
affects the price of the commodity. In perfect
competition a tax on profit is considered to be
better than sales tax because it does not affect
equilibrium condition of the market.
Transportation cost also affects decisions relating
to production and establishing of a firm. The
Govt. also unnecessarily affects the price of a
good by giving subsidies to producers or by
implementing dual price policy.
In reality, we come across monopolistic
competition in the market. A market structure
where there are many sellers of closely related
goods, competiting in a non price manner is called
monopolistic competition. The number of
consumers and sellers in such a market is large.
The goods are close substitutes of each other
but differentiated in nature. To increase the
demand every producer has to incur a cost on
advertisement. The short run equilibrium is at
the point where MC=MR. In the long run, new
firms can enter the market.
Markets and Price Determination : 123
Perfect competition and monopoly are two
opposite market structures. In reality, we see
monopolistic competition. In India, we see
monopolistic competition only in some selective
areas such as textile. In other sectors the
competition is imagination in nature such as in
soap industry. As the competition is limited in
nature few producers earn large profits. In local
markets monopolistic competition is clearly
visible such as among garment or grocery shop
keepers.
(7)
12.6 Exercises
(1)
(2)
What do you mean by perfect
competition? Explain its features and need
to study this market structure.
How is price determined in a perfect
competition? How is the equilibrium of
firms and industry attained in short and long
run?
Explain the situation of monopolistic
competition market in India.
12.7 Field Work
(1)
Go to a Agriculture Market Committee
(market yard) near your village and note
down how prices are determined there.
(2)
Write your own experience about how the
advertisement on television affects your
demand.
(3)
Interview a few sellers regarding the
measures they adopt to increase the
demand for their goods.
(4)
Which advertisement has had maximum
effect on you and why?
12.8 Books for Futher
Reading
(3)
Illustrate with the help of an example how
sales tax and tax on profit affect market
in perfect competition.
(1)
(4)
How does spatial distribution in long run
affect firms which are nearer and those
which are farther than the market ?
Dastane, Godbole, Geet, Commercial
Economics (Part - I), Mumbai, Sheth
Publisher Pvt. Ltd.,
(2)
(5)
Illustrate with an example the effect of
‘compulsory purchases’ and ‘controlled
price policy’ of Govt. on the market.
Mahajan, Barve, Pawar, Commerce and
Economics (Part -I), Mumbai, Orient
Longmance.
(3)
(6)
Explain the features of monopolistic
competition. How does a firm attain
equilibrium in short and long run in their
market.
McConnel and Gupta, Economic (Vol.-1),
Delhi, Tata Mcgraw Hill Publishing
Company.
(4)
Sommuelson, Paul, Economics, New
York, McGraw Hill.
Markets and Price Determination : 124
Unit 13 : Market Structure Analysis (2)
Index
13.0 Objectives
13.1 Introduction
13.2 Subject Description
13.2.1 Monopoly : Meaning and
Features
13.2.2 Monopoly : Classification
13.2.3 Monopoly Market : Price
Determination
13.2.4 Do We Find Monopoly in Reality?
13.2.5 Price Discrimination : Conditions
for Success
13.2.6 Duopoly
13.2.7 Oligopoly : Meaning and Features
13.2.8 Oligopoly : Price Determination
13.2.9 Regulation of Monopoly
13.3 Words and their Meanings
13.4 Answers to Questions for Self Study
13.5 Summary
13.6 Exercises
13.7 Field Work
13.8 Books for Further Reading
13.0 Objectives
After studying this unit you will be able to
know :
 Meaning of monopoly and features of
monopoly market.
 Classification of monopolies.
 Process of price determination in a
monopoly market.
 The need to study monopoly market
structure.
 Planning of price discrimination.
 Conditions necessary for the success of
price discrimination.
 Meaning of duopoly.
 Process of price discrimination in duopoly
market.
 Meaning of oligopoly.

Process of price determination in oligopoly.

Price leadership in oligopoly market.

Need for control over monopoly.
13.1 Introduction
Perfect competition is not seen in the real
world. But to understand the merits of perfect
competition like social welfare, efficient use of
resources and financial efficiency, we study
perfect competition. In few industries we do see
a bit of perfect competitions. Monopoly is also
a market structure like perfect competition which
is rarely seen in the real world. Monopolist
produces the good which has no substitute. He
has full control over the price and output of the
production. Perfect competition and monopoly
are exactly the opposite cases. The market in
the real world is a combination of both these
markets. In reality what we see is not monopoly
or perfect competition but monopolistic
competition. In real world firms produce goods
which are close substitutes to each other and
have monopoly of their own brands over a group
of consumers. They have to compete with many
other firms simultaneously. Product
differentiation and advertisement attract
consumers toward a commodity. Lack of
knowledge and irrational thinking limits the
sovereignty of the consumer. Though monopoly
is not seen in real market, some industries are
dominated by one firm which supply a very big
share of the total market demand in such a
situation firms negotiate between themselves and
create a monopoly like situation. Such a market
is called oligopoly market. In this market,
producers take all the decision regarding price
and production, taking into account response of
other firms. Sometimes a big firms rules the
market and sometimes a small but efficient firm
rules the market.
Markets and Price Determination : 125
In this unit, we would study monopoly,
duopoly and oligopoly markets. We shall also
see in detail how price is determined in these
markets.
13.2 Subject Description
13.2.1 Monopoly : Meaning and
Features
It is a market structure, where there
are many buyers but only a single seller /
producer and there is no close substitute
of the product, produced by him. So that
he can decide any price of his commodity,
is known as Monopoly market.
time. He can decide only one of them. Let’s
look into this with the help of an example.
Suppose, there is only one producer in soap
industry. He desires to see 10,000 soap per
month at a price of Rs. 7 for a soap of 100
grams. But the consumers think the price of Rs.
7 to be high. So, at this price what they will buy
is 8000 soap. So he cannot sell 10,000 soaps. If
he wants to see the desired sum, he has to keep
the price at Rs. 6. Therefore, if he wants to sell
10,000 soaps price will he decided by the
consumer demand. But if he wants Rs 7 as the
price, the quantity will be decided by the demand
at that price. In short.
1.
2.
In other words, a market structure
wherein no competition exists is known as
Monopoly market.
Features of Monopoly
(1) Number of Consumers : There is a
large number of consumers in this market. The
demand of a single consumer is a very small
part of total demand. Therefore only change one
consumer demand doesn’t affect the total
demand and thus the price. Every consumer has
to adjust his demand with the market price.
Therefore he is a ‘price-taker’. This condition
in exactly like that in perfect competition.
(2) Number of sellers: There is only one
seller in the market. This only seller can be a
person, a group of persons, a firm or a group of
firms. Important is that the supply is concentrated
in the hands of one single authority. That’s why
‘complete control over supply’ is considered to
be the basic definition of monopoly.
A control over supply also implies a control
over price. By changing the supply, he can
determine any price of his commodity. That’s
why the monopolist is a price-maker. However,
there are limitations over the monopolist’s
capability to determine price. He has full control
over the price and supply but not over consumer’s
demand. That’s why a monopolist cannot
determine both supply and price at one point of
Price
If decided by
the monopolist
(e.g. Rs.7)
Determined on
the basis of
consumer
demanded.
Supply
Will be decided
on the basis of
demand by
consumer.
Will be decided
by monopolist
(e.g. 10,000
soaps)
The implication is that even if the
monopolist has control over supply and thereby
the price, his degree of control is not infinite.
The demand restricts his complete control. He
has to choose one of the options from the above
table. The monopolist will prefer the first option.
(3) Nature of Good : The good produced
is homogeneous in this market. In above
example, the soaps are homogeneous. There is
no difference between them. Also, there is no
substitute available to this good. Soap is only
produced by one producer. Thus, consumers
have only 2 options, buying the soap at Rs7 or
bathing without a soap.
‘Buy it or live without it are the two options
available to the consumers.
(4) Knowledge of the Market : There
is complete knowledge about the market on the
part of buyers and seller. Specially the buyer is
fully aware of the supply and price in the market.
On the basis of this knowledge he decides the
demand. At this stage, price is important.
(5) Entry in the Market : There is only
one firm in the market entry to new firm is
restricted. The only firm wants to protect its
Markets and Price Determination : 126
monopoly over production and supply. An entry
of new firms would mean end of monopoly and
competition in the market. Therefore, the
monopolist tries to restrict the entry of new firms
in different ways. These restrictions can be
financial or institutional in nature. Many a times
these restrictions are purposefully created. In
short no new firm can enter the market as the
entry to new firms is restricted.
(6) Seller’s Demand Curve : The
capacity of monopolist is restricted by the
consumer’s demand. The monopolist prefers to
decide the price. If he wants to sell more units,
he has to bring down the price. As in our
previous example, if he fixes the price at Rs 7,
he can sell only 8000 units. If he wants to sell
10,000 units, he has to reduce the price to Rs.6.
A reduction in cost increase the price.
That’s why demand curve faced by the seller is
downward and sloping the the right. See fig
(13.1)
Y
short, we come across monopoly market quite
monopoly and there would be often.
Questions for Self Study -1
(A) State whether the following
statements are true or false. Put ()
or () in bracket.
(01) A market structure, where there are many
buyers and only one seller and there is no
close substitute to the commodity sold by
him is called monopoly market. ( )
(02) The consumer in monopoly market is a
price taker. ( )
(03) Monopolist has no control over supply in
monopoly market. ( )
(04) There are no limitations for the monopolist
regarding the determination of price. ( )
(05) The monopolist can control both the price
and the supply at same point of time.( )
(06) Monopolist prefers to control the supply
rather than the price. ( )
(07) There is complete knowledge about the
market on part of buyers and sellers in
monopoly. ( )
Revenue, Price
D
(08) There are no restrictions regarding
the entry of new firms in monopoly
market. ( )
Price = MR
(09) The demand curve in monopoly is
downward sloping to the right. ( )
MR
(10) Pure monopoly does not exist in the real
world. ( )
D1 (AR)
X
0
Quantity
13.2.2 Monopoly: Classification
Fig. 13.1 : Demand Curve
Where do we see Monopoly in Reality?
Now we would try to find out where do
we come across monopoly in the real world.
We come across monopoly market in production
of many goods and services. Electricity supply
from Maharashtra State Electricity Board, water
supply from municipal Corporation. State
transport facility, Railway are some examples
of monopoly. The Cotton Monopoly Scheme in
Maharashtra, is also example of monopoly
market. If there is only one shop of cloth in a
village, the shopkeeper is the monopolist. In
We have already seen that a control over
supply of goods and services is monopoly. This
control emerges due to different reasons. On
the basis of this monopoly can be classified into
following categories. The following chart shows
these types.
Classification on the basis of reasons
Natural
Monopoly
Markets and Price Determination : 127
Legal
Monopoly
Economic
Monopoly
(1) Natural Monopoly
Sometimes, the natural resources in a
particular area makes that region a dominant
producer of a commodity. For example the
natural conditions in Bangladesh and West
Bengal are best suited for the cultivation of jute
than anywhere else in the world. Therefore, this
region has got monopoly over the production of
jute. Brazil produces 95% of the coffee
production of the whole world. Thus it has
monopoly over the production of coffee.
Human being also gain from inborn talents
(nature gifts) exactly like the regions. Singer is
gifted with a suitable voice which makes him
rule the music industry. Lata Mageshkar could
be an example as she has literally ruled the music
industry for decades.
a huge initial capital investment is needed. There
are hardly any (only one) firms who can afford
this huge investment. This results in monopoly
of a private or govt. firm in these sectors. In
these industries easy entry of new firms is not
possible.
Economic monopoly is generally created
purposefully. Suppose there are five firms
producing tyres. If they operate separately they
shall have to face competition. To avoid this,
these companies come together mutually by
establishing a holding company to control supply
and mutually benefit from it. This leads to
monopoly like situation. Monopoly is created
using these methods of business combination.
The objective is to avoid fierce competition and
mutually benefit from it.This is also termed as
‘Cartel’.
(2) Legal Monopoly
Natural monopoly is limited as it depends
upon the natural resources. In real world
monopoly is mostly, deliberately created. There
are some objectives behind it. One kind of
monopoly arising due to man-made reasons is
called Legal Monopoly. Such a monopoly is
generally created by govt. by legally supporting
a firm to supply a commodity or a service.
Electricity by MSEB and railways are few
examples. Generally govt. maintains monopoly
over services of public utility. This is done by
legally authorising an authority to supply a
particular service. Nobody can enter this industry
without permission. There are legal limitations
regarding the entry of new firms which are
called restructions.
Legal monopoly also exists over
production of commodity. We are well aware
of examples such as patents, trade mark,
copyright, etc. A firms gets the sole legal right
to produce a newly discovered good with the
help of patent right. Other firms are restricted
from producing this good. Every firm has its own
trade mark. Consumer buys goods seeing this
trade mark. This mark is registered with the govt.
so no other firms can use it. The printing of
books, audio and video tapes is guarded by copy
rights.
(3) Economic Monopoly
In some industries such as steel, iron,
nuclear energy, railways, shipyard, Airport, etc.
A
B
C
D
E
Individual Firms
Contract / holding company
Control over Supply / Price
Questions for Self Study- 2
(A) State whether the following
statements are true or false. Put ()
or () in bracket.
(1) Some regions have the advantage of
natural resources and gain form it to form
monopoly over production of certain
good. ( )
(2) Even in the case of Human beings some
inborn talents help a person to create
monopoly over some industry. ( )
(3) Natural Monopoly can be established
without any limitations. ( )
(4) In legal monopoly with help of a legal right
a firm gets the monopoly or sole right to
produce a particular good. ( )
(5) It’s unfair to have monopoly of Govt. over
services of public utility. ( )
(6) Due to the need of large scale initial
investments, economic monopoly is
created in some industries. ( )
Markets and Price Determination : 128
(7)
Sometimes there are only few firms in an
industry which come together mutually to
avoid fierce competition and establish
monopoly together. ( )
(7)
As the firms come together the
emergence of monopoly is restricted. ( )
(9)
Other firms cannot use trademark and
patents of particular firms. ( )
13.2.3 Monopoly Market : Price
Determination
Let’s look into how price is determined in
monopoly. In monopoly also the process of price
determination is the process of equilibrium
attainment. The maximum that a firm should
produce is decided where MR=MC. The
equilibrium process can be explained on this
basis.
In monopoly there is only one firm in the
industry. Thus the firm is the industry. The
process of equilibrium, we will see now, will be
from the point of view of the firm. First, let’s
consider how is price determined :
(1) Price in Short Run
Aim of every firm would be to maximise
its profit and minimise its losses. The level of
output, where MR=MC, is the equilibrium level
of output.
MR=MC is the condition of equilibrium.
A firm maximises profit or minimise its loss at
this equilibrium point. Let’s see how :
Equilibrium : Excess Profit
Let’s take an example of an electricity
generation station. The revenue and cost of this
station are shown in table 13.1.
According to table 13.1 if the price is kept
Rs. 8 mega watt, no electricity will be sold and
produced. The firm will have to bear a loss of
Rs. 6 which is the fixed cost. To reduce the
loss, the firm increases the production to 1 mega
watt and the loss comes down by Rs. 1. At Rs.
6 mega watt the firm produce 2 megawatt of
electricity and earns a profit of Rs.3. At Rs. 5
mega watt, 3 mega watt electricity is produced
and the firm earns a profit of Rs. 3. At price of
Rs. 4, the firm has to bear a loss of Rs. 4. at Rs.
3 mega watt, 5 mega watt is produced and the
loss is now Rs. 20.
When the table in seen carefully. We see
that the maximise profit to this firms can be of
Rs. 3. But it is possible at two different levels of
production. At production level of 2 mega watt,
though the profit is Rs. 3, but MR>MC. Thus it
cannot be the equilibrium point as the condition
of MR=MC is fulfilled. As this condition is
fulfilled at production level of 3 mega watt.
There equilibrium output is determine at 3 mega
watt and price at 5 mega watt Rs. 3 is the excess
profit.
Now, we will present the same schedule
in the form of a figure. We will have to bring
together the revenue curves in monopoly and
the short run cost curves. We have to use the
same short run curves that we have used in
perfect competition. (Try and draw the figure
on a separate piece of paper )

Draw X and Y axis name them as shown
in the figure.

Draw short run AC, AFC, AVC.

Draw downward sloping demand curve
DD1 as shown in the figure. Bu-take care
that it remains to the right of AC curve.
Draw MR curve anywhere to the left of
demand curve.
Table 13.1 : Revenue and Cost for Electricity Organisation
Production
(M.Wat.)
Price
Rs./M.Wat
0
1
2
3
4
5
8
7
6
5
4
3
Total
Revenue
(Rs.)
0
7
12
15
16
15
Marginal
Revenue
(Rs.)
7
5
3
1
-1
Avg.
Revenue
(Rs.)
7
6
5
4
3
Total
Cost
(Rs.)
6
8
9
12
20
35
Markets and Price Determination : 129
Marginal
Cost
(Rs.)
2
1
3
8
15
Avg.
Cost
(Rs.)
8.0
4.5
4.0
5.0
7.0
Total
Profit
(Rs.)
(-) 6
(-) 1
3
3
(-) 4
(-) 20

Locate the equilibrium point E at the
intersection of MR and MC curves.

Draw a line perpendicular to X axis from
point E. we get N at this point ON is the
equilibrium level of output.

E : Equilibrium (MR = MC)
ON = Level of Output
OP = MN = Price
QN : AC  Price > AC
Extend E to the demand curve to get ‘M’.
Draw perpendicular line from ‘M’ to Y
axis to get P. OP is the equilibrium price.
The profit-loss situation of firm is as follows:
Per Unit
=
Price
-
Profit
What is the AC incurred in producing ON?
To get this locate a point on MN. When
MN touches AC curve name it ‘Q’. AC is
‘QN’.
Y
Cost, Revenue, Price
(Sheded region)
Avg.
Cost (AC)
D
PMQR = Total profit
Equilibrium : Loss
At equilibrium in short run, the firm does
not always get excess profit. It may also have
to bear losses. Fig. 13.3 shows this situation of
losses. The steps to draw this figure are same
as losses explained earlier. Important is that, as
we want to show the condition of loss, price
should be shown less than AC. Thus, demand
curve should be drawn between AC and AVC.
MC
Y
AC AVC
D
Profit
P
R
MC
M
Q
DD
E
=A
R
D1
MR
AFC
MR
0
X
N
Cost, Revenue, Price

MQ = Profit per unit
AC
Loss
P
M
DD=AR
MR
E
Quantity
MR
0
*
*
AFC
D1
N
Fig. 13.2 : Equilibrium Excess Profit
*
AVC
Q
C
Quantity
Fig. 13.3 : Equilibrium : Loss
When the price of the good is MN the AC
is QN.
E : Equilibrium (MR = MC)
(a)
Price (MN) > AC (QN)
ON : Level of output
(b)
Thus, the per unit profit
OP = MN = Price
MQ = MN - QN
QN : AC  Price < AC
Total profit can be calculated on the basis
of per unit profit. Draw a line from Q,
perpendicular to Y axis, PMQR rectangle
which is shaded is the total profit of the
firm.
Profit over and above AC is excess profit.
In this diagram
X
QM = Per Unit Loss
CQMP = Total Loss (Shaded region)
Equilibrium : Normal Profit
The third possibility in short run is that of
normal profit. Let’s explain this situation with
the help of Fig. 13.4. The steps are same as
Markets and Price Determination : 130
earlier. The important thing in about demand
DD1. We want to show the situation of ‘no profit,
no loss. Price and AC will be equal (price =
AC). Thus draw DD1 such that it touches AC
at M such that M lies to the left of minimum
point of AC curve. At the same level of
production MR intersects MC. The steps to this
are same or earlier.
When this stage of MR=MC is attained
by the monopolist, then he earns maximum
excess profit.
Equilibrium : Excess Profit
We shall bring together revenue and cost
curves of the monopolist. This has been shown
in Fig. 13.5.
Y
Y
MC
D
Revenue, Price
Cost, Revenue, Price
D
MC
AC
P
M
AVC
DD
=A
MR
E
MR
0
AFC
AC
P
S
Q
M
E
R
AR
D1
N
X
0
Quantity
N
MR
X
Quantity
Fig. 13.4 : Equilibrium : Normal Profit
E : Equilibrium (MR = MC)
ON = Level of Output
OP = MN = Price
MN = AC  Price = AC
No Profit No Loss i.e. normal profit
in monopoly, equilibrium in short run
can be attained at any of the 3 situations.
(1) Price > AC Excess profit.
(2) Profit < AC, Loss
(3) Price = AC Normal Profit
(2) Price in Long Run
Test of Equilibrium
In long run, the monopolist has just one
aim and that is to maximise his profit. The
equilibrium condition is attained after following
the same test as earlier.
The level of output at which Marginal
Revenue (MR) is equal to Marginal Cost
(MC) is the equilibrium level of output.
Fig. 13.5 : Equilibrium : Excess Profit
The steps to draw the figure are same as
earlier.
The equilibrium point E in Fig. 13.5 shows
the point of intersection of MR and MC curve
and line from E perpendicular to X axis would
give point N, ON is the level of output at
equilibrium. NE curve when extended intersects
AR curve at S. it intersects AC curve at M.
when a line is drawn perpendicular from ‘S’ to
Y axis we get the price OP. When a line is drawn
perpendicular from M to Y axis, we get AC,
OQ. On the basis of all this, we can calculate
the total profit to the monopoly firm. Details can
be explained as follows :
E = Equilibrium (MR = MC)
ON = Quantity
OP = SN = Price
MN = AC  Price > AC
SM = Profit per Unit
PQMS : Total Profit (SM x QM)
 Excess profit (shaded region)
Markets and Price Determination : 131
Questions for Self Study - 3
(a) Dominance in the Market
(A) State whether the following
statements are true or false. Put ()
or () in bracket.
Monopoly emerges in this way. A firm
produces something which is new in the market.
Consumers react favorably to this product. He
develops himself as the major player in the
market. For examples, Dalda vegetable ghee is
prepared by sunflower. The equation in the minds
of people is Dalda = Sunflower. Now, even if
new players enter the market, their sale will be
negligible in comparison with the sale of
sunflower. Similarly, Colgate has a share of 65%
in the toothpaste market. The new comers are
less powerful than the industry (firm) in every
respect, say, capital, employment, level of output,
etc. This is how functional monopoly comes into
existence.
(1)
In monopoly, firm and industry are the
same. ( )
(2)
The condition of equilibrium, in monopoly
also, is MR=MC. ( )
(3)
A firm always earns excess profit in short
run in monopoly. ( )
(4)
Firm earns normal profit when price is
more than the average cost (AC). ( )
13.2.4 Do We Find Monopoly in
Reality?
Like perfect competition, we do not find
monopoly in reality. In order to esablish pure
monopoly, the good which is being sold by the
monopolist, should not have any substitute. But
this condition is not satisfied in reality. e.g. Don’t
you think that transistors and tape recorders are
alternatives to Television? Suppose the producer
of television raises the prices of his product at
such a high level that it is not possible for the
consumer to purchase it, then in such conditions
what will the customers do? They will definitely
go for other alternatives of entertainment and
purchase transistors and tape recorders.
Secondly, a monopolist should have
tremendous control over the price. This also is
not possible. Suppose there is a single kite seller
in entire village. Taking the advantage of this he
can sell kites at Rs. 2 instead of Re. 1. But if he
fixes the price at Rs. 40, no kite will be sold.
Thus we see that there is a discrepancy
between theory and practical. Then, how is the
monopoly in the real world.
(a)
In spite of many sellers only one is
dominent.
(b)
Monopolist can do price discrimination for
different group of buyers.
(c)
A monopolist can not freely exploit the
customers.
Let’s consider these points in detail now.
(b) Price Discrimination
When the monopolist sells his
homogenous good to different consumers
at different prices it is known as ‘price
discrimination’.
Monopoloy
Simple Monopoly
Same Price to all
the customers
Discriminating Monopoly
Different prices for
Different consumers
The monopolist, in order to maximise his
profit, takes into consideration its consumer
groups. These groups are poor-rich consumers,
consumers using good for consumption and those
using it for commercial purposes etc. In private
tuitions, many a times, poor students have to
pay less fees than rich students. This policy of
charging different prices for the same good is
known as Price Discrimination.
Markets and Price Determination : 132
Methods of Price Discrimination
Price discrimination can be of three types.
It is as follows :
Personal Price
Discrimination
Price
Discrimination
there are as many markets as there are prices.
The markets should be naturally or artificially
separated. Following conditions should be
attained :
(a)
It is not possible for consumers buying
goods in costlier market to go to markets
where goods are available at cheaper
prices. So the markets are segmented well,
i.e. well separated.
(b)
It is impossible to buy the goods from a
cheaper market and sell the same in the
dearer markets. No possibility of resale.
Trade
Discrimination
Spatial
Discrimination
Let’s see how it is attained.
(1) Personal Price Discrimination
(1) Market Imperfections
When same goods are sold at different
prices to different people, then it is known as
‘personal price discrimination’. For example,
doctor, lawyer and teachers take high fees from
rich clients and less fee from poor people.
There has to be some kind of imperfection
in the market for this to happen. Now we shall
see why does imperfection emerge in the
market.
(2) Trade Discrimination
If a same good is used for different
purposes, it is priced differently. For example, if
is electricity is used for household purposes, it
charged at less price per unit consumed.
Electricity used for production purpose is
charged at a high rate. Fares for fast and super
fast buses are discriminated. This is known as
‘Trade discrimination’.
(3) Spatial Discrimination
Under this type the same good is priced
different at different places. For example, the
price of petrol in Delhi, Mumbai and Nashik is
different. Petrol sold is the same in all three
places, but the prices are not. Same is the
condition of cooking gas. In international trade,
the policy is that the goods are sold at cheaper
rates in domestic market and at higher prices in
international market. Sometimes goods are sold
at cheaper rates in foreign markets in order to
capture this market. This is known as ‘dumping’.
When is Price Discrimination Possible?
The monopolist should be able to keep the
consumer groups, whom he charges different
prices, away from each other. He should be
able to keep his markets separate. The concept
of market says that price in a market are the
same. Therefore in case of price discrimination,
(a) Lack of Knowledge about the
Market : Complete knowledge on the part of
consumer is a sign of perfection for any market.
But it is not usually so. Many a times consumers
are unaware of the market selling goods at
cheaper rates. Monopolist tries to take
advantage of this unawareness.
(b) Lack of Rational Behaviour : Many
times consumers relate high price with high
quality. Some times, buying goods from costlier
markets is considered a symbol of status.
(c) Monopoly : Without having monopoly
no seller can discriminate between consumers
by offering them different prices. Thus monopoly
is an essential condition.
(2) Geographical Distance
Two markets can be easily kept separate
if there is geographical distance between them.
For example, petrol in Mumbai is Rs. 50/Ltr.
and in Nashik, it is Rs. 52/Ltr. The distance
between Mumbai and Nashik is so large that
consumer can not get his petrol filled from
Mumbai. Nor can a consumer buy petrol from
Mumbai and sell it at higher rates in Nashik as
his transportation cost will be definitely more
than Rs.2 per litre.
(3) Nature of Goods or Services
Price discrimination also depends upon
nature of good or service. For example, in case
Markets and Price Determination : 133
of doctor’s service to the patient, the patient
has to go to the doctor. He cannot be treated by
anyone else and then he has to give the doctor
whatever fee he demands.
(4) Legal Permission
In case of electricity, the electricity
authority has the legal right to charge different
prices depending upon the end use of electricity.
In Cinema halls, the tickets for balcony are
legally more than that of first class. In railways,
a consumer cannot buy the ticket of second
class and travel in first class. There is a criminal
offence.
Questions for Self Study - 4
(A) State whether the following
statements are true or false. Put ()
or () in bracket.
(1)
Exactly like pure competition, monopoly
does not occur in real world. ( )
(2)
It is impossible that there is absolutely no
substitute anywhere for a particular
good. ( )
(3)
A producer / seller can establish his
monopoly even in the real world of with
the help of quality and perseverance. ( )
(4)
(5)
When monopolist price his goods
differently for different consumers, then it
is known as price discrimination. ( )
It is not the case that price discrimination
can only be implemented in monopoly. It
can also be implemented in perfect
competition. ( )
(6)
In personal price discrimination,
consumers are devided into groups by the
monopolist, for whom he charges different
prices. ( )
(7)
When there is price discrimination on the
basis of the use to which the good is put, it
is known as trade price discrimination. ( )
(8)
(9)
When the same good is priced differently
in different markets, it is known as spatial
price discrimination.
The price discrimination can be
implemented even if the geographical
distances between the two markets is very
less and there is a contact between
consumers of both the markets. ( )
(10) A monopolist is able to implement price
discrimination because there is an
incompleteness in the market. ( )
(11) The price discrimination in some cases is
legal or legally permitted. ( )
(12) The more the rational behaviour of the
consumer, the more successful is price
discrimination. ( )
13.2.5 Price Discrimination :
Conditions for Success
For the price discrimination to be
successful the elasticity of demand in different
markets should be different. If the elasticity of
demand is same everywhere, the marginal
revenue is same everywhere. And if the
marginal revenue is same then the price is also
same everywhere, there is no scope for the
monopolist to implement price discrimination.On
the other hand, the profit of monopolist increases
if he shifts some goods from the market where
the elasticity is high to the one where the
elasticity of demand is low.
(a) Consequences of PriceDiscrimination
Following are the consequences :
(1) Increase in Profit : Monopolist earns
more profit than he does in simple monopoly.
(2) Increase in Production : As the
monopolist divides his market, he can sell more
quantity of goods in one particular market by
reducing the price if he decides to do so. Price
and supply in other markets does not change.
His loss (due to reduction in price) is wiped out
as he manages to sell more number of units in
this market.
(3) Gain to Poor Consumers : The
example of a doctor charging less to his poor
patient, fully explains the gain of price
discrimination to poor people.
(4) Social Welfare : Whether social
welfare is attained due to price discrimination
depends upon who is gaining from it. If the rich
are charged more and the poor are charged less,
then, this price discrimination leads to social
welfare.
Markets and Price Determination : 134
(b)
Combining these two conditions, it can be said
that
Equilibrium in Monopoly with Price
Discrimination
MR1 = MR2 = ------ MRN = MC
Equilibrium Condition
We know that in simple monopoly,
equilibrium is attained where MR=MC. Same
is the case here. Monopolist fixes different
prices in different markets. There are as many
markets as there are prices. Hence, marginal
revenue in each market has to be the same. On
this basis.
(1)
Marginal revenue in each market should
be the same and
(2)
The marginal revenue of the firm should
be equal to it marginal cost in each market.
Y

market 2, —— market N respectively.
Process of Equilibrium
To make this process simple to
understand, we assume that the monopolist fixes
just two different prices i.e. he sells his goods in
only two markets. The elasticity of demand in
both the markets in different.
First, we will draw the Fig. 13.6. The steps
are as follows
Y
Y
Market (1)
Cost, Revenue, Price
Here 1,2 —— N number show market 1,
Market (2)
Equilibrium of Firm
G
G
MC
F1
P1
P2
Q
E1
Q
A
A
F2
R
E
Q
E2
AR2 B
o
MR 1
N1
X
Quantity
D
 MR
MR2
AR1
o
N2
X
Quantity
o
N
X
Quantity
Fig. 13.6 : Equilibrium in Monopoly with Price Discrimination

The monopolist sells goods in two markets.
In one figure we will have to show the
equilibrium of the firms. So that we get
the total production by the firm. As there
are two markets, the figure of each market
will have to be drawn separately. Thus,
we have to draw, three figures in all.

As all the three figures are closely related
they should be drawn in a straight line. First
draw three X and Y axis as shown in the
figure. Name all the three figures ‘Market1, Market-2’ and ‘Equilibrium of firm’
respectively.

Next, draw AR curve in Fig. 1. the
demand here is inelastic. Thus the curve
will be steep. Name it AR1. Draw MR
curve to the left of it and name it MR1.

Draw AR for Fig. 2 Here the demand is
elastic. Thus draw the AR curve flatter.
Name it AR2. Draw MR curve to the left
of it and name it MR2.

Then, in third figure we will draw MR
curve for the firm. This curve is the sum
of MR 1 and MR 2 . Let’s see why. The
MR1 of market 1 starts from G. Draw a
straight dotted line parallel to X axis from
G to the last figure. Name the point ‘G’
where it intersects Y axis. The firms
collective MR will start from this G. MR2
of market two will start from A. Draw a
dotted line from A parallel to X axis
covering the second and third figure. In
the area of GA, there is only MR1. Thus,
the collective curve should be drawn
Markets and Price Determination : 135
parallel to it. In Fig. 3, it is given as GR.
Now MR2 will be added to it. Thus GR
bends slightly towards right. Now, see RD.
GRD is the collective MR curve. It should
be shown as MR (in mathematics ‘’ is
used to show addition). Here MR=MR1
+ MR2.

Now, draw ‘U’ shaped MC curve as we
draw usually.

First, we want to show the equilibrium of
the firm. The main condition of equilibrium
as we know is MR=MC. Name this point
where MR=MC as E. Draw a
perpendicular from E to X axis. ON is the
total output of the monopolist. We shall see
how this output is divided into market 1
and market 2. The total profit to the
monopolist is shown by GBE.

Now, we shall show equilibrium in each
market. The condition for the markets -
Two things can be concluded from this :
(a)
The demand in market-1 is inelastic.
That’s why the supply is kept low
and price is fixed at a higher point.
(b)
The demand in market-2 is elastic.
That’s why here supply is kept high
keeping the price low.
Market - 1
Market - 2
Firm
Demand :
in elastic
Demand :
Elastic
Combined MR
Curve : MR
Equilibrium
Condition :
MR1=MC
Equilibrium
Condition :
MR2 = MC
Equilibrium
Condition :
MR = MC
Suppy: ON1
Supply : ON2
Supply : ON
Price : OP1
Price : OP2
Total Profit
GBE
Market 1 = MR1 = MC
Market 2 = MR2 = MC



In figures of both the markets, we have
not drawn MC because we want to use
that MC which is there at the equilibrium
level of the firm. Therefore, draw a dotted
line from E parallel to the X axis, as shown
in the figure. Name it as Q. OQ is the MC
at equilibrium.
Now in market 1, the point where
MC=MR1 is to be named as E1. E1 is the
equilibrium point of market 1. Draw a line
perpendicular to X axis from E. We get
point ‘N1 ’. ON1 is equilibrium level of
output in market 1. But at what price will
he sell this output. To find out that draw a
straight line from E1 till AR1. We get point
F1. Draw a perpendicular line to Y axis
from F 1 . We get P 1, OP 1 is the market
price.
Complete the figure for market-2 in same
manner. In market - 2 E 2 will be the
equilibrium, ON2 level of production and
OP2 the price.
Thus, the total ON output is
distributed in the following manner.
Market
Price
Supply
1
OP 1
ON 1
2
OP 2
ON 2
(c)
Government Monopoly and Price
Discrimination
Sometimes, govt. invests in some
industries and produces goods and services of
social benefit. We have mentioned a few
industries, where central and state govt. have
monopoly e.g, Railway, atomic energy, etc. Such
a monopoly is created by law.
The objective of this monopoly is social
welfare and making available certain goods and
services at reasonable rates. The objective
behind price discrimination in such industries is
to make available goods at cheaper rates for
poor and at a higher rate for rich so that the
costs are covered.
(d) Monopoly and Exploitation
According to the theoretical explanation,
we have seen that the monopolist earns
supernormal profit. He can exploit in two ways.
One he can exploit the consumers by keeping
prices high and second he has great control over
consumers in the sense he buys their services
in the factor market. As he is the only one
consumer in the factor market, consumers have
to sell their services to him only. He is monopolist
in consumer goods market as well as factor
Markets and Price Determination : 136
market. Obviously, he pays less to the factors
of production.
(2)
The monopolist , on one hand exploits
the consumers by keeping the prices high,
on the other hand exploits them by paying
them less factor income.
But we don’t come across such a situation
in reality.
(1) Labour Unions : According to the
theory propounded by John Galbraith, the rise
of monopoly leads to rise of labourers. Who get
together in labour unions reducing the strength
of the monopolist? Therefore, it is not possible
to exploit the consumers in two ways.
(2) Competitors : What, if a firm gets
unreasonably high profit. This leads to a
possibility of new entrants in the industry in
future, if not now. Secondly when govt. gives
the monopoly to a company, it forces the firms
to keep price reasonable. Thus there is a
restriction on his earning unreasonable profit.
(3)
(4)
(5)
(3) Demand for increase in wages : A
rise in profit of the monopolist brings with it a
pressing demand for increase in wages, bonus,
etc. If the labour unions are strong, these
demands are accepted because if it is not
accepted, it may harm the goodwill of the
company because of the clash between
entrepreneur and labourers.
(4) Threat of nationalisation : Many a
times a profit making monopoly is taken over by
Govt. i.e. the firm is nationalised for the greed
of profit.
Price discrimination has following effect
on the profit - The profit
(a)
Increases
(b)
Decreases
(c)
Doesn’t Change
(d)
Is at the level of normal profit.
The monopolist sells the good in a market
with high elasticity of demand at
(a)
Less price
(b)
Higher price
(c)
It is not decided
Price discrimination ——— the social
welfare
(a)
Increases
(b)
Decreases
(c)
Does not affect
(d)
Depends upon, who gains from price
discrimination
The condition necessary for equilibrium of
a firm implementing price discrimination
is that (a)
MR and MC are equal in every
market and MR should be equal in
all market.
(b)
MR should be equal to MC in any
one market.
(c)
MR and MC in any market are
equal.
(d)
There is no possibility that MR and
MC will be same in any market.
(5) Elasticity of demand : A monopolist
has to take the consumers demand as given. In
a market with more elastic demand, a firm does
not keep its price high and level of output low.
Instead, it keeps prices a bit low and level of
output high.
(B) State whether the following
statements are true or false. Put ()
or () in bracket.
(1)
In a market with inelastic demand,
monopolist keeps the prices high and
supplies less. ( )
Questions for Self Study - 5
(2)
In a market with elastic demand, the
monopolist keeps the prices low and
supplies more. ( )
(3)
The objective of monopoly of Govt.
enterprise is social welfare. ( )
(4)
Monopolist exploits the consumer by two
ways, one by charging prices for goods,
secondly paying less to them as factors of
production. ( )
(A) Choose the right option.
(1)
For the price discrimination to be
successful for the monopolist, the elasticity
of demand should be
(a)
Same in different markets
(b)
Same in one market
(c)
Different in different markets
Markets and Price Determination : 137
(5)
Monopolist can earn unreasonably high
profit for long. ( )
(6)
The higher the unreasonable / supernormal
profit, the more improbable is the entry of
new firms. ( )
(7)
There is a threat of nationalisation of a
firm which is earning supernormal profit
with the objective of social welfare. ( )
13.2.6 Duopoly
In 1838, Cournot tried to propound a
market which is more realistic than the
improbable and ideal markets of perfect
competition and monopoly.
When there are only two sellers in a
market and innumerable buyers and the good
produced by the two producers is the same, then
such a market is called Duopoly.
Now, how will the firms behave in such a
situation? If a firm reduces its prices, to attract
the consumers, the other firm reduces them even
more. Due to this competition price falls even
below the market price. When one of the two
fails to bear the losses anymore, he exits the
industry or stops his business for some time.
The firm which is still in the market, now
increases the prices till the monopoly price level.
When the supply of this monopolist finishes, he
takes some time to supply more. The other firm
utilise this time and comes back into the market
and attracts the consumers. This is the situation
in short run.
In long run, the whole market is divided
into two sellers. According to Edgeworth, the
price keeps on fluctuating between the price
levels of perfect competition and monopoly.
Stackleberg has called the first seller, who
takes the first decision as the ‘leader’ and the
other as ‘follower’. Who gives reaction to the
leader’s decisions.
The former realises the fact that the entry
of a new firm would reduce the price as the
supply would increase. Therefore he reduces
his supply. Price increases and the follower
supplies more. The former further reduces the
prices and the other firm forms its own consumer
group. Now both the firms mutually decide to
increase the prices. At the same time they do
not forget that they are competitors. Thus
competition can start again anytime and the
prices go down.
But according to Chamberlin, there can
be an equilibrium in the duopoly also. Both the
firms have a mutual agreement through which
both try to attain maximum profit by deciding
the price level. Both the firms abide by the
agreement till it is beneficial to both. Thus
instability doesn’t arise. Moreover, today we see
that every firm wants to earn maximum profit.
Also, the behaviour of each firm depends upon
that of the other. Suppose, one firm breaches
the agreement and earns temporary profit. But
in long run he may have to face losses,
considering the reactions of the other firm. If
the firms think of the future too, none would
breach the agreement and stick to the decided
price level. This price level is less than that in
monopoly market and more than that in perfect
competition. None would sell below this price.
The less the number of sellers the more the
certainty in such market.
Questions for Self Study - 6
(A) Answers in short.
(1)
What is meant by duopoly?
(2)
How would firms behave in a duopoly
market?
(3)
What does Chamberlin have to say about
duopoly market?
(4)
What does Stackleberg say about
duopoly?
13.2.7 Oligopoly : Meaning and
Features
What is Oligopoly?
We have already studied monopoly,
monopolistic competition and perfect
competition. What we see in real world is an
altogether different condition. There are very
few number of firms in an industry. Such
industries, for example, are steel, refrigerator,
scooters, petroleum, LPG, etc. Such a market
with very less number of firms is known as
Oligopoly.
Markets and Price Determination : 138
Oligopoly can be defined as a market
structure with very few producers producing
homogeneous or goods which are close
substitutes of each other.
reactions of other firms. The producer in this
market is ‘price-maker’.
On the basis of the policy implemented by
the oligopolist, oligopoly is divided into two parts.
(A) Features of an Oligopoly Market
Types of
Oligopoly
(1) Number of consumers
In this market also the number of
consumers is very large. So no single consumer
can influence the price. Therefore, the consumer
can not decide the price and only has to adjust
his demand according to it. The consumer is a
‘price-taker’.
(1)
Non-Collusive
Oligopoly
Collusive
Oligopoly
Partial
Collusion
Complete
Collusion
Price
Leadership
(3) Cartel
(2) Number of sellers
The number of sellers is very less and
generally ranges between 2 to 10. For example,
there are very less number of firms in petroleum
and LPG industry as Hindustan Petroleum,
Bharat Petroleum, IBP, Essar, Indian Oil and
Reliance.
In an oligopoly market, each producer gets
a large share of the market and therefore,
control both the demand and price of his product.
To a certain extent he is a monopolist. Suppose
a producer of small cars decides either to reduce
the prices or increase the supply. Then, there is
possibility of other firms reciprocating to this
action. For example, Maruti brings down its
prices by Rs. 10,000 then other companies will
also reduce the prices. In short, every firms has
to take into account, other firm’s reactions
before taking any decision. In other words the
policy of one firm depends upon that of the other.
What if other firms also reduce the price
when one has done so. The implications of this
will be that the firm would not get any increase
in demand, but its profit will be reduced due to
reduction in prices. This is called price war and
cut throat competition. To avoid such a
competition, firms openly or tacitly come together
for mutual benefit. In these agreements the level
of production, price and markets are decided.
But this doesn’t always happen. Every
entrepreneur wants to do something new in some
industry. So he takes all his decisions considering
(2)
If this chart is seen carefully, there are 3
types of monopoly. It is shown by 1,2 and 3.
The process of price determination is different
for all three.
(3) Nature of good
The goods are of two types in oligopoly,
viz, homogeneous and differentiated. Goods of
both the types can be seen in India. Petrol of all
the firms (BP, HP, IBP, Essar) is the same. Small
cars of all producers are differentiated. The type
of good has an effect over the process of price
determination.
Homonogenous
Nature of Goods
Differntiated
(4) Knowledge about the Market
As the number of sellers is limited,
consumers know well about the market, the
sellers, the products and the prices. Thus,
complete knowledge of the market is an
important feature of oligopoly.
Markets and Price Determination : 139
(5) Entry in the Market
There are two different policies regarding
the entry of firms.
Free
Entry
Open
Oligopoly
Restriction
on Entry
Closed
Oligopoly
Entry in
the Market
In open oligopoly there is a free entry to
new firms. But in a closed oligopoly, the
producers create a collective monopoly and don’t
allow new firms to easily enter the market.
(6) Demand Curve
As there is less number of producers
depending upon each other, there is always a
kind of uncertainty in this market. One producer
can never be sure of the other’s reaction.
Similarly there is an uncertainty regarding price
of a good and demand at that price. Thus, the
demand curve in oligopoly is uncertain.
(B) Kinky Demand Curve
Paul Sweezy introduced kinky demand
curve based on the uncertainty in the market.
Demand curve is nothing but the sellers average
revenue curve.
Price
Y
curve as a dotted line. The slope of DS is related
to the slope of DE of AR curve. Now draw TM
curve which is MR curve relating to ED1 part
of AR. There will be no marginal curve in ST
region i.e the MR curve will be in fragments as
DS and TM.
As shown in the figure OP = EN is the
price established in the market and PE is the
total demand for goods of firm. If one firm
reduces prices, all other firms will do so. Thus,
the first firm would not get an opportunity to sell
more goods and his demand will not increase.
This curve is ED1 and is inelastic. On the other
hand, what will happen if one firm increases its
prices? No other firm will increase their prices
in response and the firm’s demand will go down
drastically i.e. the demand curve will become
elastic as DE curve. We have seen, that due to
difference in the reactions of the sellers, the
demand curve becomes kinky at point E. This
point E shows the price in the market i.e. OP
(=EN). Due to this kinkyness of the AR curve,
the MR curve corresponding to that is broken
between S and T.
Price Determination in Oligopoly
Following are problems that arise in price
determination in oligopoly.
(1) The demand curve is uncertain i.e. shape
of demand curve of every producer is not
the same.
(2) In perfect competition, a firm tries to get
maximum profit by selling maximum
number of output. The output level is
determined at the point where MR=MC.
This is not that obvious in oligopoly. Though
each firm wants maximum profit, not every
firm gets it. To remain in the business
becomes the prority for many.
D
Questions for Self Study - 7
E
P
P
(A) State whether the following
statements are true or false. Put ()
or () in bracket.
S
T
D1
(1)
A market structure with few sellers selling
homogeneous or substitute goods is known
as Oligopoly. ( )
Fig. 13.7 : Average Revenue Curve
(2)
While drawing the Fig. 13.7, demand curve
should be drawn flatter till point E and steeper,
after that draw the MR curve to the left of this
As the number of consumers is high, no
single producer can individually affect the
price by affecting the demand. ( )
(3)
Seller in oligopoly is price maker. ( )
0
N
Units of Output
X
M
Markets and Price Determination : 140
(4)
If one firm reduces its price, it is not
necessary that other firms would also
reduce their prices. ( )
(5)
There is no influence of other firms
decisions on the decisions of any firm. ( )
(6)
The demand curve in oligopoly is kinky
because of the fact that firms reduces
prices if one does so, but one increases
prices in response to an increase in prices
by one firm. ( )
(7)
The demand curve of each seller is
uncertain in oligopoly. ( )
(8)
In oligopoly, the policies of other firms can
be more precisely calculated, as compared
to any other market. ( )
(9)
It can be precisely expressed, what would
be the reaction of other firms to the
decisions of one firms. ( )
(10) A monopoly like condition emerges when
firms in oligopoly come together. ( )
13.2.8 Oligopoly : Price
Determination
In oligopoly, reactions to the decision of
any firm are uncertain. The process of price
determination depends upon the type of oligopoly.
Now, we shall study the process of price
determination based upon the type.
(1) Non Collusive Oligopoly
demand for soap will increase as consumers will
shift from other soap to ‘Lux’. This forces other
firms to bring down their price to Rs 5 in order
to regain their consumers. The consumers will
again shift to their previous prefernce. Thus the
producers of Lux would not earn the expected
profit. What would happen when firms reduce
prices.
(a)
Producer of ‘Lux’ would not gain from
reduction in prices.
(b)
Decrease in prices of soap in general will
increase the total demand and all firms will
gain from it.
In short, as any producer cannot gain from
reducing the prices, he will not try to lower down
the established price.
Now the second option that the producer
of Lux has is that he may increase the price
from Rs 6 to Rs.7 to earn more profit. This move
is less likely to be imitated by other firms as it is
beneficial to sell their good at price less than
that of ‘Lux’. Lux will only face loss from this
move because its consumers will shift to other
soap and demand for ‘Lux’ will decrease.
Therefore, the producer of Lux will not increase
the price. In short, as he cannot gain by increasing
the price, he will stick to the established price.
In other words in non-collusive oligopoly, it is
difficult for any firm to increase profit by
increasing or decreasing prices. Thus all firms
stick to the established price. This is called ‘price
rigidity.’
In oligopoly, as we know, there are only
few sellers producing homogeneous or substitute
goods. Many times producer take their decisions
about price and output independently anticipating
the reaction of competitor firms. Such an
oligopoly is known as ‘non-collusive oligopoly’
Let’s see with the help of an example.
(2) Collusive Oligopoly
We will take the example of soap industry.
Suppose the seller of ‘Lux’ soap has his price
fixed at Rs 6. Other firms are selling their soaps
with their brand. In such a case, the producer
of Lux would like to increase his profits. He
can do this by altering the price. Let’s see what
would be the reaction if he does so.
In this type, one firm decides the price
which is accepted by all other firms. The firm
which takes the decision regarding price is
known as ‘price-leader’. Who would be the price
leader is decided on two parameters and this
type is again divided into (a) Dominant firm type
leadership and (b) Barometric price leadership.
Suppose, the price of ‘Lux’is reduced from
Rs 6 to Rs 5. While taking this decision it is
assumed that other firms will not reduce their
prices. Now, as the price has reduced, the
(A) Dominant Firm Type Price
Leadership : Sometimes so happens that only
one firm supplies a major share of total supply.
Other firms supply only little. In such a situation
To avoid this price-rigidity, the firms prefer
collusive oligopoly. This can be further subdivided into (a) Partial collusion and (b) Perfect
collusion.
Partial Collusion - Price Leadership
Markets and Price Determination : 141
this dominant firm decides the price and it is
accepted by other small producers. If any firm
tries to sell at a price more than the price decided
by the dominant firms, its demand may go down
sharply. On the contrary, no firm sells at a lower
price than established price because there is no
need of it as each firm can sell its whole output
at the market price.
Efficient
Firm
Leader
Firm
Follower Firm
The condition of the market can be
explained by following chart.
PriceMaker
Price-takers
A
Large
Firm
B
C
D
E
Small Firms
Leader
Firm
Follower Firm
PriceMaker
Price-takers
(B) Barometric Price Leadership
This is second type of price leadership
when all the firms in an industry are equally large
and no one is particularly dominant, the
responsibility of deciding the price is given to a
firm, which has the ability to precisely anticipate
the condition of market demand and supply. This
firm is chosen with the consent of all other
firms.
This firm, now decides the price, other
firms accept it. All firms charge the price as the
leader charges it. This leader is regarded as the
barometer. The idea behind this name is that as
a barometer anticipates changes in atmosphere,
the barometer firm anticipates changes in the
market. The price decided by him is a sign of
equilibrium between demand and supply. The
leader is not necessarily dominant in this case.
Any seller can be the leader who has the ability
to precisely anticipate conditions in the market.
Thus the price leader can be different at different
point of time. This market condition can be
explained with the help of following chart.
A
B
C
D
Less Efficient
Firms
Perfect Collusion-Cartel
In this type all the firms came together
and form a central association. It is through this
association that the level of production of each
firm is decided. A price is decided through this
mechanism that is acceptable to all. The
objective behind this to avoid cut throat
competition. The price is decided considering
the production cost of all the firms so that the
collective profit of all the firms is maximum.
But there are some problems in price
determination through this process. They are(1) It is less probable that the price decided by
the cartel and other decisions regarding
production are acceptable to all. (2) It is not
necessary that the government would approve
the agreement of such a cartel. (3) This
mechanism would not last if new firms enter
the market.
Following chart explains this concept of
oligopolyA
B
C
D
E
Holding Company
This firm takes policy decisions on following :
(1) Total production and output of each firms
(2) Price
(3) Share of market
(4) Share of Profit
Thus, Holding firm controls price and supply
Monopoly - like situation
Markets and Price Determination : 142
Questions for Self Study - 8
(A) Give Reasons (1)
Price rigidity exists in non-collusive
oligopoly.
(2)
Price leadership exists in oligopoly.
(3)
The central association-controlling sale of
the product may not be always successful.
13.2.9 Regulation of Monopoly
The dominance of one single firm on the
industry is called monopoly. We have also seen
how monopolist exploits consumers in a twoway manner.
Monopolist creates artificial scarcity in the
market. That means that the level of production
is less in monopoly as compared to that in
perfect competition. Also, the total cost is high
as the optimum level of production is not
attained. This is the sign of an inefficient
producer. Due to high price, monopolist always
earns profit and is criticized by the society.
Monopoly leads to exploitation of the society.
Therefore, there is a need to regulate monopoly.
We have already seen, how in some
industries, monopoly is inevitable. Industries
demanding huge capital investments remain in
monopoly. Also, an increase in number of firms
in such an industry would mean loss to the nation
as a whole because more natural resources will
be unnecessarily used. Thus, in such an industry,
monopoly is the best option and govt. also
supports it.
are affordable to the general public. These
committees fix the quality and price of goods
and services. The price decided by these
committees is the final price. These prices are
charged to the consumers. As inflation occurs
in the economy prices are reconsidered. Earlier,
in England, the govt. used to appoint such
committees while permitting companies to
establish monopoly in certain industries including
railways and shipping. In India, we see snack
centers in railway stations. The railway board
fixes these rates.
(3) Taxation
The monopolist is taxed by the govt. in
following ways :
(a)
Tax on Monopoly Right : The Govt. taxes
the monopolist while giving him the
permission to establish monopoly.
Transportation charges are fixed for any
ferry service running between two banks
of a rivers.
(b)
Tax on Production : Such a tax on
production levied by the govt. is not really
beneficial to the society as this tax is borne
by the consumers in the form of increase
in price.
(c)
Tax on Excess Profit : This tax is
beneficial for the society as it is collected
by the govt. and spent for social welfare.
Also, as the cost is already covered, the
monopolist does not increases the prices.
But govt. takes many measurers to
regulate such monopolies. They are as follows :
Questions for Self Study - 9
(1) Control through Legal Restrictions
(A) State whether the following
statements are true or false. Put ()
or () in bracket.
In many countries, Govt. ensures that
monopoly does not emerge in any industry. For
this, many legal acts are implemented. In this
context, U.S. Anti-Trust. Acts, Anti-Merger
Acts, or Monopoly and Restrictive Trade
Practices Act are some example. Other than
these, the objective of industrial licensing, etc.
are implemented in various countries with the
same objective.
(2) Price and Quality Determination
The govt. appoints various committees to
ensure that the quality in maintained and the price
(1)
Monopolist can exploit the consumers in
a two way manner, one by fixing high price
for his goods and secondly by paying low
wages to the factors of production. ( )
(2)
It is better to have monopoly in those areas
where the capital investment is very high.
( )
(3)
The govt. many times puts restriction, so
that monopoly does not emerge and
consumers are not exploited. ( )
Markets and Price Determination : 143
(4)
A tax on production by the Govt.
encourages the firm to produce more. ( )
(5)
The monopolist has to reduce the
production, if Govt. taxes the excess profit
of monopolist. ( )
Questions for Self Study- 4
(1) (), (2) (), (3) (), (4) (), (5) (),
(6) (), (7) (), (8) (), (9) (), (10) (),
(11) (), (12) ().
Questions for Self Study- 5
(A) (1) (3), (2) (1), (3) (1), (4) (1), (5) (1)
13.3 Words and their
Meanings
(B) (1) () (2) (), (3) (), (4) (), (5) (),
(6) (), (7) ().
Questions for Self Study- 6
Public Utilities - Firms producing goods for
social welfare. Profit is not thought about
in these firms.
Simple Monopoly - Monopoly where all the
consumers pay same prices for same
goods.
(1)
(2)
Price Differentiation - Same good is priced
differently for different consumers.
Duopoly - Market with only to firms.
Sellers Market - Market dominated by sellers.
Non-Price Competition - Competition through
tools such as advertisements, prizes, gifts,
etc. other than price.
Collusive Oligopoly - Firms mutually come
together and sign an agreement and
thereby form an indirect monopoly.
(3)
13.4 Answers to Questions
for Self Study
Questions for Self Study- 1
(1) (), (2) (), (3) (), (4) (), (5) (),
(6) (), (7) (), (8) (), (9) (), (10) ().
Questions for Self Study- 2
(1) (), (2) (), (3) (), (4) (), (5) (),
(6) (), (7) (), (8) (), (9) ().
Questions for Self Study- 3
(1) (), (2) (), (3) (), (4) ().
(4)
A market structure where there are
innumerable consumers but only 2
producer producing similar goods is called
Duopoly.
If a firm reduces its prices to attract the
consumers, the other firms reduces them
even more. Due to this competiion price
falls even below the market price. When
one of the two firms fails to bear the losses
any more, he exits the industry or stops
his business for some time. The other
producer prices his goods as he wants. The
next firm enters the market when the
supply of this producer ends. In short run,
we come across this condition and in long
run market is divided into two producers.
According to Chamberlin, there can be
equilibrium in the duopoly also. Both the
firms have a mutual agreement through
which both try to attain maximum profit
by deciding the price level. Both the firms
to abide by the agreement till it is beneficial
to both. Thus instability does not arise. If
a firm breaches the agreement, he may
earn profit in short run. But in long run this
would prove to be harmful for him.
Stackleberg calls the seller who takes
initiative as Leader. The second seller is a
follower. The former realises the fact that
the entry of a new firm would reduce the
price as the supply would increase and
the follower supplies more. The former
further reduces the prices and the other
firm form its own consumer group. Now
both the firm mutually decide to increase
the prices. At the same time they do not
forget that they are competitors. Thus the
competition can start again any time and
the prices go down.
Markets and Price Determination : 144
Questions for Self Study- 7
(1) (), (2) (), (3) (), (4) (), (5) (),
(6) (), (7) (), (8) (), (9) (), (10) ().
Questions for Self Study- 8
(1)
In non collusive oligopoly, every firm
decides its own price policy. But he has to
take into consideration the other firms
reaction. If a firm reduces price to attract
new customers, other firms also do the
same. Thus first firm fails to increase his
sale. In the other hand, if a firm increases
the price, no other firm would do so because
this will reduce their demand. Therefore,
the firm would prefer trying to increase
the sale at same price rather than attiring
the price. This leads to price-rigidity.
(2)
In oligopoly, only few producer are there
in business. If each firm takes its own
decisions, there emerges price rigidity.
Many times there is a firm which has a
major share of total market. Other firms
produce comparatively little. These firms
can not decide the price. So they follow
the price decided by the dominant firm.
When all the firms share approximately
same share of the market, the firm which
is efficient in anticipating market trends
decides the price.
(3)
There is a possibility that the decisions
taken by the central association controlling
the sale of the product may not be
acceptable to all the firm. Also, Govt. may
not permit the establishment of such an
association.
Questions for Self Study - 9
(1) (), (2) (), (3) (), (4) (), (5) ()
13.5 Summary
On the basis of competition markets are
divided into perfect competition, monopoly,
oligopoly and monopolistic competition. In
perfect competition there are innumerable
buyers and sellers, selling homogenous goods.
In monopoly there is only one seller and there is
no close substitute to his product. He has
complete control over supply and price. There
are restrictions to the entry of new firms. The
demand curve is downward sloping to the right.
Natural condition, legal support etc. lead to
emergence of monopoly. Equilibrium is at the
point where MR=MC. Though there does not
exist price monopoly in real world, a producer
can be called a monopolist due to his dominance
in the market.
When a firm sells same product at
different prices to different consumers, it is called
price discrimination. This can be based on
personal, trade or spatial factors. Different prices
for poor and rich, electricity at different rates
and different prices in different cities is a good
example. The monopolist should be able to keep
these different consumers unaware of price
discrimination. Monopolist is able to earn profit
because of lack of knowledge on the part of
consumers, spatial difference, legal permission,
lack of logical behaviour, etc.
The elasticity of demand in different
markets has to be different for the price
discrimination to succeed. In a market where
demand is inelastic, monopolist sells less of the
product at higher prices. In a market where
demand is elastic, monopolist sells more at low
prices. Price differentiation increases the profit
of the firm, the production and poor people also
gain from price discrimination. Whether price
discrimination helps in the social welfare or not
is decided upon which group of people it
benefits. In a monopoly with price-discrimination
equilibrium is at the point where MR equals MC
in each market.
In reality no monopolist can earn
unreasonably high profit due to existence of
trade unions, danger of nationalisation, etc. In
duopoly there are only two sellers. There is an
agreement between them regarding price
determined or competitions regarding it. In long
run firms try to avoid instability in the market
through agreement.
In oligopoly, there are few sellers and
innumerable consumers. There is price
competition in such a market. All the firms have
to take decision taking into consideration
reactions of other firms. We often come across
price rigidity in such a market because other
sellers also reduce price in response to price
reduced by one seller. But if one firm increases
price, other firms do not do so. The result is that
Markets and Price Determination : 145
the price remains rigid and the demand curve
becomes kinky. In oligopoly , we come across
mutual agreement between the sellers. This
leads to price leadership. A dominant firm in
the industry takes decisions regarding price and
output of all firms while considering their
capacity. In case, where all the firms are equally
big price is decided by an efficient firm which
can precisely interpret market trends and
anticipate the future trends. This is called
Barometric price leadership. Many times, a
central association is established to take
decisions regarding price and output. But the
decisions of this association may not always be
acceptable to all. Many times, the Govt. does
not acknowledge the establishment of such an
association.
(7)
Explain features of oligopoly.
(8)
What do you mean by collusive oligopoly?
How does it emerge?
(9)
Explain the concept of kinky demand
curve.
It is essential to have control over
monopoly to avoid consumer exploitation. This
is done through methods like taxation, price and
quality determination, implementation of various
acts.
13.6 Exercises
(1)
Explains the features of monopoly. Explain
how equilibrium is attained in short and long
run in monopoly.
(2)
Differentiate between monopoly in theory
and monopoly in real world.
(3)
Explain various types of monopoly.
(4)
What is price discrimination? Explain the
same and the conditions necessary for it
to be successful.
(5)
(6)
‘A monopolist con not earn unreasonably
high profit.’ Explain it.
Explain in short the duopoly market.
(10) Explain the need of control over monopoly
and its methods.
13.7 Field Work
(1)
List the monopolists in your village. Try to
find out the objective behind their business.
(2)
Note, how doctors in your village charge
their patients.
(3)
Get information from the shopkeeper in
your village regarding the producer of soap,
toothpaste, tea, coffee, etc.
(4)
Get information about various Monopoly
and Restrictive Trade Practices in India.
13.8 Books for Further
Reading
(1)
Bhave,
Kelkar,
Mulyasiddhant
(Marathi), Dastane Ramchandra and Co.
(2)
Koutsoyinannis, A Modern Micro
Economics, London, ELBS, Macmillan,
(Second Edition).
(3)
McConnel and Gupta - Economics (Vol.
I), Bombay, Tata Mcgraw Hill Publishing
Company.
(4)
Mutalik, Desai, Joshi, Aarthik Vishleshan
(Marathi), Part - 1, Nirali Prakashan,
Pune.
Markets and Price Determination : 146
Unit 14 : Price Determination Techniques
Index
14.0 Objectives
14.1 Introduction
14.2 Subject Description
14.2.1 Price Determination in Case of
Multiple Goods
14.2.2 Decision of Price Determination:
Responsible Factors
14.2.3 Price Determination Methods
14.2.4 Elasticity of Demand and Price
Determination
14.2.5 Price Determination and
Objectives of Firms
14.2.6 Price Determination of Factors
of Production
14.3 Words and their Meanings
14.4 Answers to Questions for Self Study
14.5 Summary
14.6 Exercises
14.7 Field Work
14.8 Books for Further Reading
14.0 Objectives
After studying this unit, you will be able to
explain :
14.2 Introduction
In modern times, all firms produce more
than one good. In such a situation, the question
that arises is how the prices of those goods be
determined. The general principle that is followed
is that the total revenue should be more than
total cost. The decision of price determination
is to be taken once and not over and again. The
price is not changed frequently. It is changed
only in the circumstances of increase in cost of
raw material, price change by competitors,
introduction of new product. The price is so set
that the firm gets slightly more than the costs.
Price elasticity plays a major role in price
determination. Firms have different objectives
such as earning maximum profit, capturing the
market, restricting competitors from doing so,
etc. Price is used as a tool to attain these
objectives. Prices of factors of input also play a
major role. The demand for factors of production
is an indirect demand. Factors of production are
paid in the form of wage, rent, interest and profit.
In this unit we would study the price
determination of goods when a firm is producing
more than one good, the condition in which the
decision of price determination is to be taken,
effect of elasticity of demand on price
determination, price determination and objectives
of the firm and price determination of factors of
production.

How a firm producing more than one good
decides the prices of these goods.

Uner what conditions does a firm take
decisions regarding price determination.

Various methods of price determination.

How does the elasticity of demand affect
price of the good?

How is price determination used as
medium to fulfil the objectives of a firm?
14.2.1 Price Determination in
Case of Multiple Goods

How is the price of factors of production
determined?
In traditional theory of price determination,
we assume the firm to be producing only one
14.2 Subject Description
Markets and Price Determination : 147
good. In real world, however, we come across
firms producing more than one product. Example
could be of a firm into milk business. It also
produces cream, ghee, butter, etc. A firm like
Raymond’s also produces textile alongwith
cement. Wipro is in ghee production alongwith
the production of computers, Hindustan Lever
produces soap, toothpaste, animal food, etc.
Questions for Self Study - 1
(1)
In traditional price theory, it is assumed
that each firm produces only one product.
( )
When these products are joint in nature,
there is no need of calculating the total cost of
each good separately. For example, when crude
oil is purified, we get a host of products such as
petrol, diesel, etc.
(2)
A tough competition in the market forces
the firm to reduce the price. ( )
(3)
If there is no tough competition in the
market, each firm can determine its own
price. ( )
As these products are joint and costs are
collective, the price determination is based upon
the nature of demand, capacity of consumers,
profit alongwith average cost, etc.
(4)
In real world many firm produce more than
one good. ( )
(5)
In case of joint products, the cost of each
product has to be calculated separately.
( )
(6)
Firms producing more than one good try
to earn profit from the sale of each product.
( )
(7)
When a firm wants to introduce a new
product it price this product high as the
initial production costs are high. ( )
In our country, price of petrol and diesel is
determined such that the price covers slightly
more than the cost. As diesel is used for vehicles,
which are mainly into transportation of lifeessential goods, it is priced lower than petrol
which is priced more because of the capacity
of consumers. Govt. gets a major part of this
revenue in the form of taxes which is used for
building of infrastructure and other goods of
public utility.
In contrast, Kerosene is priced below its
average cost as it is mainly used by poor people.
Cooking gas is also sold at a price equal to its
average cost of production. Products like
Naftha, white petrol, etc. are however, sold at a
price much above the average cost. Thus,
whenever a firm produces more than one good,
the principle it follows is simple. Its total revenue
from all sources should be more than total cost
incurred on these sources. In other words, even
if every product does not yield a profit,
collectively the firm should earn profit. If some
thing is sold to poor at low price, this should be
recovered through the price of the product sold
to rich people. When a firm wants to introduce
a new product in the industry, it keeps the price
low. In such a condition only the production cost
is taken care of and not the total cost. As the
response of consumers increases, price also
increases. Gradually, the firm recovers even the
losses that it had to bear in initial stages.
This is possible for that firm which
produces many goods. Any firm producing only
one good can not do it.
(A) State whether the following
statements are true or false. Put ()
or () in bracket.
14.2.2 Decision of Price
Determination :
Responsible Factors
The decision of price determination is not
to be taken frequently. The average total cost
includes a fair amount of profit. It also includes
commission to traders and discount to
consumers. Cost like transportation, sales tax,
octroi, etc. once added need not be reviewed
over and again. The maximum retail price of
the good is mentioned on the packing and the
seller charging more than this price may be
punished if consumer complains against him.
Price determination, thus, is needed in only
following situations.
(1)
New Product : The decision regarding
price determination is to be taken when a
producer introduces a product in the
market.
(2)
Change in Production : Price has to be
determined again if the change in
production leads to a change in the average
cost of that product.
Markets and Price Determination : 148
(3)
Change in price of the products of
competitors : Producers have to review
their prices if some competitors reduces
the prices so as to avoid the adverse effect
on demand.
(4)
Increase in production cost : A
producer has to review prices if there is
an increase in the cost of raw material,
wages, etc. if the average cost increases,
price has to be increased accordingly.
(5)
Increase in demand : There can be a
number of reasons for an increase in
demand such as increase in income,
increase in the price of substitute good;
fashion, trends etc. To encash such trends
the price of a product is reviewed. Similarly
a firm has to review its prices in case of
exactly opposite condition and reduce the
prices to remain in the market.
(6)
Govt. policy and taxation : A firm has
to sell a stipulated part of his produce to
the govt. The rest is sold whenever, he
feels like selling it depending upon the
market price.
There are many real life examples of
above given situations. The producers of
Promise toothpaste kept the price of their new
product ‘ Babool’ toothpaste stable at Rs.10/
200 grms for several months to attract the
consumers when other companies were selling
it at Rs. 20/- 200 grams. Bajaj Co. increased
the price of their moped M-80 by Rs. 2000 when
it was introduced in place of M-50. Companies
offer goods at discount after the end of a season
calling it ‘off season’ sale. They reduce their
profit by reducing the price. This is because
today, consumer is called the king. But the case
is not the same with engineering goods. A rise
in price is brought into practice as soon as
possible in these industries because there is no
threat regarding demand. Similarly, the price of
things in fashion is hiked suddenly and comes
down only when the trend fades. The effect of
taxation can be felt on the very second day of
the declaration of Union Budget. Producers do
not even wait for the new year to begin and
decrease the price hike on the very next day.
When there is no demand for a good, it is tried
to be sold by appearing the buyers to buy it at
pre-budget rates.
Questions for Self Study - 2
(A) State whether the following
statements are true or false. Put ()
or () in bracket.
(1) A firm does not change its price related
decision frequently. ( )
(2) If a firm reduces prices, other firms too
have to consider the price-review
decision. ( )
(3) An increase in the price of inputs does
not affect the total cost of making the
good. ( )
(4) After selling a stipulated part of its produce
to the Govt, a firm would sell rest of his
product in the market only when he gets a
fair price. ( )
(5) An increase in demand due to trends and
fashions does not affect the price. ( )
14.2.3 Price Determination
Methods
In traditional price theory, MR = MC is
the determinant of equilibrium. At this point a
producer earns normal profit in perfect
competition and supernormal profit in monopoly.
In real world, as we know, we don’t come
across these extreme conditions. The industry
in which there are less number of producers
and not so tough competition, the firm can take
its own decision regarding price determination.
Following are some of the techniques of doing
so.
(1) Target Return Pricing
The objective of maximum profit is
outdated today. Firms invest a lot in capital goods.
They atleast expect that return from these
investments, what they would have got in any
other investments. Any firm first sets an
objective and then fixes price, taking into account,
total cost, sellers commission, etc. These
objectives can be any of the following such as
earning 5-10% of total turnover, 20% of the total
capital, etc. The tax that is to be given to the
govt. is also taken into account. But the success
of these objective depends upon :
(a)
(b)
Whether the consumer accepts the price
decided by the firms.
A firm should be able to calculate how
much it would be able to sell at this fixed
price.
Markets and Price Determination : 149
(c)
A firm should be able to anticipate the
effect of this price in long run. A
supernormal profit would encourage new
firms to enter the market. Thus, a firm
should not charge unreasonably high
prices.
They are as follows :
(a)
Ignoring Demand : Price more than AC
ignores the demand side completely. Price
does not depend only on supply. If demand
is less, price has to come down.
(b)
Competition : In case of competition no
firm can freely decide the price. Each firm
has to adjust its average cost with the
market price.
(c)
Level of Production : The average cost
is high at lower levels of production and
no unit will be sold at a price higher then
market price.
(d)
Variety of Products : Now a days firms
produce a host of products. Thus, it is
difficult to find out the average cost of one
particular product. Due to these limitations
this principle can not be used always.
(2) Cost Plus or Mark-up Pricing
Any producer decides the price at such a
level that his average costs are fully covered.
This is known as the principle of ‘price more
than Avg. Cost’. However, how more than the
average cost depends upon various factors. If
the consumers bring the good very often, a small
profit per unit is fair enough. If a firm aims at
capturing the market, less profit is again fair. A
large number of sellers do not allow large profit.
The govt. regulation on prices has to be agreed
to. But in contrary conditions, a firm can freely
price its products and earn huge profit.
Suppose a textile firm wants to determine
the per meter price of cloth. The average cost
of it has been given in table 14.1
Table 14.1 : Average Cost
Details
Cost
Rs.per mtr.
(1)
(2)
(3)
(4)
(5)
(6)
(7)
Cost of raw material
Wages
Other direct cost
Fixed costs
Administrative cost
Sales, Transport,Distribution
Excise, Sales tax
Octroi, etc.
21.00
4.00
5.00
10.00
2.00
10.00
10.00
Total Cost
62.00
Profit Ratio ( 20 %)
12.40
Cost plus price
74.40
Suppose, sellers are to be given a
commission of 20%. What should be the price?
Approximately at Rs. 93/meter, a producer
would get Rs. 74.40/meter after subtracting
20% commission (Rs. 18.60) to the seller.
Thus, we see that price determination is
very simple. But there is certain limitations also.
(3) Other Techniques
Firms usually use the above-explained two
techniques only. But, when a commodity is
introduced under ‘Delux’ or ‘Super’ category,
how is the price of this product determined. The
production cost although basic, is not very
important. The price is determined on the basis
of target group of this product. The price
depends upon purchasing power of this target
group. A simple radio may cost Rs. 800/-, but a
designer radio with attractive features may cost
Rs. 2500/-. Let’s see how price in such a
condition is determined.
(a) Initial Discount
Initially the price is determined at the level
where only variable costs are covered. Thus,
price is very low which attracts the consumers.
Then, the price is increased gradually.
(b) Skimming Price
This is just the opposite of the above
explained case. The firm has already established
its name in such a case and now wants to
introduce a new product. As the brand name is
popular the price is kept very high from the
beginning. Since high price makes it possible only
for the rich to buy it, it becomes a symbol of
status. Gradually price is brought down to obtain
new consumers.
In India, the situation during the
introduction of colour television was similar. A
Markets and Price Determination : 150
television costs around Rs. 30,000, then suddenly
it became a status symbol. Gradually the prices
came down to Rs. 10,000 and the response of
the consumers was tremendous.
(c) Charming or Enchanting Prices
This is the American way of pricedetermination. Price of a good in this method is
not expressed in round figure. For example a
pair of shoes in priced at Rs. 797.95 instead of
Rs. 800. Consumers perceive such a price as
cheap.
14.2.4 Elasticity of Demand and
Price Determination
Till now we considered only cost in the
context of price determination. The elasticity of
demand is also a very important factor in price
determination. A producer can maximise his
profit by increasing prices in an inelastic (market
where demand is inelastic) market and
decreasing prices in an elastic market. Let’s
consider the example of salt and soap.
As the demand for salt is less elastic, an
increase in price from Rs. 2 to Rs. 3 would
reduce the demand only by few units. Thus, the
firm revenue will increase. Fig. 14.1 shows the
same.
(d) Seasonal Prices
Prices of goods change according to the
season. Things are usually expensive during
festive seasons. June, July are seasons of sale.
Sales in a recession period encourage demand.
Spare parts of any commodity are
generally priced high. This is because demand
for spare parts is always higher than the good
itself. Any consumer would prefer to buy spare
parts from that firm from which it bought the
good. Thus, the price of this company’s spare
parts are higher than that of other companies.
D
Price (Rs.)
(e) Price of Spare Parts
Y
3
2
1
D1
0
4
X
5
Demand for Salt (Kgs)
Fig. 14.1 : Less Elastic Demand
Questions for Self Study - 3
Price (per Kg.) Demand (Kg.)
Total
(A) State whether the following
statements are true or false. Put ()
or () in bracket.
Rs. 2
5
Rs. 10
(1)
Equilibrium is attained at the point brackets,
where MR=MC. ( )
Rs. 3
4
Rs. 12
(2)
The only principle of maximising profit is
outdated today. ( )
(3)
If the level profit is very high due to high
price of a good, there is a large possibility
of new firms entering the market. ( )
(4)
The lower the level of production, the lower
the average cost. ( )
(5)
In the recession, sellers reduce the prices
to increase the demand. ( )
Revenue
The opposite case will be that of soap.
Consumer has many options, because soap as a
product has many brands available in the market.
Thus, the elasticity of demand is high. An
increase in price reduces the revenue and a
decrease in price increases the revenue
tremendously. The Table and Fig. 14.2 explain
this. At Rs. 5, the demand is 1 lakh units. When
price decreases to Rs. 4.50, the revenue increase
by Rs. 4. lakhs. But when price increases to
Rs. 6, revenue actually decreases by Rs. 80,000.
Markets and Price Determination : 151
We can conclude that the decision
regarding reducing or increasing price is taken
on the basis of elasticity of demand.
Price
5
5
4.5
6.00
(in Rs.)
Sale
1 Lakh 1 Lakh 1,20,000 80,000
(Units)
Total units sold = 2 Lakh
= 2 Lakh
Total
5 Lakh 5 Lakh 5,40,000 4,80,000
Revenue
= 10 Lakh
= 10,20,000
Y
Price
D
8
7
6
5
4
3
2
1
0
Same Price in
If different prices
Mumbai &
in Mumbai &
Nagpur
Nagpur
Mumbai Nagpur Mumbai Nagpur
D1
0.5
1
1.5
X
2
The result of different prices in different
market is that the firm earns an additional
revenue of Rs. 20,000 (Rs. 5,40,000 + 4,80,000)
- Rs. 2 lakes
Thus, this option of different price, earns
the firm more revenue.
Units of Soap
Fig. 14.2 : More Elastic Demand
Many a times the elasticity of demand for
the same commodity is different in different
markets. In such a situation different prices in
these different markets would earn the producer
maximum profit. Let’s take an example.
Price
Demand
Total Revenue
(per unit)
(Units)
(Rs.)
Rs. 4.50
2,00,000
9,00,000
Rs. 5.00
1,00,000
5,00,000
Rs. 6.00
70,000
4,20,000
Suppose, in two cities Mumbai and Nagpur
each 1 lakh units of soap are demanded at Rs. 5
per unit. Thus, the producer’s total revenue will
be Rs.10 lakh (Rs. 5 x 2 lakh).
Questions for Self Study - 4
(A) State whether the following
statements are true or false. Put ()
or () in bracket.
(1)
Elasticity of demand also plays an
important role in price determination. ( )
(2)
A producer can charge higher price for a
good whose demand is less elastic. ( )
(3)
It is wise to charge less for a good, whose
elasticity of demand is high. ( )
(4)
It is wise to charge same price in two
different markets with different
elasticity’s. ( )
Suppose, the firm changes its policy. As
the demand in Mumbai is elastic it is possible to
sell more units here by reducing price. At Rs.
4.50 the demand increases upto 1,20,000 units.
Thus, in Mumbai the firm would earn Rs.
5,40,000 (Rs. 4.50 x 1,20,000). On the other
hand, demand in Nagpur is inelastic. An increase
in price would not have much effect on demand.
Thus at Rs. 6/-, 80,000 units will be demanded
earning the firm a revenue of Rs. 4,80,000 (Rs.
6 x 80,000).
14.2.5 Price Determination and
Objectives of Firms
The result/effect of this policy adopted is
shown in the following table.
This is the prime objective of the firm.
Today’s firms produce various products. Each
Firms have different aims. The business
in the market is done with the objective of
fulfilling these aims. Thus price determination is
a way of fulfilling these objectives.
Kotler has mentioned following objectives
of price determination.
(1) Profit
Markets and Price Determination : 152
product is not considered separately. Prices of
various products are so determined that the total
revenue is more than total cost of the firm. Thus,
some products are deliberately priced low and
they remain in the business inspite of making
losses. Some products are priced above average
cost and thus earn profit. The only thing that is
taken care of is that total revenue remains well
above total cost.
(2) Restricting the Entry of Competitors
This is the second objective of price
determination. To avoid the entry of competitors,
high price is not charged even if it is possible as
high price would mean high profit and high profit
is an incentive for new firms to enter the
industry.
(3) To Capture the Market
Price determination is also used as a tool
for capturing the market. Especially, when a new
firm enters the industry, it has to compete with
established firms. Thus, it has to keep the prices
low inspite of having to bear losses.
if any, in the traditional work culture of the firm,
etc. The organisers are held responsible for
both profit and loss of the firm.
(7) Protecting the Interests of
Distributors and Sellers
The firm has to take into consideration the
interests of the distributors and sellers while
deciding the price. No firm can just think of itself
and the consumers as distributors and the sellers
are a link between them. Thus, for any firm to
capture the market, the distributors and sellers
are a link between them. Thus, for any firm to
capture the market, the distributors and the
sellers should get sufficient returns.
(8) Considering the Selling Cost
Selling cost is more important than the
production cost in price determination. Selling
cost creates demand for a product. Thus today
cost incurred on advertisements, hoardings, sales
representatives, promoters etc. has become very
important.
(9) Maintaining Flexibility in Decisions
(4) To Face the Changes
Every firm has to update its product
according to the latest available technology to
remain in the business. For example, today many
sellers of video cassettes have closed down their
business. Any seller or producer tries to earn as
much profit as he can till there is demand for his
goods.
(5) To Avoid Major Fluctuations in
Revenue
There is no problem with constantly
increasing revenue but fluctuation are not
affordable to the firms. A situation of ‘sometimes
loss, sometimes profit’ poses a threat to the
stability of the firm. Thus, every firm has to price
its products such that there is atleast a certain
minimum demand to its products.
(6) Safety
Emphasis on safety is more in those firms
which are by professional managers. These
organisations emphasise principles that the firm
does not have to take any risk, it acquires the
price leadership rather than following the
competitors, it has to make no or little changes
In business, no price related decision can
be permanent in nature. It is necessary to
acquire information about demand, market
conditions, actions of the competitors from time
to time and review decision according to the
situations.
(10) Abiding by the Rules and Decisions
of the Government
Today, government policy towards a
particular industry plays a very important role in
price determination. Govt. takes decisions
regarding price depending upon the objectives
of the economy, good as well as bad effects of
a firms behaviour on various fronts, social
welfare.
In inflation, govt. tries to control prices.
The method of controlled distribution is used in
such a situation. When prices fall down govt.
fixes them at a certain minimum. To ensure that
the price does not go below this certain minimum
govt. buys the products. Thus, govt. works both
ways to lessen the burden of consumers
sometimes and producers sometimes and
implements dual price policy. Public enterprises
price their products below average cost to attain
Markets and Price Determination : 153
social welfare. The govt. artificially decides the
price of product of basic industries. While doing
so, the interests of various sectors of the
economy are kept in mind. All these prices are
called administrated prices. In such a situation,
a firm has to take price related decisions within
the frame work of govt. policies.
Questions for Self Study - 5
(A) State whether the following
statements are true or false. Put ()
or () in bracket.
(1)
Maximizing profit is the main objective of
firms. ( )
(2)
Firm producing more than one product
consider each product separately while
determining the price. ( )
(3)
If the level of profit is high, firms increase
the prices to increase the total profit. ( )
(4)
Sometimes firms have to bear losses in
order to capture the market. ( )
(5)
The growth of a business is possible only
when it is updated with newest
technologies. ( )
(6)
There is no need of reviewing price
decisions, once price is determined. ( )
(7)
Every firm has to abide by the govt.
policies and rules. ( )
14.2.6 Price Determination of
Factors of Production
Till here, we have seen how price of a
commodity or a service is determined. Now we
would look into how factors of production are
priced. This is the second type of market where
the ‘seller of goods and services’ of the first
market is a consumer in the market of factor of
production and the ‘consumers’ in the former
are ‘sellers’ here. The role of both of them is
interchanged. In factor market, landlords,
labourers, capitalists and entrepreneurs offer
their services and get rent, wages, interest and
profit in return respectively. A major part of these
returns is spent on buying those goods, whose
they contributed to production.
The demand for factor of production in
the factor market is an indirect demand. This
emerges because there is demand for the good
that these factors of production produce. Thus,
this demand is called derived demand. Producers
need factors of production in the same way
consumers need goods. As the consumers look
for the utility of goods and services, producers
look for the productivity of these factors of
produciton. When this productivity is multiplied
by the price, we get revenue productivity. To
maximise profit, a firm tries to equalise the
marginal revenue productivity and the returns
given to the factors of production.
As in normative economics there is the
principle of price = marginal utility, in the context
of price of goods and services, there is the
principle of returns (price) = marginal revenue
productivity in the context of price of factors of
production. The theory based on this principle is
called the theory of marginal productivity.
Let’s understand this with the help of an
example. Suppose, there are 100 workers in a
firm and 1 new worker wants to join in. How
would a firm decide whether he should be taken
or not? If the firm has to pay his worker a
monthly salary of Rs. 2000, there must be an
increase in total revenue by Rs. 2000 if the
worker joins in. If the increase is less than that,
it will not be affordable for the producer to hire
this new worker as this will reduce his existing
profit. In other words the marginal revenue
productivity of the worker should be equal to
the returns given to firm. A firm will employ
new factors of production only till the point where
Marginal Revenue Productivity = Returns to the
worker. The worker is not employed if his
marginal revenue productivity is less than his
price. However this does not mean that the
worker is inefficient.
Other than this theory, there are several
other theories put forward for different factors
of production separately. Ricardo, Marshall and
Robinson propounded the theories of rent, Mill
and Tousing propounded theories of wages,
Fisher, Senior, Ohlin, Bom Bowark, Keynes,
Hanson, Hayek propounded theories of interest
and economists like Clark, Schumpeter and
Knight propounded the theories of profit.
In managerial economics, a study of
market structure can explain the price
determination. But govt. policy should also be
considered as the govt. sometimes interferes and
fixes the prices of factors of production
Markets and Price Determination : 154
Rent
Ricardo first forwarded the theory of rent.
Modern economist describe how all factors of
production (not only land) earn rent. According
to them rent is the difference between actual
earning and opportunity cost. For example, a
farmer plants sugarcane in his field and earns
Rs. 25,000. Had he used the same land for
planting oilseeds, he would have earned Rs.
22,000. Actual earning is Rs. 3,000 more than
the alternative earning. This Rs. 3000 is the rent
of the land. Ricardo defines rent as difference
between earning due to differences between
fertility of land.
How is rent in day-to-day practice
decided? Firstly, rent is decided using traditional
methods. When a landlord gives a farmer a piece
of land to plough, he fixes the same rent as
other land lords. Secondly, supply of land is
limited. As population increases, available land
decreases and rent goes up. In other words, rent
is also decided on the basis of scarcity.
Rent is sometimes situational in the sense
that it is less for some piece of land at one point
of time and may be more for the same piece of
land at some other point of time. For example, a
piece of land in suburbs of a city may be cheap
initially. But as business increases in that region,
the place gains importance and the prices rise.
Rent can also be different depending upon
the use to which the land is put. An infertile land
may have less rent for agricultural purpose. But
for the construction of a building, this land might
be suitable and may have higher rent.
Other than these, factors like financial
progress, transportation cost etc. also are
important determinants of rent.
Wages
Labour is different from all other factors
of production in the sense that it relates to human
beings, who sell their physical and mental skills
in the market? Labour can never be separated
from the labourer and cannot be saved. Thus,
the labour has to go to the work place and if not
used, labour is wasted. It is easy to throw a
defective machine out of work, but a
handicapped worker cannot be. Considering all
this, many theories of wages have been
propounded from both the positive and normative
view.
We have already seen the example of
price determination of worker while studying the
price determination of factors of production. Any
firm would employ a worker only if his marginal
revenue productivity is more than or at least equal
to his price. In this case firm will earn profit and
if this condition is not maintained, the firm would
make losses or face a reduction in profit.
The normative theory is based on the
condition of perfect competition. Labour is
assumed to be completely homogenous and
mobile. But, in real world, we come across
monopolistic competition, monopoly or oligopoly.
In such a condition, it is necessary that workers
come together in the form of trade unions and
play a major role in the wage determination. In
real world, when trade unions negotiate with the
entrepreneur, the latter thinks about his interests.
A wage rise would mean decrease in profit, if
he is not in a position to increase the price. Thus,
to attain an equilibrium of marginal revenue
productivity and wage rate, the entrepreneur
reduces the number of workers i.e. some
workers become unemployed when there is a
wage rise. Thus, a trade union has to choose
between wage rise and unemployment. If it is
possible for the entrepreneur to increase the
prices, trade unions can have both and need not
choose only one.
Skilled labour is always less than what is
demanded. Thus, the wages of these workers
are always high. Technicians, managers,
organisers, famous artists, economists earn high
and also get other perquisites. Thus, their real
wages are high.
On the contrary, supply of unskilled labour
is unlimited. The wage rate is very low and the
workers are exploited. In such a situation govt.
interferes and fixes a minimum wage rate.
Paying below this wage rate, becomes illegal.
Govt. in a socialist country takes price
and wage related decision only after considering
consumption level, capital formation, availability
of production, etc. It also implements controlled
distribution methods. If the consumption needs
to be reduced, the govt. reduces wages and
increases price level. The number of goods per
head sold through public distribution system is
also reduced. On the contrary, if govt. wants to
increase consumption it increases wages,
reduces price level and increases the availability
of goods per head through public distribution
Markets and Price Determination : 155
system. We see, that govt. does not care for the
equilibrium in the market and takes decisions
according to its own will.
Interest
In traditional theories of interest marginal
efficiency of capital, demand for loan and supply
of money for lending were considered important
determinants of interest rate. Interest is the price
given for the use of capital and is determined at
the equilibrium point of loan demanded and loan
supplied. According to Hawtrey, Hyke, Keynes,
interest is a purely monetary phenamenon.
In real world, interest is decided in
accordance with the policies of the central bank.
These policies are effective if the money market
and capital market are developed. When the
central bank increases the rate of rediscounting
bills, sells securities in open market and asks
the banks to increase CRR the interest rate
increases. The reserves with the banks are
reduced and they have less money for credit
creation. Thus, the money supply in the country
decrease. On the contrary, when the central
bank reduces its rediscounting rate, buys
securities in the open market, asks banks to
reduce CRR, interest rate decreases, the banks
are left with more money for credit creation.
Thus, the money supply in the country increases.
Today, non banking financial institutions
also have gained importance along with banks
in the context of interest rates. These institutions
also provide credit. The central bank tries to
control these and other unorganized institutions
such as indigenous bankers and credit societies.
The interest rate is also affected by the business
of these institutions. In real world, the concept
of money, has changed drastically. Money is cash
or liquid. The general public and the investors
hold money in various forms such as gold, silver,
jewels, shares, real estate, promissory notes,
hundis, etc. If the need arises these instruments
can be mortgaged or pledged as the case may
be and money can be obtained. The credit is
created on mortgages. To earn profit, this cash
is used for commercial or trade related
purposes. Other assets are created of this cash.
Certificate of deposit, gold, real estate etc. can
be mortgaged or pledged to get credit which is
used to buy other assets whose prices are likely
to increase in future. When prices increase these
assets are sold and the loans are rapaid
mortgages are released. There is a profit in these
kinds of actions. Other than this demand for
credit, producers also demand for capital.
Demand also affects the interest rates.
In short, the interest is determined by
demand and supply of capital as well as cash.
The central bank tries to control this rate.
Profit
Profit is considered as the residual amount.
When production and other costs are subtracted
from the total revenue, we arrive at profit. J. B.
Clark said that profit arises because of
constantly changing economic condition.
According to F. H. Knight, profit arises because
of the risk and uncertainty borne by the
entrepreneur. Shumpeter says that innovation
gives rise to profit.
Today, the organisation of business has
changed. Entrepreneurship and proprietorship
has given way to joint stock companies. The
entrepreneur do not have to bear any risk or
uncertainty in such a market as they all are hired
organisers. The number of real owners
(Shareholders) of the firm is very high. The
principle behind this is that of limited liabilities.
Thus, there is almost no risk.
Thus, in a joint stock company, profit is
considered surplus. When all costs are
subtracted from the revenue (including
depreciation of capital), taxes are paid from the
remaining part and the remaining is called
disposable profit. Some of this is distributed
among the shareholders as dividend and some
is transferred to the reserve fund. In fact,
dividend is paid after transfering a defined sum
to reserve fund.
Dividend depends upon factors like total
profit, market price of the shares, any plans of
expansion of the company. Firms take care that
the dividend would not reduce in future if it is
increased at some point of time. A large part of
profit goes to reserve funds. Dividend also
depends upon the plans of the firm of
capitalisation of reserve. In real world many
firms are known for distributing high dividends
which helps shareholders greatly.
Markets and Price Determination : 156
Questions for Self Study - 6
Questions for Self Study- 2
(A) State whether the following
statements are true or false. Put ()
or () in bracket.
(1) (), (2) (), (3) (), (4) (), (5) ().
(1)
Demand for factors of production is an
indirect demand. ( )
(1) (), (2) (), (3) (), (4) (), (5) ().
(2)
In order to maximise profit firms, pay the
factors of production equal to their
marginal revenue productivity. ( )
Questions for Self Study- 4
(3)
As the demand for land increases, supply
of land also increases. ( )
Questions for Self Study- 5
(4)
When production cost and other costs
are subtracted from revenue, we get
profit. ( )
(1) (), (2) (), (3) (), (4) (), (5) (),
(6) (), (7) ().
(5)
According to J. B. Clark profit arises due
to constant changes in the economy. ( )
(6)
According to F. H. Knight, profit works
as a lure to encourage entrepreneur for
taking risk. ( )
(7)
In joint stock Company, the ownership is
with the individual. ( )
14.3 Words and their
Meanings
Multiple Product Pricing : Price
determination of various products produced
by one single firm.
Target Rate Pricing : Pricing the good, such
that investment yields a certain rate of
return.
Skimming Price : Price yielding huge profit.
Cost Plus Pricing : Determining price of a
good such that expected profit is added in
the average cost.
14.4 Answers to Questions
for Self Study
Questions for Self Study- 1
(1) (), (2) (), (3) (), (4) (), (5) (),
(6) (), (7) ().
Questions for Self Study- 3
(1) (), (2) (), (3) (), (4) ().
Questions for Self Study- 6
(1) (), (2) (), (3) (), (4) (), (5) (),
(6) (), (7) ().
14.5 Summary
In the real world, there are firms producing
more than one product. All these products are
not priced separately. The principle that is used
is that the total revenue of the firm from all
products should be more than the total cost. The
decision of price determination is not to be taken
very frequently. These decisions are to be
reviewed only in the case of change in level of
production, change in prices of substitute goods,
introduction of new good etc. Sometimes, price
is kept low initially to capture the market. There
are various techniques of price determination
such as target rate pricing, skimming price, costplus pricing, differential pricing. Elasticity of
demand also plays major role in price
determination. Price is more in a market with
inelastic demand and vice-versa.
There are various objectives of firms.
Price is used as a tool to attain these objectives.
Maximising profit, restricting entry of new firms,
capturing the markets etc. are some of the
objectives.
Like the market for goods and services,
there is also a market for factors of production.
Demand for factors of production is indirect
demand because goods produced by them has
a demand in the market. These factors get
returns in the form of rent, interest, wage and
Markets and Price Determination : 157
profit. Land gets rent, labour gets wages, capital
gets interest and entrepreneur gets profit. Total
revenue less total cost is the profit of the firm.
There are various theories regarding emergence
of profit. According to some economists it is
due to economic conditions, some say it is due
to the innovation done by entrepreneurs.
In recent times, joint stock companies have
come up in large numbers. After all costs and
taxes are paid, residual profit is distributed
among shareholders as dividend.
(7)
Explain the normative theory of rent
determination.
(8)
What role do trade unions and govt. play
in wage determination?
(9)
How is interest rate determined in real life
practices? How does liquidity affect
interest rate?
14.7 Field Work
(1)
Visit a factory in your area. Get information
about how the products produced in this
factory are priced.
(2)
Visit a bank in your locality and inquire
about various interest rates on different
amounts of loans.
(3)
Visit small traders in your locality. Get
information about the difficulties in their
business, experience about competitors and
their future plans.
14.6 Exercies
(1)
Explain various polices that companies
implement for multiple product pricing.
(2)
Explain the conditions when it becomes
necessary to price related decision.
(3)
Illustrate with an example the principle of
mark-up or cost plus pricing.
(4)
Explain the following
(i) Initial discount in price
(ii) Skimming price
(iii) Charming or Enchanting prices
(iv) Seasonal price changes
(v) Price of spare parts
(5)
Illustrate with an example the effect of
elasticity of demand on price determination.
(6)
How does objectives of a firm affect price
related decisions.
14.8 Books for Further
Reading
(1)
Joel, Dean, Managerial Economics,
Delhi, Prentice Hall of India.
(2)
Savage and Small, Introduction to
Managerial Economics, Hutchinon of
London.
Markets and Price Determination : 158
Yashwantrao
Chavan
Maharashtra
Open University
MGM 224
Managerial Economics
Book Three
Principles of Business Firms and Investment
Analysis
Writers
: Prof. S. G. Bhanushali, Prof. A. R. Padoshi
Unit 15 : Firm : The Basic Concept
1
Unit 16 : Behavioural Theory of Firm
11
Unit 17 : Business Behaviour of Firm
19
Unit 18 : Profit : Concept and Analysis
32
Unit 19 : Capital Budgeting
42
Unit 20 : Risks, Certainty and Uncertainty
52
Unit 21 : Decisions of Public Investments
57
Managerial Economics (MGM 224)
Syllabus
Book 1 : Managerial Economics : Nature and Concepts
Unit 1 (A) : Managerial Economics : Nature, Objectives and Scope
Unit 1 (B) : Economic Analysis
Unit 1 (C) : Methods of Economic Analysis
Unit 1 (D) : Basic Concepts
Unit 2 (A) : Nature of Managerial Decisions
Unit 2 (B) : Methods of Studying Managerial Economics
Unit 2 (C) : Some Basic Concepts : Plant, Firm, and Industry
Unit 2 (D) : Size of the firm
Unit 2 (E) : Business Decisions
Unit 3
: Concept of Demand
Unit 4
: Demand Analysis
Unit 5
: Elasticity of Demand
Unit 6
: Demand Forecasting
Book 2 : Markets and Price Determination
Unit 7
: Cost of Production : Concept, Types and Curves
Unit 8
: Production Function
Unit 9
: Break-even Point of Production
Unit 10
: Supply
Unit 11
: Market Conditions and Price-Output Decisions
Unit 12
: Market Structure Analysis – 1
Unit 13
: Market Structure Analysis – 2
Unit 14
: Price Determination Techniques
Book 3 : Principles of Business Firms and Investment Analysis
Unit 15
: Firm : The Basic Concept
Unit 16
: Behavioural Theory of Firm
Unit 17
: Business Behaviour of Firm
Unit 18
: Profit : Concept and Analysis
Unit 19
: Capital Budgeting
Unit 20
: Risks, Certainty and Uncertainty
Unit 21
: Decisions of Public Investments
Unit 15 : Firm : The Basic Concept
Index
15.0 Objectives
15.1 Introduction
15.2 Subject Description
15.2.1 Market, Business Firm, and
Industry
15.2.2 The Theories for Firms
15.2.3 Economists’ Theories of Firms
15.2.4 Criticism on Economists Principle
15.3 Words and their Meanings
15.4 Answers to Questions for Self Study
15.5 Summary
15.6 Exercises
15.7 Field Work
15.8 Books for Further Reading
15.0 Objectives
After studying this unit, you will be able
to :
«
«
«
«
«
Understand the concepts of market, firm,
and industry.
Gain knowledge about the assumptions on
which the laws of business are based.
Evaluate the laws of business firms.
Gain knowledge about the need for
developing new models about business
firms.
Gain practical knowledge about the
existing market conditions.
15.1 Introduction
In the earlier section we have studied the
concepts of price determination and output
determination. These give us an idea about the
importance of market, business firms and
industry. In reality price and output is
determined by the nature of market, number of
business firms and the size of the industry. In
order to study these, economists have developed
several models and based on the assumptions
they have developed various laws as well. In
managerial economics it is important to study
these laws and understand how they can be
practically applied. Hence first we make an
attempt to explain these basic concepts.
15.2 Subject Analysis
15.2.1 Market, Business Firm,
and Industry
In order to understand the concept of
theories of business firms, it is important to
understand the concepts of market, business
firms, and industry. These have been explained
as follows:-
(a) Market
The market structure has been explained
in the earlier section. Here again we have given
a brief explanation of it.
(1) Perfect Competition: When there are
large number of buyers and sellers, homogenous
product, free entry and exit of firms, no transport
cost, perfect knowledge about market conditions
and no price discrimination, it is called perfect
competition. Though there is competition it is of
healthy nature.
(2) Monopoly: When there is only one
seller and large number of buyers, it is called
monopoly. The seller here is the ‘price marker’,
he decides the market price.
(3) Monopolistic Competition: When
several firms sell the same product with little
variations, they enjoy the benefits of monopoly
as well as competition. There is competition in
the market but because of product differentiation
the sellers can enjoy benefits of monopoly.
(4) Oligopoly: A group of few sellers
producing either homogenous or heterogeneous
product. Here each seller while deciding its
product and market strategy, is always alert and
Principles of Business Firms and Investment Analysis : 1
cautious about the possible reactions of other
firms in the market.
The following chart gives a brief
classification of the above given information.
Quantity elasticity
=
Change in Price of Product of Firm Y
Change in Quantity for Product of Firm X
Table 15.1: Characteristics of Market
Market
No. of
sellers
No. of
buyers
Nature of
product
Nature of Entry
into the market
unlimited
unlimited
Homogenous
Free Entry
One
unlimited
Homogenous Restricted Entry
(3) Monopolistic Competition
Large
unlimited
Product
differentiation
Free Entry
(4) Oligopoly
Small
unlimited
homogenous
or Product
differentiation
Free Entry
(1) Perfect Competition
(2) Monopoly
Based on this classification we can draw
several tests for different market conditions.
(1) Substitution Effect
It can be measured with the help of cross
elasticity of demand for the products of 2 firms.
The effect of change in price of a
commodity produced by one firm on the price
of goods of other firm is called ‘Elasticity of
substitution’.
Elasticity of substitution
=
Change in Demand for Product of Firm Y
Change in Price for Product of Firm X
Greater is the elasticity more is the
substitution, hence elasticity of substitution
indicates how close substitutes the 2 goods are
and also it determines the stillness of
competition. Lesser is the competition more are
the chances of monopoly in the market. Even
with price discrimination we can have a finite
and well-defined cross elasticity of demand. If
the goods are not substitutes to each other, then
cross elasticity may be zero.
(2) Interdependence of Business
Firms
Elasticity of demand is the effect of
demand for a product of one firm on the price
of the goods of other firm.
These concepts help determine the
interdependence of firms with one another.
Greater is the elasticity more is the
interdependence.
(3) Entry of New Firms
The type of market will be decided on the
basis of how easily can new firms enter into
the market. If there is free entry of the firms
there will be more competition in the market
and if entry is restricted more chances are there
that there will be monopoly. The difference
between the price decided by a competitive
market and the actual price put up by a firm will
decide how freely new firms will be allowed to
enter the market, lesser is the difference
between the two, more will be the competition
in the market.
This can be explained with the help of
following formula:
E=
Pa - Pc
Pc
Where
E = Entry of new firms
Pc = Price of a competitive market.
Pa = Actual Market Price.
The feasibility of entry of new firms into
the market will depend on the difference
between the price decided by a competitive
market and the actual market price.
For example, let us assume that the price
of the commodity in a competitive market is
Principles of Business Firms and Investment Analysis : 2
Rs. 5/- per unit whereas in reality the existing
firm is selling it at Rs. 7/- per unit i.e. Pc is Rs.
5/- and Pa is Rs. 7/-. When these values are
substituted in the above given formula,
E=
7-5 2
= = 0.40
5
5
This indicates that there is 40% restriction
for new firms from entering into the market as
described by J.S. Bain in his concept for
restricted entry. If the existing firms can restrict
new firms from entering into the market they
can charge a higher price.
Questions for Self Study - 1
(A) Fill in the blanks.
(1) Perfectly competitive market does not
_____________ in reality.
(2) In monoplistic competition non ________
competition is practised at large.
(3) Elasticity of substitution is the effect of
change in price of one commodity on the
change in ______________ for other
commodity.
(4) Quantity elasticity is ratio of change in
price of commodity Y to change in
_____________ of commodity X.
(b) Firm
E.A.G. Robinson has defined a firm as An entity under the same management,
dealing in financial transaction, raising capital
and risk taking is called a firm. It could be termed
as a system created to maximise market share
and profit.
(c) Industry
A group of firms closely related to each
other, form an ‘industry’. The behavior of firms
in an industry is independent on each other. In
case of firms there is individual equilibrium and
in case of industry there is group equilibrium.
This 2 sided equilibrium can be seen only in
the long run. In the short run even if the industry
shows disequilibrium, there can be equilibrium
in the firm. The decisions of the firms will
depend on the mutual relations of the firms in
the group. The behavior of each individual firm
is interdependent.
The concept of ‘industry’ is useful for
several reasons, they are as follows:
(1)
We can group firms under industries
depending upon different criteria, like the
type of commodity, its use etc.
(2) For each industry we can have a set of
rules based on which we can have a code
of conduct for industries for e.g. firms of
an industry producing luxury goods for the
higher class may set an upper limit for the
maximum price and those producing
necessary goods for lower class will set
the lower limit commonly.
(3) This concept of industry helps to control
entry of new firms in the market,
equilibrium price and equilibrium output.
(4) Within the limits of an industry each firm
plans out its business strategies. The limits
of industry help us to study these.
(5) Most of the Govt. policies are designed
for industries. The concept of industry
helps us to study the effects of these
policies and develop new ones.
Hence it is necessary to classify industries
according to different criteria.
(a) Product Criterion : All close
substitutes produced by different firms are taken
under one industry e.g. in the market bathing
soaps of different brands are available, but the
purpose of each is same, so they all are clubbed
together as one industry namely ‘soap industry’.
These products are close substitutes to each
other; hence they can be grouped under one
industry. When the mutual elasticity is infinite
between these firms, it becomes perfect
competition.
(b) Process Criterion: When there is
similarity between technology, use of raw
material, technique of production, distribution
etc. then those firms are grouped into an industry
e.g. in handloom textile industry the technique
of production is same. Each firm decides its own
price, output, nature of commodity,
advertisement, investment etc. But only while
taking decisions regarding process it takes into
consideration the competition put forward by
other firms in the market.
Questions for Self Study - 2
(A) State whether the following statements
ü ) or (û
û ) in
are true or false. Put (ü
bracket.
(1) Group of firms closely related to each other
is called industry. ( )
Principles of Business Firms and Investment Analysis : 3
(2)
(3)
Group of firms producing close substitutes
to each other is called industry. ( )
Group of firms using similar techniques of
production is called industry. ( )
15.2.2 The Theories of Firms
From the above discussion we can draw
a conclusion that an industry is a group of firms
of different sizes, established in different places,
classified under different criteria and having
different levels of efficiency. The behavior of a
firm depends on the industry to which it
belongs. Still there can be difference between
behaviour of firms belonging to the same
industry hence the need for a study of theorems
of firms is felt. Any theorem has 2 objectives.
They are (1) The theorem should explain the existing
situation.
(2) The theorem should help us reach the ideal
situation which in practice does not exist.
Thus a theorem should have both
explanatory and futuristic values. Explanatory
value means the ability to start with assumptions
make general statements, which can be used for
further analysis. It should be based on
observations and should be able to state how
the market will move in future.
How good a theorem is? It is decided on
the basis of its explanation, applicability in the
long run, how genuine its assumptions are its
practicability and simplicity. Amongst the above
given criteria there is a difference of opinion
regarding which criterion is more important. For
example, Milton Friedman gives more emphasis
to long run applicability of theorem, whereas
Paul Sameulson lays greater emphasis on the
ability of the theory to explain a situation and
the practical applicability of assumptions.
The theory should develop models that
would analyse different market structures and
their working. These models should be able to
explain how price and output are determined in
the market, how does a firm decide on its price
and output, its expenses on advertisement, sales
promotion and expenses on growth, etc.
There should be generalization of
theorems, so that it does not limit to
observations of only one firm but can be applied
to all firms of similar nature. A study of a single
firm is ‘case study’, but to formulate a theory
there is a need for several such case studies.
With the flow of times the complexities of
the market have increased, along with it have
increased the varied types of industries. The
economists have tried to study the reality as
closely as possible and based on it derived
several modern theories at different levels.
These have been classified as follows:
(1) Economists Theories of firms.
(2) Behavioural Theories of firms.
(3) Managerial Theories of firms.
In this chapter we shall study only the
economist’s theories of firm. The behavioural
and the managerial theories, we shall study in
the following chapters.
15.2.3 Economists’ Theories of
Firms
We have studied these theories in details
in the 14th chapter of our IInd book. In the 14th
chapter of this book we have studied Perfect
competition, monopolistic competition and in
the 13th chapter we have studied certain small
topics like monopoly and oligopoly. In all these
topics we studied how a firm decides its
optimum price and output in the market. Besides
these there are several other markets like
monopsony, bilateral monopoly etc. In the
following points we have tried to summarize
these theories.
(1) Firms Work as Agents of One
by One Transformation
Economists use the term Firm in general
sense. According to them any organization
carrying out one by one transformation of inputs
into output is a business firm. These include
farms, factories producing goods, mines,
consultancy services, banks, hospitals,
educational institutions, etc. They may be
involved in producing finished goods, semifinished goods, consumer or capital goods, or
in providing services.
(2) Business Firms Help to
Generate Surplus
It creates surplus value by converting
factors of production into goods which have
value or else according to Economics. It is a
waste of resources. During the process of
transformation value gets added to inputs. The
value of output is more than that of inputs. This
Principles of Business Firms and Investment Analysis : 4
is surplus. If the value of a piece of furniture is
not more than the wood then there is no use of
transforming it into furniture. Through
transformation a firm can create place utility or
form utility and thus the value of goods increases,
in Economics this is called profit. It is the
difference between the value of finished good
and the value of inputs. In other words we can
say that surplus or profit is the difference
between the selling price and the cost price of a
good.
(3) Business Firms Aim at Profit
Maximisation
The main aim of transformation work of
firms is profit maximisation. Profit indicates the
level of efficiency of a firm. A part of the profit
goes to the investors as a return on their capital
investment. The rest of it is used for the growth
and replacement in the firm. Thus this indicates
that greater the profit, more does a firm benefit
out of it; hence all firms aim at maximisation of
profit.
(4) Firms Follow the Equimarginal
Principle
Firms follow the equimarginal principle to
maximize their profits. (MR = MC). We have
already seen that profit is the difference
between total revenue and total cost. In a form
of an equation:
Total Profit = Total Revenue – Total Cost
P
=
R
–
C
----------- (1)
Since both revenue and cost both depend
on the quantity produced, we can rewrite the
above equation as.
P(Q) = R(Q) - C(Q) ------------ (2)
From the second equation we can derive
third equation
∆P  ∆R ∆C 
−
=
∆Q  ∆Q ∆Q 
----------- (3)
If the principle of equimarginality is
considered in case of the above equation, then
the answer would be zero.
The firms necessarily follow MC = MR
approach to arrive at equilibrium irrespective
of the market they are in. For an industry the
equilibrium condition would be based on the
principle of average. It would be average cost
= average revenue. The industry earns normal
profit in case of such an equilibrium. Until all
the firms in the industry attain this type of
equilibrium, where they earn just the normal
profits until then that market or industry would
be unstable. This is because there would be entry
and exit into and from the industry.
(5) Firms have the Complete
Information and Knowledge
about the Conditions of the
Concerned Market
The firms are completely aware of the size
of the firms, goods produced, factors of
production, demand for the product and its
supply, the number of competitors in the market,
the structure of the industry and the movement
of the competitors. The firms also are aware of
the market they are operating in. The firms know
the conditions of the market and use this
information for framing their policy decisions.
The firms don’t have to spend on collecting such
information and it operates under the conditions
of certainty. Most of the economic models have
been developed on the assumption of certainty.
But some of the models do talk about uncertainty
in the market and incorrect and incomplete
information.
(6) The Firms Determine
Operational Variables for
Maximising Profits
The firms determine operating variables
on the basis of market information. The firms
are aware of both their goals and the hurdles in
attaining these objectives. The variables
associated with both these are used by the firms
to take a right decision. For example, in perfect
competition firm is a price taker while in the
imperfect market price maker. If the elasticity
of demand in the market is different, firms can
try price discrimination. In some cases depending
upon the market conditions firm should be a price
leader or follower. In monopolistic competitive
market firm concentrates on advertisements,
selling costs and such other non-price factors.
Principles of Business Firms and Investment Analysis : 5
Firms in place of working on variable like price
work on units of production their grading and
other physical factors. The decisions regarding
operational variable ultimately depends on the
nature of the market.
The explanation above shows that the
economic theories of firms explain to us the
process of combination of decision variables by
the firms. In the given set of assumptions how
would a firm behave is what these theories
explain to us.
The gist of economic theories of firms is
given in table 15.2
Table 15.2 : The Economic Theories of Firms
A point from the theory Explanation
(1) Transformatory unit Transformation of
an input into an
output.
(2) Creation of surplus Value of the output
value
produced would be
greater than the
value of inputs.
(3) Earning maximum Increasing the levels
profits
of profits and its rate
and increasing
efficiency
(4) Following the
The level of profit is
principle of
determined by
equimarginality
MC = MR.
(5) Knowing the
Obtaining the
market conditions. market information
and deciding the
policies accordingly
(6) Determining
From out of
operational
available variables
variables for
choosing the most
maximising profits. important ones.
Questions for Self Study - 3
(A) State whether the following
ü)
statements are true or false. Put (ü
û ) in bracket.
or (û
(1) A group of firms with different levels of
efficiency and different types of
organisation is called an industry. ( )
(2) A unit that transforms inputs into output is
called a firm. ( )
(3) A firm operating in any market is in
equilibrium if it has its AR = AC.
(4) In a perfectly competitive market, firm is
a price maker. ( )
(B) Fill in the blanks.
(1) Any theory should explain _______ things
in detail.
(2) In theories of firms these should be
minimum _______.
(3) Firms act as _________ units.
(4) Firms create ________.
(5) Firms follow the Principle of ________.
(6) Firms have ________ information about
the conditions of the concerned market.
(C) Tick the correct option.
(1) What does the theory of firms express on
the basis of observation?
(a) Explanation (b) Future
(2) What does the theory of firms explain
about firms?
(a) Their decision making (b) Behaviour
(3) What is the objective of firms?
(a) Maximum profit (b) Normal Profit
(4) What do the firms determine to maximise
profit ?
(a) Internal variable
(b) operational variable
(5) Economic theories explain the process of
assembly of (a) behavioural variables
(b) decision variables
15.2.4 Criticism on
Economists Principle
Let us start with basic assumption of
Economists principles of the business firm, so
that we can comment on this assumption and
their practical measures. We can say in the same
flow that there is an alternate to these principles.
If we check the examples in the previous
chapter, we can realize that the economist’s
principles are based on two basic assumptions:
(1) Motivational, (2) Cognitive.
Motivational assumption is generally
stated on profit maximization. To earn profit is
the main objectives of the business firms that
mean profit maximization is prime objective of
the business firms. There are two sides of these
assumptions. First, business firm tries to
maximize profit and does not take into
consideration any other decision variable.
Second, Business firm earns maximum profit
and out of this maximization clarifies its
behavioural objective.
Cognitive assumption is stated under
complete information or Business certainty.
Principles of Business Firms and Investment Analysis : 6
Business firm has complete knowledge of its
surrounding environment in which it has to
operate. That’s why business firm can adhere
to the rule of total decision and operate on
decision variable. In other words we can say
that business firms are aware of the
surroundings and the market in which they
operate. It is indicated from this assumption that
there is no expenditure for the firm to collect
the information. This also means that the market
environment is risk free, without any
uncertainty and everything is known, certain
dependable and practicable.
Many authors have criticized these two
assumptions. Lets analyze these criticisms.
These authors have two basic questions
about the motivational assumptions.
(1) Do the business firms really maximise
profits?
(2) Do the business firms only maximise
profits?
In practice, it is indicated that earning profit
is not the only objective of the business firms.
Production, stocks, market share, consumer
awareness, social responsibilities are the other
objectives of the business firms. It is not
necessary that they always maximise profits but
they should be satisfied with their other
objectives also.
From the angle of general observation and
criticism the author has indicated alternative set
of thoughts as under.
(1) Rather than maximising only the profit
function which is the motive of the
manager, shareholders, consumers, govt.
etc., the firms aim at maximising the overall
performance of the entity. Business
objectives of firms grow out of the interests
of various stake holders in a firm and from
out of this emerges a general perference
function. (Papanderou)
(2) Primary motive of a firm is its long run
survival, it aims at long run stability and
security. (K. Rothschild)
(3) When the competition is limited then
business firm is interested in maintaing safe
distance. (Phelnex)
(4) To keep the financial control business firm
sacrifices objective of profit. To maintain
control over the working of the business
firm, firms manage internal financial
system from out of its undistributed profits.
(Reder)
(5)
Business firms like Banks always carry
sufficient funds to gain strong financial
position and control. But a business firm is
mainly interested in maintaining liquidity
sufficient enough to ensure its financial
position and control.(Cooper)
(6) Business firms through its executives may
elect to maximise profit and sacrifice
leisure; or may elect total leisure and
sacrifice the entire profits may decide on
some combination of both. (T. Scitousky)
(7) Considering the constraints on the profits
of firms put by external factors, these firms
are found maximising their revenue by way
of sales. Firms try to attain a steady growth
in their revenue, considering the variable
conditions. Large firms do not maximise
profits but try to maximise sales revenue,
subject to a minmum profit constraint.
(Baumol)
(8) Business firm never maximise its profit.
It maximizes the satisfaction under
discretionary power. (Williomson)
(9) Business firm always tries to achieve
balanced growth by considering the
financial and management limitations.
(Marris)
(10) Attaining maximum profit is not the
interest of the oligopoly firm; but they are
interested in maintaining their market share
and the source of profit associated with
the same. The firms get in a sophisticated
way and act as leader follower to share
the market and profit. (Stackelburg)
(11) Firms rather try to ‘satisfy’ than to
‘maximise’. An entrepreneur (a firm) is
interested mainly in earning a satisfactory
level of profit than earning maximum level
of profit. (Simon)
There are many other thoughts like these.
It is also observed some times that business firms
forgo profit to complete the social responsibility.
Some times business firms give preference to
the customer service, pollution control, social
welfare, self sufficiency, autonomy. In this some
of the objectives are against profit objective. It
is found in co-operative business in our country.
Now let us turn to the second assumption.
Cognitive assumption is also not supportable.
Trade decisions are relevant to surrounding
changes. Many changes in the situation are not
known and such changes are not known in
context of their directions and impacts.
Principles of Business Firms and Investment Analysis : 7
So, the situation around the decision is full
of danger and uncertainty. For this believing that
there is complete information is unrealistic. In
other words, it is difficult for the business firm
to aim at profit maximization on the basis of
incomplete information. Economists when
consider profit, think about production
expenditure and Marketing (sales) Expenditure.
It is not justifiable to ignore information
expenditure. It is necessary for a business firm
to spend on collection of information, processing
the same, storing it and even dissiminating the
same. That’s why a system of Management
Information System (MIS) has been developed
for any modern business firm. It cannot be taken
as assumption that the expenditure is zero while
collecting information. Business firm has to give
direction to its financial work and find out new
source of information and choose relevant
information. In this context some other ideas
are suggested. Some of them are.
(1) Business firms approach is towards
adjustment than to maximize. (Gorden and
Margollis)
(2) A theory based on an assumption of having
such knowledge that can not be known
would not guide the behaviour of the
busines firm. (Boulding)
(3) ‘An enterpreneur expects to earn
maximum profit without knowing his
entrepreneurial capabilties and
expectations’, is a statement which is not
consistant with reality. (Papanderou)
(4) Business firms do not earn maximum
profit. Not only that they cannot earn
maximum profit because they are not
aware of what should be the level of
maximum profit. In practice, instead of
following the marginal principle to achieve
maximum profit, they follow rules of the
thumb to achieve their objectives. (Hall
& Hitch)
If we have a look at the points mentioned
above, it can be seen that they have heavily
criticized the economist’s principles of business
firms. Some economists have tried to defend
their principles. For example, Milton Friedman
claims that the test of that principle is dependent
on how good the principle can explain the
situation. The soundness and the significance
of any principle is dependent on its functional
utility. That is why their assumption is not a
subject of criticism. As per Machlup, the old
economic principles of the business firm are
reasonable. The thought of profit maximization
is always a guiding one to trading decisions.
Profit maximization is subjective thought and it
is not measured by objective method. If required,
principle of marginalism could be improved and
replaced by the principle of incrementalism. This
principle has proved decisive for many firms.
Horowitz has reconstructed the theory of
firms under conditions of uncertainty. The scope
of the concept of maximisation can be extended
to a level so as to incorporate the risks and
uncertainties of the real world. The theories of
the recent times such as the Game theory, theory
of probability and models analysing the economic
decisions, etc. offer strength to the concept of
maximisation. The optional improvements in the
theory of firms in the form of behavioural and
managerial theories are complementary to
economic theories and not substitutes. We shall
acquire more information about the same in the
next chapters. From the observation of the
existing firms that are professionally managed
one can conclude that firms may not always be
earning maximum profit but they definitely have
some policy about profit. In the objective
functions of a firm profit may or may not be
clearly expressed.
Profit may be expressed as a constraint
rather than objective function of a firm but inspite
of this profits remain an index of the operational
efficiency of a firm. Hence, firms definitely have
some policy regarding size, rate, origin and
distribution of profit. Firms have to formulate
some policy about profit. In the short run firms
may have other objectives to pursue but in the
logn run profit remains the encouraging factor
for firms. One can relate the objective of profit
with other objectives of the firm. So in practice
firms have various objectives and various
techniques can be used to attain the same.
Questions for Self Study - 4
(A) State whether the following
ü)
statements are true or false. Put (ü
û ) in bracket.
or (û
(1) Economist’s theory of business firms is
based on realistic assumptions. ( )
(2) Business firm has an objective of
maximising overall performance. ( )
(3) Business firm always prefers to earn
excess profit. ( )
Principles of Business Firms and Investment Analysis : 8
(4)
Business firm’s behaviour is many a times
towards gaining satisfaction. ( )
(B) Fill in the Blanks.
(1) Business firms are _________ to identify
the market conditions they are in.
(2) Firms under oligopoly are ___________
interested in gaining maximum profits.
(3) Policy of business firm is __________
rather than the maximization.
(4) ________ is the indicator (index) of a
firm’s operational alterness.
15.3 Words and their
Meanings
Elasticity of Demand : Ratio of change in
demand for one object to the change in
the price of other object.
Flexibility: Ratio of change in the price of one
object to the change in the object.
Personal Balance: Situation of optimum
income of the Business firm alongwith its
expenditure.
Group balance : Average Revenue = average
expenditure.
Monopsony : Market with a single buyer but
many sellers.
Bilateral Monopoly : Market with a single
buyer and a single seller.
Surplus : Difference in value of input and
output value.
15.4 Answers to Questions
for Self Study
(3)
(5)
(C) (1)
(3)
(5)
Transforming,
Optimisation,
(2),
(2),
(2).
(4)
(6)
(2)
(4)
Surplus,
complete.
(1),
(2),
Questions for Self Study - 4
(A) (1)
(3)
(B) (1)
(3)
(û),
(û),
able,
coordination,
(2)
(4)
(2)
(4)
(ü),
(ü).
not,
profit.
15.5 Summary
A firm is a decision making unit. It is a
unit that takes micro level decision considering
the industry and the existing market conditions.
The decision making process of any business is
complicated. The process of decision making
depends on the nature and operational efficiency
of the firm. Making a generalised statement
about the economic behaviour of a firm is
difficult. Economists have still tried to extend
some arguments about the same. Economists
have extended the concept of profit
maximisation.
Firms come forword with various
objectives. Economists believe that the concept
of profit maximisation is applicable to all the
firms irrespective of differences existing in them.
There are alternatives to the objective of profit
maximisation, which have also been suggested.
The optional improvements in the theory of firms
in the form of behavioural and managerial
theories are complementary to economic
theories and not substitutes.
15.6 Exercises
Questions for Self Study - 1
(1)
(3)
Exist,
demand,
(2) Price,
(4) Quantity demanded.
Questions for Self Study - 2
(1) (ü), (2) (ü), (3) (ü).
(1)
(2)
(3)
Questions for Self Study - 3
(4)
(A) (1) (ü), (2) (û), (3) (û), (4) (û).
(B) (1) Existing, (2) Generalisation,
(5)
State the difference between perfect
competition and monopolistic competition.
Differentiate between Monopoly and
Oligopoly.
Explain the correlation between Business
firm and an Industry.
State the measures of Industrial
classification.
State pointwise the summary of
economist’s principles of business firms.
Principles of Business Firms and Investment Analysis : 9
(6)
(7)
State how the economic principles of
business firms is incomplete.
What alternative concepts exist for
Economists principle of business firms.
(3)
Evaluate how surplus can be Generated
in agriculture.
15.7 Field work
15.8 Books for Further
Reading
(1)
(1)
(2)
Visit the factory in your township and get
the information or study how market pricing
decisions are taken in that factory.
Study the agricultural market in your town
and state category of market it fits in.
(2)
McConnel and Gupta, Economics (Vol.I),
New Delhi, Tata McGraw Hill publishing
Company.
Koutsoyiannis, A., Modern Micro
Economics, London, English Language
Book Society, Macmillan, (1979), Second
Edition.
Principles of Business Firms and Investment Analysis : 10
Unit 16: Behavioural Theory of Firm
Index
16.1 Introduction
16.0 Objectives
16.1 Introduction
16.2 Subject Description
16.2.1 Simon’s Theory of Satisfying
Behaviour
16.2.2 Reactions Simon’s Theory
16.2.3 Cyert and March’s Behavioural
Theory of Firm
16.2.4 Process of Decision Making :
Cyert and March’s Argument
16.2.5 Argument of Cyert and March
Regarding Behavioural Theory
16.2.6 Evaluation of Behavioural Theory
of Firm
16.3 Words and their Meanings
16.4 Answers to Questions for Self Study
16.5 Summary
16.6 Exercises
16.7 Field work
16.8 Books for Further Reading
16.0 Objectives
After studying this unit, you will be able to
explain :
« few major concepts of behavioural theory
of firm.
« The assumptions of behavioural theory of
firm.
« how a firm producing various products and
having different objectives takes various
decisions in an imperfect competition of
Simon, Kohen
« difference between satisficing and
maximizing behaviour of a firm
« contributions and limitations of
Behavioural theory of firm
The traditional economic theories have
been challenged due to many reasons. Some
economists have propounded instead the
behavioural theory of firm. In this theory
economists have tried to analyze the concepts
and conditions surrounding a firm. The theory
divides the process of decision making and
consequences in two different parts. It is an
alternative to the tradition decision making of
firms. For example, it says that a firm does not
change only one goal, but is a dynamic entity
chasing many goals. In other words, firms do
not have just one goal of maximizing profit, but
also goals like production target, inventory
target, sales target, market share etc. Each firm
chases that goal which it considers to be
satisficing. While doing so it has to satisfy the
firms having opposite intervals. Thus, the firm
becomes an entity which is more interested in
satisfying its expectations than maximizing
profits.
This theory originated in early 1950’s. The
foundation was laid by Simon in 1955 through
his article on ‘A Behavioural Model of Rational
choice in a magazine called Quarterly Journal
of Economics. Cyert and March also wrote on
the topic. The argument of Kohen and Cyert is
explained in the next chapter.
16.2 Subject Description
16.2.1 Simon’s Theory of
Satisfying Behaviour
Due to the incompleteness of theories on
firms and their behaviour in economics, many
economists started writing various papers on the
same. Simon was the first among those. He
wrote his first paper on theory of firm Behaviour
in 1955.
Principles of Business Firms and Investment Analysis : 11
According to him, an incomplete
knowledge on part of the businessmen is
necessary because complete knowledge would
make things to complex that the decisions might
not be brought in practice. Even if the firm
assumes that the conditions are going to remain
as they are, it would never be able to know if its
earning maximum profit or not. Therefore a firm
doesn’t chase the goal of maximizing profit but
satisficing its various expectations.
According to Simon, the behaviour of
firms and human beings can be compared. Like
every human being, every firm keeps record of
its success failure, aims etc. A firm decides its
expectations depending upon its needs, targets
and will power. It reviews its goals from time to
time. Three different consequences arise from
this.
(1)
Performance is not upto the mark.
(2)
Performance is upto the mark.
(3)
Performance is better than expected.
First condition may arise due to insufficient
information about the future. Firms try to
improve their performance in such a situation.
It also happens if the expectations are
unrealistically set. Thus, there are two reasons
for the first situation: (1) Fluctuations in financial
matters. (2) Qualitative decline in performance
level.
Now, we shall take into consideration the
second condition of performance being upto the
mark as expected. At this level firms are
satisfied. The firm verifies that its expectations
are not too low of its capabilities.
In third situation the success is really
admirable. Though the firm is satisfied it must
confirm that the qualitative levels have not gone
down in the process of achieving its targets. In
such a condition success should be analyzed
which is rarely done and if a firm does so, it can
more efficiently frame its policies in future and
can judge the quality of its performance.
It is clear from the above explanation that
firms are happy in the last two situations. If a
firm is in the first situation, it must analyze its
failures and try to rise above them. Of course, it
is very improbable in a short period of time. The
only way out of it for any firm is to frame an
aggressive policy.
Questions for Self Study - 1
(A) State whether the following
ü)
statements are true or false. Put (ü
û ) in bracket.
or (û
(1) Firms generally chase one single goal. ( )
(2) Businessmen accept the way of satisfying
expectations rather than maximizing
profits. ( )
(3) A firm is satisfied when it achieves targets
and satisfies expectations. ( )
(4) A firm has to work harder if its
performance is not upto the mark of
expectations. ( )
(B) Fill in the blanks.
(1) The theory of consumer behaviour divides
the _____________ of decision making
and the ___________ of decision making.
(2) Businessmen accept the way of ________
rather than maximizing profits.
(3) A firm sets __________ depending upon
its needs, targets and ___________.
(4) If a firm analyzes its success impartially,
it can judge the ___________ of its
performance.
16.2.2 Reactions to Simon’s
Theory
Simon has based his theory on the
similarities between human behaviour and
behaviour of firms. The theory appears to be
plausible as it is connected to the motivation
theory of Psychology which says that actions
are derived from motivations and when the
motivation stops, action stops too. Simon has
combined psychology and Economics in his
theory. Any firm is more inclined towards
deciding mark up price so as to earn reasonable
profit. Big companies set a target of satisficing
returns on invested capital. Simon’s theory is
suitable for observing the behaviour of both of
the above explained people.
The limitation of this theory is that it
doesn’t give an operational statement so as to
what level of performance should be considered
satisficing. Some critics say that theory of
maximizing profit sounds more realistic than
Simon’s theory as certain decisions can be taken
in the former by fixing optimum level of profit
related to various variables. However, there
could be different levels of satisfaction for
Principles of Business Firms and Investment Analysis : 12
different groups. In this context, there is no
significant operational value to Simon’s theory.
A firm has to satisfy many groups through its
actions. Shareholders would not be satisfied if
an attractive dividend is not given to them.
Workers will not be satisfied at low wages.
Consumers can only be satisfied at low wages.
Consumers can only be satisfied at low prices.
Capitalists need high return on their investment.
Managers will not be satisfied without high
wages and perks to them. Govt. must get a
certain amount of tax. A firm has to satisfy such
a profit level which satisfies all of these groups,
which is practically not possible.
Questions for Self Study - 2
(A) State whether the following statements
ü ) or (û
û ) in
are true or false. Put (ü
bracket.
(1) Simon’s theory is based on
_____________ between psychology of
human beings and psychology of firms.
(2) A Businessman is inclined towards fixing
_____________ of a good so as to earn
reasonable profit.
(3) Big companies try to earn
_____________returns on investment on
capital.
(4) There could be _____________of
satisfaction for various groups interested
in actions of firm.
16.2.3 Cyert and March’s
Behavioural Theory of
Firm
Cyert and March published the book ‘A
Behavioural theory of firm’ in 1966. The firms
producing more than one good in an imperfect
competition market are discussed in this book.
The ownership and management is in hands of
two different people in such a market. Cyert
and March have shown a keen interest in one
process of decision making of firms rather than
expectations and maximization of profit.
To understand the theory of Cyert and
March, following concepts are to be known.
Following are the features of firms as
adaptive and rational organizations.
(1) The system of firms has various stages.
A particular system is preferred over the
other on account of certain reasons.
(2)
There are external factors which shakes/
disturb this management of the firm. These
factors are beyond firm’s control.
(3) In this system there exist many internal
decision variables. These variables are
controlled according to certain decision
principles.
(4) Every combination of ‘external shock’ and
‘internal decision variable’ changes the
stage (condition) of the system. The
combination creates a new stage of a firm.
(5) The decision resulting in the most favoured
stage would be prefered in future.
On the basis of above statements we can
conclude that the behaviour of a firm is logical
in nature. With the help of this logical behaviour
a firm adjusts with the external shocks which
lead to a new situation. Such constant change
of situation leads to a firm establishment of the
firm.
One theory of firm’s behaviour also says
that firm is a coalition. We have already seen
that already a firm has to satisfy various groups
such as owners, managers, consumers, govt.,
suppliers, financial institutions, govt. officers and
ministers etc. Success of any firm implies that it
has satisfied various groups of contrasting
interests. This coalition of firm should remain
unshaker for the firm establishment of the firm.
When a firm is expanding the success or failure
of this expansion depends upon how nicely it
balances the interests of various groups.
The organisational goals of the firm are
related to its objectives. Like human beings,
firms also set objectives to give a specific
direction to the business. All the members of
the firm interested in its progress come together
decide the objectives and ways to achieve them.
Following are few major points regarding the
objectives of firm:
(1) Coalition members of a firm decide the
goals of the firm through mutual actions.
(2) All the goals in a coalition are not decided
on the basis of monetary factors. Coalition
members are given monetary benefits for
being loyal to the objectives of the firm.
(3) Some goals of the firm are idealistic in
nature.
(4) Some goals are expressed in a form other
than business.
(5) When the goals of a firm are expressed in
the form of practical targets, expectations
can be compared with the achievements.
Principles of Business Firms and Investment Analysis : 13
Periodic analysis helps the coalition to
improve its objectives. At the same time,
process of determination of expectations
can also be reviewed.
(6) Maximizing profit is not the only aim of
firms they have many other goals.
Organizational Slack: The coalition is
viable only if the monetary benefits given to the
coalition member satisfy them. The coalition is
easily managed if the firm has huge monetary
resources but if the firm doesn’t have the same
frequent friction is observed among coalition
members. This difference between monetary
resources and the need for them is known as
organizational slack. This occurs when coalition
members are given more benefits than the
existing resources of the firm.
If a firm is working in imperfect
competition market, many such organizational
slacks arise. Shareholders are given more
dividend than what is required to keep them with
the firm. Laborers are given more wages than
what is required to keep them working with the
firm. Revenue officer is given more than his
opportunity cost. Consumers are given discount
even if they are ready to buy goods at existing
prices. All these expenses on the part of a firm
add to its deficits. In traditional theories at least
in an equilibrium condition, we don’t come
across such a slack position. But in real world
we come across such slacks frequently. These
slacks are essential for a firm in order to adjust
with the external shocks. Those who control
these shocks work as shock absorbers. Thus,
help in stabilization of firm and creating
favourable conditions for the firm.
Questions for Self Study – 3
(A) State whether the following
ü)
statements are true or false. Put (ü
û ) in bracket.
or (û
(1) Cyert and March show keen interest in
the process of decision making of firms.
( )
(2) Firms don’t behave in a logical manner.
( )
(3) Like human beings, firms also set some
goals to give a definite direction to their
business. ( )
(4) Organizational slack doesn’t play any role
in maintaining the coalition of different
groups. ( )
(B) Fill in the Blanks.
(1) In Big firms _____________ and
_____________ of the firm are not the
same person.
(2) Using the internal _____________ firms
logically adjust with the ___________.
(3) A firm is a _____________ of groups of
various interests.
(4) _____________help in stabilization of
firm and creating favorable atmosphere for
the firm.
16.2.4 Process of Decision
Making : Cyert and
March’s Argument
Targets sets by organizers at the apex level
are implemented through the decisions. Decisions
are taken at various levels of organization. Two
of these levels can be easily seen. (a) Apex level.
(b) Administrative level.
Two levels of
Decision making
Level
Functions
Apex level of
Mangement
Setting the
targets (Goods)
Lower level of
Mangement
Implementing the
decisive measures
attaining the
targets
(1) Apex Level of organisation
This apex level of organisation keeps an
account of total resources of the firm and
distributes this amount among various sub
divisions. Each department is separately
considered in the budget. However, how much
resources each department gets, depends upon
the efficiency and negotiation capability of the
head of the department. The head of the
department negotiates on the basis of
Principles of Business Firms and Investment Analysis : 14
achievements of his department, efficient use
of the resources in the previous year etc. While
distributing the funds to various departments, the
apex level of organization saves some funds for
distribution as and when needed. The apex level
of organization takes any decisions only after
considering all the proposals and the information
available. Following are the two criteria
considered while estimating the proposals:
(a) Financial Criteria : Availability of funds
for the project.
(b) Criteria of Improvement : The
contribution of the project towards
modernization etc. of the firm.
The organizer needs a lot of information
to be able to take any decision. Labour and time
is needed to acquire this information. In other
words, there is cost involved in acquisition of
information. The equilibrium of this cost and
profit from it is not attained through the traditional
theory of marginal revenue and cost information
acquired is limited only upto the department and
the problem concerned. The objective behind
this is to spend minimum money on this.
Information plays an important role as different
groups set their expectations on the basis of this
information which in turn helps the apex level
of organization to set it targets. The information
should be carefully managed to reduce the gap
between performance and expectations. But this
doesn’t happen in the real world. Every
organizer supplies information only to the extent
that would keep intact his position in the firm.
Information can also be distorted and if
sometime, acquired with delay this depends on
the medium through which the information had
been acquired. In short the decisions taken by
apex level of organization are not always based
on correct, appropriate and sufficient
information.
(2) Administrative Level
There is a lot of freedom regarding the
implementation of decisions at the administrative
level. Every head of the department has the
freedom to use the money allocated to his
department. For example: The sales manager
decides the distribution of resources among sales
agents. The day to day decisions are made
simple by handing over the rights to various
heads of departments. These HOD’s learn by
experience the process of decision making. Thus
it can be said that Firm is a rational entity
adjusting with the external and internal situations.
Workers also in such a firm, adjust themselves
with various kinds of situations.
16.2.5 Argument of Cyert and
March Regarding
Behavioural Theory
We will take the example of duoply
market where there are homogeneous goods
which are sold at one single price. It is assumed
that inventories do not change. Following are
the major points of the argument of Kohen and
Cyert published in 1965 in the book called
“Theory of firm”.
(1) Anticipation about the reactions of
competitors: Each firm responds to the
decision taken by another firm. Thus the
direction of the responses of a firm can be
anticipated depending upon their moves in
previous years. Statistical methods are used for
this anticipation.
(2) Anticipation about demand for
goods of the firm: This is also anticipated on
the basis of previous experience and with the
help of statistical methods.
(3) Estimation of cost: It is assumed that
the current cost is equal to the cost in previous
periods. But there is a significant change in the
current cost as current cost is the sum of cost in
previous period and organizational slack.
(4) Clarity regarding the targets: The
profit is also determined on the basis of profit
in previous period. A firm decides its profit
target on the basis of revenue and cost of the
firm.
(5) Comparative Evaluation of
expectations and targets: Firms first decide
their targets then, the price, production and
quantity of output are decided. Once the entire
output is sold, revenue and profit are compared.
A firm is satisfied if expectations and
performance equalize. If this does not happen
i.e. if the performance is not upto the mark, firm
is unsatisfied. To satisfy its expectations, a firm
acquires information, processes it and then takes
decisions.
(6) Reviewing the cost: If the set target
of profit is achieved, firm reviews its cost
because some costs like organizational slack are
under the control of the firm. Thus, these can
Principles of Business Firms and Investment Analysis : 15
be reduced to achieve the set target of the
project.
(7) Reexamine the demand: If the set
target of profit can be achieved by reducing the
costs, a firm does so. But if this is not the case,
firm examines its demand and then changes are
made from the supply side.
(8) Evaluation of innovative moves:
If the targeted profit is not achieved even after
reviewing cost and demand, firm evaluates its
expectations. But before that firm tries to
achieve the target with improved cost and
demand.
(9) Recalculating Expectations: This is
the last option with the firm. If by all means
firm fails to achieve targeted profit, it finally
reduces its expectations to a more reasonable
level.
In real world however, a firm has many
objectives. Profit is just one of them.
Production, sales, market share etc. can be other
objectives. In such a case, instead of profit
maximisation a firm takes the route of
‘satisficing’ expectation. Targets and goals keep
on changing with time, performance, expectation
etc. When a firm analyses its failure, it gets new
information about the market which can be used
for the improvement of the firm because a firm
has to simultaneously face the problem of
change in taste of consumers, obsolescence,
reactions of the competitors etc.
Questions for Self Review - 4
(A) State whether the following statements
ü ) or (û
û ) in
are true or false. Put (ü
bracket.
(1) In an organization, decisions are taken at
the apex level. ( )
(2) Projects are evaluated on the basis of 2
criteria namely finance and improvement.
( )
(3) Loss occurs if the rights in each department
are transferred to people at lower levels.
( )
(4) Firms having more than one objective
follow the role of profit maximization.
( )
(B) Fill in the Blanks.
(1) In a firm, decisions are taken at 2 levels
namely ________ and_____________.
(2) The negotiation capability of each
(3)
(4)
department depends upon __________
of previous years.
Workers in administrative levels learn from
_______ how decisions should be taken.
A firm is _____________ if performance
is equal to _____________.
16.2.6 Evaluation of
Behavioural Theory
of Firm
(a) Contribution of Behavioural
Theory
This theory has played a major role in the
development of theories of firm. Following are
some main points regarding the same.
(1) It provides complete knowledge regarding
how targets are decided. There is a conflict
among various groups in one single firm.
This theory gives a realistic description so
as to how a firm brings these groups of
opposite interests together. The first step
of achieving the goals is to eliminate
conflicts between these groups. Managers
implement the targets decided unanimously
by the coalition of these different groups.
(2) The theory provides practical knowledge
about decision making. Setting the goals,
deciding the ways to achieve them,
evaluating expectations etc. are the
indispensable parts of process of decision
making. This behavioural theory of firm
is logical in nature and thus close to the
real world.
(3) The theory is explained from the point of
view of distribution of monetary resources
among various departments of a firm. This
is not the case in traditional theories. Firms
adjust themselves with the external as well
as internal shocks.
(4) The terms ‘Slack’ and ‘Shocks’ are
practical significance. Organisational slack
gives a firm stability. This concept of
‘slack’ is similar to the concept of rent in
traditional economics. Cyert and March
only discuss the organisational slack. But
other slacks are also equally significant.
(b) Limitations of the Theory
(1)
Simulation approach has been used to
describe the complexity of firm having
Principles of Business Firms and Investment Analysis : 16
many objectives and producing many
products. This approach does not describe
the process, it only describes the logic of
the process making.
(2) This theory doesn’t explain the
equilibrium situation. It doesn’t explain
the mutual action and interdependence of
firms. It doesn’t explain how price and
equilibrium output of a firm are determined.
There is no explanation regarding entry
of new firms and threat to existing firms.
(3) The explanation of the theory is in context
of short run. A firm acquires information
only on that front where it faces a problem
i.e. a short term solution is found out. The
theory doesn’t explain long run and
dynamic nature of new projects and
innovations.
(4) When a firm fails to perform upto the
mark, expectations are recalculated and
set at a realistic test of measuring whether
the performance is upto the mark or not.
(5) The theory doesn’t tell how a firm should
behave. It doesn’t analyze the ideal and
actual behaviour of the firm and the reason
behind it.
(6) The empirical base of the theory is very
small as the study is based on case study
of only 4 firms and experimental study of
2 hypothetical firms.
However, the theory has shown that there
can be other objectives of a firm than
maximizing profit. When a firm faces various
constraints within and outside the firm, it
automatically has to shift its focus from
maximizing profit to some other objectives.
Questions for Self Study - 5
(A) State whether the following
ü)
statements are true or false. Put (ü
û ) in bracket.
or (û
(1)
The behavioural theory of a firm provides
practical knowledge about the process of
decision making. ( )
(2)
Cyert and March discuss all types of slacks
in their theory. ( )
(B) Fill in the Blanks.
(1) _____________implement the targets
decided unanimously by the coalition of
these different groups.
(2) The information about dynamic actions of
coalition is acquired through distribution of
_____________.
(3) Slacks help in _____________of the firm
and creating _____________ for the
firms.
(4) Firm acquire knowledge only about that
department, where the problem has
occurred. Thus, the firm finds a
_____________ solution to the problems.
16.3 Words and their
Meanings
Maximization: Attaining a maximal point of
the target.
Satisficing Expectations: The process of
attaining certain level of the set goal.
Motivation: an inspiration to do a particular
thing.
Mark up price: Cost + expected profit.
Operational: Something which can be
implemented immediately.
Coalition: The process of bringing together
different groups of opposite interests.
Slack: The difference between resources with
a firm and demand for them.
16.4 Answers to Questions
for Self Study
Questions for Self Study - 1
(A) (1) (û), (2) (ü), (3) (ü), (4) (û).
(B) (1) process, consequences,
(2) satisficing expectations,
(3) expectations, will power,
(4) quality.
(3)
Simulation approach describes the
behaviour of firm. ( )
Questions for Self Study -2
(4)
The theory is based on the assumption of
short term. ( )
(A) (1) similarity,
(3) reasonable,
Principles of Business Firms and Investment Analysis : 17
(2) Mark up price,
(3) different levels.
Questions for Self Study -3
(A) (1) (ü), (2) (û), (3) (ü), (4) (û).
(B) (1) owners and managers,
(2) decision variables, external shocks,
(3) Coalition,
(4) Organizational slack.
Questions for Self Study - 4
(A) (1) (û), (2) (ü), (3) (û), (4) (û).
(B) (1) Apex level of organization and
Administrative level,
(2) performance,
(3) experience,
(4) satisfied, expectations.
Questions for Self Study - 5
(A) (1) (ü), (2) (û), (3) (û), (4) (ü).
(B) (1) Managers,
(2) Resources,
(3) Stabilization, fovourable situation,
(4) Short term.
16.5 Summary
The behavioural theory of firm was
propounded as an alternative to the traditional
theory. The firm in this theory is a firm with
more than one objective and producing more
than one good. It is a rational entity adjusting
itself with internal and external shocks. The
objective of the firm is not to maximize profit
but to satisfy its expectations.
A firm spends on acquiring knowledge as
it reduces the difference between performance
and expectations. Organizational slack has been
mentioned in this theory which was not decided
in traditional theory. These slacks work as
absorbers of shocks.
Decisions are taken at the apex level of
organization on the criterion of finance and
improvement. Administrative level of
organization implements these decisions.
The theory has largely contributed to the
concept of differentiation between process of
decision making and resource allocation.
The theory takes simulation approach and
thus many limitations can be cited in the theory.
More research is needed to strengthen the
concept of firm behaviour.
16.6 Exercises
(01) Explain how a firm satisfies various
coalition members having opposite
interests.
(02) What are the 3 situations that can arise
regarding performance and expectation of
a firm?
(03) Mention the similarities between
behaviour of human being and a firm.
(04) How does a firm decide ‘mark up price’?
(05) Differentiate between profit maximization
and satisficing expectations.
(06) Mention various shocks that a firm has to
bear.
(07) Regarding which issues does a firm take
internal decisions?
(08) Which are the additional benefits given to
coalition members to keep their interests
intact with the goals of the firm?
(09) What do you mean by Organizational
Slack?
(10) Mention slacks other than organizational
slack.
(11) Mention various levels of organization of
a firm and decisions taken by them.
(12) Mention important arguments of Cyert
and March’s behavioural theory of firm.
(13) Explain the merits of the behavioural
theory of firm.
(14) Explain the limitations of behavioural
theory of firm.
16.7 Field Work
(1)
(2)
(3)
What are the objectives of firms in your
locality?
Visit a firm in your locality and get
informed about its objectives.
What do entrepreneurs in your locality do
when they earn less profit than expected?
16.8 Books for Further
Reading
(1)
Koutsoyiannis
A.,
Modern
Microeconomics, London, English
language Book Society, Macmillan (1979),
Second Edition.
Principles of Business Firms and Investment Analysis : 18
Unit 17 : Business Behaviour of Firm
Index
17.0 Objectives
17.1 Introduction
17.2 Subject Description
17.2.1 Baumol’s Theory of Sales
Maximization
17.2.2 Marris’ Model of Managerial
Enterprise
17.2.3 Williamson’s Managerial Utility
Function
17.2.4 Comment on Managerial Theory
17.3 Words and their Meanings
17.4 Answers to Questions for Self Study
17.5 Summary
17.6 Exercises
17.7 Field work
17.8 Books for Further Reading
17.0 Objectives
After studying this unit, you will be able to
explain :
« difference between behaviour of a firm
and its manager.
« assumptions regarding the 3 theories of
utility maximization of the manager.
« difference between these 3 theories.
« comparison between traditional theories
and the theory of business behaviour.
« objectives, constraints and policies of
modern firms wherein the owners and
managers of a firm are different persons.
17.1 Introduction
Theory of business behaviour is a subpart
of theory of firm behaviour that we studied in
Unit 16. As we know, firm is a coalition of groups
having contrasting interests. It is essential that
objectives of each group, more or less, coincide.
The apex level of management is an important
factor in any firm because it has all the relevant
and necessary information about the firm and
has the sole right of decision making. Different
ownership and management is the key feature
of Business firm. Promoters and shareholders
are the owners of the firm who have the right to
appoint managers and members at apex level
of management. All the decisions regarding
development or strategies of the firm are taken
by this management until the profit percentage
of the firm and growth rate of the firm in
comparison to other firms is acceptable to the
owners. Thus it is necessary that owners get a
reasonable share of profit. Only then can the
position of managers of the firm be intact. This
difference between ownership and management
leads the firm to a goal other than profit
maximization. At the same time, managers get
the opportunity of strengthening their position in
the firm merely by keeping owners happy with
the reasonable rate of profit.
17.2 Subject Description
17.2.1 Baumol’s Theory of
Sales Maximization
In 1959, W. J. Baumol’s book called
‘Business Behaviour- Value and Growth’ was
published. In this book the concept of sales
maximization was put forth as an alternative to
profit maximization He has explained this
concept using two models : (a) single period
stable, (b) Multi-period dynamic model. Both
these were described in both the situations of
inclusion of advertisement cost and execution
of advertisement cost. Baumol’s principle has
an imperial base which can be looked into to
analyze the principle.
Due to the following 6 reasons, managers
of a firm find sales maximization more attractive
than profit maximization.
Principles of Business Firms and Investment Analysis : 19
Remunerations given to managers are
more related to sales than profit.
(2) Financial institutions are more keen to give
funds to firms with increasing sales
rather than increasing profits.
(3) It is easier to solve the problems of the
workers when sales are increasing.
(4) Increasing sales increases the reputation
of the managers.
(5) Managers give more importance to a slow
but steady grower or rise in the
performance.
(6) Increasing sales but favorable conditions
for firms to plan competition strategies.
Usually there is a separate department
responsible for innovations in products or
production process in a firm. The
implementation of these innovations is spread
over a long period. Thus, there should not be
major fluctuations in performance of a firm
because of the tendency of a firm of achieving
slow but steady progress; it can establish itself
firmly in the market.
According to Baumol, though firms in
oligopoly are interdependent, they assume that
their decision would not lead to any change in
behavior of competitors.
Baumol’s principle is based on following
assumption.
(1) Firms take decisions taking into
consideration a certain period of time.
(2) With the background of constraints on
profit of a firm tries to maximize its sales.
It doesn’t think how decisions taken in this
time period would affect the time to come.
(3) The maximum profit is decided on the basis
of expectations and demands, shareholders,
banks and financial institutions. A certain
minimum profit has to be maintained to
keep the prices of the shares increasing. If
profit goes below this minimum, manager
might have to loose their jobs.
(4) The traditional average cost curve is ‘U’
shaped and the average revenue curve is
downward sloping to the right Baumol’s
principle assumes the same.
On the basis of these assumptions 4
models can be extended.
(1) Model of a firm producing one good
without advertisements.
(2) Model of a firm producing one good with
advertisements.
(3)
Model of a firm producing many goods
without advertisements.
(4) Model of a firm producing many goods
with advertisements.
Let us study these four separately.
Model - 1 : Firm Producing Single
Good without Advertisement
In fig. 17.1 shows total cost and revenue
curves. At point D, the elasticity of demand is
1. At this point marginal revenue and slope of
TR curve is zero.
The curves in fig. 17.1 are as follows.
Y
Revenue, Cost,Profit
(1)
P
Q
OAN
TC
F
D
E
TR
M
N2
N3
R0 R1R2 R3 N1
Quantity of Profit
X
Fig. 17.1
TR: Total Revenue. The revenue goes on
increasing on X axis upto R2 level of production.
At R2, revenue is at its maximum. After this point
revenue goes on decreasing.
TC: Total Cost. Curve starts from ‘Q’ on
y axis. This implies that even if production is
zero, OQ cost is incurred. It is the fixed cost
initially TC increases at determining rate and
later goes on increasing rapidly.
NN1: This is the curve showing total profit.
Uptil ON level of production, there is no profit.
At ON, where TR and TC curve intersect, profit
is zero. From this point ‘N’ on X axis, starts the
profit curve. At point R0, profit is maximum as
the difference between TR and TC curve (FM)
is maximum. When TR and TC intersect each
other at point E at OR3 level of production,
marginal profit is zero. After this point, profit
turns into loss. This is shown by profit curve
going below X axis.
When the marginal revenue of a firm is
zero, its total revenue is maximum. This is known
Principles of Business Firms and Investment Analysis : 20
as absolute activity level principle. A firm
interested in profit maximization follows the
relative activity level principle. This principle is
always expressed as MR = MC. In above
explained sales maximization principle, the
equation that is expected is MR = 0. Such a sales
maximizing firm has the elasticity of demand as
unity, when it is in equilibrium. The formula for
measuring elasticity of demand
ep =
AR
AR − MR
When MR = 0 ,
ep =
AR
=1
AR
As shown in fig. 17.1, at point D, where
the total revenue is highest, production is equal
to OR2. The dividend to shareholders at this point
will not be satisficing them. E is the break even
point where TR and TC intersect each other.
But at this point the profit to the firm is zero. It
is expected out of a firm to give its shareholders, satisfactory profit. This essential level
of profit has been shown as QN2 in fig. 17.1.
When we draw a line perpendicular from the
point of intersection of NN1 and QN2 (essential
profit and profit curve) to X axis, we arrive at
point ‘R1’. In other words, shareholders would
be satisfied at OR1 level of production. But OR1
is less than the maximum level of production.
Thus, it can be concluded that there could
be two equilibrium conditions for a firm.
(a) At OR2 firm attains sales maximization.
Thus the attainment of minimum essential
profit is not a constraint.
(b) As firms earn QN2 level of profit at OR1
level of production, profit constraint is not
a problem in this equilibrium situation too.
As the profit constraint is already decided,
a firm can freely decide its price related
policies without worrying about reaction
of other firms.
In conditions where profit constraint is
effective, following can be said about the
behavior of the firm, as described by Boumal.
(1) A firm aiming at sales maximization
produces more than a firm aiming at profit
maximization.
Profit maximization firm will produce
OR0 firm level of output where MR = MC.
Sales maximizing firm will produce OR2
level of output where MR = 0. The
difference between the production of the
two firm will be R0R2
(2) Sales maximizing firm would sell its goods
at cheaper rates than profit maximizing
firms. Point D is the highest point on TR
curve. ‘F’ is the point on TR relating to
profit maximizing output. D relates to the
sales maximizing output. Slope of OD is
less than slope of OF. In other words price
charged by sales maximizing firm are less.
(3) Sales maximizing firm would earn less
profit than profit maximizing firm. The
former would get only OQ level of profit
where as latter will earn OP level of profit.
(4) Sales maximizing firm would not choose
a point of equilibrium where price elasticity
of demand is less than unity.
(5) If fixed cost of firm increases due to, say,
lump sum tax levy, the firm will reduce
its production and increase the process.
This is because increase in fixed cost
would push the profit curve downwards.
There would not be any effect of increase
in fixed cost on profit maximising firm.
(6) If variable cost increases, both the firms
will increase the prices and reduce the
production. But profit maximizing firm will
increase the prices more and reduce the
production more than the sales maximizing
firm.
Change in demand would bring about an
increase in production and sales revenue of sales
maximizing firm. But the effect on price will
depend upon the kind of change in demand and
the cost condition of the firm.
Model - 2 : Firm Producing Single
Good with Advertisements
This depends upon following assumption.
(1) Advertisements always lead to an increase
in revenue. This is because advertisements
shift the demand curve to the right thereby
increasing the sales.
(2) Price of the good remains stable. This
assumption is aimed at making the
analysis simpler.
(3) Total production cost is not affected by
advertisement costs. Baumol also accepts
that this is not the reality but for the
simplification of analysis, he has assumed
the same. Exactly like the second
Principles of Business Firms and Investment Analysis : 21
assumption, this assumption need not be
there for the analysis.
unrelated to the advt. cost. When advt. cost is
added to production cost, we arrive at total cost.
Advertisements are a medium to increase
sales. A profit maximizing turn in perfect
competition need not advertise its goods as it is
selling homogeneous goods at a fixed price. But
in imperfect competition, firm is the price maker.
Thus, advertisements play an important role. In
such a situation, the budget for advertisements
plays an important role. The number of
advertisements is decided by the effect of
advertisements on sales in a sales maximizing
firm.
When total cost is subtracted from total
revenue at each level we arrive at profit for
that respective level. The profit curve is NN1.
In oligopoly a firm would prefer increasing
advertisement cost rather than decreasing the
price. How much will price decrease / increase
bringing about change in demand depends upon
the elasticity of demand. But if the marginal
revenue is positive one can be sure that
advertisements increase the sales. When profit
constraint is not effective, a firm cannot attain
equilibrium under this model. Curves in fig. 17.2
are as follows.
Revenue, Cost, Profit
Y
TC
TR
Advt. Cost
P
N1
450
R R1
Advertisement Cost
As said and done, the analysis does not
prove a positive correlation between advt. and
revenue. Also, the third assumption says that
advt. cost doesn’t affect production cost. In such
a situation, the production should remain the
same even after advertising which means that
an increase in revenue is not due to advt. but
due to price rise which is contradictory to the
assumption 2 which says that price remains
stable. This implies that Baumol’s model and
the figure for supporting are actually not
supportive of each other.
Model - 3 : Firm Producing many
Goods without Advertising them
P1
N
O
Model-2 of Baumol’s principle shows that
production increases when advt. cost increases
(From R to R1). According to our assumption 1,
increase in revenue is more than increase in advt.
cost i.e. the marginal revenue is positive. In such
a situation, sales cannot be raised to any limit.
A firm can increase the sales by spending more
on advt. only if the price change leads to sales
upto that level where revenue is more than what
is needed to keep shareholders satisfied. In other
words, the advt. cost of sales maximizing firm
will be more than that of profit maximizing firm.
X
Fig. 17.2
TR: Total revenue curve. The slope of
this curve first increases and then decreases.
Initially total revenue rises faster than price and
thereafter only at a slow pace.
TC: Total cost curve. This curve starts on
y axis from point P. The fixed cost is OP when
production is zero.
Advt. Cost: A straight line from point O
measuring 450 to both X and Y axis is the
advertisement cost curve.
PP1 shows the production cost and is
If a firm has limited resources and stable
cost, the firm would distribute limited resources
among various goods. In a sales maximizing
firm the distribution will be the same. The scale
given by Baumol is - A firm is in equilibrium
when the proportion of marginal revenue and
marginal cost of one good is equal to that of
another.
MR
MC
∆X A ∆X A
=
MC
Symbolically, MR
∆X B ∆X B
This situation can be shown with the help
of following diagrams.
Principles of Business Firms and Investment Analysis : 22
Model - 4 : Firm Providing many
Goods with Advertisements
Y
Firm has to attain a level of maximum sales
taking care of the profit constraints. The firm
would spend on advt. for each good in such a
way that the marginal revenue from each good
is the same. If the condition is not so, firm would
spend more on advt. of that good where the
marginal revenue is more.
Y Good
T
Y
E
R4
R3
R2
Questions for Self Study - 1
R1
O
X T1
X Good
X
Fig. 17.3
Suppose this firm produces 2 goods X and
Y. R1, R2, R3 and R4 are the isorevenue curves.
TT1 is the product transformation curve. The
slope of this curve is the marginal rate of
substitution. It is equal to the proportion of
marginal cost of these 2 goods.
This curve is concave which means that
there are many restrictions in transferring
resource from production of good X to good Y
i.e. the costs increase in such a case. TT1 is the
curve showing maximum limit of available
resources.
These resources should be used
completely such that the sales are maximum and
the firm is in equilibrium. On R1 and R2 curves,
firm is not using available resources efficiently.
R4 curve demands more resources than are
available to the firm. R3 touches TT1 at ‘E’ i.e.
at this point slope of R3 and TT1 are the same
and the marginal rate of substitution is the same.
Out of increased revenue due to increased sales,
some part will be kept for further increase in
production given that resources are limited.
If a firm can gather more resources,
situation will be different. An increase in
production will increase the profit upto a certain
level. But as the demand curves of 2 goods are
downward sloping, isoprofit curve will be
concave to them. Thus profit will go on
decreasing and even loss may occur. In such a
condition, firm will be in equilibrium where
isorevenue and isoprofit curve touch each other.
(A) State whether the following statements
ü ) or (û
û ) in
are true or false. Put (ü
bracket.
(1) Sales maximizing firm will produce more
than profit maximizing firm. ( )
(2) In Model-2 of a firm producing one good
with advt., production doesn’t increase
with increasing advt. cost. ( )
(3) If resources are limited, a firm producing
many goods will distribute these resources
such that the proportion of marginal
revenue and marginal cost of both the
goods is equal. ( )
(4) A firm distributes the advt. cost according
to the marginal revenue from advertising.
( )
Baumol’s Dynamic Model
In Baumol’s stable model we assumed a
particular time period and that the profit is
determined externally. Now in this model
Baumol has extended the time horizon and
assumed that profit is determined internally.
Following are the assumptions of the
theory.
(1) A firm in its entire life span tries to
maximize the rate of growth of sales.
(2) The capital needed for growth of sales is
financed from the profit of a firm. Thus
every firm decides its own period.
(3) Demand curve is downward falling and
cost curve is ‘U’ shaped as in the traditional
theory.
(4) Profit is not a constraint, but an
instrumental variable. Through profit firms
try to maximize sales. Capital can be
collected from internal as well as external
services. But as there are limitations to
external ways, internal means are adopted.
For simplicity of analysis, we assume that
capital is financed out of profit.
Principles of Business Firms and Investment Analysis : 23
‘R’ shows the sales revenue of the firm
and ‘g’ shows growth rate of sales. Thus the
total sales of the firm in its total life can be
symbolically expressed as
2
1+ 9 
1+ 9  1+ 9 
R, R 

 ......R 
, R 
 1+ r 
 1+ r   1+ r 
n
‘r’ shows the discount rate which is
determined by expectations and risk taken by
the Govt. In short the total sales can be
symbolically expressed as
 1+ 9 
S = ∑ R

 1+ r 
t =0
n
t
‘t’ shows the number of years.
A firm tries to maximize the value of
current sales. The value of current sales (S),
Sales revenue (R) and growth rate of sales (g)
are positively correlated.
The growth rate depends on the
undistributed profit which depends on current
level of undistributed profit (R), cost (c), growth
rate of sales (g), the discount rate (r). Firms try
to maximize its current sales at (e), selecting R
and g from various sets. This is shown in fig.
17.4.
explanation which shows combination of g and
R giving sames. In fig. 17.5, ‘R’ is shown by ‘P’
on X-axis and ‘g’ by D on y axis. Lines joining
these two will be parallel to each other. They
are usually linear but not always. The slope of
isorevenue curve can be shown asS = (b1.g) + (b2.R)
Where, b 1 and b 2 are constants. g can be
calculated by
g=
After solving this equation, we can now
calculate isorevenue curve. Coefficient of S are
as follows,
b1 = 250, b2 = 0.5
Now,
g=
Y
Growth Rate Sales Revenue (D)
Growth Rate Revenue
O
1
0. 5
R
S−
250
250
g = 0.004S - 0.002R
With the help of this, fig. 17.5 can be
drawn. The slope of isorevenue curve depends
on coefficient of S namely b1 and b2. The farther
the isorevenue curve from 0, the greater the
source of discounting of income.
Y
D
b
1
S− 2 R
b1
b1
B
N
Revenue
X
F
0.09
0.08
0.07
0.06
0.05
0.04
0.03
0.02
0.01
O
S=20
S=10
20
30
40
10
Current Sales Revenue (P)
X
Fig. 17.4
Fig. 17.5
As shown in the fig., firm earns maximum
profit at point ‘N’, uptil where D also increase.
After ‘N’, ‘D’ starts falling with an increase in
revenue. Thus, after ‘N’, revenue (R) and growth
rate of sales revenue (g) become competitive
objectives.
Now, we will add isopresent curve to the
A firm will produce at the level where P
and D are maximum possible and are on the
upper most possible isorevenue curve. [As the
isorevenue curve, here , is downward sloping to
the right, the maximal level of R and (g), i.e.
point ‘B’ in 17.4 can’t be attained. Wherever
the OBF curve touches the isorevenue curve,
Principles of Business Firms and Investment Analysis : 24
there will be equilibrium level of production for
the firm.] This is shown in fig. 17.6.
Growth Rate
Y
B
E
D
O
N K
Revenue
S1
X
Fig. 17.6
OBEK shows the attainable growth rate
of sales ‘g’ at any given level value of sales
revenue. The firm is in equilibrium at point E.
The growth rate is at ‘D’ and revenue at level
ON. SS1 is the maximal attainable isorevenue
curve.
Questions for Self Study - 2
(A) Fill in the Blanks.
(1) Growth rate depends upon __________
profit of firms (distributed / undistributed)
(2) In Baumol’s dynamic model, profit is
determined by _____________factors.
(External / Internal)
(3) The value of sales revenue and its growth
rate are _____________ correlated.
(positively/ negatively)
(4) After the maximal point of profit, revenue
and growth rate of revenue become
___________ objectives.
(complementary/ competitive)
17.2.2 Marris’ Model of
Managerial Enterprise
According to Marris, owners and
managers of firms are different. Thus, it’s prime
object is to maximize its growth rate at
equilibrium level, which depends on 2 factors.
(a)
Growth rate of demand for the goods
of the firm.
(b)
Growth rate of supply of capital
essential for the firms.
According to Marris, though there is
conflict between interests of owners and that of
managers of a firm, but some times these interests
coincide. Only in such a condition equilibrium
growth of a firm is possible. According to Marris,
this conflict is not as serious as assumed on the
theory of business behavior of a firm, as the
objectives of both the owner and the manager
depends upon a common variable i.e. the size of
the firm. Though, there are different parameters
for measuring the size of a firm, they all are
included in the ‘long run growth rate’ parameters.
Managers of the firm do not try to maximize the
absolute size of the firm but the growth rate of
the size of the firm.
Based on this assumption, Marris mentions
two utilities.
(a)
Managerial utility: This depends upon
the salary, designation, rights and job
security of the managers.
(b)
Ownership utility: This depends upon
capital, production, market share,
reputation etc.
A firm has to face 2 major constraints while
trying to maximize the equilibrium growth.
(1) Managerial Constraints: There are
constraint regarding the efficiency and
skills of the existing team and the addition
of new members to the team.
(2) Financial Constraints: A manager
wants to maximize his utility to the firm,
thereby securing his job. Managers adopt
such a financial policy which observes risk
with the help of financial tools such as
leverage or debt ratio, liquidity ratio,
retention ratio etc. This way, the manager
also gets job security. But there is a
satisfaction level pertaining to this job
security. Beyond this level, any increase
in job security has got zero marginal utility
and below this level, marginal utility is
infinite.
Let us study how a firm attains equilibrium
growth along with these constraints. The
equilibrium growth rate is attained by managers
and owners by maximizing their respective
utilities. The utility of owners (shareholders)
Principles of Business Firms and Investment Analysis : 25
depends upon the growth rate of supply of capital
needed by the firm. Growth rate of demand (gDd)
is determined by the diversification rate. Growth
rate of supply of capital (gc) depends upon
average rate of profit. Managers can change
the diversification rate by expanding the range
of the product. A firm can change gc by changing
the structure of the capital through changing
liquidity, leverage or debt and retention ratio.
But, in an oligopoly market the price is taken as
given. A firm can always determine its
expenditure, on research and advertisement. The
more the expenditure, the lesser the profit.
From this explanation, we can make our
Marris’ model assume price and production cost
to be given. Thus, any firm has 3 policy variables
through which the firm tries to attain its
objectives.
(a)
Financial safety coefficient
(b)
Diversification rate
Average rate of profit
Fig. 17.7 shows the curve of growth rate
of supply of capital and growth rate of demand
assuming a given level of profit.
of capital within the limits of managerial and
economic constraints.
Table 17.1 : Comparison between
Baumol’s and Marris’ Model
Sr. Baumol’s Model
No.
(1)
Owner increases
his utility.
Both owner and
manager do so.
(2)
Maximization of
demand through a
change in sales
revenue.
Maximization of
demand through
diversification
rate.
(3)
Growth of capital
– implicit
objective.
Growth of capital
Explicit objective.
(4)
Equilibrium
growth rate and
profit are
competitors
according to
dynamic model.
They aren’t
competitors,
when monetory
policy is fixed.
(5)
Price policy is the
parameter.
Price policy is the
parameter.
(6)
Price is
determined by
Average revenue.
Price is
determined by
Average revenue.
(7)
Output level is the
policy variable.
Output level is the
policy variable.
(8)
Firm, is a
‘producer’ & not
a ‘pricemaker’
Output level is not
fixed.
(9)
Advt. cost plays a
major role.
No mention of
Advt. cost.
(c)
Growth Rate
Y
S4
S3
S2
S1
O
K
M
B
N
D
K
D1
D2
D3
D4
X
Revenue
Fig. 17.7
D1, D2, D3 and D4 are curves originating
from ‘O’ and show various growth rates of
demand at different profit levels. S1, S2, S3, S4
are growth rates of supply of capital at various
levels of profit. S1 intersects D1 at B. In the
same manner, we can achieve intersection
points such as K, M and N. The curve joining
B, K, M and N is called balanced growth curve.
Any firm will choose that point where it
maximizes growth rate of demand and supply
Marris’ Model
(10) Research and
Development not
considered.
Cost on R and D
are included in
profit.
(11) Doesn’t discuss
economic policies
of firms.
Economic policy
plays a major
role.
Questions for Self Study - 3
(A) Fill in the blanks.
(1)
The firm attains the growth rate when the
interest of owners and managers coincide
at _____________.
Principles of Business Firms and Investment Analysis : 26
The objectives of managers and owners
of the firm depend on the only variable i.e.
_____________.
(3) The managers of the firm try to keep the
growth rate of _____________ to its
maximum.
(B) Differentiate between Baumol and
Marris models on the Basis of the
following.
(1) Factors, maximizing their own utility
(2) Methods of maximizing demand.
(3) Relationship between objectives of growth
and profit.
(4) Advt. cost
(5) Economic policy.
17.2.3 Williamson’s Managerial
Utility Function
According to Williamson, managers try to
increase their own utility by using various
policies instead of maximizing profit and
increasing shareholders utility. This is known
as Williamson’s managerial utility function.
Financial market and shareholders expect only
a certain minimum profit from the firm. A
manager may lose his job if this minimum profit
is not attained. All actions of a manager are
governed by this constraint of minimum profit.
In managerial utility function salary, security,
reputation, power, are also included. Among all
these only salary, is the cardinal variable i.e. it
can be measured in numbers.
The other variables which can not be
measured are defined as expense preference by
Williamson. It can also be defined as slack
payments, available to the manager for
investments. A manager can attain security,
rights, reputation and achievement with the help
of these expense preferences. He achieves utility
and other perks due to this expense preference.
Though there are some restrictions regarding
perquisites but the manager also gets rebate on
tax. Just because this amount is not very big it
doesn’t attract share holders attention. Any
Manager has the right to spend the money above
the dividend and day to day transaction cost.
This money, he uses to materialize projects
according to his preference.
Expenditure on workers, emoluments and
managerial investment expenditure can be
measured.
On the basis of above explanation
Williamson’s model can be expressed as follows.
Managerial utility (U), depends on
expenditure on workers (x), and investment by
managers (M). There can be curves which show
same utility with different combinations of X
and M. Fig. 17.8 shows the same.
Y
Managerial Investment
(2)
U3
U2
U1
X
O
Expenditure on Workers
Fig. 17.8
Each utility curve shows various
combinations of X and M giving same utility.
These curves are as usual convex to the origin.
This implies that the marginal rate of substitution
is decreasing. These isoutility curves do not
touch any of the axis which means that X and
M always remain positive and the utility is also
positive. The profit earned by a firm depends
on price (P), expenditure on workers (S) and
market environment (e) Equilibrium or optimal
level is decided with the rule MR=MC. Figure
17.9 shows relationship between managerial
profit (πD) and expenditure on workers. It
emoluments are assumed to be not given,
managerial profit (πD) is equal to investments.
At point ‘K’ in fig. 17.9 both managerial
profit and expenditure on workers is maximum.
After point ‘D’ the expenditure on workers
increases but managerial profit goes on
decreasing. The minimum profit constraint is
not attained if expenditure on employers/workers
is less than point ‘B’ and more than point ‘E’.
This implies that equilibrium is between points
‘B’ and ‘E’. But as isoutility curves are
downward sloping to the right and as the
equilibrium is at the point of intersection, the
Principles of Business Firms and Investment Analysis : 27
equilibrium will be between points ‘K’ and
‘E’.
be more and price and profit will be less than
profit maximizing firms.
Managerial Profit
Y
Managerial Profit
Y
K
O
D
X
K
T
U3
U2
U1
O
B
D
D1
E
B
Expenses on Employees / Workers
Expenses on Employees / Workers
Fig. 17.9
Fig. 17.10
Fig. 17.10 is just a combination of fig. 17.9
and fig. 17.8. X axis shows the expenditure on
employees and Y axis shows managerial
investments which is same as managerial profits.
BKE curve touches U3 isoutility curve at T
which means that at OD1 level of expenses on
employees, the managerial investment (which
is managerial profit also) is equal to TD1. But
the maximum level of profit i.e. KD cannot be
attained. This implies that a firm in Williamson’s
model will spend more on employees (OD1) than
profit maximizing firms (OD). Also, the
production of firms in Willaimson’s model will
X
Questions for Self Study - 4
(A) State whether the following
ü)
statements are true or false. Put (ü
û ) in bracket.
or (û
(1) Managers increase the utility of
shareholders. ( )
(2) Expense preference provides managers
with security, rights, reputation and
achievement. ( )
(3) Managers try to maximize their utility by
balancing managerial investment and
expenditure on employees. ( )
Table 17.2
Basics of Comparison
(1) Conditions of
Equalization
(2) Decision Variables in
equilibrium
(3) Change in Market
Demand
(4) Changes in Tax Rate
(5) Effect of Lump sum Tax
Profit Maximization firms
MR = MC
Utility Maximization firms
MR = MC
marginal cost of employees to less
Marginal cost of employees
than 1
Total profit undistributed profit = 1 Total profit undistributed profit < 1
Managerial emoluments
Positive emoluriments
Expenses on employees = 0
Positive expenses on employees
No managerial investments
Positive managerial investment
Price remains unchanged
Price changes
No changes in slack payments
Change in slack payments
Tax burden can be reduces by
Tax burden cannot be avoided by
innerves slack payments and
changing price
thereby reduced profit
Tax burden can be brought down by
Tax burden cannot be avoided by
changing production or expenses on reducing production and slack
payments. The effects will be same
employees. The effect will be the
if fixed costs are changed
same if fixed costs are changed
Principles of Business Firms and Investment Analysis : 28
(B) What is the firm trying to maximize if
production and expenses on employees
move in the same direction as change in
demand , but price moves in the opposite
direction.
(C) Fill in the blanks.
(1) A firm in Williamson’s model produces
_____________ than profit maximizing
firm and the price and profit of such a firm
are _____________ than that of profit
making firm.
17.2.4 Comment on
Managerial Theory
Williamson’s model is practical. The
concept that the manager has the freedom over
‘expense preference’ is tested in this model. The
real life situations are supporting of the concept.
(1) Expenditure on employees and
emoluments increase in boom period and
are reduced in recession.
(2) Firms respond to a change in taxation.
(3) Firms bring about changes in expenses on
employees, emoluments , production etc.
if fixed cost changes.
(4) The productivity of apex level of
management is kept the same, but there is
tremendous reduction in expenses on
employees.
The model, however, needs more empirical
data to be fully proved. Following are some of
the limitations of the model.
(1) The interdependence of firms in noncollusive oligopoly market cannot be
explained using this model.
(2) The model relates only to big firms where
diversification of production and
managerial investment is possible.
(3) The process of price determination in the
market is not discussed.
(4) There are various types of constraints
involved like social, cultural and physical
constraints in real world. Marris discusses
two of them viz. economic and managerial
but williamson’s model doesn’t discuss any.
(5) Behavioural and Managerial theories
cannot compete with traditional theories.
In contrast, they indirectly prove firm’s
profit maximizing behaviours.
(6) The equilibrium of industry is not taken
into consideration.
(7)
The concepts of traditional theories have
been put forth using different names. For
example ‘economic rent’ in traditional
theory is called ‘slack payment’, but in
behavioural theory, ‘internal diseconomics
of scale’ are named as ‘managerial
ceiling’.
17.3 Words and their
Meanings
Absolute Activity Level Principle : Activity
level where sale of an additional unit of a
commodity produced does not add to total
revenue. In this case the marginal revenue
is zero.
Relative Activity Level Principle : Activity
level where the additional unit of a
commodity produced generate by its sale
the revenue equal to the cost incurred on
its production.
Product Transformation Curve : A curve
showing the various combinations of two
products which a firm could produce using
the factor inputs available with them.
ISO Present Value Curve : It is a curve
showing that the discounted present value
of the sales revenue and growth rate in
sales revenue are equal.
Managerial Utility Function : Managers using
certain policies, try to increase their own
utility by maximising profits, instead of
increasing the utility of the shareholders.
Expense Preference : Funds made available
to the managers for his free expenditure.
He is free to spend this amount as per his
choices.
17.4 Answers to Questions
for Self Study
Questions for Self Study - 1
(A) (1) (ü), (2) (û), (3) (ü), (4) (ü).
Questions for Self Study - 2
(A) (1) Undistributed,
(3) Positively,
Principles of Business Firms and Investment Analysis : 29
(2) Internal,
(4) Competitive.
Questions for Self Study - 3
(A) (1) equilibrium level of output,
(2) the size of the firm,
(3) Size.
(B)
Sr. Baumol’s
Marris’
No. Model
Model
(1) Maximising growth Rate of growth of
rate of revenue
demand and supply
(2) Rate of sales
Diversification
revenue
rate
(3) Competition
No competition
(4) Important role
Not mentioned
(5) Not mentioned
Decisive role
medium to attain maximum growth rate of sales
which depends on undistributed profit of the firm.
A firm selects that combination of revenue and
growth rate of revenue where in the current
value of sources of revenue is maximum.
Marris’s Model
The objective of a firm is to maximize
equilibrium growth rate. It becomes possible
only at the point where the interests of managers
and owners coincide.
Given price and production cost, firms try
to attain equilibrium growth rate by changing
financial security coefficient, diversification rate
and average profit rate.
Questions for Self Study -4
(A) (1) (û), (2) (ü), (3) (ü).
(B) The firm tries to maximize its utility.
(C) more, less.
17.5 Summary
A firm is a coalition of various groups
having conflicting interests. According to Baumol
managers of a firm try to maximize sales revenue
rather than maximizing profits.
A firm producing a single good without
advertising considers the ‘principle of unbiased
business’ and tries to attain minimum satisfactory
level of profit. This may not be maximum level
of output.
A firm producing a single good with
advertisements first attains maximum
satisfactory level of profit and then tries to
maximize its sales revenue by advertising its
product.
A firm producing many goods without
advertising allocates its resources in such a
manner that all the resources are efficiently used
and sales revenue is maximized.
A firm producing many goods with
advertisements first attains minimum satisfactory
level of profit and then tries to maximize its sales
revenue using advertisements in such a way that
advertising cost equals marginal revenue.
Williamson’s Model of Managerial
Utility
Managers use all rights available to them
to maximize their utility. They give preference
to projects of their choices and attain
satisfaction. The utility of managers depends
upon expenses on employees and managerial
investment. A firm in Williamson’s model spends
more on employee than a profit maximizing firm.
Williamson’s model is, though very supportive
of real life situations, it neglects physical, social
and cultural constraints.
17.6 Exercises
(1) Differentiate between (a)
Baumol’s stable and dynamic model.
(b)
Objectives of firms in Baumol’s and
Marris’s model.
(c)
Equilibrium condition of profit
maximizing firm and utility
maximizing firm.
(2)
Compare the role of profit in Baumol’s
stable and dynamic model.
(3)
What are the 2 factors that determine the
growth rate of a firm in Marris’s model.
Baumol’s Dynamic Model
(4)
In this model, Baumol considers long run
and says that profit is determined internally. Profit
is not taken as the ultimate objective but just a
How do firms maximize the rate of
demand in Baumol’s and Marris’s model.
(5)
Why do firms emphasise on spending on
employees in Williamson’s model?
Principles of Business Firms and Investment Analysis : 30
17.7 Field Work
17.8 Books for Further
Reading
(1)
Do we come across firms as in Baumol’s
model in the real world?
(1)
(2)
Can you name a firm in the real world
wherein managers and shareholders
maximize their utility.
(2)
(3)
What are the different kinds of managerial
investments done by managers in India?
(3)
Koatsoyiannis
A,
Modern
Microeconomics, English Language Book
socity/Machmillan, Second Edition, 1979.
Baumol W. J., Business Bahaviour, Value
and Growth, Harcourt, Brace and World
Inc., Revised Edition, 1967.
Marris R., The Theory of Managerial
Capitalism, Macmillan, 1964.
Principles of Business Firms and Investment Analysis : 31
Unit 18 : Profit : Concept and Analysis
Index
18.0 Objectives
18.1 Introduction
18.2 Subject Description
18.2.1 Concepts of Profit
18.2.2 Functions of Profit
18.2.3 Measurement of Profit
18.2.4 Economic Theories of Profit
18.2.5 Planning and Controlling Profit
18.2.6 Profit Related Policies
18.3 Words and their Meanings
18.4 Answers to Questions for Self Study
18.5 Summary
18.6 Exercises
18.7 Field Work
18.8 Books for Further Reading
18.0 Objectives
After studying this unit, you will be able to
know :
« different concepts of profit
« problems on measurement of profit
« various principles of profit
« factors determining profit related policies
« planning, controlling and managing profit.
18.1 Introduction
Profit maximization is the central idea of
traditional economic theories. Even behavioural
and Managerial principles couldn’t do away with
the concepts of profit. The concepts like ‘actual
profit’, ‘reported profit’ and targeted maximum
profit have emerged from these priciples. Some
times profit is considered endogenous. It can be
concluded that profit is a very complex concept.
Thus, it becomes essential that profit be anlysed
in the context of business related decisions. We
will look into the sources and uses of profit. Profit
should also be seen as a deciding factor.
18.2 Subject Description
18.2.1 Concepts of Profit
Various Economists have defined profit
in various ways.
(1) Accounting Profit
An excess of revenue over costs in books
of account is called accounting profit. In this
concept, implicit and opportunity cost are not
accounted for.
(2) Economic Profit
When we deduct implicit and explicit, both
the costs from total revenue we get economic
profit. Some options have to be sacrificed while
taking any decision which implies that opportunity
cost is taken into consideration during decision
making.
According to accountants, as opportunity
cost varies with each individual it cannot be
precisely accounted for the difference between
economic profit and accounting profit is the
accounting cost. If the accounting profit is less
than opportunity cost, it will be a loss in
economic sense even if it is profit in books of
account.
As opportunity cost can only be felt and
not accounted, firms do not usually take into
account economic profit. Accounting profit can
be calculated using the following tables.
Table 18.1 : Profit
Revenue - Actual Cost
(Labour, Raw material,
Variable Cost)
= Contribution of Firm - Fixed Cost
= Operating Profit - Depreciation
= Net Profit - Divident
= Net Undistributed Profit
Principles of Business Firms and Investment Analysis : 32
Table 18.2 : Performance
(1)
Net Profit
= Total Performanc e
Net Assets
(2)
Revenue
×
Contributi on
×
Operating Profit
Investment
Revenue
Contributi on
= Operating Management Performance
Net Profit
(3)
×
Contribution
Operating Profit
Net
= Financial Management Performance
Combing (1), (2) and (3) we get
Total performance = Operating Management
Performance x Financial Management
Performance.
Table 18.3 : Du-Pont Control
Rate of
Rate of Return
Revenue - sales
percent
Renue / Sales
Sales Revenue - Cost
Sales Cost = Sales
expenditure +
Administrative
expenditure
Return
Sales Turnover
Sales / Total
Capital
Fixed Capital +
Working Capital +
Cash + Stock +
Receivables
The study of these tables introduces us to
various concepts of accounting profit which are
used at different stages depending upon method
of accounting and convenience of the
accountant. The above mentioned table
mentions following eight concepts.
(1) Accounting Profit
(2) Total Profit
(3) Net Profit
(4) Contribution
(5) Total Operating Profit
(6) Interest and Profit before Tax
(7) Undistributed Profit
(8) Rate of Return
Economic profit also has four different
concepts.
(1) Actual Profit
(2) Reported Profit
(3) Decisive Minmum Profit
(4) Targeted Profit
Questions for Self Study - 1
(A) Fill in the blanks.
(1) Profit is a very _____________ concept.
(2) In Accounting profit _____________ or
_____________ is not taken into
consideration.
(3) When ____________and ________ or
_____________ are subtracted from total
profit, we arrive at Economic profit.
(4) Economic profit is calculated by _______
_____________ from Accounting profit.
(5) Opportunity cost cannot be measured
in __________.
(6) _____________ is a deciding factor in
the process of _____________.
18.2.2 Functions of Profit
It can be understood now that profit plays
an important role in the process of decision
making. Following could be the functions of profit
on the basis of the previous discussions.
(1) Profit is an indicator of operational
efficiency of a firm :
Other things being normal, profit indicates
operational managerial and financial
performance of a firm.
(2) Premium over and above the minimum
price needed to remain in the business is
profit :
A firm incurs costs on heads like
replacement, obsolescence and risk.
These costs are recovered from project.
(3) Profit reflects the internal financial position
of a firm :
As replacement costs are recovered from
undistributed profit of the firm, profit reflect
the solvency and security of any firm.
(4) Finance related decisions are taken on the
basis of level of profit and rate of profit :
Profit is an established parameter of
project valuation and evaluation.
(5) Profit reflects the fulfillment of social
responsibilities of a firm :
All the programmes of social welfare are
financed from project of any firm. Thus,
even the public enterprises have to make
profits to be able to work for the society.
(6) Profit gives us a platform for comparing
various firms, industries and their products.
Principles of Business Firms and Investment Analysis : 33
(7)
Profit reflect the areas of control,
management and planning.
No firm can remain in business without
profit. No firm can decide its policies without
considering profit. Thus, profit is an important
factor.
Questions for Self Study - 2
(A) State whether the following
ü)
statements are true or false. Put (ü
û ) in bracket.
or (û
(1) Profit gives us an idea about operational
performance of a firm.
( )
(2) Mistakes in management lead to profit.
( )
(3) Greater the profit, greater the solvency of
the firm. ( )
(4) Firms can be compared on the basis of
profit. ( )
18.2.3 Measurement of Profit
It is essential to calculate profit per period
as it gives us the rate of return. It also tells us
the profit in percentage term of sales revenue.
This helps the firm to take decisions regarding
an increase or decrease in production. Thus
measurement of profit becomes essential.
This measurement of profit becomes
difficult due to the difference between
Accounting profit and Economic profit.
Measurement of economic profit becomes
difficult because of concepts like opportunity
cost. However, direct as well as indirect
accounting cost can be easily calculated, the
fundamental principle of which is as follows.
The source of funds and use to which they
are put is mentioned in the funds flow statement.
Following are the three methods of
measuring profit. We get different results due
to difference in methods of measuring
accounting and economic profit.
(1) Depreciation
It is measured by using different methods.
Straight Line Method : According to
this method, depreciation is charged by
means of equal periodical deductions over
the useful life of the asset.
(b) The Declining Balance Method : The
declining balance method is sometimes
called the fixed percentage method.
(a)
Annual Rate of Depreciation

  Estimated SalvageValue
1
= 1


Cost of Asset
 Lifeof Asset

(c)
Units of Production Method : This
method is based on the estimated number
of units produced rather than the estimated
number of years of service. The difference
of the value of fixed asset is taken from
its salvage value and is divided by the
expected life of the asset to arrive at annual
rate of depreciation.
Annual Rate of Depreciation
 Cost of Asset - Salvage Value 

 Expected Life of Asset 
=
(d) Annuity Method : In this method, while
determining the value of the asset the rate
of interest paid on the capital investment
made on the asset is considered.
Annual Rate of Depreciation
 Cost of Asset + Interest paid on Capital 


borrowed for Purchase




of Such Asset
=

Expected Life of Asset








In economics this accounting method is
not useful. An economist estimates depreciation
in terms of opportunity cost. Hence, he would
not consider the (original) cost of asset but the
replacement value of the asset. The replacement
value could be arrived at by deducting the
salvage value of the old machine from the new
investment. It may be possible that during price
rise the replacement value may be more than
the original value of the asset and less when
prices fall.
Annual Depreciation
=
Cost of Asset − Salvage Value
Life of the Asset
(2) Inventory Valuation
By this method also, we arrive at different
figures of accounting and economic profit. All
Principles of Business Firms and Investment Analysis : 34
goods which are in the process of production
are called inventory. According to another
method, the difference between production and
consumption is inventory. Thus, inventory
emerges only when production exceeds
consumption. It would not have been difficult to
evaluate inventory, had the process been stable.
But, so is not the condition in real world. Prices
keep on changing. Let us now see which
conditions can be used in this regard.
(a) First In First Out : (FIFO) : The raw
material is used for production in the same
sequence in which it is bought. Thus the
current production cost will be based on
the oldest raw material.
(b) Last In First Out : The raw material
that has been bought recently is first used
for production. The current cost of
production is based on the latest raw
material.
(c) Weighted Average cost : Sometimes
raw materials bought at different times are
together used in production. The above
methods cannot be used in such a case,
average of prices is taken of the goods
bought at different prices.
Production calculated at FIFO basis show
huge profit during inflation and less profit during
deflation.
Economists believe that, none of the
methods of calculating accounting profit, take
into consideration change in profit in real terms.
Accountants consider only the nominal prices.
For calculating real profits production should
be valued at constant prices.
(3) Unaccounted Value Changes
Some costs do not affect the current
production. However, these costs are expected
to bring about higher profit in future.
Expenditure on research and development,
advertisements, appointment of efficient
managers are few of them. Accountants do not
calculate future profits on this. Thus, the books
of account will show current profit more than
the actual profit and future profit more than the
actual profit. Thus, accounting profit would not
show the economic profit.
Questions for Self Study -3
(A) Choose the right option.
(1) Why is it essential to evaluate profit?
(a) To bring about changes in
management.
(b) To bring about any changes in
production, if required.
(c) To access the reputation of the firm.
(2) Accounting profit is more than Economic
profit because
(a) Accountant considers original price
of asset as its value.
(b) Economist considers the present
value of the future income (inflows)
from the asset.
(c) Accountants calculate depreciation
using different methods.
(B) State whether the following
ü)
statements are true or false. Put (ü
û ) in bracket.
or (û
(1) The value of inventory remains the same
even if prices change. ( )
(2) If FIFO is used for valuation of inventory,
its value comes out to be less. ( )
18.2.4 Economic Theories of
Profit
Table 18.1 shows the summary of different
theories of profit.
Table 18.4 : Theories of Profit
Theories of Profit
Traditional
Theories
Modern
Theories
Recent
Theories
1. Adam Smith 1. J.B.Clark 1. Kaldor
Ricardo
Schumpeter 2. Pessinetti
2. Karl Marx
2. Hawley
3. Walter
3. F.H.
4. Marshall
Knight
(a) Traditional Theories
(1) Adam Smith, Ricardo : They studied
profit and interest together. Both of them are
considered profit in their theories. According to
them profit is nothing but the residual amount
after paying the rent for indestructible properties
of soil and wages for labour.
Principles of Business Firms and Investment Analysis : 35
(2) Marx : According to Karl Marx, only
wages are earned, income and rest all i.e. rent,
interest and profit are unearned incomes.
According to him labourers put in more efforts
and value to the firm than is essential to keep
them into work. This surplus is taken away by
the entrepreneur. This leads to exploitation of
labour class. Thus profits are not justified from
the point of view of social justice.
(3) Walker : Walker’s ‘rental ability’
theory is based upon the Ricardian theory of
rent. Ricardo says that rent arises due to
difference in quality of land and this is a
differential surplus. Walker says that an
entrepreneur is a worker of best the quality and
then he enjoys profit because of his efficiency
and skills which are superior than normal
labourers. This is his principle of ‘rental ability’.
(4) Marshall : Marshall divided factors
of production into land, labour, capital and
enterprise and their remunerations as rent,
wages, interest and profit. According to him,
arises in the short run and in the long run profit
is a part of total cost. Profit depends on the
productivity of the entrepreneur.
The Neoclassicals developed a theory
called Marginal Productivity Theory of profit
based on same the principle. It all the factors of
production are paid according to their marginal
productivity the total cost of production will be
the sum of remuneration paid to all factors of
production. But in real world, it is difficult to
measure marginal productivity of the
entrepreneur. Thus, for accounting purpose profit
is calculated as Profit = Total Cost - ( rent + wages + interest )
In perfect competition and this expression
holds true. As an improvement in this theory,
the co