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Concept of Business Economics
Managerial economics is the application of economic theory and quantitative methods
(mathematics and statistics) to the managerial decision-making process.
Simply stated, microeconomics with special emphasis on those topics of greatest interest and
importance to managers is applied to managerial economics.
According to Dominick Salvatore:
“Managerial economics refers to application of economic theory and a tools of analysis of
decision science to examine how an organization can achieve its aim or objective most
Managerial economics extracts from microeconomic theory those concepts and techniques that
allow managers to select strategic direction, efficiently allocate the organization's available
resources, and respond effectively to tactical issues.
Economics Theory Simplifies
Theory allows people to gain insights into complicated problems using simplifying
assumptions to make sense out of confusion, to turn complexity into relative simplicity.
Using economic theory is in many ways like using a road map.
A road map abstracts away from nonessential items and concentrates on what is relevant
for the task at hand.
Likewise, the economic approach to understanding business reduces business problems
to their most essential components.
Decision Making Process
The crucial step in tackling almost all important business and government decisions begins with a single question:
What is the alternative?
Defining a Problem
Consider the fourth problem in the case:
● Is the crux of the problem minimizing pollution from utilities?
Presumably cost is also important.
Thus, the problem involves determining how much pollution to clean up, by what means, and at what cost.
Or is the problem much broader: reducing U.S. dependence on foreign energy sources?
If so, which domestic energy initiatives (besides or instead of utility conversion to coal) should be undertaken?
The majority of the decisions we study take place in the private sector.
Managers representing their respective firms are responsible for the decisions made in five of the examples.
By contrast, the third and fourth examples occur in the public sector, where decisions are made at all levels of
government: local, state, and national.
The recommendation concerning construction of a new bridge is made by a city agency and must be approved
by the state government.
The chain of decisions accompanying the conversion of utilities from oil to coal involves a surprising
number of public-sector authorities, including the Department of Energy, the Environmental Protection
Agency, state and local agencies, the Department of the Interior, and possibly the Nuclear Regulatory
As one might imagine, the larger the number of bodies that share policy responsibility and the pursuit of
different goals, the greater is the likelihood that decision-making problems and conflicts will occur.
Determine the Objective
Attainment of maximum profit worldwide is the natural objective of the multinational carmaker, the drug
company, and the management and shareholders of Barnes & Noble, Borders Group, BP, NBC, and CBS.
The objective in a public-sector decision, whether it be building a bridge or regulating a utility, is broader than the
private-sector profit standard.
The government decision maker should weigh all benefits and costs, not solely revenues and expenses.
According to this benefit-cost criterion, the bridge in the third example may be worth building even if it fails to
generate a profit for the government authority.
One difficulty is posed by the timing of benefits and costs.
● Should a firm (the drug company, for example) make an investment (sacrifice profits today) for greater profits 5 or 10 years
from now?
● Are the future benefits to commuters worth the present capital expense of building the bridge?
● Both private and public investments involve trade-offs between present and future benefits and costs.
The presence of risk and uncertainty has a direct bearing on the way the decision maker thinks about his or her
Both BP and the pharmaceutical company seek to maximize company profit, but there is no simple way to apply
the profit criterion to determine their best actions and strategies.
BP might pay $50 million to acquire a promising site it believes is worth $150 million and find, after thorough
drilling and exploration, that the site is devoid of oil or natural gas.
The drug company cannot use the simple rule “choose the method that will yield the greater profit,” because the
ultimate profit from either method cannot be pinned down ahead of time.
There are no profit guarantees; rather, the drug company faces a choice between two risky research options.
Similarly, public programs and regulatory policies generate future benefits and costs that cannot be predicted
with certainty.
Explores the Alternatives
In the first example, the carmaker is free to set prices at home and abroad.
These prices will largely determine the numbers of vehicles the firm can expect to sell in each market.
It still remains for the firm to determine a production plan to supply its total projected sales; that is, the firm’s
other two decision variables are the quantities to produce in each facility.
The firm’s task is to find optimal values of these four decision variables—values that will generate a maximum
level of profit.
BP faces a myriad of choices as to how and where to explore for oil, how to manage its wells and refineries,
and how to sell its petroleum products.
The drug company might appear to have a simple either/or choice: pursue the biochemical R&D program or
proceed with the biogenetic program.
But there are other alternatives. For instance, the company could pursue both programs simultaneously.
This strategy means investing resources and money in both but allows the firm to commercialize the
superior program that emerges from the R&D competition.
Alternatively, the company could pursue the two R&D options in sequence.
After observing the outcome of an initial R&D program, the company could choose to develop it or to
reject it.
After terminating the first program, the company could then pursue the second R&D approach.
The question raised by the sequential option is, which approach, the safer biochemical method or the riskier
biogenetic alternative, should the company pursue first?
The manager faces a sequence of decisions from among alternatives.
For instance, in the battle for David Letterman, each side had to formulate its current negotiation stance (in
light of how much value it might expect to get out of alternative deals).
To sum up, in view of the myriad uncertainties facing managers, most ongoing decisions should best be
viewed as contingent plans.
Predict the Consequences
What are the consequences of each alternative action?
Should conditions change, how would this affect outcomes?
If outcomes are uncertain, what is the likelihood of each?
Can better information be acquired to predict outcomes?
In complicated situations, however, the decision maker often must rely on a model to describe how options
translate into outcomes.
A deterministic model is one in which the outcome is certain (or close enough to a sure thing that it can be
taken as certain).
A probabilistic model accounts for a range of possible future outcomes, each with a probability attached.
Make a Choice
A private firm (such as the carmaker) can compute the profit results of alternative price and output plans.
A government decision maker may know the computed net benefits (benefits minus costs) of different
program options.
The decision maker could determine a preferred course of action by enumeration, that is, by testing a
number of alternatives and selecting the one that best meets the objective.
This is fine for decisions involving a small number of choices, but it is impractical for more complex
For instance, what if the car company drew up a list of two dozen different pricing and production plans,
computed the profits of each, and settled on the best of the lot?
How could management be sure this choice is truly the best of all possible plans?
What if a more profitable plan, say, the twenty-fifth candidate, was overlooked?
The decision maker need not rely on the painstaking method of enumeration to solve such problems.
A variety of methods can identify and cut directly to the best, or optimal, decision.
These methods rely to varying extents on marginal analysis, decision trees, game theory, benefit-cost
analysis, and linear programming.
These approaches are important not only for computing optimal decisions but also for checking why they
are optimal.
Perform Sensitivity Analysis
What features of the problem determine the optimal choice of action?
How does the optimal decision change if conditions in the problem are altered?
Is the choice sensitive to key economic variables about which the decision maker is uncertain?
In tackling and solving a decision problem, it is important to understand and be able to explain to others the
“why” of your decision.
It depended on your stated objectives, the way you structured the problem (including the set of options you
considered), and your method of predicting outcomes.
Thus, sensitivity analysis considers how an optimal decision is affected if key economic facts or conditions
Scope of Business Economics
Economics has two major branches namely Microeconomics and Macroeconomics and both are applied to
business analysis and decision-making directly or indirectly.
Managerial economics comprises all those economic concepts, theories, and tools of analysis which can be used
to analyze the business environment and to find solutions to practical business problems .
In other words, managerial economics is applied economics
The areas of business issues to which economic theories can be applied may be broadly divided into the
following two categories:
● Operational or Internal issues; and
● Environmental or External issues
Micro Economics Applied to
Operational Issues
Operational problems are of internal nature
They arise within the business organization and fall within the purview and control of the
It includes
Theory of demand and demand forecasting
Production and cost decision
Pricing decisions
Profit decision
Capital Decisions
Macro Economics Applied to Business
The environmental issues fall within macro economics, therefore the following constitute the scope of
managerial economics:
Issues related to Macro Variables
Issues related to Foreign Trade
Issues related to Government Policies
Use of Business Economics in Business
Decision Making
First, it gives clear understanding of various economic concepts (i.e., cost, price, demand, etc.) used
in business analysis. For example, the concept of ‘cost’ includes ‘total’, ‘average’, ‘marginal’, ‘fixed’,
‘variable’, actual costs, and opportunity cost. Economics clarifies which cost concepts are relevant
and in what context.
Second, it helps in ascertaining the relevant variables and specifying the relevant data. For example,
it helps in deciding what variables need to be considered in estimating the demand for two different
sources of energy—petrol and electricity.
Third, economic theories state the general relationship between two or more economic variables and
events. The application of relevant economic theory provides consistency to business analysis and
helps in arriving at right conclusions. Thus, application of economic theories to the problems of
business not only guides, assists and streamlines the process of decision-making but also contributes
a good deal to the validity of decisions.
William Baumol pointed out three main Contribution of economic theory in business decision making
First, ‘one of the most important things which the economic (theories) can contribute to the management
science’ is building analytical models which help to recognize the structure of managerial problems,
eliminate the minor details which might obstruct decision-making, and help to concentrate on the main issue.
Secondly, economic theory contributes to the business analysis ‘a set of analytical methods’ which may not
be applied directly to specific business problems, but they do enhance the analytical capabilities of the
business analyst.
Thirdly, economic theories offer clarity to the various concepts used in business analysis, which enables the
managers to avoid conceptual pitfalls.
Basic Concept and
Measuring Profit
Business Profit (Accounting Cost)
Economic Profit
Two former MBS students worked in the World Bank at a Salary Rs 30,00,000 each for one year
after they graduated. After a year, they decided to quit their jobs and start a research institute. They
used Rs. 15,00,000 to overheads (i.e., computers, furniture etc.). For the next year, they took in Rs.
1,50,00,000 in revenue each year, paid five research assistants Rs. 10,00,000 annually each and
rented an office for Rs. 10,00,000 per year with miscellaneous expenses Rs. 5,00,000 per year.
A. Define accounting and economic cost.
B. Compute accounting profit and economic profit. Should they remain in research institute after
the year if they are indifferent between working for themselves or other in a similar capacity?
Less: Explicit Cost
Miscellaneous expenses
Accounting Profit
Less: Implicit cost/opportunity cost
Economic Profit
Production Possibility Curve
Every gun that is made, every warship launched, every rocket fired signifies, in the final sense, a theft
from those who hunger and are not fed.
President Dwight D. Eisenhower
In debating whether the United States should invade Iraq in 2003, people wanted to know how much
the war would cost. The administration said it would cost only $50 billion, while some economists said
it might cost as much as $2000 billion. These are not just mountains of dollar bills. These numbers
represent resources diverted from other purchases. As the numbers began to climb, people naturally
asked, Why are we policing Baghdad rather than New York, or repairing the electrical system in the
Middle East rather than in the U.S. Midwest? People understand, as did former general and president
Eisenhower, that when output is devoted to military tasks, there is less available for civilian
consumption and investment.
Let us dramatize this choice by considering an economy which produces only two economic goods,
guns and butter.
The guns, of course, represent military spending, and the butter stands for civilian spending.
Suppose that our economy decides to throw all its energy into producing the civilian good, butter.
There is a maximum amount of butter that can be produced per year.
The maximal amount of butter depends on the quantity and quality of the economy’s resources and
the productive efficiency with which they are used.
At the other extreme, imagine that all resources are instead devoted to the production of guns.
Again, because of resource limitations, the economy can produce only a limited quantity of guns.
These are two extreme possibilities. In between
are many others.
If we are willing to give up some butter, we can
have some guns.
(‘000 kg)
(‘000 units)
If we are willing to give up still more butter, we
can have still more guns.
How can a nation turn butter into guns?
Butter is transformed into guns not physically but
by the alchemy of diverting the economy’s
resources from one use to the other.
We can represent our economy’s production
possibilities more vividly in the diagram
The production-possibility frontier (or PPF ) shows the maximum quantity of goods that can be
efficiently produced by an economy, given its technological knowledge and the quantity of available
Points outside the frontier (such as point I ) are infeasible or unattainable. Any point inside the
curve, such as U, indicates that the economy has not attained productive efficiency.
Opportunity Cost
When Robert Frost wrote of the road not taken, he pointed to one of the deepest concepts of
economics, opportunity cost.
Because our resources are limited, we must decide how to allocate our incomes or time.
When we decide whether to study MBA, buy a car, or go to job, you will give something up—there
will be a forgone opportunity.
The next-best good that is forgone represents the opportunity cost of a decision.
In a world of scarcity, choosing one thing means giving up something else.
The opportunity cost of a decision is the value of the good or service forgone.
Risk and Uncertainty
When the outcome of a decision is not known with certainty, a manager faces a decision-making problem
under either conditions of risk or conditions of uncertainty
A decision is made under risk when a manager can make a list of all possible outcomes associated with a
decision and assign a probability of occurrence to each one of the outcomes.
The process of assigning probabilities to outcomes sometimes involves rather sophisticated analysis based on
the manager’s extensive experience in similar situations or on other data.
Probabilities assigned in this way are objective probabilities.
In other circumstances, in which the manager has little experience with a particular decision situation and
little or no relevant historical data, the probabilities assigned to the outcomes are derived in a subjective way
and are called subjective probabilities.
Subjective probabilities are based upon hunches, “gut feelings,” or personal experiences rather than on
scientific data.
In contrast to risk, uncertainty exists when a decision maker cannot list all possible outcomes and/or
cannot assign probabilities to the various outcomes.
When faced with uncertainty, a manager would know only the different decision options available and
the different possible states of nature.
The states of nature are the future events or conditions that can influence the final outcome or payoff
of a decision but cannot be controlled or affected by the manager.
Even though both risk and uncertainty involve less-than-complete information, there is more
information under risk than under uncertainty.
Risk Averse
People are said to be risk averse if, facing
two risky decisions with equal expected
profits, they choose the less risky decision.
Risk averse: diminishing MU profit
Risk Lover
Term describing a decision maker who
makes the riskier of two decisions that have
the same expected value.
Risk loving: increasing MU profit
Risk Neutral
Term describing a decision maker who
ignores risk in decision making and
considers only expected values of decisions
Risk neutral: constant MU profit
Information and Risk
Competitive markets ensure efficiency in the economy as they are based on the basic characteristics
of complete or perfect information.
In other words, both economic agents-consumer and firms have perfect knowledge about goods and
services under perfectly competitive market.
Complete information avoids uncertainties underlying in economic transactions so that economic
efficiency can be achieved.
Here we will discuss situation where the characteristic of perfect information does not exist.
The situation can be one of incomplete information or of asymmetric information.
In a situation of asymmetric information, one economic agent of the transaction has more
information than the other economic agent.
Asymmetric Information
The side with better information is said to have private information or, equivalently, asymmetric
There are several sources of asymmetric information.
Parties will often have “inside information” concerning themselves that the other side does not have.
Consider the case of health insurance.
A customer seeking insurance will often have private information about his or her own health status
and family medical history that the insurance company does not.
Consumers in good health may not bother to purchase health insurance at the prevailing rates.
A consumer in poor health would have higher demand for insurance, wishing to shift the burden of
large anticipated medical expenses to the insurer.
Other sources of asymmetric information arise when what is being bought is an agent’s service.
The buyer may not always be able to monitor how hard and well the agent is working.
The agent may have better information about the requirements of the project because of his or her
expertise, which is the reason the agent was hired in the first place.
Asymmetric information can lead to inefficiencies.
Insurance companies may offer less insurance and charge higher premiums than if they could
observe the health of potential clients and could require customers to obey strict health regimens.
With appliance repair, the repairer may pad his or her bill by replacing parts that still function and
may take longer than needed—a waste of resources.
There are basically three types of information asymmetry:
● Adverse selection
● Signaling
● Moral Hazard
Adverse Selection
Adverse selection refers to a situation where a selection process results in a pool of individuals
with economically undesirable characteristics.
A classic example of adverse selection occurs in used-car markets.
A used-car buyer who thinks that the used cars that are for sale are of average quality will be
sadly mistaken.
The problem of adverse selection also applies to insurance markets.
The customers that are most likely to want insurance are the people who face the highest risks,
but these are the people that insurance companies would least like to have as customers.
Signaling is a mechanism used to get information on a hidden characteristic.
Hidden characteristic is a situation in which one party knows some characteristic which the other
party would like to know.
An important way to deal with private information problems in signaling.
Signaling involves taking steps that communicate otherwise unobservable information from one party
to another.
In 1998-1999 two giant firms entered the used car business in United States.
These two firms were Auto Nation and Car Max.
Their strategy was to sell used cars at relatively high price and to signal to consumers that all of their
used cars were goods.
The signaling involved a lot of advertising as well as extended warranties.
Moral Hazard
Suppose that you have just purchased a fairly priced insurance policy that completely reimburses you
for any damage that your car suffers as a result of an automobile accident.
Now that you know that you are fully insured, how careful will you be?
Perhaps not as careful as you would have been had you not been fully insured.
Perhaps you drive faster or behave more recklessly under adverse weather conditions.
Perhaps you take less care to protect your car against vandals or thieves (e.g., by parking it on the
street rather than in a garage)
This illustrates the concept of moral hazard, whereby an insured party exercises less care than he or
she would in the absence of insurance.
Phenomenon whereby an insured party exercises less care than he or she would in the absence of
insurance is Moral Hazard.
Profit Maximization Theory
Baumol’s Sales Revenue Maximization
Wealth Maximization
Morris Hypothesis of Maximization of Growth Rate
Williamson’s Model of Managerial Discretion
Behavioral Theories
Profit Maximization Theory
From over a century of economic theory, profit as an aim has emerged.
Profit is the rational objective, because:
The profit of the firm became the income of the owner. Maximization of profit then ensured the
self-interests of the owners. If profit was positively related to the efforts of the Owner, maximizing
profit would require maximum effort.
The force of competition imposed profit maximization upon the firm. Given the large number of
other firms, any firm that did not maximize profit would not survive in business. Any firm that
made economic profits was, by definition, doing better than some other firms.
The force of competition imposed profit maximization upon the firm.
Given the large number of other firms, any firm that did not maximize profit would
not survive in business.
Any firm that made economic profits was, by definition, doing better than some
other firms.
There are two approaches of profit maximization. They are
 TR-TC approach
 MR-MC approach
TR-TC Approach
When the difference between total revenue (TR) and total cost (TC) becomes the
biggest, profit becomes maximum regardless of the market situation.
𝜋 = 𝑇𝑅 − 𝑇𝐶
𝜋 = 𝑃𝑟𝑜𝑓𝑖𝑡
𝑇𝑅 = 𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
𝑇𝐶 = 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡
According to the total revenue–total cost
(TR–TC) approach, a profit maximizing
monopoly firm is in equilibrium at the level
of output and price at which it’s TR–TC =
Total Profit is maximum.
It is obvious that total profit is maximum
where the vertical difference between TR
and TC curves is maximum.
The maximum difference between the TR
and TC curves can be obtained by a simple
technique, i.e., by drawing parallel tangents
to TR and TC curves as shown by the
tangent ab and cd.
As a matter of rule, the vertical gap
between tangential points P and M is
MR-MC Approach
The objective of the firm is to maximize profit i.e.
Objective Function: Maximize 𝜋 𝑄 = 𝑇𝑅 𝑄 − 𝑇𝐶(𝑄)
For profit maximizing we take the first derivative of objective function and equates it
to zero
Now setting
𝑑𝜋 𝑑𝑇𝑅(𝑄) 𝑑𝑇𝐶 𝑄
𝑑𝑇𝑅(𝑄) 𝑑𝑇𝐶(𝑄)
Thus the first order condition for maximizing profit is 𝑀𝑅 𝑄 = 𝑀𝐶(𝑄)
For second order condition
𝑑2 𝜋
𝑑2 𝑇𝑅(𝑄) 𝑑2 𝑇𝐶(𝑄)
𝑑2 𝑇𝑅(𝑄) 𝑑2 𝑇𝐶(𝑄)
𝑑𝑄 2
∴ 𝑠𝑙𝑜𝑝𝑒 𝑜𝑓 𝑀𝑅 < 𝑆𝑙𝑜𝑝𝑒 𝑜𝑓 𝑀𝐶
So the second order condition for profit maximization is the slope of MC must be
greater than slope of MR.
There are two conditions that have to be
fulfilled to maximize the profit. Those
conditions are known as:
Necessary or first order condition
The first-order condition for maximizing profit requires
marginal cost (𝑀𝐶) to be equal to marginal revenue
(𝑀𝑅), i.e. profit at the maximum output Level (𝑄) to
Sufficient or second order condition
Under the condition of rising marginal costs, the
normal second-order condition of profit maximization
requires that the first-order condition must be met.
𝑖. 𝑒. 𝑆𝑙𝑜𝑝𝑒 𝑜𝑓 𝑀𝑅 < 𝑆𝑙𝑜𝑝𝑒 𝑜𝑓 𝑀𝐶
Numerical Example
Let, revenue function 𝑹 = 𝟐𝟎𝑸 − 𝑸𝟐 and cost function 𝑻𝑪 = 𝟓𝟎 + 𝟒𝑸. Compute profit
maximizing output, price, TR and maximum profit.
Revenue Function: 𝑅 = 20𝑄 − 𝑄 2
Cost Function: 𝑇𝐶 = 50 + 4𝑄
We know that,
𝜋 =𝑅−𝐶
= 20𝑄 − 𝑄 2 − (50 + 4𝑄)
= 20𝑄 − 𝑄2 − 50 − 4𝑄
= −𝑄 2 + 16𝑄 − 50
First order condition for profit maximization is,
𝑑(−𝑄2 +16𝑄−50)
= −2𝑄 + 16
−2𝑄 + 16 = 0
𝑜𝑟, 2𝑄 = 16
𝑜𝑟, 𝑄 =
Maximum profit
𝜋 = −𝑄 2 + 16𝑄 − 50
= −(8) + 16 × 8 − 50
= 14
Total revenue
𝑅 = 20𝑄 − 𝑄 2
= 20 × 8 − (8)2
= 96
= 20 − 𝑄
= 20 − 8
= 12
Baumol’s Sales Revenue Maximization
An alternative model which recognizes the importance of profit, but assumes that
managers set the company's goals, is that of maximizing sales.
Baumol (1959) developed this model, arguing that managers have discretion in
setting goals, and that maximizing sales revenue was a more likely short-run goal than
maximizing profit in firms operating in oligopolistic markets.
 Sales revenue is a short-term goal that is more useful to the firm than profit.
 Sales are measurable and can be used to motivate staff as a specific target, whereas
profits, which are a residual, are not so easily used in this way. It is thought that
specific sales targets are clearly understood by everyone within the company.
 Senior managers' rewards are often tied to sales revenue rather than profit, as they
are for lower personnel levels.
 It is assumed that an increase in revenue will more than offset any associated cost
increases, so that additional sales will increase profit; therefore, shareholders
consider increasing the size of the firm as measured by sales revenue or turnover as
a good proxy for short-run profit increases.
 Increasing sales and, therefore, the company's size makes it easier to manage, as it
creates an environment in which everyone believes the company is successful. A
firm that faces declining sales will be seen as failing and will lead to calls for
managers to reassess their policies.
The Static Single Period Sales Maximization Model
The static model assumes that:
1. The firm produces a single product and has total cost and revenue functions of a
non-linear nature.
2. The firm makes its price / output decision without taking into consideration the
actions of other companies.
3. The firm's goal is to select a level of sales or output that maximizes sales revenue
(𝑇𝑅) subject to a minimum shareholder profit constraint (𝜋).
Sales maximization does not mean an attempt to obtain the largest possible physical
Sales maximization under profit constraint does not mean an attempt to obtain the
largest possible physical volume.
Rather, it refers to maximization of total revenue, which, to the businessman, is the
obvious measure of the amount he has sold. Maximum sales in this sense need not
require very large physical outputs.
To take an extreme case, at a zero price physical volume may be high but sales
volume in monetary term will be zero.
There will normally be a well-determined output level which maximizes monetary
This level can ordinarily be fixed with the aid of the well-known rule that maximum
revenue will be obtained only at an output at which marginal revenue is zero.
This is the condition which replaces the “marginal cost equals marginal revenue”
profit-maximizing rule.
𝑤𝑒 𝑘𝑛𝑜𝑤, 𝑇𝑅 = 𝑃 × 𝑄
𝑑𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑡𝑖𝑎𝑡𝑖𝑛𝑔 𝑤𝑖𝑡ℎ 𝑟𝑒𝑠𝑝𝑒𝑐𝑡 𝑡𝑜 𝑄, 𝑤𝑒 𝑔𝑒𝑡
= 𝑃.
+ 𝑄.
𝑜𝑟, 𝑀𝑅 = 𝑃 + 𝑄.
𝑄 𝑑𝑃
𝑜𝑟, 𝑀𝑅 = 𝑃 1 + .
𝑃 𝑑𝑄
𝑜𝑟, 𝑀𝑅 = 𝑃 1 + 𝑃 𝑑𝑃
𝑄 𝑑𝑄
𝑜𝑟, 𝑀𝑅 = 𝑃 1 +
∴ 𝑀𝑅 = 𝑃 1 −
At the point of maximum revenue slope of the total revenue curve is zero
= 𝑀𝑅 = 0
∴0=𝑃 1−
Given P˃0, we have
𝑒𝑃 = 1
But this rule does not take account the profit constraint.
That is, if at the revenue-maximizing output the firm does, in fact, earn enough profits
to keep shareholders satisfied, then it will want to produce the sales-maximizing
But if at this output profit are too low, the firm’s output must be changed to a level
which, though it fails to maximize sales, does not meet the profit requirement.
Given the cost and revenue functions, profit is
maximized at the output level Qm.
Maximum sales revenue is at the highest point
on the total revenue curve, corresponding to
output Qs.
Sales revenue maximization is a substitute for
profit maximization, since it produces more
If the profit constraint is above π1 then output
Qs does not produce enough profit to satisfy the
Then output must be reduced, reducing total
revenue but pushing the firm back up the profit
In general, we expect behavior somewhere
between Qm and Qs, so that the firm gives up
some profit to gain extra sales revenue.
A manufacturing company operating in Kathmandu Valley with the demand function
given as P=40-Q, and the total cost function as C=Q2+8Q+2.
If the company wanted to maximize profit what is the price-output combination and
the total profit and revenue? The management of the company realizes the need for
capturing market. Therefore, it started to promote its product with the strategy of
sales revenue maximization instead of profit maximization. What will be the priceoutput combination and total profit under the condition sales revenue maximization?
The shareholders of the company did not like market capture strategy (sales revenue
maximization) followed by the management. The shareholders showed strong
dissatisfaction against the management in its Annual General Meeting (AGM). They
argued that management should not be given opportunities for free play in the
company. The shareholders’ meeting consensually decided to put restriction with
minimum profit of Rs 10. Under this condition, what is the optimum price-output
combination and total revenue?
Under profit maximizing condition,
𝜋 = 𝑇𝑅 − 𝑇𝐶
𝑃 = 40 − 𝑄
𝑜𝑟, 𝜋 = 40𝑄 − 𝑄2 − 𝑄2 + 8𝑄 + 2
𝑇𝑅 = 𝑃 × 𝑄
𝑜𝑟, 𝜋 = 32𝑄 − 2𝑄2 − 2
𝑇𝑅 = 40 − 𝑄 𝑄
Under profit maximizing model
𝑇𝑅 = 40𝑄 − 𝑄2
We have,
𝑑(32𝑄−2𝑄2 −2)
𝑇𝐶 = 𝑄2 + 8𝑄 + 2
We know,
𝑜𝑟, 32 − 4𝑄 = 0
For profit maximizing,
𝑜𝑟, 32 − 4𝑄 = 0
𝑜𝑟, 4𝑄 = 32
For profit maximizing price,
Under sales maximization model, we know,
𝑃 = 40 − 𝑄
𝑜𝑟, 𝑃 = 40 − 8
𝑜𝑟, 𝑀𝑅 = 0
𝑃 = 32
We have,
For total profit, we have profit function as,
𝑇𝑅 = 40𝑄 − 𝑄2
𝜋 = 32𝑄 − 2𝑄2 − 2
Substituting the value of Q in profit function
𝑑(40𝑄−𝑄2 )
𝜋 = 32 8 − 2(8)2 − 2
𝑜𝑟, 40 − 2𝑄 = 0
= 256 − 128 − 2
𝑜𝑟 𝑄 = 40
= 126
For sales maximization price,
𝑃 = 40 − 𝑄
𝑜𝑟, 𝑃 = 40 − 20
∴ 𝑃 = 20
Again the profit function is
𝜋 = 32𝑄 − 2𝑄2 − 2
Substituting the value of Q in the profit
𝜋 = 32(20)2 − 2(20)2 − 2
= 640 − 800 − 2
= −162
Since the profit is negative, firm is in loss of
For sales revenue maximization under
profit constraint of Rs. 10
𝜋 = 𝑇𝑅 − 𝑇𝐶
𝑎𝑛𝑑, 𝜋 = 10
10 = 32𝑄 − 2𝑄2 − 2
𝑜𝑟, 32𝑄 − 2𝑄2 − 12 = 0
𝑜𝑟, 2𝑄2 − 32𝑄 + 12 = 0
Comparing with 𝑎𝑥 2 + 𝑏𝑥 + 𝑐
We have 𝑎 = 2, 𝑏 = −32 𝑎𝑛𝑑 𝑐 = 12
Using the quadratic equation formula
−𝑏± 𝑏 2 −4𝑎𝑐
32± 322 −4×2×12
15.67 𝑜𝑟 0.79 𝑢𝑛𝑖𝑡𝑠
Now for price
We have
𝑃 = 40 − 𝑄
Taking 15.67
𝑃 = 40 − 15.67
𝑃 = 24.33
Again taking 0.79
𝑃 = 40 − 0.79
𝑃 = 39.21
Wealth Maximization
To maximize the value of the firm, managers should maximize shareholder wealth.
Shareholder wealth is measured by the market value of a firm’s common stock, which is
equal to the present value of all expected future cash flows to equity owners discounted at
the shareholders’ required rate of return plus a value for the firm’s embedded real options:
𝑽𝟎 =
+ ⋯+
+ 𝑹𝒆𝒂𝒍 𝑶𝒑𝒕𝒊𝒐𝒏 𝑽𝒂𝒍𝒖𝒆
(𝟏 + 𝑲𝒆 )
(𝟏 + 𝑲𝒆 )
(𝟏 + 𝑲𝒆 )
(𝟏 + 𝑲𝒆 )
𝑽𝟎 = σ∞
(𝟏+𝑲𝒆 )𝒕
𝑾𝒉𝒆𝒓𝒆, 𝑽𝟎 = 𝒕𝒉𝒆 𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒗𝒂𝒍𝒖𝒆 𝒐𝒇 𝒂 𝒔𝒉𝒂𝒓𝒆 𝒐𝒇 𝒔𝒕𝒐𝒄𝒌
𝝅𝒕 = 𝒆𝒄𝒐𝒏𝒐𝒎𝒊𝒄 𝒑𝒓𝒐𝒇𝒊𝒕𝒔 𝒆𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝒊𝒏 𝒆𝒂𝒄𝒉 𝒐𝒇 𝒕𝒉𝒆 𝒇𝒖𝒕𝒖𝒓𝒆 𝒑𝒆𝒓𝒊𝒐𝒅𝒔
𝑲𝒆 = 𝒓𝒆𝒒𝒖𝒊𝒓𝒆𝒅 𝒓𝒂𝒕𝒆 𝒐𝒇 𝒓𝒆𝒕𝒖𝒓𝒏
A number of different factors (like interest rates and economy-wide business cycles)
influence the firm’s stock price in ways that are beyond the manager’s control, but
many factors (like innovation and cost control) are not.
Real option value represents the cost savings or revenue expansions that arise from
preserving flexibility in the business plans the managers adopt.
Wealth maximization model is a superior model because it obviates all the drawbacks
of profit maximization as a goal of a financial decision.
 Firstly, the wealth maximization is based on cash flows and not profits. Unlike the
profits, cash flows are exact and definite and therefore avoid any ambiguity
associated with accounting profits.
 Secondly, profit maximization presents a shorter term view as compared to wealth
maximization. Short-term profit maximization can be achieved by the managers at
the cost of long-term sustainability of the business.
 Thirdly, wealth maximization considers the time value of money. It is important as
we all know that a dollar today and a dollar one-year latter do not have the same
value. In wealth maximization, the future cash flows are discounted at an
appropriate discounted rate to represent their present value.
 Fourthly, the wealth-maximization criterion considers the risk and uncertainty
factor while considering the discounting rate. The discounting rate reflects both
time and risk. Higher the uncertainty, the discounting rate is higher and vice-versa.
Capital investment decisions of a firm have a direct relation with wealth
All capital investment projects with an internal rate of return (IRR) greater than 1 or
having positive NPV creates value for the firm.
These projects earn more than the ‘required rate of return’ of the firm.
The model of managerial utility was developed by Williamson, and once more
assumes that managers have both the desire and discretion to pursue objectives
other than profit maximization, subject to some minimum profit constraint.
Managers achieve their objectives directly by spending any profits above the profit
constraint on items that give rise to managerial satisfaction or utility.
According to Williamson, managers can influence both the level of profits and how
these profits are spent.
This is not a new idea, and is implicit in most of the managerial models.
Williamson's contribution was to give operational value to the concept by identifying
those variables he saw as giving rise to managerial satisfaction.
The basic Williamson model can be expressed in the form
𝑈𝑚 = 𝑓(𝑆, 𝑀, 𝐼𝑑 )
where Um is the utility of managers, S is expenditure on staff, M denotes managerial
emoluments and Id measures the managers' discretionary power for investment.
Managerial utility is then maximized subject to the minimum profit constraint. The
identified variables can be justified as follows.
Staff expenditure
Increased expenditure on staff generally increases profits by increasing output and/or
sales, but expenditure is continued beyond the profit maximizing level because staff
expenditure represents both power and prestige to the manager.
Managerial emoluments
These include expenditure in items such as expense accounts, luxury offices,
company cars, etc. and give rise directly to managerial satisfaction.
This non-salary expenditure on the personal comfort and well-being of managers
appears in the company accounts as a necessary cost, but adds little to the operating
efficiency of the organization.
Direct salary expenditure to managers is much more easily identified from company
accounts, and may give rise to shareholder disquiet.
The Discretionary Power for Investment
The manager gains prestige and status by being able to finance capital projects
beyond what is strictly necessary to the functioning of the firm.
The manager is able to spend company money on 'pet' projects, often involving
fashionable new technology in the form of computer based office equipment,
justified as necessary but once more adding little to operating efficiency.
Each of these expenditure items remains hidden in the firm's accounts as necessary
The optimal solution involves a trade-off of expenditure from profits above the profit
constraint on these items, depending on the preferences and power relationships
within the management team.
The theory goes on to explain that in times of rapid economic growth, expenditure
on these discretionary items will increase rapidly, whilst in times of depressed
markets, these items represent a cushion against economic adversity, in that
expenditure in these items can be reduced without adversely affecting output.
In normal circumstances, discretionary spending implies levels of staff, managerial
emoluments and discretionary investment considerably in excess of profit maximizing
The demand of the firm
It is assumed that the firm has a known downward sloping demand curve, defined by
the function
𝑄 = 𝑓1 (𝑃, 𝑆, 𝜀)
𝑃 = 𝑓2 (𝑄, 𝑆, 𝜀)
𝑄 = 𝑜𝑢𝑡𝑝𝑢𝑡
𝑃 = 𝑃𝑟𝑖𝑐𝑒
𝑆 = 𝑠𝑡𝑎𝑓𝑓 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒
𝜀 = 𝑡ℎ𝑒 𝑐𝑜𝑛𝑑𝑖𝑡𝑖𝑜𝑛 𝑜𝑓 𝑡ℎ𝑒 𝑒𝑛𝑣𝑖𝑟𝑜𝑛𝑚𝑒𝑛𝑡𝑎𝑙 ( 𝑎 𝑑𝑒𝑚𝑎𝑛𝑑 −
𝑠ℎ𝑖𝑓𝑡 𝑃𝑎𝑟𝑎𝑚𝑒𝑡𝑒𝑟 𝑟𝑒𝑓𝑙𝑒𝑐𝑡𝑖𝑛𝑔 𝑎𝑢𝑡𝑜𝑛𝑜𝑚𝑜𝑢𝑠 𝑐ℎ𝑎𝑛𝑔𝑒𝑠 𝑖𝑛 𝑑𝑒𝑚𝑎𝑛𝑑)
It is assumed that the demand is negatively related to price, but positively related to
the staff expenditure and to the shift factor 𝜀. Thus,
< 0;
> 0;
An increase in the staff expenditure is assumed to cause a shift in the demand curve
upwards and thus allow the charging of a higher price. The same holds for any other
change in the environment (𝜀, for example and increase in income) which shifts
upward the demand curve of the firm.
The production cost
The total production cost (TC) is assumed to be an increasing function of output
𝑇𝐶 = 𝑓3 (𝑄)
Actual Profit
The actual profit is revenue from sales (TR), less the production costs (TC), and less
the staff expenditure (S)
𝜋 = 𝑇𝑅 − 𝑇𝐶 − 𝑆
Reported Profit
This is the profit reported to the tax authorities. It is the actual profit less the
managerial emoluments (M) which are tax deductible
𝜋𝑅 = 𝜋 − 𝑀
𝑜𝑟, 𝜋𝑅 = 𝑅 − 𝐶 − 𝑆 − 𝑀
Minimum profit
This is the amount of profits (after tax) which is required for an acceptable dividend
policy by the shareholders.
If the shareholders do not receive some profit they will be inclined to sell their shares
or to vote for the change in the top management.
Both actions obviously reduce the job security of managers.
Hence they will make sure to have a minimum profit adequate to keep shareholders
For this the reported profits must be at least as high as the minimum profit
requirement plus the tax that must be paid to the government
𝜋𝑅 ≥ 𝜋0 + 𝑇
𝑇 = 𝑡𝑎𝑥
The tax function is of the form
𝑇 = 𝑇ത + 𝑡. 𝜋𝑅
Where 𝑡 = 𝑚𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒
𝑇ത = 𝑎 𝑙𝑢𝑚𝑝𝑠𝑢𝑚 𝑡𝑎𝑥
Discretionary Investment
Discretionary investment is the amount left from the reported profit, after subtracting
the minimum profit (π0) and the tax (T)
𝐼𝐷 = 𝜋𝑅 − 𝜋0 − 𝑇
Discretionary profit
This is the amount of profit left after subtracting from the actual profit (π) the
minimum profit requirement (π0) and the tax (T)
𝜋𝐷 = 𝜋 − 𝜋0 − 𝑇
We will present the model in two stages to simplify the exposition. In the first stage
we assume that there are no managerial emoluments (M = 0), so that the actual
profit is the reported profit for tax purposes.
The simplified model may be stated formally as
𝑀𝑎𝑥𝑖𝑚𝑖𝑧𝑒 𝑈 = 𝑓(𝑆, 𝐼𝐷 )
𝑆𝑢𝑏𝑗𝑒𝑐𝑡 𝑡𝑜, 𝜋 ≥ 𝜋0 + 𝑇
Since there are no emoluments, discretionary investment absorbs all the
discretionary profit. Thus we may write the managerial utility function as
𝑈 = [𝑆, 𝜋 − 𝜋0 − 𝑇 ]
For simplicity we may assume that there is no lump-sum tax so that 𝑇 = 𝑡𝜋, Thus the
managerial utility function becomes
𝑈 = 𝑓[𝑆, 1 − 𝑡 𝜋 − 𝜋0 )]
Where, 1 − 𝑡 𝜋 − 𝜋0 is the discretionary profit.
Marris Model of Managerial Growth
The goal of the firm in Marris's model is the maximization of the balanced rate of
growth of the firm, that is, the maximization of the rate of growth of demand for the
products of the firm, and of the growth of its capital supply:
𝑀𝑎𝑥𝑖𝑚𝑖𝑧𝑒 𝑔 = 𝑔𝐷 = 𝑔𝑆
𝑔 = 𝑏𝑎𝑙𝑎𝑛𝑐𝑒𝑑 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒
𝑔𝐷 = growth of demand for the products of the firm
𝑔𝑆 = growth of the supply of capital
In pursuing this maximum balanced growth rate the firm has two constraints.
Firstly, a constraint set by the available managerial team and its skills.
Secondly, a financial constraint, set by the desire of managers to achieve maximum
job security.
The rationalization of this goal is that by jointly maximizing the rate of growth of
demand and capital the managers achieve maximization of their own utility as well as
of the utility of the owners-shareholders.
The utility function of managers includes variables such as salaries, status, power and
job security, while the utility function of owners includes variables such as profits, size
of output, size of capital, share of the market and public image.
Managers want to maximize their own utility
𝑈𝑀 = 𝑓(𝑆𝑎𝑙𝑎𝑟𝑖𝑒𝑠, 𝑝𝑜𝑤𝑒𝑟, 𝑠𝑡𝑎𝑡𝑢𝑠, 𝑗𝑜𝑏 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦)
While the owners seek to maximization of their utility
𝑈𝑂 = 𝑓 ∗ 𝑝𝑟𝑜𝑓𝑖𝑡𝑠, 𝑐𝑎𝑝𝑖𝑡𝑎𝑙, 𝑜𝑢𝑡𝑝𝑢𝑡, 𝑚𝑎𝑟𝑘𝑒𝑡 𝑠ℎ𝑎𝑟𝑒, 𝑝𝑢𝑏𝑙𝑖𝑐 𝑒𝑠𝑡𝑒𝑒𝑚
Marris argues that most variables appearing in both functions are strongly correlated
with a single variable: the size of the firm.
Marris limits his model to situations of steady rate of growth over time during which
most of the relevant economic magnitudes change simultaneously.
Maximizing the long-run growth rate of any indicator can reasonably be assumed
equivalent to maximizing the Long-run rate of most others.
Marris argues that the managers do not maximize the absolute size of the firm
(however measured), but the rate of growth.
In the real world the mobility of managers is low.
Various studies provide evidence that managers prefer to be promoted within the
same growing organization rather than move to a larger one.
Hence managers aim at the maximization of the rates of growth rather than the
absolute Size of a firm.
The size and rate of Growth are not necessarily equivalent from the point of view of
managerial utility.
Marris argues that since growth happens to be compatible with the interests of the
shareholders in general, the goal of maximisation of the growth rate (however
measured) seems a priori plausible.
From Marris's discussion it follows that the utility function of owners can be written
as follows
𝑈𝑜𝑤𝑛𝑒𝑟𝑠 = 𝑓 ∗ (𝑔𝐶 )
𝑔𝐶 = 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
Furthermore from Marris's discussion of the nature of the variables of the managerial
utility function it seems that he implicitly assumes that salaries, status and power of
managers are strongly correlated with the growth of demand for the products of the
firm: managers will enjoy higher salaries and will have more prestige the faster the
rate of growth of demand.
Therefore the managerial utility function may be written as follows
𝑈𝑀 = 𝑓(𝑔𝐷 , 𝑠)
𝑔𝑑 = 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑔𝑟𝑜𝑤𝑡ℎ 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑝𝑟𝑜𝑑𝑢𝑐𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑓𝑖𝑟𝑚
𝑠 = 𝑗𝑜𝑏 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦
Marris, argues that there is a constraint to 𝑔𝐷 set by the decision making capacity of
the managerial team.
Marris suggests that 's' can be measured by a weighted average of three crucial
ratios, the liquidity ratio, the leverage debt ratio and the profit-retention ratio, which
reflect the financial policy of the firm.
With this assumption the managerial utility function becomes
𝑈𝑀 = 𝑓(𝑔𝐷 )𝑠ҧ
Where, 𝑠ҧ is security constraint.
Equilibrium of the firm
The managers aim at the maximization of their own utility, which is a function of the
growth of demand for the products of the firm (given the security constraint).
𝑈𝑚𝑎𝑛𝑎𝑔𝑒𝑟𝑠 = 𝑓(𝑔𝐷 )
The owners-shareholders aim at the maximization of their own utility which Marris
assumes to be a function of the rate of growth of the capital supply.
𝑈𝑂𝑤𝑛𝑒𝑟𝑠 = 𝑓 ∗ (𝑔𝐶 )
The firm is in equilibrium when the maximum balanced-growth rate is attained, that
is, the condition for equilibrium is
𝑔𝐷 = 𝑔𝐶 = 𝑔∗
The first stage in the solution of the model is to derive the 'demand' and 'supply‘
functions, that is, to determine the factors that determine 𝑔𝐷 and 𝑔𝐶 ·
The behavioral model of Cyert and March
The behavioral theory of firm was developed by Cyert and March.
It focuses on the decision making process of the large multi product firm under
uncertainty in an imperfect market.
They deal with the large corporate managerial business in which ownership is
Their theory originated from the concern about the organizational problem with the
internal structure of such firms.
The firm is not treated as a single-goal, single decision unit, as in the traditional
theory, but as a multi goal, multi decision organization coalition.
The firm is as a coalition of different groups which are connected with its activity.
The behavioral theory recognizes explicitly that there exists a basic dichotomy in the
firm, there are individual members of the coalition firm and there is the organization
coalition known as ‘the firm’.
The consequence of the dichotomy is a conflict of goals; individuals may have
different goals to those of the organization firm.
Cyert and March argue that the goals of the firm depend on the demand of the
members of the coalition.
Demand of these members are determined by various factors such as aspiration of
members, their success in the past in occupying their demands.
Given the resources of the company, not all demands, which confront the top
management can be satisfied.
The top management of a company is often in conflict with the demands of the
various groups within the company.
It is the job of the top management to resolve the conflict
The goals of the firm are set by the top management, which the main five goals of the
firm are:
Production Goal:
Main goal of production manager is smooth running of the production process.
Production should be distributed evenly over time, irrespective of possible seasonal
fluctuations of demand.
Avoid excess capacity and lay off of workers at some periods.
Inventory Goal:
The inventory goal originates mainly from the inventory department if such a
department exists.
The sales department wants an adequate stock of output for the customers.
Sales Goal:
The sales goal and the share of the market goal originate from the sales department.
The same department will also normally set the ‘sales strategy’ that is decided on the
advertising campaigns, the market research programs, and so on
Profit Goal:
The profit goals is set by the management so as to satisfy the demand of share
holders and the expectations of bankers.
Share of the market goal:
While making decisions, the firms are guided by these goals.
All goals must be satisfied but there is an implicit order of priority among them.
The conflict among different goals may crop up.
The law of diminishing returns holds for managerial work as for all other types of
labor, writes David Frum.
The goals of the firm are ultimately decided by the top management through
continuous bargaining between the groups of the coalition, he says.
Frum argues that satisfying behavior is rational given the limitations, internal and
external with in which the operation of a firm is confined.
The firm is not a maximizing but rather a satisfying organization, he writes.
The goal of the behavioral theories is to attain a 'satisfactory' overall performance,
rather than maximize profits, sales or other magnitudes, Frum says.
The top management wishes to satisfy as many as possible of the demands with
which the various members of the coalitions confront it, he argues.
But it is not clear in the behavioral theory what is a satisfactory and what an
unsatisfactory attainment is.
Conflicting Goals
The aspiration levels of the individuals within the firm which determine these goals
change over time as a result of organizational learning.
Demands of coalition members equal actual side payments only in the long-run.
In the short-run, new demands are being constantly made and the goals of the
organization are continually adapted to take account of these demands.
A problem will arise when the organization is not able to accommodate the demands
of its members even sequentially, because it lacks the resources to do so.
Each person in the organization has a satisfying level for each of his goals.
In fact, the aspiration levels change with the process of satisfying. each of the people
within the organization.
The aspiration levels for each person change with experience.
Concept of Elasticity of demand
According to the law of demand, when the price of a good increases, the demand for
the good decreases, and when the price of a good decreases, the demand for the
good increases, ceteris paribus.
While the law shows the direction of change and depicts the negative relationship
between price and quantity, it does not indicate as to how responsive the demand for
a good is to its price.
In other words, it does not give the magnitude or the degree of the change.
This is given by the elasticity of demand.
Elasticity of demand is measured as
𝐸𝐷 =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑑𝑒𝑡𝑒𝑟𝑚𝑖𝑛𝑎𝑛𝑡𝑠 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑
The quantity demanded of a good is influenced by many factors, for example,
price of the good, income, and price of other goods.
Hence, we determine the magnitude of the relationship of these factors to demand
by analyzing the price elasticity of demand, income elasticity of demand, and the
cross price elasticity of demand and others.
The types of elasticity that we discuss here are
1. Price Elasticity of Demand
2. Income Elasticity of Demand
3. Cross Elasticity of Demand
4. Promotional Elasticity of demand
Price Elasticity of Demand
The concept was first discussed by Alfred Marshall.
Price elasticity of demand is a measure of the responsiveness of the quantity
demanded of a good to a change in the price of the good
Price elasticity of demand can be defined as the ratio of the percentage change in the
quantity demanded of a good to the percentage change in the price of the good.
𝐸𝑃 =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒
𝐸𝑃 =
𝐹𝑖𝑛𝑎𝑙 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦−𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦
𝐹𝑖𝑛𝑎𝑙 𝑃𝑟𝑖𝑐𝑒 −𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑃𝑟𝑖𝑐𝑒
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑃𝑟𝑖𝑐𝑒
𝐸𝑃 =
𝑄1 −𝑄
𝑃1 −𝑃
× ∆𝑃
Types of Price Elasticity of Demand
Following are the types of Price Elasticity of Demand
1. 𝑃𝑒𝑟𝑓𝑒𝑐𝑡𝑙𝑦 𝐸𝑙𝑎𝑠𝑡𝑖𝑐 𝐷𝑒𝑚𝑎𝑛𝑑 (𝐸𝑃 = ∞)
2. 𝑃𝑒𝑟𝑓𝑒𝑐𝑡𝑙𝑦 𝐼𝑛𝑒𝑙𝑎𝑠𝑡𝑖𝑐 𝐷𝑒𝑚𝑎𝑛𝑑 (𝐸𝑃 = 0)
3. 𝑅𝑒𝑙𝑎𝑡𝑖𝑣𝑒𝑙𝑦 𝐸𝑙𝑎𝑠𝑡𝑖𝑐 𝐷𝑒𝑚𝑎𝑛𝑑 (𝐸𝑃 > 1)
4. 𝑅𝑒𝑙𝑎𝑡𝑖𝑣𝑒𝑙𝑦 𝐸𝑙𝑎𝑠𝑡𝑖𝑐 𝐷𝑒𝑚𝑎𝑛𝑑 (𝐸𝑃 < 1)
5. 𝑈𝑛𝑖𝑡𝑎𝑟𝑦 𝐸𝑙𝑎𝑠𝑡𝑖𝑐 𝐷𝑒𝑚𝑎𝑛𝑑 (𝐸𝑃 = 1)
Note: since relationship between price and quantity demanded is inverse thus, the
value of price elasticity is negative and it is implied.
Perfectly Elastic Demand (𝐸𝑃 = ∞)
In such a situation, any price change,
which may be very small, leads to an
infinite change in the quantity
demanded of good.
𝑃 ↓⟶ 𝑄 ↑= ∞
The demand curve is shown in
Figure as a straight line parallel to
the x axis.
Such a situation exists under the
perfect competition.
𝑃 ↑⟶ 𝑄 ↓= 0
Perfectly Inelastic Demand (𝐸𝑃 = 0)
In such a situation, the ratio of
percentage change in the quantity
demanded to the percentage
change in the price of the good is
The demand curve is shown in
Figure as a straight line parallel to
the y axis.
Example: Medicines.
This implies that whatever is the
price of the good the quantity
demanded remains the same.
Relatively Elastic Demand (𝐸𝑃 > 1)
In such a situation, the ratio of
percentage change in the quantity
demanded to the percentage
change in the price of the good is
The demand curve shown in Figure
is relatively flatter.
Example: Luxuries.
This implies that the percentage
change in the quantity demanded is
more than the percentage change
in the price of the good.
In such a situation, the ratio of
percentage change in the quantity
demanded to the percentage
change in the price of the good is <
This implies that the percentage
change in the quantity demanded is
less than the percentage change in
the price of the good.
The demand curve is shown in
Example: Necessities.
Relatively Inelastic Demand(𝐸𝑃 < 1)
In such a situation, the ratio of
percentage change in the quantity
demanded equals the percentage
change in the price of the good.
The demand curve is shown in
Example: Normal goods.
Unitary Elastic Demand(𝐸𝑃 = 1)
Measurement of Price Elasticity
1. 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑀𝑒𝑡ℎ𝑜𝑑
2. 𝐴𝑟𝑐 𝑀𝑒𝑡ℎ𝑜𝑑
3. 𝑃𝑜𝑖𝑛𝑡 𝑀𝑒𝑡ℎ𝑜𝑑
Arc Method
To measure arc elasticity, we take two finite points on a
demand curve, which are close to each other as in
Arc elasticity is to be calculated on the demand curve
𝐷𝑥 over the arc 𝑀𝑁.
𝐸𝑃 = ∆𝑃 ×
𝑃1 +𝑃2
𝑄1 +𝑄2
𝑄2 −𝑄1
𝑃2 −𝑃1
𝑃1 +𝑃2
𝑄1 +𝑄2
Point Method
Along a linear demand curve, which is downward sloping, price elasticity varies at
different points along the demand curve.
In Figure on the demand curve DD′, we can calculate elasticity by the formula.
𝐸𝑃 =
𝐿𝑜𝑤𝑒𝑟 𝑆𝑒𝑔𝑚𝑒𝑛𝑡
𝑈𝑝𝑝𝑒𝑟 𝑆𝑒𝑔𝑚𝑒𝑛𝑡
At point D on Y-axis
At M, the Midpoint on the demand
curve 𝐷𝐷′
At point 𝐷′ on X-axis
Thus, as we move down a demand
curve, the price elasticity goes on
Importance of Price Elasticity of Demand
Decisions by the Business Firms
When a firm is in the process of deciding whether to increase the price of the good
that it is producing, it is important to consider the price elasticity of the demand. If
elasticity of demand is high, then a decrease in price will lead to an increase in the
sales of the good. Under the monopoly when a monopolist goes in for price
discrimination of charging different prices in different markets, he determines the
price in each market by taking into consideration the price elasticity of demand in
each market
Decisions by the Government
Important decisions have to be made by the government in its formulation of policies.
These include the following:
Fixation of minimum support prices for agriculture. The elasticity of demand for
agricultural products including wheat, rice and vegetables is low since they are
necessities. A good harvest leads to an increase in supply, and given the demand
there occurs a fall in the price. Since the demand is inelastic, a fall in the price does
not lead to an increase in demand. Hence, the farmer’s income does not increase
much in spite of a good harvest. Here, the government plays an important role in
formulating the policies relating to minimum support price such that the prices of
the agricultural products are stabilized and not subject to the vagaries of nature.
While formulating policies relating to taxes, if the government is aiming at maximizing
its tax revenues to finance the government expenditures, then it should levy high
taxes only on goods with low elasticity of demand. In case the elasticity is high, a tax
will lead to an increase in the price of the good leading to a decrease in the demand
for the good and thus a fall in the tax revenue. Then, the government will be unable
to fill its coffers through the collection of taxes.
Decisions Relating to International Trade
In analyzing the issues relating to the international trade, the elasticity of demand
plays a very important role. If a country is facing problems on the balance of
payments, the situation can be tackled through devaluation. Devaluation leads to an
increase in the price of imports and a decrease in the price of exports of the
devaluing country. Hence, devaluation can be successful only if the elasticity of
demand for the country’s imports is high so that an increase in the price of imports
leads to a decrease in the demand for imports and the elasticity of demand for the
country’s exports is low so that a decrease in the price of exports leads to an increase
in the demand for exports.
Income Elasticity of Demand
Income elasticity of demand is a measure of the responsiveness of the quantity
demanded of a good to a change in the income of the consumer, ceteris paribus.
Income elasticity of demand can be defined as the ratio of the percentage change in
the quantity demanded of a good to the percentage change in the income of the
𝐸𝑃 =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐼𝑛𝑐𝑜𝑚𝑒
𝐸𝑃 =
𝑄1 −𝑄
𝑌1 −𝑌
𝐸𝑃 =
𝐹𝑖𝑛𝑎𝑙 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦−𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦
𝐹𝑖𝑛𝑎𝑙 𝐼𝑛𝑐𝑜𝑚𝑒 −𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑐𝑜𝑚𝑒
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑃𝑟𝑖𝑐𝑒
Types of Income Elasticity of Demand
1. Positive Income Elasticity (𝐸𝑃 > 0)
a. Income elasticity greater than unity (𝐸𝑃 > 1)
b. Income elasticity equals to unity (𝐸𝑃 = 1)
c. Income elasticity less than unity (𝐸𝑃 < 1)
2. Negative Income Elasticity (𝐸𝑃 < 0)
3. Zero Income Elasticity (𝐸𝑃 = 0)
Refers to a situation when the demand for
a product increases with increase in
consumer’s income and decreases with
decrease in consumer’s income.
The slope of the curve is upward from left
to right, which indicates that the increase
in income causes increase in demand and
vice versa.
Therefore, in such a case, the elasticity of
demand is positive.
Positive Income Elasticity (𝐸𝑃 > 0)
In such a situation, the ratio of
percentage change in the quantity
demanded to the percentage change
in the income is >1.
This implies that the percentage
change in the quantity demanded is
more than the percentage change in
the income.
When the consumer’s income
increases, the quantity demanded of
the good increases more than
Example: luxuries.
Income Elasticity Greater than Unity (𝐸𝑌 > 1)
In such a situation, the ratio of
percentage change in the quantity
demanded is equal to the
percentage change in the income.
When the consumer’s income
increases, the quantity demanded
of the good increases
Example: Comforts.
Income Elasticity Equals to Unity (𝐸𝑌 = 1)
In such a situation, the ratio of
percentage change in the quantity
demanded to the percentage
change in the income is < 1.
This implies that the percentage
change in the quantity demanded is
less than the percentage change in
the income.
When the consumer’s income
increases, the quantity demanded
of the good increases less than
Thus, here income elasticity is
positive but < 1.
Example: Necessities.
Income Elasticity Less than Unity (𝐸𝑌 < 1)
In such a situation, there does not
occur any change in the quantity
demanded when there is a change
in the income.
It is very difficult to specify the type
of good, which will have zero
income elasticity.
Income Elasticity Equals to Zero (𝐸𝑌 = 0)
In such a situation, an increase in
the income leads to a decrease in
the quantity demanded of the
Negative Income Elasticity (𝐸𝑌 < 0)
Example: Inferior goods.
Significance of Income Elasticity of Demand
First, the concept of income elasticity can be used to estimate the future demand for
a product provided the rate of increase in income and income elasticity of demand
for the product are known. The knowledge of income elasticity can be used for
forecasting demand, when a change in personal income is expected, other things
remaining the same.
Secondly, the concept of income elasticity can also be used to define the ‘normal’ and
‘inferior’ goods. The goods whose income elasticity is positive for all levels of income
are termed as ‘normal goods’. On the other hand, the goods for which income
elasticities are negative, beyond a certain level of income, are termed as ‘inferior
Cross Elasticity of Demand (𝐸𝑋𝑌 )
Besides the price and the consumer’s income, there are many other factors which
influence the demand for a good.
An important determinant of demand is the price of the related goods.
Cross price elasticity of demand is a measure of the responsiveness of the quantity
demanded of a particular good to a change in the price of another good, ceteris
Cross price elasticity of demand can be defined as the ratio of the percentage change
in the quantity demanded of good 𝑥, to the percentage change in the price of good 𝑦.
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝑋
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑌
Types of Cross Elasticity of Demand
1. Positive Cross Elasticity (𝐸𝑋𝑌 > 0)
2. Negative Cross Elasticity (𝐸𝑋𝑌 < 0)
3. Zero Cross Elasticity (𝐸𝑋𝑌 = 0)
Positive Cross Elasticity (𝐸𝑋𝑌 > 0)
In such a situation, the two goods x
and y are substitutes, for example,
tea and coffee.
𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑌
An increase in the price of good y
leads to an increase in the quantity
demanded of good x and vice-versa
𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑋
In such a situation, the two goods x
and y are complements, for
example, coffee and sugar; Car and
Petrol etc.
An increase in the price of good y
leads to a decrease in the quantity
demanded of good x.
𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑌
Negative Cross Elasticity (𝐸𝑋𝑌 < 0)
𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑋
In such a situation, the two goods x
and y are independent goods or
goods which are not related to each
other, for example, car and mobile
𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑌
Zero Cross Elasticity (𝐸𝑋𝑌 = 0)
An increase in the price of good y
does not lead to any change in the
quantity demanded of good x.
𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑋
Significance of Cross Elasticity of Demand
Most often firms are interested in analyzing the cross elasticity of demand for their
goods with respect to other goods, especially the complementary and substitute
goods. This is important so that the effect of any changes in the prices can be
evaluated and taken into consideration when the firm is planning on its production
and pricing strategies.
Promotional (Advertisement) Elasticity of
Nowadays, most firms spend on sales promotion activities, including advertising, to
influence the sales of a good.
It is important to note that although advertising does increase the sales, however, the
degree to which it does so differs at different levels of the sales.
Hence, it is of great importance to determine the optimum level of expenditure that
should be incurred on advertising.
This is even more important when a firm has to compete with other rival firms who
are also involved in advertising their products.
Advertisement elasticity is a measure of the responsiveness of the quantity
demanded of a particular good to a change in advertising, ceteris paribus.
Advertisement elasticity can be defined as the ratio of the percentage change in the
quantity demanded of good or sales to the percentage change in advertising.
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑
𝐸𝐴 = 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐴𝑑𝑣𝑒𝑟𝑡𝑖𝑠𝑒𝑚𝑒𝑛𝑡 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒
𝐸𝐴 = ∆𝐴 × 𝑄
Relationship Between Price Elasticity of
Demand and Price Elasticity of Demand
An important piece of information for the management of a firm is knowledge of the
shape of its demand curve.
The slope of the demand curve tells managers how many extra units the firm will sell
in response to any change in the price of the good.
𝑤𝑒 𝑘𝑛𝑜𝑤, 𝑇𝑅 = 𝑃 × 𝑄
𝑑𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑡𝑖𝑎𝑡𝑖𝑛𝑔 𝑤𝑖𝑡ℎ 𝑟𝑒𝑠𝑝𝑒𝑐𝑡 𝑡𝑜 𝑄, 𝑤𝑒 𝑔𝑒𝑡
𝑃. 𝑑𝑄
𝑜𝑟, 𝑀𝑅 =
𝑜𝑟, 𝑀𝑅 =
+ 𝑄. 𝑑𝑄
𝑃 + 𝑄. 𝑑𝑄
𝑄 𝑑𝑃
𝑃 1 + 𝑃 . 𝑑𝑄
𝑜𝑟, 𝑀𝑅 = 𝑃 1 + 𝑃 𝑑𝑃
𝑄 𝑑𝑄
𝑜𝑟, 𝑀𝑅 = 𝑃 1 +
∴ 𝑀𝑅 = 𝑃 1 −
For decision-making purposes, three specific ranges of price elasticity have been
identified. Using 𝜖𝑃 to denote the absolute value of the price elasticity, three ranges
for price elasticity are
𝜖𝑃 > 1, defined as elastic demand
𝜖𝑃 = 1, defined as unitary elastic demand
𝜖𝑃 < 1, defined as inelastic demand
If demand is elastic, a price increase lowers total revenue and a decrease in price
raises total revenue. Conversely, when demand is inelastic, price decrease generates
less than proportionate increase in quantity demanded, so total revenues fall.
Following Price Increase
Following Price Decrease
Elastic Demand 𝜖𝑃 > 1
%∆𝑄 > %∆𝑃
Revenue Decreases
Revenue Increases
Unitary Elastic 𝜖𝑃 = 1
%∆𝑄 = %∆𝑃
Revenue Unchanged
Revenue Unchanged
Inelastic Demand 𝜖𝑃 < 1
%∆𝑄 < %∆𝑃
Revenue Increases
Revenue Decreases
Demand Forecasting
Rabin Dahal
Concept of forecasting
Meaning and types of forecasting:
Projection (forecast based on the extrapolation of current and historical trend into the
Prediction (forecast based on explicit theoretical assumption.)
Conjunctures (forecast based on subjective judgment about future states of society.)
"Forecasting aims to reduce uncertainty about tomorrow, so that effective decision can be
made today by providing predictions of future values of variables from past and present
information” – Reekie and crook
“Forecasting is like trying to drive a car blind-folded and following direction given by a
person who is looking out of the back-window”. Philip Kotler
Meaning of Demand Forecasting:
Prediction of future demand of the product on the basis of current state of relationship
between the determinants of demand.
Steps in Demand Forecasting
1. Specifying the objectives
2. Determining the price perspective
3. Making choice of method for demand forecasting
4. Collection of data and data adjustment
5. Estimation and interpretation of result
Specifying the objective
The objective or the purpose of demand forecasting must be clearly specified
The objective may be specified in terms of
a. short-term or long term demand
b. Industry demand for a product or for firm’s own product
c. The whole or only a segment of the market for its product.
d. Firm’s market share
The objective of forecasting must be determined before the process of forecast
Determining time perspective
Depending on the objective demand may be forecast for short period or long period.
In demand forecasting for a short period, many determinants are need to be taken
In long run determinants of demand may change significantly.
Therefore , the time perspective of demand forecasting must be specified as it helps
in making choice of appropriate determinants of demand.
Making choice of method for demand
There are various methods of demand forecasting
All methods are not suitable for all kind of forecasting.
Data requirement of a method, availability of data and time frame of forecasting vary
from method to method.
Choice of method generally based on the purpose, experience and expertise of the
It depends also to great extent on the availability of required data.
The choice of methods saves times and cost as well as ensures the reliability of
Collection of data and data adjustment
Collect the required data
Primary or secondary
The required data may not be available in the required mode
Thus data must be adjusted as per requirements.
Estimation and interpretation of data
To make the estimate of demand for predetermined years or the period.
Here estimates appear in the form of an equation, the result must be interpreted and
presented in a usable form
Criteria for Good Forecasting
Accuracy : accurate as far as possible
Simplicity: simple method is always more comprehensive than complicated
Durability : reasonable and continuous link between past and the present and future
is also necessary
Flexibility : able to accommodate and absorb frequent changes occurring in the
Economy: involve less costs as far as possible
Availability : availability of data is vital requirement
Techniques of demand
Survey Methods
Used to make short-term forecasts.
surveys are conducted to collect information about consumers' intensions and their
future purchase plan.
Basically, new products require the use of survey method only because of absence of
any historical data.
i) Consumer's survey method;
ii) Opinion survey of market experts and sales representatives; and
iii) Market studies and experiments.
Consumer's Survey Method
direct interview of the potential consumers.
ask them what quantity of the product they would be willing to buy at different prices over a
given period, say, one year.
survey can be conducted by simply stopping and questioning people at the shopping centers
or any other places.
carefully constructed questionnaires and trained interviewers is necessary.
3 alternative ways :
Complete enumeration method;
Sample Survey method; or
End-use method
Opinion survey of market experts and
sales representatives
supposed to possess knowledge of the market, e.g., sales representatives, sales
executives, professional marketing experts, and consultants. Opinion survey method
a. Expert-opinion method;
aims at collecting opinion of those who are supposed to have knowledge of the market.
They are supposed to know about future purchase plans of their customers, their reaction to the
market changes and the demand for competing products.
The estimate of demand thus obtained from different regions are added up together to get the
overall probable demand for a product
b. Delphi method
developed by Olaf Helmer, Dalkey and
Gordon in 1940.
it had found its application in
environmental forecasting and estimation
of strength of bombardment.
In business management areas, its
relevance is in human resource planning,
demand estimation.
similar to market opinion method.
Panel of experts selection- view collectionrevise- final forecasting
Market Experiment Method
conducted in the actual market place.
There are many ways of performing market experiments.
One method is to select several markets with similar socio-economic characteristics
(population, income level, cultural and social background, choice and preferences).
Market Experiment is conducted by changing commodity price in some markets or stores,
packaging in other markets or stores, and the amount and type of promotion in still other
markets or stores, the record the purchases of consumers in the different market.
Market experiments are helpful to a firm in determining its best pricing strategy, promotional
campaigns, and product qualities.
It is useful in the process of introducing of products for which no other data exist. And, it is
also useful in verifying the results of other statistical technique.
Laboratory Experiment
The participants are given a sum of money and asked to spend it in a stimulated store.
Reaction of participants regarding changes in the commodity prices, product
packaging, displays, price of competing products, and other factors influencing
demand will be noted.
Participants are selected so as to closely represent the socio-economic characteristics
of the market of interest.
The experiment reveals the consumers' responsiveness to changes made in prices
packages etc.
laboratory experiments are more realistic than consumer survey in that it reflects
actual consumer behavior.
Statistical Methods of
Demand Forecasting:
Statistical methods are considered to be superior technique of forecasting for the
following reasons:
Method of estimation is scientific;
Estimation is based on the theoretical relationship between the dependent
and independent variables;
Estimations are relatively more reliable; and
Estimation involves lower amount of cost.
Time Series Analysis
Classical method of business forecasting.
Statistical data presented in chronological order is called time series data.
Also known as trend projection, extrapolation or lost horse method.
Mathematically, time series is defined as:
Y = f(t)
Where,Y = dépendent variable
t = indépendant variable
Objective of time series are
- to study the past behavior of the data; and
- to forecast the future behavior;
Components of Time Series
i) Secular Trend (S)
ii) Seasonal variation (V)
iv) Random or irregular fluctuation (R)
iii) Cyclical variation (C)
Secular Trend:
Trend is movement in the average (or mean) value of the forecast variable y over time. A
straight line describes the increase or decrease in the time series over a period of time.
Seasonal Trend:
It is a special case of a cycle component of time series in which fluctuations are repeated
usually within a year (e.g. daily, weekly, monthly, quarterly) with a high degree of
regularity. For example, average sales for a retail store may increase greatly during festival
Cyclical Trend:
A business cycle may vary in length, usually more than a year. The movement is through
four phases: from peak (prosperity) to contradiction (recession) to trough (depression) to
Irregular Trend
Irregular variations are rapid charges or bleeps in the data caused by short-term
unanticipated and non-recurring factors. Irregular fluctuations can happen as often as day
to day.
Two models are used to analyze the fluctuations or variations in time series data, which are
Additive Model :
The additive model is used when it is assumed that the four components of a time series are
independent of one another.
These components are considered independent of one another when the occurrence and the
magnitude of movements in a particular component do not affect the other components.
This model analyzes the fluctuations of time series data by adding the probable fluctuation in
above stated four causes of fluctuations.
Y = dependent variable
S = secular trend
V = seasonal variation
C = cyclical variation
R = random or irregular fluctuation
b) Multiplicative Model
This model analyze the fluctuations of time series data by multiplying the probable fluctuations in causes of
In a multiplicative model, it is assumed that all the four components of time series are not independent and
the overall variation in the time series is the combined result of the interaction of all the forces operating on
the time series.
Y = dependent variable
S = secular trend
V = seasonal variation
C = cyclical variation
R = random or irregular fluctuation
Taking log on both sides
log Y = log C + log V + log C + log R
Moving-Average Method
Simple device of reducing fluctuations and obtaining trend values with a fair degree of
The forecasted value of a time series in a period (month, quarter, year, etc.) is equal to
the average value of the time series in a number of previous periods.
The forecasted value of the time series for the next period is given by the average value
of the time series in the previous three periods, under three period moving average.
The greater the number of periods used in the moving average, the greater is the
smoothing effect because each new observation receives less weight.
Consider the following data for sales of product ‘X’ for the period September 2012 to
August 2015 (given as Quarter 12).
𝑅𝑜𝑜𝑡 𝑀𝑒𝑎𝑛 𝑆𝑞𝑢𝑎𝑟𝑒 𝐸𝑟𝑟𝑜𝑟(𝑅𝑆𝑀𝐸) =
For three quarter moving average forecast
= 2.95
For Five Quarter Moving Average
= 2.99
𝐴−𝐹 2
Regression Analysis
most popular and most useful tool of determining the strength of relationship between
dependent and independent variables.
The value of dependent variable is determined on the basis of independent variables.
Regression line can be used to forecast the value of dependent variable which represents the
mean value of independent and dependent variable relationship.
In case of demand forecasting, demand of a product is dependent variable and its value is
forecasted with the help of its determinants (independent variables).
Two types of regression:
a) Simple Regression Analysis
b) Multiple Regression:
Simple Regression Analysis
only one independent variable or demand of a product depends upon only one determinant,
simple regression is used to forecast the value of single variable demand function.
The least square equation for simple regression could be shown as:
'a' is intercept (constant variable)
'b' is marginal change;
'Y' is dependent variable; and
'x' is independent variable
In the given least square equation, the value of regression coefficients a and b can be derived by solving
following two least square equations or normal equations:
Y = na + bx
xY = ax + bx2
By solving these two equations, we get the values of a and b. When we substitute these values in regression
equation, it helps to forecast the value of dependent variable with given independent variable
Multiple Regression
If the value of quantity demanded of a commodity depends on two or more determinants of
demand, we can use multiple regression equation to forecast.
Multiple regression equation can be presented as,
Y = a + b 1 x 1+ b 2 x 2
‘a’ is intercept
‘Y’ is dependent variable.
x1, x2 are independent variables.
b1, b2 are regression coefficients.
Linear Trend Model:
The method of least squares from regression analysis is used to find the trend line of
best fit to a time series data.
Let the time series equation be
𝑌 = 𝑎 + 𝑏𝑥
The two normal equations are
σ 𝑌 = 𝑛𝑎 + 𝑏 σ 𝑥
σ 𝑥𝑌 = 𝑎 σ 𝑥 + 𝑏 σ 𝑥 2
Now substituting the values from the table into equation (𝑖𝑖) and (𝑖𝑖𝑖) we have
5𝑎 − 𝑏 = 260
−𝑎 + 23𝑏 = 76
Multiplying equation 𝑣 by 5 and adding equation 𝑖𝑣 and (𝑣)
We have
5𝑎 − 𝑏 = 260
−5𝑎 + 115𝑏 = 380
114𝑏 = 640
∴ 𝑏 = 5.61
Substituting the value of 𝑏 in equation (𝑖𝑣)
5𝑎 − 5.61 = 260
𝑜𝑟, 5𝑎 = 260 + 5.61
𝑜𝑟, 𝑎 =
∴ 𝑎 = 53.122
Here, the time series equation is
𝑌 = 53.122 + 5.61𝑥
When, 𝑋 = 2015, 𝑥 = 2015 − 2011 = 4
And 𝑋 = 2016, 𝑥 = 2016 − 2011 = 5
∴ 𝑌2015 = 53.122 + 5.61 × 4 = 75.56(′000)
∴ 𝑌2016 = 53.122 + 5.61 × 5 = 81.17(′000)
Barometric Forecasting Method
This method was first developed and used in the 1920s by the Harvard Economic Survey.
revived and developed by the National Bureau of Economic Research (NBER) and the Conference Board.
Barometric forecasting follows the method of meteorologist use in weather forecasting.
They use barometric to forecast weather condition on the basis of movements of mercury in the barometer.
The barometric technique is based on the idea that the future can be predicted from certain happenings in
the present.
Mainly, following three types of time series/indicators could be observed in barometric techniques of
Leading Indicators;
Coincidental Indicators; and
Lagging Indicators
Leading Indicators
if there is a consistent change in one series before the change in other series, that is
called leading indicator.
The variable that moves downward before peak and moves upward before trough are
called leading indicator.
Coincident Indicators
If two series of data frequently increase or decrease at the same time, one series may
be regarded as a coincident indicator of the other.
sometime series move in step or coincide with movements in general economic
activities and are therefore called coincident indicators.
For example, consumption expenditure increases due to increase in income of the
Lagging Indicators
Still other follow or lag movement in economic activity and are called lagging
For example, the bank rate is the leading indicator, the rate of interest charged by
commercial bank is coincident indicator and the rate of interest charged by the
money lender is a lagging indicator
Limitations of Demand Forecasting
Choice of Technique
Availability of Data
Statistical Error
Change in Determinants
Study of Consumer’s Psychology
Lack of experienced experts for forecasting
Calculation of least possible cost
Determination of relationship among the determinants of demand etc.
Theory of Production
Rabin Dahal
Concept of Production
In economics, the term ‘production’ means an activity by which resources
(men, material, time and so on) are transformed into a different and more
useful commodity or value-added service.
In general, production means transforming inputs (labour, machines, raw
materials, time and so on) into an output.
This concept of production is, however, limited to only ‘manufacturing’.
Transporting a commodity in its original form from one place to another where
it can be consumed or used in the process of production is production.
In general, production is process of creation of utility.
Short-Run and Long-Run
The reference to time period involved in production process is another important
concept used in production analysis.
The two reference periods are short run and long run.
Short run refers to a period of time in which the supply and the use of certain inputs
(e.g., plant, building, machinery and so on) is fixed.
In the short run, therefore, production of a commodity can be increased to a limited
quantity by increasing the use of only variable inputs.
The long run refers to a period of time in which the supply of all the inputs is elastic,
but not enough to permit a change in technology
That is, in the long run, all the inputs are variable.
It is important to note here that ‘short run’ and ‘long run’ are economists’ jargon.
They do not refer to any fixed time period.
Short-Run and Long-Run Production function
The short-run production function or what may also be termed as ‘single-variable
production function’, can be expressed as
𝑄 = 𝑓(𝐿, 𝐾)
ഥ = 𝐶𝑜𝑛𝑠𝑡𝑎𝑛𝑡 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
In the long-run production function both K and L are included and the function takes the
𝑄 = 𝑓(𝐿, 𝐾)
both capital (K) and labour (L) are treated as variable factors
Production function with single variable
The short-run production function is also referred to as the total product of labor—
the amount of output (or total product) that a given amount of labor can produce
holding the quantity of other inputs fixed.
The marginal product of labor (MPL) is the change in total output resulting from using
an extra unit of labor, holding other factors (capital) constant.
The marginal product of labor is the partial derivative of the production function with
respect to labor,
𝜕𝑄 𝜕𝑓(𝐿, 𝐾)
The average product of labor (APL) is the ratio of output to the number of workers
used to produce that output
Capital (K)
Labour (L)
The law of diminishing returns
The decline in the 𝑀𝑃𝐿 is a reflection of the law of diminishing returns.
This is an empirical generalization or a physical law, not a proposition of economics.
It postulates that as more units of a variable input are used with a fixed amount of
other inputs, after a point, a smaller and smaller return will accrue to each additional
unit of variable input.
In other words, the marginal product of the variable input eventually declines.
This occurs because each additional unit of the variable input has less and less fixed
inputs with which to work.
Optimal combination of single variable input
The following assumptions underlie our analysis:
A. single commodity 𝑄 is produced in a perfectly competitive market. Hence P x is
given for all firms in the market.
B. The goal of the firm is profit maximization.
C. There is a single variable factor, labour, whose market is perfectly competitive.
Hence the price of labour services, 𝑤,
ഥ is given for all firms.
This implies that the supply of labour to the individual firm is perfectly elastic.
can be denoted by a straight line through 𝑤
ഥ parallel to the horizontal axis.
At the going market wage rate the firm can employ (hire) any amount of labour it
Technology is given.
The slope of the production function is the marginal physical product of labour
The 𝑀𝑃𝑃𝐿 declines at higher levels of employment, given the law of diminishing
If we multiply the 𝑀𝑃𝑃𝐿 at each level of employment by the given price of the
output, 𝑃𝑋 , we obtain the value-of-marginal-product curve 𝑉𝑀𝑃𝐿 .
This curve shows the value of the output produced by an additional unit of labour
The firm, being a profit maximizer, will hire a factor as long as it adds more to total
revenue than to total cost.
Thus a firm will hire a resource up to the point at which the last unit contributes as
much to total cost as to total revenue, because total profit cannot be further
In other words the condition of equilibrium of a profit maximizer in the labour market
ഥ = 𝑉𝑀𝑃𝐿
Given that,
ഥ = 𝑀𝐶𝐿
The equilibrium of the firm is denoted by 𝑒.
𝑉𝑀𝑃𝐿 , 𝑤
At the market wage rate 𝑤
ഥ the firm will
maximize its profit hiring 𝐿∗ units of labour.
This is so because to the left of 𝐿∗ each unit of
labour costs less than the value of its product
(𝑉𝑀𝑃𝐿 >𝑤
ഥ ), hence the profit of the firm will be
increased by hiring more workers.
Conversely to the right of 𝐿 the (𝑉𝑀𝑃𝐿 < 𝑤
ഥ ),
and hence profits are reduced. It follows that
profits are at a maximum when 𝑉𝑀𝑃𝐿 = 𝑤.
Two Variable Inputs
The new things we have to consider with two factor inputs are
The production isoquants
The law of diminishing marginal rate of substitution
The effect of change in total cost outlay on production
An isoquant is a curve along which
quantity is the same.
Quantity refers to quantity of output
or total product.
With two inputs, labour and capital,
isoquants gives the different
combinations of labour and capital
that produce the same output.
The word ‘iso’ is of Greek Origin and
means ‘equal’ or ‘same’
Marginal Rate of Technical Substitution
MRTS is the rate at which the quantity of capital can be reduced for every one-unit
increase in the quantity of labour, holding the quantity of output constant
The rate at which the quantity of capital must be increase for one-unit decrease in
the quantity of labor, holding the quantity of output constant.
The marginal rate of technical substitution is analogous to marginal rate of
We know,
𝑄 = 𝑓 𝐿, 𝐾
𝜕𝑓(𝐿, 𝐾)
𝜕𝑓(𝐿, 𝐾)
𝑑𝑄 =
. 𝑑𝐿 +
. 𝑑𝐾
0 = 𝑀𝑃𝐿 . 𝑑𝐿 + 𝑀𝑃𝐾 . 𝑑𝐾
−𝑀𝑃𝐿 . 𝑑𝐿 = 𝑀𝑃𝐾 . 𝑑𝐾
Diminishing Marginal Rate of Technical
As the units of labour which can substitute one unit of capital or MRTS goes on
The reason is that both the factors are subject to diminishing returns
As the number of labour increases, its marginal productivity decreases.
On the other hand, with the decrease in capital, its marginal productivity increases.
There fore to substitute each subsequent unit of capital, more and more units of
labour are required to maintain same level of production
Diminishing Marginal Rate of Technical
As the units of labour which can substitute one unit of capital or MRTS goes on
The reason is that both the factors are subject to diminishing returns
As the number of labour increases, its marginal productivity decreases.
On the other hand, with the decrease in capital, its marginal productivity increases.
There fore to substitute each subsequent unit of capital, more and more units of
labour are required to maintain same level of production
Elasticity of substitution
A measure of how easy it is for a firm to substitute labor for capital.
It is equal to the percentage change in the capital–labor ratio for every 1 percent
change in the marginal rate of technical substitution of labor for capital as we move
along an isoquant.
capital–labor ratio is The ratio of the quantity of capital to the quantity of labor.
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑙𝑎𝑏𝑜𝑟 𝑟𝑎𝑡𝑖𝑜
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑀𝑅𝑇𝑆𝐿 𝑓𝑜𝑟 𝐾
In general, the elasticity of substitution can be any number greater than or equal to 0.
What is the significance of the elasticity of substitution?
If the elasticity of substitution is close to 0, there is little opportunity to substitute
between inputs.
If the elasticity of substitution is large, there is substantial opportunity to substitute
between inputs.
Iso-Cost Line
In order to construct a cost function, let us assume that a firm has a limited money to
spend as its total cost, C, on both K and L and that price of capital (PK) and price of
labour (PL) are given
Given these conditions, the firm’s cost function may be expressed as
𝐶 = 𝑃𝐿 × 𝐿 + 𝑃𝐾 × 𝐾
the quantity of capital, K, and of labour, L, that can be hired out of the total cost, C,
can be obtained as follows:
− 𝐿
𝐿 = − .𝐾
A line which represents the
alternative combination of K and L
that can be hired from the given
total cost, C. This curve is known as
The iso-cost is also known as the
budget line, or the budget
constraint line.
Given the factor prices, if the total
cost increases, the larger quantities
of both K and L can be hired,
making the iso-costs shift upwards
to the right and vice-versa
Similarly, given the total cost, if the
factor prices decrease
proportionately, the iso-cost line
will shift upward and vice-versa
Slope of Iso-Cost Line
We have,
𝑃𝐿 . 𝐿 + 𝑃𝐾 . 𝐾 = 𝐶
𝑜𝑟, 𝑃𝐾 . 𝐾 = −𝑃𝐿 . 𝐿 + 𝐶
𝑜𝑟, 𝐾 = − . 𝐿 +
Comparing with 𝑦 = 𝑚𝑥 + 𝑐
𝑠𝑙𝑜𝑝𝑒 = −
Optimal Output Maximization
We assume a given production function
𝑄 = 𝑓(𝐿, 𝐾)
And the given factor prices, 𝑤 𝑎𝑛𝑑 𝑟, for labour and capital respectively.
The firm is in equilibrium when it maximizes its output given, its total cost outlay and
the prices of the factors, 𝑤 𝑎𝑛𝑑 𝑟
Following are the condition for equilibrium of producer
a. The slope of isoquant must be equal to iso-cost line or Isoquant must be tangent
to iso-cost line
b. Isoquant must be convex to origin
The maximum level of output the firm
can produce, given the cost constraint
is 𝑋2
Defined by the tangency of the iso-cost
line, and the highest isoquant.
The optimal combination of factors of
production is K2 and L2 , for prices w
and r.
Higher levels of output (to the right of
e) are desirable but not attainable due
to the cost constraint.
At the point of tangency (e) the slope
of the iso-cost line (w/r) is equal to the
slope of the isoquant.
The second condition is that the
isoquants be convex to the origin.
Optimal Cost Minimization
There must be tangency of the (given)
isoquant and the lowest possible isocost curve, the isoquant must be
However, the problem is conceptually
different in the case of cost
Curves closer to the origin show lower
total-cost outlay.
The iso-cost lines are parallel because
they are drawn on the assumption of
constant prices of factors: since w and
r do not change, all the iso-cost curves
have the same slope w/r.
The Expansion Path and Returns to Scale
It is necessary to distinguish between
the long run and the short run
To economist, the long run is a period
of time sufficient to alter quantities of
all inputs into the production process.
Thus in short run, some inputs are
fixed in quantity
When we draw the long-run
expansion path, we assume that
there is enough time to adjust the
quantities of all inputs to the optimal
levels for the given output.
In short run, we may treat capital as
fixed. In this case only the labour
input can be changed.
Example of Two Variable Inputs (CobbDouglas Production Function)
The Cobb-Douglas production function is based on the empirical study of the
American manufacturing industry made by Paul H. Douglas and C.W. Cobb.
It is a linear production function which takes into account two inputs, labour and
capital, for the entire output of the manufacturing industry.
The Cobb-Douglas production function can be expressed as
𝑄 = 𝐴𝐿𝛼 𝐾𝛽
𝑄 = 𝑜𝑢𝑡𝑝𝑢𝑡
𝐿 = 𝑙𝑎𝑏𝑜𝑢𝑟
𝐾 = 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
𝐴, 𝛼 𝑎𝑛𝑑 𝛽 = 𝑝𝑜𝑠𝑖𝑡𝑖𝑣𝑒 𝑝𝑎𝑟𝑎𝑚𝑒𝑡𝑒𝑟𝑠
Properties of Cobb-Douglas Production
It is log linear
Both factors are essential or indispensable
Marginal products are positive
Average products of Factors
Marginal rate of substitution
Elasticity of substitution
Measure of Factor intensity
The efficiency in Production
Returns to Scale
When inputs have positive marginal products, a firm’s total output must increase
when the quantities of all inputs are increased simultaneously—that is, when a firm’s
scale of operations increases.
Often, though, we might want to know by how much output will increase when all
inputs are increased by a given percentage amount.
The concept of returns to scale tells us the percentage increase in output when a firm
increases all of its input quantities by a given percentage amount:
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑂𝑢𝑡𝑝𝑢𝑡
𝑅𝑒𝑡𝑢𝑟𝑛𝑠 𝑡𝑜 𝑆𝑐𝑎𝑙𝑒 =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐼𝑛𝑝𝑢𝑡𝑠
Three Laws of Returns to Scale
When both labour and capital are increased proportionately and simultaneously,
there are technically three possible ways in which total output may increase:
Output may increase more than proportionately to increase in input
Output may increase proportionately to increase in input and
Output may increase less than proportionately to increase in input.
These three law of returns to scale are explained below first graphically with the help
of isoquants and then through the production function
Increasing Returns to Scale
When both the inputs—labour and
capital—are increased proportionately
and simultaneously and output
increases more than proportionately, it
gives the law of increasing returns to
The law of increasing returns to scale
implies that output increases more
than proportionately to the increase in
inputs and the rate of increase in
output goes on increasing with each
subsequent increase in inputs.
For example, suppose inputs are
increased by 50 per cent and output
increases by more than 50 per cent,
say by 75 per cent, and when inputs
are again increased again by 50 per
cent and output increases by 100 per
cent and so on.
Constant Returns to Scale
When change in output is
proportional to the change in
inputs, it shows constant returns to
In other words, if quantities of both
the inputs, K and L, are doubled
and output is also doubled, then
the returns to scale are constant.
Diminishing Returns to Scale
When output increases less than
proportionately to increase in
inputs, K and L, and the rate of rise
in output goes on decreasing it is
called decreasing returns to scale.
A proportionate increase in all input
quantities resulting in a less than
proportionate increase in output.
Economies of Scale
The economies of scale refer to cost saving resulting from the increase in the scale of
production while diseconomies of scale refer to cost escalation due to increase in the
scale of production.
Economies of scale are distinguished into real economies and strictly pecuniary
economies of scale.
Pecuniary economies are economies realized from paying lower prices for the factors
used in the production and distribution of the product, due to bulk-buying by the firm as
its size increases.
Such strictly monetary economies do not imply an actual decrease in the quantity of
inputs used but accrue to the firm from lower prices paid for raw materials (bought at a
discount due to the large volume of the purchase), lower interest rates (and lower cost of
finance in general) as the size of the firm increases, or lower wages and salaries.
Lower wages are rare and can result only if the firm becomes so large as to acquire the
power of a labour monopsonist or near-monopsonist.
Real economies are those associated with a reduction in the physical quantity of
inputs, raw materials, various types of labour and various types of capital (fixed or
circulating capital).
We may distinguish the following main types of real economies:
production economies
selling or marketing economies
managerial economies
transport and storage economies
Economies of Scope
A production characteristic in which the total cost of producing given quantities of
two goods in the same firm is less than the total cost of producing those quantities in
two single product firms.
For a firm that produces two products, total costs would depend on the quantity Q1
of the first product the firm makes and the quantity Q2 of the second product it
We will use the expression TC(Q1, Q2) to denote how the firm’s costs vary with Q1 and
Q 2.
Mathematically, economies of scope are present when:
TC(Q1, Q2) < TC(Q1, 0) + TC(0, Q2)
Why would economies of scope arise?
An important reason is a firm’s ability to use a common input to make and sell more
than one product.
For example, BSkyB, the British satellite television company, can use the same satellite
to broadcast a news channel, several movie channels, several sports channels, and
several general entertainment channels.
Companies specializing in the broadcast of a single channel would each need to have
a satellite orbiting the Earth.
BSkyB’s channels save hundreds of millions of dollars as compared to stand-alone
channels by sharing a common satellite.
Rabin Dhal
■ A game is any situation in which players (the participants) make strategic decisions—i.e., decisions
that take into account each other’s actions and responses.
■ Examples of games include firms competing with each other by setting prices, or a group of
consumers bidding against each other at an auction for a work of art.
■ Strategic decisions result in payoffs to the players: outcomes that generate rewards or benefits.
■ For the price-setting firms, the payoffs are profits; for the bidders at the auction, the winner’s
payoff is her consumer surplus—i.e., the value she places on the artwork less the amount she
must pay.
■ Strategy is a rule or plan of action for playing the game.
■ For our price setting firms, a strategy might be: “I’ll keep my price high as long as my competitors
do the same, but once a competitor lowers his price, I’ll lower mine even more.”
■ The optimal strategy for a player is the one that maximizes the expected payoff.
Payoff Matrix
■ Payoff is defined as a result of outcome of strategy.
■ It is pivot of game theory.
■ It is usually expressed in terms of losses and gains.
■ If the playoff is negative, a player is said to be looser.
■ . Let us suppose, a market with two competing firm whose objective is to increase their profits by
price changes.
■ We can further assume that each firm has two possible strategies.
■ It can maintain its price at present level or it can increase its price.
■ In the game, there are four possible combination of strategies: both firm increases their prices,
neither firm increases price; firm A increases its price but firm B does not increase its price and
B increase its price but A does not increase its price. These results can be shown as a payoff
matrix as follows:
Price Increase
No Price Change
(40, -20)
Price Increase
(-20, 40)
No Price Change
Dominant Strategies
■ Strategy that is optimal no matter what an opponent does.
■ It means dominant strategy is the one which yield higher return to the player.
■ This approach has to be done by element comparison between the rows or between the columns.
■ The inferior strategies are not adopted as they give smaller benefit to the player.
■ I’m doing the best I can no matter what you do. You’re doing the best you can no matter what I do.
■ The four possible outcomes for this simple game are illustrated it above payoff matrix. if both
firm advertise, firm A will earn a profit of 5 and firm B will earn profit of 3.
■ The bottom left cell of the payoff matrix, on the other hand, shows that if firm A doesn’t
advertise and firm B does, firm A will have a profit of 2, and firm B have profit of 6. The other
payoffs in the second column can be similarly interpreted.
■ The best strategy for firm B is to advertise whether firm A does advertise or not. Firm B profit
would always be greater if it choose its best regardless of what strategy of firm B.
■ The dominant strategy is the optimal choice for a player no matter what the opponent does
Nash Equilibrium
■ Nash equilibrium is a set of strategies (or actions) such that each player is doing the best it
can given the actions of its opponents.
■ Because each player has no incentive to deviate from its Nash strategy, the strategies are
■ I’m doing the best I can given what you are doing. You’re doing the best you can given what I
am doing.
Firm B
Don’t advertise
Firm A
Prisoner’s Dilemma
■ The concept of prisoner’s dilemma can be used to analyze the behavior of firm under price and
non-price competition as well as in cartel.
■ It has great relevance to the oligopoly theory.
■ The incentive of firm to fulfill its own interest under price, non-price competition and cartel is best
explained by ‘Prisoner’s Dilemma.’
■ It is the story about two criminals who have been arrested by the police.
■ It helps to understand the behavior of firms who do not know about their rival’s action.
■ Prisoners’ dilemma describes many of life’s situations.
■ It shows that cooperation is difficult to maintain even if cooperation would make both players in
the game better off.
■ It is the self-interest that makes difficult for the oligopoly to maintain the cooperative outcome
with low production, high prices and monopoly profits.
■ Two criminals say Ratne and Kale are captured after committing a bank robbery.
■ However, the proofs are not sufficient to make robbery charge unless one or both
criminals confess.
■ Ratne and Kale are isolated from one another and interrogated so that no
communication is possible between them.
■ The office of Chief District Officer promises no punishment for the suspect who does not
■ . If both Ratne and Kale do not confess, then both will go free.
■ Similarly, if both confess, they will get the sentence of 10 years.
■ The following table shows the situation of criminal:
The above payoff matrix shows that both criminals have two strategies available to them and they
face dilemma.
• To confess and go free if other does not confess or get 10 years of sentence if other
• Remain silent and go free if other doesn’t confess or get 20 years sentence if other
■ Here confessing is a dominant strategy as we spend less time in jail if he confesses
irrespective of whatever other does.
■ So, not to confess is worse situation for both the players as they are uncertain regarding the
decision of one another.
■ If communication or cooperation were possible, or if they have learned from past experience to
trust each other, they would both plead not to confess and go free, and thereby maximizing
their gain.
■ In non-collusive oligopoly, firms are interdependent to each other.
■ It means firms make decision with the uncertainty about how their rivals will react to their
■ Firm makes decision to fulfill their own interest rather than promoting the common interest.
■ . Firm has strong interest to cheat which results worse off of the common interest of members.
■ . Firm has the incentive to cheat in cartel by secretly cutting prices to sell more than allocated
The above example shows that firms are in prisoner’s dilemma.
Both firm will charge low price and earn a smaller profit.
It is because if it charges the high price, it cannot trust its rival to charge higher price.
Market Structure
Rabin Dahal
Market Structure: Concepts
• In the real world, there is a mind - boggling array of different
markets. We observe widely different behavior patterns by
producers across markets: in some markets producers are
extremely competitive; in others, they seem somehow to
coordinate their actions to avoid competing with one another;
and, as we have just described, some markets are monopolies in
which there is no competition at all.
• In order to develop principles and make predictions about
markets and how producers will behave in them, economists
have developed four principal models of market structure:
perfect competition, monopoly, oligopoly, and monopolistic
• This system of market structures is based on two dimensions:
– The number of producers in the market (one, few, or many)
– Whether the goods offered are identical or differentiated
• Differentiated goods are goods that are different but considered
somewhat substitutable by consumers (think Coke versus Pepsi).
• In monopoly, a single producer sells
a single, undifferentiated product.
• In oligopoly, a few producers—more
than one but not a large number—
sell products that may be either
identical or differentiated.
• In monopolistic competition, many
producers each sell a differentiated
product (think of producers of
economics textbooks).
• And finally, as we know, in perfect
competition many producers each
sell an identical product
Concept of Oligopoly Market
• An oligopoly is an industry with only a small number of producers.
• A producer in such an industry is known as an oligopolist.
• Oligopoly is the market structure in which there are a few sellers
selling homogeneous or differentiated products.
• However, economists do not specify what number of sellers
make the market oligopolistic.
• However, two sellers is the limiting case of oligopoly.
• When there are only two sellers, the market is called duopoly.
• In any case, if oligopoly firms sell a homogeneous product, it is
called pure or homogeneous oligopoly.
• For example, industries producing bread, cement, steel, petrol,
cooking gas, chemicals, aluminum and sugar are industries
characterized by homogeneous oligopoly.
• And, if firms of an oligopoly industry sell differentiated products, it
is called differentiated or heterogeneous oligopoly.
• Automobiles, television sets, soaps and detergents, refrigerators,
soft drinks, computers, cigarettes, etc., are some examples of
industries characterized by differentiated or heterogeneous
Features of Oligopoly
• Small Number of Sellers
• Interdependence of Decision Making
• Barriers to Entry
• Indeterminate Price and Output
Collusive Oligopoly
• One way of avoiding the uncertainty arising from oligopolistic
interdependence is to enter into collusive agreements.
• There are two main types of collusion, cartels and price leadership.
• Both forms generally imply tacit (secret) agreements, since open
collusive action is commonly illegal in most countries at present.
• Although direct agreements among the oligopolists are the most
obvious examples of collusion, in the modern business world trade
associations, professional organisations and similar institutions usually
perform many of the activities and achieve in a legal or indirect way
the goals of direct collusive agreements.
• For example, trade associations issue various periodicals with
information concerning actual or planned action of members. In this
official way firms get the message and act accordingly.
• When two or more than two producers’ collusively determines the
price and output in the market, it is called cartel.
• But cartel faces two major problems. They are
– Firstly, how much output to produce altogether and at what price to sell it so
as to maximize profit
– Secondly, how to allocate the production of the optimal (profit-maximizing)
output between the two plants.
• Thus, to solve these problems following models of cartels are discussed
– Joint Profit Maximization
– Market Sharing Cartel
– Non-Price Competition
– Market sharing on the basis of quota
Joint Profit Maximization
• Cartels imply direct (although secret) agreements among the
competing oligopolist with the aim of reducing the uncertainty
arising from their mutual interdependence.
• In this particular case the aim of the cartel is the maximization of
the industry (Joint) profit.
• We concentrate on a homogeneous or pure oligopoly, that is,
an oligopoly where all firms produce a homogeneous product.
• The firms appoint a central agency, to which they delegate the
authority to decide not only the total quantity and the price at
which it must be sold so as to attain maximum group profits, but
also the allocation of production among the members of the
cartel, and the distribution of the maximum joint profit among
the participating members.
• The authority of the central cartel agency is complete.
• Clearly the central agency will have access to the cost figures of the
individual firms, and for the purposes of the present theory we
unrealistically suppose that it will calculate the market-demand curve
and the corresponding MR curve
• From the horizontal summation of the MC curves of individual firms
the market MC curve is derived.
• The central agency will set the price defined by the intersection of
the industry M R and MC curves.
• For simplicity assume that there are only two firms in the cartel.
∑MC=MC1 + MC2
𝑃 𝑃𝑟𝑜𝑓𝑖𝑡
𝑃, 𝐶, 𝑅
𝑃, 𝐶, 𝑅
𝑃, 𝐶, 𝑅
Market Sharing Cartel
• This form of collusion is more common in practice because it is
more popular.
• The firms agree to share the market, but keep a considerable
degree of freedom concerning the style of their output, their
selling activities and other decisions.
• There are two basic methods for sharing the market
– Non-Price Competition
– Sharing of the market by agreement on quotas
Non-Price Competition
• In this form of 'loose' cartel the member firms agree on a
common price, at which each of them can sell any quantity
• The price is set by bargaining, with the low-cost firms pressing for
a lower price and the high-cost firms for a high price.
• The agreed price must be such as to allow some profits to all
• The firms agree not to sell at a price below the cartel price, but
they are free to vary the style of their product and/or their selling
• This form of cartel is indeed 'loose', in the sense that it is more unstable than the
complete cartel aiming at joint profit maximization.
• If all firms have the same costs, then the price will be agreed at the monopoly level.
• However, with cost differences the cartel will be inherently unstable, because the lowcost firms will have a strong incentive to break away from the cartel openly and
charge a lower price, or to cheat the other members by secret price concessions to
the buyers.
• However, such cheating will soon be discovered by the other members of the cartel,
who will gradually lose their customers.
• Thus others may split away from the cartel, and a price war and instability may
develop until only the fittest low-cost firms survive.
• Another possibility is that the members of the cartel in conjunction may decide to start
a price war until the firm which split off or cheated is driven out of business.
• Whether this policy will be successful depends on the cost differential (cost advantage)
of the splitter relative to the other cartel members as well as on the liquidity position
and the ability of obedient members to finance possible losses during the period of the
price war.
Sharing of the market by agreement on
• The second method for sharing the market is the agreement on quotas,
that is, agreement on the quantity that each member may sell at the
agreed price (or prices).
• If all firms have identical costs, the monopoly solution will emerge, with
the market being shared equally among member firms.
• For example, if there are only two firms with identical costs, each firm will
sell at the monopoly price one-half of the total quantity demanded in the
market at that price.
• However, if costs are different, the quotas and shares of the market will
• Allocation of quota-shares on the basis of costs is again unstable.
• Shares in the case of cost differentials are decided by bargaining.
• The final quota of each firm depends on the level of its costs as well as on its
bargaining skill.
• During the bargaining process two main statistical criteria are most often
adopted: quotas are decided on the basis of past levels of sales, and/or on
the basis of 'productive capacity'.
• The 'past-period sales' and/or the definition of 'capacity' of the firm depends
largely on their bargaining power and skill.
• Another popular method of sharing the market is the definition of the region in
which each firm is allowed to sell.
• In this case of geographical sharing of the market the price as well as the style
of the product may differ.
𝑃, 𝐶
𝑀𝐶 = 𝑀𝐶1 + 𝑀𝐶2
𝐷 = 𝐷1 + 𝐷2
Price Leadership
• Another form of collusion is price leadership. In this form of coordinated
behavior of oligopolists one firm sets the price and the others follow it
because it is advantageous to them or because they prefer to avoid
uncertainty about their competitors' reactions even if this implies
departure of the followers from their profit-maximizing position.
• Price leadership is widespread in the business world.
• It may be practiced either by explicit agreement or informally.
• In nearly all cases price leadership is tacit since open collusive
agreements are illegal in most countries.
• Price leadership is more widespread than cartels, because it allows the
members complete freedom regarding their product and selling
activities and thus is more acceptable to the followers than a
complete cartel, which requires the surrendering of all freedom of
action to the central agency.
• If the product is homogeneous and the firms are highly concentrated
in a location the price will be identical.
• However, if the product is differentiated prices will differ, but the
direction of their change will be the same, while the same price
differentials will broadly be kept.
• There are various forms of price leadership.
– Price leadership by a low-cost firm.
– Price leadership by a large (dominant) firm.
– Barometric price leadership.
• The characteristic of the traditional price leader is that he sets his price
on marginalistic rules, that is, at the level defined by the intersection of
his MC and MR curves.
• For the leader the behavioral rule is MC = MR.
• The other firms are price-takers who will not normally maximize their profit
by adopting the price of the leader.
• If they do, it will be by accident rather than by their own independent
Low Cost Price Leadership Model
• We will illustrate this model with an example of duopoly.
• It is assumed that there are two firms which produce a
homogeneous product at different costs, which clearly must be
sold at the same price.
• The firms may have equal markets (or they may come to an
agreement to share the market equally) or they may have
unequal markets (or agree to share the market with unequal
• The important condition for this model is that the firms have
unequal costs.
𝑃, 𝐶
𝑃, 𝐶
𝑄 = 𝑄1 + 𝑄2
𝑄𝐴 𝑀𝑅1 = 𝑀𝑅2
Model of Dominant Frim
• Dominant firm is that type of firm which has some control over the market
over his brand or it has some command due to his extra knowledge about the
market and the consumers.
• In this model, dominant firm determines the price of commodity on the basis
of maximization of his profit i.e. MC = MR principle, whereas other firms will
act as the follower firms which follows the price.
• In this situation, dominant firm acts as the residual monopolist supplier of the
product and other firms act as competitive firms.
• They not only follow the price but also divide market share on the output left
by dominant firm as a part of market demand.
Price /Cost
Price /Cost
In the above diagram, dominant firm has no demand at price higher than OP. Dominant firm
will be in equilibrium at ED (Panel B) determining output as OQD and price OPD. Total demand
of product in the market at that price is OQD (Panel A). Since, decrease in price creates excess
demand of CD i.e. QRQD. That portion of demand is fulfilled by dominant firm and remaining
portion OQR is fulfilled by other following firms in the market.
Similarly as low cost price leadership model, dominant firm will be leader for long run if and
only if price determined by the dominant firm will give opportunity to all the follower firms to
realize profit. Otherwise, the firms will refuse to follow the dominant firm and this pricing
mechanism will fail to operate.
Barometric Price Leadership
• In this model it is formally or informally agreed that all firms will follow (exactly or
approximately) the changes of the price of a firm which is considered to have
a good knowledge of the prevailing conditions in the market and can forecast
better than the others the future developments in the market.
• In short, the firm chosen as the leader is considered as a barometer, reflecting
the changes in economic environment.
• The barometric firm may be neither a low-cost nor a large firm.
• Usually it is a firm which from past behavior has established the reputation of a
good forecaster of economic changes.
• A firm belonging to another industry may also be chosen as the barometric
• Barometric price leadership may be established for various reasons.
• Firstly, rivalry between several large firms in an industry may make it
impossible to accept one among them as the leader.
• Secondly, followers avoid the continuous recalculation of costs, as
economic conditions change.
• Thirdly, the barometric firm usually has proved itself as a 'reasonably'
good forecaster of changes in cost and demand conditions in the
particular industry and the economy as a whole, and by following it
the other firms can be 'reasonably' sure that they choose the correct
price policy.
Kinked-Demand Curve Model
• The kinked-demand curve as a tool of analysis originated from
Chamberlin's intersection of the individual curve of the firm and its
market-share curve.
• However, Chamberlin himself did not use 'kinked-demand' in his analysis.
• Hall and Hitch in their famous article 'Price Theory and Business Behavior''
used the kinked-demand curve not as a tool of analysis for the
determination of the price and output in oligopolistic markets, but to
explain why the price, once determined on the basis of the average-cost
principle, will remain 'sticky.‘
• That is, Hall and Hitch use the kinked-demand curve in order to explain
the 'stickiness' of prices in oligopolistic markets
• However, in the same year (1939), P. Sweezy published an article in which he
introduced the kinked-demand curve as an operational tool for the
determination of the equilibrium in oligopolistic markets.
• His model, which still holds (surprisingly) an important position as an 'oligopoly
theory' in most textbooks, may be presented as follows.
• The demand curve of the oligopolist has a kink reflecting the following
behavioral pattern.
• If the entrepreneur reduces his price he expects that his competitors will follow
suit, matching the price cut, so that, although the demand in the market
increases, the shares of competitors remain unchanged.
• Thus for price reductions below P (which corresponds to the point of the kink)
the share-of-the market- demand curve is the relevant curve for decisionmaking.
• However, the entrepreneur expects that his competitors will not follow him if he
increases his price, so that he will lose a considerable part of his custom.
• The equilibrium of the firm is defined
by the point of the kink because at
any point to the left of the kink MC is
below the MR, while to the right of
the kink the MC is larger than the
• Thus total profit is maximized at the
point of the kink.
• However, this equilibrium is not
necessarily defined by the
intersection of the MC and the MR
• Indeed in general the M C passes
somewhere through the
discontinuous segment AB.
Concept of Market Failure
Market failure occurs when resources are misallocated, or allocated inefficiently.
It arises because exchange is impeded.
Market failure result in waste or lost value.
There are four causes of Market Failure: Viz.
Market Power(Imperfect Market),
Public Goods,
Externalities and
Imperfect Information
Market Power or Imperfect Competition
Perfect competition is a market situation in which the number of buyers and sellers is
so large that none of them is able to influence the market price.
Each individual firm in this case is price taker and merely adjusts its output in such a
way as to maximize profits.
When this assumption does not hold i.e. when single firms have some control over
price and potential competition, the result is imperfect market.
such imperfect market results in inefficient allocation of resources.
Imperfect market are generally classified into three categories:
Monopolistic Competition
Suppose this industry was monopolized
Dead Weight Loss
A reduction in net economic benefit resulting from an inefficient allocation of
resources is called dead weight loss.
The difference between the net economic benefit that would arise if the market were
perfectly competitive and the net economic benefit attained at the monopoly
equilibrium is called dead weight loss due to monopoly.
The effect that an action of any decision maker has on the well-being of other
consumers or producers, beyond the effects transmitted by changes in prices.
In general, the defining feature of an externality is that the actions of one consumer
or producer affect other consumers’ or producers’ costs or benefits in a way not fully
reflected by market prices .
Externalities are positive if they help other producers or consumers.
We frequently observe positive externalities from consumption.
For example, when a child is vaccinated to prevent the spread of a contagious
disease, that child receives a private benefit because the immunization protects her
from contracting the disease.
Further, because she is less likely to transmit the disease, other children in the
community benefit as well.
Externalities can also be negative if they impose costs on or reduce benefits for
other producers or consumers.
For example, a negative externality from production occurs if a manufacturer of an
industrial good causes environmental damage by polluting the air or water.
Why do firms produce too much in an otherwise competitive market when there are
negative externalities?
If the producers do not have to pay for the environmental damage their pollution
causes, each firm’s private cost will be less than the social cost of producing the
The private cost will not include the cost of the damage that the toxic waste does to
the air or water around the plant.
With a negative externality, the marginal social cost exceeds the marginal private
The marginal private cost curve MPC measures the industry’s marginal cost of
producing the chemical.
With a positive externality, the marginal social benefit from the good or
service exceeds the marginal private benefit.
Other people around a consumer also benefit when the consumer furthers her
education or keeps herself in good health.
Similarly, when one firm succeeds in developing a new product or technology with a
program of research and development, the benefits often spill over to other firms
and, ultimately, to consumers.
Just as firms overproduce when there are negative externalities, so do firms under
produce when there are positive externalities
And just as the overproduction is the
result of consumers’ not taking external costs into account, so is the underproduction
a result of consumers’ not taking external benefits into account.
That is, when you decide whether to buy a good, you consider the benefits you will
receive (the marginal private benefit), but you do not consider the benefits your
consumption will have for others.
Public Goods
A public good, in general, has two defining features: first, one person’s consumption
of the good (e.g., driving x miles on the highway) does not reduce the quantity that
can be consumed by any other person (all other drivers can still drive as far as they
want on the highway); and second, all consumers have access to the good (any driver
can drive on the highway) .
Public goods benefit all consumers even though individual consumers do not pay for
the provision of the good.
Public goods have two characteristics: They are nonrival goods and nonexclusive
With a non rival good, consumption by one person does not reduce the quantity that
can be consumed by others.
An example of a non rival good is public broadcasting.
When one viewer tunes in, the number of others who can watch or listen
is not diminished.
The marginal cost of providing output to another consumer of a non rival good is
A nonexclusive good is a good that, once produced, is accessible to all consumers; no
one can be excluded from consuming the good after it is produced.
Once a nonexclusive good is produced, a consumer can benefit from the good even
if he does not pay for it.
Examples of nonexclusive goods are abundant, including
national defense, public parks, television and radio signals, and artwork in public
Free Rider Problem
There are often thousands, or even millions, of consumers of public goods such as a dam, a
public park, or public broadcasting.
To finance an efficient level of output for a public good, consumers must jointly agree that
everyone contributes an amount equal to his own willingness to pay.
However, since the provision of a public good is nonexclusive, everyone benefits once the
public good is provided.
Consequently, individuals have no incentive to pay as much as the good is really worth to
A consumer can behave as a free rider, paying nothing for a good while anticipating that
others will contribute.
The free-rider problem makes it difficult for a private market to provide public
goods efficiently.
It is generally easier to organize effective efforts to collect voluntary funding when the
number of people involved in paying for a project is small because each person
recognizes that his or her contribution is important.
However, when the number of consumers of a public good becomes large, it is more
likely that many consumers will act as free riders. Public intervention may be
necessary to ensure the provision of a socially beneficial public good.
The government therefore often produces a public good itself or subsidizes the
enterprises that produce the good.
Incomplete Information/Asymmetric
The side with better information is said to have private information or, equivalently,
asymmetric information.
There are several sources of asymmetric information.
Parties will often have “inside information” concerning themselves that the other side
does not have.
Consider the case of health insurance.
A customer seeking insurance will often have private information about his or her
own health status and family medical history that the insurance company does not.
Consumers in good health may not bother to purchase health insurance at the
prevailing rates.
A consumer in poor health would have higher demand for insurance, wishing to shift
the burden of large anticipated medical expenses to the insurer.
Other sources of asymmetric information arise when what is being bought is an agent’s
The buyer may not always be able to monitor how hard and well the agent is working.
The agent may have better information about the requirements of the project because of his
or her expertise, which is the reason the agent was hired in the first place.
Asymmetric information can lead to inefficiencies.
Insurance companies may offer less insurance and charge higher premiums than if they could
observe the health of potential clients and could require customers to obey strict health
With appliance repair, the repairer may pad his or her bill by replacing parts that still function
and may take longer than needed—a waste of resources.
There are basically three types of information asymmetry:
Adverse selection
Moral Hazard
Adverse Selection
Adverse selection refers to a situation where a selection process results in a pool of
individuals with economically undesirable characteristics.
A classic example of adverse selection occurs in used-car markets.
A used-car buyer who thinks that the used cars that are for sale are of average quality
will be sadly mistaken.
The problem of adverse selection also applies to insurance markets.
The customers that are most likely to want insurance are the people who face the
highest risks, but these are the people that insurance companies would least like to
have as customers.
Signaling is a mechanism used to get information on a hidden characteristic.
Hidden characteristic is a situation in which one party knows some characteristic
which the other party would like to know.
An important way to deal with private information problems in signaling.
Signaling involves taking steps that communicate otherwise unobservable information
from one party to another.
In 1998-1999 two giant firms entered the used car business in United States.
These two firms were Auto Nation and Car Max.
Their strategy was to sell used cars at relatively high price and to signal to consumers
that all of their used cars were goods.
The signaling involved a lot of advertising as well as extended warranties
Moral Hazard
Suppose that you have just purchased a fairly priced insurance policy that completely
reimburses you for any damage that your car suffers as a result of an automobile accident.
Now that you know that you are fully insured, how careful will you be?
Perhaps not as careful as you would have been had you not been fully insured.
Perhaps you drive faster or behave more recklessly under adverse weather conditions.
Perhaps you take less care to protect your car against vandals or thieves (e.g., by parking it on
the street rather than in a garage)
This illustrates the concept of moral hazard, whereby an insured party exercises less care than
he or she would in the absence of insurance.
Phenomenon whereby an insured party exercises less care than he or she would in the
absence of insurance is Moral Hazard.
Principal Agent Problem
Models of asymmetric information can quickly become quite complicated and so,
before considering a full-blown market model with many suppliers and demanders,
we will devote much of our analysis to a simpler model—called a principal-agent
model—in which there is only one party on each side of the market.
The party who proposes the contract is called the principal.
The party who decides whether or not to accept the contract and then performs
under the terms of the contract (if accepted) is called the agent.
The agent’s actions taken during the term of the contract affect the principal, but the
principal does not observe these actions directly.
The principal may observe outcomes that are correlated with the agent’s actions but
not the actions themselves.
This first model is called a hidden-action model.
The hidden-action model is also called a moral hazard model.
In a second model, the agent has private information about the state of the world
before signing the contract with the principal.
The second model is thus called a hidden-type model. For historical reasons
stemming from its application in the insurance context, which we discuss later, the
hidden-type model is also called an adverse selection model.
Managerial Skill
Efforts, Executive Decision
Job Skill
Home Owner
Appliance Repairer
Skill, Severity of Appliance
Efforts, Unnecessary Repairs
Subject Knowledge
Preparation, Patience
Value for Goods
Care to Avoid Breakage
Health Insurer
Insurance Purchaser
Pre-existing Condition
Risky Activity
Moral Fiber
Government Response to Market Failure
Regulating competition (Antitrust) policy
Price and utility regulations, Patent system
Taxes and Subsidies
Operating controls
Regulations of environment pollution
Public choice theory
Regulating competition (Antitrust) policy
Competition is desirable because it reduces price as well as increases output and
efficiency in the allocation of resources, but the economy can’t achieve the situation of
perfect competition due to political decision making and complexity of market.
workable competition is the realistic goal for the policy makers or the goal of antitrust
policy is to achieve the workable competition. Generally, antitrust policy is related to
the structure and conduct of the industry.
Antitrust law restricts business practices that are considered unfair or monopolistic.
the laws brought with the objective of controlling monopoly and maintain workable
competition among the producers is known as antitrust policy.
It is the primary device used to encourage competition. Imposition of fines or fixing
prices in unison is the examples of antitrust policy.
Edwin Mansfield, “The antitrust laws are aimed at promoting competition and limiting
Antitrust Policy in Nepal:
The antitrust policy adopted in Nepal is , “Competition Promotion and Market Protection Act,
2063 (2007)”.
aims to make national economy more open, liberal, market-oriented and competitive by
maintaining fair competition among the firms.
also aims to protect markets against undesirable interference and to control monopoly and
restrictive trade practices.
The act defines following activities as anticompetitive practices and prohibits conducting such
1. Prohibition on Anti-competitive Agreements
2. Prohibition on Abuse of Dominant Position
3. Prohibition on Merger or Amalgamation with Intent to Control Competition
4. Prohibition on Bid Rigging
5. Prohibition on Exclusive Dealing
6. Prohibition on Market Restriction
7. Prohibition on Tied Selling
8. Prohibition on Misleading Advertisement
Patent System:
The granting of special right to produce, use or sale any invention to any firm for the specified
period by the government.
It is used to promote and prevent inventions.
Pappaz and Brigham, “Patents are the government grant of exclusive right to produce, use or
sell an invention or idea for a specified period of time.”
Milton H. Spencer, “A Patent is an exclusive right conferred by a government on an inventor
for a limited time period.”
In conclusion, patent is a method to promote invention by providing temporary but legal
monopoly power to the inventors. So that, the inventors firm will be able to take advantage
of its inventions.
USA practiced Patent Right for 20 years.
In Nepal, According to Patent, Design and Trade Mark Act (1965)- patent can be provided for
7 years and can be renewed not more than twice.
Arguments in favor of Patent:
It is an important incentive to induce the inventor to make inventions.
It is a necessary incentive to induce the firms to work more and invest in new
The inventions are disclosed soon due to patent act but if there was no such act it will
not be disclosed for long time. So, in long-run newly invented commodities or
services are easily available for the consumers.
Arguments against Patent:
New knowledge will not be much used. So, there is no possibility of decrease in MC.
Patent right system in general increases the imitation cost. This discourages the new
entrants. So, it is ineffective.
If it is misused, it creates further market inefficiency.
It increases monopoly thinking of individuals and firms.
Price Regulation
Price regulation refers to the policy of setting prices by a government agency, legal
statute or regulatory authority.
Under this policy, minimum and/or maximum prices may be set.
Sometimes a government may impose a price ceiling in a market, such as a maximum
allowable price.
Price ceilings will affect the distribution of income and economic efficiency
when they hold the price for a good or service below the level that would be
observed in equilibrium without the ceiling.
In other cases policy makers may impose a floor on the price allowed in a market.
For example, many governments have enacted laws that specify a minimum wage
that must be paid to workers.
The price ceiling is below the equilibrium price in a market with an upward-sloping
supply curve and a downward-sloping demand curve, the ceiling will have the
following effects:
The market will not clear. There will be an excess demand for the good.
The market will under-produce relative to the efficient level (i.e., the amount
that would be supplied in an unregulated market).
Producer surplus will be lower than with no price ceiling.
Some (but not all) of the lost producer surplus will be transferred to consumers.
Because there is excess demand with a price ceiling, the size of the consumer
surplus will depend on which of the consumers who want the good are able to
purchase it. Consumer surplus may either increase or decrease with a price ceiling.
There will be a deadweight loss.
The government imposes a price floor higher than the free-market price, we
observe the following effects in a market with an upward-sloping supply curve and a
downward-sloping demand curve:
The market will not clear. There will be an excess supply of the good or service
in the market.
Consumers will buy less of the good than they would in a free market.
Consumer surplus will be lower than with no price floor .
Some (but not all) of the lost consumer surplus will be transferred to producers.
Because there is excess supply with a price floor, the size of the producer surplus
will depend on which of the producers actually supply the good. Producer surplus
may either increase or decrease with a price floor.
There will be a deadweight loss.
Utility Regulations
In some industries, economies of scale operate (i.e., the long-run average cost may
fall) continuously as output expands, so that firm could supply the entire market more
efficiently than any number of smaller firms.
Such a large firm supplying the entire market is called natural monopoly.
The distinguishing characteristic of a natural monopoly is that the firm’s long run
average cost curve is still declining when the firm supplies the entire market.
Examples of natural monopolies are Public utilities.
To have more than one such firm in the market would lead to duplication of supply
lines and too much higher costs per unit.
To avoid this, local governments usually allow a single firm to operate in a market but
regulate price and quantity of services provided, so as to allow only a normal riskadjusted rate of return on investment.
Tax refers to the compulsory obligation of peoples to government
Economists often use a partial equilibrium model to study the effects of an tax on a
competitive market.
In a market with an upward-sloping supply curve and a downward-sloping
demand curve, the effects of an excise tax are as follows:
The market will under-produce relative to the efficient level (i.e., the amount
that would be supplied with no tax).
Consumer surplus will be lower than with no tax.
The impact on the government budget will be positive because tax receipts are
collected. The tax receipts are part of the net benefit to society because they will
be distributed to people in the economy.
The tax receipts will be less than the decrease in consumer and producer surplus.
Thus, the tax will cause a reduction in net economic benefits
Instead of taxing a market, a government might decide to subsidize it.
We can think of a subsidy as a negative tax.
Many of the effects of a subsidy are the opposite of the effects of a tax.
The market will overproduce relative to the efficient level.
Consumer surplus will be higher than with no subsidy.
Producer surplus will be higher than with no subsidy.
The impact on the government budget will be negative. Government expenditures
on the subsidy constitute a negative net economic benefit since the money to pay
for the subsidy must be collected elsewhere in the economy.
Government expenditures on the subsidy will be larger than the increase in
consumer and producer surplus. Thus, there will be a deadweight loss from
Operating Controls:
The government also tries to control market failure associated with external diseconomies.
For this, government uses operating controls. Operating control refers to the control imposed
by the government to limit the activities of the business firm.
The main Controls of Govt. are:
1. Control on Environment Pollution and Degradation
2. Control on food products and drugs
3. Control on industrial work conditions
4. Control on price
5. Control on wage rate
6. Control on services of financial institutions
7. Control on public services like transportation etc.
Regulations of environment pollution
Environment Pollution is the best example of external diseconomies of scale.
Since environment pollution is also causing market failure because it increases social
cost and decreases social benefit. For which the government should implement the
appropriate measures to control it.
The optimum level of pollution control can be explained with the help of pollution
cost curve and pollution control cost curve.
Pollution Cost: It is the social cost realized by the society due to the pollution emitted
by the industries. Pollution cost increases with increase in quantity of pollution
emitted. It means pollution cost curve is positively sloped.
Pollution Control Cost: It is the cost required to control pollution. It decreases with
the increase in quantity of pollution emitted due to which pollution control cost curve
is negatively sloped.
Optimum level of Pollution Control:
Optimum level of pollution is determined by the interaction between positively
sloped pollution cost curve and negatively sloped pollution control cost curve as
James Buchanan (noble prize winner in economics,1986) and Gordon Tullock developed the
concept of public choice theory in their most famous work, The Calculus of Consent (1962).
They argued that unless constitutional rules are structured in a manner that will bring the
self-interests of the political players into harmony with the wise use of resources,
government action will often be counterproductive.
Public choices (political actions) are affected by self interest and incentives of mainly three
players i.e. voters, politicians and bureaucrats.
All these want to maximize their self interest due to which public policies fail.
There are four major reasons why the political allocation of resources will often result in
1. Special interest effect
2. Short sightedness effect
3. Rent seeking
4. Inefficiency of government operation
Traditional Approach of MR=MC may not work in all market conditions.
 Reality may differ with abstract theories.
 Practical pricing models vary with traditional theories of pricing.
The procedure of cost-plus pricing has received increased attention
following considerable empirical evidence of its favor in practice.
 This determines price on the basis of the addition of three
components: price = average fixed cost + average variable cost +a
'reasonable' profit margin.
 Two steps are involved in cost-plus pricing.
 First, the cost of acquiring or producing the good or service must be
 The total cost has a variable and fixed component.
 In either case, cost are computed on an average basis
The second step in cost-plus pricing is to determine the mark up
over costs.
 The overall objective is set prices that allow the firm to earn its
targeted rate of return.
Where m is a mark up on cost, P is the product price and C is the
average cost.
 We get price of the product as
The firm should change the price of the product or its output;
introduce a new product, or new version of a given product or its
product, accept new order and so on, if the increase in total
revenue from the action exceeds the increase in total or
incremental cost.
 For example, an airline should introduce a new flight if the
incremental revenue from the flight exceeds the incremental cost.
Every product progresses through certain stages during its life
cycle. The four major life stages being development, growth,
maturity and decline.
 Consumers respond differently to a product depending on its life
cycle stage.
 From the launch day of the product, until it reaches the decline
stage, the consumers’ perception of the product changes drastically.
 At every step, the buyer’s level of interest fluctuates.
 Some become price-sensitive, others convert it into loyal customers
while some lose interest and switch to other brands.
Now, here is when product life cycle pricing theory comes into play.
 The pricing technique helps businesses make wise decisions on
product/service pricing according to the life cycle of the product.
 To make it easier to understand, we are describing the stages
below with life cycle stage pricing examples and effective strategies
for each stage.
 Development Stage
 The most delicate time in the life cycle of a product is the
development stage.
 During this stage, a product is the most vulnerable as it requires
significant capital investment to develop, test its effectiveness and
gain the interest of the consumers.
 The risk is generally high, and there is no certainty whether the
product will move to its later stages or not.
What should be the pricing strategy?
 At this stage, you can either set the prices high and trust the
reputation of the product or lower and penetrate the market with
an alluring offer
 Growth Stage
 It is the stage when businesses witness rapid growth and are more
likely to earn bigger revenues.
 Once in the initial stage, the demand for the product is created, it
is followed by the growth stage when potential customers begin
asking for it.
 During the growth-stage retailers show interest in purchasing the
 Businesses may have to invest in promotions to create this
What should be the pricing strategy?
 Keep the prices on the average level to maintain competitiveness
but maximize profits while convincing more and more people to try
 At this stage, you can adopt a competitive pricing strategy to keep
your product in high demand.
 Maturity Stage
 At this stage, a product reaches its saturation point as, by this
time, most people have some perceptions about the product or
 At this stage, most of the people will have your product or either
have an idea about what you are offering so; there will be much
less demand due to the absence of curiosity.
 Many businesses will continue to make additions to their product
so that buyers show interest in choosing their product over other
What should be the pricing strategy?
 To avoid losing to cheaper products and continue being a trusted
brand in the market, you can reduce prices.
 Now, price reduction does not necessarily mean that you decrease
the rates, but instead you must introduce them in the form of
discounts, put them on sale or provide special offers.
 While reducing prices, make sure that you do not reach the breakeven point.
 Decline Stage
 The decline stage situation for every business varies. Here is how!
 Some businesses continue to flourish, the sale proceeds to increase
gradually, and the footprint of the brand name continues to spread
either through word of mouth or the planned marketing
Everything happens at a slow pace.
 Customers that become loyal towards the brand will continue
revisiting to buy the product and avail the services.
 While some businesses begin to lose their customers and sales
drop, the reason for this could be either that you are not able to
offer what people are asking for or maybe the taste of the consumer
has changed.
 What should be the pricing strategy?
 Businesses need to revamp the product and present it in a whole
new fashion, make new offerings or follow the concept of bundling.
 Bundling is a marketing concept in which businesses sell their
product along with other products, as one single unit. Another way
to survive the situation is by decreasing production and
development costs.
In today’s competitive market, almost all companies produce multiple
models, styles or sizes of output and each of these variations can represent a
separate product for pricing purposes.
 Although, multiple product pricing requires same basic analysis (i.e. two
basic conditions of profit maximization) as for single product, the analysis
will be complicated due to demand and production interrelations.
 Multiple products may have demand interrelations (substitutes or
complements) or production interrelations.
 There are two cases of Joint product pricing with Fixed proportions or
Variable Proportions.
When the products are jointly
produced in fixed proportions,
those products are considered as
‘Production Package’ for which
separate allocation of costs can not
be made.
 Pricing is done by considering
When the products are jointly
produced in fixed proportions,
those products are considered as
‘Production Package’ for which
separate allocation of costs can not
be made.
 Pricing is done by considering
Useful to determine the price of the commodities which can’t be stored eg.
Electricity, transportation, telephone etc.
 High price will be determined at the time with high demand i.e. peak time
and low price will be determined at off time.
 There should be variation of demand in different times.
 Eg. Telephone fare in day and night, internet charge in day and night etc.
 The main conditions required for peak load pricing are:
Product cannot be stored.
There must be variation of demand for the product according
to time.
Average cost of production remains same for all time period.
Transfer pricing refers to the intra-industry pricing in which different
production divisions determine the price of intermediate product and final
 Intermediate products are used within the same industry to produce final
 Example: Bajaj Motorcycle Company establishes its own Tyre industry. Bike
production unit is parent industry and Tyre production unit is subsidiary
 Parent industry can either purchase tyre from its subsidiary firm or can
purchase from competitive market.
 There
are two cases under transfer Pricing. Which are:
Price fixed for the export products or services which the exporter
intends to sell in the overseas market is called export pricing.
 Export price of a given product is determined by many factors.
 Export Pricing can be determine by the following factors:
Range of products offered.
Prompt deliveries and continuity in supply.
After-sales service in products like machine tools, consumer durables.
Product differentiation and brand image.
Frequency of purchase.
Specialty value goods and gift items
The practice of charging consumers different prices for the same
good or service is price discrimination.
 Price discrimination (charging different prices for different
consumers) offers the monopolist, or any firm with market power,
an opportunity to capture more surplus.
 Certain market features must be present for a firm to capture
more surplus with price discrimination:
A firm must have some market power to price discriminate.
The firm must have some information about the different amounts people
will pay for its product.
A firm must be able to prevent resale, or arbitrage
There are three basic types of price discrimination:
First Degree Price Discrimination
Second Degree Price Discrimination
Third Degree Price Discrimination
The firm tries to price each unit at the consumer’s reservation price (i.e.,
the maximum price that the consumer is willing
to pay for that unit).
For example, when a firm sells a product at an auction, it
hopes that consumers will bid up the price until the consumer with the
highest reservation price pays that price for the product.
The seller hopes that the price will be close to the maximum amount the
winner is willing to pay for the good.
First-degree price discrimination is ideal from the seller’s viewpoint.
If the seller can perfectly implement first-degree price discrimination, it
will price each unit at the maximum amount the consumer of that unit is
willing to pay.
he firm offers consumers quantity discounts—the price per unit goes
down if the consumer buys more units.
For example, a software firm might set a price of $50 per unit for
consumers buying between 1 and 9 copies of a computer game, a price of
$40 per unit for 10 to 99 copies, and a price of $30 per unit for 100 copies.
A form of second-degree price discrimination in which the consumer pays
one price for units consumed in the first block of output (up to a given
quantity) and a different (usually lower) price for any additional units
consumed in the second block.
Subscription and Usage charges
The practice of charging different uniform prices to different
consumer groups or segments in a market is called price
 The firm identifies different consumer groups, or segments, in the
market, each with a different demand curve.
 Then, to maximize profit, the firm sets a price for each segment by
equating marginal revenue and marginal cost.
 For example, if an airline identifies business and vacation
travelers as segments having different demand curves for flights
on the same route, it can charge a different price for each
segment—say, $500 per ticket for business travelers and only $200
per ticket for vacation travelers.
Segmentation of market according to their elasticities and Different price for
different market.
 High price in inelastic market and low price in elastic market.
 The aggregate marginal revenue can be derived by combining the marginal
revenues of the two sub-markets.
 Conditions of equilibrium:
An auction is a process of buying and selling goods or services by
offering them up for bid, taking bid and then selling the item to the
highest bidder.
 Auctions are designed to push sales prices closer to a buyer’s
willingness to pay.
 While the highest bidder for an object of art or a tract of land may
not have to pay as much as the bidder is willing to pay, the seller
hopes to capture as much of the surplus as possible by making
potential buyers compete for the good being sold.
 While in auction a base price is set for the item and bidders bid the
price according to their willingness to pay for that particular item